Why will consumer demand collapse?

John Maynard Keynes said that, a fall in bank lending leads to a fall in consumer demand creating recession.

He was right, a fall in bank lending does create a fall in consumer demand, it also creates recession and in extreme cases can cause a complete meltdown of the entire economy as in 2008.

So the question is, why does bank lending fall? A rise in interest rates can make new borrowing too expensive, it can also lead to existing borrowers defaulting on their loans. This was the catalyst for the 2007 subprime crash in the United States. The graph below shows that US interest rates went from 1% to 5% in the run up to the subprime crash.

_45156616_us_rates_oct08_1_226 (1)

Interest rate rises can accelerate a fall in borrowing and a fall in demand, but interest rate rises are not the cause of these falls. Borrowing would eventually, slowly fall over time even if interest rates had remained low.

Most of us are now aware that banks create new deposits when they loan, they don’t lend other peoples deposits. How they do it is not important, accepting that they do, is fundamental to understanding the problem. See graph.


The bank creation of money via lending and debt is nothing new, what has changed is the amount of money creation and the ability to recycle this new money back to the debtors.

The large increase in debt over the last 30 to 40 years has funded a massive increase in consumerism, consumerism is no longer constrained by wages but rather by how much debt people can accumulate. The graph below shows the result.

Screen Shot 2013-03-08 at 11.36.19 AM

Basically we have a trickle up effect, workers take on debt that fuels the profits of the corporates that dominate the consumer supply chains. However this rise in corporate profits has not been recycled back into the real economy via workers wages. There will come a point where the workers can no longer take on more debt. When this happens consumer demand will fall, wages will fall and unemployment will rise. Existing loans made by workers will fall into default, creating another banking crisis. If the banks are not saved by government or central bank intervention the credit created by the banks will become worthless. So, it is in the interests of the wealthy elite to protect the banking system whatever the cost to the rest of society. In the end the wealthy elite will themselves, destroy the financial system by taking so much of it that demand collapses.


Exposing problems are easy, finding solutions are not, so here is one solution.

Now imagine for one moment that banks did not create new deposits everytime they made a loan. Imagine that they were forced to lend existing deposits.

For a start money would become more scarce, banks would compete for our savings. Interest rates would rise as savers looked for the best returns on their money. Central banks would be unable to fix  interest rates.  Borrowers would not be able to afford huge loans, house prices would decrease, consumer demand would be more reliant on peoples wages, not ever increasing credit card debt. Supply would reflect this fall in demand, there would be less waste. Corporate profits would fall, many would go bankrupt or seriously downsize their operations. Small local businesses would rapidly take their place, supplying local demand in a sustainable way. Unfortunately high interest rates would also harm the ability for small busineses to borrow and expand,  sustainable economic growth would be slow. However if banks were allowed to create money at low interest rates for business loans, that created productivity. The speed of sustainable economic growth would be accelerated. (Trade credit has never created a financial crisis or recession. ) If bank money creation was constrained to productivity, local community banks would be able to compete with the big corporate banks. Profits from these community banks could be used to fund local infrustructure projects and good causes.

Using this system of finance, the profits from usury ( reward for risk) would be recycled back into the communities. Worker cooperatives would also ensure company profits are shared and not hoarded by one or a few individuals. Recycling of money is the key to a healthy society.  ( If oil was not recycled around your car engine it would soon stop working.)

Low interest rates don’t create unproductive debt, it is the creation of unproductive debt that creates low interest rates and unstainable growth.

Author Paul Fear.



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