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Archive for October, 2013

Banks and Credit

October 19, 2013 4 comments

Here is the next installment dealing with credit and banking.  The next installment will go into the expansion of credit by banks in more detail.

A primitive credit model

Credit is a fundamentally different economic phenomenon from money, though they are often confused or conflated.  The two, of course, are intimately related but in theory, there is no reason that either one could not exist without the other.  Indeed there is some debate over which developed first.  The answer to this question is of no importance to the issues discussed here.  I have already laid out a story to explain the emergence of money from a barter economy without credit.  To understand credit, I will first develop the institution of credit in a barter economy with no money.  Then I will put money and credit together.

Consider a very small town where everyone knows everyone else and assume that they all generally trust each other to keep to their word.  In this town there is a butcher, a baker and a candlestick maker.  The butcher regularly buys bread from the baker and the baker regularly buys meat from the butcher.  One way that they could conduct this trade is to trade bread and meat directly.  The drawbacks to this method are well understood, most important is the fact that they would have to continuously trade quantities of equal value.

As an alternative to barter, they could each hold some amount of some other good such as gold or silver and trade this for bread and meat.  In this way if there were a trade surplus between them, it would be reflected in a balance of payments in gold or silver from one to the other.  If, for instance, the baker wanted to purchase meat of greater value than the bread that the butcher wanted to purchase, he could pay the excess in silver coins.  The butcher could then use those coins to buy other things from other people.  Meanwhile the baker would have to get the extra coins by selling bread to other people.

In this way some quantity of money can circulate in an economy and act as a store of value and a medium of exchange.  People accumulate money as a result of delivering more goods than they collect from others.  Money such as precious metals works well for this purpose because it holds its value well.  This is mainly due to its durable nature and the fact that the supply in the long run is limited by nature (highly inelastic).

It is possible though to carry on trade without this type of “hard” money.  Imagine the same butcher and baker but with no gold or silver nor any other good suitable to use as a store of value and medium of exchange.  When the baker wants to buy meat, he can simply promise to deliver some number of loaves of bread at some point in the future that the butcher may find suitable.  He may write ten notes that say “I, the baker, owe you, the butcher, one loaf of bread to be delivered at any time upon presenting this note” and bearing his signature.  These notes would then represent a contract which could be enforced by the courts. Read more…

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Commodity Money

October 9, 2013 4 comments

Have been out of the game for a while but I think I made a breakthrough.  I want to work up to it though by developing the paradigm that I am working in from the beginning.   This will take a few posts.  This one will describe the organic rise of commodity money in the context of a free-market economy and explain the function of real interest rates, nominal interest rates, and the rate of “inflation” (change in the value of money).  I can’t stress enough that this is a hypothetical free-market economy with no central banking.  This economy would be different in several ways from most modern economies.  Much of the confusion about monetary issues comes from not fully understanding these differences.  From this starting point, I will try to work my way up to an economy with a central bank and fiat money and contrast the two.  The next post will be a primitive model of credit.  That will be followed by a model of banking.

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