Re-imagining Money and Banking

I’ve written a new paper motivated by my belief that the recent financial crisis was in no small part a failure of economic theory and therefore of economic thinking. In particular, there is a missing model of banking that was well understood a century ago, but is completely unfamiliar to modern scholars and practitioners. The goal of this paper is to introduce modern students of money and banking to the model of money that shaped the 19th century development of a financial infrastructure that both supported modern economic growth for more than 100 years and was passed down to us as our heritage before we in our hubris tore that infrastructure apart.

Another goal is to illustrate what I believe is a fundamental property of environments with (i) liquidity frictions and (ii) a large population with no public visibility but a discount factor greater than zero: in such an environment anyone with a notepad, some arithmetic skills, and some measure of public visibility can offer – and profit from – the account-keeping services that make incentive feasible a much better allocation than autarky for the general populace. Importantly collateral is completely unnecessary in a bank-based payments system.

This model has two key components. First, banks transform non-bank debt into monetary debt. Thus, the transformative function of banking is not principally a matter of maturity, but instead of the nature of the debt itself, that is, of its acceptability as a means of exchange. Second, monetary debt is money (contra Kocherlakota 1998). There is no hierarchy of moneys where some assets have more monetary characteristics than others. Instead there is only monetary debt and non-monetary debt. When we study this very simple model of money in an environment with liquidity frictions using the tools of mechanism design, we see that the economic function of the banking system is to underwrite a payments system based on unsecured debt and thereby to make intertemporal budget constraints enforceable or equivalently to make it possible for the non-banks in our economy to monetize the value of the weight that they place on the future in the form of a discount factor. Banking transforms an autarkic economy into one that flourishes because credit is abundantly available. In this model, constraints on the economy’s capacity to support debt are not determined by “deposits” or by “collateral”, but instead by the incentive constraints associated with banking.

In this environment, banking provides the extraordinary liquidity that is only possible when the payments system is based on unsecured debt. Underlying this form of liquidity is the banks’ profound understanding of the incentive structures faced by non-banks, as it is this understanding that makes it possible for banks to structure the system of monetary debt so that it is to all intents and purposes default-free. (This is actually a fairly accurate description of 19th century British banking. The only people who lost money were the bank owners who guaranteed the payments system. See Sissoko 2014.) Although this concept of price stable liquidity is unfamiliar to many modern scholars, Bengt Holmstrom (2015) has given it a name: money market liquidity.[1] In such a system the distinctions between funding liquidity and market liquidity collapse, because the whole point of the banking system is to ensure that default occurs with negligible probability. Thus, the term money market liquidity references the idea that in money markets, the process by which assets are originated must be close to faultless or instability will be the result, because the relationship between money – when it takes the form of monetary debt – and prices is not inherently stable (cf. Smith 1776, Sargent & Wallace 1982).

This paper employs the tools of New Monetarism, mechanism design, and more particularly the model of Gu, Mattesini, Monnet, and Wright (2013) to explain the extraordinary economic importance of the simplest and most ancient function of a bank: in this paper banks are account-keepers, whose services support a payment system based on unsecured credit. Unsecured credit is incentive feasible, because banks provide account-keeping services and can use the threat of withdrawing access to account-keeping services to make the non-bank budget constraint enforceable.

The basic elements of the argument are this: an environment with anonymity, liquidity frictions and somewhat patient agents is an environment that begs for an innovation that both remedies the problem of anonymity and realizes the value of the unsecured credit that the patience of the agents in the economy supports. I argue that the standard way in which economies from ancient Rome to medieval Europe to modern America address this problem is by introducing banking – or fee-based account-keepers – in order to alleviate the problem of anonymity that prevents agents from realizing the value inherent in the weight they place on the future. I demonstrate that in this environment, the introduction of a bank improves welfare. The improvement in welfare can be dramatic when the discount factor is not close to zero.

This paper uses the environment of Gu, Mattesini, Monnet, and Wright (2013) but is distinguished from that model, because here the focus is on a different aspect of banking. We study how the account-keeping function of banks serves to support unsecured credit, whereas GMMW studies how the deposit-taking function of banks is able to support fully collateralized credit.

The model of banking in this paper has implications that are very different from much of the existing literature on banking. This literature typically assumes the anonymity of agents and then argues – contrary to real-world experience – that unsecured non-bank credit is unimaginable (see, e.g., Gorton & Ordonez 2014, Monnet & Sanches 2015). In other words, the existing literature takes the position that in the presence of anonymity, no paid account-keeper will arise who will make it possible for agents in the economy to realize the value of unsecured credit that their discount factor supports. In the absence of unsecured credit, lending is generally constrained as much by the available collateral or deposits, as by incentive constraints themselves. This paper argues that standard assumptions such as loans must equal deposits (see, e.g. Berentsen, Camera & Waller 2007) or debt must be supported by collateral (see e.g. Gu, Mattesini, Monnet, and Wright (2013), Gorton & Ordonez 2014) are properly viewed as ad hoc assumptions that should be justified by some explanation for why banking has not arisen and made unsecured credit available to anonymous agents.

[1] While Holmstrom (2015) and this paper agree on the principle that money market liquidity is characterized by price stability, the mechanism by which that price stability is achieved is very different in the two papers: for Holmstrom it is the opacity of collateral that makes price stability possible.


21 thoughts on “Re-imagining Money and Banking”

  1. I’m asking how similar are your views to Steve Keen’s such as he puts forward in “Debunking Economics” 2011? It seems there’s a consensus/conspiracy to push a false view forward which suits a small but v powerful sector of society, at the expense of the rest. Money manipulation which does has a trickle down effect but contrary to the prevailing view, it’s all to the detriment of most and benefiting this small v powerful group

    1. I haven’t studied Steve Keen’s work closely. I think his motivation is correct, but would have to look at the work closely before making meaningful comments.

      I am confident there is no “conspiracy.” Money and banking is a very hard topic and what I believe has happened is that the mainstream literature has fallen into habits of thought (or assumptions) that are so fundamental they are virtually invisible to mainstream academics. This paper is an effort to communicate with those academics and show them one of these foundational assumptions.

      It does seem to me that the banking industry is skilled at exploiting the flaws in the academic theory — and particularly the gap between lawyers’ and economists’ understanding of these theories — to promote policies that are profitable for the industry at the expense of the public. Definitely not a “conspiracy,” just good old-fashioned self-interested lobbying.

  2. Hi Carolyn,

    I really like your line of reasoning here (though I can’t claim to any deep knowledge of the literature). But I still wonder why, or perhaps whether, the monetary system you envisage can’t sit alongside other ways of delivering integrity to the payments system – by conservatively managed deposit taking and by the state issuing fiat money.

    Your material argues that Lombard st delivered money that facilitated trade that wouldn’t have been there without it. So it’s definitely beneficial. But if it’s value enhancing, why can’t this be done alongside collateralised lending or indeed against a quite different monetary system – as for instance with the Chicago Plan for 100% fractional reserve banking?

    1. Hi Nicholas,

      I don’t see any problems with a legal/regulatory framework that permits the existence of multiple vehicles for savings together with a banking system including vehicles that finance collateralized lending (along the lines of building societies or savings and loans) and those that offer 100% government reserves. In order to participate in the payments system, however, the collaterized and 100% reserve intermediaries will have to have commercial accounts with the banks.

      Competing payment systems are difficult to structure, because regulation will tend to favor one or the other. And there’s a lot of reason to believe that communities settle on a single payment system due to network effects. I would predict that if regulation doesn’t favor the other systems (e.g. by imposing costs on banks that the other payments systems don’t face. Think MMMFs regulated as if 100% government reserve, but permitting riskier investments.) the partial reserve payment system is the one that would outcompete the others.

      1. Except that we could have a risk free payments system operating by allowing anyone who wanted one to have an account with the central bank into which they could make payments, receive the overnight cash rate and make payments to others with like accounts. That’s an essentially risk and cost free payments system for those with excess balances, leaving those who need payments systems built on credit to others to use those systems which it seems to be will inevitably have higher risks and costs.

        As we’ve discussed this is the sort of payments system envisaged in my proposal for “Central banking for all”. You needn’t bother with the proposal in that paper for central banks to lend to all (with the collateral as that’s effectively a different proposal in no way dependent on the proposal for us all to be given access to the central banking system to effect payments).

    1. The corollary of the payments system that you are proposing is that businesses can’t fund their working capital (e.g. payroll and inputs) by borrowing from banks. So in order to have “central banking for all” you are going to have to shift to a world in which the only startups that can operate are those that have the funds to make payroll before they’ve produced and sold anything. This is a world that is not in fact in the interests of people who aren’t rich.

      Now it may be true that our banking system isn’t doing a good job of funding the working capital of start-ups right now. If so, that is definitely a failure and we should work on fixing it. Making such funding impossible by switching to “central banking for all” does not appear to me to be a good solution.

      In my view, a growing economy requires a well-designed credit-based banking system.

      1. Apologies – I’ve been travelling and unable to respond to this.

        As we both know the vast bulk of the money that banks lend they lend against collateral. A small amount of the money they lend, they lend to businesses, but the vast bulk of that is to existing businesses. I accept that start-ups need credit, but if they’re start-ups the vast bulk of this will always be and should be, equity because start-ups are high risk and usually can’t attract a lot of debt – and analogous companies couldn’t have done so in the glory days of Lombard St.

        The way you present the case for Lombard St is very compelling, but if such structures work, and enable trade to take place, I can’t see why they can’t prove themselves in the marketplace.

        So in my model of the world, the super low risk super collateralised lending that the banks are making out like bandits with can be more efficiently provided by the central bank and people should be able to bank with it as commercial banks can. So it should be. That would drain the rent out of commodity lending by commercial banks, but would still leave them free to specialise in riskier higher loan to valuation collateralised lending and trade credit and similar business. Perhaps that would actually push them to develop that part of their balance sheets. And if it didn’t it might well make sense to develop some mechanism that would encourage them to do it (perhaps by direct subsidy).

        In the meantime it seems pretty strange to not move towards a more efficient structure for banking around half the assets on banks’ balance sheets (super-collateralised loans) because we want to tax them to cross subsidise start-ups or trade credit – when we know that vanishingly small amounts of a huge subsidy actually get through to this trade expanding activity.

        What am I missing?

    1. Hi Nick, I too was busy and had to make time to get back to your comment.

      Re: Bagehot was a Shadow Banking. That paper was actually motivation for my current research agenda. Here’s my initial reaction:

      And here’s my related analysis of shadow banking:

      Regarding the history of banking there’s a lot of low quality information out there, so you have to really check your sources and how they are viewed by historians. The evolution of banking to be mostly built on collateralized loans is a relatively recent phenomenon, see Jorda, Schularick and Taylor’s work. The ubiquity of credit availability for commercial purposes in 18th to 19th c. Britain is one of the common themes that runs through Smith, Thornton, Bagehot, etc. — not to mention Parliamentary Reports — so the facts are clear.

      I think that current bank regulation is built on a failure to understand the nature of banking, and as a result our banks don’t do what they should. You are correct to object vociferously to this state of affairs. I don’t dispute a need for dramatic reform. It is, however, also my view that attempts to shift to a payments system that is mostly government-centered are likely to have harmful effects on productivity — unless a bank-like system of payments-system credit is tied into the government payments system. So there might be a way to revise your system so it does what my theory of banking says it needs to do.

      I don’t really understand how you imagine that having two separate payments systems compete against each other is a viable proposal. Nor, given the obvious network effects involved, what “competition” means in this context.

  3. Thanks Carolyn,

    As far as I understand your arguments about the trade expanding characteristics of Lombard St, banks collaborated with their clients to finance trade that could not otherwise take place. Our payments system contains virtually none of these characteristics.

    Moreover it doesn’t seem to me to be of the essence that Lombard St’s trade expanding finance was around a payments system. If offered a sophisticated ecology in which a mix of collaboration and competition created the trust necessary to expand trade. I don’t know why that can’t be done again – except perhaps that the banks are too busy making merry without needing to go to the trouble. I just don’t understand why it needs to be
    1) tied to the payments system
    2) based entirely on debt – as opposed to other forms of finance like equity for instance and further
    3) why if it is necessary that this system in some sense form the heart of a payments system, all other people needing a payments system need to use this particular one – seems to me like it holds the whole system ransom to a particular function.

    We have multiple payments systems already. We have the commercial banks’ system which operates largely electronically and we have central bank-notes. Moreover I’m suggesting that the central bank operate a kind of ‘giro-bank’. It would give that giro-bank greater utility to connect it up to the existing commercial bank sponsored payments system. As each would charge various fees (or implicit fees in the form of holding money without paying interest on it), it seems unproblematic to connect them up – they each gain network externalities from each other as Android and Apple OSs talk to each other in various ways.

    Ultimately over time if I’m right and the central bank giro-bank system is more efficient, the other payments system will atrophy to some extent.

  4. Hi Nick,

    I really think we’re talking past each other at this point. I have many papers and posts discussing the connection between the payments system, debt and economic performance, including those I cited in my previous post, and refer you to them.

    When you write: “if I’m right and the central bank giro-bank system is more efficient, the other payments system will atrophy to some extent” you appear to be referencing what I call naive economic theory. Because payments systems are built on network effects, we have no reason to believe that “competition” will have the effect of demonstrating that the “winner” is more efficient. This is basic modern economic analysis. Repeating like a mantra a naive approach to economics that was disproved decades ago is not productive.

    1. Thanks Carolyn,

      This reminds me of the ‘debate’ between Paul Krugman and Steve Keen. When we wanted the two of them to work out precisely what they agreed and disagreed on, they instead detected theological errors in each other’s words from the get-go and each went off in a huff.

      You’re misreading my comments but refusing to respond to my challenges preferring instead to imagine that they’re embodying simple misunderstandings about what money is. I don’t think that’s right. But even if it were there would still be reasons for responding to some of my challenges many of which retain interest even outside the context of wider agreement about the necessary nature of money.

  5. Hi Nick,

    I have no idea which of your challenges you feel I did not reply to. My work on the payments system, debt and economic performance includes my Financial History Review paper and that should answer your questions.

    The biggest problem I have with your claims is that you’re not addressing the fact that payments systems are subject to network effects, so “competition” is not likely to result in an efficient outcome. Would love to know your response to this.

    1. Thanks Carolyn,

      You have a particular model of banking you advocate and it seems compelling, though I don’t know how one brings it about from where we are now. If you’ve written on this, I’d be interested to read it.

      In the meantime, I have a very different kind of  proposal. It seems to me that one of its merits is that it doesn’t rely on a particular theory of what money is or should be, but, simply follows the logic of a competitive neutrality question “in the age of the internet, what is the justification for the central bank providing its services only to a favoured cadre of businesses (commercial banks largely), when it would be quite practicable for us all to receive such favours – in an appropriately cut down form?” As I asked that question I liked more and more about the system that resulted from applying the logic implicit in it.

      But I’ve always been worried about the way in which it might interdict any genuinely trade creating role of private money creation, so I was interested in your response to my ideas coming as it does from a compelling perspective. Unfortunately most of your response to my ideas seems to have been that they’re not the ideas you favour. I can understand that, but I was after an appraisal of their good and bad points when considered amongst potential reform measures.

      I’d be interested in your reflections on whether you think my proposal for central banking for all would be an improvement on the system we have. I accept it may take us further from an ideal you prefer but there are no signs we’ll be heading in that direction any time soon.

      You think that I’m arguing for competition to determine our payments system and say that this is naïve about network effects. I haven’t thought about it that way. I’ve thought about the costs to the system of the privately created money and the fact that it’s now very easy to give people access to the payments system the central bank provides the commercial banks. So I’ve tried to open up access to that as a self-evident good based on the principle of competitive neutrality.

      Since that seems to me to be a superior payments system every way I look at it, I’m then happy for it to be in the market ‘competing’ with other systems. But it’s the merit of the system itself that leads me to advocate it – and in my expectation, it would out-compete the existing payments system. That’s subtly different to arguing that the best payments system will necessarily emerge from competition between payments systems or that the main engine of getting a better payments system is to intensify competition between parts of it.

      I do acknowledge that the system I’m advocating could well displace the kind of trade creating money creation you describe as typical of London’s 19th-century monetary arrangements. I’m not sure how large this prize is even in theory in today’s economy, but I can’t see any practical likelihood of getting our banking system there from here – hence my question to you above – can you?

      So in summary, some challenges – or questions (and apologies – I’ve not read everything you’ve written)

      Would my proposal improve the monetary arrangements we have now (even if it takes us further from your preferred world)?
      You refer to network externalities and the way in which they interfere with the best possible system emerging from competition. This is a fair point, but there are some safeguards in competition (it typically drives micro-economic costs down, even if it may, in the process vitiate some external or network benefits). Simply saying that there are network effects and that the monetary system is a public good doesn’t mean that your proposed system is optimal. It seems to me that your preferred system has substantially higher micro-economic costs (of a rich set of explicit and implicit cross-guarantees between commercial banks and customers engaged in trading with each other together with various regulatory costs, risks and potential central bank liabilities). This is justified by the wider system-wide benefits. But it would be interesting to see these measured at least in principle and traded off against each other explicitly to demonstrate the point.
      My proposal too has external benefits – in addition to what seems to me to be very low micro-economic costs. It would take central banks from creating around 3% of our money supply (bank-notes) to around 50% of it in the form of super-collateralised loans on which interest would be paid – back to the money creator – the central bank. This generates a large amount of government revenue which can displace costly taxes or support greater government spending. How do we compare the external benefits of my proposal (and what I’m arguing is its lower micro-economic cost) against the eternal (trade creating) benefits of the approach you’re advocating?

      1. Apologies – I had html code for an itemised list of three numbered questions at the end of my comments – the numbers of which seem to have been scrubbed out by the system.

      2. I don’t have a policy proposal. Where I’m coming from is that it’s important to understand the nature of the system that we’re trying to change, before we write proposals. I find that most proposals are based on a model of money that doesn’t include a role for the banking system, and I think this is a mistake. The fact that I’m still at the most preliminary stages of developing policy proposal means that I may not be the best person to comment on your proposal, at least if what you’re looking for is an answer to the question: “What should we do?”

        You write: “in the age of the internet, what is the justification for the central bank (CB) providing its services only to a favoured cadre of businesses (commercial banks largely), when it would be quite practicable for us all to receive such favours – in an appropriately cut down form?” I can only tell you the historical justification which is that when the CB is doing it’s job (which it currently is not) it delegates the job of determining who should get payments system loans to the banks, supervising them carefully and putting them in the right kind of competition with each other to ensure that much of the benefit of the system flows to the public not the banks. I don’t think shifting to a pre-funded payments system will work (so maybe this is a prediction that your proposal would fall flat). Just think of payroll without credit lines from banks: How many businesses would have a problem if they had to prefund their payroll? Would this be enough for them not to use your system? If payroll is done through a different system, how likely is your system to succeed? Presumably you address this issue in your proposal.

        “whether you think my proposal for central banking for all would be an improvement on the system we have.” I have no idea whether your proposal would be an improvement over what we have. It’s entirely possible that your proposal could be improved so that — in the presence of network effects — a good system would not be prevented from growing up to replace it. Which is what I would expect to happen if the proposal were properly designed, but I also have no problem with losing that claim. That is, I’m not really opposed to the possibility of having the two systems “compete”, but we need to respect the nature of the environment we’re dealing with and avoid placing a finger heavily on one side of the scale and calling it “competition.”

        You write: “How do we compare the external benefits of my proposal (and what I’m arguing is its lower micro-economic cost) against the eternal (trade creating) benefits of the approach you’re advocating?” Well, since part of my theory is that modern economic growth is one of the externalities of a good banking system, you know which system I favor. As more of a response to your question, I know of no reliable method to compare policy proposals regarding the monetary system. (I’m sure you’re aware of the critiques of cost-benefit analysis when applied to the financial system.) And let’s remember I don’t actually have a policy proposal yet. So I have no idea how to go about answering this question.

        As I’m thinking about my replies. I do think the key to making your proposal viable is to tackle the practicalities of the payroll question. What would induce businesses to choose to make payroll using your system? If they don’t what would prevent the owners of the existing payments system from discouraging transfer of payroll balances by workers into your CB accounts? Maybe you have good answers to these questions.

        I hope you find this exchange more helpful. Sorry, that my time is constrained so my replies are brief.

  6. Thanks for your lengthy reply.

    Regarding payroll, firms need working capital which they can either pre-fund – as you say – from retained earnings if they’ve been around for a while or from equity as a start-up. That would make it harder to start a business. But according to the system I propose, firms that want to use credit to pay their payroll will generally be able to do so as they do now – though if there’s some cross subsidy in the system its cost might rise somewhat. And if banks won’t fund credit for payroll then other firms could step into the breach. Non-banks provide plenty of factoring finance today.

    I accept that this may not be ideal – that the system you propose might solve this problem more efficiently and that it might create more trade in this regard than mine. But that has to be weighed against all the costs of the system you propose – which is that risk sits in the banking system and the payments system is tied to it even where people have plenty of cash to make payments – even where people don’t need credit to transact. That and the way in which our system seems to channel rents into the credit system from collateralised lending to no trade-creating effect. Those costs seem to me to be large, whereas the potential benefits of the kind of system you’re talking about seem modest when compared with alternatives (like factoring).

    That’s where I think ‘competition’ within payments makes sense. If I have the money to make a simple – non-credit based – payment to you – that’s a lower cost transaction for the payments system to handle and I think the costs users face in using the payments system should reflect that – which they don’t now, or under the kind of system you envisage. I think (I’m not sure) that that is wrong – that this is an inefficient (perhaps very inefficient) way to fund the public good of a payments system for those who need credit to settle their payments.

  7. There are parts of this that are interesting. Money has always been debt, the barter narrative is just false. (See Michelle Innes. Part 1, Part 2) In the comments you implied that the current system is fractional reserve, it’s not, nor is it financial intermediary banking, its still is credit creation. Here is proof. You correctly chastise the mainstream for ignoring banks and money. Here is a benchmark stock flow consistent agent based model.

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