Saving, Investment and Prosperity
By Duncan Whitmore
In a recent article for Free Life, I noted that, for me, the urge to pen a rebuttal to the work of others come not from trawling through the drivel of a statist, leftist or mainstream pundit. Rather, it comes in response to a libertarian who has spouted some piece of nonsense in spite of being in a position to know better. Today, we will address something similar of this ilk in the realm of economics from Alistair MacLeod, Head of Research at Goldmoney.
MacLeod produces detailed, well informed articles concerning the state of the global financial system, tracing its problems back to the existence of freely floating, paper currencies issued unilaterally by governments. While it often helps to have something of a technical understanding of finance and banking in order to comprehend some of the details, he is a clear advocate of a “sound” money standard based upon gold and silver, going at lengths to explain why he believes such standards lie in our future. For those fond of cryptocurrency, MacLeod may prove to be something of a disappointment – he is not a fan, nor, needless to say, does he have any faith in central bank digital currencies. However, this stance is probably to be expected from an analyst working for an investment firm specialising in precious metals.
He is also clearly familiar with the Austrian School of Economics, offering, in one of his recent articles, this brief summary of the Austrian attitude towards fractional reserve banking:
Since bank credit is reflected in customer deposits, a cycle of excessive bank credit expansion and contraction renders a currency fundamentally unsound. The solution advocated by economists of the Austrian school is to ban bank credit entirely, replacing mutuum deposits, whereby the money or currency becomes the bank’s property and the depositor the creditor, with commodatum deposits where ownership remains with the depositor. Separately, under these proposals banks act as arrangers of finance for savers wishing to make their savings available to borrowers for a return.
We might note that, strictly speaking, Austrian economists do not advocate the banning of anything. Economics is a value free science; its practitioners can tell you what the effects of a certain policy will be, but whether that policy should be either embraced or rejected requires a value judgment. This is not pedantry on my part; the mis-categorisation of economic and monetary policies as mere scientific or technical matters which should be in the hands of “experts” has played an enormous role in sheltering them from public scrutiny. Indeed, it is merely another version of the “follow the science” mantra that was used to justify lockdowns and social distancing during COVID-19. Apart from that, however, MacLeod makes a reasonable summary of what most Austro-libertarians believe should be the case. Depositors of money in a bank for safekeeping should retain 100% title to their money and pay a fee to that bank for custodian services. They can withdraw their money for spending at any time. However, those wishing to lend their funds to borrowers in order to earn an interest return would deposit their money under different arrangements. The depositor would transfer title over the money to the bank (thus becoming a creditor of the bank) for an agreed period of time. The bank would then use that money to make loans to borrowers, paying back the funds (together with the interest credit) to the depositor on the date the agreed duration of the loan comes to an end (usually referred to as the “maturity date”). Critically, during the period of the loan, the depositor would not be able to access the funds, at least not without incurring a penalty. Under this set of circumstances, there would be no unfunded expansion of bank credit.
Unfortunately, MacLeod follows this up with this strange paragraph:
The problem with this solution is that of the chicken and the egg. Production requires an advance of capital to provide products at a profit in due course. The real world of free markets therefore requires credit to function. And savings for capital reinvestment are also initially funded out of credit. So, whether the Austrians like it or not we are stuck with mutuum deposits and banks which function as dealers in credit.
MacLeod seems to be of the opinion that the entirety of investment, production and economic progress would grind to a halt if banks were not able to advance loans to borrowers through unfunded credit expansion. In other words, for him, such expansion is a positive thing, becoming a problem only if it is done to excess. This attitude is reflected in his proposed “solution”, which we will address later.
MacLeod does not explain the theoretical basis for this view, so I won’t speculate on where this might lie (and there are many possible options). It is, however, utterly erroneous. In fact, as we shall see, not only can economic progress proceed without unfunded credit expansion, but it is vital that all such expansion is eliminated if we ever wish to have a stable currency and long term prosperity devoid of boom and bust. The remainder of this article will be devoted to demonstrating why this is so.
Commodity Credit and Circulation Credit
In spite of having noted the fact that banks “can act as arrangers of finance for savers wishing to make their savings available to borrowers for a return”, the problem with MacLeod’s view seems to lie in his indiscriminate understanding of the term “credit”. The Austrians, going back to Ludwig von Mises, distinguish between two different kinds of credit, each of which has a very distinct impact on prices and the structure of production:
One must be careful not to speak simply of the effects of credit in general on prices, but to specify clearly the effects of “increased credit” or “credit expansion.” A sharp distinction must be made between (1) credit which a bank grants by lending its own funds or funds placed at its disposal by depositors, which we call “commodity credit” and (2) that which is granted by the creation of fiduciary media, i.e., notes and deposits not covered by money which we call “circulation credit.”
In other words, Mises distinguishes between the lending of real money on the one hand (which can lead to sustainable economic growth), and lending out of thin air through printing more currency units on the other (which can ignite an unsustainable boom). MacLeod, however, seems to view all “credit” as being of the second type only , leading to his conclusion that “savings for capital reinvestment are also initially funded out of credit.” Not only is this untrue, but in placing credit before saving, it is MacLeod, not the Austrians, who has confused the chicken with the egg.
Savings, Lending and Capital Goods
If we wish to increase our level of economic prosperity, then we need to create more capital goods – i.e. machines, tools and factories – which, in turn, will allow us to accomplish more productivity during each hour of work that we do. For instance, a man who has taken the time to build a shovel can move a greater volume of earth in the space of one hour than a man who can dig with only his bare hands; a man with a bulldozer can shift more than he who has only a shovel; and so on.
However, the creation of these capital goods takes time before they are able to yield an increase in the production of consumer goods. A bulldozer does not just appear in a day. As such, one needs a source of sustenance for the period of time that must elapse between the start of a capital project and its completion. That source is savings.
In order to illustrate this, it helps to think in terms of real goods, rather than in terms of money. Let’s say that Peter is a fisherman using a net to catch fish from the shoreline. With this net, he is able to catch ten fish per day. Desiring a bigger, daily catch, Peter decides to build a boat equipped with large nets so that he can sail farther out to sea where the stock is more plentiful. However, building the boat will take time, a period during which Peter will not be able to catch any fish. He therefore needs a stock of saved fish in order sustain him through this period of creating his new, capital good. Let’s say that Peter calculates that it will take him twenty days of work to complete the boat, and that to sustain himself throughout each day he will need to consume five fish. Therefore, out of his current, daily catch of fish, Peter will need to save a total of one hundred to see him through to the completion of the boat.
Only when Peter has accumulated this quantity of fish is it possible for him to see construction of the boat through to completion. He must be willing to forego the consumption of those fish if he wishes to obtain his boat. If those one hundred fish had not been saved but had, instead, been consumed by Peter each day he caught them, then construction of the boat would be impossible on account of the fact that he will starve a few days into construction. Similarly, if Peter had underestimated the number of fish required to see him through – let’s say he saved only fifty – he would have to suspend work on construction once he ran out, returning to catching fish with the net. Of course, he does not necessarily need to save all of the fish in one go and construct the boat on consecutive days; he could, for instance, save only ten or twenty at a time, working on the boat as much he can before returning to the shoreline to catch more fish once his saved stock runs out. However, over the entire course of the construction, regardless of how it is timetabled, he must have a total saving of one hundred fish.
If Peter is successful in constructing his boat, the latter may enable him to yield a daily catch of fifty or even a hundred fish – a remarkable increase in Peter’s standard of living from his previous, daily catch of only ten. None of this increase would have been possible without his decision to save a stock of one hundred fish. In order to illustrate more clearly the link between savings and investments, one might say that, as the building work progresses and the boat takes shape, the depleting stock of saved fish is “transformed” into the boat. In other words, his prior saving has now become an investment in an asset. The increased quantity of fish he is able to catch represents his return on that investment.
This example of an autistic economy shows how economic progress is made possible through funding capital goods out of one’s own savings. But these basic facts do not change in an economy involving more than one person. Economically, all investment must be funded out of savings. The only complication is what to do if it is Peter who wants to invest in the boat, but another person, Paul, is the one in possession of the stock of saved fish necessary to complete that investment. In order to get around this problem, Peter and Paul must come to some kind of mutually beneficial arrangement that serves to transfer the savings between them.
Clearly, if Peter had funded the investment in the boat entirely out of his own stock of saved fish, he would be the owner of the boat. However, if he wishes to fund the boat out of Paul’s savings, he could offer to make Paul a part-owner of the new boat once it is completed. Should Paul accept, then the latter would be entitled to a pro rata share of the daily catch with the new boat, representing a return on the investment of his savings.
In modern parlance, this arrangement would be known as equity finance. Companies do this when they sell shares to investors; in order to benefit from the capital of those investors, the company makes the latter part-owners of the business who share in its profits and losses. This arrangement could be more attractive for Peter if he is somewhat apprehensive about the prospect of catching more fish with the boat; by inviting Paul to become a part owner, he offloads some of the risk of the project failing. On the other hand, this arrangement would be good for Paul if the latter thinks the boat will be highly successful, as he will be rewarded with a handsome share of the extra catch.
However, another option is for Peter to borrow one hundred fish from Paul. In this instance, Paul would not become a part-owner of the boat; instead, Peter would be obligated to pay him back the one hundred fish at an agreed date in the future, together with an extra, fixed amount as interest on the loan. The duration of the loan is entirely up to them. Paul could want his fish back after just a year, together with just one year’s worth of interest. Alternatively, Paul could agree to a multi-year loan – even rolling it over at the maturity date – so as to pocket the fixed rate of interest year after year as a source of income.
This would be known as debt finance, and is the basic arrangement when companies issue corporate bonds or otherwise borrow money from third parties. There is a number of reasons why each of Peter and Paul may prefer this path to the previous option.
For one thing, Peter may not want to make Paul a part-owner of his new boat. Thus, this way, he is basically using Paul’s savings in return for a fixed fee. This option would be especially attractive for Peter if he expects the boat to yield an enormous return. Out of this huge increase in his catch, Peter would only have to pay a relatively small portion of it to Paul as interest, whereas if Paul was a part-owner Peter would have to hand over a lot more. Indeed, by being able to pocket this additional surplus for himself, Peter is effectively earning an income with Paul’s funds. Paul, for his part, may not even want to become a part-owner. He may be willing to sacrifice his savings of one hundred fish for a period of time, but would prefer to have them back at a set date in the future rather than tie up his savings in the form of a boat (or he may prefer to earn a definitive, fixed rate of interest year after year if he lends to Peter for the long term). This option would be attractive for Paul if he doesn’t want to share in the risk of the enterprise. What if the boat doesn’t yield a significantly greater catch of fish? If that was to be the case, Paul could feel that his savings had been wasted. Accepting instead a fixed return would insulate him from this risk, although he would also have to forfeit any share of a bumper profit in the event that the boat was successful.
In the real world, companies are often funded through a mixture of equity finance (shareholders’ funds) and debt finance (bondholders’ funds, bank loans, etc.). All of this money is then pooled together to fund the assets of the business. Hence, the basic equation of the company balance sheet:
Assets (what the company has) = Equity (what its shareholders have) + Liabilities (what it debtholders have).
Critically, however, we can see that both methods of funding have their source in savings. The only thing that is different between them is the legal relationship through which those savings are advanced. This may be illustrate in the following diagram:
Once we realise this, not only do we see that credit must come from savings rather than vice versa, but that – contra MacLeod – an economy does not even need debt in order to grow. It is perfectly possible for all investments in new assets to be funded entirely out of equity finance. The only purpose of debt relationships is to provide flexibility in facilitating the transfer of funds from those who are rich in cash but poor in ideas to those who are rich in ideas but poor in cash.
Banks and Intermediaries
This situation does not change when you introduce an intermediary such as a bank, or some other financial institution, into the equation. Let’s say that Peter and Paul, instead of dealing with each other directly, decide to handle their arrangements through a bank. In this instance, Paul wishes to place his 100 saved fish on deposit with the bank in order to earn a return. Paul relinquishes title over the fish for the duration of his deposit, becoming, in the process, a creditor of the bank. Under this arrangement, he cannot withdraw his fish from the bank until the agreed term of his deposit has elapsed. The bank then arranges to lend the 100 fish to Peter so that the latter can build his boat. Having built his boat and increased his daily catch of fish, Peter is now in a position to repay the loan plus interest to the bank. Once this event has occurred, the bank can repay Paul the 100 fish plus interest, minus a fee for having acting as an intermediary.
Notice, in particular, how the timing of each event must line up with that of the others: the bank must be able to borrow the fish from Paul for at least as long as it can lend them to Peter. Only when Peter has paid those fish back to the bank is the latter in a position to return them to Paul. The bank cannot borrow the fish from Paul for one year but lend them to Peter for two, at least not without another source of funding. Of course, in the real world in which banks are dealing with thousands of depositors and borrowers, all of this will be aggregated. The bank must ensure that a sufficient quantity of its loan book is maturing on or before the date it has to make payments back to depositors. If it falls short because, say, a particular borrower has defaulted, the bank must make up the difference with its own funds.
The essence of fractional reserve banking and the expansion of credit is that this temporal harmony between these different relationships is disrupted.
Say that Paul has deposited his fish in the bank not to earn a return but for safekeeping, with a right to withdraw them at any time. If this is the case, it is obvious that Paul’s stock of deposited fish could not be advanced as a loan to Peter. Either one of Peter or Paul can use those fish – they cannot both use them at the same time. So if Peter turns up to the bank asking for a loan of 100 fish to fund his boat, the bank would have to turn him away on account of the fact that there is no available stock of savings with which to sustain him for the duration of his construction project. Theoretically, the bank – attracted by the possibility of earning an interest return from Peter – could surreptitiously lend Paul’s stock of fish to Peter while still promising to pay them back to Paul on demand. But in a simple relationship like this, the game would be up pretty quickly, for when Paul turns up to collect his fish from the bank, he would discover that they are not there. The bank would then have to call in its loan from Peter immediately while the latter is only part way through his construction of the boat. Work on the boat would have to be abandoned. We can, however, observe here the essence of a boom and a bust: an initial bout of lending out of deposited funds sparks an investment boom which must later be abandoned when it is realised that sufficient funds are not, in fact, available for investment.
However, the reason why such an ultimately unsustainable arrangement can appear to advance economic progress for a time is because the entire pool of savings is not claimed in its entirety on one, single date. Depositors typically withdraw only a portion of their deposits at a time, while borrowers demand only small loans for each stage of the construction process. It is because of this fact that lending out of demand deposits can appear sustainably profitable to banks.
To illustrate, say that Paul deposits his 100 fish in the bank for safekeeping, with a right to withdraw them on demand. However, Paul withdraws only five fish per week. Along comes Peter, asking to borrow not one hundred fish but only five so as to fund just the first stage of his project. Knowing that Paul is only likely to withdraw five fish a week, the bank spies an opportunity to earn some interest with Paul’s fish by lending them to Peter. Thus, it agrees to lend Peter five of those fish. Therefore, after the first week, five fish have been withdrawn by Paul, while five have been lent to Peter, leaving a stock of ninety fish remaining on deposit in the bank – more than enough with which to honour Paul’s likely demand for withdrawals in the near future.
However, after the second week, Paul withdraws another five fish, while Peter demands another loan of an equal amount. Thus, the quantity of available fish left in the bank has now been whittled down to eighty. In the third week, the same thing: five are withdrawn by Paul, and another five lent to Peter; the total remaining is now seventy. This process continues week by week, thus:
For the first ten weeks, everyone is happy. Paul is able to fund his lifestyle from his weekly withdrawals; the bank thinks it will earn a profit from its loans, while Peter is looking forward to the day his boat is completed and he will be able to haul in a huge catch of fish.
However, by the time we reach the eleventh week, there is clearly a problem. Paul – thinking he still has fifty fish available in the bank for withdrawal – comes along expecting to be able to make his weekly withdrawal. However, the bank is empty as a result of having lent the balance of Paul’s fish to Peter. So once again, in order to pay back Paul, the bank has to call in its loans to Peter early. Peter, however, having borrowed only fifty out of the one hundred fish he needs to build his boat, is only half way through construction. With no more loans available, and with no means to pay them off, he must stop work on the boat and return to his previous lifestyle, either paying off the loans gradually from his old level of income, or defaulting (most likely the latter). Construction of the boat has been revealed as a malinvestment – a wasted effort.
This arrangement does, of course, look pretty silly from the point of view of an individual bank which is likely to be aware of the fact that its whittling down its funds considerably as time continues. Unfortunately, however, it doesn’t appear to be quite so stupid in a complex economy in which construction of a capital good such as a boat (or any lengthened process of production) wouldn’t be undertaken by a single entity such as Peter. Rather, different parts will be manufactured at different times by different companies, each of which will need relatively small loans to fund their particular part of the process. Each of those loans will be made by different banks, and can be paid off from the sales of their parts. For any one party, the entire process can provide immediate rewards, lending the appearance of sustainability. In fact, those who get into this process at the earliest part of the credit expansion can often do very well for themselves, whereas it is the later borrowers and lenders who tend to be left high and dry. This is illustrated most clearly in a stock market boom. If you can borrow money to invest in stocks at the beginning of the cycle (when both interest rates and stock prices are low), you can ride the multi-year rally all the way to the top. Should you be skilled enough to get out in time, you can pocket the cash and pay off your cheap debts. But the person you are selling to has likely taken out a very expensive loan in order to fund a position right at the top of market – a time at which stock market mania and the illusion of permanent prosperity are likely to be at their most hypnotic. Such an individual is likely to face ruin in a matter of months.
Moreover, such booms are associated with full employment and a plethora of economic activity which makes everyone feel as though they are getting wealthier, and so governments and central banks are always keen to keep the party going. As such, the illusion that there are plenty of funds available for investment can be sustained for many, many years. Eventually, however, the façade must be torn down.
The situation doesn’t change when everything is transacted through the medium of money; the only difference is that people are dealing with the ability to purchase resources rather than with resources themselves. So if Paul deposits not 100 fish in the bank but £100, it is because he wants that money ready to be able to buy 100 fish for consumption (assuming one fish costs £1). Similarly, if Peter borrows £100 from the bank, it is because he wants to buy 100 fish to sustain him through his construction project. But it is still the case that Peter and Paul cannot each consume the same fish. If the bank prints an extra £100 to lend to Peter, no new resources have been created. Instead, the bank has simply transferred purchasing power over the fish from Paul to Peter. As there is now £200 in circulation instead of £100, the price of fish will rise from £1 to around £2. While Paul may be able to get his £100 out of the bank in full, he can use it to buy only fifty fish rather than the 100 he was expecting. Similarly, Peter will find that his loan of £100 will only buy fifty instead of the 100 that he was expecting. While the precise effects in a complex economy are somewhat more complicated, we can see that, once this shortfall is realised, the bust sets in, and the whole situation must be unravelled.
It is for this reason that unfunded credit expansion cannot lead to permanent prosperity. And it is for this reason that MacLeod’s proposed solution to excessive credit expansion is really beside the point:
[T]he solution to the disruptive cycle of bank credit is to limit its extent by making the owners of banks, including outside shareholders, liable for all losses by removing from lending institutions the protection of limited liability. This would also ensure that banks would become smaller, more local, more specialist, and more numerous. The existence of today’s megabanks and the requirement for a central bank to ensure systemic integrity would fall away, and with it the need for bank regulation. Banks creating credit must stand or fall on only their reputation.
The ethics of limited liability are, of course, not an irrelevant topic for libertarians. But in this instance, it really has nothing to do with it. The problem is in credit expansion itself, not that it is done to excess. In fact, because large banks and governments have a vested interest in finding a way to maintain credit expansion without the risk of loss, the realpolitik of it being practised at all would most likely lead to a return of the situation that MacLeod wants to get rid of: a megabank cartel supervised by a lender of last resort.
We should add that, according to libertarian ethics, it is not utterly impossible for a depositor to agree to cede title over demand deposits to the bank while being perfectly happy to take the risk of that bank over-lending those deposits such that they could be lost. However, shorn of the security of title, rights over the deposit could no longer qualify as perfect money substitutes, and so would trade only at a discount in exchange for goods and services – with the height of the discount dependent upon the creditworthiness of the bank. To illustrate, if you were to deposit in a bank 100 gold coins in exchange for 100 certificates of deposit guaranteeing title to those gold coins, then so long as the bank maintained a reputation as a reliable custodian, each certificate could be used as a money substitute to buy goods and services as if you were exchanging actual gold coins. If, however, you deposited 100 gold coins in the bank in exchange only for IOUs (i.e. not titles to gold but promises to pay back the gold only if the bank has a sufficient stock on hand), then clearly these IOUs would have to trade for less than either actual gold coins or certificates of title to gold. So instead of being worth one gold coin, each of these IOUs may be worth, say, only 0.95 gold coins, so that you would need more of them to buy what you want in the marketplace. In our current monetary system this kind of discounting is prevented by legal tender laws (which require a creditor to accept a bank deposit as the legal equivalent of cash in settlement of a debt) as well as the general cartelisation of the banking industry as a whole. But it would return in a monetary system devoid of state interference. Such a practice is therefore likely to have limited attraction to borrowers.
What we have seen, therefore, is that savings are the critical source of all investment leading to economic progress; credit is only one method of advancing those savings towards investment projects. Only when credit is funded by an available stock of savings is it possible to create sustainable economic growth and real prosperity.
Since this essay was written, MacLeod has published another, more detailed piece on the subject of bank credit. In addition to introducing a number of additional errors (such as his treatment of the rate of interest as a monetary phenomenon rather than the product of time preference), he effectively confirms my understanding of his views that I laid out above: that bank credit expansion is a positive thing that leads to economic prosperity (his main argument in this regard being his post hoc ergo propter hoc recounting of the history of the Industrial Revolution). His opposition instead is concentrated on government cartelisation of the banking system (which removes, to use his phrase, the “self-correcting” mechanisms that temper cycles of bank credit), leading to massive, speculative bubbles and degradation of the currency. With this opposition, I certainly agree, but not, as we explained above, with his general approach to bank credit expansion.
In closing, I would say that it’s a pity that a talented analyst who cites Mises and Hayek with regularity does not seem to have bothered to study in detail their theories of capital and of the business cycle.
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 Ludwig von Mises, Monetary Stabilization and Cyclical Policy (1928), Chapter 2 in The Causes of the Economic Crisis and Other Essays Before and After the Great Depression, Ludwig von Mises Institute (2006), 53-154 at 104-5. Cf. Idem, The Theory of Money and Credit, Ludwig von Mises Institute (2009), 264-5. Fritz Machlup uses the terms “transfer credit” and “created credit” to describe the same concepts. See Fritz Machlup, The Stock Market, Credit and Capital Formation, trans. Vera C. Smith, William Hodge (1940), 24n.
 This seems to be confirmed by his later endorsement of a quote from J P Morgan: “Gold is money. Everything else is credit”.
 More accurately, Paul would be entitled to a share of the profit, i.e. of the amount of fish remaining after deducting the costs of operating the boat, such as Peter’s labour time.
 To illustrate more clearly: say that a company’s operations are able to yield a return of 10%, but the company can borrow money at a rate of 5%. If the company borrowed £1,000,000, and invested those funds in its operations, it would yield a gross return of £100,000, of which only £50,000 would have to be paid as interest to the lender. The firm’s shareholders would be able to pocket the other £50,000 for themselves, even though it was effectively earned with the lender’s money. This is one type of circumstance in which borrowing money can be a sensible option.
 We should note, however, that it isn’t possible to insulate lenders from the risk of loss entirely. After all, if Peter failed to catch enough fish with his new boat in order to pay Paul back, then Paul would be left high and dry. However, mechanisms are available in order to ameliorate this risk to lenders. One is to charge a higher rate of interest to less creditworthy borrowers; another is the legal priority given to debt holders ahead of equity holders in the event of a borrower’s insolvency; and a third is securitisation, i.e. Peter could agree to forfeit ownership of the boat to Paul in the event that the former cannot repay the loan.
 As we noted earlier, in the real world it is likely that a depositor could opt to withdraw his funds early, but only if he forfeits the interest or incurs some other penalty.
 In the real world, this fact would be communicated through the height of interest rates. A dearth of saving would lead to higher rates, sending a signal to entrepreneurs that long term, capital projects are not sustainable.
 In certain circumstances, however, it is still the case that cash transactions can attract a discount compared to electronic transactions on account of the financial privacy it affords the vendor.