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Does Bank Lending Cause Boom and Bust Cycles by Itself?

What happens when banks lend money? It depends the lending process itself. If lending comes about because of an expansion of credit, then it creates problems.

According to prevalent belief, banks are the primary force in the expansion of credit. Nevertheless, is this the case?

Take Joe, a farmer who produces two kg of potatoes, as an example. One kilogram is needed for his own usage, and the remainder is lent for one year to the farmer Bob. The one kilogram of potatoes he offers to lend represents his savings.

Savings are required as a prerequisite for lending, as loans must be secured by savings. By lending one kilogram of potatoes to Bob for a year, Joe commits to relinquish ownership of these potatoes. In exchange, Bob gives Joe a written assurance that he will repay 1,1 kilograms of potatoes plus 0.10 kilograms of interest after one year.

The introduction of currency has little effect on lending's fundamentals. Instead of lending one kilogram of potatoes, Joe will first convert one kilogram of potatoes into, say, ten dollars. Joe may lend his money to Bob for one year at the market rate of 10 percent interest. Observe that the introduction of currency did not alter the order of saves and lending.

Lending Out of “Thin Air” and Banks

It will be difficult for ordinary lenders to lend what they do not possess. However, things change as we incorporate the data into our analysis databases.

Joe sells his stored kilogram of potatoes for ten dollars and deposits the proceeds with Bank A. Note that Joe demonstrates his need for money by holding demand deposits at Bank A. Joe may have also exercised his right to receive money by concealing it in a jar at home or under a mattress.

Suppose Bank A lends Bob $10 by deducting $10 from Joe's account. This situation is identical to the one in which a thief steals $10 from Joe's pocket. Remember that Joe continues to exercise his $10 demand. He has an unrestricted claim to the $10. This indicates that he is permitted to withdraw the $10 from his deposit whenever he feels it essential. It is not different if Joe retains the ten dollars in his pocket and, when he thinks it essential, exchanges it for some products.

Also, note that when a thief steals the $10 from Joe's pocket, this is a breach of Joe's property rights, which is punishable by law. There is no difference, however, when the bank withdraws $10 from Joe's deposit without his permission, even if this is not considered a breach of Joe's property rights because the law accepts it.

One could argue that enabling Bob to spend the $10 instead of Joe may not have a large overall economic impact, if any. This could very well be the case. However, the breach of Joe's property rights is the issue at hand.

In a free market devoid of a central bank, if Bank A takes Joe's deposit without his permission and lends it to Bob, there will undoubtedly be problems. Bank A could not accommodate Joe and Bob's simultaneous withdrawal of $10 from their respective demand deposits, totaling $20, because it only possesses $10.

Consequently, Bank A faces the possibility of failing. Therefore, in a free market, the risk of bankruptcy is likely to discourage banks from lending demand deposits without the depositor's permission.

Within the scope of the existence of the central bank, this is conceivable. By use of monetary injections, the central bank prevents the insolvency of banks that make unauthorized loans to depositors. Observe that, in the context of the central bank, lending depositors' funds without their knowledge circumvents the requirement for consent through monetary pumping.

This results in unbacked by savings lending, also known as "loan out of thin air." Once Bob, the borrower of the $10, utilizes the borrowed funds, he engages in a transaction in which nothing is exchanged for something. The reason for this is because the $10 is not supported by savings; it is "empty money." Here, we have $20 that is only supported by $10 in cash.

Clearly, this form of lending hinders the creation of wealth. Obviously, a decline in the production of wealth reduces the ability of debtors to repay their obligations.

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Credit Out of “Thin Air” Makes Money Disappear

When borrowed funds are fully backed by savings on the maturity date of the loan, they are returned to the original lender. Bob, the borrower of $10, will return the principal plus interest to the bank on the due day. The bank will then transfer $10 plus interest and bank fees to Joe, the lender. The money completes a full circle by returning to the original lender. Note that the bank in this case is merely a middleman and not a lender; hence, the borrowed funds are returned to the original lender.

In contrast, when credit originates from "thin air" and is returned to the bank on the maturity date, this results in a withdrawal of funds from the economy, or a drop in the money supply. Since there was no saver/lender, this credit "materialized from thin air." Using our example of a bank making a $10 loan to Bob, we must recognize that the bank unlawfully deducted $10 from Joe's demand deposit. Therefore, we have $20 in demand deposits funded by $10 in cash.

Joe never committed to lend the $10 to Bob, and he has unrestricted access to his deposited $10. When Bob repays the $10, the money exits the economy because the bank is not compelled to forward it to the original lender. The bank has produced the $10 loan from nothing, thus there is no initial lender.

Credit Out of “Thin Air” Encourages Nonproductive Activities

If banks continue to create loans out of thin air, nonproductive behaviors will continue to increase. As soon as the continual creation of credit raises the rate of wealth consumption above the rate of wealth formation, the positive flow of savings is halted and a decrease in the savings pool is initiated.

As a result, the performance of company investments declines and the number of bad loans at banks rises. In reaction, banks reduce their lending activity, causing a drop in the money supply. (Remember that the money supply decreases when loans resulting from credit expansion are repaid and not renewed.)

As the decline in the money supply undermines nonproductive bubble activity, the economy enters a recession. (Note that nonproductive activities are incapable of standing on their own. To be able to maintain themselves, they require expanded credit. The credit created from "thin air" diverts wealth away from wealth producers.

According to numerous prominent economists, a severe economic downturn or depression is caused by a significant decline in the money supply. This approach of thinking was popularized by Professor Milton Friedman and the Chicago school.

The economic slump is not caused by a fall in the money supply, but rather by the response to the shrinking pool of savings as a result of easy monetary policy in the past. The fall in the money supply is caused by the shrinkage of the savings pool. Even if the central bank is effective in halting the decline of the money supply, a depression cannot be averted if the savings pool is shrinking.


In conclusion, banks are merely intermediaries for the loan of savings. Banks assist the flow of savings by connecting the providers with the consumers. By acting as intermediaries, banks play a significant role in the process of wealth creation.

Once banks engage in loan activity that replaces actual lenders/savers, the boom-bust cycle and economic deprivation become a threat. Genuine credit cannot be increased without a matching increase in savings.

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