How Banking Created the Wealth of Nations: A Riff on Desan’s Making Money

How banking created the wealth of nations
Did the British reforms constrain sovereign power over money excessively?
Was the “liberal” market vision born of “good” banking?
Did the British reforms grant excessive power to the banks?

How banking created the wealth of nations

A closing sentence of Desan’s Making Money encapsulates what I find truly extraordinary about her book: “Arguably capitalism … constructed a money [based on] individual exchange for profit, institutionalizing that motive as the heart of productivity.” In her closing chapters Desan effectively argues that Britain’s reconstruction of its monetary system over the course of a long 18th century (starting in 1694) by transferring the “making of money” to the private sector and constraining the role of the government to that of an “administrator that standardized money and stabilized it” also had the effect of generating an enormous flow of liquidity that was tied to real economic activity. Desan aptly observes that the famed “commitment” to private property rights of the British polity was in many ways less a matter of constitutions and more a matter of the closely interrelated development over the course of the 18th century of the monetary and fiscal systems.[1] While her focus tends to be on a critique of these changes, she in effect explains how the reform of the monetary system may have set the stage for modern economic growth.

In short, in my view Desan’s greatest contribution in Making Money is a clear explanation of how monetary reform set the stage for modern economic performance. On the other hand, Desan is so critical of these changes that I believe her argument needs to be reframed in order to set forth a more positive view of these transformative events. This is what I would like to do here.

In the process of reframing Desan’s thesis, I am going to position the reforms of the long 18th century in the context of European banking history with an emphasis on the private issue of money. This contrasts with Desan’s approach which builds on a fascinating and very detailed history of England’s currency and argues that even at its founding Bank of England notes were effectively public, not private, liabilities. As will be seen below, my analysis raises the possibility that the reformers of the long 18th century knew what they were doing – not in the sense that they could predict the details of its transformative effect, but in the sense that they were deliberately laying the foundations of transformative change by transferring control over the money supply to the private sector – with the acquiescence of the government.[2]

The Bank of England was established in 1694 by sophisticated financiers who were familiar with the European money market of their day. The contemporary European money market was centered in Amsterdam and together with earlier incarnations of the money market had been using “bank money” rather than any sovereign money as its unit of account for more than a century and half prior to the Bank’s founding. Bank money, unlike sovereign money, had a fixed value in terms of gold and could on this basis be converted into any sovereign coin.[3] In the mid-16th century the money market had been centered on fairs in Lyons where the imaginary ecu de marc was the unit of account (see Boyer-Xambeu et al. 1994). At the end of the 16th century Venice made a successful play for the European money market by establishing the Banco della Piazza di Rialto which used the imaginary bank ducat as its unit of account. Amsterdam’s Wisselbank was modeled on the Venetian bank and anchored the European money market by the time the Bank of England was founded.

Thus, the merchant elite of Europe preferred to use bank money rather than a sovereign currency as the unit of account for their liabilities. Bank money was preferred, because the Bank was run by people who were a part of the network of European merchants and could be trusted to maintain bank money’s value whereas no king or politician could be trusted to do so. Thus, when we study the founding of the Bank of England from the point of view of the bank origins of money, we find that Bank liabilities circulated because they were issued by a merchant-run corporation that was immediately integrated into the European money market and the network of merchants that operated the money market.

In fact, of course, the full explanation for the circulation of Bank notes probably lies somewhere between the public origins and the bank origins explanation. The Bank of England’s structure likely was shaped by the lessons learned in Venice and Amsterdam. When the European money market left Venice, the circulating currency of the Venetian bank was replaced in domestic trade within a short period of time by the liabilities of the Banco del Giro, which was essentially a fund of public debts.[4] And the managers of the Wisselbank had probably already found that the Dutch government turned to it (in secret) for resources when exigent circumstances loomed. By designing a bank that had a very public and clearly delineated relationship with the government – like the Banco del Giro, the European merchant elite were able to combine the benefits of an internationally-recognized bank money with a form of public support that the merchants, as lenders, could at least to some degree control. The Bank of England was truly a public-private partnership and extraordinary emphasis should be placed neither on the public nor the private aspects of the partnership.[5]

Evidence of this interdependence is to be found in a form government debt that is often presented as a purely public liability of the British government in the late 17th, 18th and 19th centuries, the Exchequer bill (Desan, p. 369). When first issued, the government had difficulty getting these bills into circulation – even after making them acceptable in payment of taxes (Clapham v. I, pp. 54 to 71). Only after the management of the bills including the business of “exchang[ing] all Exchequer bills for ready Money upon demand” was transferred to the Bank, was the government able to get them widely accepted. Indeed, because of the onus place on the Bank of England by the issue of such bills, the government was by law required to first obtain the consent of the Bank before any increase in the supply of Exchequer bills (Clapham v. I, p. 65). Thus, even Exchequer bills should be viewed as public-private instruments and not as “purely” public instruments.

This banking history-based perspective on the origins of the Bank of England also allows us to reevaluate the role played by John Locke in the Great Recoinage which commenced just two years after the Bank of England was founded. Locke persuaded the British government to reform the silver coinage by taking the unusual step of maintaining its current value and demonetizing undervalued coins. Locke argued that the value of coin is – and should be – measured by its intrinsic value or by the quantity of silver that public authorities warrant to be in the coin.[6] This is, of course, the same standard that the merchant elite where using when they denominated their transactions in bank money, and it is this standard for bank money that Paterson proclaimed was necessary in order for a banking system to operate. Thus, from the perspective of banking history Locke appears to have been deliberately laying the intellectual foundations for a world in which the European merchant elite’s bank money would have the political support to become the measure of the unit of account for a sovereign nation, and would be insulated from the sovereign’s authority to revalue the unit of account.[7] Desan astutely observes that when this structure evolved in the 19th century into the Gold Standard, the purpose was “to discipline the amount of bank currency in circulation” (p. 409, emphasis in original). This is certainly correct and is, indeed, made explicit in Paterson’s 1694 definition of bank money.

Did the British reforms constrain sovereign power over money excessively?

Desan criticizes this reform of the monetary system for two reasons. First, the gold standard committed the sovereign not to devalue the unit of account in terms of gold and, thus, removed from the government an important tool for readjusting the distribution of wealth in society and for improving overall welfare (p. 381). Second, the power to expand the paper money supply was transferred to the banking system, giving it too much power and profit while at the same time requiring periodic subsidies from the state (pp. 418-19, 428-29).

The first criticism is very interesting, because Desan – who does not have training in economics – does not apparently realize that one of the most robust results in economics is that when an agent gains the ability to commit to a future action the set of choices available to that agent expands dramatically. Britain’s 18th century reforms did commit the country to prioritize creditors over other government uses of funds, but it also enabled the government to fund far greater expenditures than had previously been imaginable while at the same time enabling the domestic economy to foster an Industrial Revolution. In short, from a theoretic point of view the fact that Britain’s commitment to a gold-based monetary system preceded one of the most extraordinary and unexplained phenomena in all of economic history could potentially be more than a coincidence. Overall, given Britain’s subsequent economic performance it does not seem unreasonable to conclude that even though commitment tied the government’s hands, this policy may well have been advantageous for society as a whole.

An interesting question is whether the architects of England’s monetary reform understood the value of commitment. Desan argues that the reformers were “unfamiliar” with the mechanisms by which domestic currencies were issued and functioned (p. 347), but given the merchant background of many reformers this seems unlikely. Surely it is possible that they wanted to promote a monetary principle which they believed to be superior to the old-fashioned domestic currencies – while at the same time understanding that this system would also be advantageous to them personally as creditors. While this issue will not be settled here, Europe’s merchant elite in the late 17th century certainly viewed commitment to a specie standard as a necessary foundation for a banking system (e.g. Paterson), and a century later the Bullion Committee would express a similar view (Desan, pp. 414-15). Through experience they had apparently seen how such commitment can underpin the credit necessary to support robust trade. Indeed, Paterson’s proposal is testimony to the fact that the reformers understood that their actions would promote economic activity (pp. 14-15).

Was the “liberal” market vision born of “good” banking?

From this perspective the relationship between banking and Locke’s “liberal” vision of the market is also worth exploring. As Desan explains medieval markets – where strangers traded – were dependent on the sovereign to provide a unit of account, means of exchange, and legal infrastructure. Medieval markets were thereby shaped by sovereign decisions. Locke, however, frames markets, trade, contracts, and even the emergence of money as phenomena that required only “mutual consent” and could take place in the absence of sovereign money and law. Desan explains that Locke’s vision was of “a world that worked on the basis of real exchange alone” where “law depended on convention, much like the customs that drew longtime trading partners together” (p. 359). The latter is, of course, also a reasonable approximation of the economic environment in which the merchant elite who managed Europe’s money market operated. This money market did not just use bank money as its unit of account, but centered in those cities which applied to the merchants’ activities the Law Merchant with its deference to the customs of merchants and juries that were carefully balanced in terms of nationality (Rogers 1995 Ch. 1). (Update 2-2-2017: Note that the Law Merchant as used by Rogers and medieval lawyers refers to a set of legal procedures and not to a body of substantive or autonomous law.) Furthermore, as Desan emphasizes, Locke’s approach to money is a good description of the use of money in international trade – according to Desan the flaws of this approach lie in its application to a domestic unit of account and the domestic economy.

This raises questions: Was Locke’s liberal vision of a market where only real exchange mattered and where money did not constrain market activity also a good description of the environment in which Europe’s international banking elite operated? The neoclassical model, which is the modern realization of Locke’s vision, makes it clear that an environment where only real exchange matters effectively assumes a credit system that operates perfectly (Sissoko 2007). Is it then possible that it was because the European money market in the 17th century was so effective at financing the trade of Europe’s merchant elite that it was possible for them to conceive of a “liberal” market where only real exchange mattered? That is, was it because European banking was so highly developed that the model of a “liberal” market economy which abstracts from money became imaginable? Does this model assume that liquidity does not constrain market activity, because the development of banking had created a world where it was possible to imagine trading in a world without liquidity constraints?

Desan’s critique of this liberal vision of the market is that, once it grew to be the predominant theory through which the economy was understood, money became invisible in a way that had never been possible in medieval economies beset with a shortage of coin (p. 421). The “market” in the modern economy is often discussed as if it were operating independent of money. In fact, money and liquidity constraints are central to much that takes place in the modern economy, just as they were central to transactions in the medieval economy. Desan is almost certainly correct that by obfuscating the centrality of money to everything that takes place in a modern economy, this liberal vision has likely played a role in the development of our current economic problems of troubled currency unions and hard-to-stabilize banking systems.

Did the British reforms grant excessive power to the banks?

Desan’s second critique of Britain’s 18th century monetary reform focuses on the power granted to the banking system over the money supply. She is certainly correct that banking constitutes a “distributive decision about money design” (p. 429), but in my view Desan underestimates the extraordinary value created by the shift from sovereign coinage to bank money. This error is a function of her basic monetary framework which is essentially monetarist, and treats cash in the form of claims on the government as the ultimate form of liquidity.[8] This framework fundamentally underestimates the transformative nature of banking and the role that bank money plays in supporting modern economic growth. By contrast, both the promoters of the Bank of England and the Directors who determined its policies a century later understood that the value of a monetary system based on bank money lay in its ability to respond dynamically to the needs of the real economy in a way that no centralized sovereign authority could possibly achieve.[9]

When criticizing this power granted to the banking system, Desan emphasizes that the State allowed the banking system to reap excessive profits from its role and was forced to subsidize it at significant cost. These concerns have much more relevance to the modern monetary system than to the one that grow out of the monetary reforms of the long 18th century, because an important principle of liberalism in the early centuries of its development was that subsidies from the government to the private sector had adverse effects on economic performance. Thus, banks in 18th and most of 19th century Britain operated with unlimited liability. Liquidity support to the banking system during panics was made available on paper that had at least three private sector guarantees of payment, and as a result through the first two centuries of its existence the Bank of England had to write off only a trivial fraction of bills (Bignon et al. 2012, p. 602).[10] Even in those rare cases, such as the Baring Crisis of 1890, where a “bailout” of a bank was organized, the Bank was very careful to place the burden of the losses first personally on the bankers who required bailout, and secondly on those members of the banking system that were most exposed to the defunct bank.[11] For a more detailed analysis of how the British banking system was structured so that it was both stable and effective in keeping the costs of banking to society quite low I refer the reader to Sissoko 2016.

Desan also argues that the modern monetary system can be understood through the lens of Britain’s long 18th century reforms and finds that in the modern system, too, banking is subsidized at significant cost to the government. I agree with her entirely on these points. Our modern monetary system is a direct descendent of 19th century British banking. Unfortunately the evolution of the banking system over the past century has left us with a monetary system that is extraordinarily unstable and remarkably dependent on government support. Indeed, the evidence that Desan cites with respect to the costliness of banking system bailouts is far more relevant to the modern banking system than to its 19th century forebear (Reinhart and Rogoff 2009; Ricks 2011; Gorton 2012; Calomiris and Haber 2014 cited at 417, 419, 429).[12]


Thus, the lesson that I draw from Desan’s Making Money is this: whereas the challenge faced by those who sought to reform the monetary system in the late 17th century was how to constrain the authority of the sovereign over the money supply, the challenge faced by modern reformers is how to constrain the power of the banks over the money supply. I believe that monetary history demonstrates that a bank-based monetary system can be well-structured so that its benefits far exceed its costs. I am in perfect accord with Desan, however, in condemning the modern bank-based monetary system as a costly boondoggle.

[1]pp. 288-292. cf. North and Weingast (1989), “Constitutions and Commitment.” Desan also observes that reform was not really a matter of a general commitment to property rights but more of a deliberate policy of favoring certain property rights over others, p. 293.

[2] Desan argues that many of the effects of these reforms were “unforeseen,” p. 376.

[3] Indeed, William Paterson’s 1694 proposal for the Bank of England is explicit on this point, pp. 9-10: “in the first place it is necessary to premise … 1. That all Money or Credit not having an intrinsick value, to answer the Contents or Denomination thereof, is false and counterfeit, and the Loss must fall one where or other. 2. That the Species of Gold and Silver being accepted and chosen by the Commercial World, for the Standard or Measure of other Effects; every thing else is only counted valuable, as compared with these. 3. Wherefore all Credit not founded on the Universal Species of Gold and Silver, is impracticable, and can never subsist neither safely nor long; at least till some other Species of Credit be found out and chosen by the Trading part of Mankind, over and above, or in lieu thereof.  Thus having said what a Bank ought to be, it remains to shew what this is designed, and wherein it will consist”

[4] We see this knowledge reflected in Paterson’s proposal where he refers repeatedly to the “Banks and Publick Funds” of Europe.

[5] This is a very different view not just with comparison to Desan, but also with respect to Calomiris and Haber 2014.

[6] Locke “Further considerations concerning raising the value of money”, p. 415 cited in Desan p. 347.

[7] Desan observes that it’s hard to tell whether Locke’s intellectual convictions derived from his political goals or vice versa, p. 345. In addition, while Desan acknowledges that an important goal of the revaluation was to “legitimate public credit” p. 374, the implications of this are much more limited than the implications of a sovereign legitimating bank money.

[8] An analysis of the monetary framework used throughout Making Money is presented elsewhere [link to be added].

[9] Paterson 1694; Bullion Committee Report 1810 quoted in Desan p. 418.

[10] Vincent Bignon, Marc Flandreau, & Stefano Ugolini, Bagehot for beginners: the making of lender-of-last-resort operations in the mid-nineteenth century, 65 Econ. Hist. Rev. 580, 602 (2012).

[11] A Baring partner and family member who had retired some years prior to the crisis set aside money to support those members of the family who were impoverished by the crisis, Ziegler 1988 p. 251.

[12] Desan cites at length Bullion Committee Report comments to the effect that profits that accrued to banks during the Suspension were improper, pp. 419-20, but fails to note that subsequent suspensions (of Peel’s Act during crises) were accompanied by the transfer of any profits from any excess note issue to the British government.

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.

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).

Finance and Economics: A Research Agenda

My research agenda employs deconstructive method to motivate a reconsideration of the meaning of neoclassical economics. Thus, an economic theory paper introduces a liquidity friction into a competitive model to study how standard models are constructed on the assumption of perfect intermediation (Sissoko 2007), an economic history paper demonstrates that in fact the markets of industrializing Britain relied on a carefully calibrated banking system that successfully stabilized money growth (Sissoko 2016a), an economic theory paper uses new monetarist methods to model banking and how it stabilizes the relationship between unsecured debt and the money supply (Sissoko 2016b), and another paper analyzes modern finance and explains how the growth of market-based lending has disrupted market liquidity by circumventing the stabilizing force of banks (Sissoko 2016c). Together these papers invert the mainstream view by arguing that starting in late 18th c Britain the banking system effectively stabilized the money supply, allowing it to be treated as a stable background condition: this made modern capitalism possible and neoclassical economics itself imaginable. This post explains the “big picture” of the role played by innovations in banking on European industrialization, and this chapter of my dissertation gives even more detail.

The 19th c. bank “bailout” that never happened

I’ve just read Eugene White’s Bank Underground post on the Baring liquidation in 1890. He is notable in getting the facts of what he calls the “rescue” mostly right. He accurately portrays the “good bank-bad bank” structure and the fact that the partners who owned the original bank bore the losses of the failure. What he doesn’t explain clearly is the degree to which the central bank demanded insurance from the private sector banks before agreeing to extend a credit line that would allow the liquidation of the bad bank to take place slowly.

These facts matter, because a good central banker has to make sure that the incentives faced by those in the financial community are properly aligned. In the case of Barings macroeconomic incentives were aligned by making it clear to the private banks that when a SIFI fails, the private banking sector will be forced to bear the losses of that failure. This brings every bank on board to the agenda of making sure the financial system is safely structured.

In the 19th c. the Bank of England understood that few things could be more destabilizing to the financial system than the expectation that the government or the central bank was willing to bear the losses of a SIFI failure. Thus, the Bank of England protected the financial system from the liquidity consequences of a fire sale due to the SIFI, but was very careful not to take on more than a small fraction (less than 6%) of the credit losses that would be created by the SIFI failure.

This is the comment I posted:

While this is one of the better discussions of the 1890 Barings liquidation, for some reason modern economic historians have a lot of difficulty acknowledging the degree to which moral hazard concerns drove central bank conduct in the 19th c. White writes:

The Barings rescue or “lifeboat” was announced on Saturday November 15, 1890. The Bank of England provided an advance of £7.5 million to Barings to discharge their liabilities. A four-year syndicate of banks would ratably share any loss from Barings’ liquidation. The guarantee fund of £17.1 million included all institutions, and some of the largest shares were assigned to banks whose inattentive lending had permitted Barings to swell its portfolio.

Clapham (cited by White), however makes it clear that the way the Bank of England drummed up support for the guarantee fund was by making a very credible threat to let Barings fail. Far from what is implied by the statement “The Bank of England provided an advance of £7.5 million to Barings to discharge their liabilities”, the Bank of England point blank refused to provide such an advance until and unless the guarantee fund was funded by private sector banks to protect the central bank from losses, Clapham p. 332-33.

In short, treating the £7.5 million (which is actually the maximum liability supported by the guarantee fund over a period of four years, Clapham p. 336) as a Bank of England advance may be technically correct because of the legal structure of the guarantee fund (which was managed by the Bank), but gets the economics of the situation dead wrong.

19th century and early 20th century British growth could only take place in an environment where central bankers in London were obsessed with the twin problems of aligning incentives and controlling moral hazard. Historians who pretend that anything else was the case are fostering very dangerous behavior in our current economic climate.

Note: Updated to make the last paragraph specific to Britain.

Negative real rates signify a broken financial system

Noah Smith reviews the debate over negative real rates, and Brad DeLong remarks on “how profoundly strange and unexpected” is the current environment. While Noah covers all the most common explanations for real rates, I think that he — and most of econo-blogosphere — are missing a key factor that is probably driving this data.

First, recall that the problem of negative real rates is very much focused on the “safe” side of the market. That is, it is Treasuries (and similar assets like Bunds) that bear negative real rates. The market rates available to non-public borrowers are much higher than the rate on “safe assets.” (The distinction between these two rates is the premise behind Caballero and Farhi’s work.)

In my view the missing element of the discourse on the low yields of safe assets is the remarkable change in the structure of the financial system that started very slowly in the 1990s, accelerated at the end of that decade, and was a full-fledged financial revolution by the end of the next decade. This change is the collateralization of inter-bank lending, that previously was unsecured and funded on the basis of reputation-type mechanism.

ISDA data shows that with the growth of swaps starting in the early 1990s, collateralization of bilateral derivatives contracts become fairly common, though far from ubiquitous. Subsequent to the 1998 LTCM crisis, collateralization of derivatives contracts became much more widespread. The 2000 Commodities Futures Modernization Act pre-empted long-standing common law and state law constraints on derivatives markets, which subsequently grew dramatically — along with the use of collateral. The 2005 bankruptcy reform act dramatically changed markets for collateral, and in particular made it possible for the repos of just about any asset to trade on a par with derivatives collateral.

In addition in the early naughties, the growth of structured financial assets that made possible synthetic assets in which “investors” sold protection on bonds (instead of investing in actual bonds) and held the collateral that was used to guarantee payment on the protection contracts in “safe assets.” Finally, financial market participants have sometimes commented that the Basel rules for banks promoted collateralized interbank lending over unsecured interbank lending (though I’ve never really investigated this point).

In short, the same data the Ben Bernanke explained in terms of a “savings glut” can also be explained by the financial industry’s massive increase in demand for safe assets that serve as high quality collateral over the same time period. The financial industry’s demand is a demand for safety and cannot be met by risky assets, so it is an excellent explanation for the 21st divergence between the behavior of “safe” interest rates and risky interest rates.

Furthermore, since the 2008 crisis the financial industry’s demand for collateral has only increased. In 2008 the unsecured interbank markets, including both the Federal Funds market and the Libor market, collapsed. They have not recovered. Interbank lending has shifted almost entirely to a collateralized basis. While it is true that the demand for collateral that was created by structured finance products has largely disappeared, this is most likely offset by regulatory changes that increase the demand for collateral.

In short, the best explanation for why private markets are forcing interest rates to zero is that the banking system is broken. The system which functioned for centuries on the basis of unsecured, reputation-based, inter bank lending no longer exists. ZIRP is just evidence that the financial industry is turning to government as a source of the liquidity that the financial industry is no longer capable of creating on its own.

Does the 2007-2008 crisis show that the universal banking experiment has failed?

The Anglo-American universal banking experiment started in 1986 with Britain’s Big Bang which was quickly followed by regulatory policies in the US that would lead to the formal repeal of Glass Steagall a decade or so later. The question that needs to be asked is whether the 2007-2008 crisis is evidence of the failure of this quarter-century of experimenting with universal banking.

In Germany universal banking has been successful over the long-run, but Germany has a civil, not a common law legal system and a social structure that ensures that companies are managed in the interests of many participants in addition to those of shareholders/management. When universal banking is combined with Anglo-American law and social norms, it is possible that it generates pathological behavior that is not evidenced by the German economy.

A standard objection to the claim that universal banking is the underlying source of the crisis is that the only banks that were allowed to fail were not universal banks, but investment banks. This objection ignores that the whole investment banking industry had been reshaped over the decades preceding the crisis by the need to compete with the universal banks, so the fact that it was the investment banks that failed tells us nothing. Furthermore there is significant evidence that one or two of the universal banks did not fail only because the government considered them too big to fail.

John Quiggin recently argued that Wall Street isn’t worth it and that we should put an end to the universal banking experiment:

The only remaining option is to separate these markets entirely from the socially useful parts of the financial system, then let them fail. Publicly guaranteed banks should be banned from engaging in all but the most basic financial transactions, such as issuing loans and bonds and accepting deposits. In particular, banks should be prohibited from doing any business with institutions engaged in speculative finance such as trade in derivatives. Such institutions should be required to raise all their funds directly from investors, on a “buyer beware” basis, and should never be bailed out, directly or indirectly, when they get into trouble.

Matthew Yglesias critiques this view arguing that “it’s a very hard concept to operationalize.” And then limits his focus to derivatives regulation. He writes:

But while it’s easy to say “we should allow derivatives trading for the purpose of hedging but not for the purpose of speculating” (certainly that’s what I think), it’s a lot harder to write precise legislative and regulatory language that accomplishes that goal. If you look at something like the Harvard interest-rate-swap fiasco, it’s difficult to say precisely where this crossed the line from a reasonable hedge to just gambling with endowment money.

Yglesias’ critique, however, misses Quiggen’s point: commercial banks shouldn’t be engaged in market making or in trading on financial markets at all. The difficulty of implementing the Volcker rule is that it’s trying to draw a line between trading that’s okay (e.g. market making) and trading that’s not okay (proprietary trading). Quiggen is stating that commercial banks should not be engaged in either of these activities. This is a much easier policy to implement (see Glass-Steagall).

This may leave open some room to allow commercial banks to be end-users of financial contracts like interest rate swaps for hedging purposes, but drawing this distinction is much less difficult than Yglesias implies. The distinction between the use of derivatives for hedging or for speculating is precisely the same distinction that is drawn in insurance markets between an insurable interest and the absence of one. Given that we know that drawing the distinction is not an insuperable problem in insurance markets, it’s far from clear why the problem suddenly becomes insuperable when the label “derivative” is placed on the financial contract.

[In addition the whole point of Felix Salmon’s post on the Harvard IRS fiasco is that it was clearly gambling at the time the swaps were entered into. Salmon states with barely veiled sarcasm “Larry was certain of two things: firstly that his beloved Allston project was a go — despite the fact that he hadn’t raised the funds for it, and secondly that interest rates would rise by the time construction started. Therefore, he decided to lock in funding costs by using forward swaps.” In short Salmon is stating that the contracts represents two gambles, first, on the future need for the funds, and, second, on the future path of interests rates. While ex post we know that in 2008 Harvard would have been better off holding on to its side of the bet rather than buying itself out of the contracts, the post is crystal clear about the fact that these swaps were never a “reasonable hedge.”]

While we can certainly debate whether or not the 2007-2008 crisis demonstrates that the Anglo-American experiment with universal banking has failed, arguments that it’s just too hard to reverse the experiment only play into the interests of the universal banks and probably should not be given much weight. If policies that were implemented at the tail end of the last century completely destabilized our financial system, it is clearly worth the effort to find a way to reverse those policies.