Monday, 23 July 2012

The nature of money

This rather rambling post is sparked by recent discussions with, among others, Positive Money and assorted goldbugs,  FTAlphaville's fascinating posts about e-money in Kenya, and the World Bank's wide-ranging investigation into forms of money used by those who don't have bank accounts - which (unbelievably) is more than half the world's population.

People seem very confused about money. We have Positive Money saying that banks create money when they lend, but that in order to make payments they have to be supplied with money by the central bank. Then we have Tim Worstall insisting that banks don't create money when they lend - despite the fact that loan accounting involves the creation ex nihilo of a real deposit which can be spent like any other sort of deposit. Yes, the spending of that deposit has to be funded - but that brings us back to Positive Money and central bank money creation for payments.......

As is usual when people have a major argument about a particular point, and neither side will give way, both are missing the point. They both define "money" far too narrowly, and therefore end up with definitions of money that not only differ from each other, but also exclude many of the forms of money used in our society. 

So first, let me define what I mean by money. Actually this is not just my definition - it is the standard economic definition. Money is a medium of exchange in transactions. Any good which is widely accepted as payment for goods and services is, by definition, money.

Once you accept this definition of "money", it becomes evident that we have more than one type of money circulating in our society. What we normally think of as "money" is actually currency, which is not the only type of money around - as I shall demonstrate. And even currency comes as more than one type of money. 

Currency is one of the factors that determines national identity and ensures self-determination, and it is therefore at least partly a political construct. The ability to define and control currency is an essential function of a sovereign state. When a country voluntarily or involuntarily adopts a foreign currency as its national currency, it loses a degree of sovereignty: it is no longer able to control the value of what is usually the main form of money in that country, and that affects its ability to manage its own economic affairs. 

In modern nations, currency comes in more than one form. Cash is made up of banknotes and coins, which in most nations are produced by the central bank and/or by authorised banks on behalf of the government. Controlling the amount of physical cash in circulation is a central bank function, and compared with other forms of money very easy to do. In developing countries, physical cash is still the primary means of settling transactions in national currency, as many people don't have bank accounts. 

But in Western countries these days, most of the currency in circulation doesn't exist in the form of physical money - it exists in the form of currency-denominated balances in bank accounts. In these days of internet banking, point-of-sale electronic payment and internet sales, bank account balances are as widely accepted as cash. They ARE money, regardless of how they were created - as are debit and credit cards. And many of those balances are created, or at least topped up, by bank lending. Bank lending DOES create money.

The situation in developing countries is somewhat different. Bank lending is much less important there as a means of money creation, and bank balances are not the main form of money as they are in the West. Cash is still king, but e-credit on mobile phones is fast becoming an equally important means of settling transactions.  E-credit can be regarded as an alternative to the national currency: it is exchangeable with national currency at a rate of exchange which is currently determined by the credit provider. Countries where e-credit is widely used, such as Kenya, can be regarded as having more than one currency in circulation. 

There are other types of money that are not convertible with national currencies. Many of these have restricted usage, but within those parameters they still meet the definition of "money" as a medium of exchange. Lewes pounds, for example, are widely accepted in Lewes in payment for goods & services, but they are not accepted anywhere else and are not convertible into sterling. Tesco clubcard points can be collected (saved) and used to pay for a wide range of goods at Tesco stores and from their online shop, but they cannot be exchanged for cash and are not accepted outside Tesco. Perhaps the most widely used form of non-currency money in the UK is Air Miles, which started life as a way of saving up for expensive air tickets and has "morphed" into a way of acquiring non-currency credits that can be accepted in payment for a wide range of goods and services. 

There are also true international e-currencies. Bitcoin is gradually becoming more accepted - despite recent security breaches. Paypal accounts have their own credits and are now available on mobile phones.

There are types of money that have specialised restricted use - that we don't normally think of as money. Some people find it helpful to think of central bank reserves as a different form of money that is created only by central banks and used only for transactions between banks. It is denominated in national currency and exchangeable one-for-one with bank credit, which is also denominated in national currency. Banks can - and do - place excess deposits in reserve accounts at central banks for safe keeping, usually for a few basis points in interest. These deposits become liabilities of the central bank, and therefore "morph" into central bank money ("reserves") while they are held on deposit there. When they are withdrawn they become private bank money again. Confusion arises because the central bank has to ensure there is enough money the system to enable all banks to keep zero or positive balances in reserve accounts overnight: when the throughput of payments increases and/or some banks choose to keep higher reserve balances, therefore, it has to create more money. This is entirely separate from the money creation that private banks do, and therefore some people prefer to think of these as completely different types of money even though they are both denominated in national currency. Personally I don't find it helpful to think of central bank reserves as a restricted form of money. I find it more useful to think of the central bank payments mechanism as a pump, and reserves as the oil that lubricates its operation: adding more reserves, up to a point, enables the pump to run faster, which increases the throughput of payments and should improve the velocity of money in the economy. It does not necessarily encourage more lending, though.

Another type of money that has a restricted use is government debt. I've noted before that currency and government debt are simply two versions of the same thing - currency is perpetual zero-coupon debt securities. Here I note the same thing the other way round - government debt is time-limited interest-bearing currency. And it acts very like money in the financial markets: the shorter the maturity, the more like money it behaves. High-quality government debt is a primary source of the collateral that lubricates money transmission in the shadow banking system.

The proliferation of types of money means that our measures of money are deeply flawed. In the UK we have "narrow money", which is notes & coins in circulation plus central bank reserve deposits. We have "broad money" (M4), which is notes & coins plus private sector deposit balances (including commercial paper). But those are not the sum total of money in circulation. They don't include Government debt apart from currency. They don't include Paypal credits, Tesco Clubcard and Nectar points, Air Miles or local currencies such as the Lewes pound. They don't include mobile phone credits (a pay-as-you-go phone is in effect a pre-loaded cash card): admittedly, in the UK mobile money is not yet widespread, mainly I think because so many people have bank accounts that it is just as easy to use the existing payment systems. But the breakdown of trust in banks means that this may change, and as it does so we will find our measures of money departing further and further from economic reality.

So if we aren't even measuring the supply of money accurately, what hope is there of controlling it? And do we really want to, anyway?  Positive Money, among others, would like to restrict all money creation to the central bank. Are they therefore proposing that the Bank of England should control Paypal credits, Tesco & Sainsbury loyalty cards, Air Miles? Hardly. They are only talking about ending bank credit creation - and personally, as I have said elsewhere, I think this is misguided. But they don't even recognise the existence of other forms of money: they believe that notes & coins, central bank reserves and private bank credit are the only forms of money in circulation. Because of this their primary aim, which is state control of the money supply as the main monetary policy tool, is fundamentally flawed.

National control of electronic money that is not denominated in national currency is simply impossible.  Paypal, Bitcoin, Air Miles, e-credit - all of these are actually or potentially international. And that I believe is the way that money will go. Countries will continue to have their national currencies, but there will also be international e-currencies which will have fixed or even variable exchange relationships with national currencies. At the moment e-Safaricom credits in Kenya are exchangeable with the Kenyan shilling. But it wouldn't be difficult to make those credits additionally exchangeable with, say, the US dollar, would it? And once exchangeable with the US dollar, they would be exchangeable with all other traded currencies too.

If the future lies with international e-currencies competing freely with national currencies, it is questionable what role if any there could be for a central bank money supply policy. More radically, it is also questionable whether interest rate management, which has been the central plank of monetary policy in Western economies for the last thirty years, would be the best way of managing national economies in a world of international currencies. Most e-currencies are not interest bearing, so it seems likely that interest rate changes would only affect them through their exchange rate with the national currency. But why would an international e-currency operating in the UK necessarily be anchored to sterling? Even if it accepted sterling credits, it could well convert them to e-credit via the US dollar. Perhaps it is time to reconsider the monetary orthodoxy that influences both money supply and exchange rates by means of domestic interest rate changes?  I would venture to suggest that when national fiat currencies exist in parallel with international e-currencies, exchange rate management may become more important than interest rate management: these currencies would be likely to act as international currency anchors rather as gold did in the Gold Standard era, and there may need to be international co-operation in the management of national exchange rates to e-currencies. Perhaps it is time for a new (virtual) Bretton Woods?

Whatever form of money people choose to use, they need to have confidence in it. When confidence in a form of money breaks down, people stop using it. Bitcoin and Paypal have both had security breaches that have affected confidence, and both have seen a significant decline in usage as a consequence. When people lose faith in a national currency, they turn to a foreign currency that they trust, often the US dollar - so we have "dollarization" in the unofficial economy, often coupled with strict exchange rate control in the official sector. This was the situation in the Soviet Union prior to the fall of the Berlin Wall in 1989. When I went there in 1982, the existence of the "dollar market" was evident. People would buy consumer goods from tourists that they could exchange for dollars: I remember being asked if I would sell my watch. Some tourists deliberately brought in goods that they could sell. Selling consumer goods for roubles meant that you got a much better exchange rate (from a tourist's perspective) than if you exchanged sterling or dollars at the official rate: we all knew that the locals would then sell those goods on the black market for dollars, which would enable them to buy things that were either unavailable or ridiculously expensive in roubles. When the population rejects a national currency and there is no exchange rate control, the currency becomes worthless and the result may be hyperinflation.

Some people confuse money (medium of exchange) with a store of value. These are the people, generally, who want money to be intrinsically valuable in its own right - gold, for example. This is nonsense. Money does act as a store of value in the sense that it creates a means of valuing goods that otherwise would be difficult to compare. But it cannot have intrinsic value in itself.  No good is "intrinsically" valuable: the value of a good is ALWAYS determined by its usefulness to the holder. If I am starving, gold is worthless to me unless I can exchange it for food - and if everyone is starving, a loaf of bread may be far more valuable than a gold ingot.  

Stores of value generally are things that don't decay and whose value tends to appreciate over time - property, art, wine, precious metals, debt securities, stocks & shares. To be actually valuable, stores of value have to be realisable in terms of some kind of money. Therefore it is not surprising that some people loosely describe "money" as a "store of value". But that is an incorrect definition of money. For example, gold is currently a store of value. But as the entire world is currently operating paper currencies, it is not currently a medium of exchange, however much some people might like it to be. It simply is not widely acceptable as payment for goods and services. Therefore gold at present is NOT "money", though it often has been in the past.  It is, however, an excellent store of value. 

It is the people who confuse money with a store of value who tend to be most scared of inflation. This is understandable, because if you believe that your personal worth is determined by the value of the money that you hold, depreciation of that money is disastrous. Paper money (what we call "fiat" currency) is not a good store of value: inflation is a feature of fiat currency systems and over time nearly all fiat currencies will depreciate to a greater or lesser extent. But that is not a good reason for adopting commodity money, such as a gold standard. Nor is it a reason to defend the international value of a currency at the price of domestic economic devastation. Rather, it is a good reason not to keep your long-term savings in the form of fiat currency!

I believe that the safest and most effective store of value is not any sort of non-perishable "good". It is investment in productive activity and engagement with society to promote economic growth and gain a return from that growth. Hoarding doesn't help anyone: if everyone hoards, money ceases to circulate, productive activity collapses, and hoarded goods become worthless as loaves of bread become more valuable than gold.....  

Related posts:

The shoebox swindle
The shoebox shortage
Do we really care who creates money?


  1. But money in bank accounts is only provisionally a means of exchange, the provision being that it's only available to spend as long as most people don't actually do so. If everyone who thinks they have money in the bank that they can spend were to go out on the same day and try to actually spend it, they would quickly discover that they're wrong. So banks don't actually create money, they just spread it thinner between different people so that lots of different people all think the same money is theirs, and as long as only a few of them try to spend it at once then everything works out.

    1. "they just spread it thinner" so then you make extra money only it is thinner. Everybody knows it is still money even if the bank runs out of paper money.
      Frances just explained how money creation actually works: you go to the bank and tell them you need money to buy a house, they create out of thin air the deposit for you to use and a loan you owe the bank. When you use your deposit and transfer the money out of your deposit into your sellers deposit there is money created and it made its way into the money supply of the nation you are transfering the money to.

  2. Your definition of money is too narrow. Money can be simultaneously a means of exchange AND a store of value (which I think is a large part of the problem**). What of these £13Bn TJN reported is hidden away in offshore accounts by the super-rich? That is money being used simply as a store of value, and who can blame anyone for holding "cash" when the prospect for profitable investment is so dire?

    ** Demurrage (?spelling), or negative interest, seems to be a good way of separating these two functions of money - such as to bring about your definition as restricted to a medium of exchange. In that case the aforementioned trillionaires would doubtless seek to invest in more constructive ways (perhaps they might even be long-sighted enough to finance the essential ramping up of renewable energy supply)

    1. On the contrary, you are confusing money and currency. I would deny that currency hidden away in offshore accounts, and therefore removed from circulation, is money at all. Nor is currency stuffed under mattresses - the non-computer equivalent. If it isn't circulating, it isn't money.

      Currency can of course be used as a store of value. I did point out in the post that fiat currency is not a good store of value because it is subject to inflation, and that less liquid investments would be preferable.

    2. But all these offshore accounts yield interest or is used to buy shares, property etc. So it is still in circulation isn't it?
      I do agree that currency stuffed under mattresses is out of circulation and is not counted as money by others than the owner. As long as it is legal to buy stuff with it he can still regard it as money.

    3. If the money is used to buy shares, property etc. then it is not in an account any more, is it? It's been converted into a true store of value, as I suggested.

      Interest on offshore accounts may or may not be money. It depends how the return is generated and what is done with the interest.

      These days you need to think about funds in NON-interest bearing accounts, too. People are hoarding currency in non-interest bearing accounts because they have government insurance - a form of safe deposit box.

      I am very reductionist in this post, so there will be "grey areas" where my definitions don't appear to fit. That's part of the fun. Humans are messy creatures and rigorous logic isn't always an adequate descriptor of their behaviour.

    4. You're absolutely right :-)
      I even know they hoard it without government insurance in offshore accounts as long as it stays out of sight of the tax department.

  3. Hello, I read your post and found it extremely interesting. I try a much less integrated approach of the "physical meaning" of banknotes in my post at, where I propose the abolition of banknotes and the use of only coins for the small transactions and electronic or mobile payments for all others.
    I' d like to have your comments on this idea that seems capable to tackle effectively the Euro zone countries' debt crisis along with a great deal of social issues.

    1. It's the direction in which we are going, I think. Cashless society and virtual payments are the future.

  4. Frances, Your article gives the impression that Pos Money are the first to advocate full reserve banking: they are not. Milton Friedman, Irving Fisher, Lawrence Kotlikoff, and several Nobel laureate economists advocate or have advocated the idea.

    Re the idea that full reserve somehow rules out Air Miles or Tesco loyalty cards, I don’t agree. Under full reserve, what’s to stop Tesco crediting customers who had spent the requisite amount just as they do now? Tesco does not create money ex nihilo, which is what advocates of full reserve object to the private sector doing. Tesco awards “credits” to those who have ALREADY spent money at Tesco. I.e. Tesco effectively gives back to customers some of the money those customers have spent.

    Re internationally transferable e-money, I agree that the easier this is to transfer and exchange for the currency of any given country, the more difficult it becomes for those running a full reserve system to control the situation. But very similar problems occur under fractional reserve.

    For example when a central bank under a fractional reserve system (and assuming no exchange controls) raises interest rates with a view to damping down an overheated economy, that just draws in hot money which counters the intended effect of the interest rate rise.

    Having said that, I’m not really up to speed on how a central bank trying to operate a full reserve system stops incoming money from boosting the money supply. But I assume Prof Richard Werner who advocates full reserve has go this worked out.

    1. Ralph,

      The issue I am raising is that central banks do not, and cannot, control the entire money supply where there are privately-created currencies circulating, especially when those currencies are international. Therefore Positive Money's central proposal that central banks should control the money supply directly as the main macroeconomic policy tool is in my view fundamentally flawed. It wasn't workable when Friedman proposed it and it's even less workable now when we have international e-currencies floating around the place. Whether those e-currencies are "full reserve" or "fractional reserve" is frankly irrelevant. The point is they aren't under central bank control and if they are international they never can be.

      I know there are many notable economists who support full reserve banking and centralised control of money. Their analyses take no account whatsoever of virtual currency. On that basis I believe their analyses are incomplete. But even if they were complete, I don't have to agree with them.

  5. Frances,

    You're right, of course, to include Tesco credit, Air Miles, and the rest of them as types of money. What you appear to be missing is the notion of 'general acceptance'.

    If any of my clients tried to pay me in any of the above I'd tell them to get lost and pay me in sterling. If I tried to pay Her Majesty's Revenue with any of the above their response would be similarly dismissive.

    Money is only money if two people agree that it is. The vast majority of us agree that sterling is our primary currency - the one that everyone will take. Dollars, euros, Tesco points, Air Miles are all secondary currencies that have limited appeal for transactions within the UK.

    Positive Money is proposing democratic control of the amount of primary currency that is available in our economy. Their proposals for exercising that control are flawed but not nearly as flawed as the present system where the amount of money in the economy and where it is spent is determined by private, profit-driven companies.


    1. Malcolm,

      I seriously suggest you stop looking at this with Western eyes, and see what is happening in the rest of the world. M-Pesa is set fair to become Kenya's PRIMARY medium of exchange, overtaking the Kenyan shilling. We are not as far ahead as that in acceptance of e-money as primary exchange media, and that is because here most people have bank accounts so it is easier to use bank payment systems. But in most of the world the majority of people DON'T have bank accounts. In the world as a whole, far more people have mobile phones than have bank accounts. That is why e-money is so important, and we will have to adopt it if we wish to do business with emerging markets in future.

      There is absolutely nothing to stop people transacting in global e-currencies if they wish - and I believe they will increasingly choose to do so. It is only a matter of time till mobile phone companies introduce e-credits here: mobile money platforms are already well established in many emerging markets, not just Kenya. They will of course enter our market as competitors to existing payments systems - but that is a good thing, surely?

      Our measures of "money in circulation" are already deeply flawed because they exclude other forms of money. Nationalising and centralising the "money supply" when currencies are becoming global and borderless is a doomed strategy. That is why I think Positive Money's ideas simply miss the point. Their definition of money is far too narrow and they don't see the implications of developments in global finance.

  6. Frances,

    Replacing one currency with another as the primary means of exchange doesn't remove the need to control the quantity and velocity of money in the economy.

    If the M-pesa replaces the shilling as Kenya's de-facto currency this means that the owners of the M-Pesa system will have become the central bank of Kenya and will have the responsibility to ensure that the Kenyan economy has an adequate supply of money.

    A global e-currency may emerge to replace the US dollar as the primary currency for international transactions but it won't become the primary currency for national/regional transactions. If it did we'd end up with a mess similar to the one we see in the eurozone. Different economies need different quantities and velocities of money to keep them running sweetly. Different societies have different ideas about how money should be used for the common good. Without political and fiscal union a common primary currency won't work.

    Regardless of it's geographical reach, the quantity and application of a primary currency will be controlled by someone. We can leave it to the operators of the exchange systems for their private benefit, or we can control it for the benefit of the population as a whole. Positive Money might not be proposing the best solution but they're certainly heading in the right direction.

    1. Money supply as such is not directly controlled by anyone: it responds to demand. Central banks indirectly control demand for money by means of interest rates and other tools - or at least they try to, though the effect is very diluted - but the monetarist notion that the money supply can be directly controlled is simply unworkable unless the central bank has a monopoly over currency issuance, which in an era of global e-currencies it can't possibly have. Restrict the supply of one good and people will switch to competitors.

      We are reaching the end of the era of national central banks, centralised money issuance and attempts at national money supply control. Just as business now transcends national boundaries, so too will currencies.

    2. Money doesn't just appear out of nowhere. A select band of people make it and destroy it to suit their purposes.

      The money supply is controlled directly by the central bank (issuing or destroying notes and coins) and by the private banks extending loans and determining the repayment period. The latter don't respond to demand, they respond to what will make them the biggest profit. In fact, they're very good at creating demand - the mortgage boom being a prime example of this, credit cards being another.

      "Restrict the supply of one good and people will switch to competitors."
      How does that work with money? If I'm short of money how can switching from sterling to an e-currency get me more money?

      "We are reaching the end of the era of national central banks, centralised money issuance and attempts at national money supply control."
      You seem to be stuck on this notion but the evidence of the eurozone is suggesting the opposite. Trying to run disparate economies with a common currency can only work with common political and fiscal policies. What makes you think this is going to happen on a global scale?

    3. I disagree that the money SUPPLY under normal circumstances is controlled by anyone. Demand for money generates profit for private banks, and it is demand for money that is manipulated both by central bank (interest rates and other tools) and private banks (interest rates and other incentives to borrow). I agree the distinction is a fine one, though. At the moment banks are actively discouraging borrowing by anyone except really good risks, and central banks are trying to counter that by keeping interest rates low.

      Do you really think that private currency creators won't respond to shortages of national currency by making it easier and cheaper to get credits? That's how competition works. Your problem is that you can't imagine having competing currencies.

      The Euro is not a global currency in the sense that I mean it - which is a currency that simply transcends national borders and is not the "national" currency of anywhere. It is the national currency of 17 independent sovereign countries, and therein lies the problem. But I did comment in the post that globalisation of currency might require international co-operation in the management of those currencies - something like a new Bretton Woods. Economic divergence would only become an acute problem, though, if global e-currencies were adopted as national currencies (i.e. nationalised in individual countries or taken over by a group of countries, Eurozone-style). Despite my comments about Kenya, I don't think this is very likely, nor do I think it is desirable.

    4. "Do you really think that private currency creators won't respond to shortages of national currency by making it easier and cheaper to get credits?"
      Well, we've been suffering from an acute shortage of sterling for the last three or four years and I haven't seen a single offer of credit from any alternative currency creator. At the moment the private currency creators (the banks) are all wedded to sterling and are competing to be as conservative as possible in issuing credit.

      "Your problem is that you can't imagine having competing currencies."
      I can imagine it. I've experienced it in countries where people accept both the national currency and the U dollar. It's inconvenient, requiring a lot of mental arithmetic to ensure you're not being ripped off. The thought is having to do the sums for three or more competing currencies is not attractive.

      Even competing means of exchange within the same currency are a pain. In the 1980s in the US my cheque from the Camden Bank was unreliable as a means of exchange even in other parts of Maine. In neighbouring New Hampshire and beyod it was useless. Scottish banknotes are still refused in some parts of England.

      Primary currencies evolve because they're convenient - general acceptance is a very powerful attraction. But when a currency becomes ubiquitous the people who control its supply control the economy and the well-being of the population that use the currency.

    5. None of the examples you give are e-currencies. What we are looking at is the development of currencies that are issued by multinational corporations, not countries, and are therefore independent of borders. And at the other end of the scale we are also seeing growth of local currencies - I cited the Lewes pound, but actually my own area, Medway, also has its own form of money, and it is not the only one. International use and local use of money are entirely different and I doubt if people will have any difficulty at all getting their heads around this. Obviously government will continue to expect its taxes in the currency that it issues, but otherwise I think competing currencies are here to stay and we need to change our measures of money to accommodate them - and recognise that our approach to monetary policy may also have to change.

    6. I'm sure you're right to say that new currencies will emerge over time, and that we need to account for these when measuring money supply and deciding policy, but there will always be a primary currency that is generally accepted within a nation's (or federation's) borders and that's the one that needs to be democratically controlled.

    7. Malcolm, that primary currency is the monetary base. No other measure of money is capable of being "democratically controlled" where there are many different media of exchange in circulation, some of which are international, others local, others with restricted use. Money is so much more than primary currency.

  7. You're getting close to the real crux now.

    You left out another major function of money: as a medium for settling accounts. This is an incredibly important function because it creates the demand for a particular currency. The state imposes taxes and decides the currency in which these taxes must be paid.

    Failure to pay in the determined currency leads to imprisonment. So as long as Her Majesty's Revenue and Customs insists on receiving GBP to settle your account with them, you'll need to get hold of GBP, regardless of what other currencies might be available.