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Do credit expansion and contraction really lead to price level changes?

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May 06, 2013 – Comments (15)

So I know the technical definition of inflation is an increase in the money supply, but in this blog I will refer to inflation as meaning price inflation, just to make less typing.

I have often heard that an increase in credit expansion leads to inflation.  I don't see why.

 

If money (cash) is printed, then there is more money chasing same goods....this is clearly inflationary.

Credit expansion seems like it could go either way though

 

If there are 1000 dollars in a simple economy that only produces apples, and there are 1000 apples produced a year, apples likely cost $1 per apple.

 

Now if a loan is taken out through fractional reserve banking that increases the total money supply through credit expansion equal to $1000, now there is $2000 in the economy....but if the loan was taken out to contrsuct a machine that produces 3000 appels a year, now there is $2000 and 4000 apples per yer, making each apple only cost fiddy cents.  This is price deflationary

So it seems as long as the loans are good loans and a good use of capital, that an incease in credit expasion would likely be deflationary. But if the marginal value is smaller than the marginal increase in money, so it will be inflationary. 

 

I bring this up because I often hear people say QE is not inflationayr because there are just excess reserves that pent up and not being lent out....but to me this does not make sense.  If the loans were lent out there would be an increase of production which as I showed, could be deflationary.  But the fed buying treasuries in the open market is putting more cash in the hands of consumers without any new investment loans, which is just more cash and same amount of goods, which is inflationary.

 

It is very possible I am missing something here....but how does credit expansion or contraction alone affect the price level? 

15 Comments – Post Your Own

#1) On May 06, 2013 at 5:11 PM, outoffocus (23.24) wrote:

My head hurts. Lol just kidding.  This is a great topic.  I hope our monetary theorists respond.

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#2) On May 07, 2013 at 10:41 AM, Frankydontfailme (27.58) wrote:

Problem is when credit expansion results in buying unproductive assets. People take loans to buy a house, car or stocks. No productivity increase, just an increase in the quality of life. As a result the prices of these assets rise. 

In theory the loan should eventually called back and the credit money destroyed. In practice, the fed fights this natural process. 

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#3) On May 07, 2013 at 11:52 AM, rd80 (97.30) wrote:

If money (cash) is printed, then there is more money chasing same goods....this is clearly inflationary.

Even this isn't always the case.  If the printed money ends up sitting in savings, bank balances or other cash equivalents, it won't be chasing goods and services and driving up prices.  That's where we've been recently - companies are sitting on large piles of cash, consumers have been (or had been until recently) paying down debt or building savings.  In that scenario, Fed efforts to juice the economy with monetary policy are like pushing on a rope.

Of course when sentiment turns and companies and people decide to start spending, the Fed could have a very tough time reversing the easy money poliicies.

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#4) On May 07, 2013 at 2:19 PM, Melaschasm (57.59) wrote:

One of the problems with credit expansion is the cyclical nature of the beast.  Generally speaking credit expansion occurs when we are already deep into the growth portion of the economic cycle.  

When times are good and profits are flowing, people and companies should be paying down debt and saving for the future.  Unfortunately US culture encourages people and companies to borrow more during the good times, which causes much higher bankruptcy rates during the bad times.

Even if the credit cycle is not inflationary in the long term, it tends to heighten the volatility of the economic cycle. 

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#5) On May 07, 2013 at 9:57 PM, ChrisGraley (29.72) wrote:

A lot of different ways to look at the subject, but let me add a couple of cents.

First of all, while credit expansion does help some businesses, particularly small businesses, the primary focus of easing credit though is to create more consumer demand. An apple business that could triple apple production with a simple machine could probably get a loan even in the tightest credit market. These loans would be easier in credit easing, but they would actually be counter to the governments goals and have a deflationary effect. The government wants to move the demand side of the equation, not the supply side. The government must ease consumer credit even further to counter deflationary effects of productivity and the job loss that comes with it.

The next thing to look at is if we already had enough apples before the credit easing. Tripling the number apples is fine if they will all be bought, but if the population only cosumes 1000 apples, 2000 others go to rot.

Posts # 2,3,4 expand on this as well, but I would disagree with rd80's post that the consumer is paying down debt and increasing savings in the current economy. I totally agree about corporate spending though and would say that it is at the tighest level that I personally have ever seen it. Corporations stop spending when they fear what is to come. Consumers still have to buy food and pay utilities even if they have to borrow. They may not borrow and buy an impulse item, but they will borrow to eat. Even though the money supply has increased, it is not getting into the hands of the consumer. The fact that companies are not using the easy money to create jobs means that the jobless consumer must borrow to survive.

If you can figure out a way to change corporate opinion on the economy, then the economy will get better. The current corporate opinion though is that the current government is just going to make the economy worse.They would invest to make more money if they thought otherwise. Maybe forcing more taxes and a healthcare burden on people that can't pay for it wasn't the best idea in a bad economy.

link

Consumers increased their spending from January through March at the fastest pace in more than two years. However, they had to trim the pace of their savings to finance the faster spending. Their after-tax income dropped by the largest amount since the final three months of the recession in 2009. Part of the drop in after-tax income reflected the increase in Social Security taxes that took effect on Jan. 1.

A person earning $50,000 a year will have about $1,000 less to spend this year. A household with two highly paid workers will have up to $4,500 less. 

 Note to the government....

People can't spend what they don't have. (Well they can, but only for a short period of time.) 

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#6) On May 07, 2013 at 10:22 PM, Valyooo (99.39) wrote:

For what reason does the government only care about demand side and not supply side? I always assumed it was just sheer stupidity

 

 

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#7) On May 08, 2013 at 6:14 PM, ChrisGraley (29.72) wrote:

The supply side is counter productive to their goals. Productivity creates less jobs not more and is in effect deflationary from a government perspective. The last thing the government wants to see is productivity. Deflation is the enemy, even though it would create a higher standard of living for the consumer.

I would agree that stupidity is a factor, because economic growth can most certainly happen during deflation.

The government cares more about productivity eating into tax revenue though. 

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#8) On May 08, 2013 at 11:07 PM, Valyooo (99.39) wrote:

So then my question is, why do they want more jobs?  If the answer is "because otherwise people will complain", then maybe, completely counter to your beliefs and mine, maybe government is necessary, or better for society, in the sense that even though it is CLEARLY inefficient, people are much happier being told what to do and with plenty of jobs, than they are with efficiency?

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#9) On May 09, 2013 at 3:53 PM, ChrisGraley (29.72) wrote:

They don't want more jobs, (which should be obvious at this point) All they want is for people to buy more stuff. The jobs are a means to the end. 

I think people are happiest during prosperity and the government can only create less properity. They might be able to replicate and sell something similar for a period of time, But the government created highs create reality driven lows.  The economic cycle swings higher and lower until it reaches a point that the government can't mimic prosperity anymore.

I am extremely happy eating bacon. That doesn't mean that eating bacon constantly is in my best interest. 

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#10) On May 09, 2013 at 10:53 PM, Valyooo (99.39) wrote:

No I get that, I was just confused about your  "supply side is counter productive to their goals".  If their goals is more tax revenue that would seem to be more easily accomplished by letting capitalism flourish (At least in terms of not creating booms and busts), and then taxing THAT (which is not capitalistic), rather than creating unproductive jobs, which they have to pay for, and seems counterproductive

 

But it just dawned on me why the government loves inflation so much.....because they tax you based on capital gains, not real capital gains.   You buy something for $100, and due to inflation it becomes worth $1000 when you sell it, you net $900 you have to pay taxes on...kinda genius in a sick way 

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#11) On May 09, 2013 at 11:13 PM, whereaminow (< 20) wrote:

It is very possible I am missing something here....but how does credit expansion or contraction alone affect the price level?

It's all relative. If prices would be falling without the expansion, the resulting price level with it could be flat, masking the changes. Of course, how can one know for certain the direction of the price level and the exact magnitude in a hypothetical?

But it just dawned on me why the government loves inflation so much.....because they tax you based on capital gains, not real capital gains

Yep. Tails you lose, heads I win.  That's a big part of it. Inflation also makes it cheaper to pay off debts, and since governments are always the biggest debtors....

David in Liberty

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#12) On May 13, 2013 at 2:11 AM, Valyooo (99.39) wrote:

Well the debt part I already knew...this is just another icing on the cake

 What you are saying about it being masked because ordinary deflation becomes price staying flat....that is true of monetary inflation, like an increase in FRN's....but I am talking specifically of loaned money.  Like, either the bank makes a loan to the apple machine maker, or he doesnt...if he does he expands credit but the loan helps cause DEFLATION because of how productive it was...if he doesn't nothing changes. 

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#13) On May 13, 2013 at 3:18 PM, Melaschasm (57.59) wrote:

Companies can aquire capital to invest in machinery which increases productivity in a variety of ways.  Debt is cheap with easy money policies, and becomes relatively more popular than it would otherwise be.  When debt is expensive, selling ownership stakes for cash can raise the money needed for what is expected to be very profitable investments in equipment.  Using internal cash flow is another method of investing in productivity, and probably the most common.  

When the government decides to make credit easier, they usually do so by increasing the money supply.  An increase in the money supply is inflationary because you have more cash chasing the same goods.  Even if such an increase helps boost productivity, the extra production is delayed, and so we still see a price spike in the short run.

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#14) On May 13, 2013 at 3:49 PM, Valyooo (99.39) wrote:

Right, I totally understand that, but in general I am talking about long term affects of CREDIT EXPANSION....the money supply itself is 100% inflaitonary no matter which way you spin it as I said in my original post...I am talking about only credit expansion created as loans though....not as additional federal reserve notes

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#15) On May 15, 2013 at 12:31 PM, rfaramir (29.35) wrote:

"US culture encourages people and companies to borrow more during the good times"

No, the Fed creating a climate of inflation expectations induces people to borrow to over-consume and producers to borrow to mal-invest in capital equipment and unnecessary workers. This is the root cause of the Boom and Bust cycle.

This is a corruption of culture, destroying both the stability of the market and the propensity to save and invest wisely.

 

"long term affects of CREDIT EXPANSION"

There is no difference in effect between fractional-reserve credit expansion and base money supply expansion. Both are fraudulent, both increase the available supply of money, and therefore both cause an increase in prices compared to sound money.

If you look at a piece of paper money in your hand, you cannot tell by looking at it whether it is backed by a reserve or not, i.e., whether it is real money or fiduciary media. That's the point of doing it that way: people would reject (or discount) unbacked notes and stick to gold notes, if given the chance. So they don't give us the chance. They make them all the same, counterfeiting accurately so we can't tell the counterfeit from the real, diluting the value of the real money.

 

You are right that productive investment leads to a lowering of the price level in an economy with sound money, as more goods are produced which are chased by constant money. Sound money loans accelerate the process of producers conforming to consumers' desires by signalling the people's time preference to investors. But fractional reserve loans distort the price of loanable funds which lies to both consumers and investors, resulting in wasteful consumption and unproductive investment.

rd80 is also right here: "If the... money ends up sitting in savings, bank balances or other cash equivalents, it won't be chasing goods and services and driving up prices." Reducing spending and saving your money (increasing your cash balance) is the free market way for consumers to signal to producers that they want fewer goods now (and which ones) and more goods later (entrepreneurs have to guess which ones). The lack of current spending tends to decrease current consumer product prices, and the increase in the supply of loanable funds decreases the loan price (interest rate), which induces the investment appropriate to consumer desires.

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