Money and Credit

This is a big subject. I've been meaning to post on this subject for some time now, but as I expand my research, it keeps getting bigger and bigger... So, I'll probably address this subject over a series of posts. I want to introduce the key themes here and provide some sources for readers to explore independently.

An any given economy there must be a means to facilitate the exchange of goods and services. Ancient systems were based on barter. This evolved to involve the concept of money where something was accepted as a commonly used medium to enable exchange. Commodity money is the most basic concept of money. Items which have an inherent value as a commodity (such as beads, stones, or gold) would serve a dual-purpose as money. Over the course of a few nuanced evolutions (largely driven by banks), we ultimately arrived at the concept of government-issued fiat money.

The general and basic understanding of monetary history speaks of government-issued commodity money whereby the state would issue currency which was "backed" by a commodity - usually gold and/or silver. One such example is the gold standard. The state would issue currency which would be redeemable on demand in gold. The state (via a central bank) would hold reserves of gold to ensure redemption could be executed.

(It should be noted that private banks have also issued private currency called banknotes. These banknotes may or may not be legal tender - something that has the force of law for resolving debts. While these concepts are important for a thorough understand of monetary history, they are not terribly relevant in this particular discussion.)

In a fiat currency system, the state issues currency which is backed by a variety of assets. Most currencies today are reserved with a combination of gold, foreign currencies, and government issued securities. Up until our recent financial crisis, the dollar has been backed largely by U.S. treasuries. The Federal Reserve issues Federal Reserve Notes (prints money) to acquire assets such as U.S. treasuries (government debt). The money goes into general circulation. Ultimately, the money is collected by the government via taxes and then remitted to the Federal Reserve to pay off the government debt. This ends the cycle.

To a large degree, most classical and modern macroeconomic and monetary theory is based on this view of currency. It is augmented by the phenomenon of fractional-reserve banking where banks expand the money supply (volume of currency/money in circulation) via lending. The traditional example is that the bank has $10M in deposits and can then loan out $9M under a reserve requirement of 10%. The $9M makes it way to another bank who can then lend $8.1M. This continues ad infinitum "creating" new money all the way along.

Unfortunately, these basic concepts upon which most economic theory and policy is based is wrong. Banks don't operate this way. The system is not this simple.

If you want to read a lot more detail, please read the following article. I'll attempt to explain the basic concepts in an upcoming entry.

"The Roving Cavaliers of Credit", by Steve Keen (my new favorite economist)