Working Paper No. 656 Money in Finance by L. Randall Wray Levy Economics Institute of Bard College March 2011 The Levy Economics Institute Working Paper Collection presents research in progress by Levy Institute scholars and conference participants. The purpose of the series is to disseminate ideas to and elicit comments from academics and professionals. Levy Economics Institute of Bard College, founded in 1986, is a nonprofit, nonpartisan, independently funded research organization devoted to public service. Through scholarship and economic research it generates viable, effective public policy responses to important economic problems that profoundly affect the quality of life in the United States and abroad. Levy Economics Institute P.O. Box 5000 Annandale-on-Hudson, NY 12504-5000 http://www.levyinstitute.org Copyright © Levy Economics Institute 2011 All rights reserved ABSTRACT This paper begins by defining, and distinguishing between, money and finance, and addresses alternative ways of financing spending. We next examine the role played by financial institutions (e.g., banks) in the provision of finance. The role of government as both regulator of private institutions and provider of finance is also discussed, and related topics such as liquidity and saving are explored. We conclude with a look at some of the new innovations in finance, and at the global financial crisis, which could be blamed on excessive financialization of the economy. Keywords: Money; Money of Account; Finance; Financial Instruments; Financial Institutions; Financial Innovation; Financialization; Liquidity; Saving; State Money; Chartalism; Shadow Bank; Hyman Minsky; Securitization; Robert Clower JEL Classifications: B14, B15, B22, B52, E12, E40, E42, E50, E51, E52, G14, G21 1 This entry will begin by defining, and distinguishing between, money and finance. It will also address alternative ways of financing spending. We next examine the role played by financial institutions, such as banks, in provision of finance. The role government plays both as regulator of private institutions and as provider of finance will be discussed. Related topics such as liquidity and saving will also be explored. We conclude with a look at some of the new innovations in finance, and at the global financial crisis that could be blamed on excessive financialization of the economy. The term “money” is often used in two different ways, first to designate the money of account and second in reference to specific money-denominated assets that fulfill several important functions associated with money (medium of exchange, means of payment, and store of value). For example, in the United States the money of account is the dollar, the measure of nominal value designated by the state. Many important economic values are denominated in dollars: taxes, prices (including wages, fees, and fines), and court-ordered restitutions. In addition, the term “dollar” is also used to describe the paper notes issued by the Federal Reserve Bank (and coins issued by the Treasury). Most economists would also include bank deposits in their definition of money—certainly demand deposits and perhaps time deposits—against which checks can be written that can be used in payment. Over the past half century, other “nonbank” or “shadow bank” financial institutions have developed a wide variety of substitutes for bank demand deposits, some of which allow holders to write checks for payment. Increasingly, credit cards and debit cards are used in payments. All of these developments appear to make it difficult to define money with precision. However, another approach is to use the term money to signify the unit of account, and to designate as “money things” the IOUs (debts or liabilities) denominated in the money of account. Some money things can be used as media of exchange for purchases and means of payment to retire debt; all can be used as stores of value (albeit some are more risky than others). We can think of a hierarchy of money things, with the government’s own IOUs (central bank notes and treasury coins, but also central bank reserves—taken together these are called high-powered money or the monetary base) at the top. Just below that would be the deposit liabilities of banks and other financial institutions with direct access (or indirect access through correspondent banks) to the 2 central bank. Other (nondeposit) short-term liabilities of financial institutions would be below that, then would come the short-term liabilities of nonfinancial corporations. Finally, at the bottom would be the short-term liabilities of households and small businesses. Taking this approach, one would be following Hyman Minsky (see Minsky 2008), who always said that anyone can create money (things), the problem lies in getting them accepted. There are three dimensions to this pyramid. As we move down from government liabilities through to household liabilities, liquidity of the money things declines. This is one of the characteristics that makes a money thing function as a medium of exchange and means of payment. Highly liquid cash can be used immediately in purchase and payment. On the other hand, the IOU of a nonfinancial firm or household is not very liquid, and must be converted to a more liquid money thing before it can be used in payment. This leads to the second dimension: convertibility. Most modern governments do not promise to convert their IOUs to anything, having long ago abandoned the gold standard. (To be sure, many governments, especially in the developing world, do promise conversion to a foreign currency such as the US dollar. In that case, we can think of the US dollar as the apex of the pyramid.) Bank checking deposits are normally made convertible on demand (hence, they are called demand deposits) to government high- powered money. Other short-term bank liabilities are convertible after some wait, often with a penalty for early “withdrawal” (conversion). And so on. Household IOUs, such as mortgages and other consumer debt, are convertible to bank liabilities—although conversion is not necessarily easy to accomplish. Finally, as we move down the pyramid, agents use liabilities of those higher in the pyramid for payment: households and firms make payments using bank liabilities, while banks make payments to each other using high-powered money. There are two universal laws of credit and debt (which are the two sides of the IOU—it is a credit for the holder and a debit for the issuer). The first is that credits and debts are denominated in a unit of account—almost always a state money of account (dollar in the United States). The second is that the issuer of an IOU must accept her own IOU back in payment, or what is called “redemption.” For example, if one has a loan held 3 by a bank, one can always repay that loan by delivering back to the bank one of its own IOUs, by, for example, writing a check on a deposit at the bank. If one owes taxes to the government, one can always pay taxes by delivering high-powered money (the government’s debt) in payment. (The debtor “redeems himself” by handing back to his creditor the creditor’s own debt—or a third party debt the creditor is willing to accept. The similarity of the terminology to religious concepts is not a coincidence. See Atwood [2008].) If a debt-issuing economic entity refuses to redeem its own IOU when it is submitted in payment that is a default. We can thus think of a network of credits and debits—entries on balance sheets— all denominated in the money of account. One is able to cancel one’s debts by delivering another entity’s debts (often an entity higher in the money pyramid)—either a second party’s debt (the party holding one’s debt as a credit) or a third party’s debt (for example, a household uses a bank IOU to make a payment on a car loan debt by the auto finance company). Banks often intermediate these payments, for example, delivering high- powered money (in the form of bank reserves) to government on behalf of taxpayers (while it appears to the taxpayer that taxes are paid by writing checks on bank accounts, in reality the taxes are paid by debiting the bank’s reserves from its account at the central bank.) Similarly, a household pays down its credit card balance by writing a check—with the bank making the payment for the household using reserves while debiting the household’s deposit account. To conclude this section, it is apparent that drawing a sharp dividing line between what we want to call a “money thing” versus what we designate merely a “debt thing” is neither possible nor desirable. All are IOUs denominated in the money of account, and all are “redeemable,” accepted in payment of debts held by their issuer. Only some can be used directly in payment (using a third party debt in purchase or in debt payment). They have varying degrees of liquidity, which is one of the factors determining whether they will circulate among third parties. For many transactions, banks operate as intermediaries, making payments for clients, because they operate a major part of the national payments system in all countries. We now turn to finance. If one wants to make a purchase, there are three options for financing the transaction: use of one’s income, use of one’s assets, or issuing debt. 4 (The sovereign currency-issuing government is in a different situation—as discussed below—as it is the only entity that makes payments only by issuing its own IOUs.) Income is a flow over time—so many dollars per hour, week, month, and year. This is accumulated as a stock, for example, as a demand deposit held at a bank.