Montreal, November 15, 2008 • No 261



Martin Masse
is publisher of QL.




by Martin Masse


          Some weeks ago, in an editorial about the financial crisis in the main section of this paper, a writer commented approvingly that: "Our currencies are no longer tied to gold, which means central banks can act to mitigate monetary deflation and interrupt the deadly feedback loop of mounting defaults, declining real wages and prices and increasingly onerous dollar-denominated debt. ... Today we are no longer in the infancy of macroeconomics."


          Every day that passes contradicts this statement. Central banks and governments around the world have so far tried a variety of means to prevent the collapse of credit markets. They have repeatedly injected cheap liquidity into banks, purchased mortgage-backed securities and commercial paper, nationalized banks, insurance firms and mortgage finance giants, increased the amounts of deposits insured and forced interest rates lower.

          Nothing has so far succeeded. Stock markets continue to slide down, investors everywhere are fleeing for safer havens and we learn every day of a new major firm on the verge of bankruptcy because it is short of cash.

          Perhaps the reason is that, contrary to the above statement, macroeconomics is far from reaching the age of maturity. It seems, rather, to be stuck in the age of fairy tales and based on the belief that credit grows on trees.

          Decades of money and credit creation by central banks and commercial institutions through the mysterious workings of the fractional reserve system have nurtured this strange belief, to such an extent that almost nobody seems surprised to read every day in the press that governments and central banks are trying to "bolster credit markets." But where in the world does all this new credit come from if resources can't suddenly appear out of nowhere?

          It is worth recalling what credit actually is, since so many people seem to have forgotten. It is necessarily based on savings, that is, the surplus left over when people choose not to spend all their earnings but to keep some for later consumption. This delayed claim on resources can then be temporarily offered at a price to other people, who either want to consume something before having the means to do so, or invest resources they don't have in capital goods to increase their production capacity and eventually their profits.

          In a free credit market, interest rates would find a natural equilibrium on the basis of the supply of savings and the demand for credit. The more people are willing to postpone consumption, the more savings there will be on the market and the lower interest rates will be, thus facilitating investments. Conversely, higher demand for credit will drive up interest rates and encourage people to save. This is how financial markets co-ordinate the actions of producers and consumers through time, making sure that resources are allocated in the most efficient manner possible.

"It is worth recalling what credit actually is, since so many people seem to have forgotten. It is necessarily based on savings, that is, the surplus left over when people choose not to spend all their earnings but to keep some for later consumption."

          Unfortunately, we don't live in such a world where credit markets are free. We live in a world where central monetary planning agencies constantly distort these markets by manipulating interest rates and the quantity of credit available in the economy.

          What happens when central banks lower interest rates as the Bank of Canada again did last November 21th? First, they make saving less rewarding and going into debt less costly, with the end result that there is less real credit—credit based on the real pool of savings—available. At the same time, with credit being cheaper, more marginal investment projects suddenly seem more attractive.

          But whatever happens to these artificially set interest rates, real resources do not suddenly become more abundant. In a free credit market, lower interest rates would reflect the actual greater availability of resources to invest. But in our financial fairy land, they simply result from more funny money being pumped into the financial system.

          This is what Austrian economists mean by malinvestments. When interest rates are lower than they should be, investment projects are embarked upon which do not reflect the real state of demand and availability of resources. This drives up prices in specific sectors where the new money goes first. Eventually, investors realize that their projects will never become profitable; consumers who got into debt find out they cannot afford what they bought at inflated prices; and financial institutions end up with huge amounts of bad debt they should never have issued.

          If there is so little credit available today, it is because it is stuck in these malinvestments and there is little real savings to resupply markets, with personal savings rates hovering around zero nowadays. Those who may have money to lend will also be reticent to do so as long as they can hardly ascertain who is solvent and who is not.

          All this bad debt first has to be liquidated to free resources from unproductive uses. Waiving a magic wand to "loosen credit markets" will just not do the trick.

          Although governments have always intervened in the banking system and caused booms and busts, the gold standard used to prevent such massive dislocations as we see today. In these presumably less enlightened times, money and credit could not be created out of thin air and financial institutions were not able to leverage to such an extent.

Now that our currencies are no longer tied to gold, governments may indeed have the power to bail out everybody, though at the cost of making us all poorer. But that's because they have the power to create the problem in the first place.


* Article first publiched in the Financial Post on October 23, 2008 (version française disponible ici).