Nature and Roles of Money and Banks

[This article is based on extracts from The Nature of the Beast: how economists mistook wild horses for a rocking chair eBook.  Guest-Posted on Steve Keen’s Debtwatch site 1 June.]

Any discussion of the nature and role of money in modern economies typically brings out a plethora of confusing or conflicting theories, claims and counter-claims about what money is, what role it plays, what dysfunctions it might be responsible for and how they might be fixed.  One common set of claims is that money is a unit if account, a medium of exchange and a store of value.  I argue the first property is a trivial one and the last is only true if the money is wholly or in part a real commodity, like a pig or some tobacco.

The money we commonly use is a token that has no immediate value, but rather an implied promise of future value.  If the world proceeds as expected then that value may be delivered, but if unexpected things happen you may be left with worthless paper and your perceived value will not have been stored.  Indeed many retirees are finding the value of their retirement fund is not as assured as they had wished.  Many argue passionately that money should be backed (in whole or in part) by gold, but gold is just another commodity and its value fluctuates widely with little reference to the needs of an economy for a medium of exchange.

Banks, too, elicit great confusion.  One key question is whether bank loans increase the money supply, and another is whether central authorities can control the money supply.  Even economics text books show that bank loans do increase the money supply, yet neoclassical economists argue they do not, and that private debt is therefore not important.    To disentangle these confusions we need to consider some simple cases of exchange and credit, from which the nature and role of money and the mystery of its creation can be clarified.

Better understanding could lead to major improvements.  If token money (i.e., money that is not a commodity) is properly understood, and if a society is a stable and trusting one, then it can function well as a medium of exchange.  Token money is an implicit social contract, involving a debt and a credit.  If this is properly understood then a banking system can be designed that does not destabilise the economy with excessive accumulations of debt and risk, and that facilitates exchange with minimal distortion.

 Basic exchange

The fundamental act of economic activity is exchange.  If Jane is good at raising pigs and Tom is good at growing wheat, then they might each do what they’re good at and then exchange a pig for some wheat.  They could do this without the use of money, or in other words they could barter.  This simple example illustrates the point of all economic exchange, which is to increase value.  Jane could grow her own wheat, and Tom could raise his own pigs, but they work more efficiently if they each do what they’re good at and then exchange.  Being able to exchange gives them more value for the work they invest.

To put it another way, Jane and Tom gain more value if they specialise and then exchange.  This is a founding principle of economics, famously expounded by Adam Smith.  The story of the industrial revolution, and indeed of civilisation, is as much a story of specialisation as it is of technical innovation.  Or to put it in Eric Beinhocker’s terms, it is as much about social innovation as technical innovation1.

I will walk us through some basic examples of exchange in order to bring out key features of money.  Sometimes we don’t think much about familiar things, just because they are so familiar, so we must make a special effort to examine them afresh.

Thus, suppose Tom would like a pig from Jane but Tom’s wheat crop is not yet ready to harvest.  If Jane trusts Tom she might be willing to give him the pig now and have Tom give her the wheat when it’s ready.  But suppose Tom is a stickler, and he writes a formal little note that says “Tom owes Jane one pig’s worth of wheat” and gives it to Jane in exchange for the pig.  Later, at harvest time, Tom delivers the wheat to Jane and she gives him the note in exchange, since she doesn’t want to claim any more wheat from Tom.  Tom can throw the note in the fire, because he has fulfilled his promise and the note has no more purpose.  Figure 10.1 is a little diagram of the two-part exchange.  Tom’s note is depicted as IOU (I owe you: Tom’s promise to Jane).

Split barter

Figure 10.1  A split barter.  (a)  Jane accepts Tom’s promise (IOU) in exchange for one of her pigs.  (b)  When the wheat is ready, Tom exchanges some of his wheat for the IOU that Jane has held.

I’m belabouring this simple example, and a couple to follow, because we’re on our way to clarifying exactly what role money plays, and some different forms it can take.  You could even say that Tom’s note is a rudimentary form of money.  Now here is a key point:  Tom’s note allowed Tom and Jane to break their exchange into two parts, as is spelled out in Figure 10.1.  In the first part, a pig is exchanged for an IOU.  In the second part, the IOU is exchanged for some wheat.  E. C. Riegel2 called such a two-part exchange split barter.

However this example does not yet bring out the full power of Tom’s IOU, and of split barter.  We can do that by looking at a three-way exchange, like the one depicted in Figure 10.2.

The well-known problem with barter is that you have to find someone who has what you want, and who wants what you have.  Harry has a pig, but he doesn’t want Tom’s wheat, he wants Dick’s potatoes.  Dick wants Tom’s wheat (which is not ready yet), but Tom doesn’t want Dick’s potatoes, and so on.  Now it happens there’s a three-way match here, and if they’re patient and trusting they might do the three-way barter, with delay, as depicted.  Notice, by the way, that Dick has to wait for Tom’s wheat, and if he’s already given Harry some potatoes then for a time he has less value:  Tom owes him a debt, just as Tom owed Jane a debt in the first example.

Three-way barter

Figure 10.2  A three-way barter, with delay.

A second possibility would be to do an indirect barter.  Even though Dick doesn’t want a pig, he might accept it from Harry in exchange for the potatoes that Harry wants, as depicted in Figure 10.3(a).  Then, when Tom’s wheat is ready, Dick could exchange the pig for some wheat with Tom (Figure 10.3b).  The pig would then have functioned as money.  Pigs are actually used as money in some cultures.  We can call the pig an example of commodity money.  In this case there is no debt: Dick always has full value, in the form of either potatoes or a pig.  This is because the pig, the medium of exchange, has intrinsic value.

Indirect barter

Figure 10.3  An indirect barter.

A third possibility is for Tom to write an IOU.  The exchanges could then proceed as illustrated in Figure 10.4.  Tom and Harry exchange a pig for Tom’s IOU.  If Dick knows and trusts Tom, he might be willing to accept Tom’s IOU from Harry in exchange for giving Harry some of his potatoes.  Later, when Tom’s wheat is ready, Dick can present Tom’s IOU and get some wheat in return.  In this example, Tom’s IOU will have circulated as money.  (Tom might have rephrased his note “Tom owes the bearer wheat to the value of one pig.”)

Three-way split barter

Figure 10.4  A three-way split barter.

We can now begin to see the full power of split barter, because if other people know and trust Tom, then his note might not pass just from Harry to Dick, it might circulate around the local community, facilitating other exchanges, before eventually returning to Tom at harvest time. Tom’s note is token money, money with no intrinsic value of its own:  it is just a piece of paper with some words on it.  The role of token money is to permit split barter, and the power of split barter is that people doing exchanges don’t have to have matching wants.  Tom can do half of an exchange with Harry, and later he can do the other half with Dick (or whoever bears his note).

Now it’s time to draw out some important properties of token money.  Tom’s note has facilitated exchange, so clearly it is a medium of exchange.  Tom’s note may appear to be backed by a commodity, namely a quantity of wheat, but the wheat did not exist when the note was written.  Tom’s note is only useful if other people trust Tom’s word, so Tom’s note is really backed by Tom’s promise.  Tom’s promise has value only in a community or society in which mutual trust exists.

In the first example, with Tom and Jane, we can see more clearly that Tom’s note is really the expression of a social contract between Tom and Jane.  Because it is a contract, it was created when the agreement was made and it can be destroyed when the agreement is fulfilled.  (With this perspective, we don’t have to be horrified that money is sometimes destroyed – Tom burnt his note, and a bank de-issues or destroys money as a loan is payed off).  To the giver of the note, it represents a promise to deliver a service – as has been explicit in our examples.  On the other hand to the bearer of the note it represents a claim on someone else’s service (in this case, Tom’s).

We now come to an especially important property of Tom’s note.  Tom’s note represents a claim on future service.  The contract between Tom and Jane links the future to the present, because Jane must agree to hold her wish for some wheat in abeyance, expecting the agreement to be fulfilled in the future.  This linking of the future to the present is fundamentally important for understanding the dynamics of an economic system, as it means, in the language of calculus, the primary signalling mechanism in the system involves time-derivatives.  The neoclassical theory deals with a static equilibrium that excludes time, so it excludes this crucial property of token money and cannot describe the way economies develop over time, nor properly describe the role and influence of money.

In the meantime Tom owes a debt to Jane and Jane is owed a debt by Tom.  Thus the note represents a debt.  With the introduction of debt comes risk.  The risk arises from the linking of the future to the present, because we can’t be sure what the future will bring.  If Tom’s crop is destroyed by a hailstorm, Jane will lose – she gave a pig but got nothing in return.  This highlights another critical property of token money, that it introduces debt and risk.

Finally, if Tom’s note functions as money, then obviously his issue of it increases the money supply.

 Money and trust

So far the discussion has been in terms of Tom’s note, which may not seem much like normal money, despite my assertion that the note functioned as money.  To make the connection clearer, suppose the people in Tom’s community like the way his note helped them to exchange things, but they realise it would be more useful if they could use a standardised form of note, or promise.  So (moving the story right along) they get the local printer to print up some notes that say “The bearer is owed goods or services to the value of one dollar”, and they agree that one dollar stands for the value of one kilogram of wheat.  They also ask the printer to keep track of how many notes are issued to each person who wants some, in other words to keep track of each person’s promises.  The printer decides to set up a side business to perform the note-printing and accounting, for which he will of course charge an appropriate fee.  The printer decides to call this business Community Bank.

These standardised notes should be more recognisable as the kind of money we are used to, yet they still have all the properties that Tom’s IOU had.  Thus the offering of a standardised note implies a contract involving the promise of delivery of a service.  The exchange also implies a debt, it links the future to the present and it thereby involves risk.

If you have a ten dollar note, the note expresses a debt owed to you by your community.  You may not be used to thinking of it this way, but think about where your money comes from.  If you are employed, then you contribute your services to your employer and in return he gives you some pieces of paper, or some numbers in a computer.  You are definitely owed!  The debt can be redeemed if you take your notes (or your debit card) to a store and buy some groceries.  On the other hand if Tom, rather than earning money, simply withdraws some new money from the bank and issues it in exchange for a pig, then Tom is certainly taking on an obligation.  His obligation is to return to the community equal value in goods or services.  He can do this by providing wheat in exchange for money, which he then deposits and extinguishes his debt.

Seen in this form, it is clear that token money has no intrinsic value, nor is it backed by any specific commodity.  Rather it is backed by the promise of the community to deliver value in goods or services in exchange for the money.  The value of token money thus depends on the existence of a trusting community.

We can dispose of the claim that money should be backed by gold, as it used to be (or was alleged to be) before the “gold standard” was discarded.  Token money, in a trusting community, does not need to be backed by gold or any other commodity.  It’s true that in order to maintain a steady value the money supply must be carefully managed, but that is a different issue.  Anyway the value of gold is also volatile, depending as it does on arbitrary fluctuations in supply as gold discoveries are made, on hoarding, and on peoples’ highly subjective valuation of gold as an ornament, as an imperishable commodity or even as a symbol of immortality.

Not all exchange occurs in a context of trust, such as in low-trust societies or in international dealings.  In situations where trust is lacking it does make sense for money to be backed by things of real value.  Bernard Lietaer3 has therefore proposed a backed currency, which he calls a Terra, backed by a ‘basket’ of commodities that can be stored in warehouses.  It could be beneficial especially for poorer countries whose currencies may be vulnerable to global forces.  The particular mix of commodities would be determined by each country using those of its products that best retain their value.

Token money, whether it is backed by community trust or by a commodity, is not itself wealth, it is a token of wealth.  We might also think of it as potential wealth.  It has no immediate value in itself, but it holds the potential of being converted into wealth.  Wealth, as I defined it earlier, is the value to a person of real things, be they food, a house, an axe, a factory, or a piece of land close to services or accessible to many potential customers.

 Banks

Most of our money comes from banks, who create it out of nothing according to their perceived needs.  Banks are not well understood by most people.  There is a general idea that banks accept deposits and make loans, but banks’ operations are much more complex than that.  Banks do operate under government-imposed rules, but the rules have been changed and loosened over the past several decades.  The rules now are so complex and jargon-laden that it is difficult for any but the most expert to really understand them.  What the banks do within those rules, and how closely they remain within them, are even harder to fathom.  Nevertheless some key underlying features can be discerned, and they have a large effect on the behaviour of our economy.

Banks developed from the practices of money changers and money lenders in the Middle Ages, who learned that they could loan promissory notes to a value greater than the reserves of coin they held, so long as everyone did not want to redeem their notes for coin all at once.  An example will be given shortly.  There is a text-book version of how modern banks issue money, and the system it describes is called fractional reserve, reflecting its similarity to the partial reserves held by money changers.  However banking has developed beyond this in at least two important ways.  One is that in some countries simple reserve requirements have been replaced with “capital adequacy guidelines”.  The other is that empirical evidence indicates that banks first loan money, then look for adequate reserves, rather than reserves leading loans.  Furthermore the amount of debt is several times greater than the amount of circulating money, contrary to what the fractional reserve story predicts.  The net result is that banks are a lot freer to create money for loans than neoclassical theorists typically assume.

The fractional reserve system can be confusing at first, and you have to step carefully through the details to see its results.  It is spelt out by Heilbroner and Thurow4, and in The Nature of the Beast (Appendix A).  I will just give the take-home messages here.  In the text-book fractional reserve system, if the reserve fraction is 10% then banks, collectively, can loan out about nine times what they have in deposits.  In other words they have to keep in reserve only about 10% of what they loan out.  The reserve fraction varies quite a lot among different countries, but that is a fairly typical value.  So banks don’t just loan money that has been deposited with them.  Instead, every time they make a loan, about 90% of it is new money, created out of nothing.

There are two important consequences of fractional reserves.  First, every time a loan is granted the money supply increases, and conversely as the loan is paid off the money supply decreases.  Second, because new money is issued as part of a loan, the bank charges interest on it.  Each of these features affects how the larger economy behaves.

This system has been extended or modified by requiring “capital adequacy”, which allows banks to count a wider range of assets than just reserves to determine how much they may loan.  Thus banks can still loan much more than they have in hand and, because reserves are now only part of the total capital of a bank, a bank’s capacity to extend loans has been expanded.

Now to the other extension of the fractional reserve system, or rather beyond the fractional reserve system, which bears on the question of whether authorities can control the amount of money.  Economist Steve Keen argues that banks make loans first, then look for reserves5.  Governments (through reserve banks) respond by creating enough “base money”, the money used for reserves, to keep the banking system functioning.  Although the US claims to run a fractional reserve system, it now only applies its 10% reserve requirement to individual deposits, and it does not have a reserve requirement for deposits by companies.  Thus banks are free to loan businesses as much as they like.  There are also many debt instruments created by a shadow banking system, and these are essentially unregulated.

Keen argues that the fractional reserve system is now a minor adjunct to the dominant money system, which is close to a pure credit system, in other words a system in which banks arbitrarily create money out of nothing.  Because bank profits result mainly from making loans, their incentive is to push as much debt as the market will bear.  A feature of shadow banking is the trading of so-called derivatives.  These are basically packages of things like bonds, shares and mortgages.  Because they are agreements requiring future payments, they involve debt, and therefore risk.  Because derivatives have been hardly regulated, large amounts of debt have been created in this form as well.  The result has been an enormous increase in the amount of private debt relative to the GDP.

 Leverage and instability

Almost every institution involved in the financial system is, in the jargon, highly leveraged.  This is as true of old-fashioned banks with fractional reserves and mainstream banks with capital adequacy requirements as it is of shadow banks.  What does “highly leveraged” mean?  It means you are betting a small amount of your own money plus a lot of other peoples’ money on a large return.  If the return is positive, you make a handsome profit.  However if the return is negative you lose not only your stake but potentially everything you own.

For example, if you invest $1000 in an enterprise that returns 15% a year later, you make $150.  However if you can persuade someone to lend you $9000 so you can invest $10,000, then the return will be $1500.  The return on your $1000 is magnified or leveraged to 150%.  However the risk is also magnified.  If the return is negative, -15%, in other words a loss, then you lose $150 on your $1000 investment and are left with only $850.  But if you invested the $10,000 then you lose $1500.  That means you lose all of your initial $1000 and you still owe your creditor $500.

Some simple parables can help us to figure out who is leveraged and who is not.

Honest Abe

Honest Abe is an old-time money changer and safe-deposit manager who issues paper receipts for coins people deposit with him, to be held in his vault.  Each receipt says it may be redeemed for the equivalent value in coins.    People would be able to use the receipts as money, standing in for the coins.  If the value of the coins in the vault is the same as or more than the value of the paper Abe has issued, then there should never be a problem.  Anyone who wants “real” money can exchange their paper notes for coins.  Abe’s business involves no leverage, and it does not increase the money supply.

Clever Clancy

Clever Clancy offers an arrangement with his depositors that he can loan some of their coins out, in return for a share of the profit he makes on the loans.  He offers them 2% interest.   His loans carry the condition that if his depositors require the coins then he can “call in” the loan, in other words require immediate repayment in coins.  He loans out ninety percent of the coins, keeping only ten percent as a reserve for people who need to redeem notes for coins.  His deposits, loans and reserves are summarised in Table 11.1, along with those of Abe, and Slick Slim (below).

This arrangement gives some protection to Clancy and his depositors, but less to his debtors.  If his depositors should want to redeem notes worth more than the coins he has on hand, he can call in some loans, retrieve the coins and pass them to his depositors.  Those whose loans are called in may suddenly have to sell things for less than their full value in order to raise the coins owed to Clancy.  If any debtors should be unable to repay their loans, then Clancy would lose and so would his depositors.  However the risk of default should not be great if he loans wisely.

Clancy’s arrangement introduces some risk for himself and his depositors, but he makes considerably more profit and his depositors also make modest profits.  So long as defaults are few, the main risk is to debtors, whose lives may be disrupted by a call-in.  Clancy’s business can be viewed as loan brokering.  However the loans are made with existing money (the coins), and so there is little risk of wider consequences.  Clancy’s business might appear to involve leverage, but since the loaned coins already existed and can be accessed if necessary then in principle all the paper is still backed by coins.  However the business does increase the circulating money supply by 900.

Table 11.1.  Summary of deposits, loans and reserves.

Abe Clancy Slim
Deposits (coin) 1000 1000 1000
Receipts (paper) 1000 1000 1000
Loans (coin) 0 900 0
Loans (paper) 0 0 9,000
Reserves (coin) 1000 100 1000
Total paper (money) 1000 1000 10,000
Total circulating money (c & p) 1000 1900 10,000

Slick Slim

Slick Slim starts out like Clancy, except he makes his loans with paper notes rather than coins.  As long as the loans total no more the 90% of the coins on deposit, his business should proceed in the same way as Clancy’s.  In fact it should run better, because there will be little chance of not being able to redeem notes for coins.  This is because the paper he has issued would amount to less than the coins he has on hand, whereas Clancy’s deposit receipts would amount to ten times the coins he kept in reserve.

Realising this, Slim makes a crucial extension.  He starts loaning more than the value of deposits.  To do this he makes his receipts and his loans identical, so they both state simply that they may be redeemed for coins.  Then he makes loans worth nine times the value of the coins on deposit.  Slim’s deposits, loans and reserves are included in Table 11.1.  If he is careful, no-one need know he has loaned out more than he has.  His reasoning is the same as before, that only ten percent of people are likely to want to exchange their notes for coins at any given time.

In making this change, Slim has leveraged his deposits by a factor of ten.  He will make ten times more profit on the loans.  Unfortunately he has also magnified his risk.  Worse, he has created a systemic risk for his community.

Slim’s scheme increases the supply of money by a factor of ten, because his notes can circulate as money.  This may for a time increase economic activity in the community, because his debtors will have spent their loan-money on whatever project they got the loan for.  It may also cause inflation.

However, if for any reason Slim’s depositors suspect that he might not be able to redeem their notes, there might be a rush to redeem notes and he will run out of coins.  He may attempt to call in loans, requiring they be repaid in coin.  This will create a shortage of coins as debtors scramble to sell things to raise the coins to repay their loans.  It will also reduce confidence in the value of his paper notes.  If merchants know Slim is having trouble redeeming his notes, they may refuse to accept any more in payment for goods.  If that happens the notes may become worthless, and anyone holding them will lose.  The supply of money will suddenly decrease, because Slim’s notes cease to function as money, so the formerly booming economic activity will slow.

Unlike Clancy’s scheme, the consequences of the failure of Slick Slim’s scheme do not fall just on Slim and those dealing directly with him.  The consequences flow through the whole community.  As he expands the money supply he may trigger inflation, which affects everyone by devaluing the money they already hold.  If people lose confidence in his notes, then anyone holding the notes loses, but the whole community also loses if the drop in the money supply impedes local economic activity.  In conventional terms, Slick Slim’s paper money first triggered an inflationary boom, then a recession.  This sequence of events occurred many times through the eighteenth and nineteenth centuries.

Fractional reserve banking is also highly leveraged.  It functions essentially in the way Slick Slim’s bank did, and it generates the same kind of risk, not only for itself but for the whole community.  If for any reason a lot of its loans should default, then it may not have enough reserves to cover the losses and it would become insolvent.  The money involved with the defaulting loans would vanish, the money supply would suddenly drop, and a recession or depression might be triggered.

Modern banks do not practice simple fractional reserve banking any more, but they are still highly leveraged and therefore they generate at least as much risk.  The shadow banking sector is overtly one of high leverage and high risk.  The financial instruments they deal in are all debt instruments, bets on the future.  They effectively multiply the money supply even more.  This is how private debt in the US came to be 47 times greater than “base money” in 2007.

In technical terms, the high leveraging of the banking system sets up a powerful destabilising (positive) feedback.  Positive feedbacks are the ones that tend to magnify a trend.  Thus in good times the feedback tends to drive the money supply up, but when bad times come the same feedback tends to drive the money supply down.  Leveraged banking is a built-in generator of instability in our economies.  It is a major factor in causing recessions and depressions.

Bibliography

1 Beinhocker, E.D., The Origin of Wealth. 2006, Boston: Harvard Business School Press.

2 Riegel, E.C., Flight From Inflation. 1978, Los Angeles: The Heather Foundation, Box 48, San Pedro, CA 90773.

3 Lietaer, B., The Future of Money. 2001, London: Century.

4 Heilbroner, R. and L. Thurow, Economics Explained. 1994, New York: Simon and Schuster.

5 Keen, S., The roving cavaliers of debt, http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/. Steve Keen’s Debtwatch, http://www.debtdeflation.com/blogs/, 2009. Posted.

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3 thoughts on “Nature and Roles of Money and Banks

  1. Rob At Smarter Barter

    great article, I’m currently working on triangles of trade similar to your example of Tom, Dick and Harry. Using our trade ‘bank’, there are a growing number of triangles developing, even squares and pentagons!

    Like

    Reply

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