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Money and Credit

In the preceding discussion it has been sufficient to treat the circulating medium from a functional viewpoint, without inquiring into the nature and characteristics of the media actually used for this purpose. When we take up a consideration of practical control measures, however, more detailed information will be required. At this time, therefore, we will make a more extensive examination of money and credit.

There is a possibility that credit may have been employed on a limited scale in even the most primitive economies, but the first extensive use of an auxiliary medium of exchange began with the introduction of money. It should not be assumed that money was an invention: something that originated from the kind of a “flash of genius” that our courts talk about in their patent decisions. Rather, is was a development, a slow and gradual growth from small beginnings. In the early days of barter all transactions were undoubtedly direct exchanges. But as trade increased, more and more situations would naturally arise wherein individuals having goods to dispose of were unable to find buyers that could offer suitable goods in exchange. Under such conditions, particularly if the original goods were perishable. there was clearly an advantage to be gained by accepting some unwanted commodity that could later be exchanged in an additional transaction with a third person for the goods that were actually desired. The more ready acceptance this intermediate commodity could command the more advantageous it would be for the purpose. Consequently, there was a gradual tendency toward the use of only the most readily accepted commodity as the exchange medium. This had the additional advantage of providing a standard of value whereby the relative worth of different goods could be more easily established.

The information that is available about the use of money under primitive conditions indicates that utility was originally the controlling factor. In each local area some commodity in general use took on the functions of the exchange medium. In one place this was cattle, in another shells, in a third salt cakes, and so on. But as time went on it became apparent that other characteristics were more important than widespread utility, since adequate utility to some consumers was sufficient to insure acceptance of an otherwise suitable commodity, even though it might be of no use to most people as an article of consumption. Aside from this reasonable amount of utility, the requirements that a commodity should meet in order to be fully satisfactory for monetary purposes are that it should be permanent, uniform, easily recognizable for what it is, easily subdivided, easily stored, easily transported, and available in sufficient quantities to serve the monetary purpose, but not too plentiful, so that its value per unit will be relatively great and the amount to be handled will be correspondingly small. On this basis, the rare metals, particularly gold and silver, gradually preempted the field.

As brought out earlier, these characteristics which make a commodity suitable for use as money are primarily those which reduce fluctuations in value to a minimum, and thus permit use as purchasing power without very much limitation as to time and location. Gold is a better medium of exchange than salt cakes, not because it possesses any essential quality which salt cakes lack, but because it possesses the desirable qualities in a greater degree, and its value is therefore more stable.

It should not be overlooked, however, that gold is money only because it is a commodity with a utility as such, independent of its utility as a medium of exchange. Only goods can play the part of intrinsic money; that is, money which exists as such in its own right and not as a representation of something else. That commodity which is accepted as the most stable form of value currently available (or at least one of the most stable forms) is money. In the earlier pages much stress was laid on the fact that goods are not only articles of consumption but also constitute purchasing power. The converse is also true; intrinsic money is an article of consumption as well as purchasing power. It is also true that the relative value of gold compared with other goods is affected very materially by the extent to which it is utilized as money, but it would not be intrinsic money at all if it lacked a value independent of its utility as an exchange medium. Originally its value as money and its value as a commodity were equal. At that time, if an individual desired to convert his assets into the most stable form, the answer was intrinsic money. Greater stability of value could be attained by exchanging those assets for money, and still greater stability could be attained by exchanging this other money for gold. Once he had possession of gold he could go no further. Any remaining element of instability had to be accepted as unavoidable.

The development of other types of circulating media in the modern economies has changed this picture very materially. In earlier days when governments were unstable and private business enterprises were subject to a multitude of uncertainties, nothing but the physical possession of intrinsic money was satisfactory. But as sound economic and political institutions gradually evolved, it because possible to take a step forward by storing the monetary commodity and circulating claims against the intrinsic money rather than passing the physical commodity from hand to hand. Such token money is far more convenient, and as long as it is fully covered by intrinsic money in storage and convertible on demand, it meets all of the requirements of a satisfactory medium of exchange.

It was inevitable, however, that the money issuing agencies, both government and private, should soon learn that they were not forced to limit their issues of token money to the amount of intrinsic money on hand, as long as there was enough available to meet the demands of those who actually did present the claims for redemption. But the additional issues of money claims which took place under this policy did not constitute the same kind of money, This was no longer token money, a representation of intrinsic money in storage; this was credit money, and it had all of the peculiarities and weaknesses associated with the use of credit.

Credit is a device for reversing the time order of economic transactions. In the normal exchange process, the results of past effort are exchanged for goods to satisfy present and future wants. By means of credit, this time sequence can be reversed, and present wants can be met by pledging future effort. Credit is not peculiar to any one type of economic organization. It simply reverses the time order of economic processes, whatever these normal processes may be. When trade is carried on by barter, credit enables obtaining goods first and later producing other goods with which to make payment. In modern practice money is first obtained by means of a credit transaction, then spent for goods. Production follows, and the proceeds are used to make payment in the final step of the process. In a barter economy credit operates through barter; in a money economy it operates by means of money.

Recognizing that credit is a money transaction in the present-day economy contributes materially to a clear understanding of its relation to the general operation of the economic system. It is true that direct credit dealings between merchants and consumers may take place without the aid of the monetary mechanism, under certain conditions. Consumers who buy goods from merchants’ stocks on open accounts or deferred payment plans are drawing directly from the credit reservoir, and the original transaction involves no money. Such transactions show up physically as reductions in the merchants’ inventories (goods storage). In spite of the large amount of business done on a credit basis, however, very little of it is carried through to completion without the use of money at one stage or another. Normally the merchants must proceed at once to replenish their stocks after sales. If they borrow money from banks for this purpose, the transactions revert back to the same status as if the consumers had borrowed from the banks. If they happen to have enough money reserves of their own to finance the credit business without the help of the banks, the result is merely a withdrawal from their money storage rather than bank storage.

This means that we can measure the changes in the money reservoirs and from them determine the variations that have taken place in both money and credit. Any increase in credit, aside from the small amount of pure credit dealings, must be reflected either by withdrawals of money from storage or by an increase in the amount of credit money outstanding (which is likewise a reservoir withdrawal). If an individual saves part of his income and deposits it in a bank instead of spending it, he has put this money into storage, and the active money purchasing power has been reduced by this amount. But when the bank turns around and lends the money to some other person for use in the goods market, the ultimate effect is exactly the same as if the first individual had spent the money himself. The original storage transaction has been reversed by a withdrawal from money storage.

The deposits (money storage) thus constitute the source from which loans (withdrawals from storage) are made, and if we limited the supply of money to the amount of intrinsic money available-that is, if we used nothing but the intrinsic money itself or token money representing intrinsic money actually present in our vaults-bank credit could not be extended in excess of the money stored: the total deposits plus the capital and surplus funds of the banking institutions. As a publication of the Federal Reserve System expresses the foregoing: “the practical experience of each individual banker is that his ability to make the loans or acquire the investments making up his portfolio of earning assets derives from his receipt of depositors’ money.” But this same publication goes on to say, “On the other hand, we have seen that the bulk of the deposits now existing have originated through expansion of bank loans or investments by a multiple of the reserve funds available to commercial banks as a group,” and it admits that this constitutes “an apparent paradox that is the source of much confusion to banking students.”

In their explanation of the way in which the banks “create” the deposits, the authors of this publication utilize the example summarized in the following table:

Loans and investments
Demand deposits
Ratio of reserves to deposits (percent)

In the original situation (1), the bank had deposits of 100 and loans and investments amounting to 80, leaving a reserve of 20, or 20 percent of the demand deposits (the legal requirement assumed for purposes of the illustration). The Federal Reserve system now makes additional reserves available to the bank, bringing the total reserves up to 30, as indicated in column (2). The reserve ratio is now 27.3 percent, and the bank is able to expand its loans and deposits up to 120 and 150 respectively, as shown in column (3), before the limiting ratio of 20 percent in again reached. This shows, the authors say, “that the issuance of a given amount of high powered money ("the dollars created by Federal Reserve action that become bank reserves,” they explain, “are often called “high powered” dollars to distinguish them from ordinary deposit dollars") by the Federal Reserve will generate a volume of ordinary money that is several times as large as the amount issued.”123

Now let us ask, What is wrong with this picture? The authors admit that in order to achieve the results specified the proceeds of the additional loans must remain on deposit, and they are so shown in the tabulation. So this “generated volume of money” is money that cannot be used. To illustrate this point, let us see what happens if the borrowers of the deposit money “created” by the bank do try to use it. They draw checks against the new deposits shown in column (3), cutting the total deposits back to 110. The bank must maintain reserves amounting to 20 percent of this amount. The new total of loans and investments therefore cannot exceed 88, which means that assets amounting to 32 must be sold to balance the accounts. Thus the 10 received from the Federal Reserve only provided 8 for actual use. The remainder of the 40 that was loaned on the strength of the additional Federal Reserve credit vanished as soon as an attempt was made to use it. “High powered money” is a myth.

The bank can lend for use by its customers any money that is actually obtained from some outside source-from depositors, from its stockholders, from the Federal Reserve System-but it cannot lend anything more. It cannot create any money for lending purposes. As the Federal Reserve publication that was quoted admits, this is “the practical experience of each individual banker,” and any comprehensive theoretical study must necessarily arrive at the same conclusion.

Economists have generally regarded the setting up of a credit on the books to the bank as the significant banking transaction, and they assert that “deposits are mainly created by the banks themselves.” Since they regard the deposits as money, this means that the banks are the principal sources of the “money supply.” But this conclusion is the result of a failure to appreciate the significance of money storage in the operation of the economic system. When we get the proper perspective, and realize that banks are primarily reservoirs in the money stream, we can see that the mere creation of a deposit by means of credit accomplishes nothing in itself. The loan by the bank to the customer and the deposit of the funds in the bank by the customer are two transactions, not merely one, even though they take place simultaneously and may be handled by means of a single piece of paper, and the two transactions have opposite effects.

The significant quantity is the amount of money in storage, the size of the bank’s reserves. A deposit by a customer of the bank is an input into storage. It increases the reserves. A withdrawal from the customer’s account is an output from storage. It decreases the reserves. A deposit set up by means of a bank loan is a balanced transaction that is neither an input or an output. The loan withdraws money from bank storage, but the return of this money to storage by means of the deposit completely nullifies all that was accomplished by the original withdrawal, and the bank reserves are not altered.

Here, again, it is essential to keep in mind that the absolute quantity of the circulating medium has no significance. It is the rate of flow in the circulating system that is important, and banking transactions affect the general operation of the economy only to the extent that they alter this rate of flow. The cooling system analogy will be helpful in getting a clear view of this situation. If we add water to a reservoir in this system, and it stays in the reservoir, then there is no change in the significant item, the rate of water flow. Under these conditions the added water has no effect on the cooling operation. It must leave the reservoir if it is to accomplish anything.

This point is of sufficient importance to justify stating it as another of the general principles of economic science.

PRINCIPLE XIV:The quantity of money existing within an economic system has no effect on prices or on the general operation of the system, except insofar as the method by which money is introduced into or withdrawn from the system may constitute a purchasing power reservoir transaction.

The existing confusion in this area is largely a result of the Quantity Theory of Money, which is widely accepted in economic circles, and has considerable influence on the thinking of many of those who do not subscribe to the theory as a whole. Basically this theory rests on the premise that the quantity of money in existence is exchanged for the quantity of goods in existence, and consequently any increase in the amount of money necessitates paying out more money for the same goods. The backers of the theory visualize a “supply of money” and a “demand for money” analogous to the supply and demand for wheat, and they deduce that an increase in the supply of money relative to the demand for money will cause a drop in the price of money (that is, an increase in the goods price level) just as an increase in the supply of wheat relative to the demand for wheat will unquestionably cause a drop in the price of wheat.

The flaw in this logic is, of course, that the premise is false. The basic economic process is not an exchange of goods for money; it is an exchange of goods for goods. Money only enters into the process as an intermediary, and since it is not changed in any way by the functions which it carries out, it can be used over and over again without limit. There is no “demand” for money in terms of quantity. It is entirely immaterial whether we use ten dollars once or one dollar ten times. Hence we can have any price level with any amount of money, subject only to the qualification that we must have enough money available to provide a working supply for each unit participating in the economic process. Similarly, we must have enough water in the cooling system to reach all of the parts that are to be cooled, but aside from this limitation it is immaterial whether we have only a few extra gallons in the circulating system or are connected to reservoirs containing thousands of gallons. If we have only a small amount, it makes the circuit frequently; if we have a greater amount it simply moves more slowly.

The original, or “crude” version of the Quantity Theory has been abandoned by most economists because it is very evident that the rate at which the existing supply of money is being used, the “velocity of circulation,” is equally as important as the absolute quantity of money that is available. Present-day opinion among those who subscribe to this theory generally favors one version or another of the so-called “Equation of Exchange,” which was expressed by Irving Fisher as


where M is the quantity of money, V is the velocity of circulation, T is the volume of trade in units, and P is the average price per unit.124

There can hardly be any question as to the mathematical validity of this equation. If we multiply the value of the existing stock of money by the number of times this stock was used during a specified period, we arrive at the total money value of the transactions during this period. Then if we multiply the total number of trade units involved in these transactions by the average price per unit, we must necessarily arrive at the same total. But the meaning of the equation is another manner. The conclusion which the supporters of the Quantity Theory draw from it, the conclusion that the price P is a function of the quantity of money M is totally unwarranted. As long as V is free to vary-which is true now, and will continue to be true as long as the use of money continues to follow anything like the present practice-price is a function of MV, not of M alone.

As it happens, there is an equation of exactly the same kind in the physical field-indeed, it is identical with the Equation of Exchange except in the letter symbols that are used-and a comparison of the conclusions which the economists draw from their equation with those which the scientists draw from exactly the same equation provides a graphic illustration of the reason why the attempts that have been made by economists to apply scientific methods to their field have been so uniformly unsuccessful. The equation which represents the behavior of the general properties of gases, the general gas equation, as it is called, is expressed as


If scientists employed the same reasoning as the economists they would deduce from the gas equation that the gas volume V is determined by the temperature T. But we do no such thing. On the contrary, we recognize that the pressure P is free to vary. The gas can occupy any volume at any temperature within the range of values in which the equation is applicable. In this instance, as in so many others, the economists have adopted a scientific form, but do not apply the scientific reasoning without which the form is useless, and consequently they arrive at conclusions that are totally different from those which the scientist draws from the same premises.

Most modern economists realize that there is something wrong with the Quantity Theory. Keynes, for instance, comments plaintively on “the extreme complexity of the relationship between prices and the quantity of money, when we attempt to express it is a formal manner.”125 Samuelson points out (correctly) that the “key issue is whether V is constant,” and notes that “one of the tenets of monetarism is that V is relatively stable and predictable.”126 As he no doubt realizes, there is no evidence to support this conclusion. It is simply an assumption introduced to reconcile the Equation of Exchange with the products of supply and demand reasoning. The Federal Reserve publication previously quoted has this to say:

In assessing the effect on economic activity of changes in the money supply, it is important to recognize that there is no simple automatic measure of the appropriate relationship between the amount of money outstanding and the level of economic activity. A given volume of money, for example, can be associated with either higher or lower levels of spending-that is, can finance more or fewer transactions-depending on how often it is used.127

Here we have at least a partial recognition of the fact brought out in the previous discussion: that any volume of business at any price level can be financed by any quantity of money, as long as there is enough money on hand to reach all individuals who have use for it, just as any quantity of water can accomplish the task of cooling the engine as long as there is enough water in the system to reach all of the parts that are to be cooled. But few of the present-day “experts” are willing to give up the idea that the quantity of money must have something to do with the situation, and even the statement quoted above, which cuts the ground out from under the Quantity Theory as a whole, still implies that some “appropriate” relation exists.

The credence given the Quantity Theory is spite of its lack of validity stems largely from the observation that substantial increases in the money supply almost invariably do increase the flow of consumer purchasing power and therefore do raise prices. Those who have noted these price increases or decreases have jumped to the conclusion that the variations in the quantity of money are the cause of the price changes. This kind of reasoning, concluding that since B follows A, it must have been caused by A, is a well-known logical fallacy. There is no assurance that such a conclusion is valid. In the case under consideration it is completely in error.

Increases in the quantity of money raise prices only to the extent that they add to the stream of money purchasing power flowing to the markets. New money that is not used in this way has no effect on the price level. If it goes directly into bank reserves, for example, it has the same status as if it had not been issued at all; it is merely stored in a different reservoir. The reason why most injections of new money into the system are inflationary is that the new money is almost always created for the purpose of providing additional money purchasing power for governments or individuals who wish to buy more goods than they have money to pay for. This means that the new money goes immediately into the markets and does raise prices. Nevertheless, it is not the creation of additional money that causes the inflation; it is the increase in the flow of money purchasing power, the effect of which is no different from that of an increased flow resulting from withdrawal of existing money from bank storage.

Credit transactions increase active purchasing power only to the extent that the money thus made available gets out into the purchasing power stream; that is, constitutes a net withdrawal from the money reservoirs. The measure of the additions to the current flow of money purchasing power due to bank transactions is neither the total loans, which are reservoir outputs, nor the total deposits, which are reservoir inputs, but the difference between the two, the net change in the bank reserves. Except as additional credit money may be issued, this difference between loans and deposits cannot exceed the amount of liquid capital put into the bank by its owners. It follows that bank credit as such (exclusive of the transactions that depend on the issuance of credit money) does not draw upon any new money purchasing power. It is merely a device whereby money already existing as bank capital and deposits can be withdrawn from storage and put to current use.

This means that bank credit by itself is not inherently a disturbing factor in economic life. On the contrary, it serves to some degree as a dampener of the fluctuations that would otherwise be caused by variations in the amount of money storage. But the economic effect of bank credit has been completely changed by the adoption of practices that make it possible to vary the amount of credit money issued through the banks practically without limit.

The term credit money, as herein applied, refers to any medium used for monetary purposes that does not constitute money in its own right (intrinsic money) and is not a representation thereof (token money). Currency is token money to the extent that it is covered by intrinsic money in the vaults of the issuing agency. It is credit money to the extent that it is not so covered. Coins are intrinsic money to the extent that the metal of which they are composed would be accepted as money without the imprint. They are credit money to the extent that value is added by the imprint.

Here we meet one of those curious theories so abundant in economics which are based on assumptions that are obviously unsound when they are isolated and subjected to examination, yet have such attractive prospects of getting something for nothing that they are continually cropping up in one form or another, and are seldom without a substantial body of support. There is one school of thought which objects to a classification such as that set forth in the preceding paragraph on the ground that currency backed by any other kind of tangible value is just as sound as currency backed by gold, and is the full equivalent of the latter. In its simpler forms this monetary theory is usually associated with the name of John Law, a Scottish financier of the eighteenth century.

Even in that day, the general public, finding themselves without money enough to buy everything that they would like to have, had lost sight of the fact that it was their inability to produce more goods that was limiting their purchasing power, and were blaming the shortage on an insufficient supply of money. It had already been demonstrated by costly experiments that simply printing additional money without adequate backing was disastrous, so much attention was being given to devising other means of accomplishing the same end. John Law argued that land, for instance, is just as truly an item of value as gold, and therefore currency backed by land values would be just as sound as currency backed by gold. In either case, the currency is only a claim against the underlying values. As might be expected, Law did not get a chance to experiment with his theories in conservative Scotland, but transferred his base of operations to France, and for a time was highly successful.

Finally his activities culminated in a wild orgy of speculation in the shares of one of his companies whose assets consisted mainly of concessions in the French possessions in the New World. Speculative values in what is now known as the Mississippi Bubble reached astronomical heights, and collapsed just as completely when the bubble burst, bringing widespread ruin in France, and disaster to John Law. Since that time “Lawism,” the issuing of money on the basis of values other than metallic money, has generally been regarded as basically unsound. For the purpose of clarifying the relation of the credit process to the operation of the economic mechanism, however, it is desirable that we should recognize just where John Law’s theory was defective.

If the holder of convertible gold-backed currency decides that he wants something more tangible, and turns it in for gold, the transaction is closed at that point. He has received what he wanted, and no value is lost in the exchange, even if many other currency holders decide to do the same thing at the same time. But if the currency is backed by land values, the holder is not through when he has converted it into the ownership of a parcel of land. Land is not money and is not accepted as such. In order to obtain a form of purchasing power that is readily usable it is necessary to sell the land, and this introduces a very large element of uncertainty into the transaction. There is no assurance that the land can be sold for an amount equal to the face value of the currency. On the contrary, it is all too likely that forced sales by those wanting to convert their currency into intrinsic money will seriously depress the price level, with the possibility of a panic always just around the corner.

The fallacy in Law’s theory lies in its assumption that a representation of a physical commodity or asset has properties which that commodity or asset itself does not possess. When we get down to fundamentals it is clear that currency based on a commodity can constitute money only to the extent that the commodity itself constitutes money. Currency based on gold is money because gold is accepted as money. Currency based on land is not money because land is not accepted as money. It is true that currency ostensibly based on land may be accepted as money for a time, but this in not because it is backed by land values; it is because the credit of the issuing agency stands behind it. In the final analysis, currency backed by anything other than intrinsic money rests upon credit. As long as the credit of the issuing agency is good-that is, as long as the public has confidence that the currency will be accepted at its face value as money-the currency is also good, but when that credit falters, the currency goes down with it, regardless of the backing that it is supposed to have.

An interesting point in this connection is that the Federal Reserve notes, the principal U. S. currency, are money of the John Law type. To the extent that this currency has any backing at all, aside from the credit of the U. S. government, it is issued on the strength of commercial credit instruments which are “rediscounted” by the member banks of the system. This is John Law’s plan in slightly different dress. It is successful in this instance only because the government credit is good.

The outstanding characteristic of credit money from a functional standpoint is that there are no limitations on its volume. Other kinds of money are limited by physical factors. There is relatively little fluctuation in the total supply of intrinsic money. Except for the net change due to additions from mining operations and losses by diversion to industry, etc., the total world stock of the monetary metals remains constant. Issuance of token money does not add to this total, as this token money is merely a representation of a now immobilized store of intrinsic money. But the supply of credit money can be increased or decreased at will without any physical limitations.

From the principles developed in the preceding pages it is apparent that the significant effect of issuing or retiring credit money, in actual practice where the new money is always created for the specific purposes of financing additional spending, is to vary the flow of purchasing power to the markets. In the terms used in this study, these monetary operations constitute purchasing power reservoir transactions. When new money is being issued and poured into the purchasing power stream, prices rise. When existing money is being withdrawn from the stream and retired, prices fall, not because the quantity of money has been altered, but because the rate of flow has been changed.

A very important point in this connection is that no type of inflation or deflation increases or decreases purchasing power in terms of goods; any change is solely in terms of the circulating medium. When additional credit money is created for spending in the goods markets, this does not enable buying more goods; the same amount of goods is bought at higher prices. Purchasing power in terms of goods is not determined by the amount of money available for spending, but by the amount of production. The community as a whole is able to buy the volume of goods produced; no more, no less (aside from the relatively minor variations due to goods storage). If the quantity of goods V is given a price P in the production market by establishing an average wage rate, then the suppliers of production services receive, for these services, an amount of money purchasing power B, which is equal to the product PV, and is therefore just sufficient to buy all of the produced goods at a market price equal to the production price P. Under these equilibrium conditions the market price is determined solely by the production price-that is, by the wage rate-and it is completely independent of the total amount of money in the system. But if more credit money is issued and used in the markets, so that the active purchasing power is increased from B to cB, then the price level rises from P to cP because the credit transactions increase only the flow in the money purchasing power stream and leave the flow of goods at the original level V.

Credit is basically a transaction between individuals, irrespective of how complicated the actual credit mechanism may be. The ability of one individual to consume before he produces is entirely dependent on his ability to gain access to goods previously produced by other individuals. The economy as a whole has no such outside source of goods (aside from foreign transactions, which we will consider later), As a community we must produce first and consume afterward. We therefore have

PRINCIPLE XV:Credit can make goods available to one individual or group of individuals only by diverting them from other individuals.

The significance of this principle is that any purchasing power in terms of goods that may be obtained by means of new issues of credit money can only be exercised at the expense of those who take part in the production process: workers and suppliers of capital services. If the government issues more currency, it is able to buy goods therewith, or to provide subsidies to individuals or groups which they can use to buy goods, but the ability of recipients of normal income (wages, etc.) to buy goods is decreased proportionately. This fact is generally recognized in the case of severe currency inflation, as it has been demonstrated over and over again in actual practice, but it should be realized that this is a general principle which applies to all money inflation, including that resulting from banking transactions. New credit money obtained from the Federal Reserve and loaned by the banks has buying power only to the extent that the buying power of current income from other sources is decreased. The new currency increases money purchasing power, but it does not alter the real purchasing power: ability to buy goods. Principle XV cannot be evaded; credit can make goods available to one individual only by diverting them from other individuals.

The result is the same when the bank lends money deposited by its customers-that is, the depositors must forego the use of their purchasing power in order to make it available to the borrowers-but in this case the depositors are parting with their purchasing power only temporarily, and they are doing so knowingly and voluntarily. On the other hand, when the bank lends money from new currency issues, the purchasing power attached to this new money is permanently abstracted from consumers in general through the mechanism of an inflationary price rise, without their consent, and, under present conditions, without their knowledge.

The truth is that money inflation due to new currency issues is a tax. It has exactly the same effect as a tax on business; that is, it diverts a portion of the income of the consumers, by means of an increase in the general price level, to the government (if the government is the money-issuing agency, as it is in modern practice). Since the new money can be issued without the knowledge of those that are being taxed, this method of meeting part of the costs of government is increasingly being used by governments whose popular support is doubtful, and might not withstand the antagonism with which a tax increase would be greeted. It has not yet become a substitute for taxation in the United States, except in wartime (the Civil War “greenbacks,” for instance), but the operations of the Federal Reserve system have the peculiar effect of allowing the banks to accomplish the equivalent of taxation to finance business expansion.

As long as the demand for new loans does not exceed the available bank reserves, each loan amounts to a temporary transfer of funds from one individual (or agency) to another, and there is no effect on the incomes of the general public. However, if the demand for loans becomes greater than the banks are able to meet from funds on hand, some of the credit instruments that they have been holding are “rediscounted” with the Federal Reserve, which issues new money on the strength of this collateral. As brought out in Chapter 12, the entry of this new money into the active purchasing power stream raises the market price level, which means that consumers in general are (without realizing it) supplying the purchasing power requirements of the business enterprises out of their own individual incomes. If the upward and downward phases of the business cycle were symmetrical, the consumers (not necessarily the same individuals) would recapture their losses when the volume of loans again contracted and the banks paid off their obligations to the Federal Reserve, but the lack of symmetry previously noted prevents this balancing of the accounts if the cyclical swing is anything more than a minor movement. Thus we have here another reason why steps should be taken to control the cycle.

An important corollary of Principle XV is that purchasing power (in terms of goods) cannot be transferred from one time to another. It is commonly assumed that we have the option of spending today’s income today or saving it for some future time. The individual obviously can and does exercise this option, but, aside from the saving that takes place automatically in the production of durable goods, the community as a whole cannot do so, beyond the very minor degree that producer storage of goods is feasible. Storage of the circulating medium does not aid in the purchase of tomorrow’s output of goods, since tomorrow’s production in itself generates all of the purchasing power that is necessary for buying the goods produced, and any additional amount of money purchasing power issuing from storage is not only superfluous but detrimental to the operation of the economy.

The foregoing comments apply specifically to goods as defined in Chapter IV; that is, things that satisfy human wants. However, we must also take into account certain things which have some of the properties of goods, although they cannot qualify under this definition. Unfortunately, the economic profession, not having looked at these items in the way in which they will be treated in this work, has not devised any terminology that will enable us to draw the distinctions that are vital to the inquiry, and it will therefore be necessary to coin some new terms. The characteristics of these quasi-goods on which the classification will be based are the same as those applying to the corresponding forms of money, and to emphasize the analogy and contribute toward a clear understanding of the presentation, the equivalent terms will be used. In addition to those goods which qualify as such in their own right, and have a standing analogous to that of intrinsic money, there are token goods and credit goods.

The term “token goods” will be used to refer to those things which are representations of goods actually existing. Included in this class are stocks, bonds, mortgages, warehouse receipts, and similar instruments. This classification should not be confused with the question of legal title. Bondholders, for instance, do not have legal title to the property involved, but the bonds do represent a certain portion of the value of the property; that is, they represent actual tangible wealth. While the bonds are outstanding, the values behind them cannot be made the basis for other such instruments. A ten million dollar corporation with three million dollars in bonds outstanding cannot persuade anyone that its stock is worth ten million dollars.

Creating token goods or retiring them does not alter the total amount of goods in existence. If a hundred thousand dollar home is mortgaged for fifty thousand dollars, this does not mean that there is now 150 thousand dollars worth of property that can be bought and sold; the total value is still one hundred thousand dollars. What has actually been accomplished is to split the hundred thousand dollar property into a fifty thousand dollar mortgage and a fifty thousand dollar equity, either of which can be sold independently of the other. The great bulk of present-day credit transactions, aside from commercial accounts, involve the creation of such token goods, and these transactions only take place to the extent that capital assets are available to back up the token goods. As the cynic puts it, a bank is a place where you can borrow money if you can prove that you don't need it. Even though it was meant to be humorous, this definition is not without its merits. It calls attention to the point that bank credit is not normally available for the purpose of furnishing purchasing power to those who do not have it, but rather to provide a convenient means whereby those possessing purchasing power in some other form can temporarily exchange it for money.

As in the case of money, however, it has been found possible to create instruments which appear to be of the same character, but which rest entirely on the credit of the issuing agency rather than on actual physical assets. Government bonds are the outstanding example. These credit goods differ from token goods in that their creation is not limited by the physical realities. Since the creation of token goods does not alter the total amount of goods that can be bought and sold, the total volume of goods flowing to the markets remains just the same as if these goods did not exist. But the creation of credit goods is another form of reservoir withdrawal. It swells the stream of goods and hence has the same effect on the markets as the withdrawal of real goods from producers’ storage. The volume of goods V now becomes eV, and if B is unchanged price P drops to P/e. The new equilibrium equation is

B/eV = P/e

But B does not normally remain unchanged, as the purchasing power obtained by the sale of credit goods is generally used in the markets. The original price P is then restored.

eB/eV = P

What has been accomplished by this credit transaction is that a volume e-1 of real goods has been obtained by the issuing agency without the need to make any monetary payment, and the individuals who would otherwise have received these goods now have the credit goods (government bonds or similar instruments) instead. The issuing agency, usually the government, has thus obtained something for nothing-at the expense of someone else, as always. Credit goods, like credit money, are basically a device for accomplishing this purpose-getting something for nothing. Governments faced with abnormal expenditures or with insufficient revenues find it politically expedient to meet their financial problems by some means which do not involve direct levies on the citizenry. In earlier times the preferred answer was a resort to the printing press, and this solution of the problem is by no means out of fashion even yet, as a glance at the financial picture around the world will readily verify. But it has become quite clear that currency inflation plunges the nation into deeper trouble, and the more advanced governments have turned from credit money to credit goods as the best means of avoiding unpleasant realities.

The essential difference between government and private borrowing is that the private borrower is not permitted to evade these realities. He cannot, except in rather unusual circumstances, obtain money on pure credit. He must put up some kind of tangible security for the loan. What he actually does is to sell some asset on a temporary basis. The individual who borrows $20,000 on the strength of a mortgage on his home is, in effect, selling a $20,000 share of the ownership with an agreement that he will repurchase it after a specified period of time. Private credit transactions thus deal with real values; they involve the sale and purchase of token goods. Most government credit transactions, on the other hand, deal only with fictitious values; they involve the sale and purchase of credit goods.

The advantage, from the government standpoint, of raising money for spending purposes by selling bonds rather than by taxation is that the former conceals the true situation and postpones the day of reckoning to some future time when the task of putting the financial house in order will fall on other shoulders. As indicated by the equation eB/eV = P, sale of government bonds in the markets does not alter the general price level as long as the government spends the proceeds in the market. These and other credit goods have all of the economic characteristics of real goods up to the time of consumption, and the effect of their entry into the system is the same as if there were an increased production of physical goods. But the bonds cannot be consumed. Unlike real goods, they must be put back into the system and converted to something else before they can yield any utility. They amount to no more than a claim against production, and they cannot be used except when and as workers and suppliers of capital give up real values to make the fictitious values good. To the government of the future there falls the embarrassing choice between two unpleasant alternatives: higher taxes or inflation. Either taxes must be raised enough to provide the money for redemption of the bonds, or new money must be printed.

One of the most unfortunate features of this situation is that the era of reckless finance, when the wealth of the nation is standing still or even slipping downward, has the appearance of prosperity, whereas the convalescent period, when sound progress is actually being made, is viewed as a trying and difficult time. This false and misleading impression is actively aided and encouraged by the prevailing methods of compiling economic statistics, which take price level variations only in an incomplete manner, and totally ignore the factor of credit goods. The level of money income has no real meaning in itself; it is significant only in relation to the price of goods. Economic well-being must be measured in real income, not in money income. In order to arrive at a measure that is representative of the true situation it is necessary to correct money income and money wages not only for the full change in the price level, but also for the amount of fictitious wealth that has been accepted in lieu of real wealth.

When we do this and get a true picture of the actual conditions, many of the anomalies that seem to exist in economic life are cleared up. We no longer have to wonder how it is possible to have “prosperity” in wartime, why labor can make “gains” and business can pile up profits while we are devoting most of our energies to destruction. It now becomes clear that there was no prosperity for the nation as a whole; there were no gains. What we saw was a mirage: an illusion created by government finance that must inevitably be followed by disillusionment. If we are to keep our feet on the ground during difficult periods of readjustment, it is necessary to realize that our headache is not due to the doctor’s medicine. It originated at a time when everything looked rosy.

The foregoing comments should not be interpreted as a condemnation of all use of government bonds and other forms of credit goods. It is not the use, but the misuse, of such devices that causes trouble. In reality, the practicability of creating credit goods which are the equivalent of real goods from the market standpoint provides a very convenient means of regulating the purchasing power stream. By issuing government bonds, selling them in the markets, and then retiring the currency received in payment, we can substitute credit goods for credit money, and diminish the purchasing power stream by the necessary amount. Likewise, by issuing new currency and repurchasing the bonds in the markets we can reverse the transaction and increase the flow of purchasing power.

If there is an inflationary withdrawal from the consumer purchasing power reservoirs which raises B to cB, market price would normally increase from P to cP, but by selling government bonds in an amount e, where e = c, and retiring an equivalent amount of currency, the market price can be held constant at the original level

cB/eV = P(c = e)

The outstanding advantage of this method of purchasing power control is that no individual gains or loses by the transactions. The exchanges that take place simply substitute an asset in one form for an asset of equal value in another form, and the desired effect on the economic system is accomplished without disturbing other economic relations. Facilities for handling transactions of this kind have already been set up under the auspices of the Federal Reserve System, and the use of these open market operations in a more systematic and organized manner for economic control purposes will be discussed at length in Chapter 25.

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