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The Credit Conversion Theory of Money
The Credit Conversion Theory of Money is a restatement of Alfred Mitchell-Innes' Credit Theory of Money, with a focus on the process whereby money is created, and on the differences between various monies.
The Credit Theory of Money
The Credit Theory of Money as expressed by Alfred Mitchell-Innes is simply that “credit and credit alone is money”1.
In Innes's writing the word "credit", which is a claim on a debt, has a number of implicit features. These only become clear after a careful reading of his texts.
The main one of these features is that credit is something that must be generally accepted, it denotes a general purchasing power. Credit also needs to be transferable, negotiable and fungible in order to circulate. That being said, Innes does write about subtle differences between different types of credit. For example, writing about the U.S.A. of 1914, he notes that "there are in any given place many different dollars in use."2 What he meant by that will be explained below.
As these concepts are not explained in detail, but are presented as obvious, it makes the word "credit" imbued with a kind of "magical" meaning which it does not necessarily have in other economic literature.
Restating the credit theory
In order to be more explicit, we propose to re-state the credit theory as follows:
Money is a particular kind of debt: a transferable and generally accepted debt instrument which can be used for repaying any debts.
Equivalently, we could say: "Money is a particular kind of credit: a transferable and generally accepted credit instrument which can be used for repaying any debts." The two statements are equivalent because the holder of money is a creditor, so in his eyes money is a credit. But underlying that credit is of course a debt, as seen from the point of view of the debtor. For now, we will stick with the first version of the definition, simply because it seems a bit clearer - although that is of course subjective.
The term "transferable" is taken to encompass all of the usual characteristics of money that we know from daily experience, including in particular fungibility and negotiability. Lack of precision in the definition reflects the fact that, historically, money was not always as convenient as it is today. For example, a tally may have circulated as a form of money, but there was obviously no mechanism to split a tally in two. As to coins, they were often issued in large denominations not suitable for small transactions.
The term "generally accepted" refers to the community of people within which the money is accepted for payment and for discharging debts. In the case of tokens issued by a tradesman, this community could be a small town. On the other end of the scale, money issued by a government or a central bank is accepted throughout a country or even a group of countries. Today, in the age of the Internet, we can image money used by groups that are not primarily defined by geography.3
Finally, the term "instrument" is used to suggest a certain degree of standardisation. For example, when the Exchequer raised tallies in medieval England, the nominal amounts were not at all standardised but represented the value of goods and services purchased on a given occasion. However, these tallies were all recognisably Exchequer tallies, and their value was expressed in the standard units of pound / shilling / pence.
The credit conversion theory of money
While all money is debt, it is obvious that not all debt is money. Some types of debt, that are not money to begin with, are converted to money. This is done via a process which we call "credit conversion", and more specifically "monetary credit conversion." A credit conversion of a debt which does not result in money could then be called "non-monetary credit conversion."
We therefore define money as follows:
Money is a debt which has undergone a monetary credit conversion, thereby making it a transferable and generally accepted debt instrument which can be used for repaying any debts.
This definition in no way contradicts the succinct definition of Mitchell Innes: "credit and credit alone is money." It simply focuses on one aspect of money that, while being fundamental, is often misunderstood. It is also the aspect that is, on a purely technical level, the key aspect of any monetary system: credit conversion.
The role of banks
The importance of banks in our societies is obvious, and the main role of banks is precisely credit conversion, which is why banks are called "credit institutions." By making loans, banks take the credit of individuals and companies and convert it into bank credit, or bank money, for a fee. That is the essential role of banks.
The reason we can speak of bank credit as being money is that, by definition, banks are institutions whose credit is money. Even though the credit of one bank may be valued differently than the credit of another, both are money. And when a bank's credit declines so far that it is no longer money, then it ceases to be a bank.
Other institutions also have a money-equivalent credit, the most prominent of these, but by no means the only one, being the central government. Some of these institutions may even, to some greater or lesser degree, engage in credit conversion. However, the particularity of banks lies in the fact that credit conversion is their main business.
Of course, banks have always had other roles, such as wealth mangers, accountants and payment facilitators. Indeed, in some cases a so-called "private bank" may act almost exclusively as asset manager, with the only credit business being Lombard loans - and even that activity will often be subcontracted to a larger bank. For the sake of clarity, we will use the term "bank" only for institutions that actually engage in monetary credit conversion, independently of their actual denomination.
Debt encompasses government liabilities
Our definition of debt encompasses government liabilities. There is therefore no fundamental difference between money issued by a government, and money issued by other persons or corporations - although there may of course differences defined by law. There is, however, one specificity of government money, and that is the nature of the liability. The liability underlying the government's money is to redeem that money via taxation, and to accept said money in payment of taxes.
Credit conversion before the emergence of central banks
Let's go back in time a few centuries and consider a well-respected tradesman in a small town. He will have credit relationships with most of his local suppliers, meaning that he will not need money except to settle balances during the seasonal debt clearing events. To pay some suppliers, and to give change to his customers, he may choose to issue tokens. If he has sufficient credit within his community, his tokens will circulate in the local economy as money, together with all kinds of other coins and tokens.
However, to pay certain out-of-town suppliers, his own credit and tokens are not accepted and he will either use his balance at the local bank, or take out a loan at that bank. He can then pay with a draft on that bank. When taking out a loan, the bank will require a payment in the form of interest: that is one type of "credit conversion fee."
When the tradesman travels to the capital to purchase some specialised piece of equipment, the draft on the local bank is no longer enough. He will have to obtain a draft on a money-center bank from his local bank. For that, he will almost certainly have to pay a fee. That is another type of credit conversion fee.
We have thus seen that a credit conversion fee can be a one-time fee, as when a draft is discounted, or expressed as an interest rate, as when a loan is made.
Mitchell Innes provides the following example, as seen from the point of view of a banker: 4
Let us suppose that I take to my banker in, say, New Orleans, a number of sight drafts of the same nominal value, one on the Sub-Treasury, one on another well-known bank in the city, one on an obscure tradesman in the suburbs, one on a well-known bank in New York, and one on a reputable merchant in Chicago. For the draft on the Sub-Treasury and for that on the bank in the city, my banker will probably give me a credit for exactly the nominal value, but the others will all be exchanged at different prices. For the draft on the New York bank I might get more than the stated amount, for that of the New York merchant, I should probably get less, while for that on the obscure tradesman, my banker would probably give nothing without my endorsement, and even then I should receive less than the nominal amount. All these documents represent different dollars of debt, which the banker buys for whatever he thinks they may be worth to him. The banker whose dollars we buy, estimates all these other dollars in terms of his own.
This example shows that the "credit conversion fee" can be both positive (a cost) and negative (a revenue).
Monetary credit conversion in developed countries today
Today, credit issued by a modern central bank can be converted to money via a simple bookkeeping operation, or by printing banknotes or minting coins. What this means is that any central bank credit denominated in that central bank's own currency is either already money, or is quasi-money which can be converted to money at any time. This is because in many countries central bank credit is the highest credit available, by definition.5
When a bank makes a loan and books a credit in a customer's account, that credit also becomes money. What happens is that the bank customer's debt, which is not money, is being converted to a bank credit, which is money. The same mechanism is applied when a bank discounts a draft on an individual or a corporation.
Now in almost all developed countries, these are the only two ways that money gets created. Note that if the money created ends up in an account of an individual, and the account balance is below the limit for the local depositor guarantee, then for all intents and purposes that money is as good as central bank money. Even if the account is not covered by a deposit guarantee, it is clear that the bank customer expects that the money he holds at his bank is EXACTLY equal to money held in another bank. In other words, if the customer has #1,000 in his account with Bank A, he can transfer that money to an account at Bank B and receive a credit of exactly #1,000 at Bank B – often with no or only very minimal transfer costs.
Compared to former times, the difference in credit rating of banks can therefore no longer be seen in the difference in price of their money. But the difference can still be seen in the level of interest rates they offer for their deposits: a weak bank will have to offer higher interest rates than a strong one. Indeed, spiking deposit rates often precede bank failures.