Turner Turns (9) Creating Credit

Adair Turner explains that Banks can create credit. What he does not explain is why they are able to do it so freely. Is this legal? Is it right?

Banks are not unique in being able create credit. Any individual can create credit too. If I supply you with goods or services and say that you can pay me in a year’s time, I have create credit. However, I can only give away stuff that I do not need for the next year, so there is a serious limit on how much credit I can create. I have to give some goods or services that I have produced or bought in exchange for an IOU from the borrower. Unless I am rich in resources, I will not be able to give much credit.

Businesses can create credit, too. If it supplies goods or services to person or another business, and agrees that no payment is required until a year later. This credit becomes money, because the person can use the money he would have paid to the business to buy something else.

However, a business has the same constraint on the amount of credit that it can create, as a person. It has to supply some goods or services to the borrower in exchange for the security it receives from the borrower. Creating credit will reduce it stock of goods or supply of cash in the bank. It can only lend stuff that it does not need for the ongoing operation of its business. The amount of credit created will be small, because most of its resources will be needed to keep the business operating.

A businesses balance sheet looks like this.

The business needs its capital equipment and building for ongoing production. Therefore, unless the business is willing to borrow the money it lends, it has to turn some of its cash at the bank or stocks of inventory into loans to debtors. This significantly limits the amount of credit it can give.