The Effects of Bank Credit Expansion Unbacked by an Increase in Saving: The Austrian Theory or Circulation Credit Theory of the Business Cycle

We have analyzed in terms of economic theory the effects of an increase in saving. It is time for us to take the next step. We will turn to page 347 of my book Money, Bank Credit, and Economic Cycles and what is perhaps the most important section in the book, “The Effects of Bank Credit Expansion Unbacked by an Increase in Saving: The Austrian Theory or Circulation Credit Theory of the Business Cycle.” As you recall, in chapter 4, we learned that the fractional-reserve banking system is able to create money substitutes (part of the money supply) in the form of deposits which are injected into the economic system as loans without anyone’s having had to save anything first. When the banking system begins a process of credit expansion and thus injects loans into the economic system, banks also begin a process in which they temporarily lower interest rates so entrepreneurs will accept the loans. Banks woo entrepreneurs and try to entice them to request loans. We have all witnessed this process in past years; banks have pursued us to give us loans. This is how money is injected into the economic system. Remember that only around 10 percent of the money supply is in the form of cash. The other nine tenths exist merely in the accounting entries which banks make in the loan-to-deposit process.