by Alexandru Cojocaru

The cause of a credit crisis is monetary expansion. The crisis generally begins in a time of reluctance of the population to buy and to borrow, and a reluctance of entrepreneurs to invest. This economic climate often exists as a result of a previous credit crisis.

In this context, the central bank creates money and lends it with low interest rates to commercial banks. The commercial banks lend the money to the public at a slightly higher interest rate, generating profits. Commercial banks are only forced by law to keep a small fraction of the customer’s money in reserve, so the credit expansion potentially rises by orders of magnitude. Loans to the private sector are generally considered a risk, but government securities are considered liquidity. Governments thus have a cheap and secure way of borrowing, to spend far beyond what direct taxation allows them.

As “confidence in the economy” grows, people start borrowing for consumption and entrepreneurs to launch new development projects. Entrepreneurs are calculating project cost-effectiveness based on low inflation and low interest payed on borrowed money. Increased consumption based on credit increasingly engages the capital goods (production tools and raw material) to full work. Soon, the economy seems to bloom. What needs to be considered is that capital goods and labor are almost entirely used to produce consumer goods for the present. Entrepreneurs, however, are borrowing for increases in production capacity and new product development for the future. There is, thus, a mismatch between the consumer’s orientation on present-day consumption and entrepreneur’s orientation towards future developments. This mismatch is generated by the credit expansion.

While borrowing and consumption grow rapidly, the production cycle may take several months for services, up to several years for complex technological processes. As the planning and industrial design phase ends, companies enter production. Several years passed since the beginning of the economic “boom.” Entrepreneurs now bid for a workforce already occupied and for production assets already engaged in production. Money and credit created from nothing did not add hands and brains for labor, working days in the calendar, raw materials and means of production. More demand, same offer: the pressure on prices is high, they will rise, and the central bank must raise interest rates significantly to avoid hyperinflation – though we should call it hyper-increase in price, since the hyperinflation occurred due to the massive increase in money supply.

By raising interest rates, government spending on interest payments for government securities increases, resulting in an increase in the budget deficit, the government’s inability to borrow and possibly even government bankruptcy. Indebted people are unable to pay back debt at high interest rates. If they still manage to pay it back, they do it by reducing their consumption. For entrepreneurs, rising prices and interest rates above what they had planned for reveal the reality: the costs are much higher than what they forecasted in their business forecasts, so the projects must be halted. Company insolvencies multiply and ongoing projects are abandoned by lack of resources. This is, at the latest, when the bubble bursts, and the crisis – or the “bust,” fully kicks in.

To get rid of the credit crises for good, the root cause of the crisis must be addressed. Namely, people should search for alternatives from man-made money and decrease the likelihood of extreme fractional reserve banking occurring. One strong alternative for this is a one hundred percent gold-based monetary system, and interest rates fluctuating freely on the market. Of course, governments would to a certain extent be deprived of the possibility to spend above what they collect from taxes. Instead, they would eventually have to live within their means – what a tragedy.

Alexandru Cojocaru is the founder of Gold’N’Roll, an online marketplace priced in gold.

The views expressed on are not necessarily those of the Austrian Economics Center.