In this finance column, we continue exploring the book Economics in One Lesson by Henry Hazlitt. So far, we’ve learned that the art of economics is about considering not only the immediate effects of policies but also their long-term consequences for everyone. Today, we’ll focus on two chapters: “Credit Diverts Production” and “The Curse of Machinery.”
Credit Diverts Production: How Banks Create Fake Wealth
Hazlitt discusses how creating too much credit may seem beneficial initially but can actually harm the economy in the long run. His ideas align closely with how modern banks operate under fractional reserve banking.
In fractional reserve banking, banks only need to keep a small portion of the money people deposit and can lend out the rest. This creates more money in the form of loans, but this money isn’t backed by real wealth.
Here’s why this can be problematic:
1.Fake Wealth: When banks lend out more money than they actually have, it creates the illusion that there’s more money in the economy. However, this extra money isn’t tied to real goods or services—it’s just debt that people will need to pay back later.
2.Bad Investment Choices: With easy access to credit, businesses might start projects that wouldn’t normally be feasible. This can lead to “bubbles” in markets like housing or stocks. These bubbles can burst when banks stop lending money, causing crashes in those industries.
3.Boom and Bust Cycles: Initially, when banks lend a lot of money, it appears the economy is growing because businesses are doing well, and people are spending. However, when banks stop lending or raise interest rates, the economy can quickly collapse into a recession, creating a cycle of growth (boom) followed by a crash (bust).
4.Wrong Allocation of Resources: Excess credit in the economy can cause some industries to grow too quickly while others are neglected. For example, construction or technology companies might thrive, while industries like farming or basic manufacturing struggle. This imbalance can harm the economy in the long run.
5.The Impact on Savings: Normally, savings drive investment and economic growth. However, in a system where banks create too much credit, the economy becomes built on debt rather than real savings. This makes the economy less stable, as it depends on people repaying loans instead of building wealth through savings.
In short, Hazlitt argues that while expanding credit can seem to help the economy in the short run, it leads to fake wealth, bad investments, and boom-and-bust cycles that ultimately harm everyone. (except those bailed out)
The Curse of Machinery: Do Machines Really Steal Jobs?
Next, Hazlitt addresses the belief that machines harm the economy by taking away jobs. Some argue that technological advances, like machines or robots, replace workers and cause unemployment. Hazlitt disagrees with this view.
1.Short-Term vs. Long-Term Effects: Hazlitt explains that while machines may replace certain jobs in the short run, they actually help the economy in the long run by making production more efficient. This results in lower prices for goods, enabling people to afford more, which boosts the economy.
2.New Jobs: As machines make production cheaper and more efficient, businesses can offer goods at lower prices. This increases demand for products, which creates new job opportunities in other industries. Therefore, while some jobs may be lost, others will be created.
3.The Luddite Fallacy: Hazlitt references the Luddites, workers from the 1800s who destroyed machines in protest, believing that machines would take away their jobs. Hazlitt argues that this fear was misguided. While machines did replace some jobs, they also made the economy more productive, leading to more wealth and new jobs.
4.The Bigger Picture: Hazlitt reminds us not to focus solely on the short-term effects of technology. Yes, machines may cause some job losses, but they also lead to lower prices, higher productivity, and a stronger economy in the long run. Machinery ultimately helps everyone by increasing prosperity over time.
Conclusion: The Big Picture and New Challenges
Credit expansion and new technology, like machines and AI, have significant effects on the economy, and these issues still apply today. As Hazlitt warned, credit expansion doesn’t genuinely help the economy.
Instead, it creates fake growth that leads to problems such as bubbles and crashes. Machines, including new technology like AI, may replace some jobs, but they also make things cheaper and more efficient, creating new opportunities in the long run.
These ideas aren’t just from the past—they remain relevant today. Here’s why:
The rise of AI is causing concern that machines will take away jobs, similar to fears during Hazlitt’s time. Industries like transportation and customer service could lose jobs to AI. But Hazlitt’s point still holds: even though some jobs might be replaced, new ones will be created in ways we can’t fully predict. The key is helping workers learn new skills to adapt to these changes.
Another issue today is fractional reserve banking, which has worsened because central banks are buying bonds, placing the population into greater debt. When banks purchase bonds, they create new money, which leads to inflation. While this may seem like a quick fix, it doesn’t increase real wealth. Instead, it raises prices while burdening people with more debt.
The increase in cronyism also means that those closest to the government, such as large companies and well connected individuals, often benefit from the new money. They gain government contracts or grants, becoming richer. Meanwhile, ordinary people face higher prices without additional money to cover them, deepening inequality and making those closest to the government, and those who understand economics richer while the rest struggle.
Hazlitt’s lessons remind us that the economy isn’t just about what’s happening now—it’s about what will happen in the future too. Expanding credit without real wealth only creates problems, and while AI might be frightening because it could replace jobs, it also has the potential to create new ones. At the same time, inflation makes life harder for most people, while the wealthy benefit.
We must carefully consider how we address these changes. If we’re not vigilant, we risk repeating the mistakes of the past. New technologies and economic policies must be designed to help everyone, not just a select few at the top.
Written by John E Middleclass
Published March 2025