Rethinking Economics is right to revisit the importance of money. Money is a very useful invention, that’s why it has been around for thousands of years, but its nature has profound implications for a modern economy. For the modern world money allowed the advantages of specialisation, observed by Smith and Ricardo, and freed investment finance from savings too, as noted by Keynes, but money can cause a lot of trouble if misunderstood. And sadly, the teaching of monetary theory in economics has deteriorated since the 50’s and 60’s when money was generally taught as being something endogenous, rather than as the exogenous money of the ‘Money Multiplier’ of more recent textbooks.
Textbooks often tediously list the functions of money as a set of points to be merely memorised, and even though ‘medium of exchange’ is clearly the prime function as the others simply flow from this. What is usually missing is a discussion of the strange nature of money, even though understanding why ‘money is money’ is vital to understanding where it comes from, how it is created and when it might disappear.
Most people think that if they borrow from a bank they are loaning money that has been placed there by other customers of the bank. They may well be shocked therefore, and feel their trust betrayed, to be told that the bank simply ‘made up’ the money to loan them. In effect, the bank merely pretended to be loaning them other people’s money, when in fact it just created the money out of thin air.
Depositors may be equally shocked too to learn that their bank account does not show how much money they have at the bank. Not only is the money in the bank not legally theirs but their account there only shows what the bank owes them, as a claim on the bank’s own cash. If the bank goes down then your money goes too. Your money simply no longer exists, ‘pop’ like a bubble bursting, although the state may help you out with some compensation from their own endless supply of money (see below).
People may feel they know what money is, as they mostly think of it as everyday coins and notes, even though they mostly use bank deposits for purchases, but in fact money is a rather peculiar ‘will-of-the wisp’ notion. Most of it has no physical form at all, just weightless electronic records in bank computers, its functions relying crucially on its credibility. The odd thing about money is precisely that it is accepted only because it is accepted!
This abstract and odd nature of money was concisely captured by Morris Perlman in the 70’s:
“Money is like a myth as it requires only imagination for its creation but faith for its effectiveness”.
Although almost anything practical, and scarce, could be used as money, gold in the ancient world and cigarettes in prison, to be a reliable and generally accepted medium of exchange money generally needs the touch of some authority. The most obvious authority being the state, and then Gresham’s law tells us that the intrinsic value of money had better be less than its face value, which is easy for electrons in a bank’s computer as they are intrinsically worth nothing at all.
Textbooks generally describe the ‘money multiplier’, whereby ‘base’ money ‘minted’ by the state is multiplied, by a process of lending and redepositing, to create a fractional reserve system of credit and deposits resting on a reserve of this state provided base liquidity. But from our insight that money is all about credibility and faith, we can already see a basic insight of so-called ‘Modern Monetary Theory’; if the state, or its agent the central bank, maintains credibility then the supply of state endorsed money is limitless. The government does not need to tax in order to spend, rather it may to spend to tax. All talk of a ‘government budget constraint’ in anything like everyday notions of a budget constraint become meaningless.
None of this is new, but somehow, even though Schumpeter essentially had it right about endogenous money way back in the 30’s, the notion of exogenous money crept back in. Indeed by the Monetarist Experiment of the late 70’s and early 80’s the control of the money supply was, briefly, the main plank of (Thatcher/Joseph’s) macroeconomic policy. The notion was that by controlling the Government’s budget the supply of new base money could also be controlled. But as Goodhart noted at the time, in what is now called ‘Goodhart’s Law’, money is slippery, try to control it in one form and it spills-out in other forms. And as Kaldor had observed earlier, it is not sudden increases in money that causes Christmas spending, it is Christmas that expands the volume of money!
In short, trying to control the volume of money supply can be like trying to put a limit on imagination. To cut a long-story short, despite dramatic rises in the price of base money as the interest rate which commercial rates are marked-up on, the central bank under Thatcher’s Government repeatedly failed to keep money within it targets. Money was again shown to be endogenous, that is, generated by finance institutions and the demands of the economy itself.
Today the Bank of England readily admits that money is endogenous:
“Money creation in practice differs from some popular misconceptions—banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits….
Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits. In normal times, the central bank does not fix the amount of money in circulation “
Like a central bank, so long as a commercial bank can maintain its credibility, it too can ‘just pretend’ it has the money and its newly created deposits will automatically actually become money. But one very important determinant of credibility is the bank’s profit, and that largely depends on the ability of its customers to repay their loans and interest. When the economy is doing well, the ability to repay loans increases and so then does the money supply. And as Minsky observed, so too does confidence and hence risk taking. Ultimately, an incautious bank may over extend its risky loans, or a sudden downturn may decrease the general ability to repay, and then a threatened bank cannot with credibility meet the demands on it with its own created money. It might crash, and that could bring down others who were relying on that bank to repay its loans, but the state cannot let this process go on for long for fear of economic collapse, and so it will step in using its own credibility to bail out the banks. This of course leads to all the concerns about ‘letting banks get too big to fail’ and the problem of moral-hazard.
This is all a long way from the familiar stable LM Curve of the Hicks/Hanson IS/LM framework, the basic macro teaching workhorse for so long. It is a more intrinsically volatile story, the LM curve does not just sit there waiting patiently for the IS curve to behave. Instead, money created in the good times can also evaporate in bad times or be instantaneously destroyed by crisis. The LM curve is useful to understand past failures of policy, but to understand the real economy, its dynamics and vulnerabilities, we need to know money is mostly endogenous. Re-thinking can sometimes be remembering the lessons economists once knew.
Visiting Professor, Birkbeck, University of London and Loughborough University
This is a guest post written for the Rethinking the Role of Banks in Economics Education campaign.