Introduction to Monetary Economics

Money is a fundamental pillar of modern economies, yet many of us are ignorant of it. We falsely believe banks use people's saving when lending money. We falsely believe that the government creates most of the money in the economy. We falsely believe money's value must come from metallic commodities like gold.

Harnessing the power of money and finance for social ends is integral for building a sophisticated and advanced economy. Even socialist economies cannot do without money. It's time socialists embraced this fact advocating progressive monetary reform, rather than a luddite approach of abolishing money. Before we can harness that power for social and material transformation, we must understand it.

All banking is a swap of IOU's. An IOU is a promise to pay someone, i.e. I owe you. All contemporary money is an IOU. What does it say on every pound sterling banknote?

I promise to pay the bearer on demand the sum of X pounds

Banknotes are IOUs distributed by the Bank of England who promises to pay the holder of that note the sum stated on the bank note. We must believe the Bank of England will fulfil that promise otherwise the banknote is a fancy piece of paper with nothing substantial about it. This is most obvious in foreign countries in which the promise of the Bank of England means absolutely nothing unless you're a foreign exchange trader.

There is nothing backing up the bank note, like a promise of paying £50 worth of minted gold. We call this fiat money.

Monetary Realism

Money exists and economists should study its actual characteristics as used in practice. Monetary realism argues for precisely this.

Overtime, money and financial systems change. This introduction is true at the time of writing. Parts of this essay likely won't be true in 50 years' time. Money will have changed. However, our approach of understanding money in the context of the day does not alter. Monetary realism is not a doctrine about what money is but a method for analysing the economy. Understanding how money works - the nature of money - is vastly important.

We cannot simply abstract away from money like neoclassical economics does. Money is not a mere veil hiding the true nature of exchange. Banks are not intermediaries facilitating payment. Banks create markets. Finance defers the funding of present investments for the real productive economy, at least that's how it should be. In reality, finance is self-indulgent. Finance creates markets for more financing initiatives for the sake of earning profit. We call this rentier speculation - profiteering for the sake of profiteering via manipulating resources, not via material progress.

What is credit?

Credit is an IOU deferring final payments for expenditure. Creditors give debtors the means of attaining resources with the expectation that a reciprocal action will occur. The word "credit" comes from the Latin credit meaning "one believes". Trust is integral in one believing. Without trust, one will not issue credit and the benefits of deferred payment.

Primitive societies rely on pure credit as a means of making payments. Reciprocity is key in such societies. IOU entails UOI - "you owe me [I]". I give you ten chickens, and you owe me a cow. Commodities themselves are IOUs. Violating the credit contract risks undermining your position in that society. Free loading is intolerable in which mutuality is essential for survival.

Pure credit economies provide flexibility. For I can defer payments for items and services I need now to a later date when I may have the means of paying available. Debtors defer payments when "one [the creditor] believes" the debtor will fulfil their future obligations. Payment may involve giving food stock you've grown towards your fellow tribesman the creditor. Alternatively, I may use luxurious commodities as a means of payment. However, let's suppose I cannot fulfil my obligations as a debtor. The debtor becomes subservient to the creditor even becoming the means of payment. Now we have slavery.

Credit is a social technology which offers a means for exchange through deferring obligations agents place on themselves in coming to a mutual arrangement. Those arrangements need fulfilling. In the primitive society being a good member of that society and doing your dues is satisfactory. Sharing begets sharing. However, once you exchange outside the confines of that primitive society doing your dues is insufficient. Another means of fulfilling obligations is necessary.

What is money?

"Money therefore only comes into existence once a payment is made" [Graziani 1990, p.11].

Money is an IOU which we accept as a means of settling payments. Economics actors get more things done because of money which makes it a social technology. (Fauvelle 2024:10). Trade with other tribes, societies, and civilisations becomes possible if mutual agreement on the means of payment exists. Traders used scarce commodities with inherent value as money. All humans appreciate a valuable commodity which confers prestige. Those that conferred prestige through other means wouldn't trade.

Money is a necessity for trade. Money originated with trade. We make no assumptions about who is trading. Private actors or community authorities could be trading. In all likelihood, community authorities like the tribe leader would trade on behalf of the whole tribe with tradesman - private actors from another tribe.

Historically, money was a commodity. Traders used shells as money because it was a rare luxurious item of intrinsic worth. Shells were money because ancient peoples used them as a means of payment with most people finding them acceptable as such. The Sumerians used barley and silver as money given prima facie evidence for historical metallism - that money originated as commodity-money. The Sumerians and the Akkadians were responsible for the first currency called the shekel, meaning: "weight" from the Akkadian 𒂅 'šiqlu'.

Shell Money

Cambridge Core - Archaeology: General Interest - Shell Money

Cambridge CoreMikael Fauvelle

Anthropological archaeologist Mikael Fauvelle in Shell Money - A Comparative Study argues that money predates sovereign authority. Hunter gatherer societies in South California used shell beads as money before the state, or a sovereign, existed. Fauvelle notes that shell money predominately facilitated trade among strangers and across boundaries. Money required novel forms of political hierarchy which enabled the rise of sovereigns and state. The state is a creature of money not money the creature of the state.

Why did money beget the state or kingdom more sovereign, not the other way round? Money requires trust; sovereigns require authority. Authority is a means of attaining trust. If the sovereign decrees that debtors must pay their creditors, that helps facilitate trust in trade. However, without credit and the means of fulfilling those payments in the first place why would the sovereign make such decrees in the first place. The sovereign arose as a means of institutionalising trust through the utilisation of the authority conferred to a sovereign.

As long as people put sufficient trust in the means of payment, the conditions arise for the begetting of money. Trust is the pillar of money. Metallic money's virtue is guaranteeing trust even when we cannot trust other people or institutions. We'll put our faith in the value of metallic elements instead. Sovereigns exerted their authority where possible, but they faced limits on how far their sovereignty extended over others. In such contexts, metallic money makes sense. In the modern age, when the stability of a governmental regime and the scope of its authority is consistent, fiat currencies make sense. Metallic money creates too much inflexibility in the system; whereas fiat currencies give the sovereign flexibility in how it utilises money.

The Four Prices of Money

All money in a particular denomination should be priced the same. £5 in banknotes should be equivalent to £5 in bank deposits. There should be no difference between the price of currency and the price of a demand deposit. Monetary economists call this the price of par - the price of money in terms of other money, e.g. the price of a unit of currency is the same as a unit in a demand deposit account at a bank.

Par is a necessity for keeping money systems stable so they can be money systems in the first place. I cannot trust a money system if I don't know whether I could gain or lose money simply by exchanging money with others. Without par, I cannot trust. The power of par is that we treat demand deposits from a bank as if it were currency. Without par, banking would be impossible and sophisticated financial systems would be impossible. Only in ad hoc cases in which I could trust the person I am trading with would I use an item as money. Trade is impossible without money and the price of par.

Interest is the price of money in terms of future money. Interest effectively acts as the price for deferring payment.

Interest is widespread throughout modern day economies. So much that it is systemic. By having a price of money in terms of future money systemically imbedded in our economies, it necessitates economic growth even if that growth is unsustainable in the long run. Paying interest requires not just earning the money in paying back a debt obligation but satisfying interest payments as well. People and businesses must earn a profit so they can effectively pay back their debt obligations. We see appreciation in house prices which makes housing unaffordable in the long run and using carbon-based natural resources which is destroying the ecosystems our civilisation and wildlife depend on. Interest is killing the planet.

Exchange rates are the price of money in terms of other denominations of money, e.g. the price of the pound sterling (£) in terms of the US dollar ($). The price-level is the price of money in terms of commodities. How many pound sterling do I need to buy an apple, for example.

The Hierarchy of Money

Money is credit. Credit is money. During booms, traders in financial markets would agree wholeheartedly with both statements. Expectations are so optimistic that money and credit are interchangeable terms. This is where the animal spirits of the financial markets take over and explain the motivators of private agents within financial markets.

In sober times, both statements are qualified in that money is secure credit and secure credit is money. Sobriety recognises that some credit is cheap in that it is bad and therefore it is not valuable for settling payments or even as credit.

In financial crises, 'Money is credit' is true in that we recognise central banks must fulfil their promise when issuing which makes that currency the best money in the system. In contrast, 'credit is money' becomes false because we lose trust in banks which makes it apparent that bank deposits are not money but credit in which the bank cannot fulfil its obligations.

All money of the same denomination should be priced on par. Quantitatively in terms of value there is no difference between a demand deposit and currency. £1,000 in bank deposits is worth the same as £1,000 in 'Notes and Coin' as the Bank of England describes it.

However, qualitatively they are not equal. We trust the Bank of England far more than we trust Barclays. Barclays may go bankrupt one day, but it is far less likely that the Bank of England will disappear. Likewise, we trust banks more than we trust shadow banks or money market mutual funds. We trust pension funds more than we trust high-risk investment institutions. Basically, some money is better than other money even if priced on par.

We call this qualitative difference in the value of money - the hierarchy of money. Some money is better than other money. Some credit is better than other credit by that virtue as well. So, there is a hierarchy of credit. The monetary economy is inherently hierarchical. The best money is scarce, and the worst money is abundant. 'Notes and coins' make up a small percentage of the money supply in the UK. Central bank reserves are typically higher in value than currency. Demand deposits from private banks make up 96% of the money supply in the UK. Again, lesser money is far more abundant than the best money.

Gresham's law - which states that "bad money drives out good money" - recognises the hierarchy at work. If you replaced all bad money with good money, then the good money will degrade qualitatively. If this money is currency, the only means of degrading currency qualitatively is through inflation.

Circuitism

Private banks create the overwhelming majority of money via demand deposits when loans are issued. They create purchasing power when they lend without any loss of purchasing power elsewhere in the economy. When banks do this, they are creating a circuit. The circuitist traces the evolution of that money and credit until someone pays off debt or tax obligations destroying money/credit in turn ending the circuit. We call this monetary circuit theory, or circuitism for short.

Money in the modern economy: an introduction

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We'll consider a simple example. Suppose we begin with £1 million in cash. This cash is part of a circuit already. However, the only purpose it serves is twofold. First, it acts as collateral for the creation of the circuit in question. Second, we will introduce an analytic tool that helps think rigorously about the economy.

You will be use this cash as collateral convincing the bank that you are worthy of a loan. We deposit this money as demonstrated in Fig.1.1. We have a Godley Table representing the balance sheet of a person, institution, sector of the economy, entire economies trading with others, etc. On the left-hand side are the assets and on the right liabilities (i.e. debt obligations). On line 1, you have £1mm in cash. On line 2, you give that cash to the bank. On line 3, the banks expands its and yours balance sheet by adding a deposit as its liability and your asset.

In Fig.1.2, the bank creates a £10mm loan for us. We'll use this £10mm loan buying equity in a green hydrogen firm. Green Hydro, the name of the enterprise, uses the money innovating a new car powered by green hydrogen generated by electrolysis within the car itself. Green Hydro pays dividend to you from the firms profits from selling these cars. You initially use that dividend as a means of paying off the loan. The entire sequence of events is an example of the circuit. We'll showcase the first steps of this circuit using Godley Tables so that we realise the power of thinking in terms of balance sheets.

On the first line you have merely deposited £1mm cash in the bank as described above. The second line is where the loan and corresponding deposits are issued by the bank. What happens is that both sides of the banks' balance sheet expands in which it has a loan as an asset and deposits as a liability. The loan is an asset for the bank because it is an income stream, while the deposit is a liability because at a whim it may convert that deposit into currency. Your balance sheet also expands as a result with you having deposits as an asset, because that's your money, and a liability of the loan which you're obliged to pay off.

(In reality, you'll likely only withdraw a maximum of £20k on demand with the bank relying on notice before fulfilling its obligation if you want the entire deposit converting into currency. The reason is that it must find £9mm in reserves while it only has £1mm at its disposal.)

Finally, in Fig.1.3, the Green Hydrogen Enterprise starts with £100mm in equity which it sells to yourself (see line 2) in return for deposits as seen on line 3. Subsequently, throughout the rest of the circuit the Green Hydrogen Enterprise will use the £10mm in creating a car using green hydrogen as its fuel.

The banks create money ex nihilo. It doesn't need reserves so that it can make this loan. The £1mm you deposited wasn't necessary for the transaction but persuaded the bank that you were an acceptable risk. There are no other reserves or assets the bank has at its disposal. It created the loan and deposits at will.

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There are rules and considerations that must be accounted for:

1. The bank must expand both sides of its balance sheet. It cannot just create bank deposits without a corresponding asset, i.e. expand one side of its balance sheet.
2. Regulation imposes limits on what banks can do. For example, laws may require that banks not lend freely with those with poor credit ratings. Alternatively, banks typically must have a set amount of reserves for lending. However, regulations impose a lag between act of lending and the implementing the reserve requirements to the previous period.
3. The Bank of England sets interest rates influencing the price of loans and demand for loans.
   1. Centrals banks set the interest rate on uncollateralised lending overnight using its facilities. Banks will typically not lend at a cheaper rate of interest than the overnight lending rate in the long run so central banks can use this interest rate as a means of influencing the system obliquely. Examples include:
      1. The Fed Funds Rate (US)
      2. Sterling Overnight Index Average -SONIA - (UK)
      3. Euro short-term rate - €STR - (Eurozone)
   2. Potential debtors will factor in their lending decisions based on interest rates. This influences the aggregate demand for lending in the economy.
4. Market forces also play a critical role in lending decisions. Banks don't lend because they're good Samaritans but because they must earn a profit. If they lose money they go out of business.
5. Banks must take steps in mitigating the risk. Financial markets have found ways of managing risk through tools such as interest-rate swaps (IRS) which manage the risk associated with changing interest rates on loans, and credit default swaps (CDS) which manages the risk of defaults on loans.
6. Households and businesses will use loans to pay off other loans off impacting how the banks lend.

Initial Financing (Flux) vs Funding (Reflux)

Initial financing involves creating IOUs (flux); whereas funding involves either destroying IOUs (reflux) or swapping IOUs considered money. Both are means of payment. Initial financing creates a circuit through the creation of credit-money. Funding requires the destruction of credit through payment via money. Regards public finances, initial financing refers to the state creating money via expenditure, and funding refers to the destruction of money via taxation and the purchase of bonds.

Let's look at our earlier example of purchasing equity in a Green Hydrogen Enterprise. The bank creates a circuit through initial financing by creating a loan and corresponding deposits. An expansion of credit and purchasing power has occurred which is flux. After buying equity in the firm and receiving lots in profit you pay off the loan in full with interest. Your final payments fund the loans and credit-money destroying them, which we call reflux.

Acts of initial financing for one person can be the funding for another. For instance, the initial purchase of equity was initial financing from your perspective but was funding for that equity from the perspective of the owners of the Green Hydrogen Enterprise. They then invested the funds in developing the product and technologies which earned profit so you can pay off the loan with interest while earning a profit yourself.

Elasticity vs Discipline

Elasticity and discipline are monetary forces at work. Elasticity refers to the abundance or scarcity of flux within the economy. Too little elasticity means we're not creating enough credit and purchasing power which hurts aggregate demand in the economy. Too much elasticity means we're creating too much credit. This will either overheat the economy creating inflation or entails we're lending recklessly ensuring the financial system is unstable.

Discipline refers to abundance or scarcity of reflux in the economy. Too much discipline means we're too focussed on paying off debts, rather than generating wealth. In a society fuelled by debt, here is a significant risk of a debt deflationary crisis setting in in which paying off debt paradoxically enhances the amount of debt within society because everyone is deleveraging and destroying money at the same time which contracts the economy faster than the rate of debt destruction. Irving Fischer attributed debt deflation as a cause for the Great Depression. Too little discipline means we're not funding our activities enough entrapping more people into debt while fuelling a reckless increase in elasticity.

Elasticity and discipline are very much like yin and yang. They are forces that need balancing. If they become unbalanced, it disrupts the entire whole monetary ecosystem with potentially devastating consequences for the economy.

Inside Money vs Outside Money

Inside money is an asset for some but a liability for someone else. For example, bank deposits are money which are your assets and the liability of banks. Fiat currency is an asset to you but a liability to the central bank that issues that currency. All of them are examples of inside money.

In contrast, outside money is an asset for everyone in the economy and is no one's liability. Gold coinage is a good example.

In the Fig.2.1, we note that the assets of the Issue Department within the Bank of England in 1924 consists of £126,234,595 of 'Gold Coin and Bullion'. This is outside money because the central bank, banks, private sector agents, and individuals all think of it as money, as an asset, and not as a liability. In contrast, the £145,984,595 of Notes issued is inside money because the Bank of England holds them as a liability while the rest of the economy holds them as assets. It should also be apparent that there wasn't a one-to-one ratio between the value of 'Gold Coin and Bullion' and the Notes Issued.

The Great Economic Debate: Chartalism vs Metallism

We've ascertained that metallism involves pegging money to the value of a metallic commodity like gold or silver. The gold standard simply means we peg money to the value of gold. The silver standard pegs money to the price of silver. For most of modern human history, societies have pegged the value of their currencies to metallic commodities.

However, suppose the gold standard emerged from traders interacting with each, it is not clear why they'd choose gold instead of diamond or platinum. Chartalists responds that the sovereigns' decrees which metallic commodity we will use backing up money. We call this view chartalism.

Chartalism holds that sovereigns give value to currency by imposing tax obligations onto their subjects which gives value to the currency. Furthermore, sovereigns make their currency legal tender which means subjects must accept that currency as a means of paying debt obligations. The sovereign decrees what the market price for gold should be or that gold not silver is the appropriate metallic commodity.

In today's economy, it's certainly true that metallism is false. All currency today is fiat currency backed by nothing but the promises of the authority of that currency - the typically publicly owned central bank, an agent of the state. Does this make chartalism true? Not necessarily. Banks create 96% of the money supply, not the state.

However, in the hierarchy of money this privately created money is cheap money. We know this because if everyone simultaneously wanted all their deposits in currency, there wouldn't be enough currency to meet the deposits. Gresham's law tells us that deposits are lesser money than currency. In other words, it is state-backed fiat currency which is the ultimate money in domestic currencies. The value of that money determines the value of private money ultimately. The facts suggest chartalism is true.

To what extent is it true? Chartalism certainly describes key facets of today's modern monetary systems. Governments determine what is legal tender and imposes taxes on the populace. However, on top of that is a vast layer of privately issued money with a life of its own. The state, or more specifically the central bank, influences private money creation through manipulating interest rates. The central bank uses monetary policy as a means of influencing the forces of elasticity and discipline keeping them in balance. Yet the central bank isn't all powerful or all knowing. The markets influence the central bank as much as the central bank influences markets.

There is an interplay between the public sphere of influence and the private sphere of influence in markets. At the heart of it is yin and yang best expressed through the term 'hybridity'. Our monetary system features public and private agents grappling with one another. Sometimes the private overpower the public and other times the public overpowers the private. Some will consider the former politically acceptable, e.g. free market libertarians, while others prefer the latter, e.g. socialists and some Keynesians. Let's look at US monetary history as described by the great American economist Allyn Young.

In 1792, President George Washington signed the Coinage Act of 1792 which established the US Mint and standardised currency within the US. Alexander Hamilton established America's monetary system inspired by the British system featuring a national bank, which we now call central banks. Not until 1913 would the US finally acquire an official central bank like the Bank of England, which America called the Federal Reserve. The Fed consists of 12 local central banks which act in coordination with one another implementing the monetary policy set down by the Federal Open Market Committee.

The Coinage Act, the handiwork of Alexander Hamilton, established the eagles ($10), the dollar ($1), the dismes ($0.10), the cent ($0.01) and others as the official currency of the US. The coins were issued in gold, silver, and copper. The Act imposed a 15:1 ratio between the value of silver and gold. It also pegged the value of the currency to the Spanish silver dollar widely used at the time.

Hamilton's Coinage Act used state decree valuing the currency under the guidelines of bimetallism meaning two metals back up the currency. The US originated with a bimetallic standard using gold and silver as standards. However, the Act had problems. The value of gold changed suddenly after the Coinage Act was passed so that it was akin to 15.5:1 ratio. Gold was undervalued so there was a lack of gold sent to the newly established mint resulting in hardly any circulation of gold currency. Instead, silver currency flooded the US.

Subsequent Coinage Acts altered the silver:gold ratio from 15:1 to 16:1 turning the dollar coin from a silver coin as envisaged in 1792 to a gold coin. From 1853, the government decreed that silver coins were only legal tender for payments up to $5. Over time, the government favoured the gold standard over the silver standard. As Allyn Young notes, the silver standard was an endorsement of cheap money. Creditors favoured gold-backed money because the value of debts rose, whereas debtors preferred the cheap money of the silver standard.

What are the lessons? The state certainly plays a critical role in determining what legal tender and even decreeing the value of the currency. However, the market has a life of its own as seen in the 1792 Coinage Act which eventually undervalued gold. The result was that the US never had enough gold coins in circulation. Even though the state decreed the value of these coins, market forces also played a role as well. Subsequent action from the US government over the next century tried fixing the discrepancies between its decrees and market forces. Finally, it suggests that the imposition of authority at the expense of economic liberty plays a role in determining whether the state or market forces primarily determine the true value of the currency. Economic liberty constrains the state's authority empowering market forces, however the constraints imposed still give the state liberty in influencing the market. When states decree what the nature of their monetary regime is, it has a direct impact on how free citizens are in that's states economy. More control is not necessarily good and too much decentralisation is counterproductive.

This essay covers concepts created by economist Perry Mehrling and none of the concepts mentioned in this essay are the authors innovations.