Credit, Finance and Market Stability

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This is part one of a two-part series on asset strategies that address financial instability.

Understanding the interplay between credit and finance is critical to recognizing the signs of economic distress. Yet this was precisely the failure that plagued economic analysis leading up to the financial crisis. Let’s take a look at the recent history of credit, finance and the underlying nature of market stability.

As the financial crisis approached in 2008, mainstream macroeconomic models missed the oncoming disaster, leaving the Queen of England to ask: “Why did no one see it coming?” Fortunately, several economists (e.g., Steve Keen, Michael Hudson, Claudio Borio, Wynne Godley and Dean Baker) did – based on approaches that incorporated credit and finance. Unfortunately, their views were not seriously considered by mainstream economists (which Andrew Haldane, chief economist with the Bank of England, has labeled a “methodological mono-culture”).

Curiously, the decision by mainstream economists to ignore finance and credit was based on the assumption (embedded in loanable funds theory) that credit cannot exceed already existing savings. This led to the conclusion that credit is “neutral” and has no effect on the real economy. A bank can make a loan of $100 only if it first has $100 in deposits. Money must first be saved before it can be deployed as credit. As if this relationship is entirely obvious, Paul Krugman wrote:

Think of it this way: when debt is rising, it’s not the economy as a whole borrowing more money. It is, rather, a case of less patient people – people who for whatever reason want to spend sooner rather than later – borrowing from more patient people.

The concept that deposits must precede loans is intuitive – almost like a law of nature. After all, we cannot lend $100 unless we have $100…..right? Credit must be neutral.

But is this perspective correct?

The answer to this important question was provided by no less an authority than the Bank of England (BOE). The answer is that, indeed, the mainstream view is wrong. In the BOE’s own words: “Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.” Banks create loans that become matching deposits.

For example, when a bank makes a loan for $100,000, it immediately credits the borrower with a deposit of $100,000. According to Richard Werner’s book, New Paradigm in Macroeconomics, this is how more than 95% of money is created in the U.S. and U.K. The notion from Economics 101 that the bank must first have deposits in hand before making a loan does not correspond with reality, according to the BOE. Today, credit and thus money can be created, ex nihilo (“out of nothing”). A bank need only make a loan – the deposit counterpart, given double-entry bookkeeping, is money, plain and simple.

So why does this matter? If the BOE’s claim is true, then credit and finance cannot be neutral! This certainly corresponds with our real-world intuition. The decision by mainstream macroeconomics to ignore credit makes no sense, especially given developments in financial markets over the past 30 years.