Why Credit Cards Cause Inflation


The basic principle of economics, that two people both benefit from a voluntary trade, is even more true when they trade on credit. The opportunity to "buy now and pay later" is a convenience for both the buyer—who may have forgotten his checkbook or must wait until payday for cash—and the seller, who can record the sale immediately and reorder merchandise for inventory. Credit saves time and cuts transaction costs. The Latin word "credit" means "he, she, or it trusts." Trust in another's honesty is an economic good.

When credit is extended to a buyer, the seller makes a bookkeeping entry to record the sale. No money has changed hands, but one very important feature of money, the unit of account, has been used. As elementary economics textbooks define money, it is (1) a medium of exchange, (2) a store of value, and (3) a unit of account. In this article we will analyze and explain the role of the government in defining (and debasing) the unit of account. Throughout this article, we will assume that "one coin" is the unit of account, although anything could be used—a cow, a bushel of corn, a silver bar. The only important element is that it be a specific unit and that the general public believe that the referent has a physical existence—even if it doesn't.


When income-tax season arrives each year, the accounting profession works overtime to balance the ledgers of professionals and businessmen who couldn't care less during the rest of the year whether their debits equal their credits. Indeed, most nonaccountants have only a vague understanding of why accountants worry about such things. Most readers probably understand that business profits and losses, as well as taxes, are calculated from this mysterious system of rules and tricks. Ludwig von Mises regarded the invention of double-entry bookkeeping a major step forward in the history of capitalism. Yet, how many readers realize that the simple logic of accounting is responsible for the abandonment of the gold-coin standard in finance during the past century? Consider the process of credit expansion.

Start with the elementary libertarian argument that two people ought to be allowed to make contracts and to trade freely, without force or fraud and without government favoritism shifting the terms of trade to one side or the other. If a wealthy man is willing to lend money to another and to accept the other's personal note as security for the loan, who among us will argue that this is wrongful? This is merely a capitalist act between consenting adults. Assume that the wealthy man, instead of directly disbursing, let us say gold coins, to the borrower, writes a letter of credit, "to whom it may concern," with the information that he is willing to underwrite any purchases of the borrower. The lender promises to pay on demand, and anyone who sells goods or services to the borrower may now come and make demand at any time for payment in gold.

To develop this argument, let us assume that the wealthy man is not in the habit of keeping a pot of gold coins in his home or office, but he knows that he can obtain gold without difficulty by selling some other assets. Maybe he keeps coins in the bank vault and uses paper certificates to prove that he owns them. Importantly, no potential seller of goods or services to the borrower is under any compulsion to honor the letter of credit, to absorb a portion of the loan. Since "credit" means "he trusts," a forced sale would be forced trust—a dubious concept. Yet, among honorable businessmen credit is the customary method of doing business. Trade credit (credit that a seller extends to a buyer for a short time period) is a monetary aggregate, just as M1, M2, or M5.


What is the cause of inflation? Too much purchasing power (money plus credit) in the economy relative to the supply of goods? We know from the history of paper money that whenever governments run their printing presses and expand the supply of certificates—which governments call money and almost always enforce with legal-tender laws—the process of supply and demand will increase prices in terms of this new, counterfeit money. A common monetarist definition of inflation is any increase in the supply of money or of money substitutes. Money substitutes are, for example, certificates redeemable on demand for a specified quantity of gold coin. Counterfeit certificates would be those issued by some agency without any gold coin to "back" them. As the supply of money substitutes grows, the number of these certificates which any seller demands in trade for real goods and services can increase without loss of sales. People have more of them to offer. This process of increasing prices would be especially prevalent if sellers begin to suspect that somebody is printing certificates. Although prices have been known to rise as well when gold is imported or discovered, 1896-1913, for example, this illustrates the general case a fortiori as regards credit expansion. A "gold certificate" is indistinguishable from a credit instrument.

Money substitutes and credit are created, not only by the printing press, but by the accounting system of double-entry bookkeeping. Checking accounts, credit cards, the "letter of credit" discussed earlier, are all money substitutes. The element of human action which holds this system in equilibrium is that money performs its three important economic functions interdependently, because both the store of value and the medium of exchange are expressed in terms of the unit of account.

As a store of value, the gold coins might sit in bank vaults or lie buried in treasure chests. Money substitutes, which circulate as the medium of exchange, might be turned in for gold coins only when the holder would want to test the bank, or the treasury, to see if the gold were really there. Or he might just want to get some gold to bury in the backyard. Paper certificates and checking accounts are superior mediums of exchange because they are more portable and often safer from theft, and the endorsed check is proof of payment without any other receipt. Credit cards and electronic funds-transfers are even better as media of exchange, but they are limited by one's supply of short-term credit, although not by the amount of money in one's pocket. The total supply of gold coin places no direct constraint on the medium of exchange, which is limited only by technological considerations and "he, she, or it trusts."


When markets are organized across several time periods, it becomes automatic to "remember" how much somebody owes you. Any asset can be traded for any other asset or service. Prior to and after the trade, the assets represent a store of value, and at the moment of the trade, they assume the quality of a medium of exchange. What makes cash money unique, however, is its third quality: the unit of account. This is the point of my argument. Prices tend to be quoted in terms of the government's unit of account. Government credit expansion, therefore, has a special impact on the economy. To see the connection, the bookkeeping process must be examined more specifically.

The foundation of accounting is the unit of account, just as the basis of all numerical analysis is the concept "one" and "one plus one equals two." Bookkeeping is a system of measuring economic magnitudes in terms of a common denominator, units of value. Double-entry bookkeeping is based on simple convention: debits must always equal credits (Dr = Cr) and assets must always equal liabilities plus equity (A =L + E). When a "gold warehouse" accepts a deposit of gold coins and prints certificates as proof for the deposit, we can analyze the transaction in terms of the accounting identity as follows:

STEP ONE (before the deposit)
Assets = Equity
(coins) = (ownership/possession of the coins)

STEP TWO (warehouseman's view)
Assets = Liability
(coins) = (possession/promises to pay)

STEP THREE (depositor's view)
Assets = Equity
(notes) = (ownership of the coins)

As can be seen, the depositor's asset is the warehouse keeper's liability. The unit of account in the above example is "one coin." A note might say, on its face, "I promise to pay one coin to the bearer on demand, (Signed) Warehouseman."


With the basic accounting identity in hand, we can return to the example of the wealthy man who lends his credit, or trustworthiness, to a friend. The "letter of credit" which he gave to his friend said, "I promise to pay one coin to the bearer on demand, (Signed) Wealthyman." The fact that he may not have a coin in his pocket to redeem the promise readily is not fraud, as some have argued, because he can sell some other asset at any time and get a gold coin. Remember, he is a wealthy man—not a counterfeiter. The gold coin is merely the unit of account that he and the borrower, and all of the merchants in town, happen to use to make their bookkeeping entries and to measure their assets and liabilities. The importance of this distinction cannot be overemphasized. It would be a matter of fraud if the wealthy man were in fact bankrupt and did not have any assets that he could sell for gold. In this case, the accounting identity would be out of balance, because the liability would exceed the assets.

The fact that the wealthy man does not continually hold gold coins to "back" his letter of credit may mean that he is illiquid, but it does not mean that he is bankrupt. The demand for liquidity, or the transactions demand for money, is an important concept in both the Keynesian theory and the monetarist theory of the economic system. Indeed, the precise reason credit is used to such a great extent in modern business practice is to supply the demand for liquidity. If one has credit, the cash can be put to use elsewhere. Units of credit are created by bookkeeping entries: a capitalist act between consenting adults.

This is precisely the operation of the banking system. The accounting identity is used by bankers to secure noncash assets, such as mortgages, automobile titles, and even the personal honor (that is, future wages) of borrowers. The banker makes a loan by opening a checking account or increasing the balance in an established account for the borrower. When an individual obtains a credit card, the card-issuer is extending credit against expected future payments, just as when a bank makes a car loan.

Observe carefully that the bank is not actually lending out anybody's money; the money stays in the vault. The bank is expanding credit, in terms of the common unit of account, performing the role of the wealthy man in our earlier example. As long as the balance sheet of the bank is correct, and as long as the bank remains sufficiently liquid to disburse coins on demand (roughly 10 percent of its assets would have to be in cash under today's business conditions), the bank will remain strong, secure, and beneficial to the community. To assure the accuracy of a bank's balance sheet, independent auditors are employed to examine the books of the bank from time to time—and this practice reinforces the trustworthiness of the bank's credit instruments. During periods of excessive demand for cash by depositors, bankers can and do trade noncash assets with each other.


Bankers and businessmen, acting within the market for goods and services, extend credit up to a certain limit and not beyond that limit. What is this limit? Why not expand credit forever? The answer is that the customary preference for liquidity precludes such expansion. Periodically, individuals will have a "balance-of-trade surplus or deficit" and will want to consolidate their holdings. When the gold bug takes all of his gold coins out of his bank and buries them in his back yard, he is consolidating his holdings. Trade credit might be carried indefinitely, but it usually isn't. The amount of cash a person desires to hold for transactions is a function of his perceived wealth, social status, expected income, and many other factors. The amount of cash in existence, that is, actual certificates that say "one unit" on the face, and the rate of turnover of the certificates (the velocity of circulation) establish a limit to credit expansion. This limit, we would argue, cannot be measured or controlled by any monetary authority—because any two individuals can agree to expand or contract their interpersonal credit. Yet, for the society's aggregate credit limit not to exist, we would have to assume that some members of society have unlimited credit—and nobody, at any single point in time, has unlimited assets.

In the future, however, technological innovations, such as electronic funds-transfers, will increase the turnover (velocity) of cash and boost the aggregate social credit limit even if the government were to reduce the quantity of cash notes. Cash notes might even be abolished, forbidden by law, and the money supply could be entirely gold coins—but credit expansion would continue just as before, except that people would liquidate their credit transactions with coins instead of notes. The paper certificate was just a technological way station in the economic history of civilization, followed by checking accounts, credit cards, and who knows what in the year 2000. The belief that fractional-reserve banking is the root of all monetary evil is wrongheaded. It is false that if we would only return to the "gold dollars" and forbid banks from "making loans with depositors' money" or expanding credit all would be well. Not only would it be a violation of the free-market principle that depositors can make any sort of contract they wish with their bankers, but it would be ineffective, because the amount of credit in society is independent of the amount of gold coins, or cash notes.


The classical argument is for a gold-coin standard. This is different, however, from the argument of the quantity theory of money that the quantity of money should be held stable (increasing at a slow and steady rate). The quantity theory of money (plus credit) is a good theory—more useful today than the Keynesian theory of income determination—but it relies very significantly on a stable velocity of circulation for the quantity of money. The confusion among economists and financial analysts as to whether M1, M2, or M5 is the best monetary aggregate to observe in order to predict the movement of economic activity depends centrally on a mechanical assumption about velocity and the relevance of certain monetary aggregates to the public's demand for liquidity. Although this topic is interesting and challenging in the short-run, it is not central to the problem of inflation.

The argument that Ludwig von Mises gives and that F.A. Hayek contends is the reason for Austrian theorists' favoring the gold-coin standard is that it puts the control of money completely outside of government control. The unit of account, they argue, should be defined as a certain weight of gold—regardless of the quantity of gold at any point in time. The ounce or the gram of gold should be the unit of account for private trade because the government cannot alter the definition of this unit. Although Mises and Hayek seem to prefer gold, it is clear that any commodity could do as well. A tabular standard, that is, a composite commodity index or table of values, might be even more ideal than a single commodity—but this type of monetary standard would be too complex for the average citizen to comprehend, and the government would reenter the picture to "manage" it; hence, Mises rejects the idea. (Mises, Theory of Money and Credit [New Haven, Conn.: Yale University Press, 1953], pp. 413-14.)

The classical argument, therefore, is a price rule for the unit of credit, rather than a quantity rule for the supply of credit. In the old days, before 1933 or 1971, the dollar was a unit of credit and a weight of gold. From the Coinage Act of 1792 until 1873, the dollar was a unit of credit and a weight of silver. Naturally, when two things have the same name and trade at a fixed price (one for one) confusion results and imbalances in supply and demand are manifested in excess supply or excess demand, rather than in price changes. In the post-1971 era, the dollar is strictly a unit of credit, as well as the unit of account for all balance sheets in the United States (and many other places). The present imbalance in the supply of credit is taking the form of price inflation. The movement of prices in an upward direction is, in fact, a misperception. What is occurring is the discounting of the unit of account by the sellers in the market. Real commodities in the world market are holding steady relative to each other, but the units of account are depreciating throughout the world. The inability of the average person to think in terms of a depreciating unit of account is called the money illusion—it explains why we talk of rising prices.

If the unit of account were not under government control, enforced by legal-tender laws for the government's certificates, and if the banking system were not organized in such a way as to use government bonds and cash notes as assets, the structure of credit and the process of credit expansion would be very different. The special position of the government in society—specifically, its ability to collect taxes by force—makes the government a very special sort of agent in the credit market. The amount of credit an individual or businessman can obtain is limited by his assets, including the estimated present (discounted) value of his future income. This is a limited amount. For the government, on the other hand, the sky is the limit! Its credit limit is only a theoretical one: the total Gross National Product of all future generations, assuming the government could confiscate this entire amount in taxes without a revolution. With the bonds of the U.S. Treasury as assets, the banking system is pleased to expand credit without limit. Needless to say, this process is inflationary. If government bonds were sold only to private savers, who would view them as advance payment against future taxes, the equilibrium in the credit system would not be disturbed. The ability of the Federal Reserve System to monetize the debt, however, is highly inflationary because every commercial bank then uses Federal Reserve Notes as liquidity to support additional private loans and deposits.


To reestablish a stable equilibrium in the money and credit system, two reforms are in order. Let us assume, for purposes of this discussion, that only the most limited reform can be achieved. It is sometimes interesting to contemplate a society starting fresh with a new constitution and all of our hindsight and experience; yet, we can't start over. We have a division-of-labor economy to attend to; there are 214,000,000 citizens with a stake in the economy of the United States, and almost every one of them suffers from the money illusion, has acted in anticipation of further inflation (in terms of dollars), and stands to lose personal collections of assets—including pension claims. We should attempt to leave the latter undisturbed as much as possible. This is a political consideration, not a judgment of the relative justice of the reforms.

The first reform would be the introduction of a gold coinage, measured by weight, into common circulation. The selection of gold is partially an historical consideration and has nothing to do with the "intrinsic value" of gold. The weight should be in common physical units—preferably grams, since the gram is an international unit of scientific measurement. It would be good to avoid exotic units of weight, such as eagle or even troy ounce, because the purpose of the coins would be to serve as a target for the free-market value of the unit of credit (the second reform, see below) and it would be important to keep the two concepts as separate as possible to minimize the natural tendency toward the money illusion. The gold coins might be issued in conjunction with the Bicentennial festivities and sold at whatever dollar price the market would bear. The entire stock of Fort Knox, which is mostly coin-melt, should be offered for sale as 10-gram, 50-gram, and 100-gram coins. A handy profit should accrue to the Treasury from this grand sale, and with proper promotion the price of gold would probably rise. It would be hoped that these coins would enter circulation alongside the dollar, and that contractors would be free to specify either dollars or gold coins for future delivery. It is important not to specify a pegged dollar price for these gold-gram coins. It is likewise important that neither dollars nor gold-gram coins should enjoy the status of legal tender, because any attempt to manipulate the market price relationship between gold-gram coins and the total dollar supply of credit would destroy the effectiveness of the second reform.


The second reform is more utopian, namely, to halt the practice of monetizing the annual Federal budget deficit via the Federal Reserve System. Ideally, the debt of the United States should not be held by financial institutions at all but only by private individuals. The reason for this proposal is that government credit expansion is not limited by real assets but represents a capitalization of future taxation—and only individuals pay taxes. To the extent that the predominant medium of exchange would continue to be the dollar, and to the extent that corporate balance sheets and tax revenues would continue to be in terms of the government's unit of account, the dollars there would be an implicit price rule established between the gold-gram coinage and the unit of credit. The rule would be: so manage the finances of the government that the public would not abandon the dollar as a medium of exchange! If the rate of inflation should accelerate, the dollar would be abandoned in very short order indeed. If inflation continued to decline, however, as the administration assures us is happening now, then the dollar would continue to be used by every American and most of the world as a unit of account and a medium of exchange.

Monetarist theory is certainly correct in the short run, when the velocity of circulation can be taken as stable, in its prediction that halting or slowing government credit expansion will reduce price inflation. The experience of the Confederacy during the Civil War, when the Treasury withdrew a significant amount of paper money from circulation and the Confederate price level fell, is an excellent case in point. As long as the rate of increase in the price level were slowing, the dollar would continue to command the favor of most economic transactions. Eventually, of course, banks would begin to offer credit accounts denominated in gold-grams as an alternate unit of account, and some long-term securities would be denominated in the new coinage as well. A dual system, without a fixed price or legal-tender restrictions, should provide the ideal free-market solution to inflation. Citizens could keep their accounts in either or both units and freely allow the "bad money" to drive out the "good money" by means of price adjustments.


Since there is reason to believe that political pressure on Congress is the cause of our present dollar inflation, it would probably be a good idea to impose the second reform by means of a constitutional amendment which would mandate a certain policy on the part of the Treasury. Any realistic system would have to accommodate political situations and yet maintain the credit price objective. Suggested language for such a constitutional amendment is: "It shall be the policy of the Treasury of the United States to stabilize the supply of cash notes and Federal credit in circulation, and thereby to preserve and increase the purchasing power of the currency of the United States." This particular choice of words accommodates both the "stable as you go" theory of Milton Friedman and the Chicago monetarist school and the price rule theory of Ludwig von Mises, F.A. Hayek, and the Austrian classical theorists. The importance of establishing the rule as an amendment to the Constitution of the United States, of course, is to fulfill the requirement of Mises and Hayek that management of the money supply be removed from government control. Putting the rule into the Constitution places it above the policies of transient congresses and administrations, above politics, and puts it into the same category as freedom of speech and religion—where it belongs, for the sake of a free society.

If the founding fathers had realized how the advance of technology would alter the monetary system, it seems certain they would have been more specific in their choice of words in Article I, Section 8. Following the Revolutionary War, the paper currency of the United States depreciated rapidly. The inability of the government under the Articles of Confederation to control inflation was a major force behind the formation of a stronger central government in 1787, as is clear from the proceedings of the Constitutional Convention:

Keynoter Edmund Randolph inveighed against the "havoc of paper money" in his indictment of the Articles of Confederation. The audience needed no reminder. Every man present could personally testify to the convulsive monetary situation. Some could speak of its compounded injustice, as for example, Washington, who had refused compensation for his Revolutionary service, then came home to have the mortgages he held paid off in Virginia paper worth ten cents on the dollar.

Madison later summed up the general sentiment in his excoriation of pre-constitutional paper money as a pestilence which inflicted nothing but destruction on the necessary confidence between man and man, on the necessary confidence in the public councils, on the industry and morals of the people, and on the character of republican government.…[Gerald T. Dunne, Monetary Decisions of the Supreme Court (New Brunswick, N.J., Rutgers University Press, 1960), p. 12.]

Under the Articles of Confederation, every state could issue its own paper currency; under the Constitution, this was forbidden to the states—and the Federal government did not start the practice until the Civil War.

No monetary system has yet been devised that has proven free of problems. Even the peaceful era of 1865 to 1896 saw a massive deflation under a gold standard, deflation that produced the populist political movement, followed between 1896 and 1913 with a more rapid gold inflation. The main point to be said in favor of the gold standard is that attempts to manage currencies have proven even more disastrous—as the deflation of 1929 to 1933 and the inflation of 1939 to date have shown. We could do worse than to combine the best of both systems, and to give each citizen a free choice as to the system he will use.

Joe Cobb is employed as fiscal officer of the Industrial Commission of Illinois. He has written a number of articles on economic topics since graduating from the University of Chicago in 1966. He is a member of the Judicial Committee of the Libertarian Party and a director of the Economic Civil Liberties Association.