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Credit is Not Currency

 Some time ago, I posted a comment to an article here on Seeking Alpha, where I mentioned the logistical problems involved in printing a trillion dollars in $100 bills. Another commentator, apparently an ex-Treasury employee, replied that (and I am paraphrasing here) 'we can make as much as we want now, with the push of a button'.

I thought about that for awhile, and I have come to the conclusion that that statement reveals a fundamental misunderstanding of what money Is.

Of course, it is certainly an understandable mistake. We live in a time where the most fashionable 'pop' economist, on his new series recently airing on PBS, says, almost at the start of the very first episode, that "Money is Credit". And after the massive credit inflation(s) of the recent past, I can't even call that a mistake - more like a useful first approximation. 

I remember a time when the average person had no credit for day-to-day use. And in that credit vacuum, you can see another definition for money - it is a liquid commodity, which a given community uses as a medium of exchange. The community's choice may not be free - it is usually forced, or just strongly encouraged, by government monopoly. But that does not change the mechanics - it is a set of physical items (e.g., different denomination notes), that people trade for enough that it becomes a liquid asset (ideally The most liquid asset around).

The keepers of this structure can debase this commodity, by making more of it. But this has famous drawbacks, for currency is a bit durable - print more, and it hangs around to haunt you.

Credit is different. Credit is an agreement about future exchanges. As such, credit is a state of mind. Thus, unlike currency, it is not the least bit durable. The state of one's credit can change as fast as the minds of one's potential creditors. If lenders (and borrowers) are optimistic, more credit will be extended. If they are pessimistic, credit will be contracted.

Note that this can happen, in either direction, without (or even in spite of) any sort of official approval. To give a real world example, a great deal of wholesale commerce in this country is done under terms of "30 days same as cash". If times are good, and men of business in a particular industry are optimistic, they can extend that to, say, 36 days. In that case, the credit supply (and thus,the money supply) in that industry went up 20%. If times are bad, they can shorten in to 24 days; credit/money down 20%. 

This volatile impermanence of credit is important, because buyers and seller take credit into account when pricing. The lender assumes he'll get his money back (or he wouldn't make the loan), and the borrower has it, and both tend to use that figure when planning purchases. Demand can be described as the aggregate amount of purchasing power that might be directed at a given product. That purchasing power is currency + credit. 

And there's the rub. In conditions of highly inflated credit, Most of the purchasing power in the system is credit, and by a large margin. There is a popular graphic making the rounds, referred to as "The Debt Pyramid", that is instructive. I believe it overstates the case a bit, but the underlying point is valid - most of the pricing in the system today, of everything you can name, is based on a huge reservoir of credit. All this credit is volatile, and can disappear Very fast. 

Which is where I come back to my original disagreement with the ex-Treasury fellow. All of the government's means to generate quick 'money' are Not currency (unless they want to embrace the logistical nightmare of actually printing t-t-t-Trillions of dollars of $100 bills), they are Credit. And the very fact of their precipitous creation calls into question the credit of the issuer, encouraging potential counterparties to spurn that credit.

If the US Treasury electronically creates trillions of $s worth of securities, holders of like securities will realize their holdings are being debased, and sell. And there's a Lot of US bond holders out there. Future bond sales would be at ruinous rates, if they moved at all. If the Federal Reserve starts buying all these securities, to try to create an artificially low rate, holders will realize that their bonds are not liquid at those artificial prices, and likewise sell.  

And if T-notes crash, what hope do other, lower rated bonds have? Commercial credit? Mortgages? 

There is Nothing the Fed can do to prevent the full depth of the coming credit contraction. The credit they create will be rejected, along with every other kind, devalued to near nothing, as ALL parties are (rightly) considered unable to pay. They can't even inflate their way out of it (at least, not anytime soon) - they can run their printing presses day and night, but until that currency supply approaches the shrinking credit supply, it will have no effect to speak of. 

None of the above is new science. The Austrian School of economics, exemplified by such lights as Ludwig Von Mises, and Hayek, spelled all of this out a long, Long time ago. But telling people there's no free lunch doesn't buy votes, so we contend with the output of Harvard Business school, et al.

Not too long ago, I saw some educators speaking on C-SPAN, and one of the panel members said, "My profession has been accused of failing our nation's children. We have - we failed to teach them free market economics." I could not agree more. If the Austrian School had been given any respect in the last 20 years that it has rightly earned, self-deluded sophists like Ben Bernanke would not have been allowed to get their grubby paws anywhere near the levers of power, and all this nonsense could have been prevented.