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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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.

Evaluating heterodox monetary theory through a New Monetarist lens

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

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

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

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

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

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

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

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

Some basic results that derive from this literature are:

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

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

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

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

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

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

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

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

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

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

Important Implications of a Credit-Based Payments Model

Settlement by clearing is a substitute for settlement by cash

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A final note

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

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

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

[2] See Bell 2001 at 159.

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

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

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

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

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

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

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

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

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

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

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

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

Acceptance banking

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

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

A simple model of money based on acceptance banking

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

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

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

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

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

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

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

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

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

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

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

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

What is money? An origin narrative

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

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

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

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

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

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

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

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

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

So what do banks do?

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

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

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

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

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

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

Conclusion: Banking as the fundamental source of liquidity

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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