By understanding that money is simply credit, we unleash it as a powerful tool for our communities.
The reason our financial system has routinely gotten into trouble, with periodic waves of depression like the one we're battling now, may be due to a flawed perception not just of the roles of banking and credit but of the nature of money itself. In our economic adolescence, we have regarded money as a "thing"--something independent of the relationship it facilitates. But today there is no gold or silver backing our money. Instead, it's created by banks when they make loans (that includes Federal Reserve Notes or dollar bills, which are created by the Federal Reserve, a privately-owned banking corporation, and lent into the economy). Virtually all money today originates as credit, or debt, which is simply a legal agreement to pay in the future.
Money as Relationship
In an illuminating dissertation called "Toward a General Theory of Credit and Money" in The Review of Austrian Economics (vol. 14:4, pages 267-317, 2001), Mostafa Moini, Professor of Economics at Oklahoma City University, argues that money has never actually been a "commodity" or "thing." It has always been merely a "relation," a legal agreement, a credit/debit arrangement, an acknowledgment of a debt owed and a promise to repay.
The concept of money-as-a-commodity can be traced back to the use of precious metal coins. Gold is widely claimed to be the oldest and most stable currency known, but this is not actually true. Money did not begin with gold coins and evolve into a sophisticated accounting system. It began as an accounting system and evolved into the use of precious metal coins. Money as a "unit of account" (a tally of sums paid and owed) predated money as a "store of value" (a "commodity" or "thing") by two millennia; the Sumerian and Egyptian civilizations using these accounting-entry payment systems lasted not just hundreds of years (as with some civilizations using gold) but thousands of years. Their bank-like ancient payment systems were public systems--operated by the government the way that courts, libraries and post offices are operated as public services today.
In the payment system of ancient Sumeria, goods were given a value in terms of weight and were measured in these units against each other. The unit of weight was the "shekel," something that was not originally a coin but a standardized measure. She was the word for barley, suggesting the original unit of measure was a weight of grain. This was valued against other commodities by weight: So many shekels of wheat equaled so many cows equaled so many shekels of silver, etc. Prices of major commodities were fixed by the government; Hammurabi, Babylonian king and lawmaker, has detailed tables of these. Interest was also fixed and invariable, making economic life very predictable.
Grain was stored in granaries, which served as a form of "bank." But grain was perishable, so silver eventually became the standard tally representing sums owed. A farmer could go to market and exchange his perishable goods for a weight of silver, and come back at his leisure to redeem this market credit in other goods as needed. But it was still simply a tally of a debt owed and a right to make good on it later. Eventually, silver tallies became wooden tallies became paper tallies became electronic tallies.
The Credit Revolution
The problem with gold coins was that they could not expand to meet the needs of trade. The revolutionary advance of medieval bankers was that they succeeded in creating a flexible money supply, one that could keep pace with a vigorously expanding mercantile trade. They did this through the use of credit, something they created by allowing overdrafts in the accounts of their depositors. Under what came to be called "fractional reserve" banking, the bankers would issue paper receipts called banknotes for more gold than they actually had. Their shipping clients would sail away with their wares and return with silver or gold, settling accounts and allowing the bankers' books to balance. The credit thus created was in high demand in the rapidly expanding economy; but because it was based on the presumption that money was a "thing" (gold), the bankers had to engage in a shell game that periodically got them into trouble. They were gambling that their customers would not all come for their gold at the same time; but when they miscalculated, or when people got suspicious for some reason, there would be a run on the banks, the financial system would collapse, and the economy would sink into depression.
Today, paper money is no longer redeemable in gold, but money is still perceived as a "thing" that has to "be there" before credit can be advanced. Banks still engage in money creation by advancing bank credit, which becomes a deposit in the borrower's account, which becomes checkbook money. In order for their outgoing checks to clear, however, the banks have to borrow from a pool of money deposited by their customers. If they don't have enough deposits, they have to borrow from the money market or other banks.
As British author Ann Pettifor observes:
[T] he banking system . . . has failed in its primary purpose: to act as a machine for lending into the real economy. Instead the banking system has been turned on its head, and become a borrowing machine.
The banks suck up cheap money and return it as more expensive money, if they return it at all. The banks control the money spigots and can deny credit to small players, who wind up defaulting on their loans, allowing the big players with access to cheap credit to buy up the underlying assets very cheaply.