Money, Trust, and Loans
Understanding the Connection
In a previous discussion, we established a framework for understanding money: it's a form of trust that has been depersonalized and made exchangeable. This transformation allows society to operate with a greater total amount of trust than would be possible through personal relationships alone, thereby fostering greater potential for prosperity.
This piece delves deeper into the financial landscape by examining loans through this same lens of trust. While money is one type of financial asset, it's crucial to recognize others like loans, stocks, bonds, and derivatives are distinct, even though we often measure their value in monetary terms. Thinking of everything purely as money is a convenient simplification, but it obscures the unique nature of assets like loans, and the unique nature of money.
Loans: The Foundation of Personal Trust
At its core, a loan is fundamentally different from money because it relies on personal trust. Consider the simplest form: loaning an object directly to someone without any formal recourse. This act is entirely dependent on your assessment of the borrower's reliability. You are extending trust based on several factors:
Intent: Do you believe the borrower genuinely intends to return the object?
Capability (Preservation): Does the borrower have the means and competence to keep the object safe from loss or damage?
Capability (Restitution): If the object is lost or damaged, does the borrower have the resources to repair or replace it?
Willingness: Does the borrower's intent extend to actively using their capabilities to protect, repair, or replace the object if necessary?
Your willingness to lend also depends on the expected value you derive from taking this risk. This value might be emotional (caring about the borrower's success), practical (their use of the object benefits you indirectly), or relational (earning goodwill).
Crucially, all these assessments and expectations are personal. They require some level of direct or indirect knowledge of the borrower. Even within large organizations or bureaucratic systems facilitating loans, a chain of personal assessment, however indirect, must exist.
Money: Trust Depersonalized
Money operates on a different principle: depersonalized trust. It allows you to acquire goods or services from someone who knows nothing about you and has no personal reason to trust you. The seller gives up something tangible (like the object you might have loaned) and receives money, which represents access to a broader, socially agreed-upon system of trust. You, the buyer, can access this because you (or someone who transferred the money to you) previously performed actions deemed valuable enough by society to be granted this token of depersonalized trust.
It's important to acknowledge that trust, both personal and depersonalized, can be acquired dishonestly. A con artist gains personal trust under false pretenses to secure a loan. Similarly, someone possessing stolen money benefits from the depersonalized trust it represents, as long as the theft remains unknown. The key difference remains: trust for a traditional loan must be established personally, while the trust represented by money is systemic and anonymous.
This distinction highlights why loans, rooted in personal relationships, could never scale to increase societal trust in the same way money has. The requirement for personal assessment inherently limits the reach and volume of trust compared to a depersonalized system.
Modern Banking: Bridging Personal and Depersonalized Trust
You might argue that modern loans do facilitate broad economic activity, seemingly contradicting the idea that they are purely personal. This is where the structure of modern banking becomes critical. Many loans today involve the transfer of money, which is the depersonalized element.
Furthermore, the banking system itself introduces a fascinating dynamic. When a bank issues a loan, it typically does two things:
Records an obligation for the borrower to repay (an asset for the bank).
Credits the borrower's deposit account (a liability for the bank).
That credited deposit functions effectively as money in the modern economy. We use deposit balances for checks, wire transfers, debit card payments, and digital transactions. In essence, by issuing a loan, the bank creates new "perceived" money based on the promise of repayment.
This ability doesn't primarily stem from government decree; it arises from the public's acceptance and trust in bank deposits as a form of money. If society didn't trust these deposits, we'd be restricted to using only physical currency. The government's role, particularly through mechanisms like the fractional reserve system, is primarily to regulate and limit this money-creation ability, not to grant it. Without such limits, banks could theoretically expand the money supply indefinitely based on lending.
Consider a simple economy: 10 people, $100 in physical currency, one bank.
Person 1 deposits the $100.
The bank, holding the $100, lends it to Person 2. Person 2 now has $100 cash, Person 1 has a $100 deposit claim.
Person 2 deposits the $100. Now the bank holds $100 cash, but owes $100 to Person 1 and $100 to Person 2 ($200 total deposits). The bank also has a $100 loan asset (Person 2's debt).
The bank can now lend again against the deposited cash. If this repeats for all 10 people, the bank holds $100 currency, has $1,000 in deposit liabilities, and $900 in loan assets.
This illustrates unregulated money creation through lending. Government regulation (like requiring banks to hold a certain fraction of deposits in reserve) slows this process but doesn't eliminate it. While depositors could theoretically regulate banks by demanding transparency and setting terms, the complexity, especially with inter-bank transactions, makes effective self-regulation impractical.
Inflation: Driven by Circulation, Expectations, and Trust
Understanding the value of money and the dynamics of inflation requires looking beyond just the supply. Money's purchasing power isn't fixed; it reflects the collective trust placed in the monetary system. More trust generally supports higher value, while eroding trust diminishes it. The numbers on currency are merely denominations of this shared trust.
Critically, the circulation (or velocity) of money—how quickly it changes hands—is as important as its quantity. Money actively used in transactions fuels economic activity and influences prices far more than idle money. Inflation often accelerates when the rate of increase in the circulation of money outpaces the rate of increase in the availability of goods and services, leading to rising prices as more money chases relatively fewer goods.
Furthermore, expectations play a powerful role. If people anticipate that money will lose value (due to expectations of faster circulation, decreased availability of goods, or general instability), they become reluctant to hold it. This expectation can become a self-fulfilling prophecy, creating inflationary pressure now. People may rush to spend money or prefer holding tangible assets, reducing the supply of goods offered for sale while increasing immediate demand.
It is through the expectation that circulation will increase that money supply has relevance to inflation. All other things being equal, one might expect the introduction of new money to increase circulation. But in the same way the expectation that money supply will increase can have the same effect. This regression doesn’t have a defined end, but the awareness of individuals to these details, accurate translation to real expectations should be expected to have a diminishing relevance with each iteration.
Ultimately, these dynamics rest on the bedrock of trust in the monetary system's stability. Declining trust fuels negative expectations, potentially accelerating circulation and discouraging saving, both contributing to inflation. However, a severe loss of trust can also paralyze commerce. If widespread economic pessimism causes a sharp drop in consumption and investment, this fall in demand could counteract or even outweigh the inflationary pressures from hesitant sellers, potentially leading to stable or even falling prices amidst the crisis.
Loans: Balancing Risk with Interest and Collateral
Returning to the nature of loans, if a lender lacks sufficient inherent interest, their expected value can be increased by a promise of monetary interest. Commercial lenders, who typically lack an inherent interest in the borrower's success beyond repayment, rely primarily on monetary interest to compensate for the risk they assume. Monetary interest is also a compensation for the opportunity cost of lending.
Commercial lenders also are more prepared to evaluate capability, then to evaluate intent and willingness. Commercial lenders thus seek other mechanisms to align intent such as collateral. Collateral is an asset pledged by the borrower that the lender can claim if the borrower defaults on the loan. Collateral both aligns intent, and reduces risk. This provides the lender with an alternative means of recovering value, making them less solely dependent on the borrower's personal reliability.
It’s useful to remember that while the trust relationship between an individual and a commercial lender will feel less personal, it’s still direct, and not the type of depersonalized trust that exists with money where the locus of the relationship has socially dissipated.
Conclusion: Personal Trust, Depersonalized Trust, and the Role of Banking
In summary, while often discussed together and frequently interacting in modern finance, money and loans operate on fundamentally different principles of trust. Loans are built upon personal trust, requiring assessment of individual reliability and intent. Money, conversely, represents depersonalized trust, a socially agreed-upon system allowing anonymous exchange based on collective confidence.
The inherent limitations of personal trust mean loans alone could not scale to support complex, large-scale economies. Money overcomes this barrier. The modern banking system acts as a crucial intermediary, bridging these two forms of trust. By accepting deposits (an act of trust by the depositor) and issuing loans (which create new deposits accepted as money by society), banks facilitate the expansion of credit and the functioning of the broader economy, typically operating within a framework of government regulation designed to manage the associated risks. Grasping the distinct natures of personal and depersonalized trust, and the mechanisms that connect them, is essential for understanding how our financial system enables economic activity.