Paul Samuelsson presents the “historical states of money” as follows: Inconvenient as barter obviously is, it represents a great step forward from a state of self-sufficiency in which every man had to be a Jack-of-all-trades and master of none…. Nevertheless, simple barter operates under grave disadvantages…. In all but the most primitive cultures. N do not directly exchange one good for another. Instead they sell one good for money, and then use money to buy the goods they wish…. Money does simplify economic life. If we were to reconstruct history along hypothetical, logical lines, we should naturally follow the age of barter by the age of commodity money. Historically, a great variety of commodities has served at one time or another as a medium of exchange: cattle, tobacco, leather and hides, furs, olive 011, beer or splits, slaves or wives, copper Iron, gold, silver, rings, diamonds, wampum beads or shells, huge rocks and landmarks, and cigarette butts.
The age of commodity money gives way to the age of paper money…. Finally, along with the age of paper money, there is the age of bank money, or bank checking deposits. (Samuelsson 1973, up. 274-6) It Is more Important to recognize the underlying view on the nature of money represented in this quote than to take the history seriously (even Samuelsson offers the caveat that the history “hypothetical, logical”). Money is something that reduces transactions costs, simplifying “economic life” by lubricating the market mechanism. Friedman 1969) Indeed, this is the unifying theme in virtually all orthodox approaches to banking, finance, and money: banks, financial Instruments, and even money Itself originate to Improve market efficiency. (Klein and Selling 2000) phenomenon: Although economists allow that money is a human invention assuming different forms in different times and places, they adopt an evolutionary perspective that De-emphasizes moneys contingency and its ultimate foundation in social convention.
As capitalist economies became more complex, money ‘naturally assumed increasingly efficient forms, culminating in the highly abstract, intangible money of today. (Caruthers and Baby 1996, p. 558) An innate propensity to “truck and barter” is taken for granted; this instinct leads naturally to the development of markets organized through a self-equilibrating relative price system. It is then “natural” to choose a convenient medium of exchange to facilitate impersonal market transactions.
The ideal medium of exchange is a commodity whose value is natural, intrinsic;free from any hierarchical relations or social symbolism. As Haltering put it: In money, the social relationships among human beings have been reduced to a thing, a mysterious, glittering thing the glazing radiance of which has blinded the vision of so many economists when they have not taken the precaution of shielding their eyes against it. (Quoted in Caruthers and Baby, 1996, p. 1556) Simmer put it more concisely: money supposedly transforms the world into an “arithmetic problem”. Quoted in Seltzer 1989, p. 344) The underlying relations are “collectively forgotten about” in order to ensure that they are not explored. (Caruthers and Baby 1996, p. 1559) The value of each marketed commodity is then denominated in the commodity chosen as the medium of exchange through the asocial forces of supply and emend. Regrettably, nations have abandoned the use of intrinsically valuable money in favor of “fiat” monies that cannot provide a relative price anchor.
Monetary growth rules, prohibitions on treasury money creation, balanced budget requirements, and the like (not to mention currency boards and dollar standards for developing nations), are all attempts to remove discretion from monetary and fiscal authorities, to make fiat money operate as if it were a commodity, thereby restoring the “natural”, asocial, monetary order. Money and banking textbooks also reduced discussion of the money supply to “an arithmetic problem” based on the “deposit multiplier” identity.
The central bank would increase the supply of bank reserves and banks would respond by increasing loans and deposits by a fairly stable multiple. (Brenner 1968) Hence, the growth of the money supply was supposed to be “exogenously controlled” by the central bank. Since money is mostly used for transactions purposes, it can be linked to nominal GAP through the equation of exchange. If “real” GAP grows at a “natural rate” (determined by supply-side factors such as technological advance and growth growth of the money supply and changes to the price level.
This is, of course, the foundation to the Monetarist approach and led to the famous call by Milton Friedman for the central bank to target reserves and thereby money growth in order to control inflation. By the late sass this view came to dominate policy-making and actually led to attempts by central bankers to target monetary aggregates. At the same time, the rational expectations hypothesis was merged with old “classical” theory and monetarism to create what came to be called New Classical theory.
The most important conclusion was that money would be neutral in the short UN, as well as the long run, so long as policy was predictable. In practical terms, this meant that an announced and believable policy could bring down inflation rapidly merely by reducing money growth rates, and with no unemployment or growth trade- off. In a sense, money became irrelevant. While we will not explore modern theories of finance in detail, developments there mirrored the evolution of mainstream economic theory in the sense that finance also became irrelevant. So long as markets are efficient, all forms of finance are equivalent.
Financial institutions are seen as intermediaries that come between avers and investors, efficiently allocating savings to highest use projects. Evolution of financial practices continually reduces the “wedge” between the interest rate received by savers and that paid by investors;encouraging more saving and investment. Domestic financial market deregulation (underway since the mid sass in the US) as well as globalization of international financial markets plays a key role in enhancing these efficiencies, and, hence, in promoting growth. The key conclusion is that if market impediments are removed, finance becomes “neutral”.
To be sure, a wide range of objections have been raised to these extreme inclusions, including existence of credit rationing, of sticky wages and prices, and of complex input-output relations;all of which could leave money non-neutral in the short run. (See Gordon 1990 for a summary. ) These have been collected under the banner of New Keynesian but it is usually conceded that they do not constitute a coherent theoretical challenge to New Classical theory. Another challenge came from Real Business Cycle theory that made money even less important, but it had to adopt assumptions that almost all economists regard as highly unrealistic.
As Manama 1989) mused, mainstream economists were left with the uneasy choice of internal consistency (New Classical or Real Business Cycle approaches) or empirical relevance (New Keynesian). The economics student faced a series of seemingly unrelated special purpose models that shed little light on money, banking and finance. By the end of the sass, orthodox policy making was also in disarray as it appeared that central banks could not control the money supply and that money was not closely linked to nominal GAP (this can be stated alternatively as velocity had become unstable).
Further, it did seem to many that money matters, in the sense that monetary policy affects unemployment and growth in fairly predictable;even if alternatives. Over the course of the sass, orthodox economists developed a “new monetary consensus” (NC) to monetary theory and policy formation. There are several versions, but perhaps the best-known includes an equation for output gap (the percentage point gap between actual and potential output), a dynamic version of a Philips curve relating inflation to the gap, and a monetary policy (Taylor-like) rule.
These can be set out as: a) = apt-I + – CTR-Et(apt+1)] + ext b) Apt= d(Apt) + WI apt-l + wet(apt+1) + zit (note www+www=1) N*t-l + g(apt-l – p*) here Y* is the output gap, R is the nominal interest rate target, is the “natural” or equilibrium real interest rate, p is inflation, and p* is the inflation target (x and z are stochastic shocks). (See Meyer 2001 . ) Note that the nominal interest rate target is set taking into account the output gap and the difference between actual and desired inflation.
This then feeds into the Is-like demand gap equation based on the presumption that the nominal rate less expected inflation (the “real rate”) influences demand. According to the consensus, in the long run only the supply side matters, while in the worth run, both supply side and demand side variables matter. Unlike the sass version of Keynesian economics, fiscal policy is given a small role to play on the demand side (although government can influence the supply side, for example through its tax policy).
Hence, monetary policy is given the larger role to play in impacting demand and hence growth. In the long run, money is neutral, but a variety of transmission avenues have been posited to allow money to influence demand in the short run. The NC rejects a simple monetarist transmission mechanism (from monetary aggregates to spending). Rather, it is recognized that central banks operate mostly with interest rate targets, but these are supposed to affect demand directly (interest elasticity of spending) and indirectly (portfolio effects).
The money supply, in turn, results from an interaction of central bank policy, portfolio preferences of market participants, and the demand for credit. There is substantial consensus that the central bank has a strong, albeit short run, impact on demand. When the economy grows too fast, threatening to set off inflation, the central bank is to dampen demand by raising interest rates; when it grows too slowly (causing unemployment and gassing the specter of deflation), the central bank lowers rates to stimulate demand. Private banks and financial markets play an accommodating role, following the central banks lead.
When the central bank announces that it will tighten, financial market participants drive interest rates up, choking off credit demand and reducing spending, cooling the economy and dissipating inflationary pressures. The NC encourages central bank transparency because effective monetary policy requires that central bank intentions are quickly incorporated in expectations and thus in rake behavior. For example, when the central bank raises nominal interest rates to fight inflation, if there are consistent expectations, markets quickly lower their inflation forecasts.
This makes the real interest rate (nominal rate less expected inflation) rise even more, depressing demand and spending, allowing actual inflation to fall. The shared expectations makes policy more effective. Further, policy changes are implemented only gradually to avoid disruptive “surprises” that could generate instability. In this way, the central bank can slow growth and inflation through a emitted series of small interest rate hikes;avoiding the problems created in the early sass when the Fed raised overnight interest rates above 20% in its attempt to fight inflation. T) Development of an alternative to orthodoxy The orthodox story of moneys origins is rejected by most serious scholars outside the field of economics as historically inaccurate. (See Davies 1994, Cramp 1962, Heinous and Steiner 1983 and 1989, Ingram 2005, Keynes 1914, Maddox 1969, Robert 1956, and Wary 2004. ) While there is evidence of ceremonial exchange in primitive society, there is nothing approximating money-less markets based on barter (outside trivial asses such as POP camps). Further, the orthodox sequence of “commodity (gold) money’ and then credit and fiat money does not square with the historical record.
Written records of credits and debits predate precious metal coins by thousands of years. Indeed, financial accounting was highly sophisticated and much more “efficient” for market transactions than use of coins that developed thousands of years later, indicating that it is highly unlikely that coinage developed to facilitate exchange. Finally, historians and anthropologists have long disputed the notion that arrests originated spontaneously from some primeval propensity, rather emphasizing the important role played by authorities in creating and organizing markets. Poland 1971) Still, orthodox economists do not insist on the historical accuracy of their story, but instead use it to shed light on what they believe to be the nature of money and the proper role for government to play. Perhaps the most interesting aspect of the orthodox story is that it completely ignores the most obvious feature of the monetary landscape: in almost every case, a money of account (or, “currency’) is associated with nation state. However, again, we can set to the side historical accuracy and ponder the implications for our understanding of the “nature” of money.
In the orthodox story, money is a handy medium of exchange and government enters the picture as an interloper that abandons “natural” gold money in favor of “unnatural” fiat money that is imposed on markets. The obvious danger is that money then has no backing, nothing to guarantee its value relative to marketed commodities. This is why orthodox policy is so intimately connected to inflation control. In addition, and related exception to this would be reference to state legal tender laws that force market participants to accept the state’s currency, and reserve ratios that are required of banks.
With a fiat money, this is said to provide seignior to government. Still, government has at best a quasi-legitimate role, but this is tempered by a strong inclination to mismanage a fiat money that in the long run is neutral, but in the short run can distort market signals. Is there an alternative, socio-economic, view? To be sure, we will never “know’ the origins of money. For one reason, it is not clear what we want to identify as money. Money is social in nature, consisting of a complex social practice that includes power and class relationships, socially constructed meaning, and abstract representations of social value.
As Hudson (2004) rightly argues, ancient and even “primitive” society was not any less complex than today’s society, and economic relations were highly embedded within social structures that we little understand. At best, our story about moneys origins identifies what we believe to be important about money by singling out past institutionalized behaviors that appear similar to those today that we wish to identify as “money’. While the alternative view is more consistent with the historical record, such as it exists, the essential point is that it sheds light on an alternative approach to finance, banks, and money.
To that end, we would locate the origin of money in credit and debt relations, with the money of account emphasized as the numerator in which credits and debts are measured. The store of value function could also be important, for one stores wealth in the form of others’ debts. On the other hand, the medium of exchange function is De-emphasized; indeed, credits and debits could predate a functioning market. Some eave suggested that we can locate the origins of credit and debt relations in the elaborate system of tribal worried designed to prevent blood feuds. Nines 1913, 1914, 1932; Goodhearted 1998, 2005; Wary 1998, 2004) Worried fines were paid directly to victims and their families, and were socially established and levied by public assemblies. Note that fines were not levied in a unit of account but rather in terms of a particular item that was both useful to the victim and more-or-less easily obtained by the perpetrator. As Hudson (2004) reports, the words for debt in most languages are synonymous with in or guilt, reflecting these early reparations for personal injury. Originally, until one paid the worried fine, one was “liable”, or “indebted” to the victim.
The words for money, fines, tribute, tithes, debts, ambiance, sin, and, finally, taxes are so often linked in language as to eliminate the possibility of coincidence. It is almost certain that worried fines were gradually converted to payments made to an authority. This could not occur in an egalitarian tribal society, but had to await the rise of some sort of ruling class. As Henry (2004) argues for the case of Egypt, the earliest ruling classes ere probably religious officials, who demanded tithes (ostensibly, to keep the gods population.
Tithes and tribute thus came to replace worried fines, and fines for “transgressions against society’, paid to the rightful ruler, could be levied for almost any conceivable activity. (See Peacock 2003-4. ) Eventually, taxes would replace most fees, fines and tribute. A key innovation was the transformation of what had been the transgressors debt to the victim to a universal “debt” or tax obligation imposed by and payable to the authority. The next step was the standardization of the obligations in a unit of count.
At first, the authority might have levied a variety of fines (and tributes, tithes, and taxes), in terms of goods or services to be delivered, one for each sort of transgression. Denominating payments in a unit of account would simplify matters, but as Grievers (1977, 1979) remarked, development of a unit of account would be conceptually difficult. (See also Henry 2004. ) It is easier to come by measures of weight or length;the length of some anatomical feature of the ruler (from which comes our term for the device used to measure short lengths), or the weight of a quantity of grain.
It is certainly not a coincidence that all the early money units (mina, shekel, liver, pound) were taken over from grain weights. For example, Hudson links the early monetary units developed in the temples and palaces of Summer in the third millennium BC to the “monthly consumption unit, a “bushel” of barley, the major commodity being disbursed”. (Hudson, Bibb, p. 1 1 1) Once we have the universal unit of account, credits and debts could be denominated in “money’. In a particularly insightful pair of articles, A. Mitchell Nines (1913, 1914) developed what might be called a credit theory of money.
See also Gardener 2004 and Ingram 2000, AAA, Bibb. ) He mocked the view that “in modern days a money- saving device has been introduced called credit and that, before this device was known all purchases were paid for in cash, in other words in coins. ” (Nines 1913, p. 389) Instead, he argued “careful investigation shows that the precise reverse is true”. (Nines 1913, p. 389) Rather than selling in exchange for “some intermediate commodity called the ‘medium of exchange”, a sale is really “the exchange of a commodity for a credit”.
Nines called this the “primitive law of commerce”: “The instant creation of credits and debts, and their extinction by being cancelled against one another, forms the whole mechanism of commerce… ” (Nines 1913, p. 393) The market, then, is not viewed as the place where goods are exchanged, but rather as a clearinghouse for debts and credits. On this view, debts and credits and clearing are the general phenomena; trade in goods and services is subsidiary;one of the ways in which one becomes a debtor or creditor (or clears debts).
Finally, banks emerge to specialize in clearing: Debts and credits are perpetually trying to get into touch with one another, so hat they may be written off against each other, and it is the business of the banker to bring them together. This is done in two ways: either by discounting bills, or by making loans. (Nines 1913, p. 402) banker who brings them together and clears them as the debts fall due. This is the whole science of banking as it was three thousand years before Christ, and as it is to- day. Nines 1913, p. 403) Banks are not intermediaries between “savers and investors” but rather allow creditors and debtors to clear accounts with third person;bank–liabilities. If “A” has debt to “B”, A does not have to find one of Bi’s Souse to settle the debt, but rather can clear accounts using a banks liability. The debtor, A, writes a check on the bank, accepted by the creditor, B, which can use it to cancel any debt owed to the bank. The bank accepts its own IOW and clears it against Bi’s 100, the banks asset.
Another important activity of banks is to operate clearing facilities between the state and its taxpayers: the taxpayer does not have to get hold of a government liability to pay taxes, because the treasury accepts bank liabilities in payment. This then leads to a deduction of bank reserves. In this way, bank reserves are not viewed as the “raw material” from which banks are able to make loans (as in the orthodox deposit multiplier story) but rather as the government liability held by banks to facilitate clearing with the government for their customers.
In addition, reserves are used by banks for net clearing with one another, for example, when debtor “A” and creditor “B” use different banks. Rather than seeing government currency and reserves (“high powered money’, HEM, or monetary base) as a “fiat money’ with no backing, the alternative approach insists that even government money can be viewed as a set of reedits and debts. On the government’s balance sheet, HEM is a liability; on the holder’s balance sheet, HEM is an asset.
What backs the government liability? Orthodoxy responds “nothing”, and insists that is the fundamental problem with “fiat” money. For a more satisfying answer, we need to explore the “very nature of credit throughout the world”, which is “the right of the holder of the credit (the creditor) to hand back to the issuer of the debt (the debtor) the latter’s acknowledgment or obligation”. (Nines 1914, p. 161) Any issuer of a debt must accept her own debt back in payment, and Nines explains quite clearly that the
The holder of a coin or certificate has the absolute government is no exception: right to pay any debt due to the government by tendering that coin or certificate, and it is this right and nothing else which gives them their value. It is immaterial whether or not the right is conveyed by statute, or even whether there may be a statute law defining the nature of a coin or certificate otherwise. (1914, p. 161) Government money;like any liability;must “reflux” back to the issuer.
Still, money is different, because it is “redeemable by the mechanism of taxation” (Nines 1914, p. 15): [l]t is the tax which imparts to the obligation its Value’…. A dollar of money is a dollar, not because of the material of which it is made, but because of the dollar of tax which is imposed to redeem it”. (Nines 1914, p. 152) In other words, what “stands own currency in payment of taxes. There is sovereign power behind state money; the power to impose fees, fines, tithes, or, ultimately, taxes. Learner 1943, 1947; prepare 2002; wary 1998) Of course, saying that dollars have value because the government imposes a dollar tax does not mean that only those with tax liabilities will accept dollars, nor does it even mean that anyone accepting a dollar in payment is consciously thinking of the tax liability that can be removed by paying dollars. People also accept bank liabilities (checks drawn on banks) without realizing that the issuing bank must accept its own check to pay down a loan it has made;the person accepting the check probably uses another bank and may not have any outstanding bank loans at all.
However, if a bank began to refuse to accept its own liabilities in payment, these would very quickly lose all value (and the banks officers would Just as quickly be taken to court). Similarly, so Eng as a government imposes a dollar tax on at least some of its citizens, and so long as it requires payment in the form of its dollar liabilities (even where banks play an intermediating role), this will be sufficient to ensure that the dollar will be desired; by someone. We do not need to make the stronger case that the tax liability is a necessary condition for acceptance of dollar currency, but only that it is a sufficient condition. ) And Just as a banks liabilities will be accepted even by those who are not bank debtors, a government’s currency will be accepted by those with no current tax abilities;and even by those with no conscious thought of tax liabilities. Iii) New directions and policy implications of the alternative approach The alternative view of money leads to quite different conclusions regarding monetary and fiscal policy.
It rejects even long run neutrality of money, although it might downplay the short run effectiveness of monetary policy. It also generates interesting insights on exchange rate regimes and international payments systems. In this section we will only briefly outline directions for alternative thinking about policy, focusing on the government budget constraint, on central bank control of none and inflation, and on international financial flows and exchange rate regimes.
It is commonly believed that fiscal policy faces a budget constraint according to which its spending must be “financed” by taxes, borrowing (bond sales), or “money creation”. Since many nations prohibit direct “money creation” by the government’s treasury, it is supposed that the last option is possible only through complicity of the central bank;which could buy the government’s bonds, and hence finance deficit spending by “printing money’.
Actually, a government that issues its own currency bends exclusively by crediting bank accounts;using banks as “agents” of government, as discussed above;while tax payments result in debits to bank accounts. Deficit spending by government takes the form of net credits to bank system liabilities while banks hold reserves in the form of central bank liabilities (we can ignore leakages from deposits;and reserves;into cash held by the non-bank public as a simple complication).
While there are fairly complex coordinating procedures followed by the central bank and treasury, the logical point is that deficit spending by the treasury results in net credits to banking system reserves. See Bell 2000, Bell and Wary 2003, and Wary 1998 for detailed analyses. ) If these net credits lead to excess reserve positions, overnight interest rates will be bid down by banks offering the excess in the overnight interbrain lending market.
Unless the central bank is operating with a zero interest rate target, declining overnight rates trigger automatic open market bond sales to drain excess reserves. Hence, on a day-to-day basis, the central bank intervenes to offset undesired impacts of fiscal policy on reserves when they cause the overnight rate to move away from target. The process operates in reverse if the treasury runs a surplus, which results in net debits of reserves from the banking system. This puts upward pressure on overnight rates that is relieved by open market purchases.
When fiscal policy is biased to run deficits (or surpluses) on a sustained basis, the central bank would run out of bonds to sell (or would accumulate too many bonds, offset on its balance sheet by a treasury deposit exceeding operating limits). Hence, policy is coordinated between the central bank and the treasury to ensure that the treasury will begin to issue new securities as it runs deficits (or retire old issues in the case of a budget surplus). Again, these coordinating activities can be varied and complicated, but they are not important to our analysis.
When all is said and done, a budget deficit that creates excess reserves leads to bond sales by the central bank (open market) and the treasury (new issues) to drain all excess reserves; a budget surplus causes the reverse to take place when the banking system is short of reserves. Bond sales (or purchases) by the treasury and central bank are, then, ultimately rigged by deviation of reserves from the position desired by (or required of) the banking system, which causes the overnight rate to move away from target (if the target is above zero).
Bond sales by either the central bank or the treasury are properly seen as part of monetary policy designed to allow the central bank to hit its target, rather than as a government “borrowing” operation. The interest rate target is exogenously “administered” by the central bank. Obviously, the central bank sets its target as a result of its belief about the impact of this rate on a range of economic rabbles that are included in its policy objectives.
In other words, setting of this rate “exogenously’ does not imply that the central bank is oblivious to economic and political constraints it believes to reign. In sum, the notion of a “government budget constraint” only applies ex post, as a statement of an identity that has no significance as an economic constraint. When all is said and done, it is certainly true that any increase of government spending will be matched by an increase of taxes, an increase of high powered money (reserves and cash), and/or an increase of sovereign debt held. But this does not mean that taxes or
