In my previous post, I explained that when one actually models monetary frictions (as new monetarist models do), it becomes immediately clear that the only full solution to these frictions is a debt-based form of money. The intuition behind this fact is simple: some people need to buy before they receive payment for what they have sold. For example, consider the case of the employee who won’t be paid until two weeks after he starts work, but who needs to eat in the meanwhile. Or alternatively, consider the case of his employer who needs to pay her employee but won’t actually receive payment for the good the employee produced until two weeks after the paycheck is due. The earliest banking systems existed to turn these claims to future payment (i.e. those which are already “earned” or receivable in accounting terms) into immediate cash at a slight discount.
In many of these cases there is virtually no uncertainty that payment will be forthcoming, so it is inefficient for employee or his employer to be unable to draw on his or her expected earnings. Observe in these examples how important debt is not just to the flow of money through the economy, but also to the flow of economic activity through the economy. Thus, banking institutionalizes and stabilizes the system of monetary debt which makes possible the flow of economic activity to which we are accustomed. The stabilization that is provided by banking includes both monitoring to minimize the degree to which cheaters are able to take advantage of the system of debt, and controls on the growth of monetary debt to make sure that it is commensurate with economic activity — and to limit the likelihood of inflation. (This stabilizing anti-inflation policy was known by the term “real bills,” but is a matter of profound confusion for modern scholars particularly in the U.S. as is explained here.)
Given the conclusions that can be drawn from the formal models that make up the new monetarist literature, from a logical point of view it is remarkable that most of modern macroeconomics studies “M” or a form of money that is not based on private sector debt. (As noted in my previous post, this phenomenon can, however, be explained by taking a sociological view of the economics profession.) It is important to be clear that it is not just monetarists, and their intellectual heirs, who make this error. James Tobin was equally confused about this issue, writing that “the linking of deposit money and commercial banking is an accident of history.” (h/t Matthew Klein).
These entirely misguided beliefs about the nature of money and the nature of banking can almost certainly be attributed to the fact that the models that were being used in the mid-20th century when the field of macroeconomics was being developed did not include monetary frictions. Thus, Friedman and Tobin and the vast majority of their colleagues failed to comprehend the simple truth that in the absence of loans to the individuals who seek to trade in an economy, there is no reason to believe that the monetary friction will be solved at all.
In short, theory tells us that that the linking of what circulates as money and commercial loans is necessary in order for an efficient economic outcome to be attainable. Under these circumstances, it seems extremely unlikely that the well-established link between the two in modern economies is an “accident of history.” It is much more plausible that, because in the presence of monetary frictions an efficient outcome is only possible when money is based on the debt of the traders in the economy, banks developed to institutionalize this efficiency-enhancing phenomenon.
Synthetic Assets 