Quote from Cutten:
How does it allow more economic growth? The increase in loans in nominal terms is offset by an identical amount by the inflation in the money supply. For every new $1 billion loan financed by a bank creating money out of thin air, the amount of other loans is collectively reduced in real value by that same $1 billion due to inflation in the money supply. If that was not the case, then you could create real economic value literally out of thin air just by printing money. There would be no need for loans at all - just run the printing presses and everyone would become rich.
Think about it - what does that new $1 billion do? It is just some paper notes. Whereas $1 billion of fully backed money represents accumulated capital - many man years of labour or real assets. The stock of real economic wealth is not increased by 1 cent, let alone $1 billion, just by increasing the amount of paper bills in circulation.
You are confusing the nominal money supply with real economic value, and ignoring the cost in inflation which offsets the apparent economic "growth" for the bank and borrower who receives the loan. Adding a zero to the number of dollars in circulation makes no difference to real economic wealth. If it did, then we could magically create value overnight just by running the printing presses and handing out newly printed bills any time someone needed a loan.
Fiat paper notes represent value in the abstract; of course they are not inherently valuable beyond what value people place in them - but the same could be said of gold or anything else. $1 billion of full-reserve specie currency doesn't represent any accumulated hours of man-labor; it represents a bunch of shiny yellow metal locked in a vault somewhere. It is linked to labor only because people choose to sell their labor for it. If they stopped doing that, it'd be worthless. The same principle holds for fiat currency - as long as people sell labor for it, it's valuable; when they stop, it's worthless.
Fiat currency created by fractional-reserve banking functions as a kind of generic faith and credit in the economy as a whole, backed by the economy itself rather than by a finite supply of metal. As long as the economy keeps growing, so can the supply of money.
The newly created money has to be
used for sustainable economic growth, not just printed and spent. Most of it has to be used for capital expenditure and investment. If the money was just printed and passed out to random people on the street who spent it all on new cars and big-screen TVs, the inflation scenario you describe would happen.
On the other hand, if it's used to start new businesses that create significant new economic value (beyond the amount lost by all the failing businesses who also receive loans and can't pay them back), then there is a net gain in value. This wouldn't work so well in a preindustrial economy since it would be very hard to do anything at all with a given quantity of money that would realize gains on the required scale, but it's possible with advanced technology - one machine/mechanized process can create many times its cost in new value over time, more than making up for the value lost to the failed businesses and also giving us all a new technology.
Aaron Brown has an interesting section in his book "The Poker Face of Wall Street" on this concept. When they started a new town in the old west, it was very dangerous for people to bring lots of gold or silver out there, so there usually wasn't enough hard money available locally to circulate in the isolated local economy. There were plenty of people willing to work, even plenty of goods for sale and potential sources of new value (e.g. mines, farming, cattle, etc.), there just wasn't enough hard currency around to facilitate exchange. The solution was to set up an (illegal) soft-money bank. What little hard money there was was deposited, and the bank printed up its own private currency on the fractional reserve system for use in the town. They gave it out as loans to a farmer or miner, who would use it to hire labor, and thus produced actual new value. The laborers could then spend the money at the local general store, saloon, and so forth.
If the bankers were honest and competent (i.e. didn't print up too much or too little money), this enabled the local economy to function in isolation.
Some businesses failed, of course, and their losses were absorbed into the local currency's value. If enough failed, the town went bust, the currency became worthless, and everyone left. If enough succeeded, the town grew and attracted outside hard capital, and the bank usually converted into a standard legal bank. People who accepted wages in the local private currency were placing a bet on the success of the town as a whole. Besides allowing the local economy to function at a much higher level than would have been possible using only specie currency, this system also encouraged people who lived there to do things that would prove beneficial to the town as a whole - they were all in it together, so they all had a personal incentive to make it work.
The same thing happens with fiat currency on a larger scale today, and I believe this is a major factor in recent US economic growth. The stagflation of the 1970s was a hangover from the attempt to maintain a gold standard during the previous period of massive postwar economic growth - with the benefits of high technology, growth vastly outpaced the increases in the amount of gold in the world (and gold held by the US government in particular, under Bretton Woods), just as happened during the Industrial Revolution, and ongoing deflation of the dollar was the result. Artificially fixed foreign exchange rates provided arbitrage opportunities and further damaged the dollar. It became vastly overvalued relative to gold and other currencies because of the fixed peg to $35 an ounce gold.
When gold convertability was ended and the dollar was allowed to float versus other currencies, stagflation was the result - no new economic growth, but massive inflation as the dollar, now unconstrained by an artificial fixed peg to gold that had no relation whatsoever to the amount of economic activity going on and value being created, rapidly adjusted on the market to its fair value relative to the size/output of other economies.
R
