5- Credit Theory of Money (Part I)

Photo by Christiann Koepke on Unsplash

In the last article “4 – State Theory of Money”, it’s shown that the cash we have in our hands now are the liabilities of the State, or the debt of the State. It’s also known as tax drive money as taxation is important to ensure people accept it in exchange for goods and services. 

When the State wants goods and services produced by the citizens (usually for public purpose such as hiring citizens as soldiers, building public infrastructure such as road), the State pay the citizens by issuing them the State’s liabilities denoted in the State chosen unit of account. 

The State’s liabilities issued by the government is known as the money that we’re holding in our hands today. Money is the liabilities of the State, money has no intrinsic value but people still want it because it’s the only instrument they can use to pay for their tax liabilities they owe to the government. Or else they will be succumb to heavy punishment by the government.

If the government can purchase goods and services by issuing liabilities, can we, the household and the firm do that too? Can we purchase goods and services by issuing our own liabilities to other people?

Yes. We have been doing that and we are already doing that.

To understand things better, we must learn the infamous extended version of State Theory of Money -“Credit theory of Money”.

In this theory, money is credit and credit is money. OK! Let’s start from the scratch. What is the meaning “credit”? Credit is just another word for debt. What A owes to B is A’s debt on B and B’s credit on A. In this way, A is B’s debtor and B is A’s creditor. A will say that “I have a debt owed to B.” B will say that “I give a credit to A”.

Before we delve deeper, think about this quote by Mitchell Innes: “By buying we become debtors and by selling we become creditors. If we are both buyers and sellers we are all debtors and creditors.”

Or we can say: “By buying we acquire debt and by selling we acquire credits.”

For example, A bought goods from B worth $100 by issuing his liabilities saying: “A owe you $100” to B. B is the creditor to A and A is the debtor of B. That’s what we mean by “by buying we become debtors and by selling we become creditor.” (under Credit Theory of Money)

How could A free himself from the debt he owes to B? A must become a seller. In other words, since A is now a debtor, the only way he could free himself from the debt he owes to B is to become a creditor. There’re two ways we can see how A could free himself from the debt he owes to B by becoming a seller (i.e. creditor):

  1. A become a seller and sell to B
    • A just have to sell goods of equivalent value, $100 to B. B pay for the goods by handing in the liabilities issued by A saying: “A owe you $100” and bags the goods from A.
    • So, A received the liabilities issued by himself to B initially. 
    • A officially free himself from the debt owed to B because he got back/redeem the liabilities he issued to B previously saying: “A owe you $100”.
    • A might probably burn off that liabilities because it’s of no value to A as A can issue its own liabilities in any amount he wants at his own will.
  2. A become a seller and sell to another person, C
    • A just have to sell goods of equivalent value, $100 to another person, C, who has sold goods to B before. So, C has the liabilities issued by B saying: “B owes you $100”.
    • C paid the goods by handing the liabilities issued by B to A and bags the goods from A.
    • A now has the liabilities issued by B saying: “B owes you $100”.
    • Later, A hand in the liabilities issued by B he got from C to B to redeem the liabilities issued by A to B when A buy from B initially.
    • Now A has the liabilities it issued to B initially back with him. 
    • A officially free himself from the debt owed to B because he got back/redeem the liabilities he issued to B previously saying: “A owe you $100”.
    • Also, A might probably burn off that liabilities because it’s of no value to A as A can issue its own liabilities in any amount he wants at his own will.

From the above 2 ways that could be taken by A to free himself from debt he owed to B, we can distill several takeaways:

  1. We could buy goods and services by issuing our own liabilities to the seller. 
  2. After that, to get rid of the debt we owed to the others, we must be able to sell, be it selling goods or services. Selling goods and services is the only way we could become a creditor to acquire the liabilities issued by other people which we can use to redeem the liabilities issued by ourselves to them and thus cancel our debt we owed to them.
  3. As a debtor, we can compel our creditor to cancel our debt owed to him by handing him the liabilities of equivalent amount issued by them. 
  4. Let’s say a person A:
    • Must accept the liabilities issued by A (himself) as a means of payment by others for goods and services he offered to the others.
    • Will also accept the liabilities issued by the buyer, B as a means of payment for goods and services he offered if he knows he will have debt owed to B in the future. (because he may buy things from B in the future)
    • Will also accept the liabilities issued by C from the buyer, B as a means of payment for goods and services he offered if he/she has debt owed to C. (because he/she can use it to free himself/herself from the debt he owed)
    • Will also accept the liabilities issued by a C from the buyer, B as a means of payment for goods and services he offered if he/she believes there’re people out there who has debt owed to C. (because if that’s the case, those people will also accept the liabilities issued by C as payment for goods and services)
  5. Thus, the liabilities issued by a person can be used as a means of payment for goods and services if the seller accept it.
  6. Liabilities is therefore the “money”.
  7. The reason why we accept someone’s liabilities as a payment for goods and services is because we believe the other person will accept it too when we want to buy from them.

Of course, today, we don’t issue our own liabilities when we buy goods and services. Instead, we used the credit of the government (i.e. the liabilities of the government) that we have acquired by selling goods and services, or by selling our time (i.e. working). And the seller is happy to accept the liabilities of the government because the seller can use it to retire the tax liabilities he owed to the government or even if the seller doesn’t owe the government tax, he knows that he can still use it to buy from the others as it will always be accepted by other seller as there’s always someone who will owe tax liabilities to the government. 

Here’s an interesting question: Let’s say D is someone that is unable to sell any goods and services, come to A and wanted to buy goods and services from A by issuing its own liabilities saying: “D owes you $100” to A. As a prudent seller, would A accept D’s liabilities as a payment for the goods and services A offered?

No! If D is someone that is unable to sell any goods and services, then D would be someone who can only acquire debt but never acquire credit. There’s no way D could make other owed him debt because he cannot sell.  Referring back to Takeaway #4 above, in this case: “A will accept the liabilities issued by the buyer as a means of payment for goods and services he offered if he/she will have debt owed to D in the future. (because A may buy things from D in the future)”.

In this case, since D don’t have the ability to sell, A shouldn’t accept the liabilities from him because A will never get to buy from D as D never sell. If A accept the liabilities issued by D, A basically accept liabilities that has no use at all. Other seller will not accept the liabilities issued by D for the same reason too.

This brings us to an interesting question to think about: “Should you accept liabilities issued by everyone in exchange for the goods and services you produce?”.

No. Would you accept the liabilities issued by an entrepreneur saying: “I owed you $100” for the goods and services you produced or the liabilities issued by an unemployed saying: “I owed you $100” for the goods and services you produced? Of course, we’ll accept the liabilities of the entrepreneur. Because the entrepreneur is more creditworthy as he is much more able to sell goods and services. You can use the liabilities issued by the entrepreneur to buy from the entrepreneur.

So, the same liabilities saying: “I owed you $100” could have different “value” depends on the issuer of the liabilities. In other words, two liabilities could have the same face value ($100), but they can have different nominal value. 

The nominal value of liabilities issued depends on its face value. However, in a trade, it’s the nominal value of the liabilities issued that matters, not the face value.

Turns out that the nominal value of liabilities is dictated by the ability of the issuer to sell (to produce goods and services)! 

We’ll see more about that in the Part II. 

The conclusion of Part I is therefore: 

  1. When we buy, we acquire debts; when we sell, we acquire credits. In other words, when we buy, we become debtors; when we sell, we become creditors. 
  1. We can use the credit we acquire from somebody to redeem the debts we owe from them in order to cancel our debts we owed to them. 
  1. In fact, this is how commerce is done: “Constant creation of debt and credit, and their extinction by being cancelled against one another.” (this is known as primitive law of commerce by Mitchell Innes) 

References:

  1. What is Money?

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