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