What Is Credit Money?

Credit money is monetary value created as the result of some future obligation or claim. As such, credit money emerges from the extension of credit or issuance of debt. In the modern fractional reserve banking system, commercial banks are able to create credit money by issuing loans in greater amounts than the reserves they hold in their vaults.

There are many forms of credit money, such as IOUs, bonds and money markets. Virtually any form of financial instrument that cannot or is not meant to be repaid immediately can be construed as a form of credit money.

Key Takeaways

  • Credit money is the creation of monetary value through the establishment of future claims, obligations, or debts.
  • These claims or debts can be transferred to other parties in exchange for the value embodied in these claims.
  • Fractional reserve banking is a common way that credit money is introduced in modern economies.

How Credit Money Works

According to recent research done in economic history, anthropology, and sociology, scholars now believe that credit was the first form of money, preceding coin or paper currency. In ancient times, some of the earliest writings found have been interpreted to be tallies of debts owed by one party to another - before the invention of money itself. This form of value obligation - i.e. I owe you X - is essentially credit money as soon as that obligation can be transferred to somebody else in kind. For instance, I can owe you X, but you can transfer your claim against me to your brother, so now I owe your brother X. You and your brother have essentially transacted in credit money.

During the crusades of the middle ages, the Knights Templar of the Roman Catholic church, a religious order that was heavily armed and dedicated to holy war, held valuables and goods in trust. This led to the creation of a modern system of credit accounts that is still prevalent today. Public trust has waxed and waned in credit money institutions over the years, depending on economic, political, and social factors.

Credit Money and Fractional Reserve Banking

"Fractional reserve" refers to the fraction of deposits held in reserves. For example, if a bank has $500 million in assets, it must hold $50 million, or 10%, in reserve. It can, however, lend out $450 million as essentially new credit money.

Analysts reference an equation referred to as the multiplier equation when estimating the impact of the reserve requirement on the economy as a whole. The equation provides an estimate for the amount of money created with the fractional reserve system and is calculated by multiplying the initial deposit by one divided by the reserve requirement. Using the example above, the calculation is $500 million multiplied by one divided by 10%, or $5 billion.

Credit Money and Debt Markets

As noted above, specific types of credit money include bonds. These are a major segment of the financial markets. For example, the market for U.S. government debt (Treasury bonds or T-bonds and Treasury notes or T-notes) ticked in at $14 trillion in January 2018. In 2018, the size of the global debt markets (more than $100 trillion) was near twice the size of the equity markets (close to $64 trillion). Together they form the global capital markets. The U.S. capital markets are the largest worldwide, with the U.S. equities market being 2.4x and the U.S. bond markets being 1.6x the size of the runner-up, the European Union. U.S. capital markets account for 65% of total funding for economic activity and drive domestic growth.

Bonds allow governments (at the national, state, and local level), corporations, and nonprofits like colleges and universities, to access funds for a variety of growth projects, including funding roads, new buildings, dams or other infrastructure. Corporations will often borrow specifically to grow their business, buy property and equipment, acquire other companies, or invest in research and development for new products and services.

Outside of banks, bonds allow individual investors to assume the role of a lender in these situations. Public debt markets can open up a particular loan to thousands of investors, providing opportunities to fund portions of the capital needed. These public markets allow lenders to sell their bonds to other investors or to buy bonds from other individuals – long after the original issuing organization raised capital.