What types of money
exist and how are they
created and destroyed?
A description of how it is,
not how it should be
Presentation by John Hermann
... in an age of illusion and universal deceit,
telling the truth is a revolutionary act.
attributed to George Orwell
Theories about the
nature of money
Debates about the nature and definition of money have
been raging for more than 200 years between different
schools of economic thought. The position adopted
here is an amalgamation of several strands – the
postKeynesian perspective, modern monetary theory
(chartalism), monetary circuit theory, and horizontalism
(endogeneity).
I do not generally subscribe to neoclassical ideas, and
in particular the quantity theory of money, nor the
commodity theories of money (including the Austrian
school).
Definition of money
Generally, money is something that
serves as a medium of exchange, a unit
of accounting, and a store of value
1. A medium of exchange must be widely accessible,
and acceptable for the purpose of buying and
selling assets, goods and services.
2. As a unit of accounting, money provides a simple
device for identifying and communicating value.
3. As a store of value, money allows the rewards of
labour or business to be stored in a convenient tool.
Money used widely within a country
must be recognised as money by a
central monetary authority
Otherwise commerce, government spending and
taxing could not work together in a consistent and
efficient manner.
A number of entities which possess money-like
properties are not recognised by central banks as
being money. These include commodities, local
currencies, banking lines of credit, and sovereign
securities.
Entities recognised by central banks as being money
(or money equivalents) are included in their regularly
published tables of monetary aggregates.
Money does not need
to have a tangible form
Most of our money supply today takes the form
of computer tokens known as bank credit money
Commodity Money
versus Token Money
A true monetary economy is inconsistent with
the presence of a commodity money, which is
by definition a kind of money that any producer
can produce for himself. But an economy using
as money a commodity coming out of a regular
process of production cannot be distinguished
from a barter economy. A true monetary economy
must therefore be using a token money. This
necessitates having an issuer of currency.
(Graziani, 1989)
Modern Forms of Money
1. State Fiat Money
Money created by a central authority (central bank
and/or central government) and acceptable for the
payment of taxes. The main forms being currency
(coins & notes, which have been declared to be
legal tender) and creditary banking reserves
(exchange settlement funds).
2. Bank Credit Money
Money created by commercial depositories (banking
institutions) as retail deposits, and exchangeable
with legal tender.
Currency - the best known form
of State Fiat Money
We have a dual monetary system
In our economy, banking reserves (state fiat money
held by banks) and bank credit money tag along after
each other. There are endless debates, both among
economists and within the wider population, having their
origins in an inadequate appreciation of the manner in
which these two forms of money relate to each other and
interact.
However it is not necessary to operate a dual monetary
system. A range of economic reformers have proposed
alternative monetary systems in which all money used in
the economy is created by a central monetary authority as
fiat money (but not as reserves). Thus bank credit money
and reserves are not essential for a workable monetary
system.
What is the Money Supply?
The money supply is the conjunction of retail
banking deposits and currency held by the
private non-bank sector.
The word banking refers to the activities of
authorised depository institutions (ADIs) –
commercial banks, credit unions and building
societies.
Retail banking refers to ADI business activity
with the private non-bank sector.
What is a deposit?
A banking deposit is a store of bank credit money, and is
usually regarded as being a claim on state fiat money. All
central banks accept deposits as being part of the money
supply.
The money supply is divided into transaction money (M1, or
narrow money) and nontransaction money (which usually
returns interest). The sum of the two is known as broad
money.
Banking deposits are generally classified as being either
demand deposits or investment deposits. A demand
deposit may be withdrawn (exchanged for legal tender or
for another deposit) at any time at the discretion of the
depositor. An investment deposit returns interest, has a
date of maturity, and early withdrawal incurs a financial
penalty.
A savings deposit occupies a half-way house between the
above two definitions.
Difference between a term deposit
and a certificate of deposit (CD)
These are similar forms of investment deposit, and
the difference is that one can cash in a CD before the
date of maturity subject to a (reduction in interest paid)
penalty stated in the CD. A term (time) deposit usually
cannot be withdrawn early but, being a sound and lowrisk financial asset, could be used as financial collateral
for a gaining a loan until the cash became available.
Bank certificates of deposit and
term deposits return interest
Banking reserve requirements
The term Banking reserves refers to the stock of state
fiat money held by ADIs as assets.
Banking institutions are obliged for several reasons to
maintain a minimal level of regulatory capital in relation
to their financial assets (loans, investments and
reserves), and a minimal level of banking reserves in
relation to their deposits.
The ratio of reserves to deposits is the reserve ratio. In
some countries there is a substantial statutory minimum
reserve ratio, while other countries - including Australia
and NZ - have no (or almost no) statutory reserve
requirement.
Assets and Liabilities
In regard to a bank loan (of bank credit money), the
accounting convention is that:
(a) The debt acquired is a liability of the borrower and
an asset of the bank;
(b) The money acquired is an asset of the borrower
and a liability of the banking system.
Difference between a deposit
and a bank borrowing
A deposit is an asset of the depositor and a liability
of the depository. The liability of the depository is an
obligation to pay the depositor legal tender if
requested (subject to time or other constraints which
might happen to apply). Accompanying a deposit are
banking reserves, which are an asset of the
depository.
A borrowing by a depository has two components:
that part which is an asset of the lender (a loan
security), and that part which is an asset of the
borrower (free reserves). The loan security is also a
liability of the depository.
More on deposits and bank
borrowings
A loan involves the reallocation of assets between lender
and borrower for a period of time. Because deposits are
associated with reserves (which are by definition bank
assets), deposited money has some of the qualities of a
loan. Moreover a loan has some of the qualities of a
deposit.
Despite this logical fuzziness, one may say that
(a) anything accepted as being part of the money supply
cannot be regarded as money loaned to a bank;
(b) anything accepted as being money loaned to a bank
cannot be regarded as part of the money supply.
Complementarity principle
A loan security is an asset of the lender and a liability of the
borrower. Deposited money is an asset of the depositor and a
liability of the depository.
An entity which can be regarded as a loan security
cannot at the same time be regarded as deposited
money, and vice versa.
Central banks are obliged to choose which position to adopt
for a particular financial entity, according to the circumstances
and the utility of doing so.
Highly liquid (short term) government securities, although not
part of the stock of reserves, behave in important ways like
money and are an important part of every bank’s measure of
liquidity. They are sometimes referred to as "near-money" or
"near-reserves".
Investment Deposits
(sometimes called nontransaction deposits)
There seems to be a mixed viewpoint amongst central bankers
and Treasury officials around the world concerning the status of
savings deposits, term deposits, and certificates of deposit manifested as the imposition of a range of reserve requirements
on these financial entities. These requirements are generally
less than the reserve requirement for demand deposits. If these
financial entities were uniformly regarded as loans or
investments, then one would expect a zero reserve requirement
in every country. This is not the case, although it is significant
that the general trend over the last few decades has been a
gradual reduction in the reserve requirement on time deposits.
Indicators of the recognition that these deposits have money-like
features is the retention almost everywhere of the word "deposit"
rather than the word "security", and also the practice of including
savings deposits in the monetary aggregate M2 and time
deposits in the monetary aggregates M3 and M4. It is not usual
for these deposits to be bought and sold in the marketplace,
although there are examples of securities formed from bundles
of such deposits which have been marketed in a similar manner
to mortgage-backed securities.
The view of an investment manager
Is a Time Deposit a Security or a Cash Item?
by James W. Kaiser, CPA Partner,
Investment Management Group
Is a time deposit a security or a cash (money) item? The
answer is both. There are very few short-term instruments that
are treated as a cash item under the 40 Act. The SEC has long
considered time deposits and various other money market
instruments to be securities. Therefore, for the purposes of
financial statement presentation, time deposits are indeed
securities.
Not surprisingly however, the IRS guidance available on this
subject is inconsistent with the SEC. There are General Counsel
Memorandums and Treasury Regulations that clearly include
time deposits in the definition of a cash item. Therefore, for the
purposes of the asset diversification test, one could reasonably
treat time deposits as a cash item. Therefore, a time deposit is
both a cash item and a security, depending on the purpose of
the classification.
Creation and destruction
of bank credit money
Commercial banks create credit money in the accounts
of their customers when they make retail loans, engage
in retail spending, purchase financial assets from the
private sector, accept currency in exchange for a new
deposit, and honour cheques drawn on the central
bank.
And consistent with what was said earlier, payment to a
commercial bank (for any reason whatsoever) entails
removal from the money supply of any bank credit
money associated with that payment. Only the reserves
(which tag along after deposits) are retained -- as free
reserves.
The idea that bank credit money is only
created when banks advance loans
This is a commonly held idea. However technically it is
true to say that spending by a bank involves crediting
an account of the payee with credit money which did
not exist previously. The same is true of the creation
of a deposit in exchange for currency and for a cheque
drawn on the central bank.
The source of this idea might be a particular interpretation
of the word “credit” in the term “bank credit money”. The
word credit has several meanings, and in the context of
a deposit account it may be taken to mean an obligation
of the depository to provide on demand legal tender
(state fiat money accessible to the public) in exchange
for a deposit.
Creating a deposit of credit money
in exchange for currency
Upon receipt by the teller, the coins are transformed
from ‘currency in circulation’ into bank reserves
Creation and destruction
of state fiat money
Central banks create new state fiat money when
they purchase securities (sovereign or otherwise)
from the private sector and from depositories.
Central banks destroy state fiat money when they
sell securities to the private sector and to
depositories.
If over a financial year the central government
happens to spend precisely what it collects from
taxes and net borrowings, then there is no net
change in the volume of state fiat money.
From a technical and MMT perspective, central
banks also create reserves when governments
spend.
Treasury’s central bank account
Treasury’s receipts and expenditures are recorded in its
general operating account with the central bank.
A chartalist (MMT) view of the flow of money would be that:
(a) bank credit money is removed from the money supply
when central government collects revenue from taxes and
borrowings, and is re-created when central government
spends, and
(b) banking reserves also are destroyed and re-created
when government taxes/borrows and subsequently
spends.
Even if it is held that entries in Treasury's general operating
account with the central bank constitutes a form of state
fiat money (which is disputable), it is technically incorrect to
describe these creditary entries as reserves.
Restraints on money creation
Banks are not free to create money willy-nilly.
They are subject to restraints imposed by both the
markets and regulators. But under current
procedures, these restraints do not arise from a
hard limit on the amount of banking reserves in the
system. They arise from the cost of lending, which
is conditioned by (a) the interest rate targeted by
the central bank, (b) regulatory and market capital
requirements and the market price for bank capital,
(c) administrative and hedging costs of lending, and
(d) the credit-worthiness and credit-hungriness of
borrowers.
Endogenous money
Part of postKeynesian economics is the idea that
money is created endogenously, driven by the
requirements of the real economy and that banking
reserves expand or contract as needed to
accommodate loan demand at prevailing interest
rates. The essential components of this theory are
that (a) 'Loans create deposits', (b) a solvent bank
is effectively never reserve-constrained, and (c)
reserve requirements are only significant at an
aggregate level.