Money, Bank Credit, and Economic Cycles - The Ludwig von Mises ...

The Credit Expansion Process 261(adversely affecting the banks’ solvency). Just as the moneysupply was expanded according to the bank multiplier, artificialeconomic expansion fostered by the ex nihilo creation ofloans eventually triggers an endogenous recession, which inthe form of a widespread repayment of loans and an increasein arrears, reduces the money supply substantially. Thereforethe fractional-reserve banking system generates an extremely elasticmoney supply, which “stretches” with ease but then must contractjust as effortlessly, producing the corresponding effects on economicactivity, which is repeatedly buffeted by successive stages of boomand recession. “Manic-depressive” economic activity, with allof its heavy, painful social costs, is undoubtedly the mostsevere, damaging effect the current banking system (based ona fractional reserve, in violation of universal legal principles)has on society.In short, bank customers’ economic difficulties, one of theinevitable consequences of all credit expansion, render manyloans irrecoverable, accelerating even more the credit tighteningprocess (the inverse of the expansion process). In fact, as inour accounting example, the bank may completely fail as aresult, in which case the bills and deposits issued by it (whichwe know are economically equivalent) will lose all value, furtheraggravating the monetary squeeze (instead of the9,000,000 m.u. decrease in the money supply caused by thereturn of a loan, here the money supply would drop by10,000,000 m.u.; that is, including the 1,000,000 m.u. in primarydeposits held by the bank). Furthermore, one bank’s solvencyproblems are enough to sow panic among the customersof all other banks, leading them to suspend payments one byone, with tragic economic and financial consequences.Moreover we must point out that, even if the public continuesto trust banks (despite their insolvency), and even if acentral bank created ad hoc for such situations provides all theliquidity necessary to assure depositors their deposits arefully protected, the inability to recover loans initiates a processof credit tightening that is spontaneously set off when loansare repaid and cannot be replaced by new ones at the samerate. This phenomenon is typical of periods of recession.When customers default on their loans, banks become more