Credit Expansion Fallacy

Credit expansion is the apparent increase in money supply resulting from lending. When a loan is issued the lender and borrower both appear to hold the same money. Due to the inflationary nature of credit expansion, it is commonly treated as an adverse effect on people. Because banks are the most visible lenders this effect is often attributed to banking itself. There is a theory that Bitcoin can eliminate the effects of fractional banking, eliminating credit expansion.

Saving is a general term for hoarding, speculating and investing. Hoarding is owning as required to satisfy expected consumption. Speculation is owning in the expectation of advantageous price change. Investing is lending to another in exchange for a fraction of the borrower’s future earnings. Hoarding and speculating are outwardly indistinguishable, as the sole distinction is in the mind of the owner. As such this topic will, in the interest of simplification, refer to speculation as hoarding. Investment implies a trade between the lender and the borrower. The borrower owns the asset and the lender owns a fraction of the borrower’s business. Investment includes both debt and equity contracts as the distinction is strictly financial, having no economic significance.

The distinction between hoarding and investment is essential to the understanding of credit expansion. A hoarded asset is under the control of its owner, as if in a vault, buried in the back yard, or stuffed in a mattress. This is inherent in the meaning of ownership. The lender of an asset is not the owner of the asset, even though a loan is considered savings.

A lender requires liquidity to operate, and as such must hoard a certain fraction of capital. When a loan is created the borrower owns the amount of capital lent. The borrower also requires liquidity, and so hoards a certain fraction of the loan. Any remainder of the loan is necessarily invested. This implies that the borrower has become a lender. The process continues until all capital that exists is hoarded.

The amount hoarded is sometimes referred to as the owner’s “reserve”, but properly it is the owner’s hoard, a fraction of that owner’s total savings. This use of the word reserve should not be confused with its use in the state money context of reserve currency. The term “fractional reserve banking” is a reference to the ratio of a bank’s hoard to its total savings.

The decision to hoard vs. invest is based strictly on each person’s time preference. Time preference is not derivable from any condition. It is, as the name implies, a human preference. Human preferences change and therefore so does time preference. Time preference determines the interest rate which can also be considered the cost of capital. An increase in the cost of capital resulting from increasing time preference causes credit available to contract, and a decrease has the opposite effect. With infinite time preference all capital would be hoarded, ending all production.

It matters not whether a lender is referred to as a “bank”, all investment implies the same behavior. If banks operated with a 100% hoard they would not be lenders. This does not imply any reduction in lending, as the rate of lending is determined by time preference alone. Bitcoin can be lent and as such does nothing to limit credit expansion. The theory is therefore invalid.

Eliminating credit expansion is equivalent to the condition of infinite time preference, an infinite interest rate, no capital available for production, and no products available for consumption. In states where debt instruments are limited or prohibited by statute (usury laws), investment simply moves to equity instruments, loan sharking, or an end to production.