My grandfather used to tell me a story of how, as a child, I watched him write a cheque. I asked him what he was doing, and he said he was writing a sum of money down on a piece of paper, to use it to pay for something. Apparently, my wide-eyed response, full of admiration at my grandfather’s cunning, was: “Great idea Bill!”.
He told this story to much laughter.
I remember being confused by chequebooks – I assumed they must cost a fortune if you can just turn them into any sum of money you like by writing on them.
Later, when I was 13, my sisters (aged 10 and 5) and I invented a game we called “banks”. Each of us ran our own bank and made deposits with each other, paid interest, and took out loans. “How fun!” I can hear you thinking. Well, it wasn’t as much fun as real banking because our deposits were fully cash backed – not even the fertile imaginations of children could come up with a concept like fractional reserves and lenders of last resort. But in any case, the fun wore off when we realised that despite the wealth we had deposited with one another, there was nothing in our little domestic economy to spend it on.
Fast forward 30 years, and I am working for a bank (sadly, not my own one). And so, I find myself thinking about the nature of money, and surprisingly, returning to the confusion about money that I had as a child.
Most adults don’t find money confusing. We think we know how it works. Money is a means of exchange – we know the bits of paper aren’t worth anything per se – but we also know that other people will give us genuinely valuable and useful things in return for them.
Perhaps a smaller subset of adults know that this is also true of gold and “precious metals”, not just paper (or fiat) money. This, after all, is the message in the story of King Midas that we all read as children. It’s a story which tries to teach us what is genuinely valuable in life, as distinct from an intermediary means of exchange to obtain those things.
But the thing that most adults get wrong about money is that they don’t understand how it is made. I don’t mean “made” in the sense of earned. They understand that all too well. I mean made in the sense of created.
They think that there is a (more or less) fixed amount of money that circulates between people and their bank accounts.
This is not how money works, because money is not “bits of paper” (or gold). Money is a promise, an IOU. In order to understand money, you need to understand this attribute: its promissory nature. Note that a promise is not really useful to anyone, just as a banknote isn’t. It’s what the promise represents that matters. Banknotes used to have a promise written on them to give you 5 pounds of silver in return for a banknote with 5 pounds written on it. But, as discussed above, this silver was itself also a promise – given by everyone in the world who used silver as currency, to deliver you silk, guns, porcelain, coffee, tea, sugar, wheat, opium, sex, a war, slaves, or whatever you want that is for sale. These days, banknotes just offer to give you another banknote of the same value in return (thanks).
While most people probably get the promissory nature of money, they don’t quite understand the consequences. The consequence is that there is no limit to how much money can exist.
Not so fast, you say. There is a limit, because money is produced by the central bank, and they carefully[1] limit the amount they put into circulation to ensure we don’t have too much money chasing too few goods (inflation).
This is not true for two reasons. The first is a technical reason, which is that money is not just created by the Central Bank – it’s also created by normal banks. In fact, this is where most money is created. When you take out a $500,000 mortgage to buy my house, the bank simply chalks up minus $500,000 against your name in their legers[2], and plus $500,000 against my name. Net balance sheet change for the bank is zero. The bank does not[3] – and I can’t stress this enough – lend you someone else’s money. It just creates a promise between us out of thin air. You have promised to pay the bank $500,000 over some period of time. And the bank has promised to give me $500,000 if and when I come to withdraw it.
Not so fast again, you say – there is a reserve (or capital adequacy, in the UK and Australia) requirement for that $500,000 deposit which means that the bank needs at least some value – say $50,000 – of “real” money (i.e. 10% reserve requirement), as distinct from the money they just typed into their balance sheet, in case I actually come to ask for it. By “real”, I mean physical cash (bits of paper) in a safe, or an electronic deposit in their account with the central bank.
Banks do need to have some physical cash on hand, in case someone comes to ask for their deposit in cash. But very few people want to walk around with half a mil in cash. Most people just wire it between accounts, and over the banking system as a whole, this (obviously) nets to zero. When we transfer our deposits between banks, the banks look at the net flows and transfer that amount between their accounts at the reserve bank (i.e. they move reserves). Our deposits are short term loans to the banks, against which they need to hold some cash, in case we call the loan (i.e. withdraw our deposit as cash). When deposits slosh from one bank to another, it is as though the first bank decreased its debt, and the second one increased it, and the associated cash (the asset) is moved over in the reserve account. The reserve requirement is the main tool by which the central bank tries to keep a lid on how many promises are created between reckless citizens like you, me and your bank manager.
But this is the interesting bit. When a bank falls below their reserve requirement, they are forced to borrow cash from other banks on the appropriately named “money market”. In case it’s not clear, this “money market” isn’t some sort of flea market for used banknotes, it’s electronic. It’s mostly about banks lending one another the money they keep in their electronic deposit accounts at the central bank (called their “reserve” accounts). And these borrowed reserves come with a cost (an interest rate), and this interest rate is the rate that the central bank sets.
That’s another key point. The central bank doesn’t set a rate that suddenly all banks have to charge by law. It tries to set a rate that it wants the banks to charge each other on the money market. It’s a target rate, not a decreed rate.
So imagine no banks want to lend my bank the $50,000 reserve requirement that they found they needed to cover the promise the established between us. What happens? They refuse the mortgage? Are you crazy!? Bankers don’t get paid to refuse loans. What happens is they offer to pay a higher interest rate on the money market than other banks are offering. And so the inter-bank rate goes up because there is a shortage of reserves.
And that annoys the central bank. After all, they set that rate for a reason – a reason based on highly sophisticated macroeconomic models built on unreasonable (and demonstrably false) assumptions, some grey hairs, a bit of voodoo, and a dash of politics.
So to get the rate back to where they want it, they put a whole lot of cash onto the market (increasing its availability, and lowering the price one needs to pay for it). They do this by buying assets that the banks hold (for example, government debt) in return for freshly created cash – cash created out of thin air[4]. This cash takes the form of electronic entries in the commercial bank’s accounts at the central bank.
So that is the first reason – the technical one – why the promise that you made to me when you bought my house resulted in $500,000 dollars in electronic deposits being created in commercial banks, and even potentially in $50,000 of new currency being created by the central bank (after a convoluted process).
That’s right – our little promise, just between you and me – combined with a shortage of reserves – resulted in $50,000 being “printed” (electronically). The central bank’s balance sheet got bigger. Cool huh.
Now the second reason why there is no limit to how much money can exist is simple: money is just a convention. It’s an agreement, like Santa Claus, to believe in something for convenience. And so just as we may believe in money issued by our governments, we can equally choose to believe in something else – like frequent flyer points (money issued by airlines), gold, silver, or bitcoin. Ok, there is a limit to how much gold and silver exist, but not to frequent flyer points, bitcoin, facebook’s proposed currency, Libra, or any other of the innumerable ways we could invent to keep track of promises between one another.
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Now that we have established the fact that 1. Money is promises, and 2. There isn’t any limit to the number of promises that we can make to one another, and therefore, to the amount of money, we can explore (and perhaps explain) some aspects of the economy today.
The first phenomena that we can perhaps explain is how the massive increase in the money supply since the 2007-08 financial crisis has not resulted in inflation, as it was widely predicted to.
Let’s return to the game my sisters and I used to play. In our small domestic economy, almost everything was provided for free (by our parents), so there was a pretty limited set of goods and services that my sisters and I exchanged just between ourselves. One thing we used to do for each other was build a “lux”, which was a sort of cubby made of pillows and blankets. So we paid one another using our bank deposits (our promises) to build these cubbies. You can immediately see that, no matter how large the stock of promises we have from each other, there is a limit to the amount of cubbies we can actually produce and consume in a day (typically, one, before we got bored and moved onto some other game).
So it is with the real economy. The vast stock of promises we issued to one another after the 2007-08 financial crisis (which was, ironically, caused by some people not honouring their promises) has not been converted into ordinary consumable goods and services, because the rate at which we consume these (and also the rate at which we can produce them) seems to be largely fixed. When you bought my house for $500,000, I did not get the urge to go out and buy $500,000 worth of bananas. Or TVs, or whatever. What I did was save those promises for the future (e.g. my retirement), or I swapped them for some other set of assets (like shares).
Given that the stock of assets didn’t experience a massive increase at the same time as our stock of money, asset prices have skyrocketed.
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So are there any “real economy” effects from increasing the money supply?
Well, yes.
Even if a lot of the increase in money flows into assets, rising asset prices does encourage people to build more assets (such as housing), at least to the extent that planning rules allow it, and that creates jobs and keeps people busy. This is one way the newly created promises get converted into current consumption (and production). Alternatively, quite chuffed with myself for selling you my house, I might decide to offer myself a new car. However, it appears that the majority of the recently created money did not actually get spent on immediate consumption, it was saved instead (or spent on existing assets like existing shares and existing houses, which does not stimulate any production).
This comes back to the basic problem my sisters and I faced – there’s a limit to how much one can stimulate consumption and production (demand and supply) – but there’s no limit to our ability to create promises about the future.
The second interesting conclusion about our new understanding of money as a promise is that we can now see that if I hold a promise from you, then you are (somehow) in debt to me. This is obvious in the example I gave above, where you clearly went into debt to buy my house, but is it necessarily the case that all money is debt?
Yes. The process of creating promises that we saw above is very much based on “owing”. That’s what an IOU is. The only entity which doesn’t really owe anything (real) for the promises it creates is the central bank, but central bank money (paper cash and electronic reserves), is a fairly small part of the overall set of promises that are circulating. Most of them are the sort of promise that you made to me when you bought my house – that is, private debt, intermediated by a commercial bank. There is also public debt, which is when government issues some promises. Just as our house-purchase deal resulted in the electronic creation of a deposit, and some newly created central bank money, issuing new government debt also creates money[5].
The continuous creation of these public and private promises has now been going on for 70 years and resulted in a steady increase in debt[6].
Does all of this debt creation really matter? I mean, in the example above, when you bought my house and created $500,000 of deposits (in my account), you still have a (real) asset worth $500,000 – the house. So your net worth is still (say) positive, despite the increase in promises and debt that you owe to me (via the bank). As for public debt incurred by governments – part of this is sold to citizens of the same country, so it’s really debt we owe to ourselves (or rather, future taxpayers owe to current savers – they could well be the same people). The other part ends up on the central bank’s balance sheet – which purchased it with freshly created money.
Debt creation does matter in three senses.
The first is in the sense mentioned – by establishing future promises we do stimulate some current activity (like housebuilding), and so we do keep everyone busy and productive when they might otherwise not be. This effect is quite natural when you think about it. If you imagine a small island economy where you grow coconuts and I catch fish, and I want a coconut now but don’t actually have a fish to swap for it, a reliable promise of a fish tomorrow is enough to convince you to do the hard work of cutting me down a coconut today.
The second is in the sense of our belief in the reliability of those promises. If the reliability of the promises is somehow thrown into doubt (as it was in 2007), suddenly the entire financial system can scream to a shuddering halt. A lot depends on our faith in these promises. And so, we can perhaps infer that the more promises that are issued, by a wider and wider group of people, the more the chance that some sub-set of these people will not honour their promises. Increasing debt fuels speculative asset bubbles which bear no relation to the underlying ability of the asset to earn income.
Thirdly, the problem with issuing promises is that you are eventually supposed to fulfill them, and so servicing (i.e. reducing) existing debt means that an increasing part of today’s production has to be dedicated to fulfilling promises you made in the past (rather than consumed by you now). In this sense, issuing promises is a way of bringing your own consumption forward in time, and by inference, decreasing your consumption in the future.
That’s not a problem, you might respond, because when you pay back the debt you enable someone else – someone who deferred their consumption in the first place – to consume.
Well, that might be true in a barter economy, but I don’t think it’s true in the economy we described above, where the act of issuing promises creates economic activity that would not otherwise take place. The act of repaying debt (i.e. to the bank) unfolds like this:
You manage to get $1,000 for the lovely bunch of coconuts you sold on the weekend, the results of your hard labour (and the bounty of nature). Of this, you give $500 to your bank to pay down the mortgage you used to buy my house, and you spend the rest, which finds its way back to the bank as a deposit (i.e. a loan to the bank).
The bank reduces your liability by $500, and its own asset by $500. Hang on… isn’t the bank’s balance sheet now in trouble? It’s just lost a $500 asset, after all. No. The $1,000 income that you initially received was withdrawn from the bank in the first place (a $1,000 reduction in their liabilities). Of this, $500 is now back as a deposit in the bank (a liability). The net position of the bank was a decrease in their balance sheet by $500 (and no net change[7]). It looks like this:
| Step | Your Assets | Your Liabilities | Bank Assets | Bank Liabilities |
| 1. the coconut buyers withdraw $1,000 from their accounts | A house | $500,000 (your mortgage) | $500,000 (your mortgage) | +$500,000 in deposits, -$1,000 which is withdrawn = $499,000 |
| 2. I sell them $1,000 of coconuts | A house + $1,000 | $500,000 | $500,000 | $499,000 |
| 3. I pay off some of my mortgage | A house + $500 | $499,500 | $499,500 | $499,000 |
| 4. I spend the rest, and the people I spend it on bank their earnings | A house | $499,500 | $499,500 | $499,000 + $500 in new deposits = $499,500 |
You can see that the middle two columns are always equal, and after the transactions settle, the bank’s balance sheet is back in balance, but is $500 lower than it was before I paid off some of my mortgage.
The main effect of the debt repayment is that it takes money (promises) out of circulation and so has the opposite of the stimulatory effect that it had in the first place. It does not convince anyone to produce something that they weren’t intending on producing at that point in time. Rather, it takes $500 out of circulation, $500 that could have been used to convince me to go and catch some fish. That “convincing” was already done a long time ago, when you issued the promises. This is how the issuance of debt brings production forward (not just consumption).
This is a really important implication. People often think of debt as patient people deferring consumption and impatient people bringing it forward. But that assumes that I was always going to catch that fish anyway. That isn’t the case. Your promise convinced me to do some economic activity that I wasn’t going to do. It brought production forward and it created consumption where they would have been none. It didn’t just move some current consumption from me to you.
The counter-effect of this is that when the promises are redeemed in the future, it also decreases production (and consumption).
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Hang on hang on, I hear you say. Is that really true? Let’s go back to the island economy where my promise of a fish tomorrow convinced you to climb up the tree and cut me a coconut today. This admittedly increased production today, but won’t that promise also increase production tomorrow, when I come to claim the fish?
Yes – it will.
But after that extra fish has been caught and delivered, that is where the magical effects of the promise will come to an end. That’s when the music stops, because the promise has been redeemed and the money has – in effect – been destroyed.
Imagine a slightly larger island economy. After handing over the coconut and pocketing the fish-voucher I gave you, you decided that rather than wait for a fish tomorrow, you’d swap it for a massage today. And your masseur was delighted with the opportunity to do some unexpected work, and later spent the fish voucher in the bar that night. The next day, the bar keeper who was pleased with takings from the previous night decided to celebrate with a fish lunch, and so she gave me the voucher. And so I had to go out and catch an extra fish to honour my promise.
The initial promise therefore sparked a chain of economic events as it was passed along like the Olympic torch, which increased production, exchange and consumption, eventually including the production from the person who issued the voucher (me).
However, when the torch gets back to me, it goes out. The extinguishing of the debt cuts the chain of economic exchange and stops it[8].
So, we can now see that in a large economy, the issuing of promises stimulates economic activity – it creates these “vouchers” (or promises) which people will accept in return for doing work and producing new, real goods. That process continues until the voucher is redeemed (i.e. the initial debt is eventually repaid). So over a whole economy, we might expect that while the rate of promise creation exceeds the rate of promise redemption, there will be a constant additive effect to the amount of goods and services which are produced and exchanged. That additive effect will stop when the rate of promise creation equals the rate of redemption, and it will go into reverse if the redemptions exceed the creation. As the Olympic torches start to get snuffed out, economic activity slows.
Think about that for a moment: paying off debts – supposedly a good thing[9] to do – causes the economy to contract. That is true for the private sector and for the public sector, and yet we have governments tripping over themselves to promise us a budget surplus (i.e. paying down of public debt and contracting the economy). Fortunately, that is one promise that is almost never honoured.
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Let us return to the question about relative levels of promises held. What happens if all of the promises are roughly evenly distributed, e.g. we all hold $100,000?
We previously saw that money is promises and promises are debt. Does money make any sense if we all have the same amount?
The answer depends on who is on the other side of the promise. If the money is electronic deposits in banks, and we all hold $100,000 in our accounts, then someone must have an equivalent debt with the banks for the same amount (to balance the banks’ balance sheets).
If the money is cash, then the “person” on the other side of the promise is the central bank. The assets on the other side of a central bank balance sheet tend to be government debt, gold and other currencies. As discussed above, domestic government debt is just stuff we owe to ourselves, and so it is analogous to the commercial bank situation described above. On the other hand, foreign government debt, gold and foreign currencies are promises that foreigners might accept, so they are “claims on foreigners” (i.e. IOUs from them). So it is technically possible for all citizens of one country to have $100,000 of genuine wealth[10] in terms of “promises from other people”, but not at a global level. If literally everyone on earth held $100,000 of promises which we could claim from everyone else, it wouldn’t represent genuine wealth. It would still be useful as a means of exchange (keeping score) for goods and services, but essentially it would be just as if we all held a bag full of cowrie shells.
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For the next thought experiment, let’s consider pensions. Historically, we didn’t bother too much with pension promises in the form of money, we simply made a social contract that young working people would look after the old during their retirement. Luckily, retirement only lasted about 2 years on average before the elderly shuffled off their mortal coil, and left us to spend our taxes on other things (like war).
However, as we’ve been living longer it has become apparent that the ratio of working people to retired people is changing. The proposed solution is to “save more money”. Governments seem to think that if, during your working life, you can save a sufficient number of promises, you can simply cash these in when you retire and support yourself until you die, without causing public finances to explode.
Recall that money is promises from other people to do something. When you’re retired, who is going to honour these promises when you want someone to bring you a nice fish coconut curry? It’s not old Betty who’s going to scamper up the palm tree is it? It will be someone young, who is still capable of cutting down those coconuts and hauling in those fishing nets.
So despite this cunning plan to “save a lot of money to pay for our retirement”, we find ourselves in an economic situation that is fundamentally unchanged from previous generations in terms of real activity: young people will need to support the old. The old will never “support themselves”. The mass of promises that the old people accumulated, perhaps by selling their houses to young people, now has to be redeemed from a much smaller group of young people. Given there is a limit to the number of coconuts a young person can cut down in a day, the logical consequence for old people is that the price of coconuts is going to be a lot higher than they thought.
The only way this will not be the case is if we use the proceeds of the promises we issued to build productive assets – ladders for coconut harvesting and nets and boats for fishing. These assets would, potentially, increase the productivity of the young to the extent that they could produce sufficient goods for all the retirees to pay the prices (and consume the quantities) they were expecting.
So if the young issued the promises to the old in return for their houses, what did the old do with the money? Did they invest it in assets which would help the young produce more in the future? Judging by the slow rate of productivity growth, they didn’t. Not only did the old not invest it in things like education, they actually dis-invested in this, and forced the young to issue yet more promises (incur debts), just to give themselves the skills they will need later on to support the old.
When faced with a choice between funding productivity improvements, and extracting more promises from the young, the elderly seem to have chosen the latter over the former. This seems like a self-defeating strategy, born from ignorance about how money and the economy actually work.
To some extent, there is a collective action problem in play here: if I can get society (i.e. everyone else) to do the investing in productivity, and yet keep my own money to spend it on the fruits of that productivity, I come out ahead. Government exists to try to sort out these collective action problems, but our governments are profoundly complicit in this ignorance. Election after election, the economically illiterate notion that national finances should be run like household finances resurfaces. The intuitive appeal of “not living beyond your means” stems from our general ignorance about how money actually works.
These questions about money are not abstract, academic ideas. They are very real and pressing public policy choices. During the global financial crisis of 2007-08, governments issued vast amounts of new money from thin air and threw it at the economy. It did not land evenly, and inequality – the underlying cause[11] of the financial crisis – increased. We have come out of the GFC more vulnerable than before, and we risk repeating the same errors with our response to the ongoing Coronavirus economic crisis. But we don’t have to.
If the plan is to restart the economy by issuing more money, we can do better than throwing it at existing asset price ponzi schemes like shares and housing.
What if we used it to change our energy mix? The objection to this has always been “it will cost a fortune”, and “we can’t afford it”. Well, the United States just issued $2 trillion dollars in new government debt (about 10% of GDP), which, as we have seen, will be “printed” by the Federal Reserve Bank. That’s almost half the estimated cost[12] of converting the entire US power generation stock to renewables.
It seems that a virus is re-defining our notions of what we can, and can’t, afford. And that is a good thing.
[1] Unless they are the Central Bank of Zimbabwe
[2] Well, that’s not strictly how they do it. They actually chalk up a liability to your account of $500,000, and an asset to their own account of $500,000, which is the $500,000 that you owe them. And for my $500,000 deposit, that’s an asset for me and a liability for them, because the bank owes it to me.
[3] https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy
[4] The central bank’s balance sheets also don’t have a net change. If you’re the central bank, cash has a funny property because you’re the person who signs the “I promise to pay the bearer” part. So, government issued cash is a liability for them (it’s a promise, albeit a pretty hollow one). The cash they create is both an asset (while they hold it) and a liability for the central bank. It’s like holding promises to yourself (sort of pointless). But when the central bank exchanges it for the government bonds (another asset), the cash which is now out in circulation remains a liability for the central bank. No net change to the central bank balance sheet, but both assets and liabilities increase by $50,000.
[5] Government debt is sold to banks who buy it with cash (reserves). If the resulting shortage of cash causes the money market interest rate to go above the central bank target, our friends at the central bank kindly relieve the commercial banks of those treasury bonds in return for freshly “printed” cash. In effect, the central bank buys government issued debt using newly created money, via the intermediary of commercial banks.
[6] https://www.imf.org/external/datamapper/HH_LS@GDD/CAN/GBR/USA/DEU/ITA/FRA/JPN
[7] This is the precise opposite of the original process, where an increase in the bank’s assets (loans) resulted in an increased in their liabilities (deposits). Here, a decrease in the bank’s assets (loan book) is funded by a decrease in their liabilities (a deposit withdrawal).
[8] And if someone decided to save the voucher at some point by keeping it in a cupboard at home, that would suspend the chain – temporarily – until they put the voucher back in to circulation. The economic effect would be similar to paying off the debt though – a suspension of the passing of the torch. I should perhaps clarify that these promises need to be tradable (which is what money is). In a large economy, if I personally issue a voucher saying that I owe you a fish, you’re unlikely to be able to use that to buy something at the supermarket. This is why the “promise creation” in modern economies requires the institutions authorised to create the tradable promises (money). It’s not like you and I can create money on our own – unless we come up with an idea for something like bitcoin, which becomes accepted and therefore, tradable. And if I had come up with bitcoin, I would probably not be sitting here typing articles on money, I would probably be fishing and drinking something alcoholic out of a coconut.
[9] If we are to believe Polonius
[10] Indeed, this is the case for Norway
[11] Suggested reading: Fault Lines, by Raghuram Rajan
[12] https://e360.yale.edu/digest/shifting-u-s-to-100-percent-renewables-would-cost-4-5-trillion-analysis-finds