TJP

The creation of credit is necessary to fuel the economy and to create employment. When banks make loans they create deposits and expand the monetary base. An increasing monetary base allows for the purchase of more goods and services, as well as the establishment of new businesses. However, many pundits, politicians, and even some unemployed resources have argued against credit.

The argument against credit is understandable, since economics is often counterintuitive, abstract and difficult to understand. As a result, many economic concepts postulated by pundits, politicians and the public are often misleading. For instance, the claim that credit (sub prime loans) caused the recession is tantamount to affirming that expansion of the monetary base causes recessions.

Economic theory and empirical evidence, however, refute the claim that monetary expansion (credit) causes recessions. On the contrary, monetary expansion (credit) tends to cause inflation, which is the opposite of a recession.

Credit creation automatically leads to money creation. And, money creation leads to higher income and employment.

It is the lack of demand for goods and service that causes recessions. And, demand depends on income and prices. As income decreases, the demand for goods and services, as well as employment, falls. Furthermore, for a given level of income, price also affect demand; the higher the price of a normal good or service, the lower the demand.

Therefore, decreases in real income cause recessions. Decreases in real income could result from external shocks, such as rising crude prices, or from open market operations by the Federal Reserve (Fed) that reduces the monetary base.

A typical exogenous shock is a sudden rise in the price of crude oil. For instance, when a gallon of gasoline is $2.00, 10 gallons cost $20.00. However, when it is $4.00, $20.00 purchases only 5 gallons. Thus, consumers’ purchasing power falls by one half.

Rising crude oil prices forces consumers to reallocate purchases, reducing the demand for certain goods and services. Such reductions cause employment dislocations, which, if uncompensated, ripples through the economy creating dislocations in other sectors and causing a general economic slowdown.

Thus, like external shocks, the Fed can also adversely affect credit by raising banks’ required reserves, paying interest on reserves, and keeping the federal funds rate low. High required reserve reduces credit availability. Likewise, paying interest on reserves and low federal funds rate create disincentives for bank lending, and hence monetary expansion and employment.

If the Fed and banking system increase the money supply above productive capacity, inflation is likely to occur and if they decrease the money supply below productive capacity, deflation will occur.

Therefore, even when the Fed uses open market operations to increase banks’ reserves, its prevailing policies could prevent credit creation. The current Fed policies of paying interest on reserves and keeping the federal funds rate near zero appear to provide a disincentive for bank lending. And, this might be the reason why a full recovery has been delayed.

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