{Conversation starter} On the functions and origin of money

A briefing exploring some aspects of what money is, and clarifying the inflammatory claim that money is literally created out of bank loans. There is much more to be said on the topic. One absolutely recommended read is Debt: The First 5000 Years a book by anthropologist David Graeber. For the fanatics, Karl Marx’s Capital, Volume I, which whatever you think of the political aspects of Marxism, remains as a book  an unbeatable insight into how our world works (I also just realised it is registered in the Memory of the World Programme of UNESCO).

€njo¥!

Xavier – 31/10/2013

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ON THE FUNCTIONS AND ORIGIN OF MONEY

Economists traditionally describe money in terms of 4 key functions:

1 – Store of value – holding money gives us confidence in our future ability to access goods and services – it gives us future ‘purchasing power’.

2 – Medium of exchange – enables people to conduct efficient transactions and trade with each other. Money enables to move beyond barter relations, and extra-economic means of coercion (also known as ‘brute force’). Under the rule of law, money requires both parties to have exactly the right quality and quantity of a commodity to make an exchange.

3 – Unit of account – without a widely agreed unit of measurement we cannot settle debts or establish effective price systems, both key elements of capitalist economies.

4 – Means of making final payment or settlement.

Whilst there is some consensus that these 4 functions are all important in constituting money, there is less agreement about their relative importance and their role. Two major theories of money compete to understand the origin money and banking properly.

I – The commodity theory of money: money as natural and neutral

Classical economists, Adam Smith, John Stuart Mill, David Ricardo, and Karl Marx argue that real economic value lay not in money but in land, labour, and the process of production. For them money is simply a symbol, a commodity representing that value. Mill, for example, states that money “is a machine for doing quickly and commodiously what would be done, though less quickly and commodiously, without it”

The classical economics account of money is as a way of optimising the efficiency of exchange. Money ‘naturally’ emerges from barter relations as people find certain commodities to be widely acceptable and begin to use them as media of exchange rather than keeping or consuming them.

The classic example is the prisoner-of-war camp where cigarettes became a substitute for money. Cigarettes were widely available as prisoners were usually given an equal amount along with other rations. They were fairly homogeneous, reasonably durable, portable, very convenient for transactions.

So modern neoclassical economics built on this conception of neutral exchange-optimising money in the 19th and 20th century as it developed ‘scientific’ models based on the mathematical rules of supply and demand. In these ‘general equilibrium’ models, which still dominate economists’ thinking today, ‘real’ transactions – those involving goods and services – are facilitated by the existence of money as a commodity.

Marx pushes this a bit further. He doesn’t regard money as a means of circulation, but gives priority to money as a measure of value. His theory of money is still a commodity theory, but an unconventional one. For him whilst money is a unit of account, or measure of value – value being determined by the costs of production, he defined this commodity in a unique way: money is understood in philosophical or social terms as human labour.

It is quite intuitive that in societies where commercial exchange is widespread, value takes on a form of its own as money, as an expression of general exchangeability. Value is a central social reality for people; they constantly think and talk about it directly or indirectly. They want some way to transfer it directly among themselves, separate from particular assets. It is the social expression of value (what something is worth) separated from the concrete particularity of any use of value (what an object actually does).

… which leads nicely to the second theory of money:

II – The Credit theory of money: money as a social relationship

This theory is more aligned with the mention appearing on the £ 10 banknotes “I promise to pay the bearer on demand the sum of ten pounds”.

10-pounds

From this perspective money is a future claim upon others – a social relationship of credit and debt between two agents. This relationship is between the issuer of the note, in this case the State, and the individual. It does not appear to have anything to do with relations of production, between an agent and an object, or with the exchange of commodities.

From an historical perspective, the earliest detailed written evidence of monetary relations is found in the financial system of Babylon and ancient Egypt. These civilisations used banking systems thousands of years before the first evidence of commodity money or coinage. Much as banks do today, they operated accounting-entry payment systems, in other words lists of credits and debts.

Another historical argument is that the practice of measuring value came from elaborate compensation schedules – Wergeld – developed to prevent blood feuds in primitive Germanic societies. These required measuring the debt one owed for injuries inflicted on others. These became increasingly formalised and determined in public assemblies as societies developed. In contrast to the orthodox economic theory, they were not the result of individual negotiation or exchange. The nature and value of these items was determined by the relative severity of the injury and had nothing to do with their exchange or use value. ‘Geld’ was the Old English term for money and is still used in Dutch and German. Both these examples of tallies and compensation show money as tokens, not necessarily having any intrinsic value, which record a social relationship between creditors and debtors.

Having exposed those 2 major theories of money, the next question is where does money comes from. This leads to the concept of banks as the creators of credit money – or “endogenous money” (endogenous meaning “created from within the system”)

To put it simply, banks create money. The concept is often misinterpreted by conspiracy theorists who like to propagate the idea that banks “create money out of thin air” (there are numerous blogs on the Internet relaying this view). That is obviously not the case. But what is true is that through their activities of providing loans, banks do create credit (debt) from which money originates. Rather than being created “out thin air”, it is created out of the promise that debt will be repaid, or the promise that assets can be repossessed – hence the collapse of the system if those assets suddenly lose value as it was the case with American houses in the lead-up to the GFC.

The process goes as follow:

Banks are not permitted to create new banknotes, but they can lend. So Banks do it by providing credit, which results in new deposits as customers put the money they received on their accounts.

The system runs smoothly because it is backed by the Reserve bank. Commercial banks can always obtain the necessary funds to settle their customers’ payments. If they run out of liquidity, the Reserve Banks will lend to them to fulfil its position as lender of last resort. This is the key to understand this process of money creation. Two commercial entities providing credit to each other simply transfer debt, they do not create money. However a commercial bank backed by the Reserve Bank does create money by generating the demand for liquidity, which the Reserve will always honour.

In economics terms, banks endogenously create money. Or as Schumpeter put it in plainer English: “the creation of new purchasing power out of nothing… which is added to the existing circulation.

Under the endogenous money theory, “if banks can borrow money at the Reserve rate and still lend money profitably, then the money available for banks to borrow will become available as necessary to support the level of consumer lending individual banks require.”

So the creation of mortgages by banks increases their assets (loans) and liabilities (deposits), identically and simultaneously to respect the rules of double accounting. And since the total stock of money in existence is the sum of the liabilities of the banking sector to the non-bank sectors of the economy, it follows that an increase in assets and liabilities of the banking sector increases the money stock.

And if the notion that private banks can really create money by simply making an entry in a ledger still feel bizarre, you can take comfort from Economist J. K. Galbraith who suggested why this might be “the process by which banks create money is so simple that the mind is repelled. When something so important is involved, a deeper mystery seems only decent.”

According to the Credit theory, “money” is a social relationship backed by the State > introducing the concept of “Trust” (yeaah… Go one favourite crowd-pleaser theme!)

The implications of the credit model of money are profound. Rather than being a neutral mechanism of exchange, money is a social and political construct. As such, its impact is determined by whoever decides what it is (the unit of account), who issues it, how much of it is issued to whom and for what purpose. Today the unit of account function continues to be determined primarily by the State, as it has been for at least 4000 years.

However while money is really nothing more than a promise to pay, what distinguishes it from, an IOU note, is its general acceptability. That’s the “trust” bit. People accept and hold money not because of its intrinsic value as a commodity but because of guarantees regarding its future re-exchangeability; the “satisfaction… of the holder does not depend on possession per se, but on possession with a view to future use for payment”

In a State where the rule of law is respected, future exchangeability of money is guaranteed by the Government in three key respects, heavily tested during the GFC:

– Through its acceptability to pay taxes

– By tax-payer-backed insurance of bank deposits

– By implicit tax-payer-funded guarantees that banks themselves will be bailed out if they get into trouble

In this paradigm we can therefore say that all money is credit but not all credit is money. And, whilst no definition is perfect, Cambridge sociologist Geoffrey Ingham’s conception of money, which follows Keynes and Schumpeter, seems appropriate: for him money is “a social relation of abstract value defined by a sovereign unit of account”. Rather than ‘appearing’ from the natural operations of the market, money is in fact issued into circulation as a social relation of credit and debt between the State, its citizens and its banks.

Which now leaves a question open… what about alternative currencies envisaged where the roles of the State and Reserve banks is significantly changing – if not diminishing? Developing such neo-currency concept will require to make sense of the two meanings (1) medium of exchange or payment (a currency), and (2) standard of value measurement or pricing unit. An alternative currency will eventually need to decouple from both meanings, with the priority probably being to decouple as a means of payment… which is what Bitcoin and Co are currently doing. The jury being still out on their ability to become trusted standards of value measurement…

Xavier – 31/10/2013

REFERENCES

Defoe, D. (1690). Essay on Projects (London), quoted in Davies, G. (2002). A History of Money. Wales: University of Wales Press.

Schumpeter, J. (1994/ 1954.) History of Economic Analysis. London: Allen &  Union, p. 1114. Quoted in Werner, R. (2005). New Paradigm in Macroeconomics. Basingstoke: Palgrave Macmillan.

Simmel, G., (2004/ 1907). The Philosophy of Money, 3rd Edition. London: Routledge.

Ferguson, N., (2008). The Ascent of Money: A Financial History of the World. London: Penguin.

Davies, G., (2002). A History of Money. Cardiff: University of Wales Press.

Goodhart, C.A.E. (1998). The two concepts of money: implications for the analysis of optimal currency areas. European Journal of Political Economy

Ingham, G., (ed). (2005). Concepts of Money: Interdisciplinary Perspectives from Economics, Sociology and Political Science. London: Edward Elgar.

BIS. (2003). The role of central bank money in payments systems, Basel: Bank for International Settlements http:// www.bis.org/ publ/ cpss55. pdf

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