Wednesday, September 21, 2011

The Theory of Pure Credit

As we saw yesterday, the most reasonable explanation of why the British government ignored William Thornton's proposal in A Plea for Peasant Proprietors in both 1848 and 1874 is that the authorities simply didn't understand the financing of new capital. They were stuck in what Louis Kelso and Mortimer Adler called the slavery of past savings. There was no consideration or even understanding of the principles of pure credit.

The basic theory of pure credit is simple. First, however, let's define what we mean by "pure credit": money created by extending credit based not on the present value of existing accumulations of savings, but on the present value of marketable goods and services to be produced in the future. The credit is "pure," that is, not dependent on what has been done in the past, only what can be done in the future. This is, in fact, how most money has been created throughout human history.

For thousands of years before the invention of currency, that is, "current money" of a uniform and standard value that circulates within an economy, money contracts existed. "Money contract" is, in fact, redundant. In a sense, all contracts are money, and all money is a contract, a promise to deliver something of value, a marketable good or service, thereby settling a debt.

A money contract is, technically, a "bill of exchange." Bills of exchange are further divided into mortgages and bills of exchange proper. A mortgage differs from a bill of exchange proper (which we shall refer to from here on simply as a "bill of exchange") in that a mortgage is backed by or represents the present value of an existing marketable good or service, while a bill of exchange is backed by the general creditworthiness of the issuer.

Usually the issuer's creditworthiness is a measure of other people's faith that the issuer will deliver the stated value in marketable goods or services, or their equivalent, at some future date or on the occurrence of some event. Most simply put, a bill of exchange is backed by the present value of the future marketable goods and services that the issuer of the bill promises to deliver to the holder in due course of the contract.

Here we have to insert a complication. What we've just described is the way private sector bills of exchange work. Governments also issue bills of exchange, except that they call it "emitting" instead of "issuing" or "drawing," and a "bill of credit" instead of a "bill of exchange."

There's one more difference between a private sector-issued bill of exchange and a government-emitted bill of credit. As we said, a bill of exchange is backed by the issuer's creditworthiness, measured by the opinion that others have of the issuer's ability to deliver the promised marketable goods or services or the value thereof on maturity: the present value of the issuer's future stream of income or production out of which the issuer will make good on the promise conveyed by the bill of exchange.

A bill of credit is also backed by the issuer's creditworthiness. In the case of a bill of credit, however, the issuing government's creditworthiness is measured by the opinion that others have of the government's ability to collect taxes in the future in order to be able to make good on the promise conveyed by the bill of credit.

In other words, the issuer of a bill of exchange has to make good on it him- or herself. The issuer of a bill of credit — always a government; "bill of credit" is a specialized "constitutional" term — on the other hand, has to be able to tax what other people produce in order to make good on the promise. The emitter of a bill of credit is, in effect, making promises for other people to keep, and relying on its power to tax them to make good on those promises. If a government loses its power to tax, or if there is nothing to tax, then the bills of credit — and the currency backed by the bills of credit — become worthless.

One more thing before we go on. A bill that is issued or emitted for no more than the present value of the expected future stream of revenue to result from production or taxation is called a "real bill," that is, it has real value. A bill that is issued for more than the present value of the expected future stream of revenue to result from production or taxation, or that has no present value behind it at all, is called a "fictitious bill," that is, a fake or a phony bill. Real bills are non-inflationary. Fictitious bills are inflationary to the extent they exceed the present value that the issuer reasonably expects to produce or collect.

The issuer of a bill can use the bill as money in one of two ways. The first, and most common, is to use the bill as money directly. An issuer or "drawer" of a bill can pay for marketable goods and services produced by others with the issuer's promise to pay in the future. Because a bill only becomes money when accepted in payment of a debt, a bill used directly as money is called a "merchant's" or "trade acceptance."

Since a bill will typically be accepted by a holder in due course at less than its face value due to the time value of money and the risk associated with the issuer's creditworthiness, an initial transaction involving a bill is called "discounting." Subsequent transactions are called "rediscounting" until the bill is presented by the holder in due course to the issuer for redemption on maturity.

Despite the fact that the greater part of the money supply in any economy has always consisted of various forms of bills of exchange used in transactions between individuals and businesses, it is sometimes more convenient to have an individual or institution of recognized creditworthiness substitute his, her or its name for that of a possibly unknown or untrustworthy issuer. This institution is called a bank — specifically, a "bank of issue" or "bank of circulation." A bill discounted or rediscounted at a bank of issue is called a "banker's acceptance."

A bank of issue is a specialized financial institution that takes deposits, makes loans, and issues promissory notes. A promissory note is a special type of bill of exchange that a bank of issue trades for a private issuer's bill of exchange. A bank's promissory note can be used to back smaller denomination promissory notes called "banknotes," or a demand deposit (checking account) created in the name of the original issuer of the bill of exchange for which the bank of issue traded its promissory note. The most common type of bank of issue today is the commercial or mercantile bank.

Another type of bank is the "bank of deposit." A bank of deposit is more limited than a bank of issue, because a bank of deposit cannot create money by accepting bills. A bank of deposit is limited to taking deposits and making loans. It cannot issue promissory notes to trade for bills of exchange, and thus cannot deal in pure credit. Common types of banks of deposit are savings and loans, credit unions, and investment banks.

A "central bank" is a "bank of issue for banks of issue." Its special function is to rediscount bills of exchange originally discounted by commercial banks and coordinate the activities of its member banks to ensure a uniform, stable, asset-backed "elastic" currency so that there is always enough liquidity in the system to keep it running. "Open market operations" are a means where by a central bank purchases paper issued by non-member banks, businesses, and individuals. In the modern world, open market operations have generally been diverted away from the private sector and used to finance government.

That's an extremely condensed version of the theory. To try and explain practice would take several volumes, and isn't relevant to our goal. All we need to understand is how a financial system can be run without relying on existing accumulations of savings — "pure credit," that is, credit that is not tied down by whatever has been accumulated in the past, but instead is tied to what can be produced in the future.

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