Chapter 3: Banking and Business Cycles

      Commercial banks do not lend money. They permit the "borrower" to issue money. The "loan," which is not in any true sense a loan because it does not reduce the money resources of the lender, is simply entered as a credit to the borrower on the books of the bank. It is a paper transaction, no money having been lent and no new money having come into existence. The borrower, however, now has legal authorization to write checks to the extent of the loan and tender them in trade. Upon their acceptance by a seller, new money comes into existence. Until such time as the borrower, through becoming a seller, recaptures the money (extinguishes the money he created) with which to liquidate his "loan," there may be many purchase and sale transactions effected by the money he issued. Yet, throughout it all, not a single unit of money has been lent or borrowed. "Borrowing money" from a commercial bank is but a figurative phrase. It is getting authorization to create money—the first step in the money creating process.

      Money may, however, be truly borrowed from existing reserves of money. True moneylenders include savings banks, building and loan associations, finance companies, and individuals. Such money, however, originated in commercial banks through the process above described, and was accrued from surpluses.

      It is interesting to ponder the question: Why does money lending exist? A little thought shows that it exists because of the deficiency of commercial bank credit. The borrower obviously borrows money because he wishes to buy something.

      The motive is the same for creating money. Borrowing money offers no advantage over creating money, and it has positive disadvantages. Interest charges are usually higher for borrowed than for created money. To the money lender it involves the hazard of default by the borrower, whereas default in a commercial bank "loan" is distributed, almost painlessly, over the entire economy. "Loans" through commercial banks are underwritten by the entire trading community, whereas a loan of existing money is supported by the resources of the borrower alone.

      Why, then do buyers resort to moneylenders rather than commercial banks for needed funds? The only answer is that the banker, the gatekeeper of the trade channel, is limited by statute in the number of passes that he can issue to personal enterprisers. Let us investigate the source and consequences of this limitation.

Bust Without Boom

      We in America are in the habit of thinking that boom-bust, the business cycle, is due to an inherent fault in the personal enterprise system. We also believe that boom means inflation, and that bust means deflation. This confusion between inflation and boom must be eliminated before we can understand the source of the business cycle. Some definitions are in order.

      Boom results from an expansion of the genuine money supply. This is not inflationary, because it justifies itself by an expansion of production and trade.

Inflation, on the other hand, is the result of the injection of monetary units into the money supply without an offsetting increase of values in the market place.

      Bust results from a reduction of the genuine money supply, which is brought about by bankers calling or, as they mature, failing to renew the "loans" upon which the money is based.

      Deflation is not to be confused with bust, for there cannot be deflation without prior inflation. Just as inflation is not an increase in the genuine money supply, so deflation is not a reduction. Both are produced by governments. By deficit financing (through borrowing from banks) water is injected into the circulation, and by surplus budgets it is extracted, in no wise affecting in either operation the substance of the money supply.

      Now, if the expansion of the genuine money supply, resulting from bank loans to personal enterprisers, is justified by the expansion of production and distribution, how can we explain the reduction of the genuine money supply that occurs during the bust part of the business cycle?

      The shrinkage of the genuine money supply, which causes the bust, is due to a limitation imposed upon banks by the political monetary system. When a bank makes loans to personal enterprisers, it assumes the legal obligation to convert all of the deposits resulting from such loans into currency on demand. But there is a limit to the actual cash the banker can deliver. This limit is determined by the amount of gold certificates and Government bonds he holds. A Government bond can requisition cash by its deposit with the Treasury, which will deliver to the banker its equivalent in currency at the mere cost of printing.

      At the beginning of the boom there exists a wide margin of safety, since demands for currency can easily be met. As the movement progresses, however, this margin is reduced, until it becomes hazardous for the banker to further extend the loan volume. His attempt to keep the volume of loans within the limit of his holding of gold and federal securities arrests the movement of the boom. As a result of this effort, business is stalemated. This further increases the banker's caution to the point where he stops making loans. As outstanding loans mature without an offset of new loans, the money supply begins to decline, and the bust movement is on its way.

      Our worst boom-bust culminated in 1929. It was aggravated if not precipitated by the action of Secretary of the Treasury Andrew Mellon, who retired the federal debt from its peak in 1919 of approximately $25.5 billions to about $16.2 billions in 1930. His reduction of the federal debt was acclaimed by leaders of banking and business. However, in so doing, Mellon cut away the foundation of the bank credit pyramid. By taking Government securities from the banks, he eliminated the margin of safety by reducing the availability of currency. Some ten thousand banks failed to meet the public demand to exchange deposits for currency.

      Since in a crisis the demand is for currency, and since the Government is the only debtor that can convert its debt into cash on demand, it should be obvious that a banker's security depends upon the ratio of public debt to private. In the years preceding the depression, the ratio was continually cut as the banks rapidly expanded private loans. When business began to contract and the demand was for cash, the banks discovered that they were short. Their frantic calling of loans further diminished the money supply, and the spiral ended in depression.

      The demand for currency need not have risen to critical levels but for still another piece of legislation, the legal tender law, which forced many in the chain of credit, if they would stay out of bankruptcy, to sue for cash payments in order to be able to satisfy the demands of their creditors, who in turn were hard-pressed for cash to meet their obligations. But for the limitations on choice imposed by the legal tender law, many creditors would have agreed to alternative, non-cash settlements, or simply let their notes run, and excessive pressure would not have built up in the system.

      Note in Figure 3, a graph of the Per Capita National Debt, the beginning of the undermining movement in 1920 as Government debt began to be cut back, contrasted with the rise from 1932 onward.

      Today we are experiencing not boom, but inflation, resulting from the great increase in public debt especially since 1940. The ratio of public to private debt is now so enormous that there is not the slightest danger to the banks in extending private loans. They hold enough securities to meet any demand for currency; hence the deflation precipitation point is practically non-existent. Nor would the banks call Government loans as they might private loans. The reason is that the Government can replace each bond with currency, and thus the banks would be exchanging interest bearing paper for non-interest bearing—a loss of interest with nothing gained, since there is no hazard to them regardless of how high the Government debt mounts.

      Consequently, there will be no deflation to follow this inflation. We are out of the boom-bust cycle, and have seen the last of that phenomenon. We are not, however, out of trouble.

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