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It happens when there's too much money chasing too few goods. You can always recognize a peak by two things: First, the media says that the expansion will never end.

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Second, it seems everyone and his brother is making tons of money from whatever the asset bubble is. Consumers lose their jobs, sell their homes, and stop buying anything but necessities. Businesses lay off workers and hoard cash. That often requires intervention with monetary or fiscal policy.

In an ideal world, they work together. That, unfortunately, doesn't occur often enough. But they disagree on the best ways to implement it. As a result, they don't take advantage of the power of fiscal policy. Expansion : When the economy is in the expansion phase, politicians are content because their constituents are happy. Peak: During the irrational exuberance phase, politicians continue to ignore fiscal policy. It all comes from the tree; the real question is, who is in charge of the tree? Indeed, Zoe herself said it is not, in the previous paragraph. Money is created when banks lend.

The rules of double entry accounting dictate that when banks create a new loan asset, they must also create an equal and opposite liability, in the form of a new demand deposit. In this sense, therefore, when banks lend they create money. It is fully backed by a new asset — a loan.

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Zoe completely ignores the loan asset backing the new money. Mortgage lending does not require ever-rising house prices: stable house prices alone are sufficient to protect the bank from loan defaults. If the bank lends so much that its equity slice approaches zero — as happened in some banks prior to the financial crisis — even a very small fall in asset prices is enough to render it insolvent. Regulatory capital requirements are intended to ensure that banks never reach such a fragile position.

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It is of course possible for banks to lend more than the population can realistically afford. But we should remember that prior to the financial crisis, political authorities actively encouraged and supported excessive bank lending, particularly real estate lending, in the mistaken belief that vibrant economic growth would continue indefinitely, enabling the population to cope with its enormous debts.

Such is the folly of politicians. In practice, most central bank money these days is asset-backed, since central banks create new money when they buy assets in open market operations or QE, and when they lend to banks. Some central banks run for years on end in a state of technical insolvency the central bank of Chile springs to mind. The ability of the government to tax the population depends on the credibility of the government and the productive capacity of the economy. It can also occur when people distrust a government and its central bank so much that they refuse to use the currency that the central bank creates.

But nowhere in the genesis of hyperinflation does central bank insolvency feature. A central bank can create money without limit, though doing so risks inflation. Now there is no gold standard, money is indeed a matter of faith.

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But faith in what, and whom? Certainly not commercial banks.

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Deposit insurance effectively turns the money created by commercial banks into government money. But even the money created by central banks requires a government guarantee. So, faith in money is, in reality, faith in the government that guarantees it. That in turn requires faith in the future productive capacity of the economy.

Should I save or invest my money?

As the productive capacity of any economy ultimately comes from the work of people, we could therefore say that faith in money is faith in people, both those now on the earth and those who will inhabit it in future. But bank money creation comes from lending, and bank lending does not in any way crowd out government investment in social programs.

Government can fund anything it wants to, if necessary by forcing the central bank to pay for it. If the central bank creates more money than the present and future productive capacity of the economy can absorb, the result is inflation.

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  5. The problem for governments and central bankers is deciding what the present and future productive capacity of the economy is, and therefore how much money the economy needs now and will need in the future. This is more of a black art than a science. But, given how difficult it is to estimate the present and future productive capacity of the economy, I find it hard to see how a public authority can be a better creator of purchasing power than banks.

    Flawed though it is, money creation through bank lending at least responds to demand.

    However, that demand may not come from the most productive sectors.