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Chapter 2, Part 1 of 3: Most of us use money every day. And as a result, we have a good feeling for what money is. Right?

Wrong. The paradox of money is that it has to feel like its valuable, but using a valuable as money introduces serious macroeconomic problems. Therefore, we have a system where something that is instrinsically worthless is given a value by the role that is plays in the system. To draw an analogy, the value of money is like the value of Benjamin Martin as played by Mel Gibson in The Patriot, not the value of Mel Gibson himself as a drunk driver spewing anti-semitic vitriol by the side of the highway.

Is this a difference that makes a difference? Misunderstanding money means that we misunderstand individual saving. Misunderstanding money means we misunderstand the national debt. So, yeah, this is a difference that makes a difference.

Modern Fiat-Currency

If you want a picture to accompany the following, you can find one here.

The traditional marginalist economic textbooks typically start their discussion with a tale about a past society, describing how money emerges from the practice of barter. And since the historical and archeological record does not back them up, it is safe to say that this tale is a myth. Like all myths, it works in part to convey a conventional wisdom about how the present day world works ... in a format that removes that conventional wisdom from looking around at the world around us to verify or refute that conventional wisdom.

So, I'll start with the present day rules of the game. This is about the general rules of the game in a reserve-banking system, which is the general system in operation in the US, Euro Zone, UK, Switzerland, Japan, China, Russia, ... well, for the moment, let me say in operation in most of the world.

Rule number 1: As long as banks have reserves on account with the central bank, they are allowed to withdraw those reserves as cash. If there is no enough currency on hand at the central bank, it sees to it that more is printed. As long as banks have cash on hand, they are allowed to deposit that cash with the central bank to be credited with reserves.

Rule number 2: Government checks issued in domestic currency do not bounce. They clear. They clear whether or not there are tax receipts received in the same period to allow them to clear. And when they clear, they introduce reserves into the private financial system.

Rule number 3: When tax payments clear, they remove reserves from the private financial system.

Rule number 1 tells us that "printing" money is not about the quantity of money in the system, but only about the form that the money will take. It also tells us that decision occurs in the private sector, not at the central bank. Under our system, reserves translate into cash and cash translate into reserves.

Rule number 2 tells us that the government injects reserves into the system when it spends, and Rule 3 tells us that it drains reserves from the system when it taxes. Therefore, while the form that the currency takes is not under government control, the tax and spend decisions of the government directly creates and destroys currency.

Rule 4: If a Central Bank lends reserves to a commercial bank, it enters those reserves in the account of the central bank without deducting from any other reserve account. And when it receives a reserve loan repayment, it deducts those reserves without crediting any other reserve account.

Rule 5: If a Central Bank buys a financial asset from the private sector, it enters reserves as payment in the account of the central bank without deducting from any other reserve account. And when it sells a financial asset, it deducts those reserves without crediting any other reserve account.

Rules 4 and 5 tells us that the monetary authority also has the ability to create and destroy reserves.

Therefore, reserves are created and destroyed by the actions of the fiscal ("tax and spend") authority and by the actions of the monetary authority. The net result of those actions determines the total amount of reserves in existence.

I am going to use the following language: I will call currency in circulation "cash"; and I will call Central Bank reserves "fiat-currency", to keep in mind that it is created and destroyed by "sovereign fiat".

Modern Money

Now, before I move on to modern money, I have to define the term. What is money?

In particular, how can we define money so that we can talk about different monetary systems, across time and place, and talk about possible reforms of monetary systems?

The approach I take is the old-fashioned "duck" approach: if it walks like a duck and quacks like a duck and flies like a duck and swims like a duck, its a duck. That is, I am going to define money by the roles that it plays ... so that anything that plays all the roles of money is money for that economy at that time and place.

And what are those functions?

  • Medium of Exchange. You can buy something with it in a market transaction.
  • Store of Value. It still works as money in the future.
  • Standard of Deferred Payment. You can draw up a contract for deferred payment in that unit, and have the court enforce payment.
  • Unit of Account. You can use it to take stock and to track receipts and payments.

Clearly, cash is money when it is in circulation. Obviously, cash held in reserve at a bank is not money, because the bank is not allowed to use it as a general purpose medium of exchange.

What else is money? I can walk into my local Taco Bell and buy a half pound Beef and Potato burrito and two standard crunchy tacos, and use a check card to complete the transaction (it would be foolish to do so, given the likely charges, but the example is about capability). Cash never changes hands. What happens is that my bank assures Taco Bell (electronically) that they will transfers reserves to Taco Bell's bank, Taco Bell accepts that assurance, and I get my faux-Mexican food fix.

So an account entry in a bank works as a medium of exchange. It is clearly a Store of Value. Given the transition, before WWII, to paying most wages and salaries by check, it is clearly a standard of deferred payment. And its in precisely the same unit as cash - which is assured by the freedom to translate back and forth between the two at a 1:1 ratio.

So an entry in a commercial bank account is money, as long as that bank can meet its obligations to its customers.

This is where money leaves the personal experience of most people, and so this is the place where the most widespread confusions about money takes root.

Modern Credit Money

Commercial Bank account entries are money as long as Commercial Banks can meet their obligations to their depositors. And the key obligation is to transfer reserves to make a payment into an account at another bank. That is, as long as a bank has credited your account, that credit is money. So I will call this "credit-money".

What rules apply to this settlement process? I'll consider two different payment settlement systems: overnight settlement, and continuous online settlement.

With overnight settlement, the total amount of payments between every pair of banks is drawn up on a nightly basis. If there is $280,000 in total payments from bank A to bank B, and $350,000 in total payments from bank B to bank A, bank B must settle by paying the net $70,000 to bank A. The central bank debits $70,000 from the reserve account of bank B, and credits $70,000 to the reserve account of bank A.

In most countries, a commercial bank cannot use its total reserve account to settle payments, since the central bank imposes "reserve requirements" on commercial banks. However, this would not present a serious problem in a pure credit-money system. If one bank is short of reserves -- they do not have as much reserves as they need -- that implies that another bank is long on reserves. So a bank that is short can borrow the reserves overnight from a bank that is long in the overnight, interbank market to lend and borrow reserves.

There is, of course, a fly in the ointment when customers can withdraw cash ... reserves that are used to acquire cash do not automatically end up in another bank. They can circulate for days, weeks, or, as in the case of a five dollar bill I once found in the pocket of my "job market interview" suit, years.

How do commercial banks cope with this? Sometimes - and increasingly - the central bank solves the problem for them. The shortage of reserves will be reflected in an increase in the interest rates charged in overnight reserve lending markets. If the central bank has a policy of stabilizing that interest rate, it will take actions to inject reserves into the system. However, that is not built into the system - its a policy stance of the central bank.

Suppose that the central bank thinks it is "targetting money growth rates", and forces banks to cope with the shortage of liquidity on their own. What can a bank do?

One way - which was a much more important tool in the past - is to increase interest rates paid on ordinary saving deposits. This serves to attract cash out of circulation into deposit, where it can be transferred to the Central Bank in return for a credit in the commercial bank's reserve account.

Another way - which has become more important over the last thirty years - is to advertise attractive rates on less liquid deposits, like certificates of deposit (CDs). Reserve requirements on CDs are lower than reserve requirements for "on-demand" deposits, so attracting funds out of "on demand" deposits into CDs and other less liquid accounts has the effect of "freeing up" some reserves so they can be used for clearing payments.

Of course, there is no guarantee how much and how quickly customers will respond to "check out our attractive rates on CD's". Therefore a third way is to sell a financial asset, like a government or corporate bond. The payment for the bond provides new reserves for the bank.

Now, selling a bond does not directly increase the reserves in the system ... its a game of hot potato. That means that it serves to spread the shortfall around the system. However, that recruits more banks into the kind of transactions that alleviate the pressure, so this kind of individual action to fine tune reserves serves a system wide function of spreading the burden.

That's the hard case. The easy case is continuous settlement. In order for continuous settlement to function at all, you have to provide commercial banks with an open-ended facility to borrow reserves from the Central Bank. This normally includes a penalty rate if those loans are not settled within the trading day. So if a bank operating under continuous settlement finds themselves in a liquidity crunch, and they cannot obtain funds in the inter-bank market at below the penalty rate, they simply hold the reserves borrowed from the central bank and pay the penalty rate.

How is Modern Credit Money Created?

New credit money is created by lending. This can be seen as an implication of a rule that we are all familar with, though we do not normally think through its implications.

Rule 6: When we borrow from a commercial bank, the funds do not come from the account of another customer.

We are all familiar with this rule in the negative. When we go to an ATM to withdraw funds from a checking account, we will fail if we were wrong about the balance. However, we will never fail because those funds have been lent to someone else. We never receive the message, "We are sorry for the inconvenience, but your money has been lent to Joe Bloggs, in a three year loan to purchase a 2003 Ford Explorer. Your funds will become available when he makes monthly payment number 25".

But if I borrow $320 to buy a folding Dahon Speed 7, and get a loan check for $320, then I expect that loan check to clear. So where does the money "come from"?

Remember that it is credit-money I am receiving - I am being credited with the amount of the loan. And that means that it "comes from" the fact that the bank wrote down a loan account entry that says, "credit BruceMcF with $320".

Once we recognize that a bank account entry functions as money, we should not be surprised that banks can create that money. They are taking on an obligation - the account that backs the loan check - and receiving an asset - the loan contract.

The crucial question is not how the bank can create the account entry. The crucial question is how it can clear the loan check. And we have already covered that above: if a commercial bank has sufficient reserves with the status of "free to use", then it can clear a payment.

Now, commercial banks do not create money on purpose. They are issuing loans to get their hands on the stream of interest payments. Those interest payments provide the income to pay the tellers, pay Diebold for the ATM machines, and pay the Bank President an exorbitant salary.

So credit money is created in a reserve-banking system as a side effect of commercial banks chasing interest income. And this chase by commercial banks is so effective that in most reserve-banking systems, credit-money is more than 80% of all money ... and in many wealthier reserve-banking economics, like the US, credit-money is more than 90% oif all money.

So what does the Central Bank do?

If commercial banks create the most common form of money in the typical modern economic system ... what does the Government do?

I have already walked through that ... I just did not underline it at the time. The Central Bank determines the interest rate for the shortest term, lowest risk type of private lending there is, overnight lending of reserves between commercial banks. And so while they do not directly control the quantity of lending that takes place, and the quantity of credit-money created, they can control (if they wish) the financial cost of the reserves that are used in the process of credit-money creation.

That's what we mean when we say that a Central Bank "sets" the interest rate.

Coming Up: Money in the Real World Versus Social Security Myths

The common "feeling" that modern money is instrinsically is intrinsically valuable is the source for a lot of confusion. And of course, once people find out that money is not intrinsically valuable, some react with the view that it should be intrinsically valuable.

But having intrinsic value would interfere with playing the role of money. If something has intrinsic value, that value can rise and fall. When it is expected to fall, that interferes with playing the role of a store of valye, and when it is expected to rise, that interferes with playing the role of medium of exchange.

Even worse, nothing can be intrinsically valuable if it can be created out of thin air ... so if money is something that is intrinsically valuable, we are setting the stage for banking panics. As long as people can withdraw reserves for use as currency, they can put pressure on the ability of banks to meet their obligations. If we had an intrinsically valuable money, there would be no certainty that the government can cover the shortfall if it wishes. Remove that certainty, and we encourage runs on a bank at a rumor of trouble.

"Solutions" to the problems of credit-money systems that involve providing an intrinsic value to money create more problems than they solve.

The understanding of what Modern Money really helped provide the foundation for the establishment of the Social Security system. Widespread misunderstandings about what Modern Money really has helped provide the foundation for past abuses that have hidden a general regressive income tax within the Social Security contribution. And the same widespread misunderstandings provide a theoretical foundation for the present effort to destroy the Social Security system and replace it with a "forced savings" system.

So that will be the topic for the case study.

Originally posted to BruceMcF on Thu Sep 21, 2006 at 12:09 PM PDT.

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