I’ve wrote a couple of posts here about my “theory” that money and credit are separate. I finally found someone who agrees with me!
http://mises.org/daily/5052/Deflation-Confusion-Money-Is-Not-Credit
http://mises.org/daily/5052/Deflation-Confusion-Money-Is-Not-Credit#ref1
Is he right? I mean the first half of the article, where he argues that
It is the volume of money alone, not the volume of money and credit, that is the primary determinant of prices generally. By focusing on money I do not deny that a credit contraction has important macroeconomic consequences, nor do I deny that fractional-reserve banking makes money and credit interdependent.
The key point is that prices are formed with money because money is the final means of payment for goods, while credit is not. The value of each unit of money rises only when there is less money or more demand for existing money. A change in the volume of credit will affect relative prices but it will not affect the overall value of each money unit in a systematic way.
Hazlitt, for example, says in page after page of his works on inflation that it is, by definition, an increase in the supply of money and credit.
And that inflation causes rising prices. Not a word in all I’ve read about the insight from that article, that increase in credit does not cause rising prices.
Somebody is in error here, please enlighten.
In our current system, whenever credit is granted it is done with new money. And whenever credit is redeemed also the supply of money is shrinking accordingly.
But there also is another type, genuine credit. E.g.: I am not a bank and if I loan you directly $10K then the amount of credit is higher, without the money supply increasing. This possibility justifies that one should differentiate between money and credit. But actually how often is credit granted the genuine way nowadays, so that this distinction really has a practical use?
What about a time deposit, is this (maybe only partly) genuine credit?
Just to make things easier, pretend we are on a gold standard. I think the principles are the same:
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Suppose a loaf of bread cost 1 gram of gold. If the supply of gold were to double, I would expect that loaf to cost 2 grams.
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If the supply of credit were to double I would expect the price of bread to rise, but not as much as as when the supply of gold doubled. Maybe from 1 gram to 1.5 grams. But then I would expect this credit bubble to “pop” and the price of bread to FALL to .5 grams. So the long term purchasing power would remain the same for 1 gram of gold.
It’s hard for me to explain why except that I feel credit can’t go forever and is not as powerful a force as printing money (or finding new gold). Suppose every year you make 50K a year and spend 50K a year. Then one year you borrow money and spend 200K. You need to make up for that in the future by spending less than 50K. So I think credit goes up and down and will cause prices to go up and down but in the long run it evens out. Whereas printing money or finding more gold permanently raises prices.
Good point about genuine credit. They way I understand it, when A lends B the money, A can no longer spend it, obviously. So lending it to B doesn’t increase demand. Even though B can now spend more, A has to spend less by an equal amount.
Now, whenever credit is extended to someone, he can go spend it. That’s what credit is for. So there is more ability to spend on his part. Has someone else lost ability to spend? Not with fractional reserve banking, they haven’t. So looking at it from this point of view, by the law of supply and demand, since demand [=ability to buy] has gone up, prices will go up.
The way I see it now, the key line [meaning the mistake] in the article is this: money is the final means of payment for goods, while credit is not.
I dunno. When the bank gives me credit, meaning a check, I can buy things with it. Why not?
So now the q becomes, assuming I am right, how did this article make it into the Mises Daily?
cr113,
If we are talking about what skylien called genuine credit, prices won’t go up at all, as explained earlier.
If we are talking about credit from fractional reserve banking, the bubble will pop when there is a run on the bank, and the FDIC does not give everyone their money. There is now less ability to spend, because the customers lost their money.
But in the United States, this will never happen. The FDIC will print money if need be to pay everyone off. With this way of looking at it, credit extended by fractional reserve banking is like a delayed reaction way of printing money. Like one of those time release capsules.
There are countries that don’t have an FDIC. Of those, many don’t have bank runs either. So in those places the bubble won’t pop. What will make it pop?
EDIT: While we are on the subject, we may as well ask, what is a bubble? What causes one, and what makes it pop?
The only kind of bubble I know about is when, for some reason, people pay high prices for something [say houses] assuming they will be able to sell it to the next sucker for more, not because they really need it. That’s the bubble. When there are no suckers left to buy the houses, they have to sell it for less, which is the popping.
I am not sure how the story of credit fits into this scheme.
I think I got it. Mr Blumen is merely saying that you cannot add up all money and credit nominally to a total sum because unlike money, credit has not to be accepted on face value because of the counter party risk.
The example with the loan of $10 grant to Smiling Dave: I own an IOU now, and let’s assume this IOU is generally highly accepted because Smiling Dave has an awesome not to say legendary reputation everywhere on the world, that I even can go to the grocery in Djibouti to buy anything I want and they would take it on face value. Then it is in fact like money. But this is of course not real. In the real world nobody gives a f*** on Smiling Dave’s reputation (no offence meant ;). So I cannot pay with it. I would need to find someone who is willing to take the IOU and give me real money for it. And also in this case he will only accept it on a discount. So you cannot blindly add up money and credit on face value.
I only read Econ in 1 Lesson from him yet, but are you sure that Hazlitt writes about aggregating money and credit, or only that the amount of money is increased through increasing debt out of thin air?
skylien,
Hadn’t thought of that. So if A lends to B, A can go to the grocery store with the IOU, B can go to the store with the cash, and prices rise.
Why not simplify things, and just have one person, A, writing IOU’s to the whole universe, thus causing prices to rise? He goes to Walmart’s and writes them an IOU in return for beer. To the doctor, and writes an IOU in return for pills. And so on.
I doubt that this kind of thing is what economists are talking about when they discuss credit. Because how much of this can one get away with? And the case you mention is probably also petty cash. Not only that, how can one find out about the existence and scope of this kind of thing? They are talking about loans banks make, by giving someone a check.
I haven’t seen Hazlitt get down to the nitty gritty of credit. Just the phrase, constantly repeated, “money and credit” as being causes of inflation, and inflation causing price increases.
Yes why not. Isn’t the FED together with the Government exactly this “A” ? And the question is how long can they issue their IOUs, how long do we grant them this reputation…
This makes my head hurt. I’m not saying that credit doesn’t drive up prices, I’m sure it does. What I’m saying is that credit acts differently compared to real money. Credit has lower and upper limits to how far it can effect the money supply. If your monetary base is 1 million there’s only so far you can raise the “aggregate” money supply. And it won’t last.
Here’s my question for you guys: Do you think the Fed can print a dollar and give it to the banks for every dollar in bad loans and not cause prices to rise? This is precisely what deflationists are saying. I think this is so patently false that it’s laughable.
One other point. If you separate credit and money I think it makes certain historical facts easier to explain. For example deflationists want to know why Japan didn’t get rising prices? The answer is easy if you separate money from credit. Japan kept interest rates artificially low but THEY DIDN’T PRINT MONEY. That’s why they didn’t get rising prices.
The inverse of that is now happening in China. China is RAISING interest rates yet they are still experiencing very high price rises. This is because they are PRINTING!
Bottom line for me is if I want to predict whether prices are going to rise or fall the main thing I’m looking at is the money printing that’s going on.
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I agree it’s laughable.
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This article seems to disagree with your statement that Japan did not print money. It says over and over that they did. 10% a year for many years.
I thought I read somewhere that they increased it by something like 10% in total over 10 years. I’ll have to check that out. Maybe I misread it.
Anyway if the facts don’t match my theory I’ll just throw out the facts!
Now that I think about it, even 10% a year is nothing compared to what we’ve done over the last 3 years. We’ve increased the monetary base by almost 300%!
Went to the Bank of Japan’s website and managed to download the money stock from 1990-2000. In 1990 it was 399,484. In 2000 it was 653,364. So it went up about 5% a year for a total of 63% over 10 years. I’m assuming this is in Yen. A good question would be what did the price of gold or silver do in Yen during those 10 years? If Japan’s CPI is anything like the US, it means nothing so the only way to verify true inflation would be thru commodities.
Like I said before, our money stock has gone up almost 300% in 3 years, and we are just getting started!
Additionally Japan had the highest savings rate of the world during this time. Well above 10% the whole decade. So the debt that the government needed to make for its stimulus programs was financed by the domestic market, and the BOJ didn’t need to step in. I think they still have 95% of all government debt kept by its own people.
When credit expands, demand deposits expand with it. That’s mathematical necessity. But what is more important than simple math: deposits and money do not raise prices unless people actually use them to purchase goods. Taking credit almost universally shows a will to purchase, as nobody will pay interest on loan and let the balance sit idle in the deposit account. Loan is taken when you actually want to purchase some good.
In Japan, government expenditure was met by domestic savings. The demand for goods by governent was met with almost the same fall of demand by its own citizens.
Thanks. This is the line that makes it clear, and I was not able to come up with.
Didn’t the supply of credit fall off the charts in 2008? I remember seeing some sort of credit charts that show pretty much a vertical drop to nothing in 2008 (sorry for being so vague, I’ll have to look it up later). Prices didn’t fall that dramatically and I don’t think we could get that severe of a drop in credit again. Personal debt is actually going down right now, back before the crash people were going into debt in record numbers.
To summarize:
In 2008 we had a gigantic loss of credit with no money printing - result: a minor drop in prices.
In the future: Much lower loss of credit with massive money printing - result: a major rise in prices.
My bet is on inflation.
I tend to agree with Mish Shedlock and Henry Hazlitt. Credit needs to be included in the measurement of money. To say we went through an inflation the past 2 years, just because the Monetary Base has expanded is upsurd. Credit tightented up, which is deflation. This is why prices began to drop.
Which prices began to drop?