The stability of the money system depends on belief in future profits and economic growth. The system of credit is a belief system (from the Latin credere = to believe). Credit is the belief in the ability of the borrower to pay back the borrowed money plus interest. Loans include interest repayments. This kind of money system forms the basis of capitalism: capital must yield a profit. The economy must always grow. Crises in the capitalist money and economic system are crises of belief. They occur when there is ‘too little’ growth, not ‘too much’. ‘Too little’ means the original calculations for growth and profit on issuance of the loan turn out to be exaggerated or the belief in them (for whatever reason) dissolves and the expectation of growth is revised downwards.
How the problem arises: the business of commercial banks is based on expectation of profitable loans. Thus they act pro-cyclically: in times of growth they tend to give more loans and relax the loan conditions (or demand lower interest). In a downturn they ‘pull in the reins’ and are slower to give loans (or demand higher interest). The fact that they are in competition with each other does not alter this basic behaviour. The result is a self-reinforcing dynamic: through too much lending – driven by exaggerated expectations of growth – more money enters the system than is justified by the actual rate of growth in real economic activity.
The excess quantity of money either causes a general rise in prices (higher inflation or even hyperinflation). Money has increasingly less value or it gets sucked into price speculation and causes bubbles in particular sectors (asset inflation). When one of these bubbles bursts, the affected investments are no longer profitable, which in turn causes value adjustments of wealth (or of profit and growth projections) in other sectors. The value of money is disastrously ‘corrected’. With deteriorating market conditions – in other words, lower growth expectations – a generally higher risk of debt default is assumed and conditions for new loans are strengthened (interest rates are raised and/or more security guarantees are required). Thus less money enters the system, readiness to invest decreases (‘investment traffic jam’) and incomes also decrease, along with the readiness to spend (decline in ‘consumer confidence’). As a consequence, businesses have less turnover than forecasted. There are more loan defaults. The outlook for growth becomes even bleaker and the cycle continues the downward spiral.
Why too little growth ends in crises: stable monetary and economic policies would always need to be able to compensate for the pro-cyclical behavior of commercial banks. States and central banks alike face a dilemma in the case of flagging growth (lowered growth expectations): if the prospects for growth recede, central banks seek to reduce the giving of credit by commercial banks through lowered base interest rates and to uphold the minimum inflation rate (+2%) in order not to fall into the trap of a downward deflationary spiral and recession (as happened in the worldwide Great Depression of the 1930s). The underlying calculation: lowered interest rates lead to increased demand for credit; and with high enough inflation people prefer to spend their money or invest it rather than holding on to it – the economy begins to ‘grow’ again.
At the bottom end of the interest scale, at 0% (“Zero Lower Bound”), the central banks reach their limits because they can no longer provide enough compelling incentives to stop the withholding of liquidity (Frank van Lerven: The Interest Rate Dilemma: Financial Crisis Either Way???). Some central banks have established ‘negative interest’ as an instrument but its effects have not yet been conclusively demonstrated.
Another strategy has been to try and influence the quantity of money by targeted release of government bonds (or the reverse, the purchase of bonds). These actions are controversial because they undermine the financial and political independence of central banks. The effected states try with (questionable) economic programs from the Keynesian toolkit (for example, car scrapping premiums: payment for swapping an old car for a promise to buy a new one) to stimulate growth and confidence. Or they become the replacement debtor (“lender of last resort”) when companies do not take on enough loans (and finally privatize state or public assets in order to balance out the associated interest burden).
All these measures do not cure the causes but simply react to symptoms. They seek to defuse the problem or cushion the effects. However, they create their own side-effects, which exacerbate and/or defer the problem to the future or displace it onto individual sectors.
To get an overview, please read more introductory articles about the problems of our money system here on our website (Growth, Debt, Redistribution of wealth) or watch a short MONNETA video .