Credit Creation

Credit creation Li Yang, Zhou Liping*1 With the development of financial markets and the rise of modern shadow banking system, new agents and new means of credit creation are constantly emerging, and their effects on the financial system and macro-economic system are also obscure. Following historical clues, this paper conducts a review and analysis of the literature on credit creation from the perspective of money so as to render some help for the understanding of credit creation in modern financial system. Keywords: credit creation, money supply, financial innovation The word “credit” has roughly two meanings in Chinese. One meaning is to trust and assign to important tasks. The other is to keep one’s promise so as to obtain the trust of others. In the Western world, the word “credit” originated from “credo” in Latin, whose original meaning was also “to trust”. It is apparent that both domestically and abroad, the core meaning of credit is to trust and to keep one’s promise; the former means the recognition of one’s integrity by others, and the latter refers to one’s self-cultivation. To trust and to keep one’s promises are the core and foundation of understanding credit and its derivative terms. As a term in economics and finance, credit’s meaning extends from the original meaning of “to trust and to keep one’s promise”. Generally speaking, credit refers to a value movement under which, in the economic process of the exchange of goods and services and conditional transfer of monetary funds, a credit grantor, based on full confidence in a borrower’s ability to fulfill his commitment, grants loans (in kind or in monetary form) to the borrower in accordance with an agreement made between, which assures that principal and additional value flow back to the lender. Here the lending vehicle can be either in kind or monetary, so there are different categories of physical credit, credit sales, or monetary credit. The lending agent can be any institution or individual, so we have distinctions of state credit, enterprise credit, bank credit, and the personal credit of consumers. In the context of pure monetary finance, credit is further abstracted to a trading equivalent and/ or a claim. The issuers of this equivalent and/or claim enjoy wide confidence among the public and the cost of this monetary claim is the lowest as it is an abstraction of material money and is * Li Yang, Vice President and Academician, Chinese Academy of Social Sciences, P. R. China; Zhou Liping (Corresponding Author, email: [email protected]), Assistant Research Fellow, Institute of Finance and Banking, Chinese Academy of Social Sciences, P. R. China. 4 China Finance and Economic Review hence generally held by the public as a medium of exchange. The “credit” discussed in this paper is based on these definitions. 1. Early-stage theory on credit intermediation and credit creation Credit and credit creation originated from temple lending 5,000 years ago in Western Europe. But these concepts were not discussed as formal academic concepts until the nineteenth century. The historical context is that, with the development of commerce, the commodity money system was evolving to a credit money system, and people needed to discard the old system and to establish a new one and required certain new ideas and theories to prove that creating such a system was reasonable. In the process of the credit money system’s establishment, consolidation, and development, two fundamental practical movements boosted the construction of credit monetary theory. Firstly, the outbreak and conclusion of World War I, banking businesses turned from the era of formulating rules to establishing systems. The banking system that had previously operated on the foundation of a few rigid and simple rules came to a conclusion with the advent of the age of credit money. The new banking system needed to answer some basic questions concerning operations of money and to propose new theories. Among the questions, credit creation, its restraints, and its possible effects were the most urgent to be answered. Secondly, while the gradual establishment, consolidation, and improvement of central banking systems around the world legally unified and monopolized the authority to issue money, a most fundamental theoretical explanation was still needed for the monetary and credit connections among central banks and financial institutions including commercial banks. Credit is the core concept to explain the internal mechanism connecting banks, money, and the real economy. Before the appearance of modern central banks, the theoretical analysis centering on the money supply and demand that we are familiar with at present did not exist. Consequently, the academic discussion about money and its relation to the real economy was centered on the credit creation mechanism. In this sense, the theory of credit creation is the predecessor of the modern theory of monetary supply. As modern market economy was still struggling to emerge from its slumber, these discussions could be nothing but unsystematic and informal, often merely a few random thoughts or words. At the early stage of the capitalist economy, commercial banks were the center of credit for all of society. Hence, almost all classical theories about credit creation centered on the functions of commercial banks and the credit instruments they issued. Most classical economists limited their research to the field of material commodities. In their opinion, savings were no more than the surplus of consumption, so the function of banks was no more than to transfer this surplus to entrepreneurs in need of investment. In the whole process of capital transfer, banks, by virtue of their credit, on the one hand, acted as representatives of the borrowers to attract savings from savers; and on the other hand, acted as representatives of contributors to allocate savings among borrowers. In this process, banks functioned only as intermediaries between saving and investment, an instrument of capital reallocation, which is the main message of the theory of Li Yang, Zhou Liping 5 credit intermediation. Other economists held a different view that, as long as banks maintained their credit and business, they were capable of shaking off the restraints of savings that they absorbed to issue loans. In this sense, the basic function of banks was to create credit for society and provide new capital sources for the real economy, which is the main message of the theory of credit creation. Certainly as economists in the classical period, the supporters of the theory of credit creation agreed that loans, and the investments sustained by the loans, were ultimately constrained by the scale of savings. But they believed that in a real economy, this restrictive relationship of equilibrium only existed in long-term dynamics. 1.1. Theory of credit intermediation The gold standard was the monetary system from the eighteenth to the nineteenth century, which is the key context to bear in mind in order to understand the theory of credit intermediation. This theory began in the eighteenth century and prevailed in the nineteenth century. Its main advocates included Adam Smith, D. Ricardo, J. Mill, and contemporary scholars such as W. Leaf, A. Lampe and H. Mannstaedt. Smith (1776) holds that banking credit can save circulation costs (e.g. the reserves held by capitalists), and reduce financial currency and circulation capital, thus having the function of enlarging production and increasing production capital. But the scale of bank credit cannot exceed the quantity of hard currency necessary for social circulation, or inflation will follow. The way to ensure this is to issue loans by way of the discounting of bills, and bills have to have real economic transactions as their foundation. This is the well-known real bill doctrine. Ricardo was Smith’s successor in credit theory. Ricardo (1817) holds that the nature of credit is to facilitate capital transfer and increase efficiency. On the one hand, bank notes and paper currency replaced coins and reduced circulation costs so as to increase national wealth and material comforts; on the other hand, credit promoted the reallocation of capital and the equalization of profit rates. Mill (1848) also maintains that credit cannot create material wealth from nothing. In particular it cannot increase means of production. The basic function of credit is to transfer present frozen capital, lend it with interest for use in production, facilitate capital reallocation, increase disposable capital, and increase total social production accordingly. Meanwhile, Mill holds that credit has the same purchasing power as cash and its growth can also have an effect on prices. The classical theory of credit intermediation is also represented among modern scholars, for instance, Walsh (2003), Mishkin and Eakins (2006) insist that financial intermediaries like commercial banks are only a medium whose function is to connect society’s savings with investments in order to distribute financial resources and guide resource allocation. 1.2. Theory of credit creation The majority of researchers believe the pioneer of credit creation theory to be the Frenchman John Law, who was also known as a fraud and fortuneteller. Other scholars such as Henry Dunning 6 China Finance and Economic Review MacLeod, Albert Hahn, M. Keynes, F. Hayek, J. Schumpeter, etc. also share this viewpoint. John Law was a well-known mercantilist at the beginning of the eighteenth century. Blood circulation was discovered in Law’s time. With this discovery, Law, together with some others, pointed out that credit was the blood of society. In his book Money and Trade: Considered with a Proposal for Supplying the Nation with Money, Law points out, “The body loses its vigor when blood no longer circulates. The same thing happens when money stops circulating.” He holds that the nature of money is notes to purchase commodities and its basic function is to purchase goods regardless of its form.

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