Money

What It Is, How It's Created, Who Gets It, and Why It Matters

Sergio M. Focardi

• Publisher: Routledge
• Year: 2018
• ISBN:
  9781315391045
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

By enabling the storage and transfer of purchasing power, money facilitates economic transactions and coordinates economic activity. But what is money? How is it generated? Distributed? How does money acquire value and that value change? How does money impact the economy, society?

This book explores money as a system of "tokens" that represent the purchasing power of individual agents. It looks at how money developed from debt/credit relationships, barter and coins into a system of gold-backed currencies and bank credit and on to the present system of fiat money, bank credit, near-money and, more recently, digital currencies. The author successively examines how the money circuit has changed over the last 50 years, a period of stagnant wages, increased household borrowing and growing economic complexity, and argues for a new theory of economies as complex systems, coordinated by a banking and financial system.

Money: What It Is, How It's Created, Who Gets It and Why It Matters will be of interest to students of economics and finance theory and anyone wanting a more complete understanding of monetary theory, economics, money and banking.

1
The Theory of Money

Basic concepts, part I

1.1 Introduction

This chapter lays the foundation for our discussion of money. It introduces some of the basic concepts of the theory of money, including its nature and function, the processes through which money is generated and distributed, and the interaction of the dynamics of money with the dynamics of the real economy. This chapter highlights the key themes of the book that can be summarized as follows.

1.1.1 On the nature, creation, and distribution of money

Money is essentially a token that represents the purchasing power of its owner. Money requires a pre-existing structure of ownership of goods, reinforced by institutions. Money does not create ownership but allows the transfer of ownership. The creation and allocation of money solve the engineering problem of making available to individuals and entities the tools necessary to exchange the ownership of goods and services and to store purchasing power for the deferred exchange of ownership.

Textbooks identify three main functions of money: (1) as a means of exchange, (2) as a means of storage, and (3) as a unit of account. For our purposes, we propose the following definition:

Money is a tool that allows implementing economic decisions freely and autonomously by transferring the ownership of things or granting the fruition of services.

To the three main functions of money, we add the concepts of ownership and free exchange. Money is enabled by ownership and by institutions that protect ownership. Money is also enabled by the willingness of economic agents to transfer ownership to others in exchange for money. Ownership logically precedes money.

As Martin Shubik (2010) remarked, money implies trust. A person or an organization gives up the ownership of something in exchange for money under the assumption (trust) that the same money will be accepted in future transactions and will allow them to acquire ownership of other goods or services of similar value.

Having outlined the basic functions of money, we can now ask: What is the nature of money? There are two main historical views on the nature of money: (1) money as something with intrinsic value, for example precious metals such as silver or gold; and (2) money as something with no intrinsic value such as cowry shells, banknotes, or bank deposits that represent the purchasing power of individuals or entities such as firms. Shubik suggests that the backing of money with something that has intrinsic value is one way to gain trust for the money. However, in advanced economies, money in the form of banknotes is no longer convertible into something with intrinsic value and now represents only a small percentage of the monetary mass (3–10%). Most money is now in the form of bank deposits. The forms of money continue to evolve over time and the present trend is clearly towards its dematerialization.

As observed in the Introductory Remarks, there are three perspectives on money: historical, engineering/institutional, and philosophical. The historical perspective seems to suggest that the current view of money as credit is a natural evolution of the practice of credit. Anthropological studies suggest that credit and debit were the first means of exchange though what concrete form they took varies. The moment it was realized that credit is transferable, the way was paved for introducing the general notion of money as credit.

Today, however, central banks are confronted with the engineering problem of deciding if and how to dematerialize money, eliminating banknotes and eventually implementing institutional changes. Introduction of digital currencies is one such major change. The engineering problems that such a change would involve would require a higher-level view of the question of money. In fact, governments and central banks would have to rethink the problem of how to distribute the means of payment to a large population within an economy that, given present trends in automation, will likely leave a large fraction of the population without sufficient means to live a decent life. In republican Rome (123 BC), the solution to feeding the large population was to provide a monthly distribution of grain – the cheapest and most efficient foodstuff then available – at a set cost (6 and 1/3 asses per modius ¹). The program was financed by the reorganization of the taxation system in the rich Asian provinces (Aly 2017).

Money is by nature hierarchical, that is to say, money at a given level depends on money at a higher level. Dependence might take different forms: for example, money of a lower level might be convertible into money of a higher level or might be a package of credits such as a money market fund formed with short-term treasury debts. At the top of the hierarchy is money with the highest level of liquidity; at lower levels, money consists of progressively less liquid assets. Today, the hierarchy of money consists of coins and banknotes at the highest level, bank deposits at a lower level, and near-money assets such as money market funds at progressively lower levels. Bank deposits are presently the most common and widely used money for transactions.

In today’s economies, the production of money either as banknotes or as deposits is a relatively simple, low-cost process while the allocation of money is a complex process, the key element being credit. New money created by minting coins or printing banknotes, hierarchically superior, is produced by central banks, “sold” to banks, and can be obtained by the public only from the banking system. Coins and banknotes are permanent money. New money as created when a commercial bank extends a loan is not permanent money. Loans are created as deposits and extended to creditworthy agents (individuals or entities) and must (in time) be paid back; once paid back, their value is destroyed. Deposits can of course be transferred between different bank accounts totally or partially, but transfers do not create new money, they only transfer money. Near-money, such as money market funds, is a complex financially engineered asset sold in the market and used as storage of value. Though the generation of near-money is complex, its distribution is a straightforward sale.

Systems for the creation and allocation of money are not fixed but are in a constant state of flux. Future evolutions might include the abandonment of coins and banknotes mentioned above or the abandonment of the strict reliance on debt to allocate money, replacing the latter with other mechanisms such as the uniform distribution of money.

Clearly, designing the process of the creation and distribution of money is both an engineering problem and a problem of political economy. In fact the creation/ distribution of money impacts the distribution of wealth and the stability of societies such as our democracies. The Classical Greek philosopher Plato believed that to ensure social peace, the income of the highest paid in society should never amount to more than five times that of the lowest paid. We might disagree with the exact figure but the principle is clear.

1.1.2 On money and prices

The relationship between money and market prices is complex. The Quantity Theory of Money (QTM) posits a simple proportionality relationship between the quantity of money in circulation and the level of prices where the level of prices is, in practice, a weighted average of prices. Though intuition and experience suggest that, other things being equal, prices increase as the amount of money available increases, the QTM seems an oversimplification.

Economic theory posits that prices are determined by the intersection of supply and demand. But demand depends on the amount of money available for purchases. Modern economies – highly unequal in terms of income and wealth – are segmented in sub-economies that have only marginal mutual interactions. The notion of a single price level for the entire economy does not correspond to empirical reality. First, the choice of a price index is largely arbitrary; different formulas can be adopted. Second, assuming that we have chosen an index, each sub-economy has a different price level, receives different inflows of money, and reacts differently to changes in the inflows of money. We suggest that the notion of an average relationship between the price levels and the quantity of money would better be replaced with a vector of different relationships between money and prices for each sub-economy.

1.1.3 On inflation, growth, and financial and economic crises

Modern economies are complex systems that output complex products and services. The market value of these products and services is only partially related to their physical characteristics. Markets attribute values to products in function of many factors, including the image of the product and its manufacturer. Given the level of innovation and the weak relationship between physical characteristics and market value, it is impossible to compute a unique true inflation rate.

Therefore, there can be no unique true distinction between real and nominal growth, as posited by mainstream growth theory and discussed in Barro and Sala-i-Martin (2003). Nominal growth is due to both monetary and physical factors, the latter including changes in quantities produced and in the complexity of products. In modern economies with a high rate of innovation even in staid sectors of the economy – be it goods or services – distinguishing real growth from nominal growth is somewhat arbitrary.

Different sub-economies might grow at different speeds. In particular, inflows of money might produce a rate of growth of financial markets that far outpaces the rate of growth of the economy, as we have seen over the period 2007–2016 with U.S. financial markets growing three times as fast as the real economy. These differences in growth rates within the same economy might produce the instabilities described by Hyman Minsky, resulting in market crashes and eventually economic crises (Minsky’s theory of financial instability will be discussed in Chapter 8).

This chapter gives an overview of these themes; their development constitutes the rest of the book.

1.2 Can we do without money?

Let’s begin our exploration of the nature and function of money in modern economies by considering a society without any form of money. Our objective is to ascertain what characteristics of human societies enable or require the use of money. In a nutshell, what characterize a society with money are a structure of ownership and the freedom to exchange goods and services.

To gain a better understanding of money it is useful to explore if and how societies can function without money. This implies identifying social structures where there is no (or a very limited) concept of ownership and where important economic decisions are implemented with tools other than monetary exchange. We can identify three basic types of societies without money:

• gift economies;
• centralized economies where economic decisions are made by central authorities and implemented via orders of some type;
• and, theoretically, post-scarcity societies where everything needed is freely available.

Consider first what anthropologists call gift economies. Gift economies, if they existed/exist, are primitive societies where goods are shared without barter or compensation. A well-known example, popularized by the BBC documentary Tribe, comes from the Anuta people, a tribe of 300 persons living in the Solomon Islands in Oceania. The Anuta have a social life based on the notion of sharing and gift-giving.

The reality behind gift economies is, however, much debated. The anthropologist Bronislaw Malinowsky (1922) studied the Trobriand people off the east coast of New Guinea and concluded that what was considered a gift economy was in reality a complex structure of power and politics. However, for the French anthropologist Marcel Mauss (1923), considered one of the founders of anthropology, the role of the exchange of gifts was to create bonds in human societies. Nephew of the philosopher and sociologist Emile Durkheim, Mauss formulated broad theories of gift-giving in primitive societies. He posited that a “gift” was not really a transfer of ownership as any gift made must be reciprocated, perhaps not under the same form.

Anyone who is familiar with life in European country or mountain villages has probably remarked that gifts are rarely welcome: receiving a gift binds one to reciprocate, possibly with a gift of a slightly larger value. In her study of traditional Japanese culture researched for the American Office of War, the anthropologist Ruth Benedict (1946) describes how, in traditional Japanese culture, people do not come to the assistance of others to avoid binding them with the duty to reciprocate. Gifts and assistance might create unwelcome bonds.

But what if there is no money in a modern economy where exchange takes place? One way to eliminate money is to eliminate ownership, centralizing it in the hands of a group of people such as a government or an army. This ruling group might then have products or services produced and distributed without the use of money, by centralized dictate, such as deliver x amount of y to z. Economies of this type are called planned (or command) economies. An example of a command economy comes from Ancient Egypt, under the Pharaohs who, in theory at least, owned all the land and in whose granaries and treasuries surplus produce was stored. Employees in the thousands working in noble or royal households were guaranteed sustenance from these surpluses. Gordon Childe (1982 [1942]) gives us a precise idea of how the labor of each of the thousand workers who were building King Seti’s temple in the second millennium BC was valued in terms of commodities: “‘4 lb. bread, 2 bundles of vegetables and a roast of meat daily, and a clean linen garment twice a month’!” (p. 131).

In modern times the classical examples of command economies are the Soviet Union, China, and, on a smaller scale, Cuba. While it is not our objective herein to analyze the characteristics and the history of these command economies, let’s remark that the Soviet Union, China, and Cuba were not economies without money. There was a very high level of central planning as regards, in particular, agriculture and industry but people were allowed, albeit with constraints and limitations, to use money to purchase goods and services.

It is often remarked that a planned society cannot gather the information necessary to its functioning and eliminates the freedom of the individual to decide the course of action he or she prefers and that this freedom is accorded by ownership and money. But this is not necessarily the case. We can envisage planned societies where individuals still have considerable freedom of action, as we will see. It is true, however, that coordinating the supply of goods and services to...

Table of contents

• Cover
• Title
• Copyright
• Acknowledgments
• Contents
• List of exhibits
• List of boxes
• Introductory remarks
• 1 The theory of money: basic concepts, part I
• 2 The theory of money: basic concepts part II
• 3 What is money?
• 4 Modelling money
• 5 How money is created
• 6 How money acquires value and how that value changes Over time
• 7 Money: how it's distributed
• 8 Money and the economy
• Concluding remarks
• Index