Central Banking and Credit Quality



There are many very serious economic negatives of a central bank that supporters of central banks ignore. Instead, they argue that the central bank is a good institution because it helps to remedy recessions. That argument is highly misleading. The central bank can and does stimulate economic activity at times, but in doing so, it creates booms, bubbles, inflation, mal-investment, and the subsequent depressions. It is as if a doctor gave amphetamines to a patient who wanted to stay awake for the next 72 hours. The patient goes hyperactive for a while before suddenly dropping dead.

The system of central banking causes a boom-bust cycle. Austrian economists for a long time have emphasized that the central bank creates a boom that lowers the interest rate and creates mal-investment while capital is consumed. Robert P. Murphy provides an excellent illustration here. In this article, I will strengthen the Austrian theory by examining the financial side of the boom-bust cycle. The central bank’s money creation has important and prominent financial effects that propel the boom. I explain these effects, relate them to money creation, and explain several channels by which the economic actors in the economy are induced to consume capital and mal-invest: (1) Central banks subsidize marginal loans that the loan markets have previously rejected. (2) The central bank’s money creation causes lenders to lower their standards of extending loans. (3) The price rises caused by the central bank’s money creation cause borrowers to ramp up speculative activity and increase financial leverage.

The overall financial effect is a noticeable weakening of the structure of credits. Loan quality declines, and this places the banking system at risk. When the production structure fails to produce the appropriate mix of goods, borrowers cannot repay loans. Interest rates rise as they attempt to secure financing. Failures begin to occur as the depression sets in. Bad loans pile up in banks. Banks become insolvent and fail. The credit system tends to grind to a halt.

These financial effects can readily be observed in the booms that lead up to panics and depressions. What is new in this article is that I emphasize these effects and that I explain how these results connect logically to the activities of the central bank and to the distortion in the structure of production.

In sum, the central bank’s money creation does more than cause mal-investment through a lower interest rate. It also causes lenders to make submarginal loans across the board and to lower their lending standards, while inducing borrowers to speculate on higher risk projects and to take out loans that are excessive in light of their ability to produce income.

The general picture

The general picture is that the central bank tends to pump up money and then, sometime later, slows down the rate of money pumping or even makes it negative and drains money.

For example, the very first money-pumping of the Federal Reserve came immediately after the Fed was created. It occurred during and after World War I. The Fed controls "high-powered money." That monetary aggregate doubled between 1914 and 1920, which was at a very high rate of 12 percent a year. Prices rose steeply. The Fed could not continue this money-pumping without causing a hyperinflation and destroying the dollar. It slowed down the rate of increase of high-powered money to zero and then made the rate negative into 1921 and 1922. High-powered money fell by 14 percent. This caused a sharp recession and many bank failures. The financial effects I speak of are described later in much more detail.

In analyzing boom-bust cycles, we are dealing with social, economic, and historical events that differ in details but often have features in common. There will be many variations in the types of central bank, the methods it uses, the reasons it inflates, the kinds of booms that occur, the kinds of depressions that occur, the events that trigger panics, and the political reactions to all these events. For example, the reasons for the central bank’s money-pumping vary from case to case. Among others, they might be to speed up an already-existing expansion, to keep an expansion going, to enable government to float debt at favorable rates, to enable a large quantity of government debt to be floated, to provide banks with loanable funds, or to remedy a recession.

The details are not my concern here. No matter what the reasons for an inflation are, the general story is the same. The bank creates excessive money by buying assets and issuing currency as the corresponding liability. It does not matter what assets it buys. The result is the same. The deposits and reserves of the banks in the economy rise.

Over-expansion of loans

Let the central bank buy the bonds of a sovereign government in the open market, which is its usual practice. To do so, it outbids another buyer. It is not necessary to argue that the central bank depresses the rate of interest. The amount by which the central bank outbids other buyers need not be great and it need only cause a temporary blip in the interest rate. At a very small increment to price (which is a very small decrease in the interest rate), the central bank can purchase a large amount of bonds. The reason for this is that the supply of bonds for sale is highly elastic at the current price, there being many close substitutes. (The very high negative elasticity of demand for financial securities is a well-established fact in the finance literature.) Unless the central bank is regarded by the market as possessing special information about bond pricing, the price need not be much disturbed and any disturbance will be short-lived. Meanwhile, the other buyers’ appetite for bonds has not changed. They also buy the bonds they want. In the vast multi-trillion dollar ocean of fixed-income securities that provide returns to investors, even the central bank’s purchases are not large.

The central bank’s purchases need not lower the bond interest rate by much or even anything at all to have their well-known effects. When the central bank’s check is deposited by the seller of bonds into his account, that bank finds its deposits have increased. This happens throughout the banking system. A bank is now encouraged to make more loans. Some borrowers who were previously rationed out of the market will now be invited to borrow using these new funds.

To understand what happens next, one must understand the financial evaluation of investment projects. An investment has expected future cash inflows and outflows. The net present value of these cash flows is found by discounting them at a rate of return commensurate with the project’s risk. If the present value of the inflows exceeds that of the outflows, the project has positive net present value and is acceptable. Negative net present value projects are rejected, as the present value of the cash outflows exceed the worth of the cash inflows.

The bank with new funds to loan had previously rejected projects with negative net present value. Banks find themselves with new deposits and the capability of making new loans. There are any number of possible reasons why this new money will be allocated to the projects previously regarded as not credit-worthy and why these projects are more likely to be projects with long durations, that is to say, why these projects are the higher-order capital projects that appear prominently in the Austrian story. (1) The new deposits may cause the banks to re-evaluate the economic environment as more favorable. Thinking this, they may raise their expectations of future cash inflows. This raises the net present value and makes a marginal project acceptable. (2) They may regard the marginal projects as now having lower risk. This lowers the discount rate. Lowering the discount rate raises the project’s net present value. It is a fact of financial arithmetic that the longer-term projects, which tend to be capital projects, have a greater portion of their net present value that traces to distant cash flows. If either these cash flows are raised in expected value or their risk (and discount rate) lowered, their net present values are raised more than projects with shorter durations. (3) The increased deposits may lower the rate of interest paid on deposits. Seeing lower capital costs, banks may lower the discount rates attaching to projects and accept more of them. Projects that had been rejected as too risky or as not having great enough future cash flows will be re-evaluated at the lower costs of capital and found to be acceptable. Their net present values will become more positive. The loans will look good. (4) Banks compete with one another in making loans. Borrowers will now be able to shop among banks more readily. There is uncertainty over the net present values of investment projects because all the cash flows lie in the future, not to mention that discount rates are unobservable and must be estimated. Loans rejected at one bank have a higher chance of being accepted at another bank when all banks have more funds and banks evaluate projects differently.

I have not yet mentioned consumer loans. These too will be stimulated. Prior to the deposit influx, there were consumers whose incomes were too low or too variable (risky) to make them good risks. All of the above arguments equally well apply to them. If banks are flush with deposits and interpret that as a sign of good times, they will view jobs and incomes as more secure. The consumers who have been turned away from capital investments like autos and homes are now relatively more likely to be found acceptable. Competition will ensue and consumers find it easier to shop from lender to lender.

All of this can happen without any changes in the standards of making loans. The latter is an entirely separate matter. Even without changing standards, the net result is that new deposits engineered by the central bank are likely to be put to work by banks among loans once thought to be of lower quality. The basic reasons for this are three-fold. The new money may change the expectations of banks as to future cash flows and their risks. The new money may lower capital costs directly. The new money may lead the ordinary competitive process into the direction of accepting previously marginal loans.

Central bank subsidy

It should be emphasized that the additional borrowing caused by central bank money creation previously did not qualify for loans because the rates of return on the projects failed to come in high enough compared to capital costs. And if the borrowers were consumers, the incomes of these consumers were too low to be able to service the higher interest rates on the loans. The market for loanable funds, left to its own devices, had intentionally rationed some borrowers out of the market. Funds-suppliers and funds-borrowers met and made their bargains. Suppliers who demanded too high a return could not extend loans, and demanders who could only service loans at low interest rates were unable to make bargains at the equilibrium rate of interest. A production structure ensued that was consistent with the financial market equilibrium.

The central bank then stepped in and provided new funds to banks. This disturbs the financial market equilibrium and then the production structure. By subsidizing the banks, providing them with money, the central bank indirectly subsidizes a set of borrowers who previously could not borrow. The boom can be thought of as induced by a subsidy to sub-marginal projects and loans that society has previously rejected. The bust occurs when the central bank withdraws or lessens this subsidy and the projects and loans fail.

I digress slightly to mention briefly a very important issue because so many critics of central banking mention it in the same breath as central banking and believe it to be a critical fault of the current system. This is the issue of fractional reserving. I intend to provide a separate and more complete treatment at a later date, since my views are at odds with one wing of Austrian thinking on this matter. I hope to persuade my friends to revise their views on this matter and allow that in a free society, there can be depositors who may be quite willing to accept fractional reserve banking because of its benefits to them and who will not by any means regard it as inherently fraudulent.

The point being made here is that central banking is the villain of the piece. In banking, there has been fractional reserving for centuries. Therefore, fractional reserve banking is one aspect of the boom-bust process. However, it is not the essential part of it, which is the central bank. In a free banking system there may well arise banks that make loans in excess of the gold or other backing they might hold to service deposit accounts. But individual banks in a free banking system cannot survive by overextending loans, for in a free banking system there is no central bank to subsidize the banks by creating deposits. Furthermore, in a free banking system, there are multiple bank notes, not a single Federal Reserve note; and this competition makes a world of difference. The central bank is the critical mover in the process of creating a boom that ends up in a recession. I provided somewhat more detail here. See also here.

Prices increase

With their new funds, the borrowers may now purchase goods and services.

New loans per se are not necessarily inflationary in a free market and free banking system because those who obtain them in open competition produce new product that is wanted. But what of new central bank—induced loans in the existing non-free banking system? What of new loans made to projects that are actually not wanted at existing prices and interest rates? Here we have expenditures on projects that were previously rationed out of the market at the old prices and interest rates and would not have been produced without the central bank’s stimulus. These new and sub-marginal projects draw resources and labor into their production away from other desired projects that were predicated on lower prices and on demands of consumers. New demand atop the old will raise prices.

Rising costs cause other lines of business to reduce production. The structure of production becomes distorted. The economy that was set to produce shoes and shirts now is producing fewer shoes and shirts and more rockets to Venus or lots of land in remote stretches of the hinterlands. A boom takes hold. The banking system now has a tiger by the tail. When the rocket and land businesses cannot sell their product, prices fall. Loans are not repaid. If a portion of the economy builds Venus rockets that no one wants, less product is made available to exchange for the products that consumers actually desire. Further money creation cannot solve this problem. The central bank is unable to maintain this distorted production structure by injecting new funds. If it attempts this, the money is likely to flow into desired goods. This will raise their prices. It will borrow demand from the future because new loans will have been made. But until production goes back into the goods that consumers want, the economy will experience inflation and unemployment, that is, stagflation.

Deterioration of loan quality

I suggested at the outset that there was a second effect of central bank money creation, namely, relaxation of loan standards. When a central bank pumps up money, member banks become all too willing to accept borrowers whom they previously regarded as bad risks. They make more loans against real estate, more loans to weak borrowers, and more loans to marginal borrowers such as foreign borrowers. Their lending goes beyond making more loans. It goes into making worse loans.

We have just been through a period (2001—2007) where worse loan quality was clearly evident. It was encouraged by government. Friedman and Schwartz in their monetary history mention that in the boom of the late 1920s there was "a reduction in the average quality of credit outstanding, in the sense that the securities issued and the loans made in the late twenties experienced a larger frequency of default and foreclosure than those issued in the early twenties."

The following account, written by Fred L. Garlock and published in the Journal of Land & Public Utility Economics describes the deterioration of loan quality in yet another boom, but they could apply to almost any boom. Garlock also presents a theory of how this comes to pass:

"[The banks’] increasing receipts, which were due to rising prices, had tended to neutralize the drafts; and, similarly, deposits increased during the summers to amounts which again upset their predictions. Banks which had been chronic borrowers found the problem of liquidation solved by the unusually large supply of loanable funds which came to them, while those which were infrequent borrowers found it necessary, in order to employ their funds profitably, to encourage borrowing by their customers.

"Rising prices affected both banks and their customers with an optimism which swept aside the conservative standards of experience and promoted extravagance and speculation. Whatever the customers purchased, whether merchandise or land, they were able to sell at an extraordinary profit; whatever was produced on their farms brought unusual returns. Some few persons, uncertain of what disposition should be made of the unexpected harvest, began reducing their fixed indebtedness. It was not long, however, until the continuously rising prices, the encouragement of the bankers, and the methods used by the government in selling war securities, had convinced the majority that debt was a blessing in disguise, as it became progressively easier to liquidate and offered a means of extending profit-making activities. Under the urge of these influences, industry expanded and thrived, promoters of all types came into their own, and thrift gave way to extravagance. Bankers found their accustomed standards of credit analysis growing obsolete, for values increased automatically with the passing of time. Hence it was that, as the speculative fever gained a foothold and grew and the demands for bank funds enlarged, credit was extended to all manner of persons on — or without — all kinds of security, excess lines became commonplace, customers’ notes given to promoters of questionable and fraudulent enterprises were discounted for rich rewards, and large sums were advanced to land speculators. Borrowing for the purpose of relending became an established practice. Time and time again the banks were saved from the effects of their ill-advised acts by the continuous growth of deposits."

The above words were written in 1926 in description of the boom of 1914 – 1920 as it affected banks in Iowa. The author writes:

"As the period drew to an end, during late 1919 and early 1920, caution was thrown to the wind by both bankers and their customers, speculation became rife, an enormous burden of debt was contracted, and economy was lost in a swirl of extravagance."

Murray Rothbard’s account of the Panic of 1819 includes material in passing that describes the speculation based on low loan standards in the preceding boom:

"Investment in real estate, turnpikes, and farm improvement projects spurted, and prices in these fields rose. Furthermore, the federal government facilitated large-scale speculation in public lands by opening up for sale large tracts in the Southwest and Northwest, and granting liberal credit terms to purchasers. Public land sales, which had averaged $2 million to $4 million per annum in 1815 and 1816, rose to a peak of $13.6 million in 1818. Speculation in urban and rural lands and real estate, using bank credit, was a common phenomenon which sharply raised property values.

"In his argument for the relief bill as a whole, Edwards went into great detail to excuse the actions of the debtors. The debtors, like the rest of the country, had been infatuated by the short-lived, u2018artificial and fictitious prosperity.’ They thought that the prosperity would be permanent. Lured by the cheap money of the banks, people were tempted to engage in a u2018multitude of the wildest projects and most visionary speculations,’ as in the case of the Mississippi and South Sea bubbles of previous centuries. Edwards sternly reminded the Senate that the government itself had encouraged public land purchases by making some of its bonds and other claims upon it receivable in payment for the lands."

The above material documents the fact that booms are accompanied by a lowering of loan standards by lenders.

Why loan quality declines

The credit-induced boom leads both to an over-expansion in the amount of credit and an accompanying decline in the quality of that credit. The two go together because the excessive bank deposits induce banks to reach lower in the barrel to loans previously considered to be sub-marginal.

Why do banks make so many of what later turn out to be unsound loans? Why does this process take hold so ferociously? Why is caution replaced by irrational exuberance? And, in this day and age of big government, why does big government do so little to stop it? Indeed, why does big government encourage it?

  1. Why does the structure of credit tend to move toward weaker credits? The existence of the central bank and a single currency is the main reason. In a system without a central bank, individual banks issue their own bank notes convertible into gold, say. If they make too many weak loans, their bank notes fall below the conversion value into gold that has been promised. The bank then experiences gold withdrawals and a reduction in its bank notes outstanding. It is forced to curtail its lending.

In the central banking system, an individual bank gets no negative signal from its depositors. All depositors everywhere are dealing in the same Federal Reserve notes, not individual bank notes. They have less incentive to monitor the strength of an individual bank (especially in these days of deposit insurance) and they cannot as easily observe that strength (or weakness) because there are no quotations on individual bank notes.

Central banking and a single currency lead to the individual banks facing a much-reduced constraint on the loans they make. They can take more chances on riskier loans, and they do.

  1. Optimism prevails because optimism is what has been paying off. Optimism has been paying off because prices have been rising. With prices rising, the tendency as the boom progresses is to under-estimate the real risks of cash flow shortfalls, or to apply too low a discount rate to the cash flows of long-lived assets. Risk premiums become too low, which is another way of saying that marginal investments are accepted and thought to be profitable.

  2. In boom times, investors think it more likely that the returns of assets will be realized in good states of the economy. That is why they began to use more borrowing (or financial leverage) in buying homes, stocks, and other assets. They expected rather more returns to be realized in good states of the economy, and returns are higher in these good states.

Garlock’s account mentions the following reasons why loan standards deteriorate, and I have discussed them in earlier articles:

  1. Rising prices. A rising tide lifts all boats. A rising price level for a time makes even bad projects looks good. Rising prices encourage the use of more debt.

  2. As the boom progresses, the apparent prosperity makes standard methods of assessing credit quality obsolete. The three C’s of credit are Character, Credit, and Capital. The borrower’s history, his ability to handle credit, and his assets all matter. But in a boom, they matter less.

  3. The encouragement of government. Booms often are accompanied not only by central banking stimulus but also by government actions. For example, Rothbard writes:

    "The boom therefore continued in 1818, with the Bank of the United States acting as an expansionary, rather than as a limiting, force. The expansionist attitude of the Bank was encouraged by the Treasury, which wanted the Bank to accept and use the various state bank notes in which the Treasury received its revenue, particularly its receipts from public land sales.”

Prior to the Panic of 1873, the government subsidized railroad construction. In modern times, home-owning has been heavily subsidized in many ways. Legislation pushed banks to make sub-standard loans. At present, government officials are encouraging banks to make loans.

Bankrupt thought

If a driver presses the accelerator to the floor, sending the car out of control and into an embankment, we do not blame the gas pedal, the engine, and the transmission. We blame the driver who revs up the engine. Today, we have had an economic crash. The tendency is to blame the lenders, the investment bankers, the financial engineers, the banks, the bond raters, and an array of financial institutions manned by imperfect souls who did not withstand the forces surrounding them. The tendency is to blame what is loosely called capitalism or free market capitalism. The tendency is to blame the engine, not the driver. And it is the driver who has survived it all who is blaming the engine and the car!

“I made a mistake,” Greenspan said, “in presuming that the self-interest of organizations, specifically banks and (other financial institutions), were such as that they were best capable of protecting their own shareholders and their equity in the firms.”

The current Secretary of the Treasury, Henry M. Paulson, Jr., is quoted as saying that the subprime crisis “came about because of some bad lending practices.”

These officials are blaming the car that they were driving for the ensuing smash-up. Their thought is bankrupt. Their thought is a negative net-present-value project. Followed out in practice, their thought destroys wealth.

We must ask why panics occur when they do and why they are preceded by booms. There is deterioration in credit quality that occurs in booms. Why does it occur then? Why does it not occur at other times? Bad lending practices and banks that seem to be incapable of watching out for their own interests do not suddenly spring out of nowhere.

Greenspan and Paulson have no rationale for their statements. They have no business cycle theory. And therefore they have no sensible remedy. Their public statements are utterly stupid. It is no wonder that security prices decline whenever they open their mouths, since they reinforce the correct conclusion that our government officials are totally clueless.

Bernanke is the same in espousing the false theory that the automobile is responsible for its own crash.

Here is Bernanke: "u2018I do believe the latter [a new supervisory and regulatory structure] does have a significant role to play in constraining excessive leverage, excessive risk taking and the other elements that lead to bubbles,’ Bernanke said, laying blame for today’s crisis squarely on Wall Street investment banks that were allowed to borrow huge amounts to make risky investments with scant supervision."

Bernanke is wrong. Excessive leverage and risk-taking do not lead to bubbles. They are manifestations of bubbles. They are caused by the central banks and other government actions that create the booms and bubbles. Bernanke is mistaking correlation for causation.

On October 15, 2008, Bernanke said in a prepared speech:

"As in all past crises, at the root of the problem is a loss of confidence by investors and the public in the strength of key financial institutions and markets. The crisis will end when comprehensive responses by political and financial leaders restore that trust, bringing investors back into the market and allowing the normal business of extending credit to households and firms to resume."

More bankrupt statements. He blames the Panic of 2008 on a loss of confidence in banks and markets and believes that the remedy is a restoration of trust. This is like saying the car sped up and crashed because the passengers didn’t trust the car and now we must restore their trust in this crashed car.

The most casual reader of the history of panics and crashes can only be impressed by the regularity with which they are preceded by excessive money creation by central bankers. Argentina crashed in 1890. Excessive speculation was involved, but was it the culprit? As usual, government and monetary policies engineered the boom and caused the crash. In this case, the government created a set of National land banks to finance the purchase of lands that it had opened up. The setup was such that land rose steadily in price and banks could make unlimited issues of bonds. This led to a widespread boom and speculation with European participation. In addition, Argentina adopted a system patterned after the national banking system of the United States, a system that led to periodic booms and busts. It was not long before their system led to excessive creation of money that lacked convertibility into gold. The national government had illegally used the gold reserves of member banks to pay off its own obligations, leaving the currency with no backing!

Bernanke espouses one fallacy after another. He and his government colleagues, who are in reality know-nothings, are standing in the way of proper remedies by posing as thoughtful and well-read intellectuals with well-thought out theories. They are nothing of the sort. Their bankruptcy of thought will lead to America’s bankruptcy. Obama and the leading Democrats are similarly bankrupt.

The central bank system is at the root of the problem. The problem is worldwide. Like Argentina in the 1880s, the rest of the world has copied the western central banking blueprint in order to entrench excessive government power. Government power and central banking are now closely linked. One cannot be dislodged without dislodging both. One cannot be against one without being against both.

To take up the cause of monetary freedom is to take up the cause of liberty. The cause of liberty is the cause of monetary freedom.