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The following was excerpted, with minor editing, from an article written by the British economist Geoffrey Gardiner for the Post-Keynesian discussion group. It offers a valuable insight into the nature of money and credit.
The first principle of creditary economics is that the division of labor and the practice of granting credit were born as Siamese twins. Once division takes place, the worker inevitably finds himself producing and supplying not for immediate reward, but in expectation of something in the future. He grants trade credit willy-nilly, even if he is part of a command economy. The word credit is Latin for "he trusts" or "he believes," and that is precisely what the producer does when he is a member of a society that has divided labor up. He produces, and he trusts he will get something back. There is an implied promise either by individuals or by the group that he will get something adequate.
A promise to supply in the future some specified thing is of necessity a store of value, and a store of value can serve as a medium of exchange. Debts can be monetized, which means their use as a means of exchange is facilitated. The oldest way of doing this was the tally stick, replaced by the Bill of Exchange when paper became cheap. All media of exchange are debts, but not all debts can be used as media of exchange. For that purpose they have to be assignable without consent.
Government debts are a very popular means of exchange, and they gave rise to the state theory of money. That theory is broadly true, but like all good rules it has exceptions. If the state does not provide a money system, the public will do it for itself, and for much of history the Bill of Exchange has fulfilled that purpose.
Although coins and notes are government debts, they are debts the government has no wish, indeed no intention, of honoring. The British £20 note actually has written on it "I promise to pay the bearer the sum of twenty pounds," and is signed by the chief cashier of the Bank of England. But if you take the note to the chief cashier and demand payment you only receive another twenty-pound note in exchange. Adam Smith noted this phenomenon. He remarked that the man with a sovereign was like a man who held a Bill of Exchange on every trader in his locality.
Coins can be described as anonymous debt tokens or equivalently as anonymous credit tokens. Originally a debt had a named creditor and a named debtor. With the invention of coins, both the creditor and the debtor became anonymous. The holder of a coin is a person who has provided goods and services greater than he has consumed, and the coin represents the difference between the two. So he is a creditor of society. The debtor is anyone who recognizes the debt by supplying goods in return for the coin.
Nowadays the bank note is in the same category. It too is an anonymous debt token even though it looks like a state debt, and even though the Bank of England religiously keeps assets to the same value as the note issue to back them.
Since any debt can be monetized, it follows that monetary economists are remiss in concentrating their attention only on the debts that have been monetized in the form of bank deposits. Creditary economists teach that all credit is important. We call bank deposits the intermediated credit supply, and the rest is the non-intermediated credit supply.
The ability of banks to allow borrowers to create new credit is limited by the capital base of the bank. The belief that it is limited by reserve requirements is a popular myth. The Basel Accord's requirements regarding capital adequacy ratios are vital. But they are not all powerful in view of the ease with which debts can be switched out of the intermediated category. In the modern jargon, they can be securitized.
A failure to pay a debt can have a multiplier effect, causing more failures. The granting of new credit can have a multiplier effect, as the new debt can be used to create secondary debt. That is, the money created can be lent again and again until it is destroyed by being used to reduce debt.
Every act of lending by a bank automatically creates the deposits that will balance it. Therefore every act of real investment that is financed by newly created credit automatically creates the savings to fund it. The way to encourage real investment is to create a favorable environment for it, not by encouraging saving.