Considering the whole capitalist system is reliant on money as circulating capital (usually via centrally-distributed currencies), there is a lot of misinformation and disinformation about the monetary system. For example, a lot of people believe taxes are required for state spending; some think that banks lend money to the Government; many assume that banks have got a fractional reserve requirement; a lot of people think that somehow capitalism produces money, like Mario or Crash Bandicoot hitting a box and producing a coin- they do not understand that money creation precedes production.
So what is money? Money1 is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts in a particular country or socio-economic context. The main functions of money are distinguished as: a medium of exchange, a unit of account, a store of value and sometimes, a standard of deferred payment. Any item or verifiable record that fulfils these functions can be considered as money. To fulfil its various functions, money must have certain properties2:
- Fungibility: its individual units must be capable of mutual substitution (i.e., interchangeability).
- Durability: able to withstand repeated use.
- Portability: easily carried and transported.
- Cognizability: its value must be easily identified.
- Stability of value: its value should not fluctuate.
Historically, commodity money has been at the forefront, where the money is made out of a valued commodity, like gold or shells. Many cultures around the world developed the use of commodity money. The Mesopotamian shekel was a unit of weight, and relied on the mass of something like 160 grains of barley.3 Representative money later developed, where a token (such as paper notes or minted coins) could be exchanged with a central banking authority and converted into a commodity. Nowadays, we have fiat4 money where the money cannot be redeemed for a commodity and the value is derived from the Government’s policies, including taxing people in their currency.
There are still many people who believe that money is still in some sort of representative form, even though since the breaking of the Bretton Woods arrangement in 1971, no gold-backed currencies exist. Bretton Woods5 was a system where a lot of countries adopted after the second world war, where their currencies would be pegged to the dollar and the dollar (at $35 per ounce) could be redeemed for gold. This convertibility was assured by gold price and currency manipulation. Britain’s pound has not been pegged to gold since 1931, although it has changed from a floating currency to a gold standard many times throughout history,6,7, as have other countries8,9.
As there is no convertibility of fiat currency into commodities, this also means that taxes are not needed for central Government’s spending. This is another wide-spread belief about the monetary system: that taxes fund Government spending. Taxes may still be used for revenue for local and state governments but not for national. As the convertibility of money into a precious commodity ceased, the need to use taxation for building back up the reserves (also taking it out of public supply, alleviating the amount that could be converted back to gold at once) and government spending also ended. In 1946, the chairman of the Federal Reserve Bank of New York, Beardsley Ruml stated what taxes are for10,given an inconvertible currency (Taxes for Revenue are Obsolete11):
- As an instrument of fiscal policy to help stabilize the purchasing power of the dollar;
- To express public policy in the distribution of wealth and of income, as in the case of progressive income and estate taxes;
- To express public policy in subsidizing or in penalizing various industries and economic groups;
- To isolate and assess directly the costs of certain national benefits, such as highways and social security.
Ruml was writing at the time after the gold standard had broken down and before the Bretton Woods agreement which re-established currency convertibility and fixed exchange rates for a while.
Instead of paying for spending, proponents of modern money theory contend that fiat money is backed by taxes. By imposing taxes, states create demand for the currency they issue. Sovereign governments must spend (or lend) the currency into the economy before taxpayers can pay taxes in the form of the currency. Spend first, tax later is the logical sequence12. Taxes therefore are idealogical in nature; an instrument of the first importance in the administration of any fiscal and monetary policy. Ensuring parts of the economy that the Government supports get subsidies or less tax, while other parts get taxed heavier due to perceived harm to society or other policy implementation (e.g. alcohol and tobacco industries). Plus taxation limits the money supply and with it inflation throughout the economy.
Modern monetary theory distinguishes among different ways to measure the money supply, reflected in different types of monetary aggregates, using a categorization system that focuses on the liquidity of the financial instrument used as money. The most commonly used monetary aggregates (or types of money) are conventionally designated M1, M2 and M3. These are successively larger aggregate categories: M1 is currency (coins and bills) plus demand deposits (such as checking accounts); M2 is M1 plus savings accounts and time deposits under $100,000; and M3 is M2 plus larger time deposits and similar institutional accounts. M1 includes only the most liquid financial instruments, and M3 relatively illiquid instruments. The precise definition of M1, M2 etc. may be different in different countries. Another measure of money, M0, is also used; unlike the other measures, it does not represent actual purchasing power by firms and households in the economy. M0 is base money, or the amount of money actually issued by the central bank of a country. It is measured as currency plus deposits of banks and other institutions at the central bank. M0 is also the only money that can satisfy the reserve requirements of commercial banks13.
Also harking back to the days of representative money, many people think that there is a fractional reserve commitment still in place. In the UK there is none and throughout the world, banks mainly try to comply with capital requirements14,15 instead. In Britain, the cash base is the notes, coins & deposits of the commercial banks plus whatever money they have in the account of the Bank of England. Since 1981, there have been no formal reserve requirements for UK banks16, with only 2 countries out of the G7 (USA & Italy) requiring over 2% reserves by 1998.
In the modern day, money creation is mainly done by private banks creating loans17,18. The Bank of England, for example, does not fix the amount of money in circulation and it is expected that ‘market forces’ to be the best regulator of money creation, along with using base interest rates to target inflation. This magical market force is believed to moderate all the issues and credit risks of letting private institutions create the money used by all. Central banks (being the lender of last resort) also uses quantitative easing along with open market operations, where the central bank can buy or sell interest bearing bonds19, to ensure policy objectives are met. If central banks want to increase the amount of money in circulation it can do so by buying up previously issued bonds.
This process of money creation underpins most economic activity, whereby prices of goods and services are linked to how much money is in existence. Furthermore, all money is created due to ‘market forces’, where perceived production/consumption needs and wants are supplied by the appropriate amount of loaned/created money. This often complex and circular activity is difficult to comprehend at times and leads people to some sort of money illusion20, or believe outright lies to make their lives easier. The perpetuation of these myths, ensure that not many of the general population question the actions of the capitalist governments and money issuing entities (as they generally need money to survive). So when the system nears collapse, any draconian policies can be rationalised as a sensible money-saving activity rather than an idealogical proceeding.
Interestingly, recent years have seen the rise of decentralised tokens called crypto-currencies21, essentially trustless payment systems. While many who use these are capitalist adherents and base their expectations on associated market economy rules, they do give the wider public much to think about when it comes to money creation and what constitutes value in the general sense.
As with most things, there are a few competing theories on what money is and how it functions. A good detailed history of some the competing theories on bank’s role in money creation – credit creation theory, fractional reserve and financial intermediation – can be found in the International Review of Financial Analysis, 201422. Entitled ‘Can banks individually create money out of nothing? – The theories and the empirical evidence’, provides a concisive overview of the theories and put to empirical test by internal audits of participating bank. It concludes that banks do indeed create money out of ‘thin air’.