Money Is an Item Fundamental to Modern Society. the Alternative to It

Home , Coincidence of wants, Medium of exchange

Money is an item fundamental to modern society. The alternative to it is barter, a system of exchange that requires a double coincidence of wants involving considerable information and transaction costs. Abba Lerner described the advantages of the monetary economy over the barter economy:

The essential superiority of a monetary economy over a barter economy is the saving of mental effort made possible by money. In a monetary economy it is not necessary to think of all the rates of exchange of every commodity for every other commodity in which one might be interested. It is sufficient to know the money price of a commodity and to use this price as a representative of all the other things that one might have instead. But this service can be rendered by money only if there is a sufficient stability in its purchasing power. (Abba Lerner ‘The Properties of Interest and Money, Quarterly Journal of Economics, 1952, p.191)

Money as a medium of exchange lowers information and transaction costs by overcoming the problem of the ‘double coincidence of wants’ inherent in a barter economy. It may appear strange to discuss still the barter economy. However, Ireland encountered elements of a barter economy during the three bank disputes which closed the commercial banks for periods of time ranging from two months to six months in 1966, 1970 and 1976 (Murphy, 1978). More recently Greece in 2014 faced a bank holiday of a couple of weeks in 2014. Furthermore preparations were made on a European scale in 2011/12 for an alternative monetary systems when the euro came under pressure.

Traditionally money has been defined in terms of its functions:

(1) Money is a unit of account, i.e. prices are expressed in monetary units such as euro and cents, dollars and cents, etc. (2) Money is a medium of exchange enabling goods and services to be purchased. Here, as will be shown there is a need to distinguish between money as a means of payment and money as a medium of exchange. (3) Money is a store of value. Money needs to retain its value across time. Otherwise if inflation arises and moves towards hyperinflation the public will rid itself of depreciated money and find alternatives. This was the case for Germany after World War 1; for many South American countries in the twentieth century and more recently for Zimbabwe.

Money, while apparently easy to understand at a basic level, proves to be a highly elusive concept when examined in greater depth. There are many layers of moneyness in the inverted pyramid of different types of money available to transactors. Traditionally the most basic layer consisted of notes and coin that people could use to purchase goods and services. Up to the late 17th century specie in the form of gold and silver coins constituted the money supply in these islands, although the Italians had developed from the 14th century a relatively sophisticated banking system and the Dutch had created a specie backed bank which facilitated the transfer of money through a centralised bank account system. In 1694 the British, influenced by the Williamite conquest of the crown, fashioned a bank, the Bank of England, on its Dutch counterpart. At the same time goldsmiths had evolved to becoming rudimentary bankers as goldsmiths notes became transferable between customers. Soon deposits with goldsmiths were transformed into bank deposits. So that the new money supply became:

Ms = C + D

Where C = Currency and D = Bank Deposits.

In the transformation of the goldsmiths into bankers the first phase involved 100% coverage of bank deposits by gold and silver reserves. The goldsmith/bankers were just deposit takers rather than deposit makers. However, these new bankers realised quickly that there was no need for 100% coverage of deposits with specie reserves because customers were content to leave their money with them as long as the bank had a secure reputation. By breaking the 100% reserve deposit ratio bankers found a highly profitable means of expanding their businesses through credit expansion. So credit expansion became a new method of financing business and consumer needs. In the initial phases of this development deposits were defined as the liabilities of a bank that could be drawn on and used for expenditure immediately or within the time to clear a cheque through incipient clearing systems. More specifically these deposits were classified as current accounts or demand deposits i.e. deposits that could be withdrawn immediately and without loss. This enabled the definition of the narrow money supply M1:

M1 = C + DD

Where DD represents demand deposits.

However, problems relating to this definition arise as the demarcation lines between demand deposits and time deposits (deposits bearing a rate of interest that are redeemable at fixed notice such as a week, one month, three months, six months) became difficult to discern. Thus, a wider definition of the money supply, M2, emerged:

M 2 = C + DD + TD

Where TD represents time deposits.

This is only a starting point in attempting to define wider definitions of the money supply. Where does one stop in the process of incorporating different forms of time deposits into definitions of the money supply? Does one include one week deposits in preference to six month deposits. If one includes six month deposits should one not also include financial instruments such as deposits with the Post Office Savings Bank and the Trustee Savings. If these are included does one not also include deposits with mortgage institutions (Building Societies/Thrifts), etc. If these are included why not incorporate bond issues in the different definitions of the money supply. How does a three month Treasury (Exchequer) Bill rank with a three month fixed bank deposit. If Treasury Bills are included why not include maturing government bonds? And so on and so on. This process results in a wide variety of definitions of the money supply ranging from M1 to M67. Instead of narrowly defining money the criterion moves towards moneyness, ie, the liquidity of a financial asset, namely the ability to turn it into purchasing power without loss or delay, or, more precisely, with little loss or delay.

Accompanying these problems of attempting to define the money supply because of the wider range of institutions offering term deposit facilities, technological changes have made it increasingly easy to purchase goods and services through credit and debit cards, electronic transfers, etc. Nonbank retail institutions issuing cards, such as supermarket chains, retail stores, petrol stations, etc., have found credit cards to be a highly profitable business, a profitability which has encouraged them to adopt more and more banking practices. In most cases these institutions are increasing the velocity of circulation of money rather than increasing the overall money supply. On a far larger scale it will be shown how, due to the perceived profitability of the business, merchant banks transformed into investment banks and developed a successful shadow banking system. The shadows of this banking system then spread to commercial banks with investment banks purchasing commercial enabling them to compete directly with the traditional commercial banks. This development, in turn, encouraged the commercial banks to counter this invasion onto their traditional banking patch by purchasing or creating their own

investment banks. This breakdown of the traditional demarcation lines between commercial banks and investment banks whilst creating the impression of improved efficiency in the banking sector interlinked all banking institutions so closely together that when a crisis hit one sector it created contagion across all sectors. Thus, for example, the invasion of the investment banks into the traditional mortgage sector took business from thrifts and banks. Then to accentuate this invasion sub primes were transformed by the investment banks, with the full assistance of credit rating agencies, into apparently less risky and higher bearing financial instruments that were sold across the financial system. Once interest rates rose and sub primes lost some of their gloss a collapsing house of cards effect generate the 2008 financial crisis in the United States.

In providing this analysis of the emergence of banking and its creation of the main part of the money supply (bank deposits) there are a number of other factors that need to be examined (1) most notably the abandonment of the idea that money needs to be intrinsically valuable and (2) the role of the state in the process of money creation.

Intrinsically Valuable Money

Surprisingly for many centuries after the creation of paper banknotes and bank deposits the idea held sway amongst economists and politicians that money needed to be intrinsically valuable i.e. that a banknote or a deposit had to have an equivalent gold or silver backing and so could be immediately translated into gold and silver coin or bullion. Economists such as David Hume, Adam Smith A.R. Turgot, Karl Marx and Alfred Marshall were, for example, highly critical of John Law because they believed that he did not understand that money needed to be intrinsically valuable. The doctrine backing this view came to be known as the gold standard, a doctrine which only fully disappeared in 1971 when the Federal Reserve Bank of the United States decided to discontinue its policy of converting dollars into gold on demand at a fixed price of $35 an ounce. It is contended that this Midas fixation on the importance of gold acted as a barrier to the development of money and banking. Others, such as Barry Eichengreen, will maintain that even as it slowly became less important, because of the emergence of banks, it provided an anchor to the global monetary system thereby giving confidence to it at times of very significant political turmoil. The issue of the convertibility of banknotes and deposits into and out of gold has produced many periods of political and economic debate. During the Napoleonic Wars Britain moved to an inconvertible monetary system for seventeen years. The fact that Britain could survive with a fiat monetary system did not generate sufficient confidence for a continuation of this policy and it returned to the gold standard in 1817. During World War 1 Britain once again went off the gold standard but returned to it in 1925. To Keynes and his followers this was perceived as a disastrous policy.

As we move up the inverted pyramid to other types of money we find that notes and coin now constitute only a very small part of what is known as money. The vast bulk of the money supply is now made up of bank deposits transferable by cheques and increasingly by a wide range of debit systems involving central clearing systems amongst banks.

The Role of the State in the Monetary Creation Process

The state has always had a strong interest in the monetary creation process because of profits associated with the provision of money. Seignorage was the term given to describing the royal revenues accruing to the monarch as a result of charges imposed for coinage. It is of French

origin (droit du seigneur – an imposed ‘right’ which was exercised, at times, in relationships other than the coinage!) denoting the exclusive feudal privilege that the monarch had in matters relating to the coinage. Quite simply the monarch exacted a seignorage charge for minting coins, usually with his/her effigy. The minting of coins provided confidence in the currency as the coins were known to be of a certain weight and fineness. There are a variety of ways in which seignorage has enabled the monarch/state to benefit from the creation of money:

(1) Mint seignorage (2) Debasement seignorage – A development that arose when the monarch reduced the value of the coinage (a) by edict relative to the unit of account or (b) by physically reducing the weight or fineness of the coins. (3) Banknote seignorage – The substitution of banknotes for specie money and ultimately the refusal to re-convert the banknotes into gold/silver. (4) Regulatory seignorage – The imposition of regulations forcing banks and financial institutions to have specified quantities of their assets in currency, central bank reserves and government securities. (5) International reserve currency issuer seignorage. Because of the need to have an international currency to facilitate global trade various countries such as Great Britain in the 19th and early 20th centuries and the U.S., since World War 1, have been able to borrow interest free through the use of their money as reserve currencies.

DOES MONEY LEAD ECONOMIC ACTIVITY OR VICE VERSA

Iriving Fisher presented his famous equation of exchange as:

MV = PT

Where T represented the number of transactions in the economy.

Due to the impossibility of measuring the total number of transactions in the economy this equation of exchange was subsequently modified with Y (Income) replacing T.

MV = PY

As a result of the development of the measurement of national income it became feasible to measure Y. However, a question still arises namely the direction of causation. Is it a case of

MV PY

Or, alternatively, is it the case that

PY MV

In this latter instance monetary changes are perceived to be endogenous and the money supply is seen as just accommodating the changes in the real side of the economy PY. If one accepts this viewpoint then money ends up having a minor role in the real economy because of the belief that the real economy is capable of generating the financial system that it requires to generate economic activity.

However, if the money supply, or, at least part of it is exogenously determined the direction of causation holds and money is seen as leading economic activity. This approach may be divided into two schools (1) monetarism and (2) Keynesianism. In the first approach, that of monetarism, it is believed that it is changes in the money supply that influence Y consisting of prices and output. Furthermore, if it is assumed that a competitive market system has generated full employment, then output may not be increased and increases in the money supply are seen as influencing just prices. An additional element of monetary theorising is that velocity is stable and predictable, enabling them to remove V from the equation and postulate that

M P

This approach produces the famous one liner from Milton Friedman that ‘inflation is always and everywhere a monetary phenomenon.’

Keynesians do not accept the assumption that the freely competitive market generates full employment. They model the economy with the unemployment and underemployment and believe that money may have a real effect on output. Furthermore they do not accept the view that velocity is stable. The Cambridge equation of exchange re-structured the approach as follows:

M = kPY

Where k represents the amount of income that people wish to hold as money.

In this approach the emphasis has shifted away from emphasising money as a medium of exchange to that of money as a store of value. Why do people want to hold money? Surely, Keynes, remarked, that where there are interest bearing alternatives to money, no one outside the inmates of an asylum should want to hold such money. And yet they do. Keynes summarised the desire to hold money, his liquidity preference theory, under three motives (1) the transactions approach; (2) the precautionary approach and (3) the speculative approach.

Keynes’s followers then analysed this in terms of the demand for money equation:

Md = f(Y,i)

Where i represents the rate of interest.

In 1956 when Milton Friedman formulated a new approach to the quantity theory of money he asserted that the quantity theory was primarily a theory of the demand for money. It did not become a theory of output and prices until the theory of the demand for money was combined with the theory of the money supply. So starting from an equilibrium position where:

Ms = Md

He then asked what happened when:

Ms was greater or lesser than Md

In the case of the Ms becoming greater than Md, and relying on his belief that the demand for money was stable, he predicted an inflationary outcome. In the second case, when Md is greater than the Ms, one not emphasised in many monetarist studies, he predicted that prices would fall and bring in their wake output reductions. This, as we will later see, was the basis of his work, along with that of Anna Schwartz, in analysing the monetary causes of the Great Depression (see A Monetary History of the United States by Milton Friedman and Anna Schwartz, Princeton, 1963).

In a subsequent debate with Don Patinkin, Friedman was forced to concede that his analysis of the quantity theory of money with its emphasis on the demand for money owed much to Keynes’s liquidity preference theory. So if both theories incorporate the demand for money (liquidity preference theory) into their analyses where does the difference lie. It all depends the assumptions made with respect to the stability of the demand for money with monetarists asserting that it is stable and that therefore there is a clear line of direction from money to inflation (in the case of an expanding money supply) and Keynesians contending that it is unstable. Additionally, the Keynesians do not accept that full employment is the norm and believe that monetary policy can have real effects on output and employment.

Despite the ascendancy of monetarism from the mid 1970s and its subsequent hijacking by New Classical Macroeconomics, a hijacking that further limited the role of money in the economy – in New Classical Macroeconomics Mark 2, with its emphasis on technological changes moving the business cycle, the role of money was further suppressed as it was perceived to be endogenously changing in line with the real economy – money re-appeared on stage as a fundamental element in the financial crisis of 2008 and quantitative easing (a euphemism for expanding the money supply) on Keynesian lines became the focal point for countering the financial implosion that had occurred.

Ironically, Friedman and Schwartz’s work on the monetary causes of the Great Depression became the centre point of the Federal Reserve’s chairman, Ben Bernanke’s approach to monetary policy. A considerable part of this approach may be developed by analysing the money supply equation.

Insert Money Supply Equation

FINANCIAL INNOVATION VERSUS FINANCIAL PRUDENCE

Everytime there is a financial crisis there is a knee jerk reaction from many commentators to blame the crisis on financial innovation. The mantra of these commentators is that financial innovation must be stopped in order to protect the financial system. However, if this type of policy had been adopted at the very beginning of the birth of the financial system we would find that we are still dealing with a primitive type of monetary economy. The emergence of banking would have been blocked. Paper credit and the national debt would have been prohibited. Ironically, one finds a major enlightenment scholar such as David Hume criticising both the stock exchange and the national debt as dangerous. Hume believed that if the equivalent of a tsunami wiped out the London stock exchange that it would only cause some stress for coffee houses and the manufacturers of quills and paper. He believed the national debt was dangerous and forecasted that Great Britain faced an imminent bankruptcy when the national bank became excessive. He favoured intrinsically valuable money and criticised credit creation. Adam Smith

similarly believed that banks and bank credit were dangerous and that whenever there was too much paper money in circulation that the financial system could collapse. He believed stock market issues should be limited to only five areas of investment. Despite the Cassandra like utterances of Hume and Smith the British financial system evolved and grew due to financial innovation providing the basic elements of finance needed to meet the investment requirements of the Industrial Revolution.

The start of the 18th century was highlighted by the emergence of new types of financial innovation involving attempts to replace gold and silver with banknotes and bank deposits. John Law attempted to do this in France and for a brief period succeeded. However, the collapse of his System brought in its wake strong public hostility to financial innovation. This resulted in the introduction of extremely strong regulatory measures which effectively prevented the development of banking in 18th century France. The collapse of the Mississippi Company in France and the apparent excesses of the bubble companies that sprouted around the South Sea Company in 1720 led to the introduction of very harsh control measures over the issuance of shares through stock markets. In Britain the introduction of the Bubble Acts in 1720 effectively prevented IPOs until the repeal of the Bubble Acts in 1825.

THE EMERGENCE OF SHADOW BANKING

The collapse of banks during the Great Depression led to the introduction of the Glass-Steagall Act (1933) which led to restrictions on the location of banks and the type of activities that they could undertake. Glass-Steagall also led to the establishment of the Federal Deposit Insurance Corporation. These regulatory changes and the increasing insurance provided by the FDIC to depsoitors (the insurance for individual deposits per bank grew from an initial $2,500 in 1933 to $250,000 by 2008) appeared to stabilise the U.S. banking system. But Glass-Steagall also promoted efforts by investment banks to circumvent it through the creation of ‘cash management accounts’ (initially launched by Merrill Lynch), a competitive substitute to the commercial banks’ deposits. The growth of these ‘cash management accounts’ nurtured the growth of the shadow banking system, a growth further accentuated by the repeal of many parts of Glass-Steagall. This deregulatory repeal movement started during the Reagan presidency further fogging up the distinctions between commercial and investment banks.