Of course, no economy runs like this, as a sort of perpetual motion machine. As Schumpeter noted, there are both external and internal factors that deflect the course of things from running in their accustomed tracks. External factors include things like weather or war. With regard to internal factors, the most important (according to Schumpeter) is innovation. This is the source of economic growth.
To take advantage of innovation, the system has to have the capacity to finance its application. This in turn depends on the kind of monetary system. As I outlined in my book Follow the Money, these come in various shapes. A system based on coinage, for instance, is restricted in its capacity for growth by the very fact of its dependence upon precious metals of which those coins are minted. By contrast, a monetary system based on credit and banking is not limited to the availability of precious metals, but rather depends on the existence of a legal system capable of maintaining the rule of law with regard to property and contract. This allows for credit to be generated on the basis of collateral (property-based monetary system), so that loans are granted, not out of previous savings (primitive accumulation) but on the basis of encumberable property, i.e., property capable of being put up as collateral. Sir James Steuart, the first economist to delineate this kind of monetary system, spoke of “melting down” property into money, an image taken from the world of coinage.
The provision of property-based credit enables the economy to be lifted out of its cyclical repetitions. It is the missing link that explains the process of economic development. Schumpeter made this the cornerstone of his theory of economic development.[1] What this means is that credit is provided to the system so that producers have a source of payment to introduce new services not paid for within the existing cycle of payments. Since all revenues in that system are just sufficient to cover all production (effective demand exactly equals production), some other source of funds from outside the system has to be found to pay for additional production. This is provided by credit.
As an aside: it is incorrect to call this “credit money” or “credit-created money” without further qualification. For it is not mere lending that creates the money, it is lending on the basis of collateralized property. As Steuart made clear, the property basis is what makes this work. Property has the effect of lifting things out of the sphere of the physical into the sphere of the intellectual. This is what distinguishes property from mere possession. Collateral is an expression of this. It is the basis of the modern monetary system. This system has a property basis, not a credit basis.
Back to credit creation: Once this process is under way, there is no longer an exact match between production and demand. Credit-fueled production exceeds demand for a time, and demand catches up with it when remunerations feed through to households and thus consumption. And this is not a one-off occurrence: it occurs continuously, so that the mismatch between funding for production (investment) and remunerations, which pay for demand and consumption, remains a fact of life.
This introduces another factor as well: that of saving. As the monetary circuit complexifies and runs without an exact synchronization, households begin to set aside some of their income rather than spend it. They do this for two basic reasons: to set resources aside for various contingencies, whether foreseen or unforeseen (“a rainy day”), and also to earn interest or dividend payments: that is, to invest in the production process and generate an income from that.
We can now add these components to the basic model of the circular flow, which comes to look like figure 2.
It is clear from this figure that banks play an extremely important mediating role between savings on the one hand and investment on the other. They essentially play the role of middleman in the provision of funds and in the payment (for savings) and the receipt (on loans) of interest. We also see from this figure that banks create deposits in the manner discussed above. This means that not all money previously existed. In fact, in the modern banking system, no money simply exists: it is called into being and extinguished in the very process of engaging and repaying loans.[2] Many errors afflicting modern financial economics stem from the simple misconception that money has a fixed existence. This conception is taken over from the age of coinage, but that age is long past us.[3]
[1] As enshrined in his Theory of Economic Development and further worked out in his Business Cycles and Treatise on Money.
[2] A good summary of the process involved is contained in Schumpeter, Treatise on Money, ch. 8, “Bank-Mediated Money Creation.”
[3] See my book Follow the Money for more on this subject.