@ZeroHedge participated in a twitter discussion recently on the nature of money. This is a topic I had spent some time on in my book. In fact, given that mankind has been using money for thousands of years it is perhaps surprising that money is still such a nebulous concept. A general definition of money is that money is anything (even tins of sardines one may argue) that people accept as payment for goods and services based on the belief that they can use the proceeds to buy goods and services from someone else. Money is the belief that someone will pay you back. For economists, money is capable of performing three functions simultaneously, that of means of exchange, a measure of value and a store of value. Historically, the use of money as a medium of exchange has been the most important, a use which in John Law’s view (see below) was the prime function of money. The second use, money as a unit of account, is one of convenience: expressing the price of all goods and services in relation to one common denominator is a lot easier than figuring out the barter value of each good against every other. Using a single currency in Jerusalem in biblical times would have eliminated the need for ‘money-changers’ that in the opinion of Jesus polluted the Temple according to the Gospels. The third use, the store of value, is useful (one would not want to be obligated to spend immediately whatever is earned), but is also the most problematic. In fact, it is this latter characteristic, of money as a store of value, that is responsible for the many peculiar characteristics of modern financial markets.
As Keynes pointed out, money saved, rather than spent, reduces demand for goods and thus depresses employment. The economy can be trapped therefore in a circle where too much is saved, too little is spent and too few jobs are available. John Law, the 18th century Scottish mathematician and early economist claimed that money is not the value for which goods are exchanged, but the value by which they are exchanged, the use of money, he continued, is to buy goods, money in itself is of no other use. The purpose of finance is to act as a conduit of funding for business activity. The consequence of this line of thinking is that one need not accumulate wealth before putting it to productive use; money can be borrowed, or created as a reflection of the wealth of society, as a consequence of optimism and confidence in the rise of this wealth. Money in other words is not a quantity of gold or silver but in essence a reflection of the potential for wealth creation.
How is money being created, if it is not borrowed from someone who previously gained it? We mentioned above that central banks can create money by ‘printing it’. In modern times central banks do not ‘print’ money, but they create it for example by purchasing government bonds or treasury bills and crediting the government’s account with a number representing money. This is the essence behind the process of quantitative easing that the Bank of England has employed since the crisis. In fact, central banks are not limited to doing this via crediting government accounts through the purchase of treasury bills, but can also do it by purchasing securities issued by private parties, like banks and corporates. The European Central Bank has employed a rather different tool (long term refinancing operations) that injects liquidity into the market by accepting lower quality collateral for loans by the Bank. Both actions represent an expansion of the central bank’s balance sheet which pumps money into the economy or state coffers. These funds are in theory repaid to the central bank when the state or a private party redeems the securities in question, but the expansion in the central bank’s balance sheet can be permanent, unless the bank then raises interest rates to reabsorb the excess liquidity. The main check on this process of money creation or liquidity enhancing (as it is called) is of course inflation. If a central bank infuses funds into the economy through such liquidity enhancing operations constantly at large volumes, there is concern that inflationary pressures will build up in the economy bringing the value of the currency down, putting a stop to the process of expansion. In the current deflationary environment on the other hand, quantitative easing has helped keep inflation to target and avoid the recessionary effects of falling prices. The ‘creation’ of money however is not a function limited to central banks. When a commercial bank lends money, it can lend in excess of its assets (within the limits set by law). This means that a bank can extend loans that are multiples of the funds it has in its vaults (or electronic balance sheets). Every time the bank lends money it ‘creates’ therefore money, it increases the total amount of money in circulation. This is the core of the notion of fractional reserve banking, and also an explanation for the confusion between the terms money and credit. If money is created via the extension of credit, are not then money and credit the same thing?
The de-materialisation of money and the severance of the link between what is perceived to be inherently valuable (eg gold) and what is valuable because it represents a commonly accepted exercise of authority (paper money) is not an automatic process, but entails the involvement of law to baptise ‘money’ and make it acceptable. In that sense, it is a misrepresentation of historical process to argue that money has evolved organically and spontaneously from the voluntary actions of trading individuals. But, if the law brings about changes in uses and functions of things like money, what motivates changes in the law? Democracy one might argue, or perhaps the diktats of orthodox economists.