Economics: The Basics: Money

In our last post we took a look at Capital and discovered that, strictly speaking, it does not include money.  Money is a claim on wealth, not wealth itself.  These are important distinctions, since if we hope to form a real understanding of how an economic system functions, we should be precise about its elements.  In light of this it is useful to spend some time on money – what is it and who is responsible for its production.

First, what is it?  A seemingly simple question but like many things in the subject of economics there are some nuances.  The coins and notes in your pocket are clearly money but what about the contents of your bank account?  Certainly they pass as money but with different characteristics.  Rather than hard currency which takes a tangible form, it has no physical form, is created by a few keystrokes and is, in fact, credit issued at interest.  More on this credit money below.

Money has been described as a means of exchange, a unit of account and a store of value.  Certainly it operates as the first mentioned and could take the form of anything that was widely acceptable.  In the past all sorts of objects have qualified as a means of exchange such as cowry shells and dried cod.  Importantly, it is not the intrinsic value of the object that qualifies it as money but its acceptance as a unit of exchange.  In fact its principal purpose is as a medium of exchange.  If it were to be acquired for example, for direct consumption, then it could cease to perform the function of money.  The fact is that we only seek to acquire money so that it can be exchanged for something we need.  Hence, its role as a claim on wealth rather than wealth itself.

To become a unit of account would follow from acceptance as a means of exchange.  It becomes a means of keeping score.  However, to become a store of value requires another step and that is that the object either has to have an intrinsic value or is declared by some sovereign power as being exchangeable or acceptable as a unit of exchange.  Coinage based upon a precious metals content would satisfy the former and the statement ‘This note is legal tender for all debts public and private’ on those dollar bills in one’s pocket satisfy the latter.  The debasement of coinage by “clipping” and the destruction of the purchasing power of a unit of exchange we must leave for another time but it does not invalidate the characterization of the object in question as money.

Thus far we have only considered what economists call Base Money, that is the coins and notes in existence.  By far the larger share of money in circulation takes the form of credit money, i.e. electronic entries in bank accounts of individuals, corporate and governmental entities.  The relationship between the two varies from time to time and from nation to nation but in very round numbers is not less than 10:1; for every $1 in Base Money there are $10 in electronic format.  In fact in advanced nations Base Money may be no more than 5% of the total money supply.  This all seems to work well enough as long as there is confidence in the system and we do not all want to withdraw our cash at the same time.

Second, let’s now look at who controls the production of money.  In the U.S., and elsewhere, the production of Base Money is in the hands of government.  Provided government has the interests of its people at heart it is reasonable to assume that it will exercise control over the amount of Base Money that exists from time to time.  It can create and withdraw from circulation notes and coins to maintain what it considers to be an appropriate level of currency to support a certain level of economic activity.

However, this Base Money is only a fraction of what is in existence at any one time.  The balance of the money supply is in the hands of the commercial banking sector, the private sector.  There are of course reserve requirements and liquidity thresholds, but the commercial banks have the capacity to create money largely at will.  This is done by lending money into existence.  It is widely believed that a bank can only lend to the extent that it has depositors’ funds available.  This is not the case.

What happens, in fact, is that assuming one’s credit is satisfactory, the bank opens an account in the borrower’s name and credits that account with the agreed loan amount which can be drawn down for the purposes agreed.  There need be nothing more than an agreement between the borrower and the bank to return the loan principal and the agreed interest at some point in the future.  There may or may not be collateral for the loan.  The bank has created the loan out of thin air, ex nihilio, out of nothing.

Two important points to note about this arrangement.  First, unlike cash or notes, credit money is not free; it carries interest.  Second, since the creation of credit money is in private hands there is competition among banks to lend and therefore pressure to extend credit on less and less onerous terms.  This tends to give rise to situations where credit is either freely available or only under extremely onerous conditions, thereby affecting levels of economic activity.  Unlike government, which, hopefully, has our interests at heart, the private sector is beholden to its shareholders.  We will examine some of the implications of this split responsibility for money creation in later posts. – Chris Wood is the Head of Economic Studies for the School of Practical Philosophy, New York


One thought on Economics: The Basics: Money

  1. Unfortunately, government often only has the interests of certain groups. Responsible government, both individually and socially should be a topic for discussion.

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