Business cycles are credit cycles

May 4, 2017·Alasdair Macleod

This article gets to the heart of why central banks’ monetary policy will never succeed. The fundamental error is to regard economic cycles as originating in the private sector, when they are the consequence of fluctuations in credit.

It draws on the author’s submission of evidence to the UK Parliament Treasury Committee’s enquiry into the failure of monetary policy in the wake of the 2008 crisisi.


  • It is incorrectly assumed that business cycles arise out of free markets. Instead, they are the consequence of the expansion and contraction of unsound money and credit.
  • Monetary inflation transfers wealth from savers and those on fixed incomes to the banking sector’s favoured customers. It has become a major cause of increasing disparities between the wealthy and the poor.
  • The credit cycle is a repetitive boom-and-bust phenomenon. The bust phase is the market’s way of eliminating unsustainable debt, created through credit expansion. If the bust is not allowed to proceed, trouble accumulates for the next credit cycle.
  • Today, economic distortions from previous credit cycles have accumulated to the point where only a small rise in interest rates will be enough to trigger the next crisis. Consequently, central banks have very little room for manoeuver for dealing with future price inflation.
  • International coordination of monetary policies has increased the potential scale of the next credit crisis, and not contained it as the central banks believe.
  • The unwinding of the massive credit expansion in Greece, Portugal, Italy, Spain and France following the creation of the euro is an additional risk to the global economy.
  • Central banks should desist from using monetary policy as a management tool for the economy.


“We are probably not going to forecast the next financial crisis, nor are we going to forecast the next recession.” - Gertjan Vlieghe, in evidence to the Treasury Select Committee, 20th Feb 2017

Mr Vlieghe, who is a member of the Bank of England’s Monetary Policy Committee has effectively admitted that there is no point to the Bank pursuing its monetary policy, because it is impossible to judge the outcome.

There are good reasons for this, and they do not lie in ineffective econometric modelling, as commonly believed. Rather, they lie in the flawed economic concepts behind business cycles, which have their origin not in free markets, but in the expansion of money and bank credit. The author of this paper demonstrates that the source of regularly occurring cycles of boom and bust is monetary policy itself.

Modern monetary assumptions

The original Keynesian idea behind monetary and fiscal stimulation was to help the economy recover from a recession by encouraging extra consumption through bank credit expansion and unfunded government deficits. Originally, Keynes did not recommend a policy of continual monetary expansion, because he presumed that a recession was the result of a business cycle that could be smoothed by the application of extra credit. The error was to fail to understand that the cycle is of credit itself, the consequence being the imposition of boom and bust on what would otherwise be a non-cyclical economy.

The belief in monetary and fiscal stimulation wrongly assumes, among other things, there are no intertemporal effects. As long ago as 1730, Richard Cantillon described the effect of the introduction of new money into an economy. It took time to disperse, driving up prices only as it did so. He noted that when new money was first spent, it raised the prices of the goods first purchased. Subsequent acquirers of the new money raised the prices of the goods they demanded, and so on. In this manner, the new money is gradually distributed, raising prices as it is spent, until it is fully absorbed in the economy. Consequently, maximum benefit of the purchasing power of the new money accrues to the first receivers of it, principally the banks that create unbacked credit out of thin air, and their preferred customers. The losers are those last to receive it, typically the low-paid, the retired, the unbanked and the poor, who find that their earnings and savings buy lessii.

There is, in effect, a wealth transfer from the poorest in society to the banks and their favoured customers. Central banks seem oblivious of this effect, and the Bank of England has even gone to some trouble to dissuade us of it, by quoting marginal changes in the Gini coefficient, which as an average tells us nothing about how individuals, or groups of individuals are effected by monetary debasement.

The Bank of England is pursuing similar monetary policies to those of the Federal Reserve Board, the European Central Bank, and the Bank of Japan. At the very least, we should question their monetary policies on grounds of both efficacy and the morality, which by debauching the currency, transfers wealth from savers to profligate borrowers.

The workings of a credit cycle

There follows a brief description of the relationship between credit and economic activity, though it must be noted that individual cycles can vary significantly in the detail.

We shall take the credit crisis as our starting point in this repeating cycle. Typically, a credit crisis occurs after the central bank has raised interest rates and tightened lending conditions to curb price inflation, always the predictable result of earlier monetary expansion. The severity of the crisis is proportional to the amount of outstanding private sector debt relative to the size of the economy. Furthermore, the severity is increasingly exacerbated by the international integration of monetary policies. While the 2007-2008 crises in the UK, the Eurozone and Japan were to varying degrees home-grown, the excessive speculation in the American residential property market, facilitated additionally by off-balance sheet securitisation, led to the crisis in each of the other major jurisdictions being more severe than it might otherwise have been.

Having acted as lender of last resort to the commercial banks, the central bank tries post-crisis to stabilise the economy. By encouraging a revival in bank lending, it seeks to stimulate the economy into recovery by reducing interest rates. However, it inevitably takes some time before businesses, mindful of the crisis just past, have the confidence to invest in production. They will only respond to signals from consumers when they in turn become less cautious in their spending. Banks, who at this stage will be equally cautious over their lending, will prefer to invest in short-maturity government bonds to minimise risk.

A period then follows during which interest rates remain suppressed by the central bank below their natural rate. During this period, the central bank will monitor unemployment, surveys of business confidence, and measures of price inflation, for signs of economic recovery. Note how all these indicators are consistent with the belief that credit is being managed to control a business cycle that emanates from the private sector, and that the failure is not credit-induced. In other words, credit is believed to be the solution, when it is the problem.

Eventually, suppressed interest rates begin to stimulate corporate activity, as entrepreneurs utilise a low cost of capital to acquire weaker rivals, and redeploy underutilised assets in target companies. They improve their earnings by buying in their own shares, often funded by bank credit, as well as by undertaking other financial engineering actions. Larger businesses, in which the banks have confidence, are favoured compared with SMEs, who find it generally difficult to obtain finance in the early stages of the recovery phase. To that extent, the manipulation of money and credit by central banks ends up discriminating against entrepreneurial smaller companies, delaying the recovery in employment.

Consumption eventually picks up, fuelled by credit from banks and other lending institutions, which will be gradually regaining their appetite for risk. The interest cost on consumer loans for big-ticket items, such as cars and household goods, is often reduced under competitive pressures, stimulating credit-fuelled consumer demand. The first to benefit from this credit tend to be the better-off creditworthy consumers, and the large corporations, which are the early-receivers of expanding bank credit.

The central bank should, if it was effectively managing credit, at this stage raise interest rates to slow credit growth. However, unemployment lags and is likely to be above the desired target level, and price inflation will almost certainly be below target, encouraging the central bank to continue suppressing interest rates. Bear in mind the Cantillon effect: it takes time for expanding bank credit to raise prices throughout the country.

Even if the central bank has raised interest rates by this stage, it is inevitably by too little. By now, commercial banks will be competing for loan business from large credit-worthy corporations, cutting their margins to gain market share. So, even if the central bank has increased interest rates modestly, the higher cost of borrowing fails to be passed on by commercial banks.

With business confidence spreading outwards from financial centres, bank lending increases further, and more and more businesses start to expand their production, based on return-on-equity calculations at prevailing interest rates and input prices. There’s a gathering momentum to benefit from the new mood. At this stage, future price inflation for business inputs is usually underestimated, uneconomic decisions begin to be implemented, speculation is supported by freely-available credit, and the conditions are in place for another crisis to develop.

Since tax revenues lag in an economic recovery, government finances have yet to benefit from an increase in taxes. Any budget deficit not financed by bond issues subscribed to by the domestic public and by non-bank corporations represents an additional monetary stimulus, fuelling the credit cycle even more at a time when credit expansion should be withdrawn.

The economy now has stabilised, and closely-followed statistics show signs of recovery. At this stage of the credit cycle, the effects of earlier monetary inflation begin to be reflected in rising prices more widely. This is due to the Cantillon effect, and only now is beginning to be reflected in the calculation of the broad-based consumer price indices. Therefore, prices begin to rise at a higher rate than that targeted by monetary policy, and the central bank has no option but to raise interest rates and restrain demand for credit. But with prices still rising from credit expansion still in the pipeline, moderate interest rate increases have little or no effect. Consequently, they continue to be raised to the point where earlier borrowing, encouraged by easy money, begins to come unstuck.

A rise in unemployment, and potentially falling prices then becomes a growing threat. As financial intermediaries in a developing debt crisis, the banks are suddenly exposed to extensive losses of their own capital. They are quick to reduce their risk-exposure by liquidating loans where they can, irrespective of their soundness, putting loan collateral up for sale. Asset inflation quickly reverses, with all marketable securities falling sharply in value. The onset of the financial crisis is always swift, and catches the central bank unawares.

When the crisis occurs, the central bank moves heaven and earth to contain it, by effectively writing an open cheque for the banking system to stem the downward spiral of collateral sales. This monetary support is an attempt to stabilise the situation. Consequently, many earlier malinvestments will survive. Over several cycles, the debt associated with past malinvestments accumulates, making each successive crisis greater in magnitude. 2007-2008 was worse than the fall-out from the dot-com bubble in 2000, which in turn was worse than previous crises. And for this reason, the next credit crisis promises to be even greater than the last.

Credit cycles are increasingly a global affair. Unfortunately, all central banks share the same misconception, that they are managing a business cycle that emanates from the private sector. Central banks through the forum of the Bank for International Settlements or G7, G10, and now G20 meetings, are fully committed to coordinating monetary policies. The consequence is credit crises are now fully global, and potentially greater as a result. Remember that G20 was set up after the last crisis to increase coordination of monetary and financial policies, reinforcing destructive groupthink even more. Not only does the onset of a credit crisis in any one country become potentially exogenous to it, but the failure of any one of the major central banks to contain its crisis threatens to worsen the crisis for everyone else.

Systemic risk, the risk that banking systems will fail, is now truly global and has worsened. The introduction of the new euro distorted credit cycles for Eurozone members, and today has become a significant additional financial and systemic threat to the global banking system. After the euro was introduced, the cost of borrowing dropped substantially for many high-risk member states. These included all the Mediterranean countries, as well as France, Portugal and even the Irish republic. Unsurprisingly, governments in these states seized the opportunity to increase their debt-financed spending. The most extreme examples were Greece, followed by Italy. Consequently, Eurozone banks became exceptionally highly geared, a situation that persists. Credit cycles for these countries have been made considerably more dangerous by this one-off event, and the task facing the ECB today is more difficult as a result. The unwinding of malinvestments and associated debt has been successfully deferred so far, but the Eurozone remains a major systemic risk and a credible trigger for the next global crisis.

The seeds are sown for the next credit crisis

When new money is fully absorbed in an economy, prices can be said to have adjusted to accommodate it. The apparent stimulation from the extra money will have reversed itself, wealth having been transferred from the late receivers to the initial beneficiaries, leaving a higher stock of money and increased prices. This always assumes there has been no change in the public’s general level of preference for holding money relative to holding goods.

Changes in this preference level can have a profound effect on prices. At one extreme, a general dislike of holding any money at all will render it valueless, while a strong preference for it will drive down prices of goods and services. This is what happened in 1980-81, when Paul Volcker at the Federal Reserve Board raised the prime rate to over 20% to put an end hyperinflation of prices. It is what happened more recently in 2007/08 when the great financial crisis broke, forcing the Fed to flood financial markets with unlimited credit to stop prices falling, and to rescue the financial system from collapse.

The interest rate cycle, which lags the credit cycle for the reasons described above, always results in interest rates being raised high enough to undermine economic activity. The two examples quoted in the previous paragraph were extremes, but every credit cycle ends with rates being raised by the central bank by enough to reduce consumer preferences for goods in favour of money.

Fed Funds Rate 2015

In the chart above of America’s Fed funds rate, which the Fed uses to manage interest rates, the interest rate peaks joined by the dotted line marked the turns of the US credit cycle in January 1989, mid-2000, and early 2007 respectively. These points also marked the beginning of the recession in the early nineties, the post-dotcom bubble collapse, and the US housing market crisis. The threat to the US economy and its banking system grew with every crisis. Successive interest peaks marked an increase in severity for succeeding credit crises, and it is notable that the level of interest rates required to trigger a crisis has continually declined. Extending this trend suggests that a Fed Funds Rate of no more than 2.5% by the middle of 2017 will be enough to trigger a new financial crisis. The reason this must be so is the continuing accumulation of dollar-denominated private-sector debt.


The origin of changing levels of business activity is credit itself. It therefore stands to reason that the greater the level of monetary intervention, the more uncontrollable the outcome becomes. This is confirmed by both reasoned theory and empirical evidence. It is equally clear that by seeking to manage the credit cycle, central banks themselves have become the primary cause of economic instability. They exhibit institutional group-think in the implementation of credit policies.

Therefore, the underlying attempt to boost consumption, by encouraging continual price inflation to alter the allocation of resources from deferred consumption to current consumption, is overly simplistic, and ignores the negative consequences.

Any economist who argues in favour of an inflation target, such as that commonly set by central banks at 2%, fails to appreciate that monetary inflation transfers wealth from most people, who are truly the engine of production and spending. They also fail to understand that prices of goods and services in the main do not act like those of speculative investments. People will buy an asset if the price is rising, because they see a bandwagon effect. They do not normally buy goods and services because they see a trend of rising prices. Instead they seek value, as any observer of the falling prices of electrical and electronic products will testify.

We have seen that the room for manoeuvre on interest rates has become progressively limited over successive credit cycles. Furthermore, the continuing accumulation of private sector debt has reduced the height of interest rates that would trigger a financial and systemic crisis. In any event, a global crisis could be triggered by the Federal Reserve Board if it raises the Fed Fund Rate to as little as 2.5%. This can be expected with a high degree of confidence.

The additional credit that resulted from the creation of the Eurozone has become a major threat to the survival of the Eurozone’s banks, and consequently to their counterparties elsewhere. The likelihood of their failure appears to be increasing by the day, a situation that becomes obvious when one accepts that the problem is wholly financial, the result of irresponsible credit expansion in the past.

An economy that works best is one where sound money permits an increase in purchasing power of that money over time, reflecting the full benefits to consumers of improvements in production and technology. In such an economy, Schumpeter’s process of “creative destruction” takes place on a random basis. Instead, consumers and businesses are corralled into acing herd-like, financed by artificial credit. The creation of the credit cycle forces us all into cyclical behaviour that otherwise would not occur.


iiCantillon’s Essai sur la Nature du Commerce en Général (Essay on the Nature of Trade in General)

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