TJP

Many pundits and politicians continue to argue that housing loans to sub prime borrowers caused the Great Recession of 2008, some even argue that the Community Reinvestment Act of 1977, and its 1995 revision, is responsible for the foreclosure crisis. Such arguments, however, preclude any understanding of monetary policy.

Bank credit, including housing loans to sub prime borrowers, expands the money supply and hence creates economic growth and employment. It is the lack of credit that contracts the money supply and strangles the economy.

David Laidler¹ notes “…that no matter how money gets into the economic system, it has effects thereafter.” Thus, when banks stand ready to make loans to consumers and merchants, borrowers use the newly created money to purchase goods and services, expanding the economy and creating jobs.

It is the quantity, as well as the velocity, of money in the economy that determines output employment and inflation. Therefore, the Federal Reserve monetary policy and the credit from the banking system determine economic expansion and contractions.

Thus, it is deceptive to claim that credit to sub prime borrowers caused the economic crisis. Using borrowed money to purchase goods or services cannot cause an economic crisis, except if the central bank, thereafter, reduces the money in circulation.

Decreasing the money in circulation contracts the economy, causing many borrowers to lose their jobs and incomes. As a result, they are unable to purchase goods and services or meet loan obligations.

Clearly, it is not the act of using credit to purchase goods and services that causes the economic crisis; rather it is the reduction of money in circulation by policy makers at the Federal Reserve.

This truth is hidden from the public, because if the public understood the manipulative power of the Federal Reserve in determining the nation’s output and employment, monetary policies that inflict suffering on the middle class would not be allowed.

Economic expansion and job creation is all about the quantity of money in circulation. And, bank credit, which creates new money, causes the money in circulation to expand and hence increases the demand for goods and services, which expands the economy.

For instance, if the value of goods and services produced is less than the money in circulation, all goods and services produced could not be purchased, except if the velocity of money was sufficient. Conversely, if the quantity of money in circulation exceeded the value of goods and services produced, consumers would bid up prices, causing inflation.

It is fear inflation, biding up of prices, that causes the Fed to believe that its only mission is price stability. As a result, it contracts the money supply when it believes that inflation is on the horizon, without regards to the human toll that it inflicts on citizens.

Thus, it is malicious and morally wrong to blame sub prime borrowers for the Great Recession of 2008, when the Federal Reserve should shoulder the brunt of the blame for restricting the money supply prior to the Great Recession (see graph).

[1] The transmission mechanism with endogenous money

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