Credit affects cash in the same way that a 50p coin affects £5 notes...Existing £5 notes are able to purchase less when extra 50p coins are added to the circulation of a currency because ten 50p coins compete at parity with the £5 note... According to the State who ultimately provide the demand for fiat currency, ten 50p coins are worth the same as one £5 note so that relationship extends into the market.
If the State have decided that one unit of bank credit is equal to one unit of cash (of whatever denomination) then extra credit will affect the price of cash. It does not matter that someone might object (to the statement that) credit is "as good" as cash, or that a £5 note is better than ten 50p coins... If most people do think that they are equivalent that is what sets the market price.
A person might have a preference for one type of coin over another, let's say they appreciate the appearance of a 10p coin... because other coins are (also) legal tender, that person is "forced", obliged to accept other coins in payment for goods and services. The purchaser can force the recipient to receive the coins (and notes) of their choice (provided they are legal tender) because otherwise the debt might not (still) be recognised by the courts; the courts will no longer assist in chasing the debts...
A debt may be established in a particular currency (such as payment in only 10p coins) but if the purchaser has offered sufficient coinage which is deemed legal tender, the debts will not be chased by the courts, even though the purchaser has changed his (or her) mind in what type of currency to pay. If the consideration is offered in legal tender, even if it was previously promised in another "currency" then, as far as the courts are concerned, there is no debt to repay.
Because the quantity of legal tender must be of equivalent (market) value to the initial promise, it obliges the recipient to accept what is the aggregate estimation of legal tender (value) and therefore does not allow (it removes) the expression of individual preferences...
If we imagine a scenario in which a person is promised a sack of potatoes in exchange for their labour, but then the debtor responds by offering only cash then the vendor must then accept the legal tender at the market price of the potatoes. So the fact that cash is legal tender drives out the individual expression of preferences for commodities and forces people to intermediate their purchases with legal tender (at the market price)... The law makes legal tender the forced medium of exchange.
Because bank credit is not "legal tender", it has value not because it is a forced currency (in the way that cash has value) but instead because the market value of credit is similar to cash. And if a person pays in credit, this can be seen as a promise (of a bank) to pay cash, so it is in fact very similar, and may be regarded as "cash" by some courts(?). If not, then the value of credit is derived only from the preferences of the (aggregate) market. Because credit cannot discharge debts in the same way that legal tender is able to do, it cannot be said to "be money" in the fullest sense. Only notes and coins are good at discharging debts...
The State creates demand for fiat currency via taxation and it is forced upon the population (into contracts which do not otherwise involve the State) as a medium of exchange through the legal tender laws (to make (with the outcome that) people generally write contracts in fiat money...). This also increases the extent to which prices stabilise out across a country, since they are all priced according to a common measure.
If credit is valued by the State (and the rest of the market) then it is able to affect the price of cash, even though it is not legal tender. Credit affects the price of legal tender because it (legal tender) competes with credit. Whatever the value of £1 is derived from, a unit of credit is worth the same (the value of the credit is derived from the value of the cash). Most people don't prefer cash because they all use bank accounts, which convert their "money" into credit... Bad money does not drive out good, because people do not hoard "good" money (cash), they instead convert it into credit by placing it in a bank account because it is financially advantageous for them to do so, they may not make a "profit" by doing this (interest) but they do at least receive free current-account banking services. The State (by guaranteeing bank deposits) incentivizes people to prefer credit over cash. The Government guarantee of bank deposits is sufficient to remove the risk premium that would otherwise be paid for holding credit (over cash). We don't prefer cash because our doubts and fears are compensated for by the State. We are paid (by the State) to treat credit as cash.
So long as people think credit is valuable it is costly to think (and behave) otherwise... When enough people start to think that cash might be preferable (beyond what the Government would be willing (and able) to issue new bank notes to support...) then the costs of preferring cash become less than the risk of holding credit which means that people will withdraw their money from the banking system.
We get paid for the risk of holding our money in the form of bank credit... (loaning it to the banking system). Credit is a risky form of money which may become worthless at any moment... extra credit affects the price of cash because cash (whilst the financial system is intact) can only be purchased for one unit of credit. More credit does not mean that a unit of cash will purchase more (credit) because credit can be exchanged for cash at any moment and so why would you sell (credit) for less than one unit (of cash). Credit is the possibility of cash... we take the risk for the convenience of banking and perhaps a fee received (compensation) for keeping our money on deposit. Credit can be exchanged for (one unit of) cash (can get one from the Government) at any time (the Government makes a market at parity...) which is the reason that the total quantity of both credit and cash is what affects prices.
Imagine two farmers, one with a crop of potatoes, another with apples. If they have roughly equivalent yields, it may be that one potato will purchase one apple (and the Government will make a market at this price). So then, what happens if the potato farmer grows a greater (more abundant) crop? Typically this would result in apples costing more than the potatoes (potatoes would get cheaper) but because the Government continues to make a market at the old price, the two crops continue to trade at parity.
Credit trades at parity with cash due to price-fixing.
The risk premium for holding credit cannot be expressed (as a price) in the market because credit can (usually) be exchanged at parity... We cannot know what the market considers the likelihood of bank run (is) until it happens.
If we fear that the market will obtain comprehensive knowledge of the banking system, we must fear that credit will eventually become worthless due to a (systematic) bank run. Because people don't know about the nature of the banking system, they will not exchange credit for anything less than parity (neither do they (yet) have to). Stupid people think that credit is worth the same as cash and people who are not stupid are willing to risk holding credit (due to convenience and possible material rewards...) up to (or just prior to) the point that the remainder evaluate the truth... They think credit is money which is why extra credit inflates prices... For as long as the banking system is intact, cash won't have increased purchasing power over credit because people do not prefer it; people will not think your cash is worth more than their credit. The amount of credit they would be willing to exchange for your cash would be only parity. Your cash buys less and less... because everyone thinks that credit is cash.
Most people think that credit is cash which is why cash will lose value when extra credit is issued...
Wednesday 15 April 2009
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