It Ain’t Just Paper
This may sound goofy, but there's a lot more money around than there is money. That's because most money is not money in the sense of base money or bills and coins issued by a central bank. Most money is credit created by banks. In other words, credit is money.
Don't buy it? Take this scenario. Abe and Bea go to the store and buy a tv. Abe pays with cash and Bea pays with a credit card. In which case cash and credit do the same thing, they work the same way. Credit is as good as cash. Credit is money. One way to look at it, cash is money from past work, credit is money from future work.
Take this second scenario. Abe deposits $100k in the bank. Bea borrows $90k of that and buys a house from Cici. Cici deposits the $90k in the bank. The bank loans $80k of that to Didi who buys a house from Effy. Effy deposits the $80k in the bank.
Now then, Abe, Cici, and Effy all have money in the bank totalling $270k. Yet there was only $100k of cash deposited to begin with. So, the extra $170k is credit. Did Cici and Effy deposit money or credit in the bank? Does it matter? All three depositor's accounts can be drawn on as money. There is no difference between them. For all intents and purposes, credit is money.
Now imagine millions of people doing the above over and over for decades. Which person's money started out as cash and which was credit? There's no way to tell. Once deposited in the bank they are indistinguishable, they are identical. Which only goes to show, credit is money.
In our financial system today the vast majority of money is credit/money and not base cash/money. There is something like $40 of credit for every $1 of base money. This means only about 2.5% of the money around is base money created by the central bank. Or, 97.5% of money is credit created by banks.
This raises the question, how much influence do central banks really have on the money supply? Under the circumstances above if the central bank doubles base money it only increases the money supply by about 2.5%. In order for the total money/credit supply to double the bank issued credit would have to double as well. But for bank credit to double borrowing would have to double.
There is where the influence of the central bank hits a roadblock as it is not simply a matter of printing money and getting it to banks, it has to be borrowed. Neither the central bank or the lending bank can force the issue, it requires borrowers.
Thing is, people don't borrow because credit is available, it's the other way around. Credit becomes available when people want to borrow. Ask yourself a simple question, would you borrow money you didn't need because the bank offered a great rate?
The same thing applies to central banking. Borrowing comes first and the money supply increases to accommodate it afterwards. The central bank can't force people to borrow, but an increase in borrowing can force, or pressure the central bank to increase the base money supply to accommodate the increase in credit created by lending banks.
This raises the next question, is there a great unfilled demand to borrow money? If not, central bank money printing will have very little effect on the money supply, the money supply being mostly credit. This is why there has been no major inflation even though the Federal Reserve has been increasing the base money supply at a high rate.
This is the short and simple explanation. The bottom line is it takes three to tango, or inflate the money supply. A central bank, lenders, and borrowers. If one of the three fail to co-operate... well the other two have a hard time forcing the issue.
copyright Terry Colon, 2011