Whose Money can I Trust
By Koh En Min ǀ 16th November 2015
The notion of money has evolved extensively over time, and has today become almost synonymous with credit.
Credit lends purchasing power, and that purchasing power is money.
The money supply in the hands of the public is bank-created money. Commercial banks create new money by making loans. When a bank creates a loan, it credits the borrower’s bank account with a deposit the size of the loan. At that moment, new money is created.
Each loan creates a fresh deposit, hence fueling further loans. Eventually, the bank required reserve ratio inhibits the money supply from growing any further.
In some countries like the UK, there is no reserve ratio. The total amount of money in the UK depends on the confidence and incentives of the banks. When commercial banks are feeling confident, they create more money by lending more, and when they are less confident, they limit their lending.
Are the numbers that the bank type into bank accounts money or just credit? The key difference between money and credit is credit risk. The number in our accounts would be credit and not money if there is credible risk that the bank will not be able to pay us back.
When the government steps in to guarantee the ‘bank credit’, the government effectively converts the risky credit of the bank into risk-free money, backed by taxpayers’ funds.
Money is risk free credit.
Commercial banks are given legal franchise by the government to leverage sovereign fiat dollars by issuing ‘loans’ to the public. They enhance credit extension of the economy beyond what individuals can.
Commercial banks play a key role in money creation by creating credit. However, not all credit creation in the economy leads to money creation.
Let us look at the example of the US. The following graph presents the change in broad money versus credit (private and government) in the US over the last 50 years. Both quantities are on logarithmic scale with equalized starting base.
One of the reasons is the interest. For every dollar of money, there is a corresponding dollar of interest bearing credit. Money is issued for the principal credit but not for the extra credit due to interest.
Another bigger reason is the non-bank credit.
Traditionally, commercial banks were the dominant supplier of credit, but their role has increasingly been supplanted by government sponsored enterprises, financial companies, broker dealers, asset back securities issuers, bond markets and money markets.
By 2015 Q1, the non-bank credit in the US was more than 3 times the bank credit.
Today’s fiat currency is closely linked to credit, which leads to the question; can money be created without credit creation?
In a barter system, the commodity that is used for the exchange becomes equivalent to money and is called commodity money. The value of commodity money comes from the value of the resource used and is limited by the scarcity of the resources.
During the gold standard era, the governments put a stamp upon a piece of gold to convey the promise that the piece of gold will be received for payment of taxes and other debts due. The stamp changed the gold from being mere commodity money to a token of indebtedness. The government accepted the gold and gave in exchange coins, bank-notes or credit in its book.
Thus, a commodity whose value is collectively trusted can be used to create money without creating credit.
Moving into the digital era, new forms of money are being created and they are backed by technology. Digital currencies can have similar properties to physical currencies and can be accepted in transactions. An example of a digital currency is Bitcoin, which is based on mathematics and secured by cryptography.
Without a central repository or legal frame work, trust in digital currencies is based on technology and collective belief of usefulness and value.
Whatever the form of money, the main thing is the “trust” behind it, whether that trust stems from the value of a commodity, or the creditworthiness of a government, or the technology.
Money in itself cannot be trusted. It is the trust that can be monetized.
This write-up is for informational purpose only. It may contain inputs from other sources, but represents only the author’s views and opinions. It is not an offer or solicitation for any service or product. It should not be relied upon, used or construed as recommendation or advice. This report has been prepared in good faith. No representation is made as to the accuracy of the information it contains, nor any commitment to update it.