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The Credit Theory
of Money

An article appearing in the "Banking Law Journal" in 1914 by A. Mitchell Innes presented an exposition of the Credit Theory of money, as opposed to the Metallic Theory.  It should be noted that the article was written in the era when precious metal coins were viewed as the only "true money."  

Up to the time of Adam Smith, not only was money identified with the precious metals, but it was popularly held that they formed the only real wealth.  To Adam Smith belongs the credit of having finally and for all time established the principle that wealth does not reside in precious metals.  But when it came to the question of the nature of money, Adam Smith’s vision failed him.  Having convinced himself that wealth was not gold and silver, he was faced with two alternatives.  Either money was not gold and silver, or it was not wealth, and he inevitably chose the latter alternative. 

If money is not wealth in the common meaning as representing “purchasing power” that alone constitutes real riches, then the whole of human commerce is based on a fallacy.  Smith’s definition of money as being not wealth, but rather the “wheel that circulates wealth,” does not explain the facts that we see around us -- the striving to accumulate money.  If money were but a wheel, why should we try to accumulate wheels.  The analogy is false.

Much has been written since the days of Adam Smith on the subject of money, but we still hold to the idea that gold and silver are the only real money and that all other forms of money are mere substitutes.  The necessary result of this fundamental error is that utmost confusion prevails in political economy.

How complete the divorce is between the experience of daily life and the teaching of the economists can best be seen by reading Marshall’s chapter on capital, with its complicated divisions into national capital, social capital, personal capital, etc.  Every banker and every commercial man knows that there is only one kind of capital, and that is money.  Every commercial and financial transaction is based on the truth of this proposition; every balance sheet is made out in this well-established fact.  And yet every economist bases his teaching on the hypothesis that capital is not money.  It is only when we understand the credit theory that we see how well it harmonizes with the known facts of everyday life.

The Credit Theory asserts in short that a sale and purchase is the exchange of a commodity for credit.  From this main theory springs the sub-theory that the value of credit or money does not depend on the value of any metal.  Rather it depends on the right which the creditor acquires to “payment.”  That is it depends on the right to satisfaction for the credit, and on the obligation of the debtor to “pay” his debt.  Likewise it depends on the right of the debtor to release himself from his debt by the tender of an equivalent debt owed by the creditor, and the obligation of the creditor to accept this tender in satisfaction of his credit.

Such is the fundamental theory, but in practice it is not necessary for a debtor to acquire credits on the same persons to whom he is debtor.  We are all both buyers and sellers, so that we are all at the same time both debtors and creditors of each other.  And by the wonderfully efficient machinery of banks to which we sell our credits, and which thus become the clearing houses of commerce, the debts and credits of the whole community are centralized and set against each other.  In practice, therefore, any good credit will pay any debt.

In theory we create a debt every time we buy, and acquire a credit every time we sell.  In practice this theory is also modified, at least in advanced commercial communities.  When we are successful in business, we accumulate credits on a banker and we can then buy without creating new debts, by merely transferring to our sellers a part of our accumulated credits. 

If we have no accumulated credits at the moment we wish to make a purchase, instead of becoming the debtors of the person from whom we buy, we can arrange with our banker to “borrow” a credit on his books and transfer this borrowed credit to our seller.  In doing so, we hand over to the banker the same amount of credit (and something over) which we expect to acquire when we in turn become sellers. 

As the greatest buyer of commodities and services in the land, the government issues in payment of its purchases vast quantities of small tokens which are called coins or notes, and which are redeemable by the mechanism of taxation.  We can use these credits on the government to pay for small purchases in preference to giving credits on ourselves or transferring those on our bankers.

So numerous have these government tokens become and so universal their use in everyday life -- far exceeding that of any other species of money -- that we have come to associate them alone with the word “money.”  But they have no more claim to the title of money than any other tokens or acknowledgements of debt. 

Of all the false ideas current on the subject of money, none is more harmful than the notion that the government has a monopoly on the issue of money.  If banks could not issue money, they could not carry on their business.  And when the government puts obstacles in the way of the issue of certain forms of money, one of the results is to force the public to use perhaps less convenient forms. 

As can be clearly proven by careful study of history, a dollar or a pound or any other monetary unit is not a fixed thing of known size and weight, and of ascertained value, nor did government money always hold the preeminent position which it today enjoys in most countries.

The notion that the government coin is the one and only dollar, and that all other forms of money are promises to pay that dollar, is no longer tenable in the face of the clear historical evidence to the contrary.  A government dollar is a "promise to pay,” a "promise to redeem,” just as all other money is.  All forms of money are identical in nature, namely a credit for the holder and a debt of the issuer.

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