Credit Expansion and Idle Resources

Advocates for expansionary credit policies often retort that increasing the volume of credit wouldn’t have a noticeable effect on the price of an economic resource unless it were closely approaching or already at full capacity.

Before tackling that specific point, I think it is worthwhile exploring why idleness or unemployment exists at all. To the extent they have any say in the matter, it’s because the people who control idle resources are withholding them from use, possibly out of an expectation that the prevailing market price of the resource is too low. Perhaps the owner is correct or perhaps the owner has made an entrepreneurial error. If an entrepreneur is correct that a consumer will not pay more than the cost of producing a private good, the economy is wealthier for it. In the hampered market that exists today, government policies — like bailouts and other special privileges — suppress the price discovery process that would determine whose judgement was correct.

Further still, in an effort to mask over the genuine desires of consumers as expressed in a market economy, central banks try to short circuit the discovery process by manipulating interest rates to devalue the currency. So whether resources are at full capacity or not, the prices of those resources are greater than they otherwise would have been. This is reckless because it rewards firms for overestimating consumer desires, distorting and delaying the entrepreneurial adjustments needed for economic recovery.

The secondary point is that credit expansion does not impact aspects of the economy simultaneously or uniformly. When credit expands, banks are the first recipients of the newly created fiduciary media. Sectors of the economy with durable, capital-intensive goods (like housing) are also early recipients. For instance, if there were idle resources in the IT industry, monetary policy would be a hamfisted remedy (because the new units of currency would first hit the housing sector and related industries). This helps earlier recipients outbid later recipients for resources, further distorting the production process.

Even assuming that we could entrust politicians responsively and accurately to fine tune the economy to the proper output capacity, a glaring methodological problem is that calculating idleness will have to involve cloaking important deviations. In finding the average production capacity, viable companies will be lumped together with less sound competitors that arguably might need to scale back production. For companies running at above-average capacity, monetary policy targeted at a specific industry would still cause an increase in their prices. For example, if monetary policy were directed to increase capacity in the IT industry by 20 percent, a firm already operating at 90 percent capacity would begin to bid up resource prices.

For a short interval of time, expansionary credit policies under select conditions can obscure the discoordination that had taken place across an economy. It can temporarily increase sales and restore confidence, but not without unpleasant long-run consequences. These same advantages could more reliably be achieved by permitting the adjustment process to proceed, rather than having central planners shortcut the choices of consumers to determine who should produce what.

A growing, flourishing economy is one of change, shifting resources from less productive to more productive uses. Government stimulus can give us more production (at least temporarily), but consumers want production of certain things and not others. More isn’t necessarily better. According to Henry Hazlitt, it gives us “only unbalanced production, misdirected production, production of the wrong things.”

Image credit: jurvetson, with Creative Commons license