It’s common in economics and in general, for people to differentiate between “money” and “credit” (Scott Sumner did it here today). This is largely the result of gold standard mythology when gold was viewed as the primary form of money and “bankers” would issue notes that were redeemable for gold. They were, in essence, issuing a claim on gold. When we went off the gold standard economists didn’t really change their model much. They just substituted central bank reserves and cash for gold and said that when banks were lending they were issuing claims on central bank money and vault cash. I think this is totally wrong.
The system we reside in today is not one designed around central bank reserves and cash. In fact, central bank reserves and cash are playing an increasingly less important role in the economy as time goes on. Reserve requirements are no longer necessary in well managed banking systems, cash is becoming a less common form of money and the importance of inside money (bank money or deposits) has become increasingly evident to the economy as the credit crisis proved.
The problem with this focus on central bank money and reserves is that it seems to get the entire focus of the monetary system wrong. We start from the government and build out from there without realizing that the private sector steers the economy and the money the non-bank private sector primarily uses (inside money) dominates how output is created, where prices settle and how we engage in the economy.
It’s also important to note that everything that involves outside money (central bank money) is a facilitating feature of what is clearly an inside money system. That is, reserves exist primarily to help settle interbank settlement. And cash exists primarily to allow an inside money bank customer to draw down an account to transact more conveniently. These forms of money like reserves, cash and coins (outside money) all facilitate the use of the dominant money – inside money. Saying that inside money or credit is just a claim on outside money is clearly false. For instance, a transaction occurring between two customers in credit at Bank of America (NYSE:BAC) doesn’t even involve outside money. But more importantly, what we’re all really after in the economy is not claims on outside money. We’re all seeking the real money – bank deposits. The primary way cash comes into circulation is when an inside money holder draws down a bank account. And the non-bank private sector cannot even access bank reserves so it’s totally illogical to build a real understanding of the economy around outside money.
Focusing on outside money and building a world view around it is like trying to understand how a man walks by studying the crutch he uses. Outside money is merely a crutch while inside money is the legs! Yes, outside money is important and it can be particularly important when your legs break (during a credit crisis), but that doesn’t change the fact that the legs are the form of money that “rules the roost” 99% of the time. There are hardly any schools of economic thought that get this balance correct. Which is a big contributing factor to why the entire “dismal science” appears so dismal at present.