Hi Jim, this was a great conversation, looking forward to purchasing your book.
I do have two questions though:
1. When you say that a bank creates money (or credit) out of thin air, why can't an entrepreneur create money out of thin air? Why can't he tell his suppliers that he will pay them back once his project is profitable? Do you address this question in the book? I presume that one answer is that banknotes earn the trust of traders because they trust the bank can redeem them with gold on demand. A second answer is that traders trust the bank's judgment on who to give a loan to. (And as a side question: were banknotes during the 19th century redeemable in all banks, not just the specific bank that issued them?)
2. Wouldn't you think it cognitively easier for people to accept that *credit* is created "out of thin air" versus money? It makes much more sense that a promise is simply "created" on the spot, but money is not: it has to be extracted from the earth, refined, minted, etc. in order to be created. With this distinction in mind, money is never created "out of thin air" (it has to be produced just like other goods), but credit can, and is. I know you adhere to Mises's definition of money, but something to think about when you introduce this topic to people.
Thank you for your clarity on this subject, and for writing the book!
Hi Natan, thanks for the question. Anyone can extend credit, and the receiver of the credit is free to attempt to use it to convey value. For example, I can give you an IOU, which you can try to exchange for something valuable. This is precisely what the goldsmith-bankers did: they relied primarily on their reputation and public trust, which is the main reason their banknotes were accepted as money - a "commonly accepted" medium of exchange. There's no inherent reason a credit instrument cannot be accepted as money on an equal par with its commodity backup. The goldsmith bankers held the public trust. Modern money depends on both public trust and a government banking license, because it is illegal for anyone but a bank to create money. For example, If you tried to pass off my IOU as money, they might arrest you for passing counterfeit. See my Appendix 2 that explains the legal basis of a banking license.
Banknotes were definitely not always accepted by all banks, even banks in the same geographical area. A banknote is a promise by a specific bank to pay out gold on demand. If I present a banknote to a bank other than the one that issued the banknote, this second bank will not honor my demand unless it trusts the issuing bank to pay it. Like other businesses, banks learn to trust and cooperate by clearing and settling accounts with each other; this cooperation contributes to the growth and efficiency of the financial network.
The question of using the term "credit creation" versus "money creation" is a good one. The bank is creating money, which is also a credit instrument. I like to say banks create "money" because their credit instrument really is used as a medium of exchange, as opposed to the credit created by a non-bank which cannot be legally used as money. Some people like to call it "credit money" or "bank money" to distinguish it from the "standard money" that sits in the bank vault or circulates in the economy, separate from the banking system. In the end, I decided to go with Mises's definition and just call banknotes and deposits "money" because that is not only accurate but fits with common usage, so everyone knows what i am talking about: money is exactly what you think it is, it is the contents of your bank account. In my book, I explain this definition of money and why the "medium of exchange" is the most fundamental and defining characteristic of money.
Hi Jim, this was a great conversation, looking forward to purchasing your book.
I do have two questions though:
1. When you say that a bank creates money (or credit) out of thin air, why can't an entrepreneur create money out of thin air? Why can't he tell his suppliers that he will pay them back once his project is profitable? Do you address this question in the book? I presume that one answer is that banknotes earn the trust of traders because they trust the bank can redeem them with gold on demand. A second answer is that traders trust the bank's judgment on who to give a loan to. (And as a side question: were banknotes during the 19th century redeemable in all banks, not just the specific bank that issued them?)
2. Wouldn't you think it cognitively easier for people to accept that *credit* is created "out of thin air" versus money? It makes much more sense that a promise is simply "created" on the spot, but money is not: it has to be extracted from the earth, refined, minted, etc. in order to be created. With this distinction in mind, money is never created "out of thin air" (it has to be produced just like other goods), but credit can, and is. I know you adhere to Mises's definition of money, but something to think about when you introduce this topic to people.
Thank you for your clarity on this subject, and for writing the book!
Best,
Natan
Hi Natan, thanks for the question. Anyone can extend credit, and the receiver of the credit is free to attempt to use it to convey value. For example, I can give you an IOU, which you can try to exchange for something valuable. This is precisely what the goldsmith-bankers did: they relied primarily on their reputation and public trust, which is the main reason their banknotes were accepted as money - a "commonly accepted" medium of exchange. There's no inherent reason a credit instrument cannot be accepted as money on an equal par with its commodity backup. The goldsmith bankers held the public trust. Modern money depends on both public trust and a government banking license, because it is illegal for anyone but a bank to create money. For example, If you tried to pass off my IOU as money, they might arrest you for passing counterfeit. See my Appendix 2 that explains the legal basis of a banking license.
Banknotes were definitely not always accepted by all banks, even banks in the same geographical area. A banknote is a promise by a specific bank to pay out gold on demand. If I present a banknote to a bank other than the one that issued the banknote, this second bank will not honor my demand unless it trusts the issuing bank to pay it. Like other businesses, banks learn to trust and cooperate by clearing and settling accounts with each other; this cooperation contributes to the growth and efficiency of the financial network.
The question of using the term "credit creation" versus "money creation" is a good one. The bank is creating money, which is also a credit instrument. I like to say banks create "money" because their credit instrument really is used as a medium of exchange, as opposed to the credit created by a non-bank which cannot be legally used as money. Some people like to call it "credit money" or "bank money" to distinguish it from the "standard money" that sits in the bank vault or circulates in the economy, separate from the banking system. In the end, I decided to go with Mises's definition and just call banknotes and deposits "money" because that is not only accurate but fits with common usage, so everyone knows what i am talking about: money is exactly what you think it is, it is the contents of your bank account. In my book, I explain this definition of money and why the "medium of exchange" is the most fundamental and defining characteristic of money.
Fascinating. I will have to read your book to wrap my head around all these issues. Thanks!