Last night was a bad night with Duncan; he was up quite a bit with gas. On the positive side, that time seemed to put my Ni engine-- Myers-Briggs people will know what that means-- into overdrive, and I had a couple of somewhat major revelations. I'll write about the first one in this post, and the second one in a separate post.

A couple of days ago I read a comment to an economics-related blog post that said (paraphrased), "All of you people bitching about central banks creating paper money are nuts-- it's nothing compared to the money created in the private economy every time someone issues credit!"

Right from the get-go that didn't sound quite right to me, but it took me a couple days of background processing to figure out why. The reason the commentor is wrong is because he's 1) confusing the part of human exchange that entails the creation of wealth, and 2) he's confusing money with wealth.

When someone extends credit, no money is created; all that happens is the creditor gives the debtor some of his money, and the debtor has to give that money back, plus some of his own (interest), at a later date. No money is created-- it's simply transferred.

So how does the debtor get the money that he pays back to the creditor in the form of interest? Why, via the money he derives from the wealth he creates via some productive process; he either exports his labor, creating wealth for his employer, or he takes higher order capital goods-- like a stick and some iron-- and creates something more valuable in the process-- like a shovel.

If you somehow doubt this first consider traditional English law: when someone can't repay a loan it's treated the same way as theft-- after all, the creditor was just borrowing the debtor the money; the money was still the property of the creditor! No new money was created, it was simply loaned.

If you still don't believe me, here is further proof: you can have an entire indirect exchange economy without ever creating new money. Let's say that you have a million potato chips, and it's impossible to ever make any more. All money-- potato chips in this case-- does is represent the total amount of wealth in the economy. Remember, money and wealth aren't the same thing.

As wealth is created in the economy, each of those million potato chips is simply worth more, because each one is representing more wealth. That's why as an economy based on a relatively fixed money supply grows, deflation-- a lower cost of living and subsequent higher standard of life-- is a natural consequence.

During the 19th century America's economy was based on gold which, like the potato chips in my example, was of a relatively fixed supply. As a result, every productive gain in society was manifested in a lower cost of living-- America had deflation throughout pretty much this entire period-- and, hence, the plight of the common man in 1900 was improved to an almost staggering degree when compared to his lot only 100 years earlier.

But that's a bit of an aside. The important thing to note is that the issuance of credit is simply a transfer of existing money, not the creation of new money. That's why we call it a borrowing of money. And as wealth is created, the money supply doesn't necessarily have to grow for prosperity to be obtained-- money and wealth are mechanically created independently of one another (the former via a value-added process, the latter via mining, or a central bank in the case of fiat money).