Over the last few weeks I’ve outlined how our current monetary system works, what problems this causes, and briefly outlined some of the ideas currently circulating for reform.
Clearly, if we are to have a healthy economy that provides enough for everyone we would need to create a functioning monetary system. However, this was not my primary reason for all this time spent discussing this system. We need to push deeper into understanding how saving and the accumulation of wealth have such a profound affect on the economy, and understanding money is just an essential building block for understanding this system of financial markets.
Yet mainstream economics generally ignores money – it is described as a ‘veil’ over the real economy (the economy for real goods and services) that doesn’t actually affect it. Those who believe money does matter are accused of suffering from ‘money illusion’. Standard economics textbooks might have a chapter, or even just part of a chapter, on the monetary system, but what is in the chapter is always factually incorrect.
I was going to write a post outlining the mainstream arguments and why they are wrong, but it would just take too long and I want to move on. I think we’ve already seen over the last few weeks that the process of money creation makes a vast difference, and the power in being able to decide where new money is first used in the economy is far from being an illusion. Mainstream economists leave money and financial markets out of their models, whereas the only economists to accurately predict the last crash (i.e. to predict the causes and the timing with a degree of accuracy, not just make vague doom-laden warnings) used models that did include them.
As my purpose in covering money has been to understand the system, I want to finish this section of the blog with a really useful model for understanding what money is. I’ve nicked this from Professor Perry Mehrling, who very much focuses on money and financial markets, and has coined the term “The Money View” to describe his approach. However, this is in no way a summary of his theory – I’ve just pinched one idea and I’m not even presenting it in the same way that he does – but I do need to credit where I got the model from.
Anyway, the idea derived from Mehrling I want to present to you is that monetary systems can best be understood if we think of them as a hierarchy. For example:
- Foreign Exchange
- Central Bank Reserves
We all think of our bank accounts (the third level in this hierarchy) as “money”. We buy things with what is in our accounts, we pay our taxes with it, and we don’t need to convert it into physical cash first. Deposits are our means of payment (the main purpose of money).
But when we make these payments, our bank has to transfer Central Bank Reserves (CBR) to the bank of the person that we are paying (an electronic transaction made between the banks’ accounts with the central bank). Final payment in any national monetary system is always in CBR, the second level of this hierarchy.
Our deposits are actually a claim on the CBR that our bank holds – our bank account is a statement of what the bank owes us. And of course, this money is created when banks make loans: all money is debt. Paper money started out as a promise to pay gold. These days, bank deposits are a promise by the bank to pay Central Bank Reserves – they will pay it to you in the form of cash, but more typically they pay it to the bank of the person to whom you need to make a payment. Bank deposits only exist because private banks are willing to lend multiples of the reserves they hold, and in that sense the money we use is created by the private sector. But this system is only stable because central banks underwrite deposits through deposit insurance, and of course they act as “lender of last resort” in a crisis. Indeed, deposit insurance and other forms of regulation were introduced because the purely private system was so unstable that the public became sick of the constant crises.
The Central Bank can create new CBR, and does so as part of monetary policy. Central Banks alter the level of reserves by buying and selling government bonds, in something called “Open Market Operations” (OMO). When it buys bonds, the Central Bank uses newly created reserves to make the payment, increasing the level of reserves in the system. If there are more reserves in the system this encourages banks to lend more, which generally leads to a fall in interest rates (if they are not already near zero) and stimulates the economy.
But the central bank creating new reserves in this way is not the same as creating new broad money, or of “printing money”. The effect of this action can only be felt on the rest of the economy if it does have the effect of encouraging banks to lend more. One of the reasons Quantitative Easing was such a spectacular failure is that banks remained highly reluctant to lend. To the extent that lending did pick up, it followed the old pattern of lending for housing and financial speculation, fuelling a house price and stock market bubble. Meanwhile, small businesses still struggle to access credit and the economy as a whole stagnates through lack of spending power. To understand the monetary system, you have to understand the role of the private sector banks in creating broad money, and the role of the public sector (the Central Bank) in creating CBR, the ultimate means of final payment.
Just as deposits are a promise to pay CBR, securities, the lowest level of the hierarchy, are a promise to pay deposits at a certain point in the future. If you own a bond, you will receive a regular fixed payment of an amount and at intervals specified on the bond, and you will receive a fixed payment at the maturity of the bond. Securities that are seen as very safe and easily traded for deposits in liquid markets – for example government bonds of stable governments – are seen as “cash equivalents”. Large institutional investors will prefer to hold their funds in securities rather than deposits, as they pay a higher rate of interest and in normal circumstances can easily be sold when deposits are needed. But in times of crisis investors may lose their confidence in securities and they can lose their value: the significance of the fact that they are not, in fact, deposits, becomes apparent. The last crash can in some respects be seen as a run on financial assets, just as in the days before deposit guarantees you would get runs on banks. This will become clearer when we look at financial markets.
Some people argue that government bonds should be included in definitions of money. Others argue that only Central Bank Reserves should be seen as money. If we see money existing as a hierarchy we gain better insight into how the system as a whole works, and also can avoid the pointless, interminable debates that abound on the econoblogosphere.
So that’s the 3 lowest levels of the hierarchy. Next week I will complete this overview of money by covering the top level: foreign exchange.