MMP Blog #14: IOUs Denominated in the National Currency: Government and Private

By L. Randall Wray

In the past two weeks we took a bit of a diversion the case of so-called commodity money consisting of precious metal coins. We also briefly discussed the gold standard. I argued that even on a gold standard, the currency is really the government’s IOU backed by taxes. And that remains true even if the sovereign stamps the IOU on a gold coin. So those precious metal coins were really what is often derided as a “fiat money”. The typical dichotomy posed between “fiat money” that has “nothing” backing it versus a “hard money” or “commodity money” with gold or silver behind it is actually false. All “modern money” systems (which apply to those of the “past 4000 years at least” as Keynes put it) are state money systems in which the sovereign chooses a money of account and then imposes tax liabilities in that unit. It can then issue currency used to pay taxes.

In the introduction to this Primer I had promised not to delve too much into history—first because our main purpose is to explain how money works today; and second because the past is admittedly cloudy (“mists of time” as Keynes said). However, I felt it was necessary to explain how things worked on the gold standard and with metal coins (as best as we can determine) in order to argue that those who think that “fiat money” systems are something strange, unnatural, and of recent vintage, are confused. Governments of the past and present can choose to tie their hands, so to speak, by standing ready to convert their currencies to precious metal or foreign currencies. Fixed exchange rate systems stand at one extreme of the modern money continuum. They are a policy choice. There is nothing “natural” about them. They do, however greatly reduce fiscal policy space—in ways to be discussed more later in the primer. The US and other sovereign countries could choose to tie policy in that manner. But they would not thereby return to some mythical utopian past with a natural self-regulating commodity money. In truth, domestic fixed exchange rate systems usually bring on more problems than they resolve, and they are typically short-lived. And international fixed exchange rate systems—such as the sterling system or the Bretton Woods system fared no better.

This week we return to our analysis of the operation of today’s monetary system, examining the denomination of IOUs in the state money of account.

IOUs denominated in national currency: government. In earlier blogs we have noted that assets and liabilities are denominated in a money of account, which is chosen by a national government and given force through the mechanism of taxation. On a floating exchange rate, the government’s own IOUs—currency—are nonconvertible in the sense that the government makes no promise to convert them to precious metal, to foreign currency, or to anything else. Instead, it promises only to accept its own IOUs in payments made to itself (mostly, tax payments, but also payments of fees and fines). This is the necessary and fundamental promise made: the issuer of an IOU must accept that IOU in payment. So long as government agrees to accept its own IOUs in tax payments, the government’s IOUs will be in demand (at least for tax payments, and probably for other uses as well).

On the other hand, when government promises to convert on demand (to foreign currency or precious metal), holders of the government’s liabilities have the option of demanding conversion. This might in some cases actually increase the acceptability of the government’s currency. At the same time, it commits government to conversion on demand—which as discussed earlier requires that it have accumulated reserves of the foreign currency or precious metal to which it promises to convert. Ironically, while it might be able to find more willingness to accept its currency since it is convertible, it also knows that increasing currency issue raises the possibility it will not be able to meet demand for conversion. For this reason, it knows it should limit its issue of a convertible currency. Should holders begin to doubt government will be able to convert on demand, the game is over unless government has sufficient access to foreign currency or precious metal reserves (either its hoards, or to loans of reserves). It can be forced to default on its promise to convert if it does not. Any hint that default is imminent will ensure a run on the currency. In that case, only 100% reserve backing (or access to lenders) will allow government to avoid default.

We repeat that convertibility is not necessary to ensure (at least some, perhaps limited) demand for the domestic currency. As discussed above so long as government can impose and collect taxes it can ensure at least some demand for a nonconvertible currency. All it needs to do is to insist that taxes be paid in its own currency. This “promise to accept in tax payment” is sufficient to create a demand for the currency: taxes drive money.

Private IOUs denominated in the domestic currency. Similarly, private issuers of IOUs also promise to accept their own liabilities. For example, if a household has a loan with its bank, it can always pay principle and interest on the loan by writing a check on its deposit account at the bank. Indeed, all modern banking systems operate a check clearing facility so that each bank accepts checks drawn on all other banks in the country. This allows anyone with a debt due to any bank in the country to present a check drawn on any other bank in the country for payment of the debt. The check clearing facility then operates to settle accounts among the banks. The important point is that banks accept their own liabilities (checks drawn on deposits) in payments on debts due to banks (the loans banks have made), just as governments accept their own liabilities (currency) in payments on debts due to government (tax liabilities).

Leveraging. There is one big difference between government and banks, however. Banks often do promise to convert their liabilities to something. You can present a check to your bank for payment in currency, what is normally called “cashing a check”, or you can simply withdraw cash at the Automatic Teller Machine (ATM) from one of your bank accounts. In either case, the bank IOU is converted to a government IOU. Banks normally promise to make these conversions either “on demand” (in the case of “demand deposits”, which are normal checking accounts) or after a specified time period (in the case of “time deposits”, including savings accounts and certificates of deposits, known as CDs—perhaps with a penalty for early withdrawal).

Banks hold a relatively small amount of currency in their vaults to handle these conversions; if they need more, they ask the central bank to send an armoured truck. Banks don’t want to keep a lot of cash on hand, nor do they need to so in normal circumstances. Lots of cash could increase the attractiveness to bank robbers, but the main reason for minimizing holdings is because it is costly to hold currency. The most obvious cost is the vault and the security guards, however, more important to banks is that holding reserves of currency does not earn profits. Banks would rather hold loans as assets, because debtors pay interest on these loans. For this reason, banks leverage their currency reserves, holding a very tiny fraction of their assets in the form of reserves against their deposit liabilities.

So long as only a small percentage of their depositors try to convert deposits to cash on any given day, this is not a problem. However, in the case of a bank run in which a large number of depositors tries to convert on the same day, the bank will have to obtain currency from the central bank. This can even lead to a lender of last resort action by the central bank that lends currency reserves to a bank facing a run. In such an intervention, the central bank lends its own IOUs to the banks in exchange for their IOU—the bank gets a reserve credit from the central bank (an asset for the bank) and the central bank holds the bank’s IOU as an asset. When cash is withdrawn from the bank, its reserves at the central bank are debited, and the bank debit’s the depositor’s account at the bank. The cash held by the depositor is the central bank’s liability, offset by the bank’s liability to the central bank.

Next week: we will begin with an analysis of how banks clear accounts among themselves, by using central bank reserves. This also leads to a discussion of “pyramiding”: in modern economies that leverage liabilities, it is common to make one’s own IOUs convertible to those higher in the debt pyramid. Ultimately, all roads lead back to the central bank.

22 Responses to MMP Blog #14: IOUs Denominated in the National Currency: Government and Private

  1. 1. Why can't Fed control inflation by adjusting the reserve ratio instead of targeting the interest rate? (It would also help to minimize interest compounding over time). 2. Since we the monetary system is fiat, why don't we practice 100% reserves banking, because fractional fiat seems to be an oxymoron. 3. Should the "interest on interest" under a fiat system differ from a "gold backed currency" for consumer credit? That is, I understand charging "interest on interest" under a gold standard or under fiat (if I personally saved that money and lent it out to another person), because this interest on interest is an "opportunity cost" of sorts. But under fiat, compound interest (interest on interest) seems fraudulent when a consumer borrows because that money never existed in the first place. That is I can't credit a person 100k (that I never saved) and charge them interest on that loan, but banks can. The question is the compound interest still appropriate for a fiat monetary system? (I would think that simple interest equal to inflation sufficient for banks under fiat. The simple interest may need to accomadate "reserves" that banks borrow elsewhere after the loan was made. Then credit quality would determine the amount that an individual could borrow. And debt insurance would be a different fee to cover for a individual/corporation with excessive debt level. I guess is compound interest another "relic" of the gold standard?)

  2. China's fixed exchange rate (or the partially gold backed Swiss franc) has fewer policy choices. For example what drawbacks?Under a floating system, the problem of managing foreign reserves is eliminated but who is "losing" reserves or national income that existed under a fixed exchange rate? Sorry for so many questions, I've been reading a lot about the monetary system and such.

  3. Randy,You probably need the deal with the IMF conversion clauses since that sort of provides for a 'promise to convert on demand'. Is that just a liquidity measure?

  4. Why do you need a lender of last resort? The Euro system doesn't appear to have one?What happens if you don't have one, or there isn't a discount window? Would 100% reserves without a discount window or lender of last resort help control credit (as suggested by the 'positive money' people out there)?

    • Technically, Positive Money advocates more than 100% reserve banking. Their new publication describes their proposal and they also contrast it against the old Chicago 100% reserve plan. Random wonky tid-bit.

  5. All entities in an economy can expand their balance sheets and create 'private IOUs' as liabilities. That is what a share certificate is for example What makes banks special?

  6. Hi,Thank you so much for this primer on MMT, I red it the whole summer through and can't wait every Monday morning for the new blog !I have two questions. 1) You said : "In such an intervention, the central bank lends its own IOUs to the banks in exchange for their IOU—the bank gets a reserve credit from the central bank (an asset for the bank) and the central bank holds the bank’s IOU as an asset"So, what kind of IOU is this "bank's IOU" that serves as collateral for a loan of CB IOU ?I guess it can't simply be the regular bank's IOU (as a bank can issue it at will, it'd be much too easy + what would the CB do with that ?)It can't neither be the CB IOU's (as otherwise it would be an exchange of CB IOU's against CB IOU's !)So are those the "loans as asset" that you mentioned in the blog ? Could you be more specific what it is and how it works ? (or even better : give an example ! :))2nd question :you wrote : "The cash held by the depositor is the central bank’s liability, offset by the bank’s liability to the central bank."I don't understand. If you are talking about cash (= CB IOU) what the regular bank has to do with that ? Do you simply mean that when cash is withdrawn from a bank, what happens is a transfer of CB IOU from bank to the "withdrawer" (excuse my English) ? If yes, (for once) I don't see the link with the preceding idea.Thanks !!!

  7. Do the commercial money center banks act to influence FOMC operations or is it the other way around? Primary dealers are in fact nothing more than procedural "market makers" for the fed? Am i thinking right on this?

  8. Since money, as you present it, is debt when it is issued, why does the government need to borrow it once again—and therefore incur debt to others on the debt it issues as money—and then pay interest on its own debt, and in its own currency, to private sector lenders? Why does the private sector need to be given a cut of the proceeds—in the form of interest payments—of money when it is issued as debt by the government? I see no reason for government to borrow money (or tax) when it can provide its own capitalization of projects necessary to maintain the general welfare. I am in agreement with John Kenneth Galbraith that the division between the private and public sector is illusory (See his “The Economics of Innocent Fraud,” page 53) There may seem to be a distinction down here, at a remove from power where most people live; but within the top command levels of government, people—along with their individual private interests—move freely between what is known to most of us as the private and public sectors.

  9. "What makes banks special?"Good question…financial innovation has enabled non-banks to do things that previously only banks could do.Consider that an industrial company with a good credit rating can issue short-term bonds which becomes "money" when purchased by a money market fund.Arguably this sort of financial alchemy should be forbidden since it results in hidden risks. But on the positive side, it results in a more competitive financial services market.

  10. Your new font is unfortunate. Everything's hard to read.

  11. Jeff,1. Why can't Fed control inflation by adjusting the reserve ratio instead of targeting the interest rate? (It would also help to minimize interest compounding over time). As is frequently reported, lack of reserves don't constrain lending and extra reserves don't encourage it. Check it out:http://www.federalreserve.gov/pubs/feds/2010/201041/201041pap.pdfAn excerpt:Finally, reservable liabilities fund onlya small fraction of bank lending and the evidence suggests that they are not the marginal sourceof funding, either. All of these points are a reflection of the institutional structure of the U.S.banking system and suggest that the textbook role of money is not operative….Changes in reserves are unrelated to changesin lending, and open market operations do not have a direct impact on lending…our results indicate that bank loan supply does not respond to changes in monetary policythrough a bank lending channel, no matter how we group the banks.Also, the new font IS unfortunate. Gives me a headache. I ran out of aspirin, so I'm drinking to get my mind off the headache. But now I'm drunk, so I can't drive to go get more aspirin OR more liquor. You see the problem here – I'm sobering up. Please change the font.

  12. Hi, Thanks for the primer, I'm a first time poster… I'd like to know more about how banking works, specifically the interaction of vertical and horizontal money. A bank can lend more money out than it has capital to back it up right? Hence the problem with runs. MMT often stresses bank loans do not create new net financial assets (the deposit created is my asset but the bank's liability, but the loan is the bank's asset and my liability, nets to zero). But what happens if, say, I take a $10 million loan and I go bankrupt (I spent the money and it's now someone else's asset), and this causes the bank to go bust, is what was originally credit money now new NFA's? And does it mess up the sectoral balances? Or is my question meaningless due to my lack of understanding of how banks transfer money to other banks via the check clearing facility?

    • Visit positivemoney.org. It’s based in the UK, so a few dates and figures you will need to Google since they refer to the UK figures, of course. But, by far, the BEST reference for banking operations.

  13. "The important point is that banks accept their own liabilities (checks drawn on deposits) in payments on debts due to banks (the loans banks have made), just as governments accept their own liabilities (currency) in payments on debts due to government (tax liabilities)."It seems to me that the gov't will also accept demand deposits for taxes and that banks will also accept currency for debts due to banks. This allows for a medium of exchange supply that "circulates" in the real economy.And, "For this reason, banks leverage their currency reserves, holding a very tiny fraction of their assets in the form of reserves against their deposit liabilities."I believe a discussion will eventually come up about whether "currency" reserves are leveraged or capital is leveraged (meaning the reserve requirement vs. the capital requirement).And, "Next week: we will begin with an analysis of how banks clear accounts among themselves, by using central bank reserves. This also leads to a discussion of “pyramiding”: in modern economies that leverage liabilities, it is common to make one’s own IOUs convertible to those higher in the debt pyramid."Good, I like that the phrase central bank reserves is there. I hope “pyramiding” will lead to a difference between "IOU's" that are 1-to-1 swapping and going into debt at a bank or something bank-like.And, "Ultimately, all roads lead back to the central bank."IMO, it will eventually lead to the amount of medium of exchange and/or its velocity.

  14. Unknown said: "A bank can lend more money out than it has capital to back it up right?"I'd rather say a bank can create more demand deposits than it has capital but basically yes.And, "Hence the problem with runs."A bank can be illiquid but not insolvent. See last resort action above in the post.It seems to me you are asking the right question(s) about the difference between NFA's and medium of exchange.Here are some links to check out:http://bilbo.economicoutlook.net/blog/?p=15038See JKH's comments towards the bottom.Also, http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/11/money-banks-loans-reserves-capital-and-loan-officers.htmlThe one of JKH's comments to look for starts with "A thought provoking post, thanks."WARNING: It is a LONG comment.

  15. Godefroy said: "So, what kind of IOU is this "bank's IOU" that serves as collateral for a loan of CB IOU ?"If I'm reading that correctly and under what would be considered "normal" circumstances, it would be a short term U.S. treasury.

  16. jeff said: "1. Why can't Fed control [price, my add] inflation by adjusting the reserve ratio instead of targeting the interest rate? (It would also help to minimize interest compounding over time)."Won't adjusting the reserve ratio (requirement) eventually affect the interest rate? By "the interest rate", I assume you mean the overnight fed funds rate.And, "That is I can't credit a person 100k (that I never saved) and charge them interest on that loan, but banks can."IMO, it is because the "powers that be" want the amount of medium of exchange to increase in a certain way.

  17. My 2 cents:What makes banks special? The government accepts bank checks for tax payments. Bank checks are twintopt. This is logically equivalent to discount window access. In effect, the government says (some) bank liabilities are as good as government liabilities, so "money in the bank" trades at par with government money. See Understanding Modern Money, p.105Companies issuing debt that becomes money is not such an innovation. There's nothing new under the sun – I'm sure there were cuneiform & hieroglyphic versions of Understanding Modern Money, back when it really was modern. :-) Bills of exchange issued by major merchants were a major part of the UK "money supply" in the 19th century, and were important in the development of modern banking.Unknown: If you go bankrupt, then the money you spent is someone else's asset, but it is also someone else's liability – the bank where the guy who has the money you spent banks at. So it is not transformed into NFA unless it is taken out in cash, which decreases that guy's bank's reserves, so never any new NFA. Your going bankrupt means your liability disappears, but so does your bank's asset. No net change in NFA.Always, always, always think of money as a relationship, not a thing. Money is always credit money. Purely private transactions can never change "NFA" – which refers to government liabilities which are private assets. The government is a monopolist over its own liabilities – just as you are (with the exception of taxes, liabilities the government imposes on you).That being said, banking can create NFA, in concert with the government, as tools of hidden fiscal spending. If your bankruptcy is big enough, it can make the bank insolvent,make violate the government's lending requirements, etc. So the government can take over the bank's liabilities essentially making them government liabilities, or just keep things going business-as-usual, letting the bank stay formally insolvent but operating. See Interview with Randy Wray, Regarding the Next Crisis (Part 2) In China, with state controlled banks, "Regarding the banks, on conventional accounting, they are massively insolvent. … The government uses the banks as a fiscal tool, it has nothing to do with normal banking. It is a fiscal tool so that the Chinese government doesn’t have a budget deficit. ….They could have just allocated the funds and built a university. We should look at this as fiscal spending. The debt will be written off, and the buildings will remain." In the US, with its ineffably corrupt bank-controlled state, we have the same sort of thing going on when the Fed buys a bankster's bad debts to buy him a Manhattan town house. But the government has to be involved in some way, has to become liable by its own act for something (e.g. buying a bad debt with good government debt / reserves) and then write the bad debt off for there to be new NFA. In China this is used to build new universities and cities. In the US, it is yet another welfare program for the already rich.

  18. I need a bit of help trying to get my head around what seems to be a fundamental aspect here. Does MMT suggest that in order to fund government spending beyond what it takes in tax revenue we should create the money "out of thin air" without the need to borrow (or sell bonds?) to finance that additional spend? Or does MMT suggest we should continue to borrow to finance that spending?

  19. "I need a bit of help trying to get my head around what seems to be a fundamental aspect here. Does MMT suggest that in order to fund government spending beyond what it takes in tax revenue we should create the money "out of thin air" without the need to borrow (or sell bonds?) to finance that additional spend? Or does MMT suggest we should continue to borrow to finance that spending?"I'm sure Randall will get to it in the future, but the US government doesn't "borrow" to finanace its spending, it just appears that way because of outdated laws which force the FED to indirectly lend the Treasury reserves instead of directly giving them the reserves.

  20. It’s interesting that a central bank can increase a private bank’s reserves without “lending” it money simply by making a deposit in a 0% interest checking account at the private bank. The private bank gains a deposit liability but it also gains a reserve asset that it deposits at the central bank.