On Money and Credit

An EPJ Daily Alert reader submitted a question that may be of more general interest, so I am posting the question and reply here:

 I do have a question: your version of the business cycle seems highly focused on money supply,  and I note that Mises first major work was on money and credit. I havent seen you touch on credit as much as  money supply and I am wondering how that factors in. The interest rate seems key here, and while the money supply might expand with rising interest rates, the credit supply may contract. I would love to see some thoughts on money vs credit expansion in your daily alert!

First, the title of the English translation of Mises' book is inaccurate. Jörg Guido Hülsmann reports in  Mises: The Last Knight of Liberalism:

In mid-December 1911, he [Mises] put the finishing touches to a manuscript with the title Theorie des Geldes und der Umlaufsmittel (Theory of Money and Fiduciary Media--misleadingly published in English as Theory of Money and Credit)

But more important is that the Federal Reserve expands the money supply by creating high powered money which banks then use to expand credit. When the banks expand credit this way, they do so by crediting a borrower's checking account with funds. Thus, the money supply and the credit side of the balance sheet go up at the same time (If it is newly created money.) So counting credit would be double counting the amount of money going out into the economy.

It is not that the credit created is unimportant, it is just that the money side (mostly checking accounts) already reflects the increase going on.

This is not to say that credit can't expand without money expansion, there can be real savings that creates credit, but generally it is money supply that is the driver of the overall credit expansion. The areas of credit expansion do change, but you don't generally see an overall contraction in credit unless it is started by a slowdown or halt in created money.

Finally, money supply expanding with rising interest rates, given the current system, would almost certainly mean expanding credit. If for example the inflation rate is 10% and the interest rates has climbed from 0,25% to 5.0% that is a very significant hike in rates, but borrowers for asset purchases would want to borrow all day long, since while borrowing at 5% for a year they are going to (based on inflation) gain 10% in nominal income, after paying back the loan there is a nice profit. It is something along these lines that I expect very likely to develop in coming years, The Fed is going to raise rates, but be very slow relative to the price inflation. Money supply climbing, under the current system, without expanding credit would be very unusual.

-RW