Would you credit it? How money is lent into existence

In Financial Times, 18th August 2011 there was published a letter from Dr. Michael Reiss:

Sir, The phrase “credit crunch” has been widely used to describe the freeze in lending that can occur at the tipping point of economic bubbles (for example “Spanish banks turn off the credit taps”, August 12). This is, however, misleading because it perpetuates the myth that “credit” is somehow fundamentally different from money.

 

Using this phrase allows the public to carry on believing the false notion that there is an essentially fixed pool of money out there and the only problem is the banks’ willingness to lend it out.

 

The truth is, credit is money. Due to the magic of fractional reserve banking, virtually every pound we spend is money that has been lent into existence. This is true even if we have no borrowings ourselves. During a so-called credit crunch, there is an aggregate preference for paying back loans over taking out new ones. This shrinks the amount of money in the economy. The opposite of lending money into existence occurs, that is to say paying back money out of existence. The fraction of people, or even politicians, that are aware of this fact, is frighteningly small.

 

A shrinking money supply has a host of unpleasant side effects, as anyone who lived through the Great Depression would testify. During the period 1929-1933 the money supply fell by a third.