Many think that if we were to return to a gold standard we would have a sound and stable financial system with no booms or busts. Some even advocate the elimination of fractional reserve banking.

The fact is that neither can be eliminated without banning all lending.

As long as people can lend, even without interest, booms and busts are possible.

Consider the following simple scenario:

1) All money is in the form of coins that are 100% gold.
2) Interest cannot be charged on any loan.

Mr. Retired is taking it easy living off his saved pile of gold.
Mr. Boat, a friend of Mr. Retired, wants to borrow 10,000 so he can buy a boat.
Mr. Retired being a good friend loans Mr. Boat 10,000. Mr. Boat gives Mr Retired a note(IOU) for 10,0000, takes the gold and runs off to Mr. Boatseller.
Mr. Boat gives Mr. Boatseller the 10,000 and takes possession of a nice boat.

So as it stands now:
Mr. Retired - has an IOU for 10,000
Mr. Boat - needs to pay back 10,000, but has a nice boat
Mr. Boatseller - has 10,000

Now Mr. Boatseller has a good friend who wants to buy a car. He loans to Mr. Car the 10,000 he got from selling the boat.
Mr. Car gives the 10,000 to Mr. CarSeller and happily drives away in his car.

Mr. Carseller then loans the money to Mr. Farmer who gives his IOU to Mr. Carseller and takes the 10,000 and buys seeds and fertilizer from Mr. Store.

Ok, let's look at how things stand now:
Mr. Retired - has Mr. Boat's IOU for 10,000
Mr. Boat - owes 10,000, but has a nice boat
Mr. Boatseller - has Mr. Car's IOU for 10,000
Mr. Car - owes 10,000, but has a new car
Mr. Carseller - has Mr. Farmer's IOU for 10,000
Mr. Farmer - owes 10,000, but has planted a crop
Mr. Store - has 10,000

As you can see, the original 10,000 has circulated around and created 30,000 in debt.
At any point someone could choose to stop lending the gold or just spend it. However as long as lending continues, debt will be created. Note that lending would also stop if no one wanted to borrow.

Let see how it continues.

Mr. Store doesn't loan the money he just just runs out and buys a small piece of land on a lake shore. He plans on building a vacation home there some day. No debt is created he just spends what he has. Mr. Landseller gives Mr. Store the deed to the land and takes the 10,000. A simple trade of gold for land has occurred. Mr. Landseller then loans the 10,000 to his friend who is owner of the ACME Lumber company. They use it to buy a new saw for the mill from WoodSaw Inc.

Ok, let's look at how things stand now:
Mr Retired - has Mr. Boat's IOU for 10,000
Mr. Boat - owes 10,000
Mr. Boatseller - has Mr. Car's IOU for 10,000
Mr. Car - owes 10,000
Mr. Carseller - has Mr. Farmer's IOU for 10,000
Mr. Farmer - owes 10,000
Mr Store - has a nice vacation spot
Mr. Landseller - has ACME Lumber's IOU for 10,000
ACME lumber - owes 10,000
WoodSaw Inc. - Has 10,000

As you can see even with no bank, no interest, and using gold as money, debt amounting to 40,000 has been created from 10,000 in real gold.

Now watch what happens.

Mr. Retired's house is hit by a storm. His roof is ruined. He needs 10,000 to repair it.
He goes to Mr. Roofer and says I need a new roof, would you take this 10,000 IOU I have from Mr. Boat?
Mr. Roofer takes the IOU and fixes Mr Retired's house.
Did you see what just happened?
The IOU was spent like money. The debt is acting like money.
Now imagine the other IOU's circulating around.
The debts have added to the money supply. Inflation!

Now you see why housing prices skyrocketed in the first half of the 2000s. As banks lent to almost anyone who asked, huge amounts of money came into existence, and housing prices were bid up, up, and up and the rest of the economy boomed because of all the money available.

The banks did all this lax lending because they no longer cared if the borrower could repay. They sold the debt to someone else.

That's were the inflation was, back then.
Now with lending collapsed to a tiny fraction of what it was, and defaults rampant, the money supply is shrinking fantastically.

The Federal Reserve and other central banks are trying to counteract the deflation by injecting massive amounts of money using various methods. The problem is they can't control what happens to the money they inject.

In addition to this, the government is borrowing massive amounts and spending it trying to keep the economy going by get more money circulating.

In short, they are trying to escape the economic contraction by borrowing as well as devaluing the money.

Think about is this way. In the above simple example, you have several IOUs in circulation around town. You owe a lot in IOUs. So many in fact, that you are having trouble paying them off. So to try and get out of this mess you borrow even more from other people and of course give them some new IOUs. But even after a lot of borrowing you are still in trouble. You're paying off old debt with new debt. It's getting harder and harder to find people willing to lend to you. Things get desperate and you decide to forget about borrowing and just write up IOUs and use them to pay off your other IOUs. However, this does two things. One is that it decreases confidence in your IOUs as you are seen just creating them at will. The other is that it increases the supply of your IOUs so their value drops. So then you have to create even more IOUs to pay off debts because of their decrease in value. Eventually people start to think you have too many IOUs and won't be able to pay them all off. People start to unload them and not accept them in an attempt to rid themselves of your IOUs. This further increases the supply of them, and their value drops even more.

There are three paths forward:
1) Quite making IOUs and somehow make enough money to pay them all off.
2) Default.
3) Continue to create IOUs, hoping they won't become totally worthless before you figure out some way to generate enough money to pay them all off.

Now consider what happens if you decide to default. In such a situation you are declaring that some or all of your IOUs will not be paid off. They become worthless since you will not pay them. The IOUs in circulation that are defaulted upon disappear from circulation because they are worthless. This is why defaults on debt contract the money supply.

In such a situation the remaining IOUs are worth more as there are fewer around and hopefully your ability to pay the remaining has increased since you owe less. However, there is also less money in circulation so it's harder to get money to pay them off. There is also the adverse consequence of causing those who hold your remaining IOUs great concern about you defaulting on them also and therefore they may try to unload them even more than before.

The above simple scenario shows how lending can create inflation, deflation, booms, and busts.
The world's financial systems may have very sophisticated methods and tools at their disposal to create, track, manage, and manipulate debt, but beneath it all is the simple fact that lending creates money.
Is this bad? Not inherently, but human emotion can wreak havoc with it.

Booms and busts exist because of people's emotions.
If you use lending in a sound manner, for example, borrowing to buy something that helps you generate income, it will work fine.
If you use it to buy today, things you want but don't need and/or can't afford, then you are headed down the road of potential doom.
The desire for things coupled with lack of discipline to save and pay cash for that TV, pool, vacation, boat, spa, cruise, etc., causes you to incur a debt. Buying things now on credit when instead you should buy them in the future with cash, creates economic activity today(boom) but later, in the future there will be a bust as borrowing and buying slows so that debt can be paid off, or in severe cases defaulted upon.

You will note that in the scenario above no interest was charged. Interest greatly exacerbates the situation as you have to pay a fee on the money you borrow. This fee can compound and can significantly affect what you owe. In the real world few people will lend money without being compensated with such a fee.

Interest is compensation for risk and opportunity cost.
When loaning someone money there is a risk you may not get paid back as much or all of what you lent. In other words you get back less then what you loaned.
Additionally, there is also the loss of income from using the money in another opportunity.
For example, instead of loaning the money, you could buy a business that generates revenue. Money can always be used to make more money with or without lending it.
The only question is how much can it make for what degree of risk.

The simple fact is that lending can cause booms and busts because of human nature.

A Brief Note About Human Nature

An experiment was conducted in the early 1970s and has been repeated many times since. In the study, young children were given a marshmallow and told that if they could resist eating the marshmallow until the researcher came back into the room that they would be given a second marshmallow. The scientists analyzed if and how long each child resisted eating the marshmallow. The results provided researchers with great insight on self control. Follow up studies done years later showed that preschool children who delayed gratification longer in the self-imposed situation correlated later in life with higher SAT scores, significantly more competence in general, as well as above average performance in many other areas of life. •

---

Log In to post a comment.