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How can money be a debt?

by on 23/06/2018

The economists claim, that in the essence of the money stands debt. Such a claim has to sound like esoteric claim to an ear of non professional. How can debt, that has negative value become money, that has positive value? It sounds like the story of alchemists, who tried to transform droppings to gold. So i would try in short assay to explain in understandable way for every ear, why is it so and what does it means, when an economist claims that money is debt?

To start with, it has to be understood, that when the economist speak about debt, they mean debt caused by government deficit, the credit given by commercial banks, that  is an other form of debt of non financial businesses or private households with capacity to create money.

At first let’s start with government deficit, and with assumption, that we have a modern economy in its starting point, with potential complexity as we know it today, with all its capacity to produce and allocate the products to its final stage, when it reaches its final destination, the consumer. To achieve this, we need some instrument of exchange, that will be acceptable to the seller and the purchaser, during the whole process of production, from it’s  form of raw material, to the final product, including investment to production and infrastructure facility needed to produce and allocate the product to its final destination. Let’s call this instrument Money. To make it happen, the money, will have to have universally accepted exchange value.

By definition, economic act is about exchange of economically valuable items in terms, that give the same level of satisfaction to purchaser and seller. It doesn’t have to happen every time and in every deal, but in long run in average it has to be so, otherwise the unsatisfied side will look for better deal, and by doibg so, it will cause change of the price of the economic item. The engine behind this price system is, that no one likes to be sucker, and we also assume, that no the long run everyone is looking for a fair price deal. If the purchaser, who bought an item A for price a, finds out, that his friend bought the same item for less, he will demand next time the reduced price. and vice versa. If this short description of price theory seems acceptable, the conclusion is: the price of any deal, will always represent a balance between buyer and supplier, or in economic terms equilibrium (except in case of suckers and cheaters, who’s act is short term).

Now it’s time to start to ask the question, “how government creates money out of debt?”. Let’s assume the government wants to give service to the citizens of a country, and it doesn’t want to make the citizens angry by rising taxes. So the government instead instead of increasing taxation prints money, that is form of security paper, with which the government guaranties, its face value against any economic item, soled within the borders of its sovereignty, in any time without delay. To give to money this universal exchange value, this security paper (money) has to be transferable between third parties without governments intervention. The government uses all it’s authority and enforcement power, to secure the exchangeability of the money at present, or anytime in the future, within the borders of its sovereignty, against any kind of economic item.

The government in principle should secure also, that the money will represent in the future the same exchange value as today. To do so it promises, that it will limit itself in its policy of money printing, or debt obligations creation, to level, that the dept it creates, and is monetized by currency it emites, will not exceed the capacity of debts repayment in form of economically valuable exchangeable items. Unfortunately there are many precedence in economic history, that governments didn’t keep this promise, usually under pretend of necessary war, and they then created inflation, that in other word is degradation of money value purchase power. It has to be emphasized, that money not necessarily is used as instrument of economic exchange between government and private entity. In contrary, most of the exchange is between two private entities, who both believe in government’s capacity to fulfill its obligation to supply or enforce non governmental entity to supply the demanded economic item, against transfer of money for freely agreed price.

When a commercial bank is involved in the act of exchange, and it is giving credit to over-bridge the time delay between the product production from its start until transfered to the consumer, and the money needed to support this process, this loan of the bank will create new money. This statement has to be explained and we have to explain the banks function in this process.

When the money holder has more money than it needs right now, and he has no plans to purchase right now anything, but rather in the future. So he collects money and probably he wants to keep it safe. The best way to keep money safe is to deposit it to vault keeper, who keeps it for him, and even pays interest on these deposits. The promise is, that the money will stay in the vault until the right time comes for the money owner to use it. Let’s call the vault keeper Bank. The bank within time, collects not only money of depositors, but also statistical information about them, out of which it understands, that not all the deposit holders will come to take out their money from the vault in one moment, but rather one by one in different time period. In the meanwhile, some new depositor will come to deposit their money, and repeatingly so. Most probably the one who received payment from the previous depositor will immediately deposit back the money recieved as payment for its product to the bank vault. In the modern banking, where no real cash is involved in the process, the money actually never leaves the bank, but rather is transferred from one account to another account. So in practice, the banks can give infinite volume of loans, unless the government interferes in the process, by creating limits to the commercial banks.
So in practical terms, the private banks create money, whenever they give a new loan, and when the loan is repaid, they reduce the amount of money available in the economy. This money is either in circulation or in potential circulation.

So the bank loans, that are debts of non financial sector to the bank are becoming new money in the economy. In this system, the privately owned commercial banks became major money creators. If so, why not to print unlimited amount of money to make unlimited profit, that is the only goal of any economic entity. First the banks are limited as to the level of credit they can give by the government, or its monetary tool, the central bank. But more importantly, the banks need to be careful to whom and to what activity they give the loans, not to create bad debts, that will be never repaid and reduce the banks profits. It is assumed, that from that perspective, the privately owned commercial banks are better guardians of money than the government, with different goals than profitability. This is the reason, why the government doesn’t nationalise the banks and provides by itself credit to the economy. To operate in such a way bank, the major asset of the banks is their trustworthiness in eyes of borrowers, that have positive credit history. Maybe this is one of the reasons, why the bank keep information about their clients so close to their chest.

The last question is, who and how in this system knows and decides, how much money a certain economic enclave needs, to secure smooth exchange of goods and services in the economy from the producers to the users, and without to degrade the money’s purchase power. To secure such a monetary system from breaking down, the government created a department, called Central Bank, that is the lenders of newly printed money to the government, to cover government debts, to provide additional services to citizens. Since the government dicided to do it without to rise taxes, the government creates deficit. To cover the deficit,  the government issues to central bank obligatory papers in form of bonds. By doing so, the central bank influxes not only newly printed money into the economy, but also government backed interest carrying securities, that are freely marketed to private investors, on the government security paper markets. One of the major traders on the government securities market is the central bank itself, that was originally issued to cover government deficite, or debt. By doing so, it can regulate the price of the securities, and this influences the level of interest, achievable on these securities according to market prices. Since central bank has unlimited capacity to print money, it can in principle purchase unlimited amount of government securities. By doing so, it will increase the price of the securities, and with it decrease the interest rate achievable on securities. But also influences the interest paid on any other kind of debt of non government entities. The central bank’s goal is to keep the money value fixed, as much as possible, while securing, that most of the economic production capacity, mainly the labour force, of the economic enclave, is fully activated.

Since the government has capacity to print infinite volume of money, its securities are without risk, while all other forms of debts do carry risk. So the height of the interest on government securities pays the lowest interest rate paid in economy, compared to any other kind of debt, available in the financial market.

Conclusion:
A. Government debt in form of government securities-bonds, created to finance deficit, creates newly printed money as opposite value to the deficit the government creates and finances by freely transferable security papers, Money.
B. Banks, that circulate repeatedly the original deposit, its source originates from the once newly printed money against government debts, multiplies this money as many times as it is lending it again and again. So on one hand banks create debts of non financial entities to the them in form of credit, on the other hand this credit is translated to additional money in the monetary system.

 

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