Recently there was a discussion on the site of money and credit and the relationship of the two. Allow me to give you my take on this issue.

While they are related, money and credit are two different concepts. As the world became more complex and people were dealing more with strangers than with people they knew, barter became rather inefficient. Having all goods and services priced in a standard unit, i.e. the currency unit, was a more efficient way to transact. That way one only had to know the price of any item in dollars rather than in terms of every other available good and service. It was even more convenient to receive payment in that form of money and to buy using such money.

In essence money in its narrow definition is that which will be accepted by the government in payment of taxes and that which is generally accepted in transactions throughout the country in question. It is a question of ultimate settlement. You can pay by credit card, but the seller is not really paid until the credit card company pays the seller in money. That is why the credit card is not really narrow money.

The narrow money or ordinary people and businesses consists of currency and checking accounts. Both can be deposited into the seller's checking account. But when banks net out all the checks drawn each other's bank, they have to settle in bankers money, namely currency (insignificant) and their reserve balances at the central bank (i.e., the Fed). The latter is referred to as high powered money. High powered money is not public money—it is banker's money. So when banks keep this idle as excess reserves, it does not impact general CPI type inflation as it cannot be used by the public to bid up the price of goods and services because it is not something that the public can spend.

In addition to narrow money, any asset that has a steady value and can rapidly be converted into narrow money at minimal costs is quasi money and is the relevant measure when one considers not only the money needed in the active transaction process but also that the public wishes to hold as liquid balances. Assets have varying degrees of such moneyness that changes as market conditions change. For example, quality commercial paper had a reasonable degree of moneyness, but the financial crisis in 2008 when it was not sure if companies could refinance and pay off such commercial paper when due, almost totally eliminated any moneyness such paper had.

There is no single measure of broader money. Rather one might choose a definition of such a variable like M2 realizing that it is only a proxy and that the demand for such money will change in part based on the available moneyness of other assets.

People produce for their own use (of great importance when people lived on farms but relatively insignificant today) and for what they can sell to others. When people earn more on what they produce than what they spend on consumption, they save the difference. They may invest some of this on their own businesses or houses. To the extent they do not invest it themselves, it is savings that must either be kept in narrow money or invested either in credit or equity. (Equity might be considered a special form of credit in which neither the return on investment or the principal is specified but dependent on residual values of the enterprise and for most of rest of this discussion considered included with credit.) So credit is the sum of production values in excess of what the producers either consume or invest themselves that in turn is borrowed by others who are either consuming or investing in excess of the value of their production. (I might add that inventories are considered self investment.)

Money is not always necessary when there is a credit transaction. For example, an business might supply drilling equipment to an oil company in return for a future payment of so many barrels of oil (a loan) or a certain percentage of the oil produced (more akin to equity). But most credit transactions are done with the exchange of money, just as most other transactions for the purchase of goods or services are settled in money. When a bank makes a loan, the borrower sees it in an increase in his or her checking account balances. They are then free to buy goods or services using their checks in payment.

In this case the bank has created narrow money and there is also a credit transaction. This is what makes this business of what is credit and what is money a bit confusing. When the borrower buys something, the seller receives a check and deposits it in his or her bank. The money is still in the system. The borrower still owes the bank for the loan but no longer has the money. These are separate items. The money is what was used to facilitate the transaction. It is not credit. Nor is the credit money. It still exists even after the money has left the hands of both the bank that created it and the borrower.

In a sense all money is credit. When you deposit a check, the bank owes you for that money. Currency is a form of non-interest bearing loan to the government. Much is made of sound money in the form of a commodity such as gold. When governments settle with each other, they can only settle in what is generally accepted by most nations as ultimate payment. Gold services such a purpose. As long as it is widely accepted, a reserve currency such as the dollar will also serve as international money. But as it relates to its use as backing for a domestic currency caution on this assumption is in order.

Gold does have value in and of itself for industrial uses and as jewelry. But to the extent there is a demand for gold as money (i.e. as a store of value or as a backing for money), total demand is increased and with it the price of gold. If people lost confidence in gold for this purpose its value as money would disappear and the price reduced again to what its industrial and ornamentation use would value it at.

In that sense it is no different than any other form of money that is dependent on its general acceptance except for its value. The general desire is to maximize the well being of people by producing as efficiently as possible. Gold requires a lot of resources to produce. Fiat money does not. Hence fiat money is a much more efficient form of money.

The main argument for the use of gold is as an insurance against overproduction of money as in the case of gold that is related to the physical availability of the metal and the difficulty of its production. But gold backing can always be stopped by government action. So the only form of insurance is to deal in and hold the gold oneself. Unless the government prohibits ownership of gold as it had in the U.S. for a few decades, there is no reason why any individual cannot do so now. Both fiat money and gold backed money are dependent on government integrity and discipline, so there is no reason not to go with the more efficient form of money.

In our economy, money is created by the Federal Reserve. It can do so in two ways. One is to lend to the banks (or, when permitted, to anyone else). Another is to buy some asset and paying by a check drawn on itself, i.e. the creation of reserves at the Fed. It does not matter for the purpose of money creation, if what it buys are Treasury bills or bottles of fine wine. What it creates is high-powered money. To convert that into public money (M1), the bank has to use its reserves to buy assets or make loans. When a loan is made, the borrower has purchasing power that allows them to consume or invest just as with any loan. When the Fed buys securities it just changes the asset composition of the seller.

A certain amount of money is necessary for the transaction process, such as the time a mailed check is in the hands of the postal system. The rest is held as for purposes of liquidity. When the supply of money is equal to the demand for these two purposes (without fueling a overall rise in prices), money does not add to the savings available for investment or to raise prices. When it is in excess of this amount, it will be spent as holders attempt to reduce money holdings from their portfolio. But since it does not change what can be produced, it means that one will eventually end up in higher inflation. Until the general rise in the price level is realized, suppliers may assume that the real value of their offerings has increased and increase production that will turn out not to be profitable (money illusion). The amount of money demanded will depend on the efficiency of the transaction process, the opportunity cost of holding money (the interest rate on investments and the inflation rate) and how cautious people are. Crisis and uncertainty clearly increase the demand.  It also depends on the moneyness of other assets, which changes with conditions.

Money is just one asset in a portfolio. The amount of money desired will often be viewed as desired percentage of the portfolio. So when excess money creation can end up being used to bid up the price of existing assets such as equities and real estate to the point where the excess creation of money is equal to the desired percentage of the increased value of the portfolio and/or to increase the nominal volume of transactions until the amount of money to support the higher level of transactions equals the increased supply of money. The monetary creation process may end up directing more activity into credit and investment at the expense of consumption as the process does impact who gets their hands on money.
If the government does not prohibit it, anyone can attempt to create private money as Bit-coin has attempted to do. It will never be a complete form of transactions money if the government refuses to accept it in payment of taxes. But if one can get most people and businesses to accept it as final form of payment and to price their goods and services in terms of it, it can be a semi-complete form of transactions money. But the large swings in price of Bit-coins in dollar terms and the limited acceptance of it as final payment for transactions means it has not made the grade. I doubt anyone prices what they sell in terms of bit-coin irrespective of what has happened to the bit-coin to dollar pricing.

Before the Fed, banks issued their own notes. They were never a complete form of transactions money in that notes from a geographically distant bank were not usually accepted in full without a discount for the uncertainty of the solvency of the issuing bank. One could argue that would be less of a problem today. In many respects that is true, but ex deposit insurance and the Fed, consider the experience of 2008 and tell me why such notes would be more trusted than prime commercial paper was during the worst of that crisis.
In times of financial crisis, the desire for more liquidity becomes manifest and financial institutions might not have enough of it forcing them to sell less liquid assets to obtain it. This depresses financial and other asset prices to distress levels. In such times, it should be the function of the Fed to provide liquidity to solvent banks (or at least those that would be solvent but for distressed pricing on their assets). Failure to do so can create a wave of bankruptcies because of lending to lenders. If loans were all just made to ultimate borrowers, the failure of those businesses and consumers would impact that institution but would not necessarily spread throughout the system. But when most lending is not for ultimate purchases, every such failure by ultimate borrowers can cascade throughout the entire financial system. That risk is compounded when institutions are highly leveraged and have only thin equity cushions to absorb losses.
Hence, gross credit is another factor to consider. When loans are made that will in turn be used to make other loans (or equity purchases), the total gross amount of debt in the system is increased. When the ultimate borrowers are not able to repay that debt, it can impact the ability to repay of all the borrowers who used credit to extent credit. When this chain of non-ultimate lending and obligations undertaken by various contingent financial instruments becomes too extensive, the whole system becomes more vulnerable to panic because in situations of distress liquidity becomes scare and there is panic selling of all saleable assets along with the depressed pricing that results and no lender can have much confidence in any borrowers convoluted balance sheets so dependent on others in the credit chain.
Net credit is dependent on the amount of savings in the economy. It can be domestic savings or foreign savings (the current account deficit).  The question is if there is enough productive investment that can make efficient use of that credit or if it will be used for consumption (i.e. most of the use of government deficits) or investment that will not earn enough to allow repayment. Someone recently asked me if the low interest rates might not mean that monetary policy has been too tight. I answered him and will send that answer out in a following post because it deals with this question in the current context.





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1 Comment so far

  1. Rich Berger on August 19, 2016 5:43 pm


    You should make your posts shorter or break them into more paragraphs.


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