The debate over the latest policy actions from the ECB has once again reminded me about one of the oldest failures in monetary debate – the confusion 0f money and credit. This has been very visible in the discussion about monetary policy over the past six years both in Europe and the US.
The confusion of money and credit again and again has caused central banks to make the wrong decisions implementing credit policies and mistaking it for monetary easing.
I should really write a blog post on this, but it has already been done. Our friend and Market Monetarist blogger Bill Woolsey did it back in 2009. Bill used to be a student of Leland Yeager who back in 1986 wrote the ultimate paper on this issue with Robert Greenfield – Money and Credit confused: An Appraisal of Economic Doctrine and Federal Reserve Procedure.
I stole this from Bill’s 2009 post Money and Credit Confused. Bill explains the crucial differences between money and credit very well:
Money is the medium of exchange. The quantity of money is the amount of money that exists at a point in time.
The demand for money is the amount of money that people want to hold at a point in time. To hold money is to not spend it.
The supply of credit is the amount of funds people want to lend during a period of time.
The demand for credit is the amount of funds that people want to borrow during a period of time.
An increase in the demand for money is not the same thing as an increase in the demand for credit.
An increase in the demand for credit means that households and firms want to borrow more. While it is possible that they want to borrow money in order to hold it, the more likely scenario is that they borrow in order to increase spending on some good or service, including, perhaps some other financial asset.
An increase in the demand for money could result in an increase in the demand for credit. People might borrow money in order to hold it. However, the more likely scenario is that people demanding more money will reduce expenditure out of current income, purchasing fewer other assets, goods, or services. Of course, they could also sell other assets.
An increase in the supply of credit isn’t the same thing as an increase in the quantity of money. While it is possible that new money is lent into existence, raising the quantity of money over a period of time while augmenting the supply of credit, it is also possible for the supply of credit to rise without an increase in the quantity of money. Purchases of new corporate bonds by households or firms, for example, adds to the supply of credit without adding to the quantity of money.
Because shifts in the share of the total supply of credit associated with money creation are possible, the quantity of money can rise over a period of time when the supply of credit is shrinking.
There are relationships between the supply and demand for money and the supply and demand for credit, both in disequilibrium and equilibrium. But money and credit are not the same thing.
As Bill notes – the first rule of monetary policy is not to confuse money and credit. Unfortunately central bankers do it all the time.
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Update: A friend of mine thinks the ultimate discussion is not Yeager, but this one: Currie, Lauchlin. “Treatment of Credit in Contemporary Monetary Theory.” Journal of Political Economy 41 (February 1933), 58-79.
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/ June 12, 2014Superficial.
Here’s Leland J. Pritchard’s (Ph.D., Chicago, Economics, 1933) formulation:
THE SAVINGS-INVESTMENT PROCESS OF THE COMMERCIAL BANKS CONTRASTED TO THAT OF FINANCIAL INTERMEDIARIES:
(A) The commercial banks create new money (in the form of demand deposits) when making loans to, or buying securities from the non-bank public; whereas lending by financial intermediaries simply activates existing money.
(B) Bank lending expands the volume of money & directly affects the velocity of money, while intermediary lending directly affects only the velocity.
(C) The lending capacity of the commercial banks is determined by monetary policy, not the savings practices of the public.
(D) The lending capacity of financial intermediaries is almost exclusively dependent on the volume of monetary savings placed at their disposal. The commercial banks, on the other hand, could continue to lend if the public should cease to save altogether.
(E) Financial intermediaries lend existing money which has been saved, and all of these savings originate outside the intermediaries; whereas the commercial banks lend no existing deposits or savings: they always, create new money in the lending & investing process.
(F) Whereas monetary savings received by financial intermediaries originate outside the intermediaries, monetary savings held in the commercial banks (time deposits & the saved portion of demand deposits) originate, with immaterial exceptions, within he commercial banking system. This is demand deposits constitute almost the exclusive net source of time deposits.
(G) The financial intermediaries can lend no more (and in practice they lend less) than the volume of savings placed at their disposal; whereas the commercial banks, as a system, can make loans (if monetary policy permits & the opportunity is present ) which amount to several times the initial excess reserves held.
(H) Monetary savings are never transferred from the commercial banks to the intermediaries; rather are monetary savings always transferred through the intermediaries. The funds do not leave the banking system.