Credit money

Credit money is any claim against a physical or legal person that can be used for the purchase of goods and services.^[1] Examples of credit money include personal IOUs, and in general any financial instrument or bank money market account certificate, which is not immediately repayable (redeemable) in specie, on demand.

Credit money is naturally used as money, and may even be the primary type of money. Banknotes which are not backed by specie (see fiat money for the latter case), may be categorized as credit money, whether or not they are legal tender, inasmuch as they are simply promissory notes issued by a certain bank, or system of banks.

Today many countries' central banks or financial regulators do not impose reserve requirements on banks during the day, such is the case in the United States, and in other countries like the UK there is no reserve requirement. In these cases, the textbook representation of fractional reserve banking becomes inapplicable. As Werner (2005) and others point out, this demonstrates that each bank has the power to create credit (and hence money).^[2][3]

Examples of credit money

An example of a credit money banknote which is not legal tender is seen in Scotland, where banknotes from a well-trusted bank function as currency. Scotland technically recognizes no legal tender, and thus functions nationally on private banknote credit money, which is represented by promissory Pound Sterling notes. These notes are issued by three major Scottish banks (among them the Bank of Scotland), however these banks must hold deposits with the Bank of England to cover the notes they issue. Bank of England notes are also not legal tender outside of England and Wales, however they are universally accepted in the rest of the UK, and legally are obligations of the Bank.

In the United States during the Great Depression, trust in banks dropped very low, and there was the risk of a bank run on a private or state-banks. In the United States, the Federal Deposit Insurance Corporation was created in 1933 to insure deposits in checking and savings accounts,^[4] thus effectively making the federal government the final creditor for bank-drafts and promisory notes issued by all participating banks and credit unions.

In the case of legal-tender banknotes, the issuing bank is generally the central bank or reserve bank of a government, which, by authorizing the note as legal tender, assumes the role of creditor. For example, in the United States, paper currency consists of Federal Reserve notes, which are banknotes issued by the Federal Reserve system of privately owned central banks. These banknotes are liabilities of the Federal Reserve, and obligations of the United States.^[5]

In terms of the money supply, credit money is generally associated with that part of M2 which is not M0.

Credit money in history

Credit money is at least as old as banking, namely about 5,000 years. In ancient Babylon (3rd Millennium BC), temples often acted as banks. Banks have for centuries served as the main creators of the money supply. This also has given them powers to allocate credit. Prominent banking systems with flourishing credit money supplies include ancient Egypt, Greece and Rome.^[6] During the Crusades in Europe, precious goods would be entrusted to the Roman Catholic Church's Knights Templar, who effectively created a system of modern credit accounts.

See also

• Fractional-reserve banking
• Money creation
• Credit
• Credit creation

References

1. ^ Mises, Ludwig von. The Theory of Money and Credit. Indianapolis, IN: Liberty Fund, Inc.. 1981, trans. H. E. Batson, 1981. [Online] available from http://www.econlib.org/library/mises/msT1.html; accessed 9 May 2007; Internet. Chapter I, section 3, paragraph 25.
2. ^ Richard A. Werner (2005), New Paradigm in Macroeconomics, Basingstoke:Palgrave Macmillan
3. ^ "Paul Tucker, Money and credit: Banking and the Macroeconomy". Bank of England. http://www.bankofengland.co.uk/publications/speeches/2007/speech331.pdf. " Subject only but crucially to confidence in their soundness, banks extend credit by simply increasing the borrowing customer's current account, which can be paid away to wherever the borrower wants by the bank 'writing a cheque on itself'. That is, banks extend credit by creating money. This 'money creation' process is constrained by their need to manage the liquidity risk from the withdrawal of deposits and the drawdown of backup lines to which it exposes them. Adequate capital and liquidity, including for stressed circumstances, are the essential ingredients for maintaining confidence ...'" 
4. ^ Federal Deposit Insurance Corporation (2006-07-24). "FDIC: The First Fifty Years (Chapter 1)". FDIC. http://www.fdic.gov/bank/analytical/firstfifty/chapter1.html. Retrieved 2007-01-15. 
5. ^ US Treasury. "US Treasury - FAQs: Legal tender status of currency". US Treasury. http://www.treas.gov/education/faq/currency/legal-tender.shtml. Retrieved 2009-02-21. 
6. ^ Richard A. Werner (2005), New Paradigm in Macroeconomics, Basingstoke: Palgrave Macmillan