Response to Robert Blumen on Deflation: Money is not Credit

Robert Blumen wrote an article at the Mises Institute about Deflation  mainly discussing Robert Prechter views, here is the link:  Deflation Confusion: Money is not credit.

Robert Blumen is right, Money is not Credit.  But the problem is that the current economic theories do not differenciate them properly, including the classic austrian school of economics.  In fact Mises did include Credit “Money” within the same category of Commodity Money (Money Proper or Money in the narrower sense).   Indeed, just the term Credit “Money” is really confusing, that´s why I am quoting the word money in that context.

Considering credit “money“, which is a future good, within the same category of commodity money, which is a present good, leads to tremendous errors.   For example, it leads to consider that someone lending out new credit “money” is granting new credit when is totally the opposite, he is receiving credit because he is issuing debt.

Only the owners of present goods shall grant new credit.   The definition of credit is lending out present goods in exchange of future goods (promises to deliver present goods in the future).

Once you are aware of this, it is very easy to see how Central Banks are not lenders of last resort but first instance borrowers, and that commercial banks are mainly debtors.  Just have a look at their balance sheet, their equity is ridiculous.  Banks are way more than 90% indebted.   Who are the creditors then? The creditors are the agents that give away present goods in exchange of Dollars, Sterling or Euros, which are future goods (bank liabilities), and those agents are mainly the “free” market (i.e. almost everyone except the banking system and the State).

So, I think that Robert Prechter´s understanding of  current monetary system is superior than that of many austrian scholars, because he has noticed that today´s money is not money, it´s credit used as a medium of exchange.  Unfortunately there´s been a long time since we don´t use money anymore (money understood as a present good).   By the way, Mises failed on providing a monetary theory that clearly separates money from credit, but at least he noted 100 years ago that most fiat currency systems are in fact credit currency systems (p. 61 of Theory of Money and Credit).  It is unbelievable how most austrians scholars describe our current monetary system as fiat!!

If we have a huge credit contraction, banks are not going to be able to issue new currency, because banks issue additional new currency when they “lend” (monetize) new credit.  But if agents are not borrowing from other agents (through bank intermediation) and instead they are paying down debts, then dollars are being withdrawn from the system, these dollars will just disappear when used to pay down debts the same way they were created.

Remember, credit is inflationary at the moment of its monetization, but it is deflationary for the rest of its existence.   There is a crucial difference between pure fiat currency and credit currency, the former will always remain in the system unless the issuer withdraws it, the later will always expire at some point in the future.

But all this credit contraction won´t happen as long as the main credit bubble, which is the Bond market, does not implode, because the Bond market is still allowing the government to issue new debt, so the banking system still has fresh new debt to be monetized and therefore pump new dollars into the system.  These new dollars are still enough to offset the destruction of dollars caused by maturing outstanding debt.

So the Bond Market is the last bastion of the credit bubble, once it bursts, deflation will enter full throttle in the monetary system.

Regarding the classic austrian monetary theory not drawing a crystal clear line between money and credit, the austrian (“mengerian”) economist Carlos Bondone provides the solution.  Departing from Carl Menger and disregarding the errors of Mises and Hayek, he proposes the following new monetary structure:

Currency:  Indirect medium of exchange and unit of account.  Currency Types:

  • Money: Present good when it is used as currency (wheat, cattle, gold, silver, deposit certificates of gold or silver, etc.).
  • Credit currency:  Any currency that is not money, it can only be credit.  Then there are the following types of credit currencies:
    • Regular Credit currency:  When the present good that cancels the debt is specified, and so is its quality, quantity and due date.  This is the case for real bills maturing in gold or old bank bills that where redeemable for gold or silver.
    • Irregular Credit Currency:  When the present good that cancels the debt is not specifed or its quality or its quantity or its due date.  This is the case for today´s currencies such as dollars or euros.

It is extremely important to clearly separate money from credit, so everyone can understand that credit currency is not money regardless that both of them may be used as currency (medium of exchange).   Considering credit as a perfect substitute of money is as dangerous as using vacuum instead of air to keep a ship afloat.

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12 Comentarios.

  1. Manuelgar, this is very interesting – I arrived here from, having read and been enthralled with Detlev’s fine book. I am working hard to get up to speed in Austrian economics, but my life gets in the way.

    Why is the distinction you make more accurate? How is it more useful? How does the distinction alter the calamity we are facing with respect to money and credit? I ask this as genuine questions – not challenges – I am largely ignorant in this field although nearly as much as most politicians and bankers I am afraid.

    I am sorry that I do not speak or read Spanish. I would be interested to read more of your posts.

  2. Hello John,

    Thank you very much for writing in my blog. First of all, I have to say that the distinction I make is not mine, It is from Carlos Bondone. Here is his book (in english!! :) )

    The monetary theroy section is very quick to read, just 15 pages. Then, if you want to go deep into the theory you can read his other book:

    Where he makes an exhaustive demonstration of his theory. His tool for the demonstration is plain double entry accounting. Nevertheless, one ot the main objectives of this blog is to spread Bondone`s Theory of Economic Time (TET), so I am completely open to new ideas, questions and challenges for new posts regarding this issue (challenges, if well conducted are very enriching, so don´t hesitate to challenge if you want). Of course if the request is in english I´ll write the post in english.

    Now, regarding your specific question, I´ll try to be brief.

    The definition of credit is giving away present economic goods in exchange of future economic goods (which are promises to deliver present goods in the future). From an accounting point of view we can easily recognize present goods, because they are not anyone else´s liability, while future goods are always someone else´s liability.

    Current theories admit that lending out dollars or Euros is granting credit. This is a tremendous error because dollars or euros are clearly future goods (they are bank liabilities). In fact is the opposite, when agents accept Euros in exchange of their present goods (his work, his house or his wheat production), they are granting credit to the entity that issues those Euros.

    Then if credit only arises from present goods but current theories wrongly admit that credit may also arise from future goods, is not surpring at all the exponential growth of credit we have, because credit is built of over credit on a endless iterative spiral.

    Hope it helps!

  3. It would be more useful than current theories in the sense that is crystal clear on what is money and what is credit.

    Monetarist don´t even think of classifying dollars or Euros as credit. Most Austrians are not clear (Bondone is also Austrian), Mises defined a type of currency calles “credit money”. Really confusing. And their position about “fiat money” is also not clear, they do not clearly specify if fiat money is a liabilitiy or a present good. Yoy might agree or disagree Bondone, but he can´t be more clear on this.

    Imagine that architects and engineers are based on a theory that admits that ground and floor are equivalent, so you can build a building in either one of them, so theoretically you could build a new building on top of the 50th floor of another building.

    Imagine that this is what is taught at schools, universities and everyone accepts that. Would it be surprising to end up with hundreds of shivering and instable buildings????

    Buildings (credit) must be built on solid ground (money, understood as a present good) if you don´t want them to dramatically collapse.

  4. Manuelgar,

    Thank you so much for this. I have downloaded those PDF’s from Carlos Bondone. I intend to read them and explore his website. I have been very much an individualist for many years and was aware of Mises and the Austrian school, but I have jumped into it after reading Paper Money Collapse by Detlev Schlichter.

    The funny thing is that in 2008 I remarked to my brother, who is in the financial services sector, that money was simply broken. I did not realize then how correct I was – and it only gets worse.

    Again thank you for the insight and the analogy. I love that metaphor and you have inspired me to read Carlos Bondone.

  5. Hi,
    I have a challenge:

    All Austrians know basic lows: credit goes up – prices up, credit is payed back – pries down.

    But I have a complex question: what happens with value of debt backed paper money (prices) if debtors default without providing any collateral (like sovereign governments)?

    In case of commodity-money, we would see strong price deflation because of its intrinsic value encouraging hoarding.

    But is that possible for debt backed fiat money? Why would savers hoard fiat money for a long time if debtors don’t need it anymore so much?

    I think that deflationary collapse would be much lower as we know it from hard money systems, followed by strong inflation even without printing.

    In a real macro-case, what would happen if PIIGS leave Euro giving middle finger to creditors (lowering demand for Euro) and core-europe (limited to Germany?) would be confronted with all the money quantity chasing its shores? I think, prices in Germany would skyrocket which isn’t deflationary at all inside the remaining currency regime.

    Is that all basically correct? Please give a small comment or write an article about. In all the talking about deflation I’m strongly missing distinguishing between hard money and fiat money systems.

  6. Hi radzimir,

    The problem is not that savers hoard currency, the problem is that the quantity of Euros contracts dramatically, but still Euros are the only medium to pay debts. Besides, there are very few net savers left in the economy, most people are debtors.

    Euros are mainly bank liabilities and most of them are account entries, not bills. If a bank that has sovereign debt in their asset, and the debt issuer defaults, the bank balance sheet gets automatically reduced, an so its liabilities, therefore less Euros in the system. If the loss is big, the bank will need to raise capital which means they are demanding euros.

    But the important thing is that default and losses mean that the supply of euros contracts. The main cause of deflation would be a dramatic contraction of supply, not an increase on demand. Nevertheless demand will remain high, because even when a bank fails, the mortgages will go to some other entity, and the mortgage debtors still will be demanding Euros to pay down their debts. Also, if the purchasing power of the Euro increases and the economy is weak, agents will be more willing to keep euros rather than investing in stocks or buying houses or just consuming.

    But all this will be conditioned by the dollar, I think that deflation in the dollar will be even stronger (there are much more dollar denominated debts), and if the dollar goes up against the Euro, and commodities are priced in dollars, that will soften Europe´s deflation for commodities, but not for assets and wages.

    If PIIGS leave the Euro, all liabilities of PIIGS banks will tranform from Euros to Dracma, Pesetas, Lira, Escudos, etc… So those Euros will just disappear.

    I agree with you that after deflation runs its course, then inflation or hyperinflation will set in.

  7. Hi Manuelgar,

    “Nevertheless demand will remain high, because even when a bank fails, the mortgages will go to some other entity, and the mortgage debtors still will be demanding Euros to pay down their debts.”

    Please understand my question – it was was not about “normal circumstances” when there are many debtors left creating demand.
    When biggest debtors default without providing collateral, cash hoarded by central banks and hedge founds isn’t needed much any more.

    “If PIIGS leave the Euro, all liabilities of PIIGS banks will tranform from Euros to Dracma, Pesetas, Lira, Escudos, etc… So those Euros will just disappear.”

    Why would Euros belonging to Greek Citizens and stored in Swiss banks or even euros in Swiss National Bank disappear? It will not. Greeks will pay own debts in fresh new printed drachma dropped from helicopters, and travel to Germany to spend their Euro for cars and real estate causing Hyperinflation in Germany.

    The thesis is, that credit contraction by repayment or default with sufficient collateral is strongly deflationary.
    But credit contraction by default without collateral, is inflationary.

  8. Ok,

    I´ll try my best to stick as much as possible to your question.

    “When biggest debtors default without providing collateral, cash hoarded by central banks and hedge founds isn’t needed much any more”

    It those sovereign assets default and their value becomes zero, and they are located on the asset side of the Central Bank / Hedge Fund, means equivalent decrease on the liability side is mandatory (the Central Bank liabilities are account entries in Euros, not bills). Either the Central Bank / Hedge Fund defaults on his depositors / investors or otherwise they have to raise capital somehow, which means demanding Euros.

    In Spain for instance, private debt is quite greater than sovereign debt. If Spain defaults, there still will be a great quantity of outsanding debt.

    “Why would Euros belonging to Greek Citizens and stored in Swiss banks or even euros in Swiss National Bank disappear? It will not. Greeks will pay own debts in fresh new printed drachma dropped from helicopters, and travel to Germany to spend their Euro for cars and real estate causing Hyperinflation in Germany.”

    If Greek citizens are able to pay their mortgages in drachmas, that means that Greek Banks will default in Euros, that´s more balance sheet contraction for the ECB and Greek creditor German Banks. If I were a Greek citizen and I had Euros in switzerland after Greece comes back to the drachma, I would wait the drachma to plunge, and then buy assets (houses or whatever has dropped more dramatically) in Greece with my Euros. That business would be much better than spending the Euros in Germany.

    I think that defaulting without collateral makes the credit contraction even bigger. If there is collateral at least some value might be recovered, if there is no collateral the balance sheet contraction is quite greater.

  9. Hi manuelgar, great blog btw

    Is there anything else which might play out in the run-up to hyperinflation and how does the current scenario compare to the previous inflationary collapse of the 1930s.
    As back then people were not indebted like they are today and what other factors (unique to this time) could potentially throw a spanner in the works of these politicians who will instruct their Central Bankers to take the path of least resistance.
    What types of assets will more likely undergo liquidation in an effort to get back to price-correction?
    Just trying to understand how far the deflation can go and what is likely to be the last stages of this period before governments attempt at reflation and makes everything ‘better’ which turns out to be worse albeit in a different manner.

    • eleconomistaprud

      Hi Justin,

      When we talk about politics unfortunately everything is possible.

      And as you said, the people is even more indebted today than during the 30´s. Sadly, politicians’ decissions are usually detrimental for the people and beneficial only for a few. Considering high private indebtness and that goventment debt is people´s debt (not Obama’a nor Bush´s Debt) high inflation would be very good for those who are very indebted.

      After deflation runs it course, and all debts are finally paid or defaulted, then I would expect very high inflation.

  10. El problema es que el dinero tiene diferentes usos y puede que todos tengamos parte de razón.

    No obstante, yo sí pienso que se puede emitir todo el dinero que se quiera, y más si todos los bancos centrales están compinchados y actúan a la vez.

    ¿Qué es lo que queda? El oro pero hoy en día no cubre las necesidades de la gente. No es “legal tender”.

    • eleconomistaprud


      Yo creo que es posible diferenciar entre dinero y crédito. Igual que en su momento la física consiguió diferenciar entre peso y masa. De hecho creo que Carlos Bondone lo consigue: Confusión entre Dinero y Crédito.

      Estoy de acuerdo que si se compinchan todos los bancos centrales pueden hacer lo que dices.

      Pero tendrían que empezar a actuar de forma totalmente distinta a lo que han hecho hasta ahora. La Fed no ha emitido un solo dólar que no fuese un pasivo (crédito) con su correspondiente partida en el activo, y esa contrapartida es siempre deuda de un tercero (un bono, hipotecas empaquetadas, otra divisa, etc…).

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