It’s common in economics and in general, for people to differentiate between “money” and “credit”. This is largely the result of gold standard mythology when gold was viewed as the primary form of money and “bankers” would issue notes that were redeemable for gold. They were, in essence, issuing a claim on gold. When we went off the gold standard economists didn’t really change their model much. They just substituted central bank reserves and cash for gold and said that when banks were lending they were issuing claims on central bank money and vault cash. I think this is wrong.
The idea that money is credit is not new. In fact, money as debt/credit goes back as far as the history of money. The Code of Hammurabi stated:
“If someone has a loan debt and a storm knocks down the grain or the harvest is bad, or the grain doesn’t grow for lack of water, that year the person doesn’t need to give his lender any money. He must wash his debt board in the water and not pay rent that year.”
All modern money did was evolve this contract into something more easily transferrable. The farmer no longer has to hold onto the loan or the deposit that he signed into. He can now transfer that claim and other people can use it as money. This is all bank deposits are these days. Bank liabilities, created in the process of loan creation, that are easily transferrable and used as money.
The system we reside in today is not one designed around central bank reserves and cash. In fact, central bank reserves and cash are playing an increasingly less important role in the economy as time goes on. Reserve requirements are no longer necessary in well managed banking systems, cash is becoming a less common form of money and the importance of inside money (bank money or deposits) has become increasingly evident to the economy as the credit crisis proved.
The problem with this focus on central bank money and reserves is that it seems to get the entire focus of the monetary system wrong. We start from the government and build out from there without realizing that the private sector steers the economy and the money the non-bank private sector primarily uses (inside money) dominates how output is created, where prices settle and how we engage in the economy.
It’s also important to note that everything that involves outside money (central bank money) is a facilitating feature of what is clearly an inside money system. That is, reserves exist primarily to help settle interbank settlement. And cash exists primarily to allow an inside money bank customer to draw down an account to transact more conveniently. These forms of money like reserves, cash and coins (outside money) all facilitate the use of the dominant money – inside money. Saying that inside money or credit is just a claim on outside money is clearly false. For instance, a transaction occurring between two customers in credit at Bank of America doesn’t even involve outside money. But more importantly, what we’re all really after in the economy is not claims on outside money. We’re all seeking the real money – bank deposits. The primary way cash comes into circulation is when an inside money holder draws down a bank account. And the non-bank private sector cannot even access bank reserves so it’s totally illogical to build a real understanding of the economy around outside money.
Focusing on outside money and building a world view around it is like trying to understand how a man walks by studying the crutch he uses. Outside money is merely a crutch while inside money is the legs! Yes, outside money is important and it can be particularly important when your legs break (during a credit crisis), but that doesn’t change the fact that the legs are the form of money that “rules the roost” 99% of the time. There are hardly any schools of economic thought that get this balance correct. Which is a big contributing factor to why the entire “dismal science” appears so dismal at present.
NB – The history of money as credit is cited extensively in Graeber and Pruessner’s work as well.
“In some times or places at least, these bullae appear to have become what we would now call negotiable instruments, since the tablet inside did not simply record a promise to pay the original lender, but was designated “to the bearer”—in other words, a tablet recording a debt of five shekels of silver (at prevailing rates of interest) could circulate as the equivalent of a five-shekel promissory note—that is, as money.”
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.