The savings glut or the death of Schumpeterian growth

In general, I read Michael Pettis, Brad Setser and Matthew Klein and am amazed by what I learn. They are experts in the best sense of the word: inquisitive, open to argument and very effective at presenting complex ideas. Based on recent posts (Klein, Setser) and an old post (Pettis), I see a gap in the analytic approach being used. (NB: I was unable to watch the Geoeconomics plenary yesterday, so this post is not informed by that discussion. Nor have I read Trade Wars are Class Wars – but only because my ‘must read’ list is too long.)

Both Pettis and Klein are explicit that in the context of endogenous money their analytic framework is based on drawing a distinction between an economy with slack and an economy without slack (or at full employment). And it is because of this distinction that “One country’s trade deficit is another’s excess production (or under-consumption/under-investment). There is no financial system capable of removing this real resource constraint.”

What I think is missing from this analytic picture is Schumpeterian growth. (Which BTW was also missing from Keynes and as a result Business Cycles was Schumpeter’s response the General Theory IIRC.) The theory of Schumpeterian growth starts from bank credit. Creative destruction can take place because the elastic flow of bank credit very fluidly and continuously redirects the flow of the economy’s resources into innovative activity that is thus enabled by the system of financing to challenge and then ‘destroy’ incumbent firms. It is essential to this theory that this finance be a monetary, bank-based activity because that is what allows a fluid, unobserved shift in the price system away from dying firms and towards innovative firms. It is bank finance that ensures that we do not notice how easy it is for consumers to choose the better product simply because its there. In Schumpeter’s world that product is there, because some banker made a decision to finance it – and to facilitate the destruction of its competitors.

The problem with the slack/no-slack framework for understanding the economy is that it misses the whole point of the modern economy, which is not full employment but creative destruction and the continuous creation of economic slack due to the continuous changing of what it means to be at full employment. From a Schumpeterian point of view ‘full employment’ is a static and somewhat bewildering concept, because in fact if the economy is doing what it should be doing, then the ‘full employment’ boundary is always dynamically changing.

Thus, a competing explanation for the savings glut is the death of Schumpeterian growth. Our financial system has been so dramatically reformed that it no longer is very effective at financing creative destruction, but instead is geared towards financing incumbent firms. In this environment there is no impetus for firms to invest; the goal instead is for firms to entrench the ‘moats’ around their market power. Thus, the ‘corporate savings glut’ – which is also necessarily a corporate investment famine – accompanied the ‘global savings glut.’ It is this fact that makes ‘savings’ as a causal driver of the contemporary world’s dynamics open to significant question.

An alternate narrative to explain the same facts is that financial reform has had the effect of promoting financialization and discouraging productive investment. What we are experiencing is in fact an investment famine due to the fundamental dysfunction of our financial system. The focus on the savings glut as a causal factor is therefore misleading – because in fact the savings glut exists, because we have broken our financial system.

In practice, most likely there is some truth to both causal narratives. But no one should be surprised when a causal narrative that appears to have convincing evidence is challenged by an alternate causal narrative. This duality exists at the very heart of economic analysis (cf Vincent Grossman-Wirth).


Taxonomy of liquidity III: modeling liquidity

The fundamental problem that economics should seek to solve is what I will call the primary liquidity problem:

  • An individual, S, has a good that she wants to sell
  • There exists a buyer, XH, with the highest valuation, H, for the good
  • However, because finding XH is difficult, S may end up selling the good at a low valuation, L

The first task of economics is to organize trade in the economy so that every individual, S, can realize the high valuation, H, of that individual’s assets. Fundamentally the primary liquidity problem is a problem of trading across time and space. Note that the economic model of competitive equilibrium does not address this problem at all, but assumes it away, substituting for the primary liquidity problem the trope of the centralized market.

The primary liquidity problem can be addressed by borrowing. If S can borrow H, the value of the asset to XH until such time as S can find and trade with XH, then S will not sell at valuation L. Thus, there is a secondary liquidity problem, which only exists if there is a primary liquidity problem. This is the problem of borrowing the value of the asset until it can be sold.

Historically, banking developed to address the secondary liquidity problem. Banking in its 17th to 19th century origins developed to monetize the value of trade bills, where trade bills represent what in modern terms are called Accounts Receivable: a transaction has taken place, delivery has been made, and all that remains is for the buyer in the transaction to make the final payment. By standing ready to encash claims for payment held by sellers, the banking system provided traders with the time and space to locate their highest value counterparties.

Indeed, given the timing of the development of the competitive model in economics over the course of the late 18th and 19th centuries – in an environment where advances in banking had solved the secondary liquidity problem – there is every reason to believe that the competitive model could be conceived only after banking had developed and successfully addressed the primary liquidity problem. That is, the capacity to abstract from the primary liquidity problem was developed, because people were living in a world where bank credit made the primary liquidity problem irrelevant.

Note that there is a related, but in fact very different problem, which is the financing problem. Unlike the liquidity problem, which is a matter of realizing the highest value of a good that already exists, the financing problem is one of funding the development and production of a future good. While the ability to borrow against future income has implications for economic activity, this problem is of second-order importance to the primary problem of realizing the value of the goods that already exist. If the primary problem cannot be solved, then future incomes will be affected and have higher variability than when the primary problem can be solved. Thus, the financing problem is a tertiary problem, to be addressed only after the liquidity problem has been addressed.

Observe that in a post-banking world, the liquidity problem is often framed as a payments problem. A payments-type liquidity problem occurs when someone with an obligation to pay does not have the means to pay it. Note that payments-type liquidity problem can reflect either a primary liquidity problem, where the debtor is having difficulty realizing the value of the debtor’s assets, or a solvency problem, where the debtor does not have enough assets to pay the debt even when the assets are valued at their highest value. The concept of a solvency problem goes beyond the scope of this post, because instead of focusing on how to realize the value of individual assets, the solvency problem is evaluated at the level of the borrowing entity and requires a comprehensive examination of that entity’s assets and liabilities.

Bottom line: the competitive markets model should not be viewed as a model of the efficient allocation of resources, instead it should be viewed as a model that shows what happens when institutional factors exogenous to the model allocate resources efficiently (i.e. to their highest value use).

Last paragraph added 8-8-20

Money market funds, repo, and monetary policy: A mechanism design problem for the Fed

Before there were money market funds — and their finance of banks and big corporations borrowing on commercial paper and other wholesale markets — monetary policy in the US used to be implemented by starving banks of funding and thereby constraining the credit they could provide to the economy (Burns 1979).

How is this possible, you ask, in a world where the money supply is endogenous? This was an environment where current accounts were required by law to pay 0% interest, bank time deposit interest rates were capped at 4-5% and all bank funding in the form of publicly issued debt was legally classified as deposits. When the Federal Funds rises to, say 6%, and other short term rates also rise, (i) the banks don’t particularly want to have to borrow reserves because they are a relatively expensive source of funding, and (ii) holdings of bank deposits become a hot potato, and banks have to adjust to a world where outflows of funds are faster and more variable, so at any given level of lending the risk of having to borrow reserves increases. Historically, banks chose to reduce their lending in this situation, making monetary policy very effective. This is well documented.

This world was completely transformed starting in the late 1960s, when so-called market-based finance first began to develop. Banks were now allowed to use Eurodollar and commercial paper markets for funding. Of course, only a select group of large banks had easy access to this “market-based” funding. These banks facilitated the development of money market funds that could invest in these market-based instruments, thereby freeing the banks from regulatory constraints associated with deposit-based funding. This created a two tiered monetary system in the US, the “money center banks” that were funding on “markets” through money market funds and through their relationships with corporations and their treasury departments, as well as earning income from providing services that made it possible for corporations to fund directly on these markets. In the meanwhile, the rest of the commercial banking system had little or no access to “market-based” funding and was thus still constrained by the regulations governing deposit based funding.

This two-tier system might not have lasted very long, had markets been allowed to function. However, in 1974 when the post-Bretton Woods monetary system had yet to prove itself, the Federal Reserve created “too big to fail” by bailing out a fraudulent bank, Franklin National, in order to stabilize the Eurodollar market — and to preserve the dollar’s position in the post-war monetary system (Sissoko 2019; Spero 1980). In fact, this was just a way of covering up the gross inadequacies of the US bank regulatory system, which continue to this day. (Allowing banks to choose their regulator is not an intelligent way of designing a regulatory system.)

In this era, the Fed’s traditional tools of monetary policy did not have much effect on the money center banks, which after the Franklin National bailout had access to funding at LIBOR, the interest rate on the Eurodollar market, and this funding was understood to carry an implicit US government guarantee. Thus, the reason people like Arthur Burns (1979) doubted that Paul Volcker could tighten monetary policy enough to control inflation was because the Fed had traction over only a portion of the banking system — and not the part of the banking system that provided funding for the biggest US corporations. What Paul Volcker proved was that monetary policy could control inflation even if it was only small- and medium-sized domestic enterprises and the general public that suffered from a significant credit contraction, while the biggest enterprises just faced an incremental increase in the cost of funds.* (Through the worst of Volcker’s interest rate hikes from December 1980 to August 1981, Libor was running 3 to 5% below the Federal Funds Rate.)

This two-tiered banking system continued to operate with the “too big to fail” money center banks receiving ever expanding forms of government support (the bailout of the banks on the backs of LDC countries, the Greenspan Fed’s regulatory lifting of the Glass-Steagall restrictions, the deregulation of derivatives and the hobbling of the CFTC, etc.) so that they grew to make up an ever increasing fraction of the banking system over the course of three decades. While monetary policy was operated as interest rate policy, monetary control was for the most part ceded to the money center banks which were allowed free reign to monetize assets by covering them with “off-balance-sheet” bank guarantees, thereby making them eligible assets for money market funds and so-called market based finance. (Money center banks were able to dominate this activity, because the credit rating agencies explicitly viewed them as having an expectation of government support.)

In 2008, the contradictions at the core of this “market-based” monetary system were exposed. Money market funds are pass-through vehicles. Under no circumstances should they ever be treated as a reliable source of funding for any asset, because it is in their DNA that they are every bit as unstable as money demand itself. The 2007 ABCP crisis took place because this fact was not understood by regulators. On the other hand, the credit rating agencies do apparently understand this instability and as a result, when MMF funding exits the market, the banks have a contractual obligation to support the assets — and as long as the banks in question are “too big to fail” that obligation will fall to the government in extremis. This is the basic structure of “market-based” finance, at least as it applies to the funding of private sector assets on money markets.

Interest rates on money markets are inherently unstable. The most basic task of a central bank is to stabilize the funding of “good” short-term assets, while taking care not to support the value of “bad” short-term assets. The former is important because a lot of very valuable economic activity will be discouraged in an environment where short-term funding rates have a habit of spiking upwards. On the other hand, providing universal access to cheap short-term funding with no credit discrimination at all is a recipe for disaster, because the funds will be misused and bankruptcy and financial instability will result. The short-term funding system has to have some mechanism for distinguishing “good” assets from “bad” assets.

In the pre-2008 monetary policy regime, the problem of distinguishing “good” from “bad” assets was delegated to banks. The Fed ensured that banks could borrow at a stable rate. In theory, a bank that used that facility to lend “badly” was at risk of failure and being closed or sold off. In practice, of course, only small banks were subject to this discipline — and as we saw most “too big to fail” banks engaged in lending practices — including providing contingent guarantees that they were unprepared to meet without regulatory forbearance — that were at best unwise.

Now the Fed is looking for another means of implementing monetary policy. The key problem is, as it has always been, how to stabilize interest rates in a way that is consistent with financial stability goals. Or in other words, to provide stable funding for “good” short-term assets, while avoiding the funding of “bad” short-term assets.

The risk here is that the Fed still seems to be prone to assuming that “markets” will do its job for it. It was caught flat-footed in September, when it learned that “markets” will not stabilize rates by themselves (See BIS 2019 and Coppola 2019 on this).

Now the Fed appears ready to step in to stabilize rates in the repo market. The question is whether the Fed understands that there must be some mechanism for distinguishing “good” from “bad” assets, or whether once again it is expecting “markets” to solve this problem — despite the fact that (i) “too big to fail” is far from having been laid to rest; and (ii) so many businesses have been operating for decades in an environment where it is very cheap to extend and pretend that there has likely been too little feedback and the standard learning process for managing business debt may not be operating effectively. To make the latter point by analogy, just as regular small fires are essential to a healthy forest, so it is important to the economy that regular business failures take place to engender a healthy measure of caution in business decision-makers. As Frances Coppola puts it: “Why are we once again allowing the Fed to provide an implicit backstop for risky non-banks, thus enabling them to misprice risk and gorge on leveraged trades without fear of market penalty? Have we learned nothing from the past?”

In response to Frances, David Andolfatto asks whether a Standing Overnight Repo Facility that serves to cap interest rates in the repo market (as was proposed here and here) is an adequate solution. Unfortunately it seems that an overnight facility is likely to be inadequate to address interest rate volatility on the repo market, since the BIS discussion makes it clear that intraday repo demand was also very high.** Zoltan Poszar’s most recent Global Money Note (#26) explains that this demand for intraday liquidity is likely to due to the fact that Basel III requires the systemically important banks to prefund their intraday liquidity needs. Unsurprisingly this leads a hoarding of reserves in order to preclude the risk of being in violation of Basel III.

Furthermore, simply establishing Fed lending that ensures that money market rates don’t spike seems to be in line with the Fed’s historical tendency to rely on stop-gap measures that have not been thought out at all in terms of their effect on financial stability, but even so become permanent. The Fed needs to think long and hard about what mechanism is going to ensure that the liquidity that it provides is going to the right kind of short-term borrowing. Sixty years ago the answer to the problem was easy: the Fed provided liquidity to the banks and if the banks made bad loans, it was the bank shareholders that were going to eat the loss. Since the rise of market-based lending and bank creditors whom the Fed perceived as needing to be protected at all costs, in the US both the managers and the shareholders of money center banks have been coddled outrageously for decades, and after the experience of 2008 not many people have much faith that they even know how to distinguish good from bad assets any more.

So the real problem is that the Fed has a mechanism design problem that it needs to solve: How is it going to design the market through which monetary policy is implemented to ensure that it is no longer perverted by “too big to fail” and to ensure that any losses on bad assets fall in a way that fully aligns incentives in the market?

* I think it is possible to both approve entirely Martin Wolf’s assessment of Paul Volcker, the man: “Paul Volcker is the greatest man I have known. He is endowed to the highest degree with what the Romans called virtus (virtue): moral courage, integrity, sagacity, prudence and devotion to the service of country.” and yet at the same time to feel that the legacy he left us is very complex indeed. We need great public servants like Paul Volcker, but we need to recognize that they cannot save us when the underlying problem is systemic.

** In fact, the degree to which the Fed is currently providing intraday liquidity (anybody know where this data can be found?) is probably a good clue to whether the stressors in the repo market are mostly overnight or also intraday.




The Dismantling of the US Economy’s Legal Infrastructure

  1. The Background
  2. Hedge funds and private equity funds: How vast pools of money escaped regulation
  3. Derivatives and the enforceability of margin
  4. Mortgage lending and investment banking: 1930s reform and the post-war years
  5. Mortgage lending and investment banking: The evolution of bank balance sheets
  6. Mortgage lending and investment banking: An aside on the financial economics of 30 year mortgages
  7. Mortgage lending and investment banking: The era of “pro-competitive” reform
    1. The transformation of mortgage finance in the 1980s
    2. The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail
      1. The development of the Eurodollar market in the early 1970s
      2. The Growth of LDC Loans
      3. The Bailout of First Pennsylvania Bank
      4. The LDC Debt Crisis
      5. The Growth of Leveraged Buyout Loans
      6. Continental Illinois
      7. Proposed solutions
    3. The era of regulatory reform: The Greenspan years
    4. The era of regulatory reform: Leading up to the crisis
  8. The Crisis
  9. Policy implications


References for Dismantling Series

Last updated: September 18, 2019


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Paul Volcker (1980). Speech: The Recycling Problem Revisited. March 1, 1980.

Volcker & Angell (1987) Dissenting Statement. Federal Reserve Bulletin May 1987 352-53.

Henry Wallich (1981). Speech. LDC debt – to worry or not to worry. June 2 1981.

Dennis Weatherstone (1979a). Statement of Morgan Guaranty Trust Vice-Chairman to The Eurocurrency market control act of 1979 : hearings before the Subcommittee on Domestic Monetary Policy and the  Subcommittee on International Trade, Investment, and Monetary Policy of the Committee on Banking, Finance, and Urban Affairs, House of Representatives. June 26, 27 and July 12, 1979.

Dennis Weatherstone (1979a). Statement of Morgan Guaranty Trust Vice-Chairman to International financial conditions : hearings before the Subcommittee on International Finance of the Committee on Banking, Housing, and Urban Affairs, United States Senate. Dec 12 and 14, 1979.

Ari Weinberg (2004). Countrywide Branches Out Beyond Mortgages. Forbes April 16, 2004.

Marc A. Weiss, Market and Financing Home Ownership: Mortgage Lending and Public Policy in the United States, 1918-1989, 18 Bus. & Econ. Hist. 110, 111-12 (1989).

Knut Wicksell, Interest and Prices (R.F. Kahn transl., 1898).

H. Parker Willis, American Banking (1916).

Devon Zuegel (2018), Financing Suburbia: How government mortgage policy determined where you live

How to evaluate “central banking for all” proposals

The first question to ask regarding proposals to expand the role of the central bank in the monetary system is the payroll question: How is the payroll of a new small business that grows, for example, greenhouse crops that have an 8 week life cycle handled in this environment? For this example let’s assume the owner had enough capital to get the all the infrastructure of the business set up, but not enough to make a payroll of say $10,000 to keep the greenhouse in operation before any product can be sold.

Currently the opening of a small business account by a proprietor with a solid credit record will typically generate a solicitation to open an overdraft related to the account. Thus, it will in many cases be an easy matter for the small business to get the $10,000 loan to go into operation. Assuming the business is a success and produces regular revenues, it is also likely to be easy to get bank loans to fund slow expansion. (Note the business owner will most likely have to take personal liability for the loans.)

Thus, the first thing to ask about any of these policy proposals is: when a bank makes this sort of a loan how can it be funded?

In the most extreme proposals, the bank has to have raised funds in the form of equity or long-term debt before it can lend at all. This is such a dramatic change to our system that it’s hard to believe that the same level of credit that is available now to small business will be available in the new system.

Several proposals (including Ricks et al. – full disclosure: I have not read the paper) get around this problem by allowing banks to fund their lending by borrowing from the central bank. This immediately raises two questions:

(i) How is eligibility to borrow at the central bank determined? If it’s the same set of banks that are eligible to earn interest on reserves now, isn’t this just a transfer of the benefits of banking to a different locus. As long as the policy is not one of “central bank loans for all,” the proposal is clearly still one of two-tier access to the central bank.

(ii) What are the criteria for lending by the central bank? Notice that this necessarily involves much more “hands on” lending than we have in the current system, precisely because the central bank funds these loans itself. In the current system (or more precisely in the system pre-2008 when reserves were scarce), the central bank provides an appropriate (and adjustable) supply of reserves and allows the banks to lend to each other on the Federal Funds market. Thus, in this system the central bank outsources the actual lending decisions to the private sector, allowing market forces to play a role in lending decisions.

Overall, proposals in which the central bank will be lending directly to banks to fund their loans create a situation where monetary policy is being implemented by what used to be called “qualitative policy.” After all if the central bank simply offers unlimited, unsecured loans at a given interest rate to eligible borrowers, such a policy seems certain to be abused by somebody. So the central bank is either going to have to define eligible collateral, eligible (and demonstrable) uses of the funds, or some other explicit criteria for what type of loans are funded. This is a much more interventionist central bank policy than we are used to, and it is far from clear that central banks have the skills to do this well. (Indeed, Gabor & Ban (2015) argue that the ECB post-crisis set up a catastrophically bad collateral framework.)

Now if I understand the Ricks et al. proposal properly (which again I have not read), their solution to this criticism is to say, well, we don’t need to go immediately to full-bore central banking for all, we can simply offer central bank accounts as a public option and let the market decide.

This is what I think will happen in the hybrid system. Just as the growth of MMMFs in the 80s led to growth of financial commercial paper and repos to finance bank lending, so this public option will force the central bank to actively operate its lending window to finance bank loans. Now we have two competing systems, one is the old system of retail and wholesale banking funding, the other is the central bank lending policy.

The question then is: Do federal regulators have the skillset to get the rules right, so that destabilizing forces don’t build up in this system? I would analogize to the last time we set up a system of alternative funding for banks (the MMMF system) and expect regulators to set up something that is temporarily stable and capable of operating for a decade or two, before a fundamental regulatory flaw is exposed and it all comes apart in a terrifying crash. The last time we were lucky, as regulatory ingenuity and legal duct tape held the system together. In this new scenario, the central bank, instead of sitting somewhat above the fray will sit at the dead center of the crisis and may have a harder time garnering support to save the system.

And then, of course, all “let the market decide” arguments are a form of the “competition is good” fallacy. In my view, before claiming that “competition is good,” one must make a prior demonstration that the regulatory structure is such that competition will not lead to a race to the bottom. Given our current circumstances where, for example, the regulator created by the Dodd-Frank Act to deal with fraud and near-fraud is currently being hamstrung, there is abundant reason to believe that the regulatory structure of the financial system is inadequate. Thus, appeals to a public option as a form of healthy competition in the financial system as it is currently regulated are not convincing.

Bank deposits as short positions: the details

So I’ve finally posted the paper I’ve been working on — a New Monetarist model of bank money — on SSRN. Warning for non-economists: lots of Greek  in this one.

Here’s the title and introduction.

The Nature of Money in a Convertible Currency World

This paper studies the nature of money in an environment where the means of payment is convertible at a fixed rate into the numeraire consumption good. By focusing on this environment we eliminate the possibility that the means of payment changes value over time, and deliberately construct a situation where the price level is disabled as a means of equilibrating the supply of money with the demand for it. To our knowledge no one else has studied such an environment in a Lagos-Wright-type framework. Our goal in this paper is to demonstrate that in this environment the first-best can still be attained – if the means of payment is effectively a naked short of the unit of account.

A naked short has the effect of creating a “phantom” supply of the shorted object that disappears when the short is closed out. We demonstrate here that banks can create this “phantom” supply of the unit of account in the form of acceptances of private debt.[1] This type of bank liability is issued when the bank stamps a private commercial bill “accepted,” and the bank obligation is put into circulation when the borrower makes purchases. Then, when the borrower pays off the loan, the phantom supply of the unit of account along with the outstanding, but contingent, bank liability that was used to create it is closed out.

Why do we model the means of payment as a naked short of the unit of account? We argue, first, that this is the best way to understand the nature of the banking system in its developmental stages. Second, by modelling the means of payment in this way our model demonstrates the efficiency gains that can be created through the introduction of a banking system. Third, by carefully evaluating the incentive feasibility conditions for our bank money equilibria, we are able to relate the monetary system to banking stability. We find that the implementation of central bank monetary policy via interest rates can be explained by the need to stabilize the banking system. Finally, we also find support for the use of usury laws as a means by which policymakers choose amongst multiple equilibria to favor the interests of non-banks over those of banks.

The monetary system modelled in this paper is based on the 18th century British monetary system as described in Henry Thornton (1802) An enquiry into the nature and effects of the paper credit of Great Britain. Privately issued bills function as a means of payment because they are “accepted” as liabilities by the banks that underwrite the monetary system. While these bills were denominated in a gold-based unit of account,[2] as a practical matter there was no expectation that they would be settled in gold. Instead, they were used as a means of transferring bank liabilities from one tradesman to another. Thus, bills that are simultaneously private IOUs and bank liabilities are used to make payment. The non-bank debtor pays off her debt by depositing someone else’s bank-certified liability into her account. (The 18th century monetary system was the precursor of the checking account system and operates just like a system of overdraft accounts.) The bank’s liability on a deposited bill is extinguished when funds are credited to the depositor’s account.

In our model productivity is stochastic, and as a result the demand for money is stochastic. We show that the bank-based money described in our model can accommodate this stochastic money demand so that a first best is attained. Thus, our model can be viewed as a model of the “banking school” view where money is issued on an “as needed” basis at the demand of non-banks.

We argue that the convertible currency environment forces a reconsideration of the nature of money. Typically the monetary literature views money as “an object that does not enter utility or production functions, and is available in fixed supply” (Kocherlakota 1998). Shifts in the price of money equilibrate the economy in these environments. Historically, however, stabilization of the price of money by tying it to a fixed quantity of gold was a foundation of economic success in the early modern period (van Dillen; Bayoumi & Eichengreen 1995). Thus, we consider how money functions in an environment where its price is “anchored”. We show that a solution is for the means of payment to be a debt instrument that is denominated in the anchored unit of account and is certified by a bank. This solution is based on actual market practice in the early modern period.

This approach allows us to reinterpret general results such as Gu, Mattesini, and Wright (2014)’s finding that when credit is easy, money is useless, and when money is essential, credit is irrelevant. While their conclusion is correct given their definitions of money and credit, we argue that this standard definition of money is not the correct definition to apply to an environment with banks. We argue that the means of payment in an environment with banks is a naked short of the unit of account, which would be categorized in GMW’s lexicon as “credit”.

This paper employs the methods of new monetarism. Our model combines an environment based on Berentsen, Camera, and Waller (2007) with an approach to banking that is more closely related to Gu, Mattesini, Monnet, and Wright (2013) and Cavalcanti and Wallace (1999a,b). Our model of banking is distinguished from GMMW because non-bank borrowing is supported not by collateral, but by an incentive constraint alone, and from Cavalcanti and Wallace because our banks don’t issue bank notes, but instead certify privately issued IOUs. We find that for values of the discount rate that accord with empirical evidence, such a payments system can be operated with no risk of default simply by setting borrowing constraints.[3] We start by finding the full range of incentive feasible equilibria of the model, and then discuss how, when there are multiple equilibria, a policymaker may choose between these equilibria.

In this environment competitive banking is incentive feasible only when enforcement is exogenous. In the case of endogenous enforcement, competition in banking typically drives the returns to banking below what is incentive feasible and the only equilibrium will be autarky. This result is consistent with many other papers that have found that the welfare of non-banks is improved when there is a franchise value to banking (Martin and Schreft 2005, Monnet and Sanches 2015, Huang 2017. See also Demsetz et al. 1996).

Thus, the challenge for a policymaker is how to regulate competition in the banking sector so that banking is both incentive compatible – and therefore stable – and also meets the policymaker’s goals in terms of serving non-banks. One solution is to treat banking as a natural monopoly, allowing an anti-competitive structure while at the same time imposing a cap on the fees that can be charged by banks. This solution explains usury laws, which by capping interest rates at a level such as 5%, the rate in 18th century Britain, is able to generate both a robust franchise value for the banks that provide payments system credit and at the same time to ensure that a significant fraction of the gains created by the existence of an efficient means of payment accrue to non-banks. An alternate solution is to impose a competitive structure on the banking industry, but also to set a minimum interest rate as a floor below which competition cannot drive the price. We argue that this is the practice of modern central banks and thus that monetary policy should be viewed as playing an important role in preventing competition from destabilizing the banking sector.

Section I introduces the model of a convertible currency. Section II describes the equilibria of the model. Section III presents the equilibria using diagrams. Section IV discusses the means by which policymakers choose between the difference equilibria of the bank-based monetary system. Section V concludes.

[1] While it would be easy to reconfigure the means of payment to be deposits or bank notes, we believe the monetary function of bank liabilities in this paper is sufficiently different from the existing literature that it useful to present it using an unfamiliar instrument.

[2] For the purposes of keeping the exposition simple, assume that we model the monetary system prior to 1797 (when gold convertibility was suspended).

[3] Indeed, we argue elsewhere that the credit based on precisely such constraints constituted the “safe assets” of the monetary system through the developmental years of banking (Sissoko 2016). Treasury bills, the modern financial world’s safe assets, were introduced in 1877 and modeled on the private money market instruments of 19th century Britain (Roberts 1995: 155).

Bank equity: a mechanism for aligning incentives

Kudos to John Cochrane. To address criticism of his narrow banking proposal, he is willing in a recent blog post to “Suppose it really is important for banks to ‘create money,’ and to take deposits, and to funnel those into risky, illiquid, and otherwise hard-to-resolve assets.” He asks the question: How can we fund banks with deposits while at the same time ensuring that banks are easy to resolve? and argues that the solution is to issue the deposits not at the level of the bank (which funds itself only with equity), but at the level of a holding company whose only asset is bank equity, but which is funded by both deposits and equity. Resolution takes place when holding company equity is wiped out and remaining losses are put to depositors.

Cochrane misses the point about what it is that banks do. As I write in a hopefully soon to be published paper:

The fundamental problem of finance is that even though debt plays an important role in production and growth, what constitutes ‘safe’ debt for a lender is precisely the opposite of what constitutes ‘safe’ debt for a borrower. Because the future is uncertain, borrowing is safe when debt is long-term, unsecured, and expected revenues more than cover interest payment on the debt. Lending on the other hand is safe when debt is extremely short-term and grants the lender the immediate right to seize the borrower’s assets as soon as there is any risk of default. The banking system offers a modicum of safety to both lenders and borrowers, not just by transforming the maturity of the debt, but more importantly by placing the burden of loss due to default on the bank owners, whose interests thus lie in making the system of maturity transformation work.

Banking was able to develop in an environment where the owners and the managers of the banks were the same people — that is, banking developed in an earlier era without access to the corporate form and where unlimited liability was the norm. Thus, an important function of the liability structure of the bank was to align the interests of the owners — and originators of the bank’s assets — with those of the depositors. Depositors could only loose money after every single one of the bank’s owners had declared personal bankruptcy (for a famous 1878 example see here).

So what are the economic functions of a bank? First, to offer both lenders and borrowers an asset that is somewhat safe for each of them; and, second, to warrant the safety provided to the lenders by engaging to bear the first loss on any bad loans. A key function of  banking is the alignment of the incentives of the originators of the illiquid, hard to value assets that finance entrepreneurial activity in the economy with those of the lenders who provide the funding for these loans. The fact that the originators bear the first loss is extremely important to the incentive structure of banking.

The U.S. experimented with corporate banking early in its history, but after a first major crisis that extended from 1837 well into the 1840s, adopted a modified form of the corporate structure. From the 1840s until the reforms of the 1930s U.S. bank owners typically faced double liability — so that an amount equal to the par value of the shares could be called up in the event that a bank failed. The assumption built into the 1930s reforms was presumably that bank regulators would be an adequate substitute for the incentives formerly created by the liability structure of the bank.

Thus, Cochrane’s plan has two flaws: First, he insulates the owners of the bank from the consequences of originating bad assets. Instead of being in a first loss position with respect to the bad assets, the owners share only proportionately in those losses. This structure ensures that their interests are not aligned with those of the depositors. Second, his system puts losses on bad assets in excess of holding company equity immediately to the depositors. But this surely means that the depositors will be unwilling to fund traditional illiquid, hard-to-value bank assets. Given the risk of loss, a reasonable depositor would surely insist that the bank’s portfolio be transparent and full of easy to value assets. As a result, Cochrane’s plan would almost certainly result less funding availability for traditional bank borrowers.

In short, while one appreciates that Cochrane acknowledges that his plan needs to address the role played by banks in ‘creating’ money, he has not yet mastered the ideas underlying this view of banking. I look forward to evaluating his next effort.


Banking theory: a monetary theory that’s more heterodox than heterodoxy (revised)

Note: This post has been revised on the basis of Nick Rowe’s excellent comments.

A basic premise of monetarism is that money defines a relationship between the government and the market and that nothing essential about the economy is lost by assuming that the banking system’s monetary role is wholly determined by the government. That is, monetarist models allow for banks, but then limit their function to that of “multiplying” deterministically the government supply of money.  Because the role played by banks in providing liquidity to the economy is not modeled, monetarism effectively assumes away any meaningful role for the banking system. On the basis of this framework, monetarism proposes that the government by controlling the money supply can promote optimal economic activity in the market. In short, while there is long tradition in economics of arguing that the banking system exists to create liquidity (Thornton 1802; Hawtrey 1919: 9-16), monetarism explicitly rejects this view. Indeed, rejection of banking theory was a primary motivation driving the development of monetarism (Mints 1945, Friedman & Schwartz 1963: 169, 192, 253, 266). By abstracting from bank-provided liquidity, the monetarist framework implicitly posits that there are only two fundamental sources of liquidity in an economy: liquidity is either generated by markets spontaneously when buyers and sellers get together or liquidity is generated by government guarantees of payment.

Unfortunately the other major macroeconomic school that developed over the course of the 20th century, Keynesianism (particularly as espoused by New Keynesians, but also by many Post-Keynesians) has embraced monetarism’s rejection of the traditional view that banking plays an essential role in generating liquidity within an economy (see e.g. Tobin 1963). While Keynesians place more emphasis on the role played by government in the economy and less on markets, they are generally in agreement with the monetarists that the fundamental sources of liquidity in an economy are either markets or the government. In short, the more nuanced banking school view that liquidity is generated by the structured interaction of banks, markets, and government has been almost entirely lost in the modern macro-economic discourse.

Because the agenda of limiting the view of money’s role in the economy to that of defining a relationship between markets and the government can be attributed clearly to Milton Friedman, and cannot be attributed to the more diverse writings of J.M. Keynes, I consider this limited vision to be part of the “monetarist” agenda, and describe modern Keynesians as having bought into the monetarist agenda when they embrace this approach. Here I discuss how a variety of strains of heterodox monetary analysis embrace this basic premise of monetarism, even as they reject the specific policy proposals associated with monetarism. Interspersed throughout this discussion is an explanation of banking theory’s approach to the same issues.

I will address in particular four themes in the heterodox literature on money that emphasize the role of government in the money supply and are revisited by many different authors[1]:

  • The government establishes the unit of account and retains the sovereign right to revalue it.[2]
  • The government puts money into circulation by accepting in payment of taxes a token that it also spends. For cartalists this is the essential means by which money is created.
  • When credit is used to trade it must be settled in cash.[3]
  • Markets and prices are derived from government forms of money.[4]

Sovereign control of the unit of account

That the government establishes the unit of account and retains the sovereign right to revalue it is a claim associated with Ingham (2006: 265, 271). It is entirely consistent with the monetarist framework, although heterodox theorists correctly observe that its importance is rarely acknowledged by mainstream monetary theorists. Of the four claims, this has the strongest support historically. For example, the U.S. Constitution arrogates to the government the power to “regulate the value” of the coinage. And medieval and early modern history has abundant examples of sovereigns that devalue or revalue the unit of account. Furthermore, modern examples of countries of which we can state clearly that this claim does not apply are few and generally consist only of countries that have so abused their authority over the currency via inflation that the government itself has lost a great deal of legitimacy and as a result the populace has chosen to denominate transactions in a more stable foreign unit of account.

On the other hand, I have argued elsewhere that an essential aspect of the transition to a modern economy involved the creation of a unit of account based on a convertible paper money supply that was managed by private sector banks. Given modern bank-based monetary systems, the authority exercised by the sovereign over the nominal value of the unit of account is much weaker than in those days when it could simply “cry up” the value of a coin with a fixed weight in gold. And, subsequent to the 2008 crisis with its origins in excessive money issue by shadow banks, the measure of control exercised by the government over the value of the unit of account is surely a little less clear than it was in the past.

Such nuances are in fact encompassed in the broader picture of Ingham’s Nature of Money. Ingham ties his analysis of the sovereign unit of account into an analysis of the role of money in markets and in capitalism itself. He argues that modern capitalism is founded on a “memorable alliance” between currency defined by the state and the issuance of credit-money by the banking sector. Indeed, Ingham acknowledges that networks of traders can form their own money of account (Ingham 2006: 271). The distinction in our approaches lies in the importance that we attribute to such private moneys of account. For Ingham they are fundamentally unstable, and not worthy of too much emphasis. By contrast, I argue that it was the integration in Britain of the sovereign unit of account with the specie-linked private money of account supported by a network of elite international merchants that laid the foundations for modern capitalism. Thus, in my view even at the level of the unit of account a private-public partnership played an essential role in the development of capitalism.

Aside: The metallist approach to money

Most of the literature on money is not focused on its role as a unit of account, but as a transactional medium that circulates, serving both as a means of payment and a store of value. There are two basic approaches to the question: What makes it possible for something to enter into circulation as money? (Observe that this is not a question regarding how something, once it gets its start as money, can become a dominant form of money. Menger described what in modern terms are called the network effects that entrench the use of a given money after its initial entry into circulation.) The Metallist approach claims that money circulates because of its intrinsic value, and treats gold coin as a quintessential form of money. Menger clearly falls within the Metallist category as his focus is commodity money. Cartalists challenge this view, arguing that all that is necessary for money to enter into circulation is that an authority – for example a government or a major bank – treats the money as a liability and accepts it in payment for amounts due as taxes or on loans.[5] In this section, I argue that Metallism, as a school of thought, originated alongside and in support of bank money, and thus that our understanding of Metallism should go well beyond the simplistic appearance that the approach presents. (Cartalism will be discussed in the following section.)

The idea that intrinsic value can serve as a foundation for the circulation of money  proved through the European experience of money in the Middle Ages to be an extremely flawed approach to money. As the appellation Metallist implies almost all proponents of the intrinsic value approach view metals as having characteristics that make them the most suitable commodities to serve as money. In the Middle Ages it became clear that the problem with a metal coinage that is meant to circulate based on intrinsic value is that the process of circulation itself reduces the metal in the coins through both wear and tear, and deliberate clipping. Thus it became clear that the ideal form of Metallist money isn’t very good at holding its value. For this reason it is extremely costly to maintain a money supply based on fixed weight metal coins as the principal medium of exchange. The typical compromise that medieval sovereigns opted for was to slowly reduce the metal weight of their coins so that existing low-weight coins did not need to be collected and recoined and could continue to circulate on a par with new coins.[6] In short, medieval experience demonstrated that as practical matter a metallist currency can only operate if inflation is built into the system.

On the other hand, the philosophy of metallism – that is, the claim that coins should have a fixed and stable value in terms of specie – was presented and argued most forcefully by John Locke at the end of the 17th century. While arguing against a reduction in the metal content of the coinage and in favor of the demonetization of below-weight coins he wrote: Metals have “as money no other value but as pledges to procure what one wants or desires, and they procur[e] what we want or desire only by their quantity” (Locke 1824[1691]: 22). “Men in their bargains contract not for denominations … but for the intrinsic value; which is the quantity of silver by public authority warranted to be in pieces of such denominations. … it is only the quantity of the silver in [the coin] that is, and will eternally be, the measure of its value.” (Locke 1824[1695]: 144-45, quoted in Desan 2014: 347).

I argue here that this claim that coins should have a fixed and stable metal content could only develop in an environment where coins were more of a reference point than an important medium of exchange. I have argued elsewhere that it was abstract “bank money” not coinage that had demonstrated the capacity to maintain a fixed relation to a specific weight of gold or silver: this was the advantage of being an abstract unit of account that was convertible into, but not tied to, the steadily deteriorating coinage. It is, therefore, no surprise that John Locke, a founding philosopher of metallism, was writing in the late 17th century when “bank money” was well-established in European money markets and indeed, when his political allies were advocating for the establishment of the Bank of England (Desan 2014: 345) in hopes of playing an important role in the European money market. In other words, when monetary scholars refer to coin as the means by which bank money was settled, they are getting the relationship backwards. Coin was able to serve as a stable reference point for the value of bank money precisely because the vast majority of transactions could take place using bank money alone and coin was used very rarely.

What the founders of the Bank of England were seeking was not a metallist money supply, but a unit of account that had a fixed value in terms of metal. (This is made clear in Paterson’s 1694 proposal for the Bank.) The elite bankers had been able to establish such a measure of value for their own transactions since the mid-16th century. By founding the Bank of England and simultaneously reforming the British coinage on metallist principles they sought a stable sovereign unit of account to which their bank money could be tied.

Thus, the philosophy of metallism, even as it espoused the view that money circulates because of its intrinsic value, was developed in order to support a system of paper-based bank money. Not only that, but the paper-based bank money in question was designed from the start to be backed by a combination of specie, sovereign debt, and private debt (in the form of commercial bills). That is, the Bank of England was founded as a partial reserve bank (in contrast to the Dutch Wisselbank), and it was understood from the start that the Bank of England’s circulating liabilities would not be fully backed by specie. On the other hand, the founders of the Bank were undoubtedly confident that the sovereign, private and metal assets of the Bank had an “intrinsic value” sufficient to support the Bank’s liabilities.

The metallists who succeeded Locke would argue that money circulates not because of its intrinsic value, but because it is backed by something with intrinsic value. The term “backed” itself already implies that there exists an entity with a balance sheet and the liability-side of the balance sheet is “backed” on the asset-side by specie or its equivalent.

In summary, Locke’s original metallist argument was actually an argument in favor of stabilizing the sovereign unit of account by tying it to specie. And even though this argument was carefully framed by Locke as a matter of “natural law,” the actual goal appears to have been to lay the foundations for a new type of monetary system, one where a bank credit-based money supply was anchored by a specie-based sovereign unit of account. Thus, the metallist argument morphed quickly into an argument in favor of bank money that is backed by specie or its equivalent and that can be redeemed in specie.

Cartalism: government puts money into circulation by accepting it in payment of taxes

Cartalism, by contrast, explains how a “token” with no intrinsic value can serve as unit of account, means of payment, and store of value. All that is necessary for token-money to circulate is that an authority to whom money is owed stands ready to accept the token in payment. The feasibility of this means of putting money into circulation was demonstrated empirically by the many colonial powers that used tax policy to put their preferred money into circulation (h/t Nick). Note, however, that the authority which puts money into circulation can also be a bank that accepts the notes that it issues in payment of loans.

One can think of cartalism as a theory of synthetic value rather intrinsic value. Even though the tokens that circulate are nominally valueless, the authority makes them valuable by accepting them in payment of obligations. In the case of taxes the obligations are imposed by force (or social contract); in the case of (voluntary) loans the obligations are generated by the authority’s wealth or lending capacity. In both cases, the tokens have value — it is just value created by the promise to accept them in payment rather than intrinsic value.

In fact, Knapp’s original statement of the cartalist view is that it is necessary for the government to accept a token in order for it to circulate as money. This was, however, true as a matter of definition: Knapp defined “circulating as money” to require that all parties accept the token including the government. Knapp also explained that banks could put notes into circulation by the same mechanism which governments use to put tokens into circulation. Thus, “when a bank note … [can] be used unrestrictedly for making payments to the bank,” it becomes “a chartal means of payment – issued privately,” and the bank’s “customers and the bank form, so to speak, a private pay community.” These bank notes cannot, however, be “currency” until the State announces that it will accept them (Knapp 1924: 133-35). Thus, the original statement of cartalism is a “state theory of money,” only by definition. The analysis explicitly allows for a cartal means of payment to be private or public (see also Minsky 1985: 4).[7]

On the other hand, because the state can demand payment of taxes from all citizens and residents, governments are understood to be particularly well-placed to put cartal means of payment into circulation. Thus, the “cartalist” theory of money is sometimes viewed simply as the claim that money has value because the government accepts it in payment of taxes. Like the role played by the sovereign in defining the unit of account, this too is entirely consistent with the monetarist framework, where formal models include a government budget constraint which assumes that the government is empowered to withdraw money through taxes or distribute it through cash grants. On the other hand, heterodox theorists are correct that mainstream monetary theorists rarely ask how money gets into circulation and thus rarely mention the cartalist approach.

The validity of the claim is somewhat more difficult to evaluate. It is certainly true that in many – or even most – environments that which is accepted as money is also accepted in payment of taxes, so there is abundant evidence that is consistent with the cartalist view. This view includes, however, a causal statement and, as always, correlation is much easier to demonstrate than causation.

The strongest version of the cartalist claim, that it is sufficient for the government to accept a token in payment of taxes in order for it to circulate as money, is easy to disprove, since a single example will do. In particular, when a government seeks to put something into circulation as money by accepting it in payment of taxes, but there is a better alternative form of money already available, the effort has in some cases failed. An example is the Exchequer bill in late 17th century England (discussed here).

Modern proponents of cartalism typically focus their attention on the role of the state and not on the way in which banks play a very similar role in putting money into circulation (Bell-Kelton 2001, Desan 2014, Glasner 2017). Thus, the weakness of the modern cartalist approach lies in the way that the modern literature edits out the earlier, more sophisticated, approach to the banking system.

Indeed, one can interpret banking theory as a means of uniting the metallist and the cartalist approaches to money. Metallists claim that to circulate bank money must be backed by “intrinsic value,” and banking theorists would reply that good bills, denominated in a stable unit of account, have intrinsic value. Thus, through banking theory metallism is converted into two requirements: (i) that the unit of account be anchored, for example, to gold or by a central bank, and (ii) that the origination practices of the banks must produce assets that have almost no risk of loss. (I refer those who reflexively assume that private sector assets are risky and never as safe as government debt to Sissoko 2016.) Cartalists claim that to circulate money must be accepted by an authority in payment of obligations to the authority, and banking theorists explain that this is precisely what banks do: they accept bank liabilities in payment of the good bills that back their balance sheets. For banking theorists, bank money circulates both because it is a cartal means of payment and because it is backed by assets that are of indisputable quality and denominated in a stable unit of account.

Cash settlement of debt

Another common heterodox claim is that credit-based forms of money must be settled in cash. Indeed, this is the premise underlying the “hierarchy of money” framework. Bell-Kelton (2001: 160) argues that “bank money is converted into bank reserves so that (ultimately)” payment is in government liabilities. Similarly, the tiers of the hierarchy as Mehrling (2012) describes it are based on settlement: securities are at the bottom and settled in bank money, bank money is settled in currency (including central bank reserves), which in turn must be settled in some form of international means of payment (e.g. gold or SDRs).

Mehrling observes that in the design of his hierarchy he is building on the distinction traditionally made by economists between money and credit. He fails to note, however, that the importance of drawing this distinction is a fundamental monetarist principle (Friedman and Schwartz 1963; Meltzer 2003: 27).[8] Thus, when Mehrling states that he seeks to avoid “sterile debates about what is money and what is credit” and instead to focus “on the point that the system is hierarchical in character” (p. 4), he is indicating that his goal is simply to refine the monetarist approach to money. This is made especially clear when he explains that the “money from the level above serves as a disciplinary constraint that prevents expansion” (p. 8). This echoes the claim in Friedman and Schwartz that the quantity of deposits is determined by the underlying supply of reserves.

Banking theorists, by contrast, view bank money – backed by high-quality private sector assets – as the form of money that sits at the top of any hierarchy.[9] Gold or central bank reserves play an important role in anchoring the value of the unit of account and thus in defining the environment in which bankers function, but are ultimately less important to determination of the quantity of money available than the quality of the debt origination practices followed by the banks when issuing bank money. (Indeed, it was only the robustness of these practices that constrained the British money supply – and inflation – when the original debate between the Currency and Banking Schools took place, since money was not convertible into gold and Bank Rate was set at its legal maximum from 1797 to 1822. As Nick observes, these practices were almost certainly influenced by the expectation that there would be a return to the old gold standard.)

Banking theorists focus on the fact that bank money transactions are settled by clearing. While it is, of course, true that some balances remain after clearing, the bank clearing system provides for the balances to be settled by borrowing. As a result of the structure of the clearing process, reserves (or gold) play a minimal role in the settlement process. (Note that I am not claiming that they play no role in the settlement process, just that it is remarkably small.) Their principal function is instead to anchor the value of the unit of account.

This function of anchoring the value of the unit of account is integral to the operation of the banking system. Without such an anchor it is far from clear that the decentralized credit-based structure of the banking system could over the long-term avoid generating so much price inflation that the banking system itself would be destabilized. Thus, from the perspective of banking theory liquidity crises are best viewed as part of the process by which the anchor constrains the credit growth generated by the banking system. As I argue below this constraint is different in nature from Mehrling’s “disciplinary constraint that prevents expansion.” To the degree that the anchor “prevents expansion,” it does so through its effect on each bank’s decision-making process with respect to loans, not through quantitative constraints. And the anchor’s effect in a liquidity crisis is not to “prevent expansion,” but on the contrary to prevent a sudden contraction of the money supply.

In a liquidity crisis, either the public that usually holds bank money or the banks that lend on a regular basis to each other are concerned about a bank default that could reduce the value of their bank-issued assets and leave them holding losses. From a metallist viewpoint, the intrinsic value of the assets backing the money supply is in doubt. From a cartalist viewpoint, the public fears that the authorities will demonetize some tokens. Such a crisis has the potential to throw into doubt the foundations upon which the monetary system is built. In this situation the authorities must draw a bright line distinguishing any bank money that will be demonetized from bank money that will not – or equivalently distinguishing those banks whose assets fail the intrinsic value test from those with adequate assets. Because of the doubts that have been generated by the (fear of) default, proof of the authorities’ support of a bank will generally be required and the classic means of indicating such approval is by providing the approved banks with a temporary but abundant supply of reserves in exchange for their assets. In a genuine liquidity crisis, no bank fails and the declaration that support is available for all the banks is sufficient to end the crisis. When a liquidity crisis is set off by an actual bank insolvency, the process can take longer. Because periodic bank failure is unavoidable in a decentralized banking system and indeed plays a part in constraining the growth of bank credit, this process of supporting the banking system through a liquidity crisis is integral to anchoring the value of the unit of account.

In short, banking theory indicates that reserves are not a “higher” form of money than bank money. Instead they are an integral part of the system of bank money. From the perspective of banking theory the “hierarchy of money” misrepresents the role of reserves or gold in the monetary system by implying that the value of this “higher” form of money exists independent of the system of bank money. This latter claim is precisely the claim made by the monetarists when they marginalized the role of the banking system in their models.

Sovereign money gives value its objective existence

Ingham presents a very subtle heterodox point. Capitalist markets can only exist if (i) there is coordination on a unit of account and (ii) that unit is sufficiently stable that market participants have reasonable predictability of future values for purposes of business planning and entering into debt contracts. Given such a money of account which in general must be imposed by the state (Ingham 2013: 300), “money is the stable measure of value which makes it possible to establish the relative prices of all commodities” Ingham (2008: 68). The idea is further explained: “ ‘value only attains social existence by means of its monetary embodiment. It is money which makes value exist objectively for all’ (Orlean p. 52 this volume), which is accomplished by its capacity to gain general assent as the legitimate expression of value” (Ingham 2013: 313).

Let me restate the argument as I understand it. The communication that must take place in order for market transactions to be effected depends fundamentally on the existence of a language in which market participants can communicate. An essential element of this language is the unit of account. Furthermore, that unit must be stable enough for market participants to engage in the forward-looking analysis of benefits and costs that underlies rational price-based behavior. Only given these antecedents can market trade generate prices that both put a value on goods and have meaning for the traders. This is the sense in which “value attains social existence by means of its monetary embodiment.”

In this literature markets are sometimes defined with reference to the neo-classical model, that is, markets are viewed as venues where traders meet and generate a single price for each uniform good before trading (Ingham 2006: 260). Ingham’s argument then provides the antecedents that are necessary in order for “market” prices to be produced, where market prices refer to what is apparently a neo-classical price vector.

As was discussed in the first section, Ingham observes that such a unit of account is usually, but not always, provided by the state. I argued above that Ingham underestimates the role of bank money in determining and stabilizing the unit of account. I continue that argument here: banks play an essential role in “making it possible to establish the relative prices of all commodities.” Economic theory indicates that achieving this goal requires not only a stable unit of account, but also that there be very many participants on both sides of every market (Geanakoplos 1987). The crucial element that ensures the presence of many buyers is the absence of liquidity constraints, or in other words generalized access to credit lines supporting the payments system (Sissoko 2007). When such credit lines are not available, price variations will be common due to the ubiquitous liquidity constraints generated by the need for working capital in order to engage in production.

In short, the bargaining problem that Ingham associates with barter is equally present in any environment where traders enter the market subject to liquidity constraints that force them to sell – their labor if they have nothing else – before they can make purchases. The neo-classical economic model with its simple price vector assumes that traders who enter the market with knowledge of how to produce can seamlessly hire workers and rent capital to take advantage of that knowledge and create goods for sale in the market to those workers and capitalists. Implicit in the seamlessness with which the production process takes place in this model is easy access to the short-term credit needed to finance the wage and rent bills. This is, of course, precisely the role played by banks in the early years of their existence.

Before capitalist bank money, the sovereign provided a unit of account, but its value was limited because liquidity constraints frequently determined prices. After capitalist bank money – at least for those with the privilege of access to bank money – short-run liquidity constraints were largely eliminated, so that prices became more neo-classical in character. At this time it made sense to generate and publish price lists of commodities, because many “market” prices were no longer determined by a process of bilateral bargaining. The key innovation making such “value” possible was the banking system and the credit that it offered to merchants and tradesmen.

In short, Ingham should revise his list of the antecedents necessary in order for “market” prices to be produced. The relative prices imagined by the neo-classical market are founded not only on a stable unit of account, but also on a banking system that provides payments system credit to finance working capital. Given that historically such a banking system was successfully established only in a “memorable alliance” with the state, the banking system should be viewed as a complement to and not a substitute for the role of the state in stabilizing the unit of account.


Heterodox monetary theory is often influenced by the basic monetarist framework which envisions markets and the state as the only sources of liquidity and deliberately denies the importance of the banking system. By explaining how banking theory relates to several heterodox approaches I demonstrate both how heterodox theory allows itself to be constrained by mainstream theory and how its horizons can be expanded by combining it with banking theory. Although Ingham recognizes the essential role played by banks in the monetary system and in capitalism itself, he underestimates the role played by banks in determining the unit of account and in the process of price formation. Similarly, banking, properly understood, turns the hierarchy of money on its head, as it is the system of bank money that gives central bank reserves their value.

Banking theory explains what makes price-stable liquidity possible (cf. Holmstrom 2015). The banking system offers a fixed rate of exchange between bank money and the money of account while stability of the money of account is managed by the central bank. On this foundation banks expand the money supply, extending payments credit and ensuring that markets are not beset by episodic local liquidity events. This has the effect of stabilizing the price structure of these markets. In short, banks provide the liquidity that makes it possible for markets to approach the neo-classical ideal. Because of the essential role played by banks in the economy, the most important factor in financial stability is the “intrinsic value” of bank assets or, in other words, the origination practices of the banks.

[1] My interest in these themes was generated by Christine Desan’s Making Money.

[2] See Keynes Treatise on Money 1930 p. 4, Ingham 2004.

[3] Some authors assume that if a debt is denominated in cash this implies that it must be settled in cash (Briggs 2009: 200; Desan).

[4] Orlean (2013) calls this the Institutionalist approach: “value and money are ontologically inseparable” and cites to Keynes and Ingham.

[5] For more on metallism and cartelism see Schumpeter 1954: 60; Goodhart 1998; Bell-Kelton 2001.

[6] Desan 2014 explains this issues in extraordinary detail. See also Lane and Mueller 1985.

[7] In the terminology of modern economic analysis it is network effects that support bank money as a cartal means of payment. For example, David Glasner reframes Knapp and Minsky’s basic intuition using network effects and concludes with “the following preliminary conjecture: the probability that a fiat currency that is not acceptable for discharging tax liabilities could retain a positive value would depend on two factors: a) the strength of network effects, and b) the proportion of users of the existing medium of exchange that have occasion to use an alternative medium of exchange in carrying out their routine transactions.” In short, modern analysis supports the view that the early cartalists were correct: the state’s power to tax may be an important means of getting money into circulation, but it is far from the only means by which a token money can be put into circulation.

[8] “Monetary policy ought to be concerned with the quantity of money and not with the credit market. The confusion between ‘money’ and ‘credit’ has a long history and has been a major source of difficulty in monetary management.” Milton Friedman, 1964 Congressional Testimony (discussion with Congressman Vanik) p. 1151 cited in Hetzel 2007.

[9] Inappositely, Mehrling cites Hawtrey’s Currency and Credit, which takes a banking theory approach, on the traditional distinction between money and credit. In fact, Hawtrey (1919: 377) “treat[s] credit as the primary means of payment and money as subsidiary.” Indeed, Hawtrey disputes the relevance of settlement itself: “Purchasing power is created and extinguished in the form of credit” (380). For Hawtrey “Credit possesses value, and it is more correct to say that the value of gold is due to its convertibility into credit than that the value of credit is due to its convertibility into gold” (371). In short, the thesis of Currency and Credit is that Mehrling’s hierarchy – from bank liabilities on up – is false, because bank liabilities are the ultimate form of money and it is bank liabilities that give value to currency, central bank reserves, and even gold.

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.