Credit Expansion, Crisis...e Reisman - Mises Daily

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Credit Expansion, Cr isis, and the My th of the Sa v ing GlutMises Daily: Tuesday, July 07, 2009 by George Reisman (ht tp://mises.org/daily/author/143/George-Reisman)

1. Credit Expansion, StandardMoney, and Fiduciary Media(http://mises.org/daily/3556#part1)

2. The Stock Market and Real EstateBubbles (http://mises.org/daily/3556#part2)

3. Evasion of Responsibility for theBubbles (http://mises.org/daily/3556#part3)

4. The Saving Glut Argument(http://mises.org/daily/3556#part4)

5. The Nonexist ence of a Saving Glut(http://mises.org/daily/3556#part5)

6. Current Account Deficits as aByproduct of the Increase in theQuant ity of Money(http://mises.org/daily/3556#part6)

7. Net Saving as a Byproduct of theIncrease in t he Quant ity of Money(http://mises.org/daily/3556#part7)

8. Summary and Conclusion(http://mises.org/daily/3556#part8)

Notes (http://mises.org/daily/3556#notes)

Readers who are already familiar wit h the nat ure of creditexpansion and the concepts of st andard money and fiduciary mediashould skip t he first sect ion. Readers who are also already familiarwith the role of credit expansion and fiduciary media ingenerating the stock market and real estate bubbles should skipthe second section as well and proceed directly to the t hirdsection "Evasion of Responsibility for the Bubbles."

1. Credit Expansion, Standard Money, andFiduciary Media

Since the mid-1990s, the United States has experienced t wo majorfinancial bubbles: a st ock market bubble and a housing bubble. Inbot h inst ances, the bubble was inaugurated and sust ained by a process of massive credit expansion,i.e., t he lending out of newly created money by t he banking system, operating with the sanction andsupport of t he country's central bank, t he Federal Reserve Syst em.

The concept of credit expansion rests on two furt her concept s: standard money and fiduciary media.Standard money is money t hat is not a claim to anything beyond it self. It is that which, when received,const itutes payment . Under a gold st andard, st andard money is gold coin or bullion. Under a goldstandard, paper notes, which were claims t o gold, payable on demand, were not standard money. Theywere merely a claim to standard money, which was physical gold. The dollar was defined as a physical

quant ity of gold of a definit e fineness, i.e., approximately one-t wentieth of an ounce of gold nine-tenths fine.

Today in the United St at es, st andard money is the irredeemable paper currency issued by t he UnitedStates government. That money is not a claim to anyt hing beyond itself. Receipt of such money t odayconst itutes final payment.

The t otal of st andard money t oday is the sum of t he out standing quantit y of paper currency plus thechecking deposit liabilities of the Federal Reserve System. Since t he Federal Reserve has t he power toprint as much currency as it likes, and thus is always in a position to redeem its out standing checkingdeposits in currency, these checking deposit liabilities can properly be viewed as a kind of differentdenomination of the paper currency, much like hundred dollar bills t hat are to be redeemed for not esof smaller denominat ion, or one-dollar bills t hat are to be redeemed for notes of larger denomination.Thus the total supply of standard money is to be underst ood as the sum of the supply of paper currencyin the narrower sense plus the checking deposit liabilities of the central bank.

These two magnitudes, currency plus checking deposit liabilities of the central bank, when takentoget her, are known as the "monetary base."



(http://mises.org/store/Capitalism-P188.aspx)

In December of 1994, the monetary base was $427.3 billion. In December of 1999, it was $608 billion. InDecember of 2007, it was $836.4 billion. In all years prior t o 2008, the overwhelming port ion of themonet ary base consist ed of currency. For example, in December of 2007, currency was $763.8 billion,while, as just noted, the monet ary base as a whole was $836.4 billion.

A portion of the currency outst anding and a port ion of the checking deposit liabilit ies of t he FederalReserve constit ute t he reserves of the banking syst em. These reserves are the st andard money t hat t hebanks possess and can use t o meet the withdrawals of deposit ors request ing currency. The reserves arealso used t o meet the demand of other banks seeking to redeem net balances accruing in their favor in

the process of the clearing of checks.

In December of 1994 such reserves were $61.36 billion; in 1999, t hey $41.7 billion; in December of2007, they were $42.7 billion.

Normally, as the overall quant ity of money in the economic system increases, bank reserves increasemore or less in proportion. The fact that reserves were almost one-third lower in December of 1999than in December of 1994, and then barely higher in December of 2007 than t hey were in December of1999, despite major increases in the quantity of money over these years, is a major anomaly. It reflectsthe long-st anding, deliberate policy of t he Federal Reserve Syst em of reducing and even alt ogethereliminat ing reserve requirements.

As a recent scholarly paper not ed,

The Depository Instit utions Deregulation and M onetary Cont rol Act of 1980 had begun phasingout interest -rat e ceilings on deposits and modified reserve requirements in complex ways.Combined with subsequent administrative deregulat ion under Greenspan t hrough January 1994,these changes left all the financial liabilities that M2 adds to M1 — savings deposits, small t imedeposits, money market deposit accounts, and ret ail money market mutual fund shares —utterly free of reserve requirement s and allowed banks to reclassify many M1 checkingaccounts as M2 savings deposits. M 2 and the broader measures became quasi-deregulatedaggregates with no legal link to the size of the monetary base. [1]

The concept of standard money underlies t he concept s offiduciary media and credit expansion. As I wrot e inCapitalism (http://mises.org/store/Capitalism-P188.aspx) , "Fiduciary

media are t ransferable claims t o standard money, payableby the issuer on demand, and accepted in commerce as t heequivalent of standard money, but for which no standardmoney actually exists." [2]

The overwhelmingly greater part of our money supply t oday consist s of fiduciary media in the form ofchecking deposits of one kind or another. For example, as of December 2007, the t otal money supply of

the Unit ed Stat es, i.e., currency plus bank deposits of all kinds t hat are subject t o the writing ofchecks, including the making of payments by debit card, was $6901.9 billion; [3] at the same t ime, themonet ary base was $836.4 billion. A ccordingly, t he amount of fiduciary media in t he United States wasequal to t he difference, which was $6065.5 billion. This was the sum of money representingtransferable claims to standard money, payable on demand by the various banks that issued t hem,accepted in commerce as t he equivalent of standard money, but for which no standard money act uallyexisted.

The only standard money that the banks had available with which to redeem their checking deposit swas $42.7 billion in st andard money reserves. These $42.7 billion of reserves were the st andard-moneybacking for a total of $6108.2 billion checking deposit s, i.e., deposits equal to t he sum of $42.7 billion

+ $6065.5 billion. To say the same thing in different words, t here was full, 100 percent standard-moneybacking for $42.7 billion of deposits, and no st andard-money backing whatever for $6065.5 billion ofdeposits, which lat ter constituted fiduciary media.

The quant ity of fiduciary media in existence at any t ime represents t he cumulative t otal of all of thecredit expansion t hat has taken place in the count ry's money supply up to that time. It represent s thesum of all of the loans and investment s that the banking system has made based on t he foundation of



the creation of money out of thin air. The difference between t he amount of out standing fiduciarymedia at two points in t ime represent s the credit expansion t hat has taken place in the interval.

The simplest way in which to understand t he process of the creation of fiduciary media and creditexpansion is t o imagine a deposit of standard money in the form of currency int o a checking account .After making t he deposit, t he depositor has just as much spendable money in his possession as he didbefore making it. Inst ead of a roll of currency, he has a checking balance of equal amount . Either way,he can spend the same amount of money. Before making his deposit , he would have had to peel offbills from his roll in order t o make payment s. Now, inst ead, he writ es checks and makes payment by

check. Inst ead of his roll of currency diminishing each time he peels off a bill, his checking balancediminishes each time he writes a check. In the one case, t he spendable money in his possession is hisroll of currency; in the other it is his checking balance.

Up to this point in our imaginary scenario, there has been no creation of fiduciary media and no creditexpansion. The money supply does not exceed the quant it y of standard money. In the one case, beforemaking his deposit, the standard money is in t he possession of an individual. A fter the individual makeshis deposit and holds money in the form of a checking balance, the same quantit y of standard money isin the possession of his bank. Under such conditions, the quant ity of money in the economic system isequal to t he quantit y of standard money held either by individuals as holdings of currency, or by banksas reserves against the checking deposit s of those individuals and equal in amount to the size of thosechecking deposits.

Fiduciary media and credit expansion enter the pict ure insofar as the banks in which st andard moneyhas been deposited proceed t o lend out the standard money t hat has been deposit ed wit h them. Tothe extent they do this, borrowers from the banks now have spendable money in their possessionwhich is in addition t o the spendable money in the hands of the banks' checking depositors. There hasbeen a creat ion of new and addit ional money, which new and addit ional money represent s fiduciarymedia and an equivalent expansion of credit .

The currency which the banks lend out can easily, and almost certainly will, be deposit ed. When it isdeposited, the same process of the creation of fiduciary media and credit expansion can be repeat ed.Indeed, under t he conditions largely creat ed by Greenspan, checking deposit s came to stand in a

mult iple of more than 160 times t he standard money reserves of the banks. In December of 2007, t herewere $6901.9 billion of checking deposits backed by a mere $42.7 billion of st andard money reserves.

In modern conditions, of course, banks do not lend currency. Rat her, they simply create new andaddit ional checking deposit s for t heir borrowers. When the borrowers spend t hose checking deposits bywriting checks of t heir own, the people who receive t he checks in turn deposit t hem in their banks.Those banks t hen call upon the banks that have created t he deposits, for payment. This ent ails ashift ing of standard money reserves from t he one set of banks t o the ot her.

To the ext ent t hat all banks have engaged in t he process of checking deposit creation, the reservebalances due from any bank may be more or less closely matched by t he reserve balances due it from

other banks. This is because t he checks writ ten by its customers to the customers of other banks willbe more or less closely matched by checks written by t he cust omers of other banks to customers of thisbank. In such a case t he only movement of reserves will be the net amount due in the clearing.

From December of 1994, prior to the start of the st ock market bubble, t o December of 2005, short lybefore the end of the housing bubble, t he quantit y of fiduciary media increased from $1.91 trillion to$4.93 trillion. This represent ed a compound annual rat e of increase in excess of 9 percent over t heeleven-year period. From December of 1999, short ly before the st art of the housing bubble, toDecember of 2005, the amount of fiduciary media increased from $3.25 trillion to $4.93 trillion, whichrepresented a compound annual rate of increase of 7.21 percent.

The increase in the quant it y of fiduciary media over the period as a whole is significant, not just t heincrease t hat t ook place over the period of t he housing bubble it self. This is because fiduciary mediacreat ed in t he years prior to the housing bubble played an important role in financing t hat bubble. A ndthe same was t rue of the role of fiduciary media created in t he years prior t o the stock market bubblein financing that bubble.

As interest rates rose in t he lat ter parts of these t wo bubbles, vast checking balances created earlier,



being earned, were drawn int o the financing of st ock market purchases in t he one case and housingloans in t he ot her. The transformation of t hese deposits from de facto savings account s into de factochecking account s was based on t he combination of their having had the potential for check writing allalong, together with a rise in the rat es of return that could be earned by swit ching their use from avehicle for savings into a vehicle for buying invest ments. The rise in rates of ret urn in t he one casewas in t he gains to be had from st ock market investment ; in the other, in rates of interest on variousvehicles for financing housing and real est ate purchases.

It might be thought that what I have said of the transformation of deposit s on which checks could be

written would largely apply also t o genuine savings deposits, on which checks could not be writt en. Forthe rise in rates of ret urn would provide the same incent ive to move funds from them int o morelucrative invest ments. This is t rue. But nevertheless, there is a crucial difference.

Before the savings deposits can be spent, they must first be convert ed into checking deposit s. All ofthe checking deposit s that come under the heading of M1, most notably t hose held at commercialbanks, require that those banks hold significant reserves, typically in an amount equal to 10 percent ofa bank's total deposits in excess of $44 million. Savings deposit s in contrast have not required theholding of any reserves what ever for many years, and even when t hey did require the holding ofreserves, it was at a far lower percent age than applied to checking deposits.

As a result, any movement of funds from savings into checking accounts ent ails an increase in requiredreserves. To obtain these additional reserves, banks must sell various asset s, the effect of which wouldbe to reduce t heir prices and to raise their effective yields to the new buyers. Unless the FederalReserve intervened to provide new and additional reserves equal to t he increase in t he need forreserves, t he effect would be not only a rise in int erest rates but a general tendency toward acont ract ion of credit . This last would result from the loss of reserves by banks whose reserves werealready at the bare minimum necessary to conduct operations.

In contrast, the use of savings held in accounts with already existing check-writing privileges t o makepurchases does not require any additional reserves. The problem of a need for addit ional reservesarises only insofar as a net movement of funds might occur, through the clearing, from checkingaccounts of a kind requiring no reserves to checking deposits of a kind that do require reserves.

Checking deposit s with no legal reserve requirement s are money-market deposit accounts and ret ail andinst itutional money market funds. Checks drawn on such accounts and t hen deposited in other suchaccounts do not require any addit ional reserves. A dditional reserves are required only when and to theextent that checks drawn on such account s and deposited in conventional checking account s exceed thevolume of checks coming from conventional checking account s and deposited in such accounts.

To the ext ent t hat the Federal Reserve is willing to supply the necessary additional reserves to meetthe greater need for reserves arising from such a movement of funds, all checking deposits come tostand on an equal footing as sources of spendable money. A nd so too do savings deposit s that end upbeing convertible int o checking deposits wit h no net increase in the scarcit y of reserves because theFed has enlarged the supply of reserves to the same or even greater ext ent t han the increase in the

amount of reserves required as t he result of such conversion.

Consistent with t he fact cited earlier t hat t otal reserves were substant ially lower in December of 1999than they had been in December of 1994 and grew only slight ly from December of 1999 t o December of2007, it must be pointed out that addit ional reserves can be supplied by t he Fed by means of itsreducing or eliminat ing reserve requirements at various points in the banking system. Thus, forexample, when the Fed eliminated the requirement that once existed that a 3 percent reserve be heldagainst savings deposit s, all of t he reserves previously held to meet that requirement becameequivalent to a supply of new and addit ional reserves of t hat same amount.

The same was true when the Fed allowed commercial banks on weekends and holidays to "sweep"substant ial parts of their out standing checking deposit s into t ypes of account s that did not requirereserves. This too made a subst ant ial port ion of already existing reserves t he equivalent of new andaddit ional reserves. Indeed, the amount of such new and addit ional reserves constit uted such an excessof reserves above the now diminished reserve requirements, t hat the Fed was obliged to reduce theoutstanding amount of reserves by means of resorting to "open-market operat ions" in which it sold someof it s holdings of government securities in exchange for newly excess reserves.



2. The Stock Market and Real Estate Bubbles

Credit expansion was t he source of the funds that fueled bot h the stock market and the real est at ebubbles. In the case of t he stock market bubble, credit expansion provided funds for t he purchase ofstocks. The sellers of t he stocks t hen used the far greater part of their proceeds to purchase otherstocks, whose sellers did likewise. In this way, the new and additional money creat ed by creditexpansion traveled from one set of stocks to another, raising the prices of the great majority of t hem.It continued t o do this so long as t he credit expansion went on at a sufficient rat e.

Ultimat ely, a sufficient rat e would have had to be an accelerating rate. This is because rising shareprices resulted in people feeling richer and thus believing themselves able to afford more luxury goods.It also led to a st epped up demand for physical capit al goods by firms coming int o possession of t henew and addit ional money by virt ue of sales of stock of their own. The issuance of such stock and useof the proceeds to finance the purchase of physical capital goods was encouraged by the fact t hat therise in stock prices made it more and more attractive in comparison with acquiring capit al goodsthrough the purchase of stocks in ot her companies.

Thus, an important later effect of the credit expansion was a tendency for funds to be withdrawn fromthe stock market, for the purchase of luxury consumers' goods and also of physical capital goods. Tooffset this wit hdrawal of funds, more rapid credit expansion w ould have been necessary.

When, inst ead of an accelerat ion of the credit expansion, there was a diminution in it s rat e, t he basisof the market's rise was doubly undercut. Since t he funds provided by credit expansion had come t orepresent an import ant part of the demand for st ocks, the reduct ion in credit expansion constit uted areduct ion in that demand. Coupled wit h the out flows of funds just described, t he result was that shareprices began to plummet. Their fall was compounded by the unloading of shares by people who hadpurchased t hem for no ot her reason than t heir expectation of a continuing rise in stock prices.

The more recent, real estate bubble originat ed in the Fed's panic-response t o the collapse of t he stockmarket bubble it had caused earlier. To overcome the effects of that collapse, it progressively reducedit s target federal-funds rat e, i.e., the rate of interest banks pay one another on the lending andborrowing of funds that qualify as reserves against commercial-bank checking deposits. In t his way, it

launched a new and more moment ous credit expansion.

For the t hree years 2001–2004, the Federal Reserve creat ed as much new and additional money in theform of addit ional bank reserves as was necessary to drive and t hen keep t he federal-funds rate below2 percent. And from July of 2003 t o June of 2004, it drove and kept it even further down, atapproximately 1 percent .

The new and addit ional money created by the banking system on the foundat ion of t hese new andaddit ional reserves appeared in the loan market as a new and additional supply of loanable funds. Theeffect was a reduction in interest rat es across the board.

Because interest is a major determinant of mont hly mortgage payments, t he fall in interest rates madehome ownership appear substant ially less expensive. As a result, a great surge in t he demand formortgage loans and t he in the purchase of homes t ook place. Inst ead of pouring into the st ock marketas in t he previous bubble, the funds creat ed by credit expansion now poured into the real estatemarket and drove up t he prices of homes and commercial real estat e rat her than t he prices of commonstocks.

In the stock market bubble and even more so in the real estate bubble there was bot h large scaleoverconsumption and malinvestment. These are t he two leading features of booms as explained by themonet ary t heory of the trade cycle developed by Ludwig von Mises. In both cases, t he rise in t he priceof major asset s — most notably, stocks and homes respectively — led people t o believe t hat they werericher and could thus afford to consume more. In both cases, particular branches of indust ry weregreat ly overexpanded relative t o the rest of the economic system, resulting in a subsequent major lossof capit al. In t he stock market bubble, the malinvest ment was mainly in such things as the "dot.com"enterprises t hat lat er went broke. In t he real estate bubble, it was in housing and commercial realestate.

3. Evasion of Responsibility f or the Bubbles





There are at least two broad and competing explanations of the origins of this crisis. The firstis that t he "easy money" policies of t he Federal Reserve produced the U.S. housing bubble thatis at the core of t oday's financial mess.

The second, and far more credible, explanat ion agrees t hat it was indeed lower int erest rat esthat spawned the speculat ive euphoria. However, t he interest rate t hat matt ered was not t hefederal-funds rate, but the rate on long-t erm, fixed-rate mort gages. Bet ween 2002 and 2005,home mortgage rates led U.S. home price change by 11 months. This correlation betweenhome prices and mortgage rat es was highly significant, and a far better indicat or of rising

home prices than t he fed-funds rate.

This should not come as a surprise. A fter all, t he prices of long-lived assets have always beendet ermined by discount ing the flow of income or imputed services by int erest rat es of thesame maturities as the life of the asset. No one, to my knowledge, employs overnight interestrates — such as the fed-funds rat e — to det ermine t he capit alizat ion rat e of real estate,whet her it be an office building or a single-family residence.

In these passages Greenspan invents a version of t he opposition to Federal Reserve sponsored creditexpansion that no opponent of credit expansion or "easy money" has ever held. No opponent of creditexpansion has ever claimed t hat reductions in t he federal-funds rate need directly affect long-terminterest rates. To t he contrary, t he significance of reductions in t he federal-funds rate is that what isrequired to bring them about in t he actual market for t hose funds is an increase in member-bankreserves. The increase in those reserves is then the foundat ion of credit expansion t o a vast multiple ofthe additional reserves. That credit expansion is what then serves to lower long-t erm int erest rates,such as mort gage rates.

The way the process works is as follows. To act ually achieve t he lower federal-funds rate that itannounces as its target , the Federal Reserve goes int o the market and buys government securit ies frombanks or t he cust omers of banks. It pays for t hose securit ies by means of the creat ion of new andaddit ional standard money. When the Fed purchases securities from banks, the banks directly andimmediately have equivalent ly more reserves in their possession. When it purchases securities from the

customers of banks, the banks gain equivalently more reserves as soon as t hose cust omers deposit t hechecks they have received that are drawn by t he Fed on t he Fed. These checks are then forwarded tothe Fed and t he reserve account s of the banks in question are equivalently increased.

Depending on the amount of their increase, t he immediate effect of the additional reserves is t oreduce or eliminate deficiencies in the required reserves of some, many, or all of t he banks that havehad such deficiencies, to replace deficiencies of reserves wit h excesses of reserves, and to increasethe excess reserves of some, many, or all of the banks t hat have had excess reserves. The effect ofthis in t urn is to reduce t he demand for federal funds, i.e., funds that qualify as reserves, whileincreasing their supply. This combination is what brings down the federal-funds rat e in t he market forfederal funds.

What is far more significant is t hat the creation of new and additional excess reserves by the Fed —reserves beyond the amount legally required to be held — places t he banking system in a posit ion inwhich it can expand the supply of checking deposits and t hus fiduciary media t o a mult iple of t headdit ional reserves. A nd thanks largely t o Mr. Greenspan that multiple came to be enormous. ByDecember of 2005, it exceeded 126 t imes. Two years later, it exceeded 160 t imes.

Thus for each dollar of additional excess reserves creat ed, a credit expansion was made possible on theorder of a vast mult iple. The new and additional fiduciary media corresponding t o the credit expansionwere the source of t he funds for st ock purchases in the st ock market bubble and for housing andcommercial real estat e purchases in t he housing bubble. Their pouring into t he home mortgage marketwas what drove down mortgage interest rates. Bet ween December of 1999 and December of 2005,almost $1.7 trillion of new and addit ional fiduciary media were creat ed and lent out.

As market interest rat es st art ed rising in t he second half of 2004 and t hen through 2005, increasingamount s of deposit s earning a modest rate of interest and on which checks could be writ ten, came t obe used more and more as checking accounts rather t han savings account s. They were drawn into t he



spending stream in response to the higher comparat ive rates of ret urn t hat could be earned throughinvestment in securit ies. This allowed the life of the housing bubble t o be ext ended unt il 2006.

4. The Saving Glut Argument

Along with denying the causal role of Federal Reserve expansionary monetary policy in the housingbubble, Greenspan advances t he claim, greatly elaborat ed by Bernanke, that what was actuallyresponsible for t he bubble was an excess of global saving. He argues in his Wall Street Journal articlethat

[T]he presumpt ive cause of t he world-wide decline in long-term rat es was t he tectonic shift inthe early 1990s by much of the developing world from heavy emphasis on cent ral planning t oincreasingly dynamic, export-led market compet ition. The result was a surge in growt h inChina and a large number of other emerging market economies that led to an excess of globalintended savings relat ive to intended capital investment . That ex ant e excess of savingspropelled global long-t erm interest rat es progressively lower between early 2000 and 2005.

In a series of lectures beginning in March of 2005 and cont inuing int o the current year, Bernankeelaborat es on this claim. A t a lecture given at the Bundesbank in Berlin, Germany, on September 11,

2007, titled

"Global Imbalances: Recent Developments and Prospects," he argued that stepped up saving indeveloping count ries was largely responsible for "t he subst antial expansion of t he current account deficitin the United States, the equally impressive rise in the current account surpluses of many emerging-market economies, and a worldwide decline in long-term real interest rat es." (For t he benefit ofnont echnical readers, the "current account" balance encompasses the difference bet ween exports andimports bot h of goods and services, the difference between incomes earned abroad and incomes paidto abroad, plus the difference between remittances from and to abroad.)

These developments, he held, "could be explained, in part, by the emergence of a global sav ing glut ,driven by the t ransformation of many emerging-market economies — notably, rapidly growing East Asianeconomies and oil-producing count ries — from net borrowers to large net lenders on int ernationalcapital market s."[4]

In a speech delivered on A pril 9 of t his year at Morehouse College in A tlanta, Bernanke st ressed that"the net inflow of foreign saving to the United States, which was about 1½ percent of our nat ionaloutput in 1995, reached about 6 percent of national out put in 2006 an amount equal to about $825billion in today's dollars." He t hen proceeded t o blame the housing boom on this inflow of foreignsavings. "Financial instit utions," he declared, "reacted to the surplus of available funds by competingaggressively for borrowers, and, in t he years leading up t o the crisis, credit to bot h households andbusinesses became relatively cheap and easy to obtain. One import ant consequence was a housing boomin the United States, a boom that was fueled in large part by a rapid expansion of mortgage lending."

Thus, according t o Bernanke, it was not credit expansion or anyt hing that he and the Federal ReserveSystem and Mr. Greenspan were responsible for, but t he inflow of foreign savings. That inflow,representing a "global saving glut ," was responsible for the bubble and its aft ermath.

Bernanke uses t he expression "saving glut " repeatedly: 9 t imes in his lecture at the Bundesbank inSept ember of 2007, 11 t imes in his lecture at the Virginia Association of Economics in March of 2005,and 10 t imes in his Homer Jones Lecture in St. Louis in April of 2005. Despite his const ant repet ition ofthe claim, it turns out t o have absolut ely no substance. Nowhere is the exist ence of anyt hing remotelyapproaching a saving glut in any way substantiated.

5. The Nonexistence of a Saving Glut

The very notion of a saving glut is absurd, pract ically on its face. A s I wrote in Capitalism:



Before the scarcit y of capital … could be overcome, capital would have to be accumulatedsufficient to enable the 85 percent of the world t hat is not present ly indust rialized t o come upto the degree of capit al intensiveness of the 15 percent of the world that is industrialized.Within the industrialized count ries, capit al would have to be accumulated sufficient t o enableevery factory, farm, mine, and st ore to increase it s degree of capit al intensiveness to thepoint presently enjoyed only by the most capital-int ensive est ablishments, and, at the sametime, t o enable all establishment s to raise t he standard of capit al intensiveness still further, tothe point where no further reduct ion in costs of production or improvement in the quality ofproducts could be achieved by any great er availability of capital…. [5]

Long before such a point could ever be reached, time preference would put an end t o further increasesin the degree of capital int ensiveness.

It is doubly absurd t o believe t hat the source of a saving glut would be precisely countries possessingvery litt le capital compared to the United States and other indust rialized count ries. But that is whatBernanke claims. He claims that countries such as Thailand, China, Russia, Nigeria, and V enezuela arethe source of the alleged saving glut . [6]

There are further t heoretical considerat ions t hat argue specifically against any form of "saving glut "

being responsible for t he housing bubble.

First, if saving had been responsible, and not credit expansion and the increase in t he quantit y ofmoney, t hen the addit ional saving taking place in t he countries providing it , would have beenaccompanied by a reduction in consumer spending in those countries. People would have had to spendless for consumpt ion in those countries, in part, in order t o make available funds for addit ional spendingon capit al goods that were exported t o the Unit ed Stat es. Such export of capital goods t o the USwould not have fueled a boom here. To t he contrary, it would have result ed in lower prices of capitalgoods in t he US. Only the portion of funds saved that was used to finance purchases wit hin the UScould have contributed to any higher prices of capital goods and land in t he US. And, of course,whatever rise in t he prices of capital goods and land t hat might have taken place in the US would havetended to be matched by a fall in t he prices of consumers' goods in the countries that had stepped uptheir saving. The only way t hat the demand for capital goods and land could rise without the demandfor consumers' goods falling would be on the strength of an increase in the quant ity of money and t hetotal, overall volume of spending in t he economic system. [7]

Indeed, t he fact that in t he absence of an increase in t he quantit y of money and volume of spending inthe economic syst em, shift s in spending serve to reduce prices as much as increase them has a parallelin the further fact t hat increases in the relative size of some of the countries in the world's economyimply equivalent decreases in the relat ive size of other count ries in the world's economy. In theabsence of an increase in the quant ity of money and volume of spending, growth in the relative size ofthe economies of many A sian countries would not by itself be sufficient for great er saving in thosecount ries serving to increase global spending for capit al goods. For t hat great er spending would beaccompanied by reduced spending for capit al goods in other count ries, i.e., countries t hat were alreadyin the cat egory of developed economies and now had to yield some portion of t heir previous relat ivesize.

In the present inst ance, what t his means is t hat greater spending for capital goods and land in t he US,financed by saving in parts of Asia, would be accompanied by less spending for capit al goods in the US(and possibly elsewhere) financed by saving in the US or financed by saving elsewhere in the world. Ifspending for capit al goods financed by saving in A sia is not accompanied by reduced spending forcapital goods financed by saving elsewhere, t he only ultimate explanation is an increase in the quantityof money and volume of spending in the world's economy. Of course the source of such an increase intoday's conditions is none ot her than t he Federal Reserve Syst em.

Second, contrary to popular understanding, when saving is divorced from t he increase in t he quantity ofmoney and volume of spending, and takes place wit hout such increase, it does not tend to grow largerfrom year to year. Nor does consumer spending t end to decrease from year to year. A nd thus moresaving would not serve t o raise the prices of capital goods or land from one year t o the next. Its effectwould essentially be limit ed to a discret e, one-t ime only increase. [8] Yet for the prices of capital goodsand land t o rise from one year to the next on t he strengt h of an increase in t he demand for capital





Third, if somehow saving were responsible for t he housing bubble, why did it suddenly collapse? Whydid people suddenly stop saving and stop making funds available for t he purchase of homes? Obviously,the explanation was t hat t he bubble did not depend on saving but on credit creat ion and itsaccelerat ion and t hat when t he abilit y to creat e sufficient ly more credit came t o an end, the propssupporting t he bubble were removed and it collapsed.

Fourt h, if saving were responsible for the bubble, why have banks and countless other firms foundthemselves confront ing an acut e lack of capit al? Saving provides new and addit ional capital. How can itbe that an alleged process of saving has resulted in widespread major capit al deficiencies? This

situat ion of insufficient capital is t he result of malinvestment and overconsumption, which are theconsequences of credit expansion, not saving.

Fifth, if saving had been responsible for t he increase in spending on capit al goods and land, the rat e ofprofit would have modestly fallen from t he very beginning, and continued it s fall unt il net saving cameto an end. It would not have risen, let alone risen dramatically, as it did during t he bubble. [9]

This is the implication of the discussion, above in this sect ion, of t he second reason why saving wasnot responsible for the bubble. In part icular it is t he implicat ion of the example of 100 more ofspending for capit al goods financed by 100 of saving derived from 100 less of spending for consumers'goods. In t hat example, in which t here is no increase in the quant ity of money or t ot al volume ofspending, the global economic syst em would have had the same total aggregate business sales revenues,with the sales revenues coming from the sale of consumers' goods diminished by the amount of saving,and t hose coming from t he sale of capit al goods equivalent ly increased. A t the same time, however, itwould have had a tendency toward a rise in the aggregate costs of production deducted f rom thosesales rev enues .

The rise in costs would have been the result of such things as additional depreciation charges on t henew and addit ional capital goods purchased, or additional cost of goods sold following addit ionalpurchases of materials and labor on account of inventory. In the example of 100 more being spent forcapital goods each year with an average life of 10 years and accompanying depreciation charges in therespective amounts of 10, 20, …, 100 in the 10 years following the rise in demand for capital goods,aggregate profit in the economic syst em would have been falling year by year by an amount equal to

the increase in depreciation.

A falling aggregat e amount of profit t oget her wit h the increasing amount of capital invested in t heeconomic system, would have progressively reduced the economy-wide average rate of profit . It wouldhave been a case of a falling amount-of-profit numerator divided by a rising-amount-of-capit aldenominator.

Tot ally cont rary t o what one would expect from t hese effects of a rise in saving, the reality, of course,was a sharply higher average rat e of profit in t he economic syst em so long as the bubble lasted. Thiscan be explained only on the foundat ion of credit expansion and an expanding quantit y of money andvolume of spending, not on t he basis of saving.

If none of these five reasons are sufficient to dispel t he not ion that a saving glut was responsible forthe bubble, then hopefully it will be sufficient t o point out that there simply w as no saving glut, butrather only a very modest rate of saving, a mere trickle of saving. For it turns out that over the 13year period 1994–2006, t he rate of saving in t he US, toget her wit h all foreign saving ent ering thecount ry in connection wit h deficits in t he current account, never exceeded 7 percent , and in 8 of those13 years was 3 percent or less. In 5 of those years it was a mere, 1 or 2 percent. And what is of specialsignificance is that in the years of the housing bubble, 2002–2006, it was especially low: 2 percent in2002, 1 percent in both 2003 and 2004, 3 percent in 2005, and 4 percent in 2006.

To see this result , it is necessary t o begin by removing all fictional element s in the report ed amounts ofdomest ic net saving and GDP. These fictional amounts consist of various "imput at ions." The leadingimputations that are relevant here are t hose that arbitrarily convert what is in fact consumptionexpenditure int o investment expenditure. These have t he effect of reducing report ed consumption andequivalently increasing reported saving. [10] , [11]

The t wo most important such imputations are t hese: 1) the t reatment of the purchase of single familyhomes t hat the buyer intends t o occupy and that thus will not be a source of any money revenue of



investment ; 2) t he treatment of government expendit ure for fixed assets such as buildings, as though itwere an investment expenditure rather t han a consumption expenditure.

When such imput at ions are removed from t he calculation of net saving and from GDP, the very modestextent of saving that has been going on over the last decade or more is clearly shown. Indeed, since2002, domestic net saving has been negativ e to the extent of several hundred billion dollars each year.

The following t able describes t he situation:

* BEA Internat ional, Table 1 (http://www.bea.gov/international/xls/table1.xls)

** BEA Table 7.12 : Imputations in the National Income and Product Account s(http://www.bea.gov/national/nipaweb/TableView.asp?

SelectedTable=299&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Year&FirstYear=1985&LastYear=2007&3Place=N&Update=Update&JavaBox=no)

The t able has 6 columns. Column 1 list s the years 1994 through 2006, t he period encompassing both t hestock market and the real estate bubbles. Column 2 shows the current account deficit in those years.This deficit is t aken as represent ing the foreign savings coming int o the United Stat es. (For t his reasonit is shown as a positive number.) Column 3 shows net saving in the United States in those years whensuch savings are calculated free of imput at ions. Column 4 is the sum of Columns 2 and 3. It shows t ot alsaving in the United St ates as the sum of foreign saving entering the count ry together wit h domest icsaving. Column 5 is GDP year by year, with all imput ations removed. Column 6 is t he sum ofimputation-free foreign and domest ic saving divided by such GDP, presented in decimal format.

The notion that t here was a saving glut behind the housing bubble is simply a fict ion. Its proponent s

could manufacture as much of a glut as they like simply by reclassifying such things as expenditure forautomobiles, major appliances, furnit ure, and clot hing as investment expenditures, on t he grounds thatthese goods t oo are durable, like houses. That would equivalently reduce consumption expendit ure andincrease reported saving in the economic system.

6. Current Account Def icits as a Byproduct of the Increase in the Quantity of Money



Bernanke and Greenspan et al. focus on deficits in t he current account as representing the counterpartof foreign saving and investment , which t hey believe must be present t o finance t he deficits. There iscertainly a very close relationship between foreign saving and investment on the one side and thefinancing of deficit s in the current account on the ot her. The following example may help t o highlightthis relat ionship.

Thus imagine Saudi Arabia back in t he days when geologists had determined that the count ry possessedvast oil reserves but before it had any oil wells, pipelines, refineries, or facilit ies for t he handling ofsupert ankers. Those things had yet to be built.

Now how could t hose facilit ies be built? The only way was by means of the arrival of shiploads ofequipment and construct ion materials from Europe and the United States. In addition, large quantities ofvarious consumers' goods were required for the foreign engineers and other workers who wererequired to carry out t he const ruction. All these goods coming int o Saudi Arabia were import s offoreign goods. But Saudi A rabia had hardly anyt hing to export before its ability to produce oil wasdeveloped. Thus, in t he interval, there was a massive excess of imports over exports. That excessrepresented foreign invest ment in Saudi Arabia. It s physical form was all of the facilities underconst ruct ion and then, ult imat ely, the complet ed facilit ies for producing oil.

Foreign investment very often, perhaps most of the t ime, has t his kind of close connect ion to theexistence of an excess of import s over exports and, more broadly, an excess of out lays of all kinds oncurrent account over receipts of all kinds on current account. (A s previously explained, t he balance oncurrent account includes not only the difference between t he imports and export s of goods, but also ofservices. In addit ion, it includes t he difference between incomes paid t o abroad and incomes paid fromabroad, and finally, the difference between remit tances to and from abroad.)

Nevertheless, it should be realized t hat the essential, core concept of the current account, namely, theso-called balance of trade, which is t he difference simply bet ween the import and export of goods,was developed long before the emergence of any significant internat ional investment. It was developedand employed by a school of writ ers known as t he mercant ilist s, who were current from t he 16t h tothe third quarter of the 18th Century, when the school was laid to rest by A dam Smith.

The main concern of the mercant ilists was the accumulation of gold and silver within the borders oftheir country and t he prevent ion of any loss of gold or silver by t heir count ry. Gold and silver were themoney of the day everywhere and, it was believed, needed to be accumulat ed wit hin the country inorder t o be available if and when t he government might need them, in order to finance militaryoperations out side t he country or any other act ivities in which circumst ances might operat e t o drawprecious metals away from the country.

Inasmuch as already by t hat t ime, most of the European count ries had no gold or silver mines wit hintheir territ ory, the only way they could gain gold or silver was by means of t he export of goods. Theimport of goods was seen as constituting a loss of gold or silver by t he country. Accordingly, the goal ofmercant ilist policy was t o maximize exports while minimizing import s. That would allegedly ensure the

great est possible accumulat ion of t he precious met als wit hin the country.

Centuries lat er, in the chapter "On Foreign Trade" in his Principles of Political E conomy and T axation ,Ricardo developed the principle that the supply of the precious metals t ends to be dist ributed amongthe different count ries essentially in proportion to t he relative size of t heir respect ive economies. Hewrote: "Gold and silver having been chosen for the general medium of circulation, they are, by t hecompetit ion of commerce, distributed in such proportions amongst t he different count ries of t he worldas t o accommodat e themselves t o the nat ural t raffic which would take place if no such metals exist ed,and t he trade between countries were purely a t rade of bart er."

The operation of this principle can, of course, be modified by the operat ion of other principlesworking alongside it . Thus a country wit h a relatively small economy, but wit h an except ionalreput at ion for the securit y of property and t he enforcement of cont ract s, might well have a quantit y ofmoney wit hin its borders far in excess of what corresponded to t he relative size of its economy. Bythe same t oken, countries wit h larger economies but in which property rights and t he enforcement ofcont ract s were in retreat, could possess a proport ion of t he world's money supply substant ially less thanwhat corresponded t o the relative size of it s economy.

'



excess of imports over export s. The gold and silver that they mine cannot all be retained wit hin theirborders. If they were ret ained, the count ry would have a disproportionat ely large supply of theprecious metals. This would serve t o raise prices in that country relative to prices abroad. The effectwould be an out flow of the precious metals until their buying power at home did not fall short of theirbuying power abroad by more t han the costs of shipping t hem abroad.

Today, the US dollar is in a position similar to that of gold under an internat ional gold st andard. Thedollar is a virtual world money — not completely, but subst ant ially. The United States is t he countrywith the "dollar mines." When dollars are created in t he US, a substantial portion of t hem w ill flow

abroad. And t his applies not just to currency, but also t o checking deposits and all other short-t ermfinancial inst ruments easily convertible t o currency.

Most of the dollars that "flow abroad" need not act ually circulate abroad but to a large ext ent serve asmere precaut ionary holdings of money, and, to an import ant extent , as reserves for financial instit utionsthat creat e various moneys ot her than dollars. These ot her moneys that are created on the foundat ionof addit ional dollars circulate abroad.

Now the fact that the United States compared t o almost all other count ries in the world st ill has t hemost reliable protection of property right s and enforcement of contracts, is responsible for t he factthat much or most of the money that "flows abroad" does not in fact leave t he country. Rat her it passesinto the ownership of foreign individuals, firms, and governments who continue to hold it within theUnited States.

The increase in such foreign owned assets within the United States has t he appearance of foreigninvestment . Actually, it is nothing more than the byproduct of credit expansion and the increase in thequant ity of money within the United States.

There is no genuine surge in foreign saving. There is domestic credit expansion and money supplyincrease t hat serves t o increase import s and shift ownership of a substant ial port ion of t he addit ionalmoney supply, and short-term claims t o money, t o foreigners.

Ironically, Bernanke himself helps to confirm this interpret ation of the increase in the current account

deficit. He says: "First, t he financial crises that hit many Asian economies in the 1990s led to significantdeclines in invest ment in those count ries in part because of reduced confidence in domestic financialinst itutions and to changes in policies — including a resistance to currency appreciat ion, t he det erminedaccumulat ion of foreign exchange reserves, and fiscal consolidation — t hat had the effect of promotingcurrent account surpluses." (Bundesbank Lecture, Berlin, Germany, September 11, 2007.)

What Bernanke describes here is not any sudden increase in foreign saving but rat her decisions t ochange the way in which a portion of previously accumulat ed savings are held, i.e., to hold them to agreat er extent in the form of US dollars and short-term claims t o dollars.

In the same passage, Bernanke presents a second reason for t he alleged growth in foreign savings,namely the sharp increase in the price of oil t hat had t aken place. He says, "sharp increases in crude oilprices boosted oil exporters' incomes by more than t hose count ries were able or willing to increasespending, thereby leading t o higher saving and current account surpluses."

Here, Bernanke overlooks t he role of credit expansion and t he increase in t he quantity of money inbringing about the higher price of oil. He also overlooks t he effect of the higher price of oil on t hereal incomes and abilit y to save of everyone who had to pay t hat higher price.

The role of credit expansion and the increase in t he quantit y of money in causing the rise in oil priceswas confirmed by the subsequent plunge in oil prices once credit expansion was brought to an end andappeared t o be about to t urn int o massive credit contraction. It has since been furt her confirmed bythe recent rise in oil prices following t he growing belief t hat the government's program of renewed

credit expansion will be sufficient to eliminat e the danger of a financial collapse and will serve tomaintain and increase the demand for oil.

7. Net Saving as a Byproduct of the Increase in the Quantity of Money



My discussion of the fallacy of a saving glut as being responsible for t he housing bubble and itsaftermath would not be complete if I did not point out that the cont inued existence of net saving isit self a byproduct of the increase in the quant ity of money and volume of spending in t he economicsystem. In t he absence of increases in the quant ity of money and volume of spending, economy-wide,aggregate net saving would tend to disappear. It would cease when t otal accumulated savings came t ostand in a ratio to current incomes and consumption that people judged to be sufficiently high that theyhad no further need t o make still great er relat ive provision for t he future.

What keeps net saving in existence is t hat the increase in the quant ity of money and volume of

spending tends continually to raise incomes and consumption in terms of money. In order t o maintainany given ratio of accumulated savings t o a rising level of income and consumption, it is necessary t oincrease t he magnitude of accumulated savings. A t the same t ime, the increasing quantity of moneyprovides the financial means of spending more and more each year for capit al goods as well asconsumers' goods and for thus maintaining the desired balance in the face of growing magnitudes ofspending.

Thus it is t he increase in t he quantit y of money and t he volume of spending that it supports t hat isresponsible for net saving continuing in being. In t he absence of t he continuing increase in t he quantit yof money, net saving would disappear, and capital accumulat ion would take place simply by means of acont inually increasing purchasing power of t he same capital funds. That growing purchasing powerwould be created by the increase in the production and supply of capital goods and the fall in prices ofcapital goods that would result .

8. Summary and Conclusion

The real estate bubble, like the stock market bubble before it, was caused by credit expansion. Thecredit expansion was instigated and sust ained by t he Federal Reserve Syst em, which could haveabort ed it at any time but chose not t o. As a result, t he Federal Reserve Syst em and t hose in charge ofit at during the real est at e bubble bear responsibilit y for major harm to tens of millions of Americans.

In order to avoid having to accept this responsibility, a specious doctrine has been advanced by A lanGreenspan and Ben Bernanke, t he former and present Chairman of the syst em, and ot hers. That is the

doct rine of a "global saving glut." Not credit expansion but the saving glut was responsible, they claim.

The t ruth is that t ime preference put s an end t o furt her saving long before it could out run t he uses foraddit ional saving. This makes a saving glut impossible. In addition, there are five major reasons whysaving could not have been responsible for t he real estate bubble in part icular. First, if saving had beenresponsible, rat her than credit expansion and the increase in the quant ity of money, there would havebeen a corresponding decline in consumer spending in t he countries allegedly doing t he saving. The factis that there was no such decline.

Second, saving implies a growing supply of capital goods, more production, and lower prices, includinglower prices of capital goods and even of land. These are results t hat are incompatible with the

widespread increases in prices typically found in a bubble.

Third, if somehow saving had been responsible for the housing bubble, t he spending it financed wouldnot suddenly have stopped. Such stoppage is a consequence of the end of credit expansion and therevelat ion of a lack of capit al.

Fourt h, if large-scale saving rather than credit expansion had been present , banks and other firms wouldhave possessed more capital, not less. They would not be in t heir present predicament of havinginadequate capital t o carry on t heir normal operations. This sit uation of insufficient capit al is the resultof malinvestment and overconsumption, which are the consequences of credit expansion, not saving.

Fifth, in t he absence of increases in the quant ity of money and overall volume of spending in theeconomic system, saving also implies an immediat e t endency toward a fall in the economy wideaverage rate of profit. This is another result that is incompatible wit h what is observed in a bubble orboom of any kind, which is surging profits so long as "the good t imes" last .

Especially not eworthy is the fact t hat in t he real est at e bubble, t here simply was no saving glut. In the13 year period 1994–2006, the rat e of saving in the US, together with all foreign saving allegedlyentering t he country in connection with deficit s in the current account, never exceeded 7 percent, and





[3] This figure is arrived at by t aking the sum of M1, sweep accounts, money market mutual fundaccounts both ret ail and inst itutional, and one half of savings deposits as t he measure of moneymarket deposit accounts, t he dat a for which are apparently otherwise unavailable. The sameprocedure is used as t he basis of all other statements of the money supply or changes in the moneysupply.

[4] Italics in original.[5] Reisman, Capitalism, p. 57

[6] "Homer Smith Lecture," St. Louis, MO, A pril 14, 2005.[7] For a comprehensive explanation of t he role of the quant ity of money in determining the volume

of spending in t he economic syst em, see Reisman, Capitalism, chaps. 12 and 19.[8] For an explanation of t he role of saving in capital accumulation, see ibid., pp. 621–642.

[9] For a thoroughgoing discussion of t he determinants of the rat e of profit and it s relationship t osaving and capital accumulat ion, see ibid., chaps. 16 and 17.[10] For a comprehensive explanat ion of t he distinction between capital goods and consumers' goodsand invest ment or, bet ter, productive expendit ure and consumpt ion expenditure, see ibid., pp. 445–456.

[11] For a detailed crit ique of the imputed income doctrine, see ibid., pp. 456–459.

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