The Child's guide

It is the achievement of high economic growth through a high level of investment, made possible through the credit-creating properties of the banking system, assisted by the central bank. Operationally, the central bank creates credit which, when multiplied through the credit-increasing activities of the banking system, finances a higher target level of investment and hence produces higher economic growth in a country.

2 How does this work? What methods are used?

The main national bank - the Bank of England in the UK, the Federal Reserve Board in the USA, the Bank of China, the Bank of Japan and so on - can create credit for the banking system to enable investment credit banks to extend long-term loans for business investment. If a country has a target investment level of (say) thirty percent of Gross Domestic Produce (GDP), and the natural level of savings in the country is say fifteen percent of GDP, the central bank can create credit which, when multiplied up through the usual credit-creating capabilities of the banking system, will make up for the shortfall.

(Methods differ, but additional credit for the investment credit banks can be created by re discounting investment credit bonds at the central bank, or by lowering fractional reserve deposits to virtually zero, or by increasing the reserves of the banking system by allowing banks to issue bonds which they exchange with one another and can lend against. These are not always alternatives, and they can be mixed in a complex pattern.)

3 Why does this matter?

Higher investment levels can produce higher growth. Put crudely, if the investment level is fifteen percent of GDP and the capital output ratio is three, then the growth rate would be (=15/3%) or five percent. By doubling the investment level to thirty percent (assuming the capital output ratio stays at about three) the economic growth rate can be doubled.

4 Why does this work?

Most countries - especially poor ones - have low and inadequate levels of saving, so (in classical economic theory) they are stuck with low growth. Because saving funds investment, governments have often tried to reduce consumption and cut living standards in order to create the funds for investment. The IMF recommend this approach all the time. This has often caused widespread and unnecessary misery. But there is no need for that. In the illuminating words of Kenneth Kurihara:

"If, therefore, greater investment can be financed partly by credits, there is no need for that 'abstinence' which the classical economists considered necessary for economic progress, any more than there is for that 'austerity' which some present day underdeveloped countries impose on an already under consuming population at the constant peril of social unrest. Nor is it difficult, in such credit-creating circumstances, to agree with Keynes' observation that investment and consumption should be regarded as complementary rather than competitive."

5 So using this technique governments can increase the annual investment level and the economic growth rate?

Yes. The less developed countries are the under-equipped countries. By providing them with a means to accelerate their plant and equipment formation rate, their economic development is accelerated. That's what investment credit creation does.

6 There must be more to it than that. What's the catch?

In economics, the world appears to be chess-like - there are simple rules with incredible ramifications. For example, there are several pre-conditions to the creation of investment credit. It helps if there is a partly developed banking system and an entrepreneurial class (a group of enterprising businessmen and merchants who wish to invest to improve their business). A partially skilled and literate population is essential. And the government needs to set up an economic planning unit, preferably in the office of the prime minister or president, to plan for a reasonable level of investment and growth through a continual assessment of the limits of the possible.

And that's only the preconditions!

There is a lot to the practice of these principles. I cannot hope to cover all of these here. Read the rest of this website, the references cited, and my previously published books. Better still, why not research for yourself how the USA, Japan, South Korea and Taiwan, and most recently China, did it? There can be no final answer to that question. There are lots of catches, no procedure is ever without risk, and it is impossible to be definitive about all the difficulties there could be.

7 Won't investment credit create inflation?

It depends what you mean by inflation. Investment credit is the least inflationary expenditure possible. It is a supply-expanding expenditure and hence is highly deflationary. Investment credit increases development, so it increases the value of fixed assets like land and semi-fixed assets like labour. There is no need for investment credit to be inflationary, if inflation is measured by the wholesale price of goods. The inflation rate of the wholesale price of goods tends to be nil or negative in an investment credit economy. The cost of labour rises sharply in an investment credit economy, and the value of work done by people continually rises by reference to the goods and services they produce. But that is a pretty good definition of what we call economic growth.

8 I thought extra government spending just increased inflation.

You may have been reading too much Friedman. Government expenditure which followed the Keynesian analysis - which was valid for the under-consuming economy which Keynes was looking at - did increase demand and when practiced in a fuller employment economy, tended to increase inflation. Government expenditure usually, in most of the countries of the West, just increases demand. Friedman is right insofar as his observations relate to demand-increasing measures.

But investment credit increases supply. It acts just like foreign investment, as if it has come into the economy just to increase the development level. But it has a great advantage over foreign investment - it is not owed to foreign companies and investors, it has a domestic source of supply, so it is more loyal to the country's development aspirations than foreign funds would ever be. And it does not need to be repaid to abroad, and it does not need a stream of foreign currency to fund it in the future.

9 Why does investment credit work so well?

Businessmen are slow to spend investment capital and they only spend it at the rate that productive plant can be put into place and economic capacity can be increased. Consumers on the other hand can spend money very quickly. So investment credit is slow-turnover money.

Investment credit works because the stream of value from the earnings from the investment exceeds the value of the original created credit. (This appears to be true for development levels up to about $35,000 per capita, but this does not work when over-investment occurs in developed economies.) The money foundation of that creation is therefore very solid, so the currencies using investment credit are usually very "hard".

10 Why don't all governments practice investment credit creation?

There is a widespread failure to appreciate what can be done, as well as a lack of understanding about the limits of the possible. Intelligent governments will practice this policy once they know more about it.

11 Is there a limit to the process of economic development?

There do appear to be two kinds of limits. One limit is on the maximum annual rate of growth, and it looks as if a whole economy can't grow at a rate exceeding about 10% a year. Another limit is on the maximum level of economic development possible with existing technology within each natural fifty-five year (Kondriatieff) growth cycle. See The Carrington Limits for a brief discussion of this topic.

12 Will all this theory work? Why are you so sure it will work?

Yes, it has worked wherever it has been tried, and I am sure it will work because all the available evidence indicates it will work. This system (or variants of it) is already in operation in Japan, China, Taiwan, and South Korea, was certainly used by the USA during the 1938-44 period, and probably has also had some use in Malaysia. Everywhere it has been put into practice it has worked with local variations. And everywhere it has produced a more prosperous economy at a more rapid rate.

Also see Frequently Asked Questions or FAQs

Home Contents Consultancy Services News

World Economic Development Publications

Book 5 Chapter headings FAQs Feedback Last words

Date last modified: 02/23/03