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Understanding modern money

Money is what money does. It serves as a medium of exchange and measure of value. These two functions of money have remained consistent through long periods of history. What keeps changing is its form. If society deems some item as a quick and easy tool to satisfy debts, then that item becomes money.

In the recent few years, we have seen highly innovative monetary policies such as Quantitative Easing and negative rates, and it looks increasingly likely that further innovations in the monetary operations are around the corner due to existing tools becoming less effective with time. Most developed countries are also clamoring for increased public spending, something that is deemed unsustainable in the current monetary framework due to the already high indebtedness of governments. Interestingly, there is a school of thought, that is growing in popularity among important politicians, and that believes a solution could be worked out on this problem by tweaking our understanding of present-day monetary systems.

Considering this information, I believe that it is vital to have a better understanding of how money works in our system so that we could have a more informed view on potential changes to the monetary regime. I hope my article helps in contributing to that.

Evolution of Money:

Just like means of organizing production have evolved with time so has the form of money. Starting from a barter economy, we went to an economy in which precious metals of various shapes and sizes were used as money. Soon based on convenience, they got replaced by receipts which merely indicated a claim to these metals. Then banks came into the picture, and they started to provide loans denominated in these receipts. Thus, individuals borrowed money in receipts with an obligation to pay back in receipts. As a result, receipts got created whenever a loan was issued and got destroyed whenever a loan was paid down. At this point, we had receipts which did not have any commodity backing and was merely a product of credit but were indistinguishable from the receipts which had metal backing. This phenomenon was rooted in the belief that not all holders of the claims to the metals would demand the underlying metals at any given time.

Modern Money:

Modern Money is primarily of two types, central bank money and commercial bank money.

Central bank money (monetary base) comprises the bank notes in circulation and the accounts that commercial banks have with the central bank (commonly known as banking reserves). The money created by the central bank and distributed in the economy has a legal basis because of which it cannot be deemed unacceptable in any transaction. Bank reserves are interchangeable with bank notes at no cost as per demand in the economy.

Anyone in possession of either of them essentially holds an IOU from the central bank that it could transfer as a means of payment.

The monetary base can be compared to the actual holding of metals by banks in our historical example since they both serve a similar purpose. The only difference is that central banks can modify its balance sheet in numerous ways to change the quantity of the monetary base.

Commercial bank money: Banks create money by issuing loans. The process involves creating a deposit at the bank for the costumer as well as imposing a liability on him. The banks' assets and liabilities undergo similar changes.

Now, since the new deposit in the customer’s account can be used for transactions, it becomes a part of the money supply. The deposit represents a claim to the monetary base by giving the right to its holder to withdraw cash (currency) or make a payment to another bank ( through reserves).

The paying down of debt causes reverse effects on the balance sheet and is thus equal to destroying money.

The banks have no technical constraint on the amount of deposits that it can create through this process. They only face constraints in lending due to the possibility of default by the costumer, in which case the bank will have to register a loss, and the limited availability and cost of reserves which they must hold in cases of withdrawals and transfers. Note that reserves can be borrowed from the central bank or in the interbank markets at rates which are determined by central bank operations. These rates are the main policy tools to control money supply in the economy.

Role of government:

The government's role is to provide to the citizens' various types of goods and services which the market may fail to provide either efficiently or equitably.

Its financial working is similar to any other economic unit like an individual or corporation to the extent that it has to secure funding for all its expenditure. One source of funding that is only available to the government is tax money. Expenditure not financed through taxation and other revenues (fiscal deficit) must come through borrowing in capital markets, i.e., by issuing government bonds.

Government expenditure takes place by crediting the bank deposit of individuals from whom it has made purchases as well as crediting the reserve balances of their banks by an equal amount. Taxation and revenue collection lead to precisely opposite effects.

Role of money:

So far, we have only discussed what is money and credit but not how it truly affects economic output.

To do that, I will bring out a handy and straightforward economic model introduced by Warren Mosler in his study on Modern Monetary Theory along with a few modifications.

Consider a parent with several children. Each of the children has a unique set of talents, like singing, dancing, etc. that he/she could perform for the benefit of others. Despite that, the parent observes that there is very little (positive) activity going on. Children are sitting idle even though they could all be happier by performing for others in return for watching others perform. This situation is due to the difficulty in negotiating the different proportions of performances to be exchanged between the children.

The parent has an idea which is to provide a given number of tokens to some of his children in return for their performances ( Government spending) and impose a liability on each one of them to furnish a fixed quantity of tokens by the end of the day (tax). Note that these tokens do not have any intrinsic value to the children. Nevertheless, a demand for the token is created to satisfy the initial liability imposed on the children which causes the tokens to be exchanged for performances such that everybody ends up with the required number of tokens. This process leads to the acceptance of tokens as a medium of exchange. Now, the performances will have prices in terms of tokens and each child would be able to do transactions in a way to maximize utility, something which was not possible earlier.

There is space for more institutional changes that could further improve the outcome. Take for example the presence of a bank that creates tokens by issuing loans. Suppose that it identifies a child that is sitting idle and wants to learn a new talent in order to command a better price for his services but does not have enough tokens to afford learning services. The bank decides to lend tokens to the child. The result could be that the child finds success in his endeavors and manages to repay the debt and increase his income. So overall, we would have a net positive impact in the economy (growth) due to an increase in the production of services.

Now consider a situation in which banks already exist but are finding it difficult to find children with the ability to repay loans. This could be due to an overall decrease in consumer confidence among children caused by increased indebtedness or uncertainty about the future. Children may have borrowed a lot of tokens over time and are now focusing only on paying down their debt and less on consumption. Alternatively, the banks themselves could be running losses due to bad loans leading to increased selectivity in loan offerings.

In both cases, and primarily in the first, reduction in interest rates will not cause more loans and more activity. Hence monetary policy becomes ineffective. There would still be unutilized capacity in the economy. As a result, the children will not be able to bring their potential talent to the economy.

This situation demands that the parent (government) add more tokens by buying performances (government spending) or by giving them for free (basic income) in order to move towards better capacity utilization.

Unfortunately, if the parent has to obey the present-day financial mechanism of governments, it will have to run deficits and issue debt to fund the excess spending. This increase in debt would lead to increased scrutiny from markets concerning interest payments, solvency and private sector crowding out, thus constraining the governments capacity to run deficits and spend in cases of downturns and recessions.

Modern Monetary Theory seeks to absolve governments of such issues arising out of government debt. It gives the power to governments to not balance their books (not issue market debt ) and judiciously use spending and taxes to maintain an economy always close to full employment.

In the existing framework, we could think of this mechanism as central bank purchase of all newly created government debt. Thus, any excess spending over revenue by government would lead to increase in reserves and a larger monetary base. The monetary base would then become a variable that is in control of the government.

This control over the monetary base by the government is what causes most academics and professionals to shudder. The government’s focus on short term outcomes and lack of technical expertise, are among the many reasons why the it is thought that that control over the money supply, whose expansion creates short term growth but more importantly risks long term inflation, should be held by semi-autonomous institutions such as the FED and not Congress.

There are arguments in favor of increased collaboration between central banks and government to work together on economic matters. However, the political economy of such a partnership remains undeveloped. In my opinion, the inevitable ( or not) quantitative tightening will serve to highlight the current framework for government and central bank to resolve contentious decisions on monetary issues and fiscal issues, which could then serve as the basis for changes in the monetary regime.

WRITTEN BY Simon Schoenherr FOR BESA


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