Why is money difficult?

As regular readers know, I emphasize two central functions of monetary systems:  payments and market-making. These are the foundation pillars of what I call the “money view”.

In my teaching, I have come to appreciate a variety of barriers that people bring with them to the study of money, and to appreciate the necessity of bringing these barriers up to consciousness as part of the process of learning.  (I would hazard a guess that 90% of dispute about money has its origin in these unrecognized barriers, and hence is basically a waste of time.  But that’s a subject for another time.)

The first and largest barrier is what I call the “alchemy of banking”.  Banks make loans by creating deposits, expanding their balance sheets on both sides simultaneously.  This process apparently offends common sense understanding of what it means to make a loan—I can only lend you a bicycle if I already possess a bicycle.  Even more, it seems to go against a fundamental principle of elementary economics that “there ain’t no such thing as a free lunch”.   Against this resistance, I insist that the essence of banking is a swap of IOUs.

The second barrier is “essential hybridity”.  Money is part private (bank deposits) and part public (central bank currency), though in normal times we hardly notice because the two kinds of money trade at par.  Similarly, central banks are part private bankers’ bank and part public government bank, with the proportions shifting over time with financial development and with the exigencies of the state (such as war).  This fact of hybridity is however apparently hard to accept, mainly because it offends political sense.  Idealizations of pure public money attract the left (quoting Knapp), and idealizations of pure private money attract the right (quoting Menger), so that the actual system seems to everyone to be somehow polluted by illegitimate extension.

The third barrier is “inherent hierarchy”, which refers to the sense in which central bank money is better money than private bank money, even though they trade at par.  You and I use bank money to settle our promises to pay, but banks use central bank money, and central banks themselves use world reserve money.  The fact of hierarchy is apparently hard to accept mainly because it offends our sense of justice as between states—the Westphalian notion of equal sovereignty.  Importantly, for economists, it also offends our sense of justice as between participants in markets within states.  Hierarchy sounds like monopoly, or power, or other non-market mechanisms of allocation that trained economists instinctively abhor.

The fourth barrier is what Hawtrey called “the inherent instability of credit”.  Promises to pay are made and accepted today, but the future to which they refer inevitably turns out different than anyone imagined at inception, so some failure is to be expected.  More important, all credit (non-bank as well as bank credit) seems to be subject to a kind of positive feedback loop since, as more and more people come to have a common view of the possible future, promises to pay in that possible future get bid up in value and that makes it easy, indeed inevitable, to overpromise.

This fact of inherent instability is something we have an especially hard time confronting, since it goes to the heart of our existential dilemma.  We don’t know the future but we are nevertheless required to behave as though we do.  Indeed, the commitments we make to one another to perform in various ways in the future form the very fabric of the society in which we live.  Marriage is like that, and so is credit.  The fact of financial instability threatens that fabric, indeed constitutes a kind of unraveling of that fabric, as default on one set of promises undermines another set as well.  As economists, we cling to conceptions of equilibrium, including intertemporal equilibrium, which have the reassuring property of excluding instability, but the resulting psychological comfort is bought at the price of abstraction from a fundamental feature of the actual system in which we live.

These are the main four barriers to understanding, according to me.  The central problem we face is that the current institutional fact of financial globalization makes all four barriers especially hard to overcome.   So-called shadow banking—which I define as “money market funding of capital market lending” and consider to be the quintessential institutional form of banking for financial globalization—disorients our intuition which is based on the comfortable but outdated image of Jimmy Stewart community banking.  We pine for a former age when alchemy/hybridity/hierarchy/instability seemed to be under acceptable social control.   Just so, the “money multiplier” promised a fixed ratio between public and private money, but no longer.

Money is always difficult, and it is more difficult than ever today.  The main difficulty however is not with the complexity of the world, but rather with ourselves, and our inherited habits of thought.

4 comments on “Why is money difficult?

  1. Hi my friend! I wish to say that this article is amazing, nice written and come with almost all important infos. I would like to see more posts like this .|

  2. Wim Barentsen on said:

    Brilliant!
    4 words (alchemy, hybridity, hierarchy,instability) that efficiently summarize an original, useful and synthetic view on money & banking.
    Thanks for your books and on-line course!

  3. moneymind on said:

    Thank you, Perry.

    Right to the point, superb insight and superb writing. It’s been a long time that I have read so much essential core understanding condensed into such little space.

    Yet, I found one obstacle to understanding money painfully missing: the paradox of thrift. Since my liability is your financial asset, financial assets and liabilities net out to zero in a closed economy. Thus, my net financial assets always equal the net financial liabilities of the rest of the world. It is impossible that all economic subjects (in the sense of each single one without exception) hold net financial assets – or net financial liabilities. It’t a zero sum game. Some call this the paradox of thrift, others the paradox of monetary profits. It’s standard in stock-flow-consistent models and has become a standard part of MMT as well (see Wray’s book “Modern Money Theory”, 2012).

    If, however, everybody STRIVES for positive net financial assets, it is clear that not everybody can be successful at that. Between states, if there is such a mercantilist race for export surpluses, it can become a race to the bottom, all states beggaring their neighbors. Keynes painfully learned this during the great depression, but Adam Smith had seen the problem of this strategy in the 18th century already:

    “The sneaking arts of underling tradesmen are thus erected into political maxims for the conduct of a great empire … . By such maxims as these, however, nations have been taught that their interest consisted in beggaring all their neighbours. Each nation has been made to look with an invidious eye upon the prosperity of all the nations with which it trades, and to consider their gain as its own loss. Commerce, which ought naturally to be, among nations, as among individuals, a bond of union and friendship, has become the most fertile source of discord and animosity.” (Adam Smith: An Inquiry into the Nature and Causes of the Wealth of Nations, Book IV, Chapter III (part II))

    I think that this paradox must be added to your excellent list – even though it is known since Adam Smith, not many people seem to clearly understand it.

    And more than that: The plan for an international clearing union that Keynes brought to the Bretton Woods Conference in 1944 had envisioned a financial mechanism designed to avoid such beggar-thy-neighbor-races to the bottom: the clearing union would not only charge net debtor countries with interest. Because for each net debtor, there must a net creditor somewhere else, the debtors can only get rid of their debt if the creditors get rid of their credit – by buying nonfinancial assets from the debtors. If the creditors refuse to get rid of their credit, it is impossible for the debtors to get rid of their debt. It’s a symmetrical relationship. To take away the desire to hoard net financial assets from nations, Keynes envisioned that not only the debtor countries had to pay a fee as an incentive to get rid of their debt. Creditor countries would have to pay a fee on their credit to the clearing union as well – as an incentive to get rid of their credit. The goal of the clearing union was to achieve a near balance of current account of all countries – to avoid another race to the bottom like the one he lived through during the great depression. Of course, creditor nations will be reluctant to make such sacrifices – at the time, the U.S. was not ready to accept such an ambitious plan.

    Keynes proposal was based directly upon his insight into the paradox of thrift – which is directly based on the simple accounting identities that form the basis of the money view. I would love to see you discuss this in more detail, possibly with Jan Kregel or Heiner Flaßbeck who both have written extensively on the subject.

    Best regards and thanks for all your great work!

    Wolfgang Theil
    (Germany)

  4. The only ones who benefit from the conflation of money and credit are the issuers of credit with no money, and economists.

    There is a difference between Money and Credit.
    Money as defined by law. Section 31 U.S.C. 5103, defines legal tender as “United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues.

    Congress has specified that a Federal Reserve Bank must hold collateral equal in value to the Federal Reserve notes that the Bank receives. This collateral is chiefly gold certificates and United States securities. This provides backing for the note issue. The idea was that if the Congress dissolved the Federal Reserve System, the United States would take over the notes (Fed liabilities). This would meet the requirements of Section 411 (Federal Reserve Act), but the government would also take over the assets, which would be of equal value. Federal Reserve notes represent a first lien on all the assets of the Federal Reserve Banks, and on the collateral specifically held against them.

    The Fed defines credit as such: “Credit dollars are a debt generated currency that is denominated by a unit of account. Unlike money, credit itself cannot act as a unit of account. However, many forms of credit can readily act as a medium of exchange. As such, various forms of credit are frequently referred to as money and are included in estimates of the money supply.”

    As an aside; why does the Fed count ‘credit’, which is primarily BANK DEBT, as if it were money and include it, even though they admit it isn’t, as being part of the ‘money supply’? Also noteworthy is the Fed’s use of the term “credit dollars”, which is a fiction, the credit/debt the Fed and the banks generate is neither dollars, money or even a currency.

    There is no law anywhere that grants to either the Federal Reserve or the banks the authority to create money. There is no law anywhere that designates or acknowledges the credit/debt they do create as being money or even a currency.

    Deposit accounts are a fiction. There is no money in any ‘deposit account’ of any type anywhere in all of westernized banking, they are all Credited Accounts, they are all Bank Debt. This means that the richest amongst us have exactly the same amount of ‘money’ in their deposit accounts as the poorest amongst us have in theirs, $0.00.

    That a bank maintains some ‘money’ on hand to placate a few requests for the actual monetary medium, does not negate the fact that all deposit accounts maintain a zero monetary balance. A ledger book entry denoting the amount of ‘money’ the bank owes to (stole from) the depositor, is not ‘money’, regardless of your ability to ‘spend’ that ledger book entry with a debit card. Passing around bank debt from one recipient to another, is not payment for anything. Crediting an account with the amount and actual payment are two different things.

    It’s really not that hard to understand. Let’s say you go down to your corner store to pick up a few things. You don’t have any money with you so the store owner lets you take the stuff after he totals it and you sign for the amount, promising to pay later. Did you just use a ‘currency’, or ‘digital credit’, or ‘dollars’ to pay for the stuff you got from the store? No, you incurred a debt obligation that requires payment at a future date.

    It works the same way when you use your debit card. All you’re doing when you use a debit card to make a purchase is, transferring your obligation to pay the store owner, to the bank, payment has yet to be made. The bank deducts the amount from its debt to you, as represented by your account with them, and adds that amount to the debt it owes to the store owner, as represented by his account with the bank. There was no money or currency of any type, digital, electronic or otherwise, used or exchanged in that transaction, just a transfer of an obligation to pay.

    The notion that we’re using a ‘digital currency’ as a medium of exchange is nothing more than a trick of the mind, a deception, it’s how we rationalize the transaction. Also, because we believe that we can go to the bank and withdraw the amount credited to our account, in cash if we wanted to, and the fact that we can successfully do this on occasion, reinforces that deception.

    Credit, an obligation to pay vs. Money, payment.