2009-10-29

Credit and deflation

Frank Shostak explains it in Does a Fall in Credit Lead to Deflation?
Note that when Joe lends his $100 to Bob via the bank, this means that Joe (via the intermediary) lends his money to Bob. On the maturity date, Bob transfers the money back to the bank and the bank in turn (after charging a fee) transfers the $100 plus interest to Joe. Observe that here money never disappears or is created; the original $100 is paid back to Joe.

Things are, however, quite different when Joe keeps the $100 in the bank warehouse or demand deposit. Remember that by keeping the money in a demand deposit, Joe is ready to employ it at any time he likes.

Now, if the bank lends Bob $50 by taking it from Joe's demand deposit, the bank will have created $50 of unbacked credit, out of "thin air." By lending $50 to Bob, the bank creates $50 of extra demand deposits. Thus, there is now $150 in demand deposits that are backed by only $100.

So in this sense, the lending here is without a lender. The intermediary, i.e., the bank, has created a mirage transaction without any proper lender. On the maturity date, when Bob repays the money to the bank, that money disappears. The money supply falls back to $100, dropping by 33%.

Hence an increase in credit out of thin air, all other things being equal, gives rise to an expansion in the money supply. A fall in credit out of thin air, all other things being equal, results in a contraction of the money supply.

So in this sense it is valid to argue that a fall in bank lending out of thin air contributes to the decline in the rate of growth of the money supply and thus to deflation.

Note that what matters here is not credit as such but credit that was created out of nothing. A fall in normal credit (i.e., credit that has an original lender) doesn't alter the money supply and hence has nothing to do with deflation. For instance, if Joe directly lent Bob his $100, when Bob repays the money we will have a fall in credit with no change in money supply.
He goes on to say that inflation of the money supply offset deflation in credit out of thin air, but that a slowing pace of money creation may lead to deflation as the decline in credit becomes the dominant factor.

Read the whole article for a good explanation of money supply.

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