When money becomes the primary concern, it creates a dynamism of its own by empowering banks and other financial institutions to expand the money supply.1 This rule encourages many financial institutions to develop complex new financial products, credit innovations, and speculative instruments that enable them to profit from a tense climate of boom or bust. A central bank, as lender of last resort, can reinforce such risk-taking since it is often left to pick up the pieces by bailing out overextended institutions popularly deemed “too big or important to fail.”
The creation of easy money leads to a situation where the money supply no longer corresponds to that which is needed for the normal exchange of goods and services that should characterize a sound economy. Instead, it leads to enormous amounts of money being used for speculation, leveraging risks, and investment bubbles that make frenetic intemperance possible, if not inevitable.
Such a system invites crises. As Mervyn King, then-governor of the Bank of England, noted in 2010: “Banking crises are endemic to the market economy that has evolved since the Industrial Revolution. The words ‘banking’ and ‘crises’ are natural bedfellows.”2
“Although many now-advanced economies have graduated from a history of serial default on sovereign debt or very high inflation,” write Carmen Reinhart and Kenneth Rogoff, “so far graduation from banking crises has proven elusive. In effect, for the advanced economies during 1800-2008, the picture that emerges is one of serial banking crises.”3
1 One way this is done is through fractional reserve banking, where banks give loans with only a fraction of cash reserves to back them up.
2 Mervyn King, “Banking—from Bagehot to Basel, and back again,” BIS Review 140 (2010): 1.
3 Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different: Eight Centuries of Financial Folly (Princeton, N.J.: Princeton University Press, 2009), 141.