Analysis by Keith Rankin
What is Money?
Money is a mystery. To most of us we receive it, we spend it, we save it, we borrow it. And if we don’t have enough, we are in trouble.
Many of us think of money as if it is tangible, like gold; something that is naturally scarce, and that must be won through toil. Those of us who think like that tend to resent beneficiaries, who, as they see it, live off the toil of others. Exceptions are made for the capitalists (and landed proprietors) who earn money through what they own rather than what they do, who don’t have to toil, because they or their ancestors must have been sufficiently productive or unscrupulous to gain a get-ot-of-toil-free card. (The correct name for this category of work-exempt people is rentiers; the word capitalist is too ambiguous.)
This understanding of money is untenable today, and never in history was actually true. Rather money is – and always has been – a set of circulating promises. Money is, and always has been, a social technology. Gold was created by supernovae (exploding stars), so is part of nature. Money was, and is, and will be, created by people, and represented on a balance sheet.
What makes money different from other promises is that the signatory is understood to be a formal authority. Even electronic money has an implicit signature, and maintains its character as an authoritative promise. To be money, a promise must be free to circulate in a social environment, it must have an imprimatur of authority, and must be accepted by all sellers in all markets. While nowadays most of our money is held as bank deposits – neither notes nor coin – it is the number (eg 10) that matters.
If we look at a $10 banknote, we see that it is an explicit signed promise; signed by the principal of the issuing Bank; in most countries, the Reserve Bank. (In the old days such a banknote was a guarantee to exchange it for coin. In practice, we almost never used that guarantee. Coins themselves are implicit promises; promises by whoever’s head is featured on the coin.) Monetary promises can be exchanged, directly, for goods and services. (Other promises should first be exchanged for money, then be used to buy goods and services; though they may be accepted by some people as if they were money. Market exchanges that do not use money are barter.)
The meaning of that number 10 is socially constructed; it means that the holder can buy an amount of goods or services that is fair (consensually appropriate) for the number 10. We understand that, in another time or another country, a different amount of goods and services may be fair for the number 10.
Promises are essentially costless to create. Any individual or organisation can produce signed promises. Such a contractual promise is a ‘bond’, an ‘agreement with legal force’. In principle, bonds can be bought and sold, with such transactions not necessarily involving the person(s) who signed them. There is an industry and an associated academic discipline that is devoted to transacting in and studying promises. It is called ‘finance’.
Banking and Bookkeeping
Money is created when any bank purchases a promise that is not money; the most obvious case is when it makes a loan in return for a promise to service that loan. In this case the bank is buying a new promise. In other cases, it may be purchasing a promise that already existed. Indeed, when a bank buys a mortgage (a ‘pledge’, an example of a promise) from another mortgagee (mortgage owner) money is also being created. If the seller is another bank, then the act of a bank selling a promise extinguishes an equal amount of money. But if the seller is not a bank, then the write-up of one bank’s balance sheet is not matched by the write-down of another’s. New money is created.
In summary, when banks buy promises (eg a loan is issued), money is created. When banks sell promises (eg a loan is repaid), money is extinguished. Banks are in the business of buying and selling promises.
In most countries the Reserve Bank is the monetary authority, and is owned by the subject people of that country. The New Zealand Reserve Bank is a cooperative, owned by ‘the public’ who ‘enjoy’ its services. Likewise, the Government is the organisational embodiment of ‘the public’. Both Government and Reserve Bank are public institutions. Their principals – their owners – are the same, ‘the public’.
The Reserve Bank ensures that enough money is being created through both its supervision of the other banks, and through its own direct action in buying or selling promises.
When a country needs more money, but there are not enough loans being made by the commercial banks, then the Reserve Bank can buy promises from the Government. If there are already plenty of government promises in circulation, then the Government is not a party to these transactions. Otherwise, the Reserve Bank can buy new promises by the government. So, in situations when the Government needs more money, and the Reserve bank independently judges that the Government should have more money, and that there is an economic need for more money to circulate, then the money is created when the Reserve Bank lends to the Government.
At this point, many people worry about the future economic burden, because the government will have to repay these loans. This putative burden, misleadingly known as the public debt (misleading because it is a credit as well as a debit, owned as well as owed), is commonly called the ‘country’s debt’ or the ‘national debt’.
There is nothing to worry about. First, the government is only required to service these loans, and if the interest rate on the loans is zero, then no actual payments are required. Second, for every debtor there is a creditor. If one party (eg the government owes money), then it must owe money to some other party. All debts owed by the government to the Reserve Bank are in fact owed to the shareholders of the Reserve Bank. The People owe the money to the People. So, when the people repay what they owe, they are also being repaid what they are owed.
With respect to the Covid-19 emergency, there is no limit to the amount of money that can be created to address the problem. Further, although the mechanism is debt, any money we repay, we repay to ourselves. Increased public debt during a public emergency need not be a public burden.
Money is lubrication oil, not petrol.
Tis the oil, which renders the motion of the wheels more smooth and easy.
David Hume, ‘On Money’, 1752
As a social technology, money can be thought of as an economic lubricant. Thus, it lends itself to the analogy of a car, an automobile.
A car’s oil sump holds its lubricating oil. For those of us who have changed the oil or topped up the sump, we use a dipstick to determine whether we have the correct amount of oil. The dipstick has two marks; the correct oil level should be somewhere between the two marks.
We may think of the Reserve Bank’s monetary policy committee as the mechanic who manages the oil level of a car. Monetary policy is like reading a dipstick. We should imagine a sump that has excess capacity; that is, the ability to hold more oil than the car requires. Thus, for our car, it is technically possible for there to be both too little oil, or too much oil.
The flow of oil can be impeded by leaks or blockages. Blockages represent structural problems in the economy, which are not part of this discussion. Leaks represent the withdrawal of lubricant from its circulation through the cars moving parts. In a monetary sense, leaks represent the hoarding of money, the non-spending of money, its withdrawal from circulation. Such leaks make the oil level in the sump too low. While, in the long run it would be nice to fix these leaks, it is the role of the Reserve Bank to top-up the sump – the balance sheet of the banking system – to compensate for monetary leakage. It does this through an active process of double‑entry book‑keeping. This process is essentially costless; money supply is infinitely elastic (though socially constrained), unlike the gold supply which is not at all elastic.
(Using the car analogy, we can imagine two kinds of leaks; one where the oil leaks onto the road and is lost permanently, or oil that leaks into some kind of container attached to the car and that can technically re‑enter circulation though is not available to the mechanic. Part of the job of the mechanic is to watch out – and adjust for – for the re‑entry of leaked money.)
Any kind of economic crisis represents a new and large leak. The link may be exogenous (eg caused by an external shock such as a new coronavirus), or endogenous (created by internal financial failings, as in the 2008 Global Financial Crisis).
There are two other kinds of crisis that are of concern to monetary macroeconomists. One is the possibility that the sump is overfull. In the quote below the result is a cappuccino froth.
What happens if oil level is too high?
It’s true that overfilling the crankcase with oil can damage the engine. When you overfill the crankcase by a quart or more, then you risk “foaming” the oil. If the oil level gets high enough, the spinning crankshaft can whip the oil up into a froth, like the stuff that sits on top of your cappuccino.
found via Google
To some macroeconomists (the classically-minded ones) this froth is called inflation, is dangerous, and is an inevitable consequence of an overfilled monetary sump. To other macroeconomists (such as myself), this leads to a reduction of the rate of flow of the lubricant relative to the supply of lubricant (called a reduction of ‘velocity’); not a perfect situation, but also not much to worry about. Whether for a car or for the economy, having too much lubricant is a far less serious crisis than having too little lubricant.
The fourth crisis is an undiagnosed structural crisis – one of undiagnosed blockages rather than leaks. The car will run much as if it was losing oil, though it isn’t. While adding more lubricant may or may not create harm (eg stagflation; simultaneous inflation and recession), it is unlikely to fix the problem.
(Blockages may be the economic equivalent of ‘fatbergs’, created by inappropriate by inappropriate items being flushed into sewers. Organisational bureaucracy may be an example here. More generally, blockages come under the generic label ‘market failure’, and require public intervention to address.)
Public Debt is a Solution, not a Burden
Technically, money created during a crisis is public debt. But, so long as the Reserve Bank at the apex of the banking system is publicly owned, it is also a public credit.
When a recovery from a crisis is well under way, private businesses (and later households) take on more debt, economic activity increases, as do taxation revenues. This means that the level of public debt will naturally fall. The Reserve Bank may sell government bonds, and purchase more commercial (business) bonds.
Also, typically for a crisis, the commercial banks have a substantial capacity to increase lending – to buy new promises from businesses. It means that, in the recovery, more of the total money supply will appear on the balance sheets of commercial banks, and less on that of the Reserve Bank. Tax revenues will increase, allowing Government to reduce its emergency debt.
What needs to be avoided is a public austerity programme which seeks to reduce government debt as a goal in itself. Rather, fluctuating public debt – which is mainly what the people owe themselves – needs to be understood as a stabilisation process. In a crisis – when the amount of money circulating would otherwise be too low – public debt should dominate the Reserve Bank’s balance sheet, and the Reserve Bank’s balance sheet dominates the combined banks’ balance sheet.
With double‑entry bookkeeping, total assets equal total liabilities, by definition. The liabilities of the combined banks’ balance sheets are the money supply. There is no upper limit to the amount of money that we have, and there is never a need for governments to undermine the monetary process through premature attempts to reduce the amount of money the public owes itself.
Governments service and manage public debt by raising the public debt when tax revenues are constrained, as in an economic crisis. And by reducing the public debt when rising tax revenues allow, that is when the private economy is thriving.
A headline in the New Zealand Herald (31 March) said:
‘Generations’ of Kiwis to pay for economic recovery, says Finance Minister Grant Robertson
It is nonsense. There is no technical upper limit to the money supply; there is no upper limit to the amount of money we can owe to ourselves. Emergency public debt is not like taking gold from the vaults, and then requiring generations to repay that gold through toil.
Many Kiwis, with reluctance, will change their career paths. Some others may choose a better work‑life balance than they experienced in the 2010s. Average living standards are a function of economic productivity. There is no connection between the high public debt and low productivity. While Gross Domestic Product may be lower than before, there is no reason to believe that productivity – that living standards – will be lower in a post-Covid19 world.