The Role of the Perverse Elasticity of Credit Money

by Andreas Hoffmann

I want to bring a recent comment by Sornette and von der Backe to the attention of the reader (in Nature 471, p. 166, May 2011). Sornette and von der Backe remind us to pay more attention to disequilibria caused by the fractional reserve banking system to explain the emergence of crises. They particularly recommend a reconsideration of the Austrian School of Economics to derive short-term policy solutions. “We should relearn and expand some of the old economic wisdom about the specific role of banks.

“Banks are important because they create credit in a fractional reserve system, and credit markets are crucial allocators of capital to entrepreneurs. However, this is not considered in macro-economic models used by central banks (indirect influence through interest rates aside).”

Largely in line with this, the economic historian Charles Kindleberger argues in his 1978 book Manias, Panics and Crashes that macroeconomics

“remains incomplete, even when it brings in production and prices .. if it leaves out the instability of expectations, speculation, and credit and the role of leveraged speculation (p.21).” “Neglect of the instability of credit began by and large with the depression of the 1930s, with the Currency and Banking schools converted into monetarists and Keynesians (p. 65).” “The monetarist-Keynesian debate leaves little if any room for instability of credit and fragility of the banking system, or impacts on production and prices when the credit system becomes paralyzed through loans rendered bad by falling prices (p.67).”

Kindleberger finds that the theory of Hyman Minsky is one of the few up-to-date exceptions that incorporates these finding.

But as Sornette and von der Backe write, there is much to be found e.g. in the (older) Austrian literature by Lachmann, Mises and Hayek that puts a strong emphasis on expectations, innovations and the perverse elasticity of bank credit (instead of solely central bank mistakes) that can be build upon to explain cyclical fluctuations. Given the globalized financial system and its growing importance for the world economy, this seems worthwhile.

6 thoughts on “The Role of the Perverse Elasticity of Credit Money

  1. Henry Simons also focused on the peverse elasticity of short-term credit. If I understand George Selgin’s position, he finds the elasticity of short-term credit a benefit while critics see it as a problem.

    As we have recently seen, the elasticity of bank credit works in both directions. Alan Greenspan recently noted that QE2 hasn’t produced any lending.

    An updated analysis must take account of shadow banking.

  2. Hi Jerry, thanks for your comment.

    I agree that it works in both directions.

    Following Minsky panics are followed by a drying up of credit supply. Like Minsky, Hayek favored to prevent such panics.

    To judge the current situation, however, I am not sure if we do not already see increased lending – from an international perspective. Banks lend heavily to emerging markets. And those are the same banks that do not lend in the US.

    I am not sure if the elasticity is a benefit or not. I guess there is no need to judge it, since one cannot hinder banks from innovating and finding new ways of producing ” credit money” without abolishing fractional reserve banking all together.

    The elasticity of credit surely guarantees that there will always be crisis and boom periods. Hayek like Minsky recognized that cycles are inherent in the credit system.

    But central banks should not reinforce them via bad policies. And – I believe – Minsky was wrong in believing that regulation is an answer.

  3. I have not yet read Sornette and von der Becke but it sounds like a reasonable argument. That said, this literature has been around for many years and largely ignored–it is hard to imagine that mainstream economics will change.

  4. Just today I received an email from a former colleague predicting a change in economic paradigms. The Great Depression of the 1930s brought us Keynesian economics. The stagflation of the 1970s brought us Monetarism.

  5. The question of the desirability of credit elasticity cannot be anlayzed apart from the monetary regime in which it operates. Under free banking (a la Selgin-White) the stock of money responds positively to an excess demand for money at the micro banking level, not at the system level. Applying this result to a central banking regime encounters such overwhelming difficulties that it is quite impossible to claim whether the central bank can ever get it right.

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