We got a number of questions recently that we couldn't answer. Well, we could answer them, but we couldn't — if you know what I mean. (I've been hanging around too many Irish-themed groups on LinkedIn, evidently.) Anyway, the questions implied a level of misinformation about money and credit that had to be corrected before we could answer the questions. (Is that any more clear?) So here goes.
"Money" is not limited to coin, banknotes, and checks. Money is anything that can be accepted in settlement of a debt. In fact, you can have something that claims to be money, but is not money because no one will accept it. In a free society, it is acceptance of something in settlement of a debt that makes something money, not the command of some authority, even the State itself. Only acceptance makes something truly money.
"Credit" is simply another form of money, or money in another form — whichever way you want to look at it. All money/credit is a promise to deliver marketable goods or services. This can be on demand, or on the occurrence of some future event, such as a due date. Money is valued at whatever the promised good or service is worth at the present time. If the good or service currently exists, and the person accepting the "money" is reasonably certain that the issuer of the money (maker of the promise) will deliver the goods or services when required, then the money is good and has a high value because it conveys real value among the people who accept it. If the good or service currently exists, yet there is some doubt that the issuer will keep his word, the money will have a low value, or won't be accepted as money at all.
We can extend this to goods and services that don't even exist at the time the promise is made. I can promise to deliver $1,000 worth of widgets to you in 90 days, and draw up a contract to that effect. I don't have any widgets. You know I don't have any widgets. If, however, you are reasonably certain that I can either obtain or manufacture widgets in the allotted time and will make good on my promise, you will accept my note — my "money." If you don't think I can deliver, you will not accept my note, and it never becomes money.
Naturally, even though you and I can both agree that I am reasonably certain that I can and will deliver $1,000 worth of widgets to you in 90 days, that is still in the future. $1,000 worth of widgets today is worth more to you than $1,000 worth of widgets in 90 days. This is where the concept of "present value" comes in, or "What is the value today of my promise to deliver $1,000 worth of widgets to you in 90 days?"
We decide between us that $1,000 worth of widgets in 90 days is worth $980 today. In financial terms, you discount my note at 2%. This is NOT an "interest rate." It is a recognition that $1,000 in 90 days is only worth $980 today. This is the "time value of money," which is actually misleading because the terminology makes it sound as if money has value simply because it is money. No, money has value because of the strength of the promise behind it.
Then there is the issue of risk, or the possibility that I won't be able to deliver $1,000 worth of widgets as promised. There are two things to consider when dealing with risk. One, what is the statistical probability that I won't be able to pay? Two, what have I got to give you to prevent you from suffering a loss if I cannot keep my word?
The statistical probability that I won't be able to pay can be quantified. This is how insurance works. For example, let us assume that, historically, 9 out of 10 people who promise to deliver $1,000 worth of widgets in 90 days actually do so, to the full satisfaction of both parties to the agreement. One out of every 10 fails to do so. The risk of failure is therefore 10%. The "risk premium" that you factor into the value of the note is 10%. The note I gave you is worth, today, $880, not $1,000, because the $1,000 face value of the note is discounted 2% for the present value of $1,000 in 90 days, and another $100 because of the risk that I might not be able to pay. In 90 days I must pay you $1,000 worth of widgets, but you only accept my note today for $880.
Even then, you can't take the risk of a loss. You demand that I pledge existing assets worth $1,000 so that you will be more sure of getting the value of $1,000 worth of widgets in 90 days should I not keep my word. These existing assets are called "collateral."
Okay. That's the first part of the "pre-answer answer." We'll try and get to the second part on Monday, after pausing for station identification tomorrow with our weekly news items.