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Central Banking and Bad Credit Explained

[center]Central Banking and Credit Quality

by Michael S. Rozeff[/center]

Introduction

There are many very serious economic negatives of a central bank that supporters of central banks ignore. Instead, they argue that the central bank is a good institution because it helps to remedy recessions. That argument is highly misleading. The central bank can and does stimulate economic activity at times, but in doing so, it creates booms, bubbles, inflation, mal-investment, and the subsequent depressions. It is as if a doctor gave amphetamines to a patient who wanted to stay awake for the next 72 hours. The patient goes hyperactive for a while before suddenly dropping dead.

The system of central banking causes a boom-bust cycle. Austrian economists for a long time have emphasized that the central bank creates a boom that lowers the interest rate and creates mal-investment while capital is consumed. Robert P. Murphy provides an excellent illustration here. In this article, I will strengthen the Austrian theory by examining the financial side of the boom-bust cycle. The central bank’s money creation has important and prominent financial effects that propel the boom. I explain these effects, relate them to money creation, and explain several channels by which the economic actors in the economy are induced to consume capital and mal-invest: (1) Central banks subsidize marginal loans that the loan markets have previously rejected. (2) The central bank’s money creation causes lenders to lower their standards of extending loans. (3) The price rises caused by the central bank?s money creation cause borrowers to ramp up speculative activity and increase financial leverage.

The overall financial effect is a noticeable weakening of the structure of credits. Loan quality declines, and this places the banking system at risk. When the production structure fails to produce the appropriate mix of goods, borrowers cannot repay loans. Interest rates rise as they attempt to secure financing. Failures begin to occur as the depression sets in. Bad loans pile up in banks. Banks become insolvent and fail. The credit system tends to grind to a halt.

These financial effects can readily be observed in the booms that lead up to panics and depressions. What is new in this article is that I emphasize these effects and that I explain how these results connect logically to the activities of the central bank and to the distortion in the structure of production.

In sum, the central bank’s money creation does more than cause mal-investment through a lower interest rate. It also causes lenders to make submarginal loans across the board and to lower their lending standards, while inducing borrowers to speculate on higher risk projects and to take out loans that are excessive in light of their ability to produce income…