## The difference between money and credit

August 3rd, 2008

For our long-time readers, we often mention the word “money” and “credit” side by side in the context of money supply (e.g. our earlier article, 363 tons of US dollars to Iraqóhow much money will eventually be multiplied into the economy?). The problem with this is that it is a form of sloppy language that can lead our readers astray in their understanding of the economy. It leads to confusion between money supply and credit. Therefore, we are writing this article to address this issue.

Before you continue reading this article, please take a read at Introduction to banking corporate accounting and Effect of write-down on bank balance sheet because we will be explaining money and credit in terms of simplified corporate accounting.

Let’s suppose there are two banks in the economy that has an initial balance sheet that looks like this:

Bank A
Assets: 0
Liabilities: 0
Equity: 0

Bank B
Assets: 0
Liabilities: 0
Equity: 0

Now, say Tom has 100 gold coins. Therefore, the total supply of money in the economy is 100. He deposits the 100 gold coins into Bank A. The outcome will look like this:

Bank A
Assets: 100 (gold coins)
Liabilities: 100 (gold coins)
Equity: 0

Bank B
Assets: 0
Liabilities: 0
Equity: 0

Now Bank A lends 90 of the gold coins to Dick. The outcome will look like this:

Bank A
Assets: 90 (loan of gold coins) 10 (gold coins)
Liabilities: 100 (gold coins)
Equity: 0

Bank B
Assets: 0
Liabilities: 0
Equity: 0

At this point in time, the money supply has increase from 100 to 190 (100 in gold coin deposits and 90 in the hands of Dick). Credit, on the other hand, had increased from 0 to 90. Now, let’s say Dick then deposit the 90 gold coins on his hands into Bank B. The outcome will be:

Bank A
Assets: 90 (loan of gold coins), 10 (gold coins)
Liabilities: 100 (gold coins deposit)
Equity: 0

Bank B
Assets: 90 (gold coins)
Liabilities: 90 (gold coins deposit)
Equity: 0

At this point in time, the money supply is still 190 and credit still at 90. Now, Bank B then loan 81 gold coins to Harry. The outcome will now be:

Bank A
Assets: 90 (loan of gold coins), 10 (gold coins)
Liabilities: 100 (gold coins deposit)
Equity: 0

Bank B
Assets: 81 (loan of gold coins), 9 (gold coins)
Liabilities: 90 (gold coins deposit)
Equity: 0

At this point in time, money supply has grown from 190 to 271 (190 as gold coin deposits and 81 in the hands of Harry). Credit has grown from 90 to 171. Let’s say Harry lost all the coins in a fit of vice by splashing them all on drugs. He then lost his job due to his drug addiction and becomes insolvent as a result. What will happen next?

Bank B’s asset will have to be completely written down:

Bank B
Assets: 0 (loan of gold coins), 9 (gold coins)
Liabilities: 90 (gold coins deposit)
Equity: -81

Bank B is insolvent in this case because its equity has gone negative. For the sake of illustration, let’s assume that there’s a massive cover-up between the government and the banking system to keep this bad news from the public. At this point in time, the total credit in the economy has gone back down to 90. Thanks to the cover-up, both banks are still operating. Therefore, the money supply is still at 271 (190 as gold coin deposits and 81 in the hands of the drug dealers, who then spends it all on other things).

Now, here comes a twist. The government needs to secretly bail out Bank B but where is it going to find all the gold coins? Since Bank B has only 9 gold coins left, it is only a matter of time before Dick will realise that his deposits are amiss. Therefore, the government decide to come up with a scam. It will raise taxes and hauled in 20 gold coins as a result. Then it will dilute the gold in the 20 gold coins and produce 81 ‘gold’ coins. It then ship the 61 counterfeit ‘gold’ coins to Bank B. Now, the balance sheet of Bank B will look like this:

Bank B
Assets: 61 (‘gold’ coins), 9 (gold coins)
Liabilities: 90 (gold coins deposit)
Equity: -20

No one discovers this scam. Officially, the money supply still stands at 271 (190 as gold coins deposit, 61 gold coins dispersed in the economy by the drug dealers’ high spending ways and 20 supposedly at the government. Total credit still stands at 90. Now, Bank B decides to lend 40 ‘gold’ coins to Thomas, a pious and enterprising businessman.  The balance sheet will now look like this:

Bank B
Assets: 40 (loan of ‘gold’ coins), 21 (‘gold’ coins), 9 (gold coins)
Liabilities: 90 (gold coins deposit)
Equity: 0 -20

Now, the money supply swells to 311 (190 as gold coin deposit, 61 gold coins dispersed in the economy, 20 supposedly at the government, 40 ‘gold’ coins in the hands of Thomas). The total amount of credit has swelled from 90 to 130.  The monetary base in the economy is at 161 (9 gold coins in Bank B, 21 ‘gold’ coins in Bank B, 61 gold coins dispersed in the economy, 10 gold coins in Bank A, 20 ‘gold coins in the government and 40 ‘gold’ coins in the hands of Thomas). You can do a quick cross check on the figures- originally there was 100 gold coins and the government took 20 and dilute it into 81 ‘gold’ coins.

That’s the end of this simple story. In summary, money and credit are related but they do not refer to the same thing.

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