Money, credit and inflation

As if there were not enough confusion over what policy the authorities should pursue and when in order to extract themselves from a mess largely of their own making (you know our answer: NONE! and NOW!), the analysts of such policy possibilities are greatly hampered in their attempts at exegesis because they are continually tripping up over their hopelessly entangled bootlaces—the one marked ’MONEY’ and the other marked ’CREDIT.’

Moreover, since few of them are careful enough to distinguish between the asset and the liability side of bank balance sheets, further conceptual errors are rife even before anyone tries to bolt his faulty monetary apparatus onto the alarmingly creaky machinery of mainstream macro.

So, let’s start at square one, in the attempt to introduce a little clarity to the situation.

Firstly, MONEY is the medium of exchange—a present good, readily exchangeable into all others at full par value, on demand, and in final settlement of all the transactions in which it participates. In the modern world, this means notes and coins in circulation and demand deposits held at monetary financial institutions by all other non-MFIs, whether firms, individuals, or government departments.

CREDIT, in contrast, is the evidence of a future money claim, of the deferral of final settlement—a very different animal. Although sometimes exchangeable in practice (with or without a haircut) in place of MONEY, it is neither so universally nor so continuously employed. Rather, its circumstantial acceptance is effectively a kind of barter transaction, albeit the kind most regularly performed in financial markets under normal circumstances

As individuals, we are of course fully entitled to give or take credit instead of demanding or offering money, as it suits our mutual convenience. This is especially likely to occur where we are habituated to repeating the process on some quasi-regular basis with a customer or supplier, or where the total invoice is too large for it to be practicable to meet this charge in full and at the point-of-sale.

Note, however, that when non-monetary actors extend credit, they are effectively exchanging enjoyment of a present good for the promise of a future one and, hence, they are principally engaged in altering intertemporal relations—typically via a discount factor. In general, this cannot be inflationary since the lender, by foregoing a cash payment, must surrender his claim on some other present good (effectively, he must simultaneously become a saver) unless he can persuade someone else to take over the claim in his place.

Even if he does succeed in doing this, the resulting swap is simply that—a substitution of one temporary abstainer for another. As such, this can certainly alter the disposition of relative prices— since the seller of the claim has now acquired the means to buy the good at the top of his unique list of preferences, while its third-party buyer has chosen to postpone the realisation of something high up on his somewhat different menu of choices—but this cannot move all (or even many) prices up together.

In contrast, once a bank enters the picture, matters are greatly altered since banks possess the privilege of being able to issue claims on themselves which unquestionably function as money, in the form of demand or other chequable deposits, in this, an era when the issuance of banknotes is typically denied to them and instead is monopolized by the state.

Armed with this capability, the bank can open a loan account for a would-be buyer, allow him to transfer the balance to his vendor, and then sit back and wait until the vendor (or some combination of persons from the chain of subsequent net sellers who are sequentially connected to the first recipient) decides to place the newly-created claim back at the originating bank (or, at minimum, with one of its counterparty banks which latter will then make an interbank loan to the originator of the credit, so as to complete the circle at one remove).

To the extent that these new deposits take the form of demand deposits, the initial CREDIT—which is an asset on the bank’s book—has generated a corresponding MONEY entry on the other, liability side of the ledger.

This is where the inflation creeps in for it implies that the act of granting the loan did not oblige anyone to give up their call on the stock of present goods as recompense for that quantum which was transferred to the debtor, since the seller now holds, not an IOU to be settled many days hence, but a freshly-spawned unit of MONEY, that present good by means of which one can have instant access to all others.

In insisting upon the point that credit granted outside such an intermediation is not inflationary in any overall sense, we do not deny that it can often serve as the basis for a loan-collateral spiral if enough people become sucked into such a Tulipmania of buying and selling a certain class of goods (or claims thereto) on tick – though it must also be accepted that such outbreaks of mass insanity almost invariably accompany periods when money itself is anything but tight and interest rates depressed.

Nor, is all banking involvement of necessity inflationary, for the newly incurred, ex post liabilities which spring up to balance its ex ante lending could take non-monetary form—as time or savings deposits, or as holdings of bank bonds or other term securities issued by the lender – according to the whim of each bank’s customer. (The holding of securities issued by a non-bank is beside the point here, since it begs the question of what their seller – on either the primary or secondary market – will himself do with the funds he has received by dint of their sale).

Moreover, even where they do materialize as demand liabilities—i.e., as money—their owner may voluntarily treat them as part of his portfolio of financial claims and choose NOT to disburse them for long periods of time. ‘Sterilization’ can thus be a passive course followed by the individual, as well as an active policy pursued by the authorities and so we should strictly talk here of such a swollen, but partly immobilized supply of money being potentially inflationary, rather than ineluctably so the instant it is augmented in this fashion.

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