In this article titled, Understanding True Credit And False Credit, by Frank Shostak at mises.org, explains the difference between real credit that is backed by savings from real production, and counterfeit credit that is created by the printing press.
Don’t think of money when we talk in terms of real credit, think in terms of real things that are first produced, then saved and finally loaned as credit. Money is how we facilitate the exchange of goods and services either in the present or at some time in the future because of saving. Credit is a part of this future exchange.
Here are some excerpts from the article.
“Banks cannot expand true credit as such. All that they can do in reality is to facilitate the transfer of a given pool of savings from savers (i.e., those lending to the bank) to borrowers.”
“Consider the case of a baker who bakes ten loaves of bread. Out of his stock of real wealth (ten loaves of bread), the baker consumes two loaves and saves eight. He lends his eight remaining loaves to the shoemaker in return for a pair of shoes in one-week’s time. Note that credit here is the transfer of ”real stuff,” i.e., eight saved loaves of bread from the baker to the shoemaker in exchange for a future pair of shoes….Note that the saved loaves of bread provide support to the shoemaker. That is, the bread sustains the shoemaker while he is busy making shoes. This means that credit, by sustaining the shoemaker, gives rise to the production of shoes and therefore to the formation of more real wealth. This is the path to real economic growth.”
“The introduction of money does not alter the essence of what credit is. Instead of lending his eight loaves of bread to the shoemaker, the baker can now exchange his saved eight loaves of bread for eight dollars and then lend them to the shoemaker….Money fulfills the role of a medium of exchange. Thus, when the baker exchanges his eight loaves for eight dollars he retains his real savings, so to speak, by means of the eight dollars. The money in his possession will enable him, when he deems it necessary, to reclaim his eight loaves of bread or to secure any other goods and services.”
“The existence of banks does not alter the essence of credit. Instead of the baker lending his money directly to the shoemaker, the baker lends his money to the bank, which in turn lends it to the shoemaker. In the process the baker earns interest for his loan, while the bank earns a commission for facilitating the transfer of money between the baker and the shoemaker….Despite the apparent complexity that the banking system introduces, the essence of credit remains the transfer of saved real stuff from lender to borrower.”
“Trouble emerges when instead of lending fully backed money, a bank engages in issuing empty money (fractional reserve banking) that is backed by nothing….When unbacked money is created, it masquerades as genuine money that is supposedly supported by real stuff. In reality however, nothing has been saved. So when such money is issued, it cannot help the shoemaker since the pieces of empty paper cannot support him in producing shoes — what he needs instead is bread. Since the printed money masquerades as proper money it can be used to divert bread from some other activities and thereby weaken those activities. This is what the diversion of real wealth by means of money out of “thin air” is all about.”
“We can thus conclude that as long as the increase in lending is fully backed by real savings it must be regarded as good news since it promotes the formation of real wealth. False credit, which is generated out of “thin air,” is bad news since credit which is unbacked by real savings is an agent of economic destruction.”
Here is a previous post titled, Printed Money Doesn’t Represent More Savings, in which we talk about how electronically printing counterfeit money doesn’t produce any good or service, it is just the creation of a piece of paper that allows who ever receives it the legal right to demand someones production.
Related Article – What Comes First, Production Or Consumption, at austrianaddict.com.
Related Article – Capital Consumption aka Eating Our Seed Corn, at austrianaddict.com.
Related Article – The Role Of Interest Rates In A Market Economy, at austrianaddict.com.