The Charlotte Gore Blog

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On Lending

June 14th, 2010 at 2:35 pm

Why some of us get very bothered by the deficit.

So how is wealth created? Wealth isn’t merely cash. You don’t simply print bank notes and announce yourself to be wealthy. Wealth, real wealth is measured by value.

We all know that when a bank lends money, it conjures most of the cash out of the thin air, which sounds alarming… but it is hopefully repaid in full with interest in due course. The loan is supposed to be spent on things of value that generate – or save – more than the amount of the loan plus the interest.

In this way, wealth is created. Simple, right? A loan represents¬†future wealth,¬†future value. You borrow money to buy a car, you’re left with a unit of value – the car itself.

So, say a bank conjures money out of thin air for me, I spend it on a machine that allows me to make bottle caps, I then sell the bottle caps which eventually pays off the loan and then the rest, for me, is profit. Wealth has been created – represented by the existence of the machine and the bottle caps it produces.

So far so good.

The people who made the machine are paid for their work building it, too, as are the people who made the parts and those who processed the raw materials and those who mined those raw materials. The people who handled the payment of the machine are paid, as are the people who brought it to my bottle top factory, as are the people who designed the brochures and the web site, and the sales staff who gave me the information I needed.

The people who risked their own money putting together a team of people to design and build the machine get to take a bit of profit, although only as much as they can get away with without losing out to a competitor. If no-one had bought their machine, they would have lost it all. They deserve their reward. Their efforts have also created wealth – a factory producing bottle top machines, and with it employment.

Every single person who’s been paid along the way gets to spend their money on food, on clothing, on putting a roof over their heads and in acquiring whatever else they wish or can get with what they have. This, in turn, creates demand for food, clothing and consumer goods – including bottled beer, with some rather funky bottle tops.

It works because the people in the banks try to make good lending decisions. They want to be sure that the money they lend creates value, creates real wealth, because this is how they’re certain they’ll make their money back. They lend money to make it, and people borrow money to make it. Typically loans are ‘secured’ against some real existing wealth – property of some kind – so that if the loan is not repaid there is still real wealth to show for the cash.

Now, in the credit crunch, when the banks were (and in some cases still are) refusing to lend, you can see how this causes a major problem for any economy that depends on it – and why it caused such a catastrophic contraction in our economy.

The reasons for their non-lending boil down to demands from the Government to increase the amount of cash they hold in their reserves and uncertainty that the wealth against which loans are secured have any real value at all. Housing that no-one will buy, for example, is very poor security indeed.

The credit crunch itself was caused by banks neglecting this most basic duty of theirs: Lending only when they are certain to get the money back, to take only good, well calculated risks. It turned out that too many loans were secured against very bad risks that other people had taken, resulting in everyone realising there was no security in the system at all whatsoever – and it nearly brought down our entire economy.

The Government’s solution was to use its own power as a Nation State to borrow and spend, thus hopefully stimulating demand. It gave people jobs directly, in the hope that they would continue spending money somewhere. It paid money to buy cars from people and destroy them, thus literally destroying wealth in the process. It printed money and used it to buy toxic assets from the banks to help them get their balance sheets in order.

Nothing it has done has replaced that carefully targeted injection of cash for the purpose of generating wealth in the same way that banks do to business. The same amount of cash lent to the entire private sector should always generate more real wealth than the same money borrowed by the Government to spend on random projects for the sheer hell of having some sort of economic activity. The decisions made by politicians will always be inferior to the combined decision making process of everyone else acting in their own self interest.

All this borrowing they’ve done, like any loan, needs to be repaid by someone. The difference, and the main difference between borrowing to invest by the private sector and borrowing by the public sector is that the private sector borrows in order to make money. The public sector borrows simply to dump cash in the system in the hope that it inflates the GDP figures, or to spend it on services that, in themselves, have no ability to create further wealth.

It is, ultimately, the private sector that has to generate the wealth to repay these loans – if it can. The Government, by its very nature, has no means of creating wealth itself. Every pound the private sector needs to spend on servicing this loan made to them against their will is a pound that cannot be spend on something that might have created a job, or been used to create more real, concrete, measurable wealth. This is the ‘opportunity cost’, and it is this great unknown, the ‘what could have beens’ that we are increasingly losing the more the Government borrows.

That’s why some of us are bothered by the deficit, you see?

The point of this post is to attempt to tackle this idea that it doesn’t matter whether it’s the public sector borrowing money and spending it, or the private sector borrowing it and spending it – it’s all just cash and it all goes around just the same, creating demand for food and clothing etc. But there IS a difference, and that difference is everything. It is the difference between real growth – increasing wealth – and simply trading other people’s ability to create wealth in the future for short term political gain.

Has this post inspired your inner pedant? Try Pedants' Corner.

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