In order to understand where our economy is, it is necessary to understand what an economy is. Let’s go back to an earlier time and see how an economy comes into existence.
If we look back, we find that people were basically barterers. Unless every product needed could be grown on one farm, it was necessary for neighbors to trade products.
Let’s say, for example, that three individuals lived in a small community. One raised cows. The second raised corn, wheat, and barley. The third manufactured horseshoes and nails.
The dairyman decided he would like to build a barn for his cows. He had lots of timber on his property. He was able to cut down his trees and store his timber until it was cured and ready to use, but he was tired of using wooden pegs to put up his buildings—it’s so much trouble to drill holes, pound pegs and sand them down. Then he had an idea.
The dairyman used nails to build his barn and was so pleased he decided to get some more to repair his house.
He went back to the blacksmith to trade for some more nails.
Perplexed by the blacksmith’s refusal, the dairyman turned to his neighbor, the farmer, for help.
Trading his cow for some corn, the dairyman returned to the blacksmith.
The dairyman repaired his house and began to promote the virtues of using nails.
Soon other people began coming to the blacksmith to trade their products for nails.
Then the blacksmith had an idea! Why make horseshoes and other items? There seemed to be a good business in nails. So he began to specialize in manufacturing only nails!
As more and more people used nails, Dan developed a flourishing business. Everybody wanted nails to trade. Nails became what we call “money.” Money, in any system, must satisfy three basic functions: It must have value, it must be storable, and it must be divisible. Dan’s nails satisfied every one of these aspects and so they were used as money.
Dan had been in business several months when a farmer came by one afternoon with a large order.
When Dan wrote out a paper declaring that he had 100 bags of nails on hand for the farmer, he created a new medium of exchange—paper money. This paper money had to satisfy the same basic functions that our original money did to be called money, and it did. Nothing new was created by this paper money. It merely represented the nails in storage.
The distribution of paper money rather than nails continued as more and more people discovered that it was easier to carry pieces of paper than nails.
Dan began to notice that most of the nails remained in his warehouse. Although they belonged to somebody else, he always had surplus nails.
He began to think, “Why should I let these nails sit idle? No sense in making more nails when all these are here.”
Then one day a farmer needed some nails but couldn’t pay for them right them. So Dan loaned him some nails to be repaid later.
But this time, rather than making new nails, he simply issued paper on nails already stored in his warehouse. What had Dan become? A banker! He stored money (nails) for some and loaned it to others.
Dan had also created a new kind of money—credit!
Now credit seemed like a good thing. Without even knowing it, others were able to use this credit to build houses and barns. Dan’s business prospered through his use of credit—other people’s money.
Unfortunately, to keep his business growing, Dan was forced to expand using more and more credit. Then one day a depositor came to collect a large order of nails that Dan was supposed to be storing for him:
Quickly the farmers called a local meeting to compare nail receipts. One had 1,000 bags coming, another 500, etc.
It was obvious that something was wrong!
So they all rushed to Dan’s bank and demanded their nails back.
What happened? Dan went bankrupt. Why?
Credit was his downfall. When his depositors lost confidence in him, Dan was finished as a banker. He just loaned too many nails that belonged to others. You see, although credit looks like money, it isn’t. Credit is storable and divisible but it lacks one essential element—value. Credit cost nothing to create.
As we will see later, this same difficulty has occurred in real economics as well. Government, playing the role of world bankers, have issued credit until few people really believe they can ever repay their debts.