What is money and what is credit? This is the dirty little secret. Since dropping gold reserves, economists have become very confused as to what constitutes money which leads to horrific problems.
Conceptually, there is one major divide between "hard money" economists like Rist, von Mises and Cassel and those of the "Currency Crank" school (whether they call themselves neo-classical, monetarist, or even supply-side).
a.) Currency Cranks believe that money should be strictly a convenient medium of exchange.
b.) In contrast Hard Money economists believe that money should be a convenient medium of exchange AND a store of value.
In the days of Hard Money economists, like Rist, von Mises, and Cassel, money was either gold coins or those paper tokens called "Bank Notes" which represented a certain measure of gold - everything else was credit.
This is a very important distinction. In a panic Federal Reserve notes were worth a certain amount of gold, while deposits of credit depended upon the ability of the borrower to repay. As economist Henry Thornton said in 1802, "If at any given moment an inventory were made of the wealth of a society, the notes issued by the bank, included among the bearer's assets, are counterbalanced by commercial drafts among the liabilities of the signatory; credit and debit equal each other and cancel each other out." Thus in a downturn, the amount of money remains constant while the amount of credit outstanding declines - along with asset prices since the total of money and credit has declined.
How did the clear distinction between money and credit become so confused?
To pay for World War I, Great Britain had both suspended the convertibility of British Pounds into gold and also greatly expanded the number of "gold tokens" called British Pounds. In the 1920s Great Britain wish to restore the convertibility of the Pound and gold. Charles Rist pointed out that they would need to FIRST devalue the pound relative to gold or they would face a scramble for gold reserves. This shortage of gold reserves would lead to an economic depression in Great Britain which was the world's largest trading partner, the United States of that day. If they lowered the value of the Pound, they would have sufficient gold reserves and their exports would be less costly and imports more dear.
Montague Norman, Governor of the Bank of England, did not like this advice nor did his government. The British Pound was always $5.60 US Dollars and would remain so. Instead he called another meeting of the four primary central bankers: Montague Norman from the UK; Benjamin Strong from the US; Charles Rist, from France; and Hjalmar Schacht from Germany. Norman and Strong proposed their scheme whereby they would equalize gold reserves rather than devalue the Pound. Since France and the US had more than sufficient gold reserves, they should trade a large portion of their gold in return for Pounds and Weimar Marks. Although this would have been in the interest of Germany, Schacht was deeply suspicious of the intentions of both Norman and Strong. Rist told them that their plan would never work and that the Bank of France would never trade gold for British Pounds, let alone Weimar Marks as long as he was a Governor.
Great Britain went back on the gold standard with the existing conversion rate. There was a run on their gold reserves. Benjamin Strong came to their rescue trading some US gold reserves for paper British Pounds and a financial crisis hit both nations. This added to the pre-existing price deflation, resulting from the collapse of the World War I commodity price bubble, was the Great Depression.
After the second world war, the United States had ended up with almost all gold reserves. Not wishing to give this up, the scheme developed by Strong and Norman was trotted out again in a new form. This resulted in the Bank of International Settlements replacing gold with SDRs, "Special Drawing Rights." Now money would be those tokens which represented a certain measure of Special Drawing Rights. All money was now fiat currency where paper Bank Notes represented a certain amount of a special type of paper called SDRs, restricted in amount. Well at least SDRs were originally restricted in supply, but that soon changed. Now the difference between money and credit becomes confused.
When the Federal Reserve was created in 1918, all member banks placed their gold banking reserves with the Fed and in return received stock in the Fed. They would "borrow" their reserves back in the form of Federal Reserve Bank Notes from the Fed. The Fed is a GSO, a Government Sponsored Organization, which is owned by and reports to the member banks. The Chairman is chosen by Congress and must report to them periodically. So the Board of the Federal Reserve must report to their shareholder banks but must also keep Congress placated.
The Fed reported both the amount of money, which consisted of Federal Reserve Notes of fixed quantity, and Credit which consisted of everything else.
Increasingly, Currency Cranks of various stripes, such as Milton Friedman, insisted that there should be no distinction between money and credit as SDRs had made money obsolete. This is the complete restoration of John Law from the early 1700s. But the Federal Reserve has gone one step further, not even envisioned by John Law.
Banks must maintain healthy Reserves, money maintained on hand against Transaction Accounts. During the collapse of the real estate bubble of the 1880s in Southern California, not one single bank failed. Each bank held money reserves of between 15% and 25% which were sufficient to ride out the storm.
By the 1920s the Federal Reserve had allowed banks to lower reserves to only 5% of Transaction Accounts. It should not be surprising that a large number of banks failed. Today the Federal Reserve allows banks to borrow reserves from them in any amount the Fed desires. Thus nominal bank reserves have been reduced to 3% and banks are unstable to a degree unprecedented in the history of banking, offset only by their ability to borrow from the Fed, should the Fed decide to accommodate them.
All of this leaves bankers and economists with a very messy problem. What is money and what is credit? We know from experience that these two have very different properties. Publicly, the Federal Reserve has four definitions for money, MZM, M1, M2 and M3. Internally, they have at least twenty different definitions for what constitutes money - none of them satisfactory. It is this confusion between credit and money which has created the current financial instability and confusion even as to where the economy stands.
The Fed does make a hollow distinction between "Permanent Reserves" which are supposed to represent money and other Reserves of various types which supposedly represent credit. But since even Permanent Reserves no longer represent a "Store of Value" the current system is fully Currency Crank in basis. So in our current economic system, money is technically the total amount of Permanent Reserves, but there is little to distinguish that from credit.
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