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. The problem with this thinking is that it misunderstands the way in which banks and bank deposits have become their own form of independent money issuers. They don’t just issue credit redeemable in reserves, but actually issue money now and bank deposits are, for most of us, the most important form of money we use in the economy.
The idea that money is credit is not new though. 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 might appear as though the government controls the money supply, but in reality the private banks have been given the ability to create their own money thru the loan creation process. The government has, to a large degree, outsourced money creation to private competitive banks.
It’s worth remembering that there are two dominant forms of money in the economy – inside money and outside money. Inside money includes all forms of money created inside the private sector (bank deposits, money market funds, etc). Outside money includes any form of money created outside the private sector by the government (central bank reserves, cash, coin).
It’s important to note that everything that involves outside money is a facilitating feature of what is clearly an inside money system. That is, things like reserves and cash exist primarily to help settle interbank settlement and allow for physical cash use. These forms of money like reserves, cash and coins (outside money) all facilitate the use of the predominant 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.
Some people like to claim that credit is a claim on money and that money has no liability. But this isn’t even true of outside money. Reserves are a liability of the Fed and the Fed is liable to process bank payments in inside money as needed by outside money. And cash is a liability of the US Treasury and must be redeemed for deposits when demanded. These things didn’t come into existence via a debt contract, but they are still liabilities of the government and the government is responsible to redeem and process these instruments as needed by the inside money system.
None of this is to say that outside money is unimportant or can’t play a central role in stabilizing the money system. But it is not analogous to a system like the gold standard where the gold is the real money and the deposits are just leveraged claims on gold. In fact, today’s system is in many ways the opposite where the inside money drives real output and outside money merely helps to facilitate various transfers in inside money.
NB – Some might say money is a medium of exchange, unit of account and store of value while credit is just a promise to pay in money. This is true to some degree, but bank deposits are the dominant medium of exchange in the modern economy and MOE is the dominant property of money. Further, outside money like cash is an inferior MOE and like credit, is also a promise to pay in cash when redeemed. So this argument isn’t consistent. It’s worth adding that some people might claim gold is money, but gold is an especially poor MOE given its properties. It’s a far superior store of value than MOE. As a result of this gold is a poor form of money since it’s not widely accepted as a means of payment.
Understanding the Modern Monetary System
The Lead Role of the Private Sector & “Inside Money”
Understanding Inside Money and Outside 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.
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