The Credit Crunch Explained

Money SupplyAn explanation of the financial crisis for everyone:

Linda is the proprietor of a bar in Cork. In order to increase sales, she decides to allow her loyal customers – most of whom are unemployed alcoholics – to drink now but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around and as a result increasing numbers of customers (still mostly unemployed alcoholics) flood into Linda’s bar. Taking advantage of her customers’ freedom from immediate payment constraints, Linda increases her prices for wine and beer, the most popular drinks. Her sales volumes and profits increase massively.

… read on: You’re having a laugh ….. seriously?: The Credit Crunch Explained.

Three themes appear often in explanations of the crisis:

  1. That bankers were greedy and irresponsible; that they made bad business decisions and sold bad products.
  2. That regulation was insufficient or inadequate.
  3. That too much money was loaned.

Greed, irresponsibility and bad business are not news: the system should have been able to cope. And we might also ask why so much bad business began.

Banks have operated under enormous amounts of regulation. See the FSA’s handbook for example. The regulators employed the best people they could and those people did the best job they could: they still failed.

So why was too much money loaned? And where did the money come from?

When people save, they are making a decision to spend more later and less now. If more people are saving, there is a greater supply of money to lend. If there is a larger supply of money to lend, interest rates should be lower — supply and demand. That is, low interest rates should be a sign that spending will increase later, so encouraging borrowing to invest is ok: projects should pay off later as spending rises.

So what happens when people are not saving — perhaps they are spending wildly now and will be spending much less later — but interest rates are held low artificially using monetary policy to encourage borrowing? What if banks are allowed to lend money that was not really saved, that is, if they are allowed to operate with a fractional reserve? These features of today’s system break the link between low interest rates now and increased demand in the future. People borrow to invest, but later demand never appears: they go bust.

This is the origin of the boom-bust cycle. It is not an inherent feature of capitalism; it is an inherent feature of forcing interest rates lower in an attempt to avoid busts and of lending money that has not been saved, but created anew. It is a tragic irony that the very measures which are intended to keep us from busts are the measures which create them.

Certainly, bankers have behaved badly, but our present difficulties have been caused by something more fundamental: the system of money and credit.

At the heart of our difficulties lies the broken link between save and invest.

For more details, try the economics posts on this site — particularly Banks, economic interventionism and the cause of the credit crisis — and also The Crisis in 10 Points from Robert Stewart at the Mises Institute.

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