The Importance of Money

by George Hatjoullis

Gold is one of the earliest forms of money. Goods are priced in ounces of gold. Exchange of goods takes place via the medium of gold. Those with excess goods will sell them and hold gold as wealth and thus defer consumption of these goods. People always need to keep some gold around to effect transactions. If they have none they need to sell something (their labour perhaps) to acquire gold. Unmediated exchange is always possible but as the economy grows larger and more complex it becomes more difficult and rarer. An habitual amount of gold is typically kept in proportion to wealth and normal levels of transactions. In other words, there is a stable demand for gold in proportion to economic activity.

At any point the supply of gold is fixed (or grows only at a steady rate determined by existing mines and the rate of gold production). This fixity of supply is important. What happens in this economy if the supply of gold is fixed but output and exchange is growing? If the demand for gold is stable as a proportion of exchange activity then growing exchange implies a growing demand for gold. However, the supply is fixed (by assumption). There is thus a chronic excess demand for gold. One way to fulfil this is to raise the price of gold in terms of goods and services. The same physical amount of gold can then serve a growing economy because the value of gold (in terms of goods and services) is growing in proportion. However, what do we call a rising value of money in terms of goods and services? Deflation.

Periodically, new mines are discovered and the supply of gold expands exogenously. This can lead to inflation and the miners expand their consumption far more quickly than goods production can respond. Eventually, the goods demand expansion may lead to a goods supply expansion and everything settles down again. However, note that economies and the volume of exchange tend to grow steadily (at least in line with population), so unless there are constant new discoveries of gold, a deflation bias will exist in an economy mediated by gold as money. The result is the gold standard.

Under the gold standard banks issue notes and coin that are ostensibly backed by gold (promissory notes). In principle one can turn up at the bank and ask for the physical gold equivalent of the coin value. In practice few do except in extreme circumstances and so the notes and coin in circulation, the promissory notes, serve as money. This is rather useful as it removes the deflation bias introduced by the fixed supply of physical gold. However, unless carefully regulated it introduces an inflationary bias. As long as people are willing to use these promissory notes as money the banks can print as many as they like and get goods and services in exchange. This seigniorage is typically purloined by the state which vests this power in its central bank. This does not automatically remove the inflationary bias though as governments are not averse to over-issuing in order to fund state spending. This is known as monetary financing.

The habit of using state issued promissory notes as money renders the need for even pretending that they are gold backed pointless. This fiat money (money because the state says it is) is now the common form of money in the modern economy (though Bitcoin is making a place for itself in some darker corners of the digital economy). In the modern banking system the state issued fiat money takes on the role of gold. The notes and coin in your pocket constitutes state issued fiat money. However, most holdings of state issued fiat money is via deposit taking institutions or banks. Th habit has developed of treating these deposits as money. However, these deposits are loans to the banks. The guarantee system insures a proportion of the deposit but anything in excess is uninsured and a, albeit senior, bank loan.

This system has worked quite well until recently because of substantial independence given to central banks and the mandate of price stability. The central banks judge how much money is necessary to support the economy to grow at its potential and aim to see that money growth proceeds at this rate. This ensures no inflationary or deflationary bias. The problem is that they do not control money creation. This is because the deposit takers intermediate. If the central bank wants money growth it has to persuade the deposit takers to lend and expand deposits. This is because it is these deposits that people primarily use as money. If they do not lend then how can the deposit base grow? If the deposit base fails to grow then the economy will experience an effect similar to there not being enough physical gold when exchange is growing, namely a deflation bias.

The 2008 financial crisis upset this situation in two ways. One is widely understood. One it seems is not understood at all. First, it stopped banks from expanding loans as fast as the central banks might have wanted. This created a deflationary bias which the central banks tried to offset via quantitative easing. However, this fell foul of the second unrecognised effect. Bank deposits above insured amounts are no longer deemed to be money. This is because the ‘too-big-to-fail’ category of bank no longer exists. Holding a deposit over and above the insured amount is no longer deemed as safe as cash. The EU banking reform has made this explicit and the Cyprus crisis has illustrated what this can mean. Greek banks may now be about to experience the same reality. QE removes safe government debt from the system and replaces it with large, uninsured bank deposits. How does this help the lack of money growth?

The purpose of this little blog is to illustrate how money growth is important in an exchange economy that is mediated by money. The gold economy is clear enough. The advent of jargon and complex processes often obscures the fact that this same mechanism applies in a modern economy. Money is whatever is deemed money but it must grow in line with the economy to avoid inflation or deflation bias. The central banks understand that the deposit taking system may not work under extreme circumstances. They appear to have missed the significance of a fundamental change in what is acceptable in the role of money.