The money generated from credit affects everybody. Transactions in credit although they do not require cash money,still add to the amount of money and therefore affect prices.

All these substitutes existed when gold and silver coins were the main medium of exchange. Some of them became so powerful that they took over the use of the specie altogether. We need to understand the nature of these substitutes,that will allow us to discriminate between what is good and what is bad for society, or between what is a useful and just use of credit and what is an abusive and pernicious use of it.

What were and what are these substitutes that do not require cash?

The first most basic form of money substitution is book credit or account deposits: Let us suppose that A and B are two dealers (as lenders by profession are improperly called), who have transactions with each other both as buyer and seller. A buys from B on credit, B does the like with respect to A. At the end of the year, the sum of A's debts to B is set against the sum of B's debts to A, and it is ascertained on which side a balance is due. This balance, which must necessarily be less than the sum of the transactions,is all that is paid in cash money; and perhaps even this is not paid, but carried over in an account to the next year. A single payment of one hundred pounds may in this manner suffice to liquidate a long series of transactions,some of them to the value of thousands.

Secondly, this basic credit operation can be brought to another level of complexity to avoid cash money with the use of bills of exchange. The debts of A to B may be paid without the intervention of money at all, even though there be no reciprocal debts of B to A. A may satisfy B by making over to him a written instrument, called a bill of exchange, which is, in fact,a debt due to himself from a third person, C. This is conveniently done by means of a transferable order by a creditor upon his debtor, and when accepted by the debtor, that is, authenticated by his signature, becomes an acknowledgement of debt.

Bills of exchange were first introduced to save the expense and risk of transporting the precious metals from place to place. Let it be supposed that there are in London ten manufacturers who sell their articles to ten shop-keepers in Istanbul, by whom they are retailed; and that there are in Istanbul ten manufacturers of another commodity, who sell it to ten shop-keepers in London. There should be no need for the ten shopkeepers in London to send yearly to Istanbul gold coins for the payment of the Istanbul manufacturers,and for the ten Istanbul shopkeepers to send yearly as many gold coins to London. It would only be necessary for them to hand over the money in question, giving in return a letter which should acknowledge the receipt of it; and which should also direct the money, lying ready in the hands of their debtors in London, to be paid to the London manufacturers, so as to cancel the debt in London in the same manner as that in Istanbul. The expense and the risk of all transmission of money would thus be saved. Letters ordering the transfer of the debt were termed bills of exchange. They are bills by which the debt of one person is exchanged for the debt of another;and the debt, perhaps, which is due in one place, for the debt due in another.

Bills of exchange were found convenient as means of paying debts in distant places without the expense of transporting the precious metals, their use was afterwards greatly extended by another motive. It is usual in every trade to give a certain length of credit for goods bought: three months, six months, a year, even two years, according to the convenience or custom of the particular trade. A dealer who has sold goods, for which he is to be paid in six months, but who desires to receive payment sooner, draws a bill on his debtor payable in six months, and gets the bill discounted by a banker or another moneylender. That is, he transfers the bill to him,receiving the amount, minus interest for the time it has still to run. It was one of the chief functions of bills of exchange to serve as a means by which a debt due from one person could thus be made available for obtaining credit from another.

The convenience of their expedient led to the frequent creation of bills of exchange not grounded on any debt previously due to the drawer of the bill by the person on whom it was drawn. They were called accommodation bills; and sometimes, with a tinge of disapprobation, fictitious bills. Their function was identical to the real bill: A, wanting £50, requests B to accept a note or bill drawn at two months, which B, therefore, on the face of it, is bound to pay; it is understood, however, that A will take care either to discharge the bill himself, or to furnish B with the means of paying it. A obtains ready money for the bill on the joint credit of the two parties. A fulfils his promise of paying it when due, and thus concludes the transaction. This service rendered by B to A is, however, not unlikely to be requited, at a more or less distant period, by a similar acceptance of a bill on A, drawn and discounted for B's convenience.

It was commonly understood that as long as the bill would represent an actual transaction or a real merchandise, the bill had a legitimate purpose. But a shadow fell when the bills originated without any genuine transaction or movement of merchandise taking place. The argument implied somehow that credit, when generated from actual property, was legitimate and when there was no property it was not. This viewpoint still differs essentially from Islamic Law as we will see later, but offers a general idea of what was then understood as good or bad concerning the creation of credit. We should notice briefly, at this stage that the Messenger of Allah, may Allah bless him and grant him peace, said (as recorded in the Al-Muwatta of Imam Malik): "Delay in payment by a rich man is injustice". Therefore we should appreciate that although credit has a place in an Islamic contract, to make use of it unnecessarily and abusively, even if you have the wealth to back it up, escapes the natural purpose of credit and it becomes a form of acquiring an unfair advantage over others.

It is important to understand that a bill of exchange, when merely discounted,and kept in the portfolio of the discounter until it falls due, does not perform the function or supply the place of money, but is itself bought and sold for money. However, when the bill drawn upon one person is paid to another (or even to the same person) in order to discharge a debt or a pecuniary claim, it does something for which, if the bill did not exist,money would be required. It performs the functions of currency. This is a use to which a bill of exchange was often applied. They not only spare the use of ready money; they also occupy its place in many cases.

Let us imagine that a farmer in the country, to discharge a debt of £50 to his neighbouring grocer, gives him a bill for that sum, drawn on his agent in London for grain sold in the metropolis; and that the grocer transmits the bill, he having previously endorsed it, to a neighbouring baker, in discharge of a like debt; and that the baker sends it, when again endorsed,to a German merchant, and that the German merchant then delivers it to his country banker, who also endorses it, and sends it into further circulation. The bill in this case will have effected five payments, exactly as if it was a £50 note. A multitude of bills used to pass between traders,in the manner which has been described, and they evidently formed 'de facto',a part of the circulating medium of the nation.

A third form, much more abstract, in which credit was employed as a substitute for precious metals was the promissory note. A promissory note is a note of hand by a person promising to pay the same sum. The difference between a promissory note and a bill drawn upon anyone and accepted by him is that the former commonly does not bear interest and the latter does; and that the former is payable at sight and the latter is commonly payable only after a certain lapse of time. But it is chiefly in the form of promissory notes that it has become, in the western world, a specific occupation to issue such substitutes for money. Dealers in money desired, like other dealers,to stretch their operation beyond what could be carried on by their own means. They wished to lend, not their capital merely, but their credit,and not only such portion of their credit as consisted of funds actually deposited with them, but their power to obtain credit from the public generally,so far as they thought they could safely employ it. This was done in a very convenient manner by lending their own promissory notes payable to the bearer on demand, the borrower being willing to accept these as so much money,because the credit of the lender makes other people willingly receive them on the same footing, in purchases or other payments. These notes perform all the functions of currency, and render unnecessary an equivalent amount of money which was previously in circulation. However, as the notes are payable on demand, the issuer must, on pain of bankruptcy, keep by him as much money as will enable him to meet any claims of that sort which can be expected to occur within the time necessary for providing himself with more. Prudence also requires that he should not attempt to issue notes beyond the amount which experience shows can remain in circulation without being presented for payment. Still, today in Scotland it is possible to see private banks issuing their own private notes which are then commonly used by the people.

The convenience of this mode of 'coining credit', was soon discovered by the governments and they issued their own promissory notes in payment of their expenses; a resource the more useful, because it was the only mode in which they were able to borrow money without paying interest, their promises to pay on demand being, in the estimation of the holders, equivalent to money in hand. The governments incapable of containing their own expanding deficits then created the legal money. The law of legal tender established that all money issued by the issuing authority must be accepted by force in payment for any debt. The legal money abolished the contractual law that guaranteed the freedom of the people to choose and it imposed on the citizens an artificial currency with a 'legal value' established by the government.

A fourth form of making credit fulfilling the purposes of cash money consists of making payments by cheques. The custom of keeping the spare cash reserved for immediate use or against contingent demands, in the hands of a banker,and making all payments, except small ones, by orders on bankers, is today the most common form of payment. If the person making the payment, and the person receiving it, keep their money with the same banker, the payment takes place without any intervention of money, by the mere transfer of its amount in the banker's books from the credit of the payer to that of the receiver. If all persons in London kept their cash at the same banker, and made all their payments by means of cheques, no money would be required or used for any transaction beginning and terminating in London. This ideal limit is almost attained in fact, as today all banks, through the intermediation of the clearing bank, function as if they were virtually one establishment. It is chiefly in the retail transaction between dealers and consumers, and in the payment of some wages that cash money is used, and then only when the amounts are small.

Every bank sends to the Clearing-house all the cheques drawn on other banks,which it has received during the day. They are there exchanged for their own cheques which have come into the hands of other bankers, the balance only being paid in money or rather new short-term loans. By this contrivance,all the business transactions of the City of London during that day, amounting to billions of pounds are liquidated by much smaller payments. This procedure guarantees to the banker that they can lend money in cheques above what they have in cash to their customers with the assurance that there will be no cash shortage at all.

Having now formed a general idea of the modes in which credit is made available as a substitute for money, we have to consider in what manner the use of these substitutes affects the value of commodities and also we ought to know who are the beneficiaries and who are the losers of such a system.

The Influence on Prices

The average price of commodities is determined by the cost of production or of obtaining the precious metals. One Dinar or one Dirham will in the long run be exchanged for as much of every other commodity as can be produced or imported at the same cost as itself. But on the other hand, an order, or promissory note, or bill payable on sight, for a Dinar,if the credit of the giver is unimpaired, is worth neither more nor less than the gold itself.

Another cause of fluctuation is the quantity of money in circulation. Other things being equal, an increase in the amount of money in circulation raises prices, a diminution lowers them. If more money is thrown into circulation than the quantity which can circulate at a value conformable to its cost of production, the value of money, so long as the excess lasts, will remain below the standard cost of production, which will naturally stop new production and will keep general prices above the natural rate.

But the introduction of things such as bank notes, bills of exchange and cheques, which may circulate as gold or silver, and will perform all the functions of money, will affect the value of gold and silver.

Suppose that, in the expectation that some commodity will rise in price,a trader determines, not only to invest in it all his ready money, but to take up on credit, from the producers or importers, as much of it as their opinion of his resources will enable him to obtain. Every one must see that by acting thus, he produces a greater effect on price than if he limits his purchases to the money he has actually in hand. He creates a demand for the article to the full amount of his money and credit taken together,and raises the price proportionally of both. And this effect is produced,although none of the written instruments, named substitutes of currency,may be called into existence, and while the transaction may give rise to no bill of exchange, nor to the issue of a single bank note. The buyer,instead of taking a mere book credit, might have given a bill for the amount;or might have paid for the goods with bank notes borrowed for that purpose from a banker, thus making the purchase not on his own credit with the seller,but on the banker's credit with the seller and his own with the banker. Had he done so, he would have produced as great an effect on price as by a simple purchase to the same amount on a book credit, but no greater effect. The credit itself, not the form and mode in which it is given, is the operating cause.

Credit already stretched to the utmost in the form of book debts, would be susceptible to a great additional extension by means of bills, and of a still greater extension by means of bank notes. The first, because each dealer, in addition to his own credit, would be enabled to create a further purchasing power out of the credit which he had himself given to others;the second, because the banker's credit which with the public at large is coined into notes, and as bullion is coined into pieces of money to make it portable and divisible, has so much purchasing power super-added, in the hands of every successive holder, to that which he may derive from his own credit.

To state the matter differently: one single exertion of the credit-power in the form of book credit is only the foundation of a single purchase;but if a bill is drawn, that same portion of credit may serve for as many purchases as the number of times the bill changes hands; while every banknote issued renders the credit of the bank a purchasing power to that amount in the hands of all the successive holders, without impairing any power they may possess of effecting purchases on their own credit. That is to say, in a state of affairs of extended use of credit, prices are likely to rise higher if the speculative purchases are made with bank notes, than when they are made with bills, and when made by bills than when made with book credits.

Credit, in short, has exactly the same purchasing power as money. As money tells upon prices not simply in proportion to its amount, but to its amount multiplied by the number of times it changes hands, so also does credit;and credit transferable from hand to hand is in that proportion more potent than credit which only performs one purchase.

We now have all the elements to make a first judgement. The more powerful credit becomes, the more dangerous it is to the inner stability of the market,for there is a point when the credit becomes a tax on all the holders of money by the artificial raising of the prices that the credit itself can generate. That power of credit increases as it increases its capacity to be transferable from hand to hand, and that depends entirely on the definition of the credit: the more abstract and removed from the actual purchase it becomes the more transferable it becomes. At this point it is essential to remember the original purpose of the debt which is to record the intention to pay a certain amount at a certain time to a certain person. The first thing to separate from the contract is its transferability, as in the case of the bill of exchange. In the case of the bill, the payment although payable to someone, can be transferred to someone else. The next level of abstraction is when it becomes payable to the bearer. The next is to make it payable not at a determined date but on demand, and this is what a promissory note is. And finally it becomes payable to a bearer, on demand with no definition of what is to be paid, and this is the modern non-convertible promissory note.

To recover soundness it is necessary to reassess the limits of the transferability of debts and to that respect Islamic Law has a precise definition of what is allowed and what is disallowed. We will look at that later.

The Losers

"There is no way in which a general and permanent rise of prices, or in other words, depreciation of money, can benefit anybody, except at the expense of somebody else. The substitution of paper for metallic currency is a national gain, any further increase of paper beyond this is but a form of robbery"
(John Stuart Mill)

An issue of notes is a manifest gain to the issuers, who,until the notes are returned for payment, obtain the use of them as if they were real capital. As the money created is added to the money of the community,all the holders of currency lose, by the depreciation of its value, the exact equivalent of what the issuer gains. A tax is virtually levied on them for the issuer's benefit. Some gains are also made by the producers and dealers who, by means of increased issue, are accommodated with loans. Theirs however, is not an additional gain, but a portion of that which is reaped by the issuer at the expense of all the possessors of money.

But beside the benefit reaped by the issuers, or by others through them(their customers), at the expense of the public generally, there is another unjust gain obtained by a larger class, namely by those who are under fixed pecuniary obligations (like wages). All such persons are freed, by the depreciation of the currency, from a portion of the burden of their debts or other engagements;in other words, part of the property of their creditors is gratuitously transferred to them. On a superficial view it may be imagined that this is an advantage to industry, since the productive classes are great borrowers,and generally have large debts with lenders and suppliers and fixed obligations to their workers plus taxation. It is only thus that a general rise in prices can be a source of benefit to producers and dealers, by diminishing the pressure of their fixed burdens. And this might be accounted as an advantage,if integrity and good faith were of no importance to the world, and to industry and commerce in particular.

A common fallacy from which the advocates of an inconvertible currency derive support is that an increase of the currency quickens industry. This idea was set afloat by Hume, in his Essay on Money, and has had many devoted adherents since: "They say that a rise of prices, produced by an increase of paper currency, stimulates every producer to his utmost exertions, and brings all the capital and labour of the country into complete employment;and that this invariably happens in all periods of rising prices, when the rise was on a sufficiently great scale." This statement is based on the expectation of getting more commodities generally, more real wealth,in exchange for the produce of their labour, and not merely more pieces of paper. This expectation, however, must have been, by the very terms of the supposition, disappointed, since, all prices being supposed to rise equally, no one was really better paid for his goods than before.

Since the prices will not rise simultaneously all at once, there will be another set of winners who will reap their benefit by being the first buyer before the rise of the prices. It seems obvious however that for every person who thus gains more than usual, there is necessarily some other person who gains less. The loser will be the seller of the commodities which are slow to rise, who by the supposition, parts with his goods at the old prices,to purchasers who have already benefited by the new. This seller has obtained for his commodity only the accustomed quantity of money, while there are already some things that money will no longer purchase as much of as before. If then the seller knows what is going on, he will raise his price, and then the buyer will not have the gain, which is supposed to stimulate his industry.

If on the other hand, the currency could not be increased at will above the aggregate produce of the country, the general prices will be the subject of a proportional diminution. This situation of lower prices nevertheless will be of no loss to the producer because, although he will receive less money, the smaller amount will go exactly as far, in all expenditure, whether productive or personal, as the larger quantity did before. The real difference will be in the increased burden in the fixed money payments for those who have to pay it, typically the employers, but it will be a bonus for the workers who receive a fixed wage.

Another set of losers are those foreign holders of the depreciating currency. If foreign merchants and producers are lured to exchange their gold or their merchandise for a higher amount of notes than they might otherwise have expected, they, by covering up the insolvency of the issuers, become passive supporters of the scheme which benefits the issuers at the expense of all the holders of the currency.

Go to Chapter 3

The Return of the Gold Dinar