Credit theory of money

The first formal credit theory of money arose in the 19th century. Anthropologist David Graeber has argued that for most of human history, money has been widely understood to represent debt, though he concedes that even prior to the modern era, there have been several periods where rival theories like metallism have held sway.

According to Joseph Schumpeter, the first known advocate of a credit theory of money was Plato. Schumpeter describes metallism as the other of “two fundamental theories of money”, saying the first known advocate of metallism was Aristotle.[2][3] The earliest modern thinker to formulate a credit theory of money was Henry Dunning Macleod (1821-1902), with his work in the 19th century, most especially with his The Theory of Credit (1889). Macleod’s work was expanded on by Alfred Mitchell-Innes in his papers What is Money? (1913) and The Credit Theory of Money (1914),[4] where he argued against the then conventional view of money arising as a means to improve the practice of barter. In this alternative view, commerce and taxation created obligations between parties which were forms of credit and debt. Devices such as tally sticks were used to record these obligations and these then became negotiable instruments which could function as money. As Innes puts it in his 1914 article:

The Credit Theory is this: that a sale and purchase is the exchange of a commodity for credit. From this main theory springs the sub-theory that the value of credit or money does not depend on the value of any metal or metals, but on the right which the creditor acquires to “payment,” that is to say, to satisfaction for the credit, and on the obligation of the debtor to “pay” his debt and conversely on the right of the debtor to release himself from his debt by the tender of an equivalent debt owed by the creditor, and the obligation of the creditor to accept this tender in satisfaction of his credit.

Innes goes on to note that a major problem in getting the public to understand the extent to which monetary systems are debt based is the challenge in persuading them that “things are not the way they seem”.[5]

A Quantity Theory of Credit was proposed in 1992 by Richard Werner, whereby credit creation is disaggregated into credit for GDP and non-GDP (financial circulation). The approach is tested empirically in a general-to-specific econometric time series model and found to be superior to alternative and traditional theories. According to Werner bank credit creation for GDP transactions Granger-causes nominal GDP growth, while credit creation for financial transactions explains asset prices and banking crises.[6] Based on this, Werner (2005) developed a new approach to macroeconomics, which integrates the nature of banks as money creators in macroeconomics – usually ignored in conventional macroeconomics.[7] Werner’s approach is based on the scientific research methodology (the inductive method), not the axiomatic-hypothetical deductive approach commonly used in macroeconomics, which assumes away the existence of banks or market rationing. Hence in his approach markets are not expected to be in equilibrium, but the short side principle applies, which emphasises the power of banks in making decisions about the amount and allocation of credit created and distributed in the economy. Werner used the Quantity Theory of Credit (also known as the Quantity Theory of Disaggregated Credit) to develop a new monetary policy for post-crisis banking systems, which he called ‘Quantitative Easing’ (Werner, 1995, published in the Japanese financial newspaper, the Nikkei), a name later adopted by the Bank of Japan and Bank of England for related policies [8]. The role of banks as creators of both the credit and the money supply has since been empirically demonstrated by Werner in widely-noted finance journal publications.[9]

Since the late 20th century, Innes’ credit theory of money has been integrated into Modern Monetary Theory. The theory also combines elements of chartalism, noting that high powered money is functionally an IOU from the state,[10] and therefore, “all ‘state money’ is also ‘credit money'”. The state ensures there is demand for its IOUs by accepting them as payment for taxes, fees, fines, tithes, and tribute.[11]

In his 2011 book Debt: The First 5000 Years, the anthropologist David Graeber asserted that the best available evidence suggests the original monetary systems were debt based, and that most subsequent systems have been too. Exceptions where the relationship between money and debt was less clear occurred during periods where money has been backed by bullion, as happens with a gold standard. Graeber echoes earlier theorists such as Innes by saying that during these eras population perception was that money derived its value from the precious metals of which the coins were made,[12] but that even in these periods money is more accurately understood as debt. Graeber states that the three main functions of money are to act as: a medium of exchange; a unit of account; and a store of value. Graeber writes that since Adam Smith‘s time, economists have tended to emphasise money as a medium of exchange.[13] For Graeber, when money first appeared its primary purpose was to act as a unit of account, to denominate debt. He writes that coins were originally created as tokens which represented a unit of account rather than being an amount of precious metal which could be bartered.[14]

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