Mike Shedlock, a blogger on the global economy, captures the conundrum very succinctly by saying credit creation comes before money creation.
I respect Mike's view very much, but the fact remains that he is self schooled in economics, or at least that is what I understand from other blogs. So, how much credence do you give to a guy who reads a lot?
Well, I think you will learn much if you read Mike's blogs. Mike is also known as Mish to his many readers, and there are many of them.
What economics classes do generally is present loads of detail about what the present state of affairs without telling you much about how they got there. Mish says credit comes first, and he is absolutely right. Credit bids up the price of money and the authorities then supply the money to reduce it's price. Without official creation of money, it's price would be too high for governments to finance their own debt, the credit we have given them to do things we voted them to do.
Mish is right to say it's important to add history to the economic analysis. If you don't have the story then all you have is the accounting, which amounts to a whole lot of balance sheets adding to zero. All the pluses must add to all the minuses, zero out in total. All the sources of finance add up to all the uses.
All entities have a balance sheet. We all do whether we realize it or not.
What then is credit?
Credit is an accounting entry on the asset side of a balance sheet, i.e. credit, by some entity that is authorized to make such entries, a lender, for some entity that is authorized to receive such entities, i.e. a customer. The lender will charge an interest rate but the actual interest rate has yet to be determined.
Before someone can use the new credit the lending entity may have to go out and buy money and make it available to the customer. For money to be created in it's balance sheet, it will bid in the money market and the price of money will go up just that small amount needed.
Assume a huge amount is lent, then a bid will raise the price of money appreciably and the market price for money will rise, that is, the interest rate for money will rise.
This is where the central bank steps into the picture because the raising of interest rates is not on its own going to increase the supply of money in the system. To keep the interest rate from rising the central bank will supply credit to the lender, or lenders as a market, by offering money at an interest rate lower than the market rate.
Thus, the central bank increases the money supply by issuing it's own credit, which results in monetary expansion. With matching monetary expansion, the interest rate does not move.
This is how credit creation drives the system in the modern economy. Advances by banks create a demand for money which is obtained within the banking system. If the system is short of money, the central ban will lend it to the market in order to avoid interest rates going up.
You might wonder whether a government operates like a bank. Well, consider that it may have a balance sheet that can create loans and the money for these loans needs to come from the central bank by the central bank giving credit to the banks that lend to the government.
So there you have it, the government behaves like a bank and has a borrowing requirement that is met by central bank loans. If the interest rate does not go up, it means that demand for credit by other entities has fallen or the central bank has created money for the system, that is, more credit for the system.
Mike Shedlock / Mish has many words of wisdom....
http://globaleconomicanalysis.blogspot.com/2010/10/german-finance-minister-accuses-us-of.html
Will not time reveal the lasting importance of friends and mutual respect? Be kind to those who think well of you and those you know and try to add positive elements to your world. Promote peace in your heart and sunshine in the minds of those around you by your own good works. Elevate the level of discussion by thinking less of the issues and more of how you can reduce the tension of stress that arises with honest disagreement. Relax by breathing more deeply and consciously.
