Credit Expansion Fallacy

The increase of monetary units, as in the case of a split or new coin, does not create credit. This is a common fallacy attributable to the relationship between state fractional banking and its hapless lender, the taxpayer.

In the case of state money, owners of the money could be considered "lenders" as a consequence of monetary inflation, though they are often unaware of the process. The inflation creates a transfer of value to the sovereign, called seigniorage, indistinguishable from the effect of counterfeit.

The lenders are never repaid for the so-called loan unless the sovereign permanently destroys an amount of the money equal to the monetary inflation plus a market rate of return on that amount. This naïvely assumes that the lenders are willing participants, as otherwise the loan can never actually be repaid.

This expansion of monetary units tends to never contract and given the existence of legal tender laws and other currency controls is involuntary. This "credit expansion" thereby acts as a perpetual tax on holders of the state money.

The effect is the same as with market credit with the exceptions that the lending is involuntary, the spending of the credit is controlled politically, and the loans are perpetually in default. These differences constitute malinvestment, which creates the associated business cycle.

The mechanism of seigniorage implies that people actually use the state money. This requires the force of law as implied by Thier's Law. The benefit of a hard money is that it cannot be counterfeited. This is why states hoard hard money as "reserve currency" and compel the use of their own soft money as a "circulating currency".

Bank lending is not materially different than any other form of investment, where the bank is an aggregate investor for its account/fund holders. However investments carry risk. The insurance of bank investments by the state, as demanded by voters, requires a constant source of capital.

When bank loans/investments are failing the cost is borne by the taxpayer. The state-licensed bank obtains money from the state at below market rates of return. The difference between the market rate and the "discount rate" is a transfer of tax money to account holders. The state finances this cost in part through seigniorage. Given little incentive to manage investment risk, the bank becomes a daily visitor to the "discount window".

To the extent that banks compete for account holders, the benefit of the tax accrues to the account holder. As a holder of the money, an account holder is ironically also a taxpayer, though this transfer is not necessarily proportional. This taxpayer insured investment process shifts money from some people to others in a complex manner.

The fractional nature of state banking is expansive of credit only in that more lending appears to occur than would otherwise be the case due to insured lending, also referred to as "risk free". However the insurance cost cannot be ignored. People have less money to lend because it is being absorbed in the process of financing bad investments/loans held in risk-free accounts.

It follows that a beneficiary of the scheme is the defaulting recipient of bank capital. This benefit accrues to all borrowers as a reduced cost of capital. Given the reduced custodial risk created by free investment insurance, known as "moral hazard", the bank and its account holders are willing participants in the scheme to transfer from taxpayers, including savers, to borrowers.

Ultimately this scheme, created by the state, exists to allow the state to direct capital. The power to direct capital is effectively ownership of it. When the state directs its licensed banks to lend to a sector at below market rates, there is a political benefit with costs paid by tax. Seigniorage can be a major source of that tax.

It should be clear that this so-called credit expansion is not simply the result of fractional banking as a free market force. It is the consequence of the state favoring debtors over savers. In a free market of banking, banks are simply investment funds. Investors on average obtain a market return on capital and suffer the risk of doing so. In state banking risk and therefore capital are rearranged according to political objectives.

It is a common error to assume that an increase in monetary units constitutes credit expansion. Credit expansion is a consequence of an increase in lending of capital, as opposed to its hoarding. Increase of capital at the same rate of lending implies an increase in the amount of lending. However, there is no relation between the amount of capital and the number of units of moneys.

An increased rate of lending in a free market is a consequence of reduced time preference, and reduces the cost of capital. There is no way to prove that creation of a split or new coin changes time preference and as such it is an error of assumption that it reduces the cost of capital. The error is presumably a consequence of improperly relating reduced cost of capital to monetary inflation.