Money can be confusing. In the past it used to be in the form of gold. But what is money nowadays? It is more like very liquid and abstract credit. And since it is credit, it is also debt. This is very confusing because we are used ot think of money as “something”. To think that every unit of money is somebody’s asset and at the same time somebody else’s liability is not easy for the untrained observer.
Here is a “fairy-tale” attempt to explain this in a way that can build intuition on how this works and how money is linked to the underlying concrete transactions which we like to call the “real” economy. This fairy tale is based on chapter 6 of John Hicks’ book “A Market Theory of Money” and is inspired by Professor Mehrling’s Money and Banking course at Coursera.
The Tale of Money and the roots of the Money Alchemy
We could imagine a pre-money society. I am a producer of apples and you want to buy some in exchange of pears. But you expect your pears to ripen two months from now. We could agree that you get the apples now and I wait for the pears to be delivered later. That would be inter-temporal trade with a normal contractual relations. But you could also offer me a paper which says “[Your name] promises to deliver 10kg of pears to the bearer of this note on [date]”. That would be something like a negotiable instrument. I am not sure these kind of things ever existed. The point is that once I get this paper I could trade with it. I accepted it because I trust you will deliver. I could pass it on to anybody else who equally trusts you.
How can I use the paper to trade with people who don’t trust you? I have to use the services of a third party that is “universally” trusted. That party should be willing to take my paper and issue its own liability, again let’s imagine in the form of paper. Here we better introduce some measure of value and say that the third party issues a paper worth 10 Guldens (the name has nothing to do with gold). This third party will have, of course, discounted my “pear paper” (i.e. with those 10 guldens I will be able to buy less than 10kg of pears). Now that I have the liability of the third party I can trade with anybody in the community, or at least with a wider circle of people than with the “pear paper”.
The third party is trusted “universally” because it is doing this transformation of debts professionally and is supposed to pick up the good promises that are unlikely to go unfulfilled. It’s trusted also because it holds a portfolio of these. So even if one of the “papers” remains unpaid the others will be and given that it discounts them at the appropriate rate all should be fine.
We can call this third party a bank…
Although this is not representing accurately what banks do, or have ever done, they do something close to that. And what central banks do is similar too. Instead of promises to pay apples/pears they usually obtain short-term government debt (but also other things like MBS recently in the US) and issue central bank reserves or banknotes in exchange.