In search of financial stability II: Re-thinking money and banking

I.   Acceptance banking
II.  A simple model of money based on acceptance banking
III. What is money? An origin narrative
IV. So what do banks do?
V.  Conclusion: Banking as the fundamental source of liquidity

The challenge for any model of money and banking is to explain the two basic elements of the modern payments system.

  • First, the money supply is comprised mostly of private sector liabilities
  • Second, this money supply is backed on the asset side of bank balance sheets by a combination of (i) “cash” (e.g. central bank liabilities), (ii) private sector short-term debt, and (iii) private sector long-term debt (e.g. mortgages)

Why this is the structure of the payments system? I will simplify the question a little by observing that the backing of the money supply by long-term debt is a very recent phenomenon (see Jorda, Schularick, and Taylor 2014), and therefore by restricting my focus to the explanation of why the modern monetary system developed backed by private sector short-term debt. (Note that this post is designed to motivate in layman’s language a formal economic model of banking that is available here.)

There two common frameworks used to discuss the two sides of bank balance sheets in the bullet points above, a standard view and a heterodox view. The standard view is the “loanable funds” approach that assumes that cash is brought to the bank by depositors and then the bank takes some of that cash and lends it out. In this framework, no loan can be made unless a depositor first brings cash to the bank. (Classic economic models of banking such as Diamond-Dybvig rely on this framework.) The heterodox view claims that it is by making loans that a bank creates deposits. In this framework, a bank first underwrites a loan, and after the loan is approved the bank funds the loan by giving the borrower a deposit account with the value of the loan in it.

Charles Goodhart (2016) points out that both of these two frameworks are missing something very important about the relationship between the asset and the liability side of the bank balance sheet: the standard view implies that it is the depositor that drives the process, the heterodox view implies that it is the bank that drives the process, and both of these are wrong.[1] Goodhart explains that it is more accurate to think of banks as setting the parameters by which loans will be made – and in fact of typically offering borrowers credit lines on pre-specified terms – and then allowing the borrowers to determine whether or not to take out the loans that will cause the money supply to expand. In Goodhart’s framework banks are simply the intermediaries that allow the private sector to expand the money supply on an “as needed” basis. I will call this the “private money” model of banking.

Since the “loanable funds” approach models the “deposit taking” function of banks and is closely tied to the “goldsmith” story of bank origins, I think it is useful to connect Goodhart’s “private money” model with a specific banking activity, acceptance banking, and to present a corresponding origin narrative.

Acceptance banking

Banking in 19th century Britain largely took the form of acceptance banking. Whereas a bank that receives a deposit opens an account for a client, a bank that approves acceptance credit for a client opens for a client a discount – or an account that may go negative to the extent of the client’s credit line. The terms of the discount are set in advance, and the client draws down the credit line on an “as needed” basis. A bank discount is identical to a bank account in terms of the ability to deposit and to and withdraw funds. The only distinction between the two is that the discount is designed to carry a negative balance for an indefinite period of time.[2]

When a bank client draws a discount down from zero, the action simultaneously creates a bank asset and a bank liability. First, the draw automatically creates a bank loan on terms pre-specified at the time the discount was approved as noted above. But, secondly, because the draw is used to make payments using bank liabilities (that is, using either bank notes or bank acceptances), bank liabilities are also increased by the amount of the draw. Thus, acceptance banking – or for that matter any form of banking based on credit lines – doesn’t just have loans causing bank liabilities to be created, but also has the private sector driving the process by which bank liabilities are created.

A simple model of money based on acceptance banking

Before discussing an origin narrative that corresponds to the “private money” view of banking, let me lay out in abstract terms how we should think about this function of banking. The crucial point of this discussion is that in Goodhart’s “private money” model the money supply is expandable to meet the needs of the private sector, subject to the terms set out by the banks. Tying this view into the credit facilities with which we are familiar in the US, one may think of credit in the private money model as being as readily available as it is to businesses today through credit cards, but – because of careful underwriting and therefore the safety of the debt – bearing a low interest rate, such as 5% per annum.

The simplest model of money is a game with three people, each of whom produces something another seeks to consume: person 2 produces for person 1, person 3 produces for person 2, person 1 produces for person 3. Trade takes place over the course of three sequential pairwise matches: (1,2), (2,3), (3,1). Thus, in each match there is never a double coincidence of wants, but always a single coincidence of wants. We abstract from price by assuming that our three market participants can coordinate on an equilibrium price vector (cf. the Walrasian auctioneer). Thus, all these agents need is liquidity.

Let the liquidity be supplied by bank credit lines that are sufficiently large and are both drawn down by our participants on an “as needed” basis, and repaid at the earliest possible moment. Assume that these credit lines – like credit card balances that are promptly repaid – bear no interest. Then we observe, first, that after three periods trade has taken place and every participant’s bank balance is zero; and, second, that if the game is repeated foerever, the aggregate money supply is zero at the end of every three periods.

In this model the money supply expands only to meet the needs the trade, and automatically contracts in every third round because the buyer holds bank liabilities sufficient to meet his demand.

Consider the alternative of using a fiat money “token” to solve the infinitely repeated version of the game. Observe that in order for the allocation to be efficient, if there is only one token to allocate, we must know ex ante who to give that token to. If we give it to person 3, no trade will take place in the first two rounds, and if we give it to person 2 no trade will take place in the first round. While this might seem a minor loss, consider the possibility that people who don’t consume in the first stage of their life may have their productivity impaired for the rest of time. This indicates that the use of fiat money may require particularized knowledge about the nature of the economy that is not necessary if we solve the problem using credit lines.

Why don’t we just allocate one token to everybody so that we can be sure that the right person isn’t cash constrained in early life? This creates another problem. Person 2 and person 3 will both have 2 units of cash whenever they are making their purchases, but in order to reach the equilibrium allocation we need them to choose to spend only one unit of this cash in each period. In short, this solution would require people to hold onto money for eternity without ever intending to spend it. That clearly doesn’t make sense.

This simple discussion explains that there is a fundamental problem with fiat money that ensures that an incentive compatible credit system is never worse and in many environments is strictly better than fiat money. This is one of the most robust results to come out of the formal study of economic environments with liquidity frictions (see e.g. Kocherlakota 1998).

Now let’s continue our discussion of the payments function of credit lines by taking our simple model (the original one without fiat money), duplicating it twice (using ‘ and ‘’ to indicate the duplicates), assuming that preferences are such that participants do not wish to trade across duplicate groups, and offsetting the trading periods for our duplicate economies. In period 1 three pairwise matches take place: (1,2), (2’,3’) and (3’’, 1’’). Posit also that at the start of time there is a banking system that has loans outstanding to agents 1’ and 1’’, and deposits owed to agents 2’ and 3’’. (This is just the simplest way of creating a more complex, overlapping pattern of trade.)

Thus, we have an environment where there is always a stock of deposits and a stock of loans outstanding. Even so, every agent is regularly paying off his debt. The money supply still exists only to meet the needs of trade, and every participant’s account balance returns every third period to zero.

Now imagine that for every one of the participants in our triplicate economy there are n identical agents who have been excluded from the economy historically. If these agents are suddenly incorporated into the economy, then the money supply will increase by a factor of n. Because this increase in the money supply occurs only to meet the needs of trade, the increase in the money supply is entirely consistent with the existing price vector.

In short, because the debt created by the banking system is carefully constructed so that its only purpose is to provide liquidity to facilitate the operation of the payments system, the bank-based money supply is able to expand to meet the needs of trade, and will – in certain circumstances – expand without any tendency to affect the price level.[3]

Observe that this framework is the basis for the “real bills doctrine.” If the only debt in the economy finances the purchase of productive inputs, and if the banking system can enforce the requirement that this debt be paid off as soon as production takes place, then expansions of a money supply backed by this debt are not necessarily inflationary, but may reflect changes in the underlying real economy. (Note that, because we have assumed an equilibrium price vector, the question of how prices are anchored in this framework remains to be answered and is not addressed here.)

What is money? An origin narrative

We have laid conceptual underpinnings that explain: first, the relationship between the use of bank liabilities as money and the fact that these liabilities are backed by short-term private sector debt; and second, the fact that a system of “private money” has the advantage that it can very naturally expand to meet the needs of trade. We now demonstrate that there are also historical foundations for the model of money presented here. Before expanding upon the historical details, we discuss in more general terms the implications of a private monetary system that is not anchored by any sovereign unit of account.

One of the great inventions at the dawn of the early modern era in Europe was that of monetary systems that existed in the abstract without any physical embodiment of the unit of account. Specifically, by the 1530s the process of clearing and settling European trade was taking place using the ecu de marc, a unit of account that was stable precisely because it was not tied to the coin issued by a sovereign.[4]

When such an abstract unit of account is combined with a sophisticated system of clearing and settlement, a monetary system is established that is purely abstract. Such a monetary system exists only in account books. While net balances will be convertible into real goods or traditional financial assets, the monetary system itself has an existence that is independent of the real economy. For example, even if the monetary system typically pays off net balances in francs, the sovereign government that issues the francs can go bankrupt and the monetary system will simply shift to paying off net balances in the next best instrument, whether it be dollars or euros or drachmae.

While a monetary system can exist purely in the abstract, the danger that the value of the abstract unit of account will be devalued is every bit as much a risk as the danger that a more traditional sovereign unit of account will be devalued. On the other hand, the abstract unit of account typically develops because a sovereign instrument is being devalued and the bankers seek to maintain the value of their own interactions. The decision to treat the “old” value of the sovereign instrument as the “true” value for the purposes of the monetary system has the effect of converting the monetary system into one that is purely abstract – but convertible into real instruments. Thus, just as a complex web of institutions (e.g. independent central bank, separate public Treasury, democratic polity) supports the value of sovereign money, so an equally complex institutional structure (e.g. personal liability for debt, shunning of bankrupts, hierarchical structure that exploits reputation effects at every level from the international to the local) is required to protect the value of an abstract unit of account.

The first observation of this phenomenon of a monetary system that existed only in the abstract took place in the mid-16th century at the Lyons fairs where the “imaginary” ecu de marc was the unit of account for the money market.[5] By the turn of 17th century the European money market had moved to Venice where the Banco della Piazza di Rialto and its bank ducat became the next “imaginary” currency of account for European trade. In 1609 Amsterdam founded the Wisselbank which deliberately copied the model of the Venetian bank and its bank ducat. By the end of the 1620s the European money market, along with its international trade had shifted to Holland.[6]

During the same time period Amsterdam adopted the techniques of decentralized clearing that had been developed in Antwerp (during a period when banking was a prohibited activity). Clearing was decentralized by formalizing legally the rules for endorsement and circulation of bills of exchange. Thus, by the time the Bank of England was established in 1694 (with the advice of Dutch financiers), (i) the intellectual foundations for a stable and imaginary bank-based unit of account – that is for fiat money – had been firmly established by a century and a half of practice in Europe; and (ii) Europe’s system of clearing and settlement had been so thoroughly established in international trade that bills drawn on European banks could circulate among merchants in Russia, India, and the Americas.

The brilliant innovation of the founders of the Bank of England was to address a political problem: sovereign authorities understood very well the challenge to their authority posed by an autonomous abstract monetary system, [7] and sometimes deliberately took action to weaken it. Thus, by combining the issue of Bank of England notes with an important role in the finance of government debt, the bankers successfully aligned the interests of the sovereign with those of the issuer of the bank-based unit of account.[8] In short, the founders of the Bank of England deliberately laid the foundations of a fiat money that was backed, not as it had been in the past by gold and private debt, but by a combination of gold, sovereign and private debt. The effectiveness of the institutional structure established in 1694 was proven a century later as the Bank of England note enabled the British economy to shift very smoothly to a Bank-based monetary standard and the Bank was thus able to play a crucial role in the finance of the Napoleonic Wars.

The point of my brief review of monetary history is this: clearing and settlement is money. There is no need for some sovereign token to serve as a final means of payment. In short, the theory of the essential role of government in the monetary system is, just that, a theory. It is true in the sense that monetary systems that develop without the consent of the governments within the boundaries of which they function rarely last more than a few decades because they compete with governments which are therefore incentivized to undermine their stability. It is not true, however, in the sense that monetary systems cannot function without being tied to some government unit of account. The history of Europe in the modern era is proof of this latter statement.

By contrast to the consensus view, there is a strong argument that the inverse of the conventional view – that is, of the view that monetary systems are dependent on sovereigns that are institutionally capable of issuing debt without defaulting and base money without inflating – is equally true: modern sovereigns are only able to issue sound debt and money, because of their close ties to banking systems that support robust economic activity by underwriting unsecured, but safe (and therefore low-cost), debt that allows the payments system to operate smoothly and facilitates access to the payments system for a broad spectrum of society. After all, historically bank-based units of account and payments systems were established centuries before British government debt became a safe asset, and the role played by the Bank of England in establishing the safety of British debt ensured that this debt was inextricably tied to the performance of both the banking system and the British economy.

So what do banks do?

So what do banks do? Banks operate the payments system. This entails not just mechanistically processing customer payment orders, but also the design and maintenance of a safe system of short-term lending to support the payments system.

Economic efficiency is fundamentally dependent on the banking system to manage and alleviate the fundamental problem that for each market participant the flow of funds is not synchronized. In the absence of unsecured credit to support payments, many market participants will face prices that are determined by the fact that they are liquidity constrained and that result in an inefficient allocation relative to an economy where these liquidity constraints are obviated by short-term credit. (In our toy model the economy is autarkic if there is no monetary instrument.)

Precisely because payments system credit addresses only the inherent timing problem in payments, these systems can be designed so that they are extremely safe. Thus, from the 17th through the 19th centuries the interest rates paid by businessmen on such credit were typically in the range of 2 to 6% per annum.[9] Then, when we say that banks operate the payments system, we need to include in that description the business of setting the terms of credit lines and monitoring borrowers’ behavior, so that borrowing for purposes of transacting is an activity that can be done at very low cost.

So what are the most important functions of the banks? They:

  • set parameters for credit lines including the credit limit and the interest to be paid
  • monitor borrowers’ use of credit lines and financial positions more generally, adjusting credit terms as needed, and
  • impose penalties on (or withdraw the credit line from) borrowers who violate the terms of the credit line

When these activities take place in an environment where there is interbank competition, the interest rates charged to businessmen with no history of default for such a credit line should be in the low single digits. If we don’t see this kind of unsecured credit readily available to almost all businessmen,[10] then we can assume that something is going very wrong with our banking system and that it is failing in its most important function.

Conclusion: Banking as the fundamental source of liquidity

The modern payments system should be understood as the modern evolution of an abstract monetary system that dates back to the 16th century and one of the earliest money markets established in Europe. At the heart of the payments system lies a system of unsecured credit in which banks set the terms of credit lines and individual market participants draw down those credit lines on an “as needed” basis. This clearing and settlement process together with the short-term credit lines that are intrinsic to its functioning comprise the fundamental source of liquidity in a modern economy.

This analysis indicates that there’s another way to define liquidity. Liquidity is created by the unsecured credit lines that are extended by the banking system in order to make the payments system function smoothly. Thus, one can define liquidity itself as the unsecured credit lines that facilitate the settlement of asset trades and other obligations. This definition is almost the same as that of “funding liquidity” or “the ability to settle obligations with immediacy,”[11] but focuses attention not on settlement, but on the extension by banks of unsecured credit lines that facilitate settlement.

Market liquidity, by contrast, is the ease with which an asset can be bought or sold and is determined by the difficulty of finding a counterparty for your trade (see Harris 2003, p. 394). Clearly when buyers have access to unsecured credit lines, this plays an important role in making it easy for sellers to find buyers, to trade in large size, and to get a good price for the asset. Thus, liquidity, as we have defined it, is also likely to be an important determinant of market liquidity. By contrast, temporary fluctuations in market prices (driven for example by bargaining dynamics in an over-the-counter market) are unlikely to have a significant effect on liquidity. After all, credit lines are generally committed, so temporary fluctuations will frequently disappear before the bank has the opportunity to change the terms of the credit line. This structure makes economic sense, because such temporary fluctuations are unlikely to affect a borrower’s capacity to repay the loan over time. Thus, while we might expect the structure of market liquidity (e.g. whether most assets can be traded on an exchange vs. over-the-counter) to affect the willingness of banks to extend unsecured credit lines and therefore to affect liquidity, as we have defined it, there is little reason to expect that day-to-day changes in market prices should affect liquidity.

Overall, by defining liquidity as the unsecured credit lines that facilitate the settlement of asset trades and other obligations we have a single definition of liquidity that determines both funding liquidity and to a large degree market liquidity. Contrast this approach to liquidity with that of Brunnermeier & Pedersen 2008 (BP). BP define funding liquidity as the fraction of an asset that a trader can finance. That is, BP assume that what is defined as liquidity here – that is, the extension of unsecured credit lines – is necessarily nonexistent. Thus, given our definition of liquidity, BP can be reinterpreted as stating that when liquidity is unavailable, adverse dynamics are easily generated by the interaction between market price fluctuations and collateralized financing constraints.

This analysis raises a host of questions: If the unsecured credit lines that make the payments system function smoothly are liquidity, then are these credit lines also money? Should they be money? If these credit lines that are so important to the operation of the payments system are not money, then what is the point of defining money at all? I am still puzzling over these questions so I only ask them and don’t pretend to answer them here.

[1] Paper presented at the Macro, Money and Finance Conference, Bath University, UK, September 8, 2016.

[2] For accounting purposes, a discount (like a derivative) creates complications. When the discount has a positive balance, it is equivalent to a deposit account and is therefore a bank liability. However, when the discount has a negative balance it is a loan made by the bank and therefore is a bank asset. For analytic simplicity the text here assumes that discounts always have negative balances and therefore are always bank assets.

[3] If we take this simple model as a metaphor for a much more complex monetary system with the same properties, we can consider the kind of monetary expansion that drove Schumpeter’s process of creative destruction (see Schumpeter 1939 which I discuss here). Thus, imagine a Walrasian economy with trading frictions where the banking system operates as described above to eliminate the frictions and make competitive equilibrium attainable. Now assume that someone has an idea for a better production method. Using the credit-based transactions system that individual can buy inputs and convert the production method into an operating business easily. Assuming the new production method is genuinely more efficient than the older one, the newcomer will sell his product more cheaply, demand for the product will slowly (due to information transmission costs and the costs of building up production capacity) shift to the new production method, and the payment system will shift very smoothly to financing the better method.

[4] The inevitable and steady devaluation of all the late medieval coinage systems due simply to the use and circulation of the coins is documented in great detail by Lane and Mueller (1985).

[5] Boyer-Xambeu, Deleplace & Gillard (1994, p. 78).

[6] This history is recounted in detail in a chapter of my dissertation, “The Political Economy of Private Paper Money,” Sissoko (2003).

[7] Montesquieu, The Spirit of Laws, XXII(13).

[8] Martin (2013) calls this monetary innovation the Great Monetary Settlement.

[9] Barbour (1963), p. 85.

[10] Those who are just starting out may be expected to have very low credit limits and/or be required to have a co-signor.

[11] Matthias Drehmann & Kleopatra Nikolaou, Funding Liquidity Risk, BIS Working Paper No. 316 (July 2010).


22 thoughts on “In search of financial stability II: Re-thinking money and banking”

  1. I’m gonna need a second read to digest this thoroughly. (But your example is what I call a “red/negative money system”, right?)

    You lost me a bit here: “Now let’s continue our discussion of the payments function of credit lines by taking our simple model (the original one without fiat money), duplicating it twice…”

    1. I think you are correct that this is a “red/negative money system”. Just as you view the Woodford model as constructed on an underlying assumption of perfect credit (or red and green money), I view competitive equilibrium itself as effectively abstracting from the liquidity frictions underlying real world trade by assuming that perfect credit resolves the frictions. In fact, I think Adam Smith was able to imagine the “invisible hand” because banks in Scotland were already doing a pretty good job of providing near-perfect credit. (Indeed, in Boyer-Xambeu et al., cited above, they speculate that the concepts of excess demand and excess supply in fact grew out of the actual practice of international bankers working to set prices that equilibrated money markets, because their letters are constantly discussing whether there’s too much paper or too little paper (claims to money) in a given city.)

      All I’m trying to do in that paragraph is to create an environment where there’s always money outstanding by creating two mirror economies and then offsetting the date at which the economy settles at zero for each of the mirror economies.

      1. Thanks Carolyn. I gave it a second read, and I think I get that bit now.

        On second thoughts, I think you have a red/green system here, in your triangle example, with “net money” (positive minus negative balances) always zero, and “gross money” (positive plus negative balances) fluctuating according to the needs of trade. Initially both net and gross money are zero. Then 2 sells a good to 1 (for say $1), so 2 has a positive balance and 1 a negative balance, so gross money is $2 but net money is still $0.

        This is good stuff. But hard.

        “Now imagine that for every one of the participants in our triplicate economy there are n identical agents who have been excluded from the economy historically. If these agents are suddenly incorporated into the economy, then the money supply will increase by a factor of n. Because this increase in the money supply occurs only to meet the needs of trade, the increase in the money supply is entirely consistent with the existing price vector.”

        True, but maybe not the best example to illustrate your point, because everything just scales up. Maybe going from your original to your triplicate economy actually illustrates that point better, because it isn’t simply trebling everything, but doubles gross money (I think?).

  2. Thank you, Nick, for your comments and for tying this into your system. We are definitely talking about the same phenomenon.

    Yes, the triplicate economy does double gross money in periods two and three, but also makes it increase from 0 to a positive number (same as other periods) in period 1.

  3. “If the unsecured credit lines that make the payments system function smoothly are liquidity, then are these credit lines also money? Should they be money? If these credit lines that are so important to the operation of the payments system are not money, then what is the point of defining money at all?”

    Carolyn, in the mind of the (potential) borrowers these unsecured credit lines no doubt represent a reserve of “money”, much as do credit cards. From a system point of view, however, it seems to me labelling undrawn credit lines as money wouldn’t be helpful.

    Once they’re drawn down, spent and redeposited into the system as fresh bank liabilities, it is of course a different matter. Then they’ve become manifest, if you like, as money, conventionally defined.

    As to your question “what is the point of defining money at all?”, it’s a good one. As I see it, defining money (the more precisely the better) is indispensable in trying to think through these sorts of issues. For me, old-fashioned though it is, a Misean type categorisation seems to work best: first, money proper (now currency and bank reserves) at the base of the pyramid; next, various forms of money substitutes (most commonly bank deposits); and, finally, what he calls secondary media of exchange (basically any product with sufficient perceived liquidity and security to at least in part take the place of direct holdings of money). The actual terms he uses are of course entirely optional; what matters, I think, is the categories themselves.

    Anyway, enough. Congratulations on getting picked up by FTAV . . . or perhaps this has become a common event for you and I just haven’t been paying enough attention!

    1. Thank you, Ingolf, for your comments.

      While I certainly understand that undrawn credit lines don’t fit any conventional definitions of money, I think that they are properly classified as liquidity. But if you agree with this statement, then this raises the question: What is the difference between liquidity and money and why do we draw this distinction?

      Why do we define money at all (and in particular give it a definition distinct from liquidity)? One of the points of this piece is that I think the pyramid view of liquidity is both a valuable theory — and, like most valuable theories, also misleading. I simply don’t buy the claim that there is historical foundation for the view that either gold or Federal Reserve Notes (or sovereign notes more generally) sit at the base of the monetary system. I think these are just tools that are used by the banking system as (temporary — taking a very long view) anchors.

      The monetary system in an economy with modern growth is built on a banking system and to me the banking system itself is more important to the concept of money, than whatever bank liabilities happen to be denominated in today.

      1. Carolyn,

        Now you’ve got me a bit puzzled. Before trying to explain why, a quick comment on your first paragraph.

        While the term “liquidity” needs a clearer definition (at least for me), in simple terms I see money as the most reliable form of liquidity. Undrawn credit lines, on the other hand, seem more a contingent form of liquidity. They’re reliable in normal times but any real crisis could see them reduced or cut very rapidly.

        Back to my puzzlement.

        As I see things, any monetary system requires agreement on what constitutes money itself. Not promises to pay money (e.g. bank deposits) but the irrevocable means of final settlement, where it’s needed. Today, that’s currency and bank reserves. I don’t quite understand, therefore, what you mean by saying that there’s no “historical foundation for the view that [some form of money proper] sit[s] at the base of the monetary system.”

        Perhaps you’re indirectly referring to the banking system’s endogenous money creation capacities, to the fact that the old-fashioned multiplier view is misleading at best. If so, no argument. However, the banking system still needs an agreed form of final settlement, an “anchor” in your terms, if I’ve understood you correctly.

        Perhaps, as implied by your last paragraph, you also mean that “anchor” can change over time, as when Fed generated notes and reserves took over from gold, then sure. Again, no argument, but I’m not sure how that changes the structural and definitional issues I thought were at the core of this discussion.

        That said, I think you’re absolutely right in saying the banking system is central to our current monetary system, not least in providing us with most of our functioning money. I guess what puzzles me most is why defining the various forms of “money” seems to make you uncomfortable.

  4. “any monetary system requires agreement on what constitutes money itself”

    This is where we disagree. “Money” is just as vague a term as “liquidity” and that’s a problem. I would say instead that any monetary system requires agreement on what constitutes a unit of account. But we need to be careful not to confuse the unit of account with the means of settling monetary obligations (even though they often coincide). We see during inflationary episodes where economies switch to foreign currencies, that it’s possible for the public and not the sovereign to switch units of account.

    Historically banking developed in part at least in order to address the problem that sovereigns are unreliable and we need a monetary system that can maintain value by using an abstract units of account, while leaving the question of how to settle obligations as something that can change depending on the circumstances.

    In short, without the private sector giving the abstract unit of account value sovereigns would not have been able to develop the reputation for reliablility that countries such as Britain did. So I find that your theory has the history precisely backwards.

    And I think this failure to understand the complex history of our monetary system plays in very directly to the financial instability issues that we are currently trying to figure out how to resolve.

    1. Despite our best efforts we seem to be talking past each other. Apologies for whatever contribution I’ve made to this confusion.

      Somehow, I suspect, we’re approaching these issues on different planes. Let me try to illustrate what I mean starting with your second paragraph.

      You say “we need to be careful not to confuse the unit of account with the means of settling monetary obligations” and use as an example how at times the public may switch from the domestic unit of account (or money, as I would have it) to foreign currencies.

      They certainly do, but don’t monetary obligations entered into prior to such a switch still have to be settled in the original unit of account? It seems to me what you end up with in such circumstances is parallel monetary systems operating within that country, interacting in complex ways but still capable of being disentangled, both for the purposes of analysis and settlement.

      Ultimately, settlement of foreign currency transactions is accomplished either by physical currency changing hands or via the settlement system in a given currency’s country of origin through correspondent banking. To my mind, while it may be complex, there’s nothing vague about any of this.

      You also wrote “we need a monetary system that can maintain value by using an abstract unit of account, while leaving the question of how to settle obligations as something that can change depending on the circumstances”. I really don’t understand what you’re suggesting here. Firstly, it’s not clear to me precisely what you mean by “abstract unit of account” in this context, nor whether you’re suggesting that the need is for a monetary system that can maintain value because of using an abstract unit of account, or despite doing so. Secondly, I don’t see how obligations entered into under one unit of account can, without mutually agreed changes by all concerned parties, be satisfactorily settled in some other unit of account.

      Final small point. You said: “So I find that your theory has the history precisely backwards”. Not quite sure why you concluded that I was suggesting sovereigns are necessary to underpin the value of money (or the “abstract unit of account”), but in any case I certainly wasn’t. The specie based monetary and banking system, for example, was very much an organic private sector creation.

      1. “I don’t see how obligations entered into under one unit of account can, without mutually agreed changes by all concerned parties, be satisfactorily settled in some other unit of account.”

        My point is that the unit of account and means of settlement are distinct. It’s my understanding that when the unit of account in serious inflations changes to foreign currency, the means of settlement frequently continues to be the domestic currency — but the rate of exchange is changing very fast due to inflation. The point is that the public can choose to cause a separation between the unit of account and the means of settlement, by simply denominating the contract in a different unit of account.

        My view of how the gold standard actually worked — and how important the banking system was to how it worked is available in this paper:
        (also available on SSRN).

  5. “It’s my understanding that when the unit of account in serious inflations changes to foreign currency, the means of settlement frequently continues to be the domestic currency — but the rate of exchange is changing very fast due to inflation.”

    Sure, but only if all parties to a transaction agree to link the settlement amount to the exchange rate then prevailing between the domestic currency and the relevant foreign currency. On a spot basis, I think what you’re alluding to is official vs nonofficial (i.e. black market) exchange rates, as in Venezuela at the moment for example. When longer term or forward contracts incorporate this kind of linkage, to my mind it’s effectively a kind of derivative transaction.

    I don’t see any of these affecting monetary mechanics, if I can put it that way. It’s just an indication that a particular form of money (or unit of account) is in the process of breaking down with participants scrambling to protect themselves (or profit) from the unfolding chaos. Settlements still occur in the normal fashion but the amounts are, by common consent, determined using an additional external factor.

    Have a good weekend, Carolyn. By the way, I’ve downloaded the paper you referred to and hope to have a chance to look at it later this weekend. If I have any useful thoughts, rest assured I’ll get back to you.

    1. Have a good weekend yourself. I don’t think our views are actually too far apart. I just think that the “hierarchy of money” approach is one of multiple valid frameworks for understanding money, and am very uncomfortable when it is treated as “the” framework for doing so.

      Would be delighted to receive your comments on the paper.

      1. Yes, I’m perfectly happy to let the topic lapse. We’ve probably given it a fair workover anyway.

        As for your paper, just superb. I thoroughly enjoyed it and learned a good deal. It seems to me your analysis, particularly your thoughts about how this history remains all too relevant, are truly pathbreaking. Have you had much constructive feedback?

    1. That’s disappointing. Quite apart from the quality of the paper I can imagine how much work went into it.

      Perhaps it’s just too far outside the prevailing paradigm. Much as with macroeconomics, a revolution of sorts is required in the monetary and banking area as well.

      Oh well, at least you know you’re doing your part. Good luck with it all.

  6. Hi, Carolyn!

    Thanks to Nick Rowe, I found your interesting posts here.

    You will probably hear more from me in the coming days, but I want to make a quick comment now.

    You said: “If the unsecured credit lines that make the payments system function smoothly are liquidity, then are these credit lines also money? Should they be money?”

    You’re not the only one who has been puzzling over these questions. Keynes was, too. You might be aware of this? Below is a footnote from a blog post of mine. (To be clear: I don’t use the word ‘money’ at all. Not even in case of “fiat money”. I don’t think there is any point in defining ‘money’. If we don’t define it, it doesn’t exist, and that makes things a lot simpler to understand.)


    [2] Alternatively, we could say that the unused overdraft is money he has, although it doesn’t reside on his account – and never will.

    Keynes (“A Treatise on Money”, Bk 1, Ch 3, 8ii(i.) “Deposits and Overdrafts”) was of the opinion that unused overdrafts should, logically, be included in monetary aggregates:

    “… it is the total of the cash-deposits and the unused overdraft facilities outstanding which together make up the total of Cash Facilities. Properly speaking, unused overdraft facilities – since they represent a liability of the bank – ought, in the same way as acceptances, to appear on both sides of the account. But at present this is not so, with the result that there exists in unused overdraft facilities a form of Bank-Money of growing importance, of which we have no statistical record whatever, whether as regards the absolute aggregate amount of it or as regards the fluctuations in this amount from time to time.

    Thus the Cash Facilities, which are truly cash for the purposes of the Theory of the Value of Money, by no means correspond to the Bank Deposits which are published.”

    I see that we have two options if we want to be logical: either unused overdrafts are money, too, or then “cash-deposits” are not money, either. I opt for the latter, not least because there is only a fine line between a pre-agreed unused overdraft and an overdraft – or a “traditional bank loan” for that matter – that the bank would be willing to provide if only the customer wanted it. Trying to find out the size of Keynes’ “Cash Facilities” is much like trying to find out the total amount of purchasing power in the economy – a hopeless task, if you ask me.

    1. Thank you for the reference to Keynes. Forced to admit that his Treatise on Money stills sits in my “to read” pile.

      1. My pleasure, Carolyn! I guess it’s not one of the first books an economist would read. I probably haven’t read those “first books” (I majored in Accounting, M.Sc., have no PhD.).

        What I like in Keynes’ Treatise, and especially in Schumpeter’s (posthumously published) “Treatise on Money”, is the “thinking out loud” quality — following a line of thought to its logical conclusion, even if one cannot always include it as a part of a coherent whole. Keynes more or less casually said that monetary aggregates should actually include unused overdrafts. Did this thought lead to something important? I don’t know. It doesn’t look like it.

        You seem to find that thought important? (You said: “If these credit lines that are so important to the operation of the payments system are not money, then what is the point of defining money at all?”) But you don’t want to draw further conclusions from it at this point?

        You discussed Adair Turner’s book in another post (a good post, that too!). He often talks about banks creating (credit, money and) purchasing power. At what point do banks create purchasing power? Some seem to think money = purchasing power, and so banks create purchasing power when they credit a borrower’s account. Someone else might point out that banks create purchasing power already when they grant a credit line (overdraft facility) to a customer. But what about a customer who would get a credit line approved by his bank any day, but haven’t yet asked? I would say this customer already has purchasing power, and a bank can only help to realise it, not create it.

        Just thinking out loud 🙂

      2. If I have to find something that slightly bothers me in your post, it would probably be your use of the word ‘liquidity’. (As one can read between the lines in my comment above.)

        I don’t (necessarily) mean that liquidity is something else than what you say it is. I just think that it isn’t a precise concept, just like ‘money’ or ‘purchasing power’ isn’t. It sounds to me that your definition of ‘liquidity’ could as well be a new definition of ‘money’ (incl. unused credit lines) or a definition of ‘purchasing power’. Is that what you’re after?

        If I defined your liquidity as “an ability to cause a credit entry on the seller’s account”, or “an ability to buy”, would I be far off?

      3. Perhaps I got it wrong. You said: “Overall, by defining liquidity as the unsecured credit lines that facilitate the settlement of asset trades and other obligations”

        It sounds like you would like to call those (unused) credit lines ‘liquidity’, if you’re not allowed to call them ‘money’?

  7. What is “money” is an age-old concept that has been debated since at least the early 19th century. The fact that the Fed stopped publishing the M3 series — and then came face-to-face with the importance of repos to the money supply in 2007-08 — is testimony to the fact that the underlying issues are unresolved.
    I am basically advocating for a new definition of “liquidity” that arguably encompasses the existing definitions. One of the reasons for doing so is precisely that the current concept is so vague. Thus, it’s unsurprising that the meaning of both terms continues to be a matter of debate.

    1. I agree. In a way, money reminds me of luminiferous aether from physics. The same goes for ‘liquidity’, I guess. If we cannot agree what they are, perhaps we should conclude that they don’t exist and concentrate on what does exist?

      An example: We are used to say that banks create money. Instead, we could say that banks do bookkeeping and make credit entries (this is phenomena) which lead to credit balances (arithmetics). Naming those credit balances ‘money’ and imagining that the money flows (not a phenomenon, but a metaphor/interpretation) creates an artificial layer on top of the bookkeeping.

      I don’t mean to sound too critical. I agree with you on most of the important issues. I’m just advocating a new perspective which might help with getting others closer to your understanding of the monetary system. Some kind of synthesis.

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