credit bubble theorys

Money isn’t exactly created out of thin air. It’s an abstraction that civilization uses as convenient proxy for the goods produced by each us. If the issuers of money create more money than the real goods produced, then money becomes devalued (inflation). If they issue too little, it becomes overvalued (deflation). Without fractional banking, the money supply would (or should) exactly match the goods produced. With fractional banking, we extend credit to individuals based on their expected future production (we could do the same in a barter economy without money).

This scheme works well in a growth economy as long as we don’t exceed each individual’s capacity to repay. The oil spike in 2008 gummed up the works, reallocating resources to energy payments instead of to credit repayments. That resulted in a credit crisis, real estate bubbles bursting, a recession, sovereign debt problems, etc. which are still ongoing to some extent. The lesson to be learned from all this is not to extend credit to unworthy debtors and not to extend credit to a debtor’s absolute limit – allow a buffer for bad times. The trade-off is growth will be slower during good times.