I'm having a hard time swallowing the whole of the article, based on assertion [A]t the global level, debt cancels out: net debt is zero. So, in paying down debt, one is also reducing credit by an equal amount.
The leverage formula is (1 / reserve) where reserve is a fraction tending to zero. This is a non-linear relationship and we all know that the lim x -> 0 (1/x) = infinity.
If lenders (e.g. banks) hold a 20% reserve, they will "expand" the money supply by 1/0.2 or 5x. If they hold a 10% reserve, they will "expand" the money supply by 1/0.1 or 10x. If they hold a 1% reserve, they will "expand" the money supply by 100x. As the reserve fraction goes to zero, the effective credit part of Martin Wolf's equation goes to infinity.
A lot of exactly that type of lending was being practiced during the "bubble", especially in the housing market where mortgage underwriters were loaning more money than the houses were worth. This was happening before the housing crash - mortgage originators were advertising "we will loan you 100% the value of your house" (sometimes more than 100%).
I'm unsure why you think the reserve fraction must inevitably tend towards zero.
You seem oblivious to the fact that current proposals (known as Basel III, after the city in Switzerland) requires banks to raise their tier 1 capital ratios, ie reduce their capacity for leverage. Currently central banks are acting as lenders of last resort, but once healthy growth resumes they will gradually sterilize that funding. That will be a limiting factor on growth, but one that seems preferable to a total credit freeze.
Ahh, I stated that too strongly and you restated it even stronger. The point I was trying to make was as the reserve fraction goes to zero, the leveraged money goes up in a non-linear fashion. At some point 1/x where x trends to zero is unsustainable.
In practice, the reserve ratio has continued to decline, and in fact, via the fraudulent FDIC underwriting practices massive moral hazard has been created in the banking sector.
In short, banks can leverage as much as they want, and the FDIC will cover their butts if they fail, but the FDIC does not charge adequate premiums based on risk. Further the federal reserve isn't really a "lender of last resort"
In fact, the term "lender of last resort" is inaccurate, as the federal reserve offers rates on money that are lower than the market. They are doing this now as a response to a crisis that was caused by them doing it in the past (as I pointed out elsewhere.)
A lender of "last resort" would be one you could always go to, but who was expensive and therefore you were incentivized - "first resort" - to go to the market.
Really? Please back up your claims with some data. Also, your theories about fractional reserve banking should hold equally true in other countries where the FDIC does not operate. And I'm a little skeptical of your complaints about moral hazard, given the frequent closures of banks by the FDIC, and the resulting haircut for those banks' investors.
"The problem is that credit is not a fixed amount due to the fact that it is leveraged" can't be true. How could the amount of credit ever be fixed? Whether banks lend or not depends on whether they can make money lending. That'll never be a constant.
Here's a pretty good post (and comments) on how FR relates to modern money:
I agree that (credit - debt) = zero. The problem is that credit is not a fixed amount due to the fact that it is leveraged... see fractional reserve banking. http://en.wikipedia.org/wiki/Fractional-reserve_banking
The leverage formula is (1 / reserve) where reserve is a fraction tending to zero. This is a non-linear relationship and we all know that the lim x -> 0 (1/x) = infinity.
If lenders (e.g. banks) hold a 20% reserve, they will "expand" the money supply by 1/0.2 or 5x. If they hold a 10% reserve, they will "expand" the money supply by 1/0.1 or 10x. If they hold a 1% reserve, they will "expand" the money supply by 100x. As the reserve fraction goes to zero, the effective credit part of Martin Wolf's equation goes to infinity.
A lot of exactly that type of lending was being practiced during the "bubble", especially in the housing market where mortgage underwriters were loaning more money than the houses were worth. This was happening before the housing crash - mortgage originators were advertising "we will loan you 100% the value of your house" (sometimes more than 100%).