Evaluating heterodox monetary theory through a New Monetarist lens

I. Using New Monetarism to motivate a closer look at credit-based payments systems
a. The failure of economic theory to incorporate banking is as old as economic theory itself
II. Important implications of a credit-based payments model
a. Settlement by clearing is a substitute for settlement by cash
b. The credit-based payments model undermines the distinction between consumption and production credit
III. A final note

Money and the issues that the economy’s dependence on money raises are some of the most difficult topics to analyze in economics. All discussions of money are founded on some underlying framework explaining what money is and what money does. My preferred framework is based on “New Monetarist” models of the economy. A variety of competing approaches are typically described as “heterodox” in the economics literature. This post is a preliminary effort at organizing a comparison of these frameworks and was stimulated by Chapter 5 of Christine Desan’s Making Money which is a highly recommended and fascinating study of the historical development of money. Desan builds her argument based on the heterodox approaches.

My organizing structure will build on a verbal discussion of the implications of new monetarism. Three related, but distinct, heterodox approaches will be addressed in the context of this structure: the hierarchy of money developed by Stephanie Bell-Kelton (explained with extraordinary clarity in Perry Mehrling 2012), the cartalist approach to money, and Geoffrey Ingham’s focus on money as a unit of account and store of value as distinct from money as a means of payment. (I am aware that both Ingham and Kelton may fall into the cartalist category, but find it convenient to discuss each of these approaches independently.)

Using New Monetarism to motivate a closer look at credit-based payments systems

New monetarism is a sub-field of macroeconomics that has grown up over the past few decades and that uses formal economic modelling techniques to study money. While the principal innovation that this literature brings to economic theory comes from liquidity frictions that generate a role for a means of payment, as in the older monetary literature, money also serves as a store of value and via the study of relative and intertemporal prices as a unit of account.

The basic intuition that can be derived from the formal analysis of a means of payment is that at any point in time a given transaction in the economy may be viewed as taking one of the following forms:

  • Barter (requires double coincidence of wants)
  • Cash purchase-Cash sale
  • Credit purchase-Credit sale
  • No trade (takes place if there is either no coincidence, or the parties are unable to settle on terms)

Because economic agents are on both sides of any transaction, every cash purchase and every credit purchase must have a corresponding cash sale or credit sale. Because both credit and cash transactions can only take place if the seller anticipates that cash or credit will have value in the future, only barter transactions do not depend on future expectations about the value of some means of payment.

Some basic results that derive from this literature are:

i.  From a theoretic perspective cash payments and credit payments are alternative payments systems (Gu, Mattesini, & Wright 2016). Because conceptually a payments system can be based entirely on one or on the other, credit – or in the extreme case gift-giving – can be the basis for the payments system.

This result may be consistent with Ingham (2004)’s argument that the payments system is dependent on the sovereign for its unit of account, since the new monetarist literature can be viewed as assuming some institutional infrastructure arguably including coordination on a unit of account. On the other hand, this result contrasts with the basic premise of the hierarchy of money theory which states that bank money – or the modern credit-based payments system – is dependent on sovereign-authorized cash for settlement.

This theoretic result is a valuable insight, because it is far from clear that the banking system – abstracting from regulatory requirements that did not exist when the system was developed in the 19th century – is dependent on sovereign “cash” for settlement. Whatever remaining balances aren’t cleared by the banking system may be carried as debt by a member of the system to the next period, and it is unclear that sovereign “cash” is necessary to the system – except perhaps as a unit of account. (This is discussed in more detail below.)

 ii. Cash and credit transactions are similar because they can only take place if the seller anticipates that cash or credit will have value in the future.

This can be viewed as a formal realization of Ingham’s contention that all forms of money can be properly viewed as debt in the sense that the holder of money, whether cash-based or credit-based, has a claim with a future value determined by social relations (2004, Ch. 4). This is also related to the cartalist view (embraced by Ingham but also espoused by many others before him) that what is money is fundamentally determined by what the state accepts in payment of taxes. On the one hand, the theoretic result is a general finding that both cash and credit depend on future expectations, whereas the cartalist view is more of an empirical claim that the most important real-world source of those expectations comes from the state’s power to tax. The theoretic literature then raises two issues with respect to the cartalist view: first, are there any other means by which money enters into circulation in addition to sovereign tax policy; and, second, what makes it incentive compatible for a public or private issuer of money to accept/redeem it.

iii.  An ideal form of credit is strictly better than cash: the set of equilibria that can be attained using cash is a subset of the set of equilibria that can be attained using credit (cf. Kocherlakota 1998. See also Sissoko 2007).

Not just the heterodox hierarchy of money approach, but also most mainstream macroeconomics — and indeed a great deal of the New Monetarist literature  –emphasizes cash as the cornerstone of the payments system. The implication that I draw from this New Monetarist result is that this emphasis is misguided. We need to re-center the discussion so that the focus is on credit- or bank-based payments systems and then evaluate the role that cash may play in supporting these systems.

The failure of economic theory to incorporate banking is as old as economic theory itself

Treating the “cash” solution to the monetary problem as the reference point and then asking how credit expands the cash system has been the default approach in economic analysis dating back to Adam Smith. Indeed, from this point of view the heterodox hierarchy of money approach is similar to the monetarist treatment of banking: banking serves only to expand an existing monetary base. (If these arguments were limited to the claim that banking is dependent on an external unit of account, they might be sustainable, but these arguments always go well beyond such modest claims.)

Banking scholars have been attempting to debunk the economists’ approach to banking for more than 200 years. Henry Thornton, the banker who first explained the role of the lender of last resort and how it affected domestic and foreign trade differently, took Adam Smith to task for failing to understand the nature of Britain’s paper monetary system in 1802. Schumpeter was engaged in much the same debate with his contemporaries a hundred years later. And today we still find that economists have difficulty with the very concept of a credit-based payments system. One might hope that the formal modeling framework of New Monetarism will help the profession remove these intellectual blinders.

Important Implications of a Credit-Based Payments Model

Settlement by clearing is a substitute for settlement by cash

Hierarchy of money theorists tend to ask “in what will this transaction be settled” and to categorize credit based on the purported means of settlement.[1] This approach accurately models the relationship to bank money of near-monies that are settled in bank money, and thus it is a very useful approach. However, when this approach is extended by analogy to the relationship between bank money and cash (or claims on the state), the approach breaks down and it loses its usefulness. (Indeed, Knapp whose cartalist approach to money underlies the hierarchy of money theory did not draw this distinction.[2]) Not only is a cancelled check – or the transfer of bank money – legally proof of settlement of tax payments as well as civil obligations, but even in a financial crisis it is central bank liabilities that expand to support the system, not “cash.” While hierarchy of money theorists seek to reconcile this fact with the theory by explaining that these central bank liabilities are like “cash” in some sense sovereign obligations, it is more accurate to view these liabilities as a core part of the system of bank money itself.

The modern credit-based monetary system is indeed anchored by a central bank that issues bank money in the form of reserves that can expand to support the system in crisis. It is also true that the central bank could not operate in this way without the sanction of the government. These facts do not, however, mean that the best way to understand this system of bank money is that it is dependent on the stock of government liabilities. The system of bank money was made effective only when it became dependent on an expandable source of central bank liabilities, and the concept of a central bank developed simultaneous with this system of bank money. Thus, bank money and the central bank liabilities that serve as the high-powered money of the banking system are part of a single bank money system such that the two parts of it cannot be disarticulated. It is misleading both to treat this relationship as analogous to the relationship between near-monies and bank money and to treat central bank liabilities as effectively sovereign liabilities.[3] Such an approach collapses the institutional detail of what is actually going on to such a degree that it risks misleading rather than clarifying the role played by money in the economy.

The processes of clearing and of interbank lending that are integral to every banking system ensure that only a small fraction of bank liabilities need to be settled at all and that many of these remaining balances are carried rather than settled. Thus, it is inaccurate to claim that when one pays by check (or otherwise by transfer of bank money) the transaction is settled by central bank reserves. The transaction is settled within the banking system itself. Furthermore, it is well established that central banks do not exercise quantity control over the stock of central bank reserves, but must issue reserves in a manner that is responsive to the demands of the banking system.[4] This is true both in normal times and in crises. Thus, the hierarchy of money framework when it claims that bank money is settled using central bank reserves creates an illusion of quantity-based central bank control over the money supply that is both erroneous and just one small step removed from the deterministic approach of the “old” monetarists.

For example, Perry Mehrling, whose theory of money relies heavily on the hierarchy, states: “At every level of the system, the availability of money from the level above serves as a disciplinary constraint that prevents expansion; credit is payable in money, but money is scarce.” Given that the specific hierarchy Mehrling is discussing explicitly places currency as a central bank liability above bank deposits, his implication is clearly that the quantity of central bank liabilities constrains the growth of bank deposits. My point is that this view misunderstands the basic function of the central bank: in order for a banking system to work central bank liabilities must expand in response to the demands of the banking system. It is true that the central bank constrains the growth of bank money, but it most definitely does not do so using quantitative controls on the supply of central bank liabilities. Instead the central bank uses interest rate policy, microprudential, and macroprudential supervision of the instruments on bank balance sheets (see Sissoko 2016).

Thus, by failing to understand the fundamentally credit-based nature of the modern payments system and by modeling the payments system as “inherently” cash-based with the banking system as simply an extension of the cash-based system, the heterodox literature perpetuates the error of the old monetarists. As Thornton argued in 1802 and many have tried to explain after him, the modern monetary system is a credit-based payments system that has properties very different from a cash payments system. Errors that can arise when scholars who are studying money fail to recognize either the possibility of or the characteristics of a credit-based payments system include:

  • The assumption that movements in a sovereign money supply determine movements in a contemporaneous credit-based money supply. This is of course a foundational principle of Old Monetarism. It is, however, also a fundamental principle of many heterodox approaches (see the discussion of Mehrling 2012 above). Desan too posits such a relationship and seeks support for it in the data on medieval English money. Unfortunately the data available from this era is sufficiently sparse that others find support for the view that credit actually expanded when the sovereign money supply shrank (pp. 225 ff).
  • The assumption that a deficiency of cash will constrain transactions. In an environment where there is clear evidence of credit-based payments, the possibility that credit fully substitutes for cash – at least within the group of individuals who participate in the system – must be considered. Even if cash is used sporadically (for example, seasonally during the harvest when it is suddenly available in a village economy), this does not necessarily imply that transactions are constrained by the absence of cash when it is unavailable.
  • The assumption that debts are paid in cash. In the absence of clear data indicating that this is the norm, the likelihood that some system of clearing or of transfer of claims is used to settle debts must be carefully evaluated. This possibility certainly cannot be rejected out of hand – and evidence that some currency is the unit of account is in no way evidence that this currency is also the means of payment. After all, almost every one of my transactions is denominated in dollars, but only a very small fraction of them are settled using dollar bills.
  • The assumption that debt that specifies a due date is actually expected to be paid off on that date. The rolling over of short-term debt obligations is such a fundamental part of historical payments systems that one must always evaluate whether or not a social norm was in place that would make it difficult to demand payment when due. For example, when studying credit in a 15th century English village, Elaine Clark establishes that 61% of the litigation over payments that arose involved debt that was incurred 4 or more years earlier and in more than half of these cases the debt was more than 7 years old. Thus, Clark concludes that in this small scale credit network the norm was for debt to be open-ended. Given examples such as this, one needs to consider the possibility that the due date for a debt is simply the date on which the terms of the credit line may be reset rather than assuming that it is a date on which payment is expected to be delivered.

The credit-based payments model undermines the distinction between consumption and production credit

The New Monetarist credit-based payments model points to an important fact about credit that is easily missed when the neoclassical model is your framework: the line that is sometimes drawn between consumption credit and productive credit begins to disappear in an environment where everybody needs to borrow in order to trade.

Desan has a very nice discussion of the implications of the ubiquitous use of what she calls “liquidity credit” (pp. 214 ff), and I prefer to call payments credit. She discusses the fact that payments credit does not sit easily within a dichotomy of (potentially exploitative) “exigency credit” and “investment credit”, but is best understood from the “revisionist” perspective that assigns a more affirmative role to credit.

I would add that payments credit lies squarely between the two poles of the dichotomy: it typically finances working capital – after all foodstuffs themselves can be considered inputs for someone whose main product is labor services and who needs payments credit in order to purchase food. While working capital has always been distinguished from fixed capital and it is the latter that is typically associated with investment, the productive role of working capital is indisputable.

Thus the credit-based payments model indicates that just as mercantile credit is viewed as being productive – precisely because it finances working capital (Desan pp. 228-29), the same reasoning justifies the view that payments credit in a rural village was also likely to have been productive.

A credit-based payments system may not be worse than a cash-based credit system

Desan discusses at length the ways in which the rural system of payments credit may have imposed costs on the poor. The main criticism I have of her analysis is that she does not spend enough time explaining how such costs might have been avoidable given a cash-based payments system. After all, the question is not whether the poor suffered in rural villages (given the heavy burden of taxation that Desan argues was a cornerstone of the monetary system, we know they did). The question is whether the fact that the payments system was credit-based made things worse.

For example, Desan argues that sellers on credit and those paying in advance could drive hard bargains with the poor (p. 223). But, as the New Monetarist framework makes clear, the presence of cash does not eliminate the bargaining problem. The poor are disadvantaged in a cash or a credit economy: if a buyer can only afford to pay cash for a quarter loaf of bread, the seller may well choose to charge that individual more than a quarter the price of a full loaf. In fact, in a world where everybody uses payments credit it may be easier to be poor, precisely because the need to borrow is unexceptional and can go unnoticed.

Desan also argues that enforcement of debt by litigation is costly, unpleasant, and can have the effect of souring relationships (pp. 218 ff). This is certainly true, but the relevant question is whether cash bargaining makes it possible for a community to avoid or at least reduce the measure of unpleasantness and soured relationships. The answer to this question is far from obvious. (While I pay my phone bills in full every month, I can assure you that the fact that I regularly have to call and have them corrected makes me feel that I know very well what a sour commercial relationship is – and it doesn’t require debt.) In short, disputes arise when people transact. When payments mostly take the form of credit, then debt litigation will frequently feature in the disputes. This is not, however, evidence that no dispute would have taken place without debt.

Desan remarks on how the credit-based payments system required vetting and long-term relationships that would be unnecessary in a cash economy (p. 218). This is certainly true, but cash is usually viewed as being most advantageous in stranger-trades where credit is impossible. Given the signs of almost universal access to credit in rural villages (Spufford, cited by Desan 209) – and the fact that these were the kind of close knit environments where credit is likely to be most effective – it’s not at all clear that these characteristics of credit were a handicap in rural villages. On the other hand, it seems reasonable to claim that the lack of cash and the reliance on a credit-based payments system may have slowed the growth of stranger trade and in this sense slowed the expansion of the economy.

Finally, Desan argues that the nonproductive nature of English credit exacerbated its dangers (p. 223), including “habituat[ing] people to living on prospect” (p. 224). As was discussed above it’s far from clear that this is the best way to view payments credit, which is indeed forward looking, but in a way that makes it possible for economic production to take place.

A final note

One of the advantages of the new monetarist approach is that it rejects the neoclassical model entirely in order to explore a variety of environments where trade is not easy. As a result, there are aspects of the heterodox monetary literature that are more reliant on the neoclassical framework than new monetarism. For example, Geoffrey Ingham appears to treat the idealized market of the neoclassical model as the basis for his general definition of a market. He writes: “a market is a system of multilateral exchanges in which bids and offers, priced in a money of account, can in principle produce a single price for a uniform good” (Ingham 2006). I find it surprising and unnecessarily restrictive to treat the idea of a market itself as referring to an environment where each good trades at a single price. Having spent time in parts of the world where the term “market” typically refers to an environment where many goods are sold and prices are reached through a process of one-on-one bargaining, the single price of the neoclassical model has always appeared to me a characteristic of the model, not of the “market.”

Precisely because discussions of money are inherently macroeconomic, requiring focus on the general operation of trade in the economy as a whole, close attention to the subtle ways in which simplifications drawn from the neoclassical model color the discourse is very important. For example, reading Desan I find that she periodically implies that if cash were in sufficient supply, prices would be neoclassical in character.[5] While this accords with Ingham’s claim that “a genuine market presupposes the existence of a money of account in which demand and supply can be expressed in prices,” it is far from obvious to me that Ingham’s market – or neoclassical prices – can be expected to exist anywhere but in the realm of purely abstract theory.[6] By introducing the reference point of idealized prices into the analysis of historical monetary phenomena and assuming that such idealized prices are specifically associated with the coin that served as a unit of account, Desan allows the neoclassical model to color her discussion of money and credit. In short, it seems to me that proponents of heterodoxy can sometimes end up taking the neoclassical pricing mechanism more seriously than many modern economists – who have after all been trained in all the shortcomings of the neoclassical model.

[1] See, e.g., Gabor & Vestergaard 2016.

[2] See Bell 2001 at 159.

[3] Bell writes: “Although bank money is part of the ‘decisive’ money of the system, its acceptance at state pay offices really requires its conversion to state money (i.e. bank reserves). That is, bank money is converted to bank reserves so that (ultimately) the state actually accepts only its own liabilities in payment to itself.” (p. 160). First, most bank money is cleared, and only a tiny residual shows up in reserves, so there is no “require[ment of] conversion to state money.” Second, central bank reserves are not state liabilities, but central bank liabilities. The fact that the archetype of a central bank operated as a privately-owned institution for most of its history should make one think twice about casually asserting an equivalence between the central bank and the state.

[4] See Stigum & Crescenzi on the Fed’s so-called monetarist experiment, pp. 372 ff, 503. See also McLeavey et al. 2014 p. 21.

[5] “The process [of monetizing an economy with coin] shakes the items traded into particular relationships of value. Eventually, those relationships produce prices for goods and other resources in terms of pennies, the units of account. The pennies, as they are spent, traded, and taxed, ultimately create a set of equivalences: 5 pennies = a sword, 5 pennies = two cows. But there is nothing essential about the sword and the cows and their equivalence. To the contrary, they are interchangeable only in the world created by this community’s activity with [pennies]” (pp. 60-61). And later, the scarcity of small coin “effectively added a burden to those most handicapped by it, whether by increasing their vulnerability to [adversely-timed lawsuits] or affecting bargaining power over prices because they had credit not coin” (p. 223). Observe that the latter statements also implies that if the supply of coin is sufficient, sellers will be price-takers (which in economic theory is a prerequisite for neoclassical prices).

[6] Indeed, in the neoclassical model money is superfluous. So it is far from clear how neoclassical prices could possibly result from the introduction of money into an economy.


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