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Loans and Savings

The next installment of my organic credit model, following on from these previous posts.

I.  Commodity Money

II.  Banks and Credit

III. Credit Expansion

Remember, this is intended to describe a decentralized free-market economy with free-market (commodity) money.  The connections between this and our current economy are not entirely straightforward.

Loans and Savings

When most people think about banks, they think of an entity whose function is to allocate capital by borrowing from people who wish to put off consumption until some point in the future and lending to people who would prefer to consume or invest today and pay for it with future goods.  And of course banks do perform this function.  However the function described above serves a different purpose.  In our model so far the purpose of the bank is purely to provide liquidity by allowing people to use bank credit as a medium of exchange in place of hard currency.  It is my assertion that this is the primary function of banks as it is the function which distinguishes them from other institutions which also serve to allocate capital such as stock markets, corporate bonds, mutual funds, venture capital firms, etc.  But since these two functions are bound up together, we must take a moment to distinguish between them and see how they interact.

All forms of credit involve a loan from one party to another and a corresponding  promise by the latter to pay the former at some point in the future.  But there are two distinctly different reasons for entering into such an agreement which are important for our purposes.  In the case where the baker buys meat from the butcher and pays with an IOU for some amount of gold or bread, redeemable whenever the butcher sees fit, credit is being extended not to shift production or consumption between present and future but simply because it makes transacting more convenient.  I will call this type of credit “short-term” credit.

This is the case with any form of credit which is payable on demand at any time.  For instance, people open checking accounts rather than carry out all trade with cash.  A modern checking account is exactly like the bank notes in the example above.  You put your money in the bank and the bank gives you notes (or a debit card) that you can give to someone else which they can redeem to get currency from the bank.  When someone writes you a check, they are extending you short-term credit.  You can redeem it for money (either cash or additional short term credit in the form of a debit to your own account at your bank) at their bank whenever you get around to it.

Similarly, the bank is extending them short-term credit.  They trade their money for a promise to pay them whenever they demand their money.  They do this because it is more convenient to carry out trade with checks or a debit card than cash.

On the other hand, if the butcher were to approach the baker and say: “listen pal, I want to buy some bread but I’m not able to pay right now, in two months, Bessy will be fat enough to slaughter and then I will be able to pay, can you let me slide until then,” and the baker were to accommodate him, this would be an altogether different type of credit transaction.  Whereas in the first case the baker had the willingness and ability to pay now but used credit because it was more convenient, in this case, the butcher is using credit to solve a mismatch between the timing of his income and his desired consumption.  I will call this type of credit “long-term” credit.

Of course there are “long term” credit contracts of all different durations, the distinction is not really about the length of the arrangement, it is about the type of contract.  Credit which is used purely for the convenience of transacting will be due on demand while credit which allocates goods and services over time will be due at a fixed date (or dates).   It could be a couple months, as in the example above, or it could be a 30 year mortgage, either way the primary purpose is to allocate resources over time not merely to make it easier to transact.

There is naturally some grey area remaining between these two types of credit.  For instance, if someone uses a credit card, the debt is due at fixed times, the bank cannot demand it whenever they want.  However, many people use credit cards to buy things merely for the convenience and pay the balance every month even though they don’t have to.  For our purposes this person is using short-term credit.  Someone who carries a balance on their credit card, on the other hand, is, at least partially, using long-term credit as they are using that credit to buy things that they otherwise wouldn’t be able to afford at the time.  It is not necessary for us to be able to distinguish in every real-world case which is being used, it is only necessary to notice that credit serves two separate economic purposes: allocating goods over time and facilitating trade.

Now the standard economic story regarding borrowing and lending in a frictionless real-goods economy is that there is a supply and demand for real loans which is derived from consumers’ preferences over consumption at different times and the investment opportunities available in the economy.  Since there are no frictions, the market real interest rate r* is determined by the intersection of supply and demand along with the real quantity of goods loaned in the market.

Figure 1: Loanable Goods Market, Frictionless

loanable goods market

In a frictionless economy, there would be no money—neither currency nor credit—and this is what the market for loans would look like.  In that case, there would be no such thing as a nominal rate or an inflation rate, being no such thing as money, and the rate of increase in the value of a durable asset like gold or silver in terms of other goods would be equal to the real rate r* (assuming no risk premium on loans) since holders of these assets would have to earn the same return they would if they traded them for other goods and loaned those goods in the market.

If we think of the Fisher equation in this economy, imagining gold to be money even though it is not being used as such and therefore carries no liquidity premium, it would be the following:


The (imaginary) nominal rate would be zero reflecting the lack of liquidity premium on our hypothetical money.

In reality, it would be very difficult to engage in real borrowing and lending in an economy with no money.  If one wanted to borrow to invest in a widget factory, one would have to find people willing to lend all of the necessary components in the quantities required at the times that they were required and for the duration required and be willing to accept payment in the form of widgets at the times which the ultimate production schedule allowed.  This notion adds far more complexity to already recognized double-coincidence-of-wants problem and would obviously make such investments very difficult to achieve.  In the face of this we can imagine the market for loanable goods looking more like figure 2.

Figure 2: Loanable Goods Market with “Friction”

loanable goods market II

If it is difficult (costly) to find lenders of the goods desired for consumption or investment, then the market for loanable funds will not clear.  In other words, there will remain some people with goods who would be willing to lend them and people willing to borrow them at mutually satisfactory real rates of interest who are unable to find each other because doing so would be too costly.  This means that the actual quantity of goods loaned in the market will be less than the efficient quantity.

It is worth noting that the actual interest rate parties agree on in this context is not necessarily defined, though I have depicted r’ as the maximum of the potential range for reasons which will become clear later.  The actual contract rate could be lower depending on the nature of the effort required to match lenders with borrowers, who pays the transaction costs, whether they become sunk upon discovering each other etc.  This issue is of little importance here, the main point is that some loans which would be mutually beneficial in a frictionless economy will not be made when transacting is costly.

But of course, in such an economy, people will find themselves holding some goods as a store of value and will find, just as with other forms of trade, that it is much easier to carry out lending using these goods than with other goods.  Or to put it another way, some good(s) will emerge as “money.”

Once money gets involved, it is much easier to borrow.  Instead of finding people who have every good required for a given investment at the times they are required who are willing to lend them for the appropriate period of time and receive payment in whatever form the investment produces, borrowers will simply need to find someone who has money and is willing to forgo consumption of goods in general over the period of the loan.  This person can then lend money which the borrower can use to purchase all of the various goods required at the various times required in their respective markets.

It is commonly understood that the interest rate, somehow defined, is the compensation people receive for forgoing consumption.  This is true but demands closer investigation.  Once we are dealing with an economy where carrying out trade is not costless, and money exists as a means of streamlining trade, we have multiple interest rates and these represent compensation for different things.

All forms of investment or stores of wealth serve to postpone consumption until some time in the future.  However, some stores of wealth are more liquid than others.  The most liquid assets are those we know as money.  Because they are more liquid than other assets they carry a liquidity premium as has already been established.  But holding these assets is still a form of putting off consumption and the increase in value of money over time is a form of market compensation for doing so.  But because of the liquidity premium on money, the reward for forgoing consumption by holding money is less than that for holding other less liquid assets.  This is because if you hold money, you are maintaining the option to consume at any time since money can be easily converted into consumption goods.

On the other hand, if you lend money to someone else for a specified period of time you are committing to forgoing consumption over that period.  In other words, you are selling the liquidity services of that money over that period.  As long as liquidity is scarce, nobody would be willing to give this away without additional compensation above the return they would receive from holding money.  Therefore, borrowers must pay an additional rate of return in the form of a nominal interest rate in order to borrow money.

Borrowers will be willing to do this because borrowing money makes it far easier for them to invest or consume.  Essentially then, the market for loanable funds is a market for liquidity services.  Those people who have money but place relatively little value on the liquidity services it provides over some period of time can sell that liquidity to people who place a higher value on those services.  That liquidity is then used by borrowers to lower the transaction costs associated with borrowing and investing.  The market for loanable goods would then look like figure 3.

Figure 3: Loanable goods market with money

loanable goods market III

In the figure, the distance (vertically) between the supply and demand curves represents the marginal contribution of liquidity to the investment process and in equilibrium this will be equal to the liquidity premium which takes the form of the nominal interest rate.  There will still be some real loans which would be mutually beneficial in a frictionless economy which will not be made because the mutual benefit of them will be less than the cost of purchasing the liquidity services necessary to make them possible.  However, the use of money in the lending process will greatly reduce the quantity of loans rendered impossible due to the cost of transacting.

In the figure we can see depicted the Fisher equation where δ is the rate of return on holding money which is the negative of the rate of inflation in the standard form equation.  Thus we have r’’=δ+i.  The demand for credit can also be seen as the distance between L’’ and L’ for any given nominal rate.  The lower the rate, the more credit demanded.  The additional credit creation will in turn lower the liquidity premium and facilitate increased investment which lowers the real rate and raises the rate of increase in the vale of money.

The “natural” (real) rate would be the rate that would prevail if the nominal rate were zero.  This would not likely occur in an economy with free banking since banks make money by charging a positive interest rate.  The prevailing nominal rate would depend on the market structure one assumes for the banking sector.  If banking is perfectly competitive, we can imagine a rate just high enough to cover the average cost of running a bank (including “economic” profits).  If banking is a monopoly, we can imagine the rate which maximizes profit (note that this rate would be higher not lower).  The lower the nominal rate in this scenario, the more efficient investment will be (though this is not necessarily the case in a modern “fiat money” economy as we will see).

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  1. March 12, 2014 at 12:26 am

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