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How can money be a debt?

by on 23/06/2018

The economists claim, that the debt is in its essence the basis for money. Such a claim has to sound like esoteric alchemy to non professional ear. 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 the economist speak about government debt created through deficit and debt created by commercial banks in form of bank credit as the money creating debts.
Let’s assume 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 so, that the product at its final stage 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 the raw materials to the final product, including investment to production and infrastructure facility, until completed product reaches its final allocation to the hands of the consumer. Let’s call this instrument money. The money, will have to have universally accepted exchange value. Yet, even if money has universal exchange value, and it represents for both sides of the deal, the seller and the buyer, the same value, and they came to an agreement as to the price of the exchanged item, we are still left with one problem to solve, discrepancy between purchaser and suppliers timeline. Most of the times the purchase of the product and the transfer of the equivalent exchange value, money, doesn’t happens in the same time. It happens, that within the act of exchange, there is a need for prepayment to the supplier, so the product could be produced and supplied to the purchaser in the future, or vice versa the product will be supplied, while still not paid, and the actual payment will be in the future. So either the money is transferred before the exchanged item is supplied, or vice versa. It doesn’t matter what discrepancy is between the timelines of the money transfer, compared to goods or services transfer, it causes in each case immediate situation of borrower and lender.

But then the lender side in the exchange is accepting within the deal two utility disadvantages if compared to the borrower. The first is the risk, that the product will never be supplied, or other risk, that the product will not satisfy the needs of lender-purchaser, even if paid for it it’s price in advance. On the opposite case the supplier has the risk, that he will never be paid for the product, it already supplied. The second disadvantage is, that the lender, be it the purchaser or the seller, has to postpone certain satisfaction of immediate needs, for getting the payment or the product in the future.
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 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 one wants unfairly exploit temporary opportunities, and 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 the cheaters, who’s act is short term). But then how can it be fair, that supplier is supplying the product for delayed money transfer, or money transfer is previous to the product supply a fair deal? In both cases it looks obviously as an unfair practice, or what should be considered as an unbalanced deal. How can exist such inconsistency in the market economic system, when the foundation of market economic systems stands on the absolute need of equivalent utility of every side of any economic deal?

Here comes to rescue the interest, paid by the borrower to the lender. The interest doesn’t have to be in form of interest payment. It can be in form of discount given to the purchaser on item price in case of cash deal,  or increased price for postponed payment.

Where are borrowers and lenders there is debt. The question is. does such a debt necessarily create new money to the economic system? Until the buyer and the supplier pay in exchange with already existing money, the answer is no. But if a bank is involved in the deal, by giving credit to over-bridge the time delay between the product transfer and the money transfer, this loan of the bank will create new money. This statement has to be explained.

But before to explain how commercial banks create money out of debt, we have to ask, 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 collecting money, prints money, that is form of security paper, that the government guaranties, with all it’s authority, (assuming that the government does have authority) the right to purchase anytime in the future, any kind of economic item, in exchange against this government security paper called Money. Since this security paper (money) is transferable against any economic item in any time without delay, it is form of debt obligation of the government to secure the equivalent purchase value, to the face value represented on the face of the money.

The government in principle should secure, that the money will represent in the future the same exchange value as today. To do so it promises, that it will limit itself with printing money or debt obligations to level, that the dept it creates will not exceed the capacity of debts repayment in form of economically valuable 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 or government obligations purchase power. It has to be said, 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.

The next step is, that 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 repeating so. Most probably the one who received payment from the previous depositor will immediately deposit back to the bank vault the money he received. In the modern banking, where no real cash is involved in the process, the money actually never lefts 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 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, either in circulation or in potential circulation. So the bank loans, that are debts 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. 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. From this also is obvious, that the major asset of the banks are his trustworthy 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. For this the government created a department, called Central Bank, that are the lenders of newly printed money to the government to enable the government to pay for additional services, without to rise taxes, the government provides to the citizens, against it 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 originally issued these securities. 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 by doing this, 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. B. Banks, that circulate repeatedly the original deposit, its source is 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 it creates debts of non financial entities to the banks, against which it creates money in form of credit, it gave to the same non financial entities.

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