Credit Expansion Creates an Artificial Economic Inequality by Showing Up in the Stock Market and Driving Up Stock Prices

Capital in the form of credit is normally and, certainly, properly, extended out of previously accumulated savings. In sharpest contrast, credit expansion is the creation of new and additional money out of thin air, which money is then lent to business firms and individuals as though it were a supply of new and additional saved up capital funds. Its existence serves to reduce interest rates and to enable loans to be made and debts to be incurred which otherwise would not have been made or incurred. Always and everywhere, to the extent that private banks participate in the process of credit expansion, they do so with the sanction and generally with the active encouragement of the government.

Economists, above all Ludwig von Mises, have shown how credit expansion is responsible for the boom-bust business cycle and how its existence depends on deliberate government policy. Nevertheless, public opinion believes that the business cycle is an inherent feature of capitalism and that the role of government is not that of causing the phenomenon but of combating it. Indeed, as Mises observed, “Nothing harmed the cause of liberalism [capitalism] more than the almost regular return of feverish booms and of the dramatic breakdown of bull markets followed by lingering slumps. Public opinion has become convinced that such happenings are inevitable in the unhampered market economy.”

The truth is that credit expansion is responsible not only for the boom-bust cycle but also for another major negative phenomenon for which public opinion mistakenly blames capitalism. Namely, sharply increased economic inequality, in which the wealthier strata of the population appear to increase their wealth dramatically relative to the rest of the population and for no good reason.

It is not accidental that the two leading periods of credit expansion in history—the 1920s and the period since the mid 1990s—have been characterized by a major increase in economic inequality. Both in the 1920s and in the more recent period, a major cause of the increased economic inequality is that the new and additional funds created in credit expansion show up very soon in the financial markets, where they drive up the prices of securities, above all, common stocks. The owners of common stock are preponderantly wealthy individuals, who now find themselves the beneficiaries of substantial capital gains. These gains are the greater the larger and more prolonged the credit expansion is and the higher it drives the prices of shares. In the process of new and additional money pouring into the financial markets, investment bankers and stock speculators are in a position to reap especially great gains.

Since it’s so important, the main point just made needs to be repeated: credit expansion creates an artificial economic inequality by showing up in the stock market and driving up stock prices. Since  the stocks are owned mainly by wealthy people, they are the main beneficiaries of the process. The more substantial and the more prolonged the credit expansion is, the larger are the gains enjoyed by wealthy people more than anyone else.

—George Reisman, “Credit Expansion, Economic Inequality, and Stagnant Wages,” George Reisman's Blog on Economics, Politics, Society, and Culture, entry posted January 12, 2008, http://www.georgereismansblog.blogspot.com/2008/01 (accessed February 15, 2020).