Explaining The Credit Cycle
This article summarises why the credit cycle leads to alternate booms and slumps. It is only with this in mind that they can be properly understood as current economic conditions evolve.
The reader is taken through three monetary models: a fixed money economy, one governed by changes in bank credit, and finally the consequences of central bank intervention.
Classical economics provided the basis for an understanding of the effects of bank credit expansion. The theory, embodied in the division of labour, eluded Keynes, who was determined to justify an interventionist role in the economy for the state.
Neo-Keynesian policies have been responsible for growing monetary intervention. This article serves as a reminder of the distortions introduced by the credit cycle and why central bank monetary policies are fundamentally destructive of the settled economic order that exists without monetary expansion.
Defining the problem
The credit cycle drives the business, or trade cycle. It should be obvious that changes in the quantity of money, mostly in the form of bank credit, has an effect on business conditions. Indeed, that is why central banks implement a monetary policy. By increasing the quantity of money in circulation and by encouraging the banks to lend, a central bank aims to achieve full employment. Other than quantitative easing, the principal policy tool is management of interest rates on the assumption that they represent the “price” of money.
But there is also a cyclical effect of boom and bust, linked to changes in the availability of bank credit, and so modern central banks have tried to foster the boom and avoid the slump.
This is the Holy Grail for interest rate policy. Assuming interest is the price of money, there should therefore be a correlation between changes in interest rates and changes in the general price level. In other words, managing interest rates should allow a central bank to manage the general level of prices, and therefore, so it is said, influence the level of consumer demand. But empirical evidence denies this. The little-known Gibson’s paradox proves that there has been no such correlation,