Essays in Monetary Theory and Policy: On the Nature of Money

By Vincent Huang*

I. Introduction

The discrepancy between the orthodox (primarily neoclassical) and the heterodox (Post Keynesian, Chartalism, MMT, etc.) schools of thought rests fundamentally in their different perception in the way the capitalist economy functions.  Such discrepancy can be described in the contrast between C – M – C’ and M – C – M’.  The orthodox school holds the former view that depicts a barter economy in which the end purpose of production is consumption.  Individuals innately engage in production because of the urge to truck and barter.  Money merely facilitates the exchange of goods and services and cannot affect production decisions.  The heterodox school, however, asserts the latter view that depicts a monetary production economy in which production is always financed through money and would not take place unless more money expects to be realized through sale of goods and services.  Hence, the orthodox school asserts money neutrality (at least in the long run) since money is simply the medium of exchange.  The heterodox school rejects money neutrality since money not only finances production but also serves as its end goal.  The distinction between the barter and the monetary economy, as discussed above, thus necessarily implies a very different understanding of the nature, origin, and role of money between the orthodox and the heterodox school of thought.  The purpose of this paper is, through examining the nature and origin of money in a historically grounded context, to demonstrate that the orthodox school of thought has completely mistaken the nature of money and consequently misinterpreted the nature of the capitalist economy.  Such theoretical misunderstanding is devastating because it manifests wrong policies that continually fail to address economic and social problems threatening a capitalist society.  Based on the heterodox theory of money, the paper also intends to shed light on alternative guiding principles behind monetary and fiscal policies.

II. Money in Orthodoxy

In the absence of any historical evidence that suggests the existence of a barter economy (Hudson, 2004; Graeber 2011), it is curious how the orthodox school can conclude that money originated from barter.  As Wray puts it, “in neoclassical theory, money is really added as an after thought to a model that is based on a barter paradigm” (2001).  Hence, the point of departure of the orthodox tale, however dubious it may be, has to begin with a pre-existing imaginary barter economy.  Case, Fair, Gartner, and Heather (1999) tell the typical orthodox story of the origin of money in Economics,

“Money is vital to the working of a market economy.  Imagine what life would be like without it.  The alternative to a monetary economy is barter, people exchanging goods and services for other goods and services directly instead of exchanging via the medium of money.

How does a barter system work?  Suppose you want croissants, eggs and orange juice for breakfast.  Instead of going to the grocer’s and buying these things with money, you would have to find someone who has these items and is willing to trade them.  You would also have to have something the baker, the orange juice purveyor and the egg vendor want.  Having pencils to trade will do you no good if the baker and the orange juicer and egg sellers do not want pencils.

A barter system requires a double coincidence of wants for trade to take place.  That is, to effect a trade, I need not only have to find someone who has what I want, but that person must also want what I have.  Where the range of traded goods is small, as it is in relatively unsophisticated economies, it is not difficult to find someone to trade with, and barter is often used.  In a complex society with many goods, barter exchanges involve an intolerable amount of effort.  Imagine trying to find people who offer for sale all the things you buy in a typical trip to the grocer’s, and who are willing to accept goods that you have to offer in exchange for their goods.

Some agreed-upon medium of exchange (or means of payment neatly eliminates the double coincidence of wants problem.”

Therefore, the orthodoxy holds that it was market complexity, which raised growing difficulty to match “double coincidence of wants,” that enabled market participants to “discover” and agree upon one particular commodity as a medium of exchange.  The nature, role, and origin of money are thus “uncovered”: 1) the nature of money is a medium of exchange that facilitates barter; 2) the role of money is to act as “lubricant” to minimize transaction costs in market exchanges; and 3) the origin of money was from a growingly complex barter system.  Therefore, if money is important at all (since it is only a veil), it is the form that matters.  The evolution of money thus reduces to a simple history of discovering a medium of exchange that possesses better physical characteristics to suffice market exchange.  Not surprisingly, some orthodox economists thus conflate the history of money with the history of coinage.

However, note that the orthodox theory about the nature and origin of money is essentially given by a thought experiment.  Without grounding its research on any anthropological evidence, the orthodox economists simply assume barter into existence by imagining an economy similar to the one we have today, except without money.  Then the argument is that surely people must have invented money for the sake of market efficiency.  Such method of inquiry is unscientific, as Graeber (2011) evaluates it, “this [barter] is not presented as something that actually happened, but as a purely imaginary exercise.”  However, failing to locate the fantasyland of barter in real historical time and space, mainstream economics textbooks still unanimously reproduce the myth of barter that has never been proved.

The problem is, not only is there a lack of evidence, but also that there is “an enormous amount of evidence suggesting that it [barter] did not [happen]” (Graeber, 2011).  While Innes rejects the orthodox tale of barter as historically false (1914), anthropologists like Graeber and Humphrey belie the “evidence” the orthodox economists cited as contradictory to anthropological findings.  Graeber’s critique of Adam Smith and Stanley Jevons’s fabled land of barter in aboriginal North America is as follows,

“In Smith’s time, at least it could be said that reliable information on Native American economic systems was unavailable in Scottish libraries.  But by mid-century, Lewis Henry Morgan’s descriptions of the Six Nations of the Iroquois, among others, were widely published – and they made clear that the main economic institution among the Iroquois nations were longhouses where most goods were stockpiled and then allocated by women’s councils, and no one ever traded arrowheads for slabs of meat.  Economists simply ignored this information…  Stanley Jevons, for example, who in 1871 wrote what has come to be considered the classic book on the origins of money, took his examples straight from Smith, with Indians swapping venison for elk and beaver hides, and made no use of actual description of Indian life that made it clear that Smith had simply made this up…  But to this day, no one has been able to locate a part of the world where the ordinary mode of economic transaction between neighbors takes the form of ‘I’ll give you twenty chickens for that cow.’”

Finally, Caroline Humphrey conducts an anthropological study on barter and gives a definitive conclusion, “no example of a barter economy, pure and simple, has ever been described, let alone the emergence from it of money; all available ethnography suggests that there never has been such a thing” (Graeber, 2011).  Graeber, on the other hand, points out that historically barter did exist, but only between strangers or even enemies with whom one does not expect ongoing relations into the future.  In other words, barter never existed as a basic economic institution among neighbors or villagers in the same society.  Rather, barter took place where credit relations are almost entirely absent among strangers or enemies.  As Graeber concludes from his study of how the Gunwinngu and the Nambikwara people bartered with other tribes, “such a society [barter] could only be one in which everybody was an inch away from everybody else’s throat; but nonetheless hovering there, poised to strike but never actually striking, forever.”

The paper has demonstrated that the orthodox theory about the nature and origin of money is an unwarranted myth.  What then, is the rationale for the orthodox economists, to engage in such an unscientific inquiry to construct the myth of barter?  Readers may further wonder that to what extent, if any, would the abandonment of the myth of barter invalidate the orthodox theorizing.  Tackling these questions, the paper finds that some of the most essential components of the orthodox theorizing will be called into serious doubt if the myth of barter is demolished.

III. Policy Implications in Orthodoxy

Perhaps the most dangerous implication of barter is to believe that even in capitalist economies productions take place due to the urge to truck and barter.  In other words, individuals would naturally engage in production simply because they want to exchange for what others would have produced, not because they want to make a monetary profit.  In light of this, the classical dichotomy is legitimized.  Since money is a veil that hides the urge to truck and barter, removing it would not affect production except for some efficiency costs due to the “double coincidence of wants” problem.  Therefore, money is a neutral veil that only obscures the market relationships behind it.  Economists thus ought to conduct a “real”, as opposed to “monetary,” analysis.

Note that such conclusion is a “natural” manifestation only for economists believing in the barter relevancy for the present capitalist economy.  Since money is merely a medium of exchange, it is almost by assumption that it cannot possibly affect the real economy (Smithin, 2003).  This is evidently the case for the neo-Walrasian general equilibrium theory, real business cycle model, and neoclassical long-run growth model, etc.  The monetarists model (as represented by Friedman), though apparently argues for short-term money non-neutrality due to mistaken expectation, nevertheless holds that money does not have long-term impact on real variables in its long-term economic model.  Even in its short-run model, it is ambiguous whether the Monetarists truly recognize money non-neutrality since according to them what causes short-run fluctuations in real variables is actually “money illusion,” not money per se.  In order to explain growth and unemployment, “monetarists simply assumed that there exists ‘natural’ rate of growth and unemployment, which are determined in the long run only by real factors of production” (Smithin, 2003).

The implication of conducting a “real” analysis is powerful.  To great extent it justifies the Monetarist concept of exogenous money and allows the Monetarists to blame the central bank if there is ever any inflation.  Milton Friedman’s definitive statement, “inflation is always and everywhere a monetary phenomenon,” is widely considered the truth, grounding itself on the fact that inflation can only be produced by a more rapid change in the quantity of money supplied.  Again, the implicit logic is that since money only facilitates transactions, it must be powerless in affecting productions except when people are suffering from “money illusion” in the short-run.  People only need the right amount of money to make purchases.  But too much money printed by the central bank inevitably chases too few goods and bids up price levels.  Therefore, the general causality in the quantity theory of money must run from the left to the right: MV=PY, where money supply only affects inflation rate in the long run.  Hence, the best monetary policy, as the Monetarists further argue, is to target a stable money supply growth.  Till now, readers may have found the name, “Monetarism,” deceitful because it actually assigns no significant long-run role to money.  Money supply growth, as controlled by the central bank’s monetary policies, can only mess up the inflation rate while contributing nothing to the real economy in the long run.  Hence, Monetarism essentially performs an apparent monetary analysis predicated on a “real” analysis, which is ultimately backed by the truth of barter and money neutrality.

It is perhaps worthwhile to look deeper into the Monetarist analysis to see how exactly money is created in its model.  A typical Monetarist would tell a story about money and banking similar to the following.  The central bank determines money supply discretionarily via three operational tools: required reserve ratio, open market operation, and discount window.  The idea is that banks will automatically decide to create loans based on the availability of the reserves they possess at the central bank’s balance sheet.  Hence, open market operations and discount window set the “base money” by changing the level of reserves through interest rate targeting, and required reserve ratio (thus acts as a money multiplier) simply “leverages” such base money into a much larger pool of money that can then be used by the bank.  This is another reason why the causality must run from the left to the right in the quantity theory of money: MV=PY.  However, this exogenous money approach, as will be discussed later in contrast with endogenous money, suffers serious flaws.  Nonetheless, the essence is that the central bank does control money supply.

A disastrous implication from the exogenous money approach is money scarcity.  Since the quantity of money supplied affects inflation rate, it is assumed that money must be scarce enough to ensure price stability.  In other words, money scarcity is simply truism at any stable price level.  If we accept money scarcity, then it is only logical to believe in the loanable funds theory that fiscal spending only crowds out private investment by bidding up interest rate for a fixed pool of savings.  Therefore, the best fiscal policy is to limit the spending of the government to allow private businesses to invest more at a lower cost of financing.  Hence, the doctrine of sound finance is legitimized.

What is important for the paper is that the above analysis shows how intrinsically connected are the ideas of barter, money neutrality, “real” economic analysis, “exogenous money,” inflation, money scarcity, and “loanable funds theory.”  These theoretical tools then allow the orthodox economists to conduct “correct” monetary and fiscal policies.  To recapitulate, monetary policy determines price levels while fiscal policy negatively affects private investment.  Hence, the solution is to target a stable money supply and to run balanced government budget as long as possible.  It is therefore that the myth of barter is crucial in the orthodox theorizing.  With no evidence that suggests the existence of barter, one sees why the orthodox economists are eager to fabricate a fantasyland of barter for us.  The myth of barter is told not only because it is consistent with orthodox theorizing but also that by telling it, the orthodox theoretical and policy implications can make more intuitive sense and thus become the unquestionable truth.  To see so, one only needs to consider how dominant Monetarism remained even after the complete failure of its empirical experiment.  The Volcker Fed completely failed to hit money supply target for several consecutive years beginning in 1979, and as a result the “New Monetary Consensus” emerged as the recognition that the central bank cannot target money supply.  Yet, the idea that the central bank somehow controls the money supply and thus messes up inflation rate is still widely accepted.

If, however, the myth of barter is debunked, then the orthodox theoretical and policy implications suffer serious criticism.  For the abandonment of the myth of barter necessarily calls the orthodox notions of money neutrality, “real” economic analysis, “exogenous money,” money scarcity, and the “loanable funds theory” into question.  Furthermore, if barter never existed in the first place, then what is the reason to model today’s economy as barter when it is evident that modern production has to be financed by money and will not take place unless profit is foreseeable?  In other words, mainstream economists ought not to view the purpose of production as satisfying exchanges.  Moreover, removing the myth of barter also brings the problem of unemployment into the picture.  As barter describes production behaviors as largely voluntary (one produces more if s/he wants to exchange for more of other’s produce, and vice versa), involuntary unemployment simply does not exist in the imagined barter economy.  Abandoning the myth of barter thus gives at least the theoretical possibility for involuntary unemployment to occur, which is missing in the neoclassical theorizing.  Finally, the policy prescriptions that follow the mythical foundation of orthodox theorizing are also subject to a re-examination.

After all, the orthodox theory of the nature, role, and origin of money was engineered to be consistent with the orthodox/neoclassical theorizing of a barter economy.  Since neoclassical theorizing is asocial and ahistorical, its theory of money similarly lacks any social or historical context.  The paper now shifts to the heterodox theory of the nature, origin, and role of money.  By doing so, the paper prepares the background knowledge to debunk the orthodox theory of money and paves the way for rethinking the alternative guiding principles behind both monetary and fiscal policies.

IV. Money in Heterodoxy

According to heterodoxy, there are two plausible explanations for the origin of money.  Innes (1932) and Wray (2001) argue that money originated in ancient penal systems.  Tcherneva elaborates this in 2005,

“Wray (2001) posits that money originated in ancient penal systems which instituted compensation schedules of fines, similar to wergild, as a means of settling one’s debt for inflicted wrongdoing to the injured party. These debts were settled according to a complex system of disbursements, which were eventually centralized into payments to the state for crimes (see also Innes 1932). Subsequently, the public authority added various other fines, dues, fees, and taxes to the list of compulsory obligations of the population.”

According to this view, money is essentially an instrument that denominates and extinguishes social debt obligation.  It first quantifies debt obligation between individuals.  For example, Joshua has conducted wrongdoing to Henry; hence the public authority determines that Joshua owes to Henry one cattle.  In this case, that cattle is the “money” that effectively extinguishes Joshua’s liability/debt to Henry.  Observe that the need for a standardized money of account was not necessary since the redemption of debt between individuals can be determined case by case.  Money of account might be a cattle between Joshua and Henry, and then ten watermelons between Helen and Linda, etc.  However, when there emerges the need to denominate debt obligation between individuals and the “society”/central authority in various forms (such as fines, fees, taxes, etc.), a standard unit of account for money was needed to serve as the standard measure of value.  By choosing a unit of account as the only means for individuals to extinguish his/her liabilities to themselves, the central authorities “write the dictionary” (Keynes, 1930).  Hence, the power of the central authority (state, temple, tribe, etc.) to impose a debt liability (fines, fees, taxes, etc.) on its population gives the former the unique right to choose a particular unit of account as the only means of payment to the central authority.

In his study of colonial Africa, Forstater similarly concludes that by imposing a debt obligation (taxes) on colonial Africans denominated in foreign currency (British Pounds), the British were able to dismantle the pre-existing economic structure in Africa and to monetize its whole economy and population (2005).  In other words, the British government succeeded in creating a new money of account (British Pounds) in colonial Africa by coercively indebting the population and demanding British Pounds as the only means of payment to extinguish the Africans’ liabilities to the colonial government.  This effectively moved the African labor power to production desired by the British colonizer since the only means to acquire British Pounds were to work at British farms or mines (Forstater, 2005).  British Pounds immediately became the new money used by the colonial Africans.  Hence, levying a tax liability denominated in foreign currency was sufficient (though not necessary) not only to compel the population to use new money but also to move labor power to desirable areas.  Note that in this process the British Pounds must first be spent into the hands of the colonial Africans to allow for any tax payment.

While Hudson (2004) in his study of Mesopotamia offers the second explanation of the origin of money that money evolved as a standard accounting unit that keeps track of surplus and inputs of production, the two heterodox explanations need not be mutually exclusive (Tcherneva, 2005).  Henry links both explanations in his study of ancient Egypt.  In essence, Henry argues that: 1) money originated in ancient Egypt from the need of the ruling “engineers” class to establish accounting basis for agricultural products and social surpluses; and 2) money also served as a means of payment to settle debt obligations (fines, fees, foreign tribute, and tribal obligations) to the kings and priests (Henry, 2004).

The significance of the above social and historical research by Innes, Wray, Forstater, Henry, and Hudson cannot be underestimated.  They are important for the following reasons.  First, these research shows that money existed prior to market.  As Goodhart observes,

“… Money first arose as an acceptable way of resolving inter-communal debt obligations, and only subsequently (when money’s functions had thus become accepted and ratified as a unit of account and means of payment), became widely adopted in market transactions” (Goodhart, 2003).

Thus, since money is anything that denotes and extinguishes one’s debt/liability to another, it was not a product of market exchanges but rather a byproduct of social relations based on debt (Graeber, 2011).  In light of this, money originated as a mean to quantify and extinguish social debt obligations.  Hudson’s explanation therefore sheds more light on the origin of a standard money of account while Wray’s posits both the origin of money (as a debt relation) and the origin of a standard money of account.

Second, the nature of money is a credit-debt relationship that can only be understood in institutional and social contexts.  Since money is a credit-debt relationship, it necessarily follows that everyone can “issue” its own money/IOU (Minsky, 1986).  This suggests that private individuals may have different units of accounts (cattle, watermelon, etc.) that are difficult to be standardized.  That is, it is unlikely that any individual could have the sufficient power to induce others to hold its liabilities as a standard unit of account.  The liability of the central authority becomes the standard unit of account because the central authority has the sufficient power to impose liabilities on its population in the forms of fines and taxes.  This is the essence of Chartalism, “Modern Money,” “Tax-Driven Money,” and “Money as a Creature of the State” (Lerner 1947, Knapp 1973, Keynes 1930, Goodhart 1998, Wray 2001, Forstater 2006).

Third, the role of money was initially an abstract unit of account and means of final payment and later as medium of exchange.  This means that money as unit of account precedes its roles as medium of exchange and store of value.  Money as store of value also becomes important since one party’s debt is necessarily another’s wealth.  It thus follows that the physical manifestation of money (the “money things”) is not necessary since money as a debt relation needs not be physically tangible.  This has been demonstrated as early as in Mesopotamian (3100 BC) where crops and silver were used as standard units of account but not as a general medium of exchange (Hudson, 2004).  Exchanges simply took the form of credit and debit entries on clay tablets, similar to our electronic payment system today.

Therefore, money originated as a byproduct of social relations based on debt and realized its standard form through the need of the central authority, as opposed to private individuals, to establish a standard unit of account to measure debt obligations or production surplus.  Our analysis also implies a hierarchy of money (debt pyramid), with the liability of the state sits on the top and the liability of individuals sits on the bottom (Bell, 2001).  It should be clear that the entire debt pyramid is effectively money/IOUs.  The state simply decides a particular unit of account that measures the value of all liabilities.  Further, the paper demonstrates that the role of money as unit of account precedes its role as store of value and medium of exchange.  The works of the anthropologists and the heterodox economists thus equip us with a historically grounded understanding of the nature, origin, and role of money.  Based on such understanding, the paper now investigates the alternative guiding principles behind both monetary and fiscal policies.

V. Policy Implications in Heterodoxy

Recall the orthodox notions of money neutrality, “real” economic analysis, “exogenous money,” money scarcity, and the “loanable funds theory.”  While the abandonment of the myth of barter calls all of the above notions into serious question, the heterodox theory of money simply invalidates each of them.  Since money denominates and extinguishes debt obligations, it is not merely a medium of exchange.  The production process has to be financed by getting one’s IOUs/money accepted with the end goal of acquiring more IOUs/money through sale.  It implies that involuntary unemployment can occur when: 1) insufficient financing leads to an insufficient amount of production that results in unemployment; and 2) business expectation of profit is low and thus production is cut back to lay off workers.  Thus, money is not only non-neutral but also critical to the production process and the involuntary unemployment problem.  This therefore invalidates “real” economic analysis (which is based on the implication of barter) and calls for a monetary economic analysis.  Furthermore, the “exogenous money” approach is debunked since money, as a debt relation, must be endogenous to the economy.  To explain, we examine the endogenous money approach advocated by the Post Keynesians.

In short, the endogenous money approach reverses two causalities proposed by orthodoxy: 1) reserve creates deposits; and 2) deposits create loan.  On the contrary, the endogenous money holds that loans create deposits that then create the need for the central bank to accommodate with reserve.  In other words, banks first make loans, and then seek reserves to meet central bank regulations.  As Wray suggests, “privately created credit money can thus be thought of as a horizontal ‘leveraging’ of reserves (or, better, High Powered Money), although there is no fixed leverage ratio” (2001).  Hence, the endogenous money approach provides a justification for why the causality between M and PY in the quantity theory of money MV=PY should be from the right to the left.

Note that the above analysis not only debunks “exogenous money” but also invalidates “money scarcity” and consequently the “loanable funds theory.”  Suppose Henry decides to hire Joshua to build a condo.  In theory, Henry could issue his own money/IOU to Joshua in exchange for Joshua’s labor time.  The problem is, Joshua would probably not accept Henry’s own liability (Henry dollar) because Henry cannot sufficiently indebt the rest of the population to create a demand for his own IOU.  Instead, Joshua agrees to exchange his labor only for the liability of the state (U.S. dollars).  Therefore, Henry needs somehow to convert his own IOU to the state IOU in order to get Joshua’s labor.  Now Henry walks into a bank and asks for a loan, the loan officer does not check the bank’s reserves at the central bank and comes back to tell Henry, “sorry, we are out of money!”  If the bank thinks Henry’s project is good, it creates a Henry loan simply by crediting the Henry’s deposit account.  To meet the reserve requirement, the bank then borrows reserves from other banks that have excess reserves or directly from the central bank.  What distinguishes the bank’s IOUs and Henry’s IOUs is that the former is directly convertible to the central bank/state IOUs while the latter is not.

In other words, the production process can be viewed as a series of exchanging IOUs.  By signing a labor contract, Henry first has Joshua’s labor time as assets and Joshua’s wage as liabilities.  To convert his IOUs to the state IOUs, Henry takes a loan from the bank.  The bank then has Henry’s promise to repay the loan as its assets and Henry’s demand deposit as its liability.  Ultimately, the bank converts its IOUs to the central bank IOUs/reserves by borrowing reserves from other banks or directly from the central bank.  Money is created when Henry signs the labor contract with Joshua that denominates the debt obligation between them.  Such debt obligation is ultimately reflected at the central bank’s balance sheet as the private bank enables Henry’s IOUs to be denominated in the state money of account.  Therefore, the central bank is simply a scorekeeper of the economy (Mosler, 2010).  The reserves at the central bank, created by keystrokes, simply serve an accounting purpose for the economy.  Money/IOU is therefore endogenous.  In light of this, the orthodox notions of “money scarcity” and the “loanable funds theory” are simply wrong, just as Henry did not compete with the federal government for a fixed pool of savings.  Borrowing at the bank, Henry actually creates money, as opposed to reduces the amount of money available for the government to spend.  Hence, the central bank cannot control money supply to fight against inflation, and the federal government spending does not crowd out private investment.  This then leads us to investigate alternative principles behind monetary and fiscal policies.

A closer look at the actual operation of central bank and the treasury reveals that the government does not facilitate its spending through taxation or bond sales.  Although imposed by political/ideological constraints, the end result as shown on the central bank and the Treasury’s balance sheets are identical to that would be if none of the constraints exists (such as the government must sell bonds prior to deficit spending or the government can only write a check on its account at the central bank).  This implies that the federal government is not revenue constrained, as recapitulated by Tcherneva (2005),

“Governments do not need the public’s money to spend; rather the public needs the government’s money to pay taxes. Government spending always creates new money, while taxation always destroys it. Spending and taxing are two independent operations. Taxes are not stockpiled and cannot be respent in order to ‘finance’ future expenditures. Finally, bond sales are necessary to drain excess reserves generated by fiscal operations in order to maintain a positive interest rate. Neither taxes nor bond sales serve a financing purpose; the former generate demand for the currency and the latter are needed to hit interest rate targets, and thus government spending is not operationally constrained by either.”

If the role of the central bank is to hit interest rate targets, we then wonder whether the central bank, with its open market operations, can impact the real economy in any way.  This paper argues that the central bank’s impact is likely to be a minimum.  As demonstrated before, “when the demand for loans increases, banks normally make more loans and create more banking deposits, without worrying about the quantity of reserves on hand. Privately created credit money can thus be thought of as a horizontal ‘leveraging’ of reserves (or, better, High Powered Money)” (Wray, 2001).  Therefore, lowering interest rate by increasing reserves does not make banks more willing to lend to businesses.  As for businesses, they produce or invest if expected profit is at least positive.  They do not borrow to make a loss even if the interest rate is historic low.

Therefore, the central bank cannot fine-tune the economy because monetary operations are largely accommodating rather than stimulating.  In order to hit a target interest rate, the central bank engages in open market operations to buy or sell government bonds.  It is important to note that bond sales do not finance government spending.  Reserves and bonds are both the liability of the state.  The only difference is that bonds earn interests while reserves do not.  This also means that the myth of the national debt indebting our future generation should be abolished.  Government liabilities, including reserves and government bonds, are effectively private wealth by accounting identity.  Further, interests on government bonds (that are “paid” by keystrokes at the central bank) add additional income to the private sector.  Hence, a large national debt is actually not a burden but a bless.  In essence, (in a two-sector economy) government deficit is necessarily equivalent to private surplus that adds to private net financial wealth, as demonstrated by Wray in his “bathtub” analogy (2012).  Wray demonstrates that the private sector accumulates claims against the government as its financial wealth, and thus deficit spending is a flow variable that adds to the stock of private net financial wealth (2012).  Hence, that the public applauds for accumulating private financial wealth but agonizes over raising the debt ceiling is an indication of misunderstanding of the nature of state money.

Since the government is not revenue constrained, the paper argues that Lerner’s functional finance ought to serve as the guiding principle behind monetary and fiscal policies.  Following Keynes’s principle of effective demand, Abba Lerner developed functional finance (1943),

“The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound or unsound… The principle of judging fiscal measures by the way they work or function in the economy we may call Functional Finance.

Lerner’s functional finance is thus in sharp contrast with sound finance.  While sound finance treats the federal government as a currency user like a household, functional finance rightly understands that the federal government faces no affordability issues since it is the monopoly issuer of the currency.  Moreover, Lerner argues that the federal government not only can spend but also should spend till full employment.  The concern, therefore, is not the affordability of full employment but the potential of inflation.  Limited by the scope of the paper, we do not tackle the issue of inflation in details here.  But the paper argues that before reaching full employment, it is unlikely that deficit spending would necessarily be inflationary.  In essence, involuntary unemployment indicates a permanent loss in production since the federal government could always have hired the unemployed to achieve public purposes.  Hence, the right to employment ought to become a basic human right guaranteed by any sovereign government.

VI. Conclusion

This paper begins by debunking the orthodox theory of money and its policy implications.  It has shown that the unwarranted myth of barter was an orthodox propaganda to justify its theories and policies.  With the heterodox theory of money, the paper demonstrates that the orthodox notions of money neutrality, money scarcity, “exogenous money,” “real” economic analysis, “loanable funds theory,” and “sound finance” should all be rejected.  This also means that the entire orthodox theorizing centered on C-M-C’ should be abolished because it is useless in understanding today’s economy (or any economy that had ever existed).  The paper also discusses the effectiveness of fiscal policy and monetary policy.  Monetary policy is accommodative in nature and thus cannot effectively elevate effective demand.  Even with the quantitative easing, the central bank is merely performing asset management as opposed to money creation.  Indeed, the heterodox theory of the nature of money implies that money creation has to be endogenous, which gives support for conducting expansionary fiscal policy till full employment.  This is consistent with Lerner’s functional finance approach and is based on the “Taxes-driven Money” approach.  While government deficit and national debt can be best understood as private surplus and private net financial wealth, the paper urges policymakers to focus on designing job creation programs that achieve public purposes, as opposed to agonize over affordability issues or some fictitious and scary moral arguments.  The paper ends by concluding that unemployment is a self-inflicted social ill that can only be cured after recognizing the utmost importance of aggregate spending and the nature of money.


*A Note:

For the next few weeks we will be running a series of articles on monetary theory and policy. These are final essays written by MA students in my class this past Fall semester. I was very happy with the results—students indicated that they had a firm grasp of both the orthodox approach as well as the heterodox approach to the subject. Most of them also included some Modern Money Theory in their answers. I asked about half of the students in the class if they would like to contribute their essay to this series. Sometimes students are the best teachers because they see things with a fresh eye and cut to what is important. They are usually less concerned with esoteric academic debates than are their professors. Note that these contributions are voluntary and are written by Masters students. I told students they could choose to use their own names, or they could choose an alias. Comments are welcome, but please be nice—remember these are students.

For your reference, here were the topics for the paper. The paper had a maximum  limit of 6000 words.

Choose one of the following. You must consider and address both the orthodox approach and the heterodox approach in your essay. Where relevant, include various strands of each.

A) What is the nature of money? Given the nature of money, what approach should be taken to policy-making?

B) What is the nature of banking? Given the nature of banking, what approach should be taken to policy-making?

C) According to John Smithin there are several main themes throughout controversies of monetary economics, each typically addressed by each of the various approaches to monetary theory and policy. In your essay, discuss how each of the approaches we covered this semester tackles these themes enumerated by Smithin. 

L. Randall Wray

Works Cited

Bell, S. (2001), ‘The Role of the State and the Hierarchy of Money’, Cambridge Journal of Economics, 25.

Case, Karl E. (1999), ‘Economics.’ Prentice-Hall Europe, 1999. Print.

Forstater, M. (2005), ‘Taxation and Primitive Accumulation: The Case of Colonial Africa,’ Research in Political Economy, 22, 51-64.

Forstater, M. (2006), ‘Taxation: Additional Evidence from the History of Thought, Economic History, and Economic Policy,’ in M. Setterfield (ed.), Complexity,

Endogenous Money, and Exogenous Interest Rates, Chetlenham, UK: Edward Elgar.

Goodhart, C.A.E. (1998), ‘The Two Concepts of Money: Implications for the Analysis of

Optimal Currency Areas’, European Journal of Political Economy

Goodhart, C.A.E. (2003), ‘A Reply to the Contributors’, in S. Bell and E. Nell (eds.), The State, the Market and the Euro, Cheltenham, UK: Edward Elgar

Graeber, David. (2011), ‘Debt: The First 5,000 Years,’ Brooklyn, NY: Melville House, Print.

Henry J.F. (2004), ‘The Social Origins of Money: The Case of Egypt’, in L.R Wray (ed.),

Credit and State Theories of Money, Cheltenham, UK: Edward Elgar

Hudson, M. (2004), ‘The Archaeology of Money: Debt versus Barter Theories of Money’s Origins’, in L.R. Wray (ed.), Credit and State Theories of Money, Cheltenham, UK: Edward Elgar

Innes, A.M. (1913), ‘What is Money?’, Banking Law Journal, May

Keynes, J.M. (1930), A Treatise on Money, London, UK: Macmillan.

Knapp, G.F. (1973 [1924]), The State Theory of Money, Clifton, NY: Augustus M. Kelley.

Lerner, A.P. (1943), ‘Functional Finance and the Federal Debt’, Social Research, 10, February.

Lerner, A.P. (1947), ‘Money as a Creature of the State,’ The American Economic Review, 37, May.

Mosler, Warren. (2010), ‘The 7 Deadly Innocent Frauds of Economic Policy.’ [St. Croix, U.S.V.I.]: Valance. Print.

Smithin, John N. (2003) Controversies in Monetary Economics. Cheltenham: Edward Elgar, Print.

Tcherneva, Pavlina. (2005), “The Nature, Origins, and Role of Money: Broad and Specific Propositions and Their Implications for Policy.” n. pag. Web.

Wray, L. Randall. (2012), Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems. New York: Palgrave Macmillan. Print. 

Wray, L. Randall. (2001), “The endogenous money approach”, CFEPS Working Paper 17, Aug 2001,


24 Responses to Essays in Monetary Theory and Policy: On the Nature of Money

  1. financial matters

    Excellent conclusion! Hope this starts making its way into mainstream thinking and policy making or that you yourself become a policy maker.

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  3. I have a question: You say “Hence, the endogenous money approach provides a justification for why the causality between M and PY in the quantity theory of money MV=PY should be from the right to the left.”

    But isn’t the MMT view of government policy the opposite? That by its own spending, the government creates money, and that spending results in increased production? Causality runs left to right, not right to left?

    • Thanks for your comment. It does seem ambiguous. But let’s look at the causal relation between M and Y: it is because of Y that M is expanded. In other words, M does not expand on its own. It expands in response to the need to have more Y. Thus, I think it is better to understand it as running from right to left in MV=PY. The process you described is M-C, where production has to be financed by money. This is right, too. So, I think it is two different ways looking at the same process.

      However, the Monetarist exogenous approach is not even arguing that it is from M to Y in the long run. For them, it is from M to P only. Thus, money does nothing except causing price level to change. I think we can both disagree with them on that.

      • No, I think M can expand because government creates it. No change in Y occurs first. Maybe there is a need for Y or not (at full employment, even MMT says that an increase in the deficit would cause inflation, not additional production).

        Suppose M expands because government sends each taxpayer a check, as in 2008. No change in Y until after those checks are spent, and inventories are depleted.

        And during the dot-com and housing bubbles, was it a need for more Y that caused all the lending? It seems to me those were examples of M “expanding on its own”, in an explosion of endogenous money. Isn’t that what it means for M to be endogenous?

        If the change in Y occurs first, would that not be the supply-side approach? Y is GDP, right? Total production?

        As for the monetarists, don’t (or didn’t) they advocate increasing M at the same rate as the expected increase in Y, in order to achieve long-run price stability? To me, that, along with exogenous money and left-to-right causality, means they believe M influences Y in the long run, not just P. And does MMT not agree with them that an expanding economy requires an expanding money supply? If an expanding economy were to cause an expanding money supply, then how would deflation ever happen?

  4. I find this statement interesting: “Hence, the right to employment ought to become a basic human right guaranteed by any sovereign government.”

    I agree that the JG is a wise policy, both economically and socially. But doesn’t everyone, in a free society, already have the same rights that Henry exercised, to go to the bank and take out a loan and hire employees and produce products? If there is to be a right to be an employee rather than an entrepreneur, that right must necessarily be created and enforced by a government, so wouldn’t that make it a civil right rather than a basic human right? More akin to the right to vote than to the right to life?

    What do you think about the notion that the right to liberty is inalienable, and that therefore employment contracts (i.e., “renting” of a person) are morally equivalent to slavery (owning of a person).

    Such a view would seem to be in direct opposition to the notion of a right to a job of the sort that is the norm today.

    • I love the “right to entrepreneurship” idea, but I think it is not as feasible. Yes, Henry has the right to walk into a bank and asks for a business loan in today’s “free” society. But whether he gets the loan or not, or whether he can compete with the already existing big firms even if he gets a loan, remains doubtful. It seems to me that our existing institutions are not ready for the “right to entrepreneurship.” But “right to entrepreneurship” is an attractive proposal. I would be all for it.

      We can disagree with the prescriptive part of MMT (ELR for example) and argue for more “radical” proposals. I personally like the Scandinavian model. But I do think that ELR is a good first step for the U.S. and many countries given their own institutions.

      I don’t view employment contracts as equivalent to slavery. Slavery turns humans into commodity by stripping them from all previous social relations. Employment contracts are not equal, but they usually do not destroy the employees’ previous social relations. However, the word “slavery” can be used in a rhetoric way. One could argue that division of labor implies interdependence, and that interdependence implies inter-indebtedness. If we look at it this way, we are all “slaves” to each other (since we are all “indebted” to each other). But “slavery” in this sense is not about ownership, but a sense of indebtedness and interdependence. Those who own more resources are able to mobilize more labor power and thus appear to be the “masters.”

      • The right to anything doesn’t guarantee success at it, only the opportunity to try. I think we all have, already, at least in the US, a right to become entrepreneurs. Whether we have the ability is a different matter. Loans are not always required, and competing with big companies can be very easy in many circumstances.

        Ellerman’s point is that since it is not allowed to voluntarily sell oneself into slavery, which is a lifetime employment contract, it should also not be allowed to rent oneself into an equivalent partial or temporary situation. That the right to liberty is inalienable, even with consent. I just thought it was an interesting juxtaposition of views about labor for money. I don’t particularly like Ellerman’s solution, either, which requires the laborer to assume the financial risks associated with the firm, whether he wants to or not.

  5. John Hemington

    Who is Vincent Huang?

  6. That was a good read, worth reading several times over with an interval between for mulling over the concepts. In my current state of mind, I have difficulty disassociating money origins from labor. The best money had universal utility; debt satisfaction is a derivative use and penal usage is yet a narrower special case. I can’t imagine money was created to pay fines. I remember reading that wealthy Chinese could hire a surrogate to receive corporal punishment, including death. Paying a fine directly is not much of a leap, along with some upsides all around. Money would need to exist before this particular use was created. I can imagine money origins including concepts such as labor coercion, a sense of ownership, taxation, all without the concept of barter. We know that Kings awarded vast tracts of land to aristocrats which were worked by peasants who paid rents. These rents became a perpetual source of income both to the aristocrats and the King. Without a sense of value, the spendthrift aristocrats became easy customers of the court banker who became the beneficiary of surplus value.

    King Leopold “civilized” the Congo by declaring sovereign land ownership and demanding rents, rents payable in a non-universal money substitute, brass rods, which were exchanged for the harvest of rubber vines and ivory. E.D. Morel was a shipping clerk that noticed the lack of civilizing trade goods being sent back to the Congo, only rifles and ammunition, to be used as part of the civilizing process. Although not obvious, there appears to be a lack of barter among these natives, barter requiring perhaps a sense of ownership, which they lacked. There is repeatedly a noticeable lack of a sense of ownership among primitive people residing in all parts of the globe. The transfer of goods more likely done by force and warfare or gifting, at a potlatch for instance. Both concepts are still alive and well today within the ghetto economy. Back in the Congo, ivory was obtained by raiding rather than coercion. When the Europeans landed the shores of America, they carried a sense of ownership and the creation of colonial money was not long in coming. A money system, a manufacturing system, a transportation system, a labor force, a source of raw materials and a sense of ownership are all that is needed to quickly recreate the European experience. Complex finance and unearned income is probably a derivative of “surplus” value.

    Over the holidays I was reading about the Clipper Ships, trading vessels designed for speed. Captains would vie for bonuses to be first in port allowing the cargo to be sold at the highest prices while the crew hit port with a year’s pay to dispose of. How many economic theories did these micro events generate with “money plenty” and demand strong?

    • Thanks for your comment. I tried to make a distinction between the origin of money and the origin of a standard money of account (state money). You rightly observe that, “There is repeatedly a noticeable lack of a sense of ownership among primitive people residing in all parts of the globe.” I argue that in these primitive societies, when Henry needs an extra pair of shoes from Joshua, he would directly ask for it. No exchange is made. More importantly, no credit-debit relation is recorded. However, both parties are aware that when Joshua needs something that Henry has in the future, Joshua would simply ask for it and Henry would probably give it to Joshua. But, this is not a relation based on reciprocity or exchange. It is a kind of primitive communalistic relation – production based on ability and distribution based on needs. In these societies, there was no money. Because there were no social relations based on debt that need to be quantified and extinguished by an instrument called “money.” Hence, money originated as a byproduct of social debt relations. Money quantifies and denominates debt obligation. But how did we get into social debt relations? I think this is where your “labor coercion, a sense of ownership, taxation, all without the concept of barter” come into play. I also think that the emergence of social surplus is important in this process.

  7. Very good! The non-barter nature of early money needs to be stressed more widely.
    Money should exist in sufficient quantity to meet the productive capacity of the nation. It doesn’t now, so a number of things happen:
    - Deflation for the bottom 80% or so that never has enough money, while inflation due to asset bubbles formed by the top 10% or so, drives prices up for everyone else at the bottom, compounding wealth inequality.
    - Alternate Currencies spring up (LETS). I’d like to see the Fed keep regular track of LETS, to help tell it when money is in too short a supply, particularly regionally.
    - Barter really DOES happen, in the absence of money to make exchanges. People have labor to spare, but not money. Timebanks are an example of this.
    - People steal. It should go without saying, but in the absence of access to things which can earn money, crime rises. OK, Duh.
    - Counterfeiters flourish. Not just here but in North Korea, etc. The demand must be filled, even with inferior supply.

    Land (all of nature’s resources, in Classical Economics) + Labor + Capital (optional, and capital is not meant to mean money here) – > production. Money is a facilitator, not necessary, but highly desirable.

  8. Excellent essay. Substantive comments later. But Huang should get an A++ for courage if he really means “underestimated” rather than “overestimated” (the word I’ve used many times myself about this research) in “The significance of the above social and historical research by Innes, Wray, Forstater, Henry, and Hudson cannot be underestimated. ” :-)

  9. Calgacus: Aha I think you caught a typo.
    John: As Prof Kelton says, Vincent is a UMKC student, but we cannot take all the credit. He was well-educated before he came to us.
    Ransome: I expect Vincent has some very interesting things to say about China. But to your point, jumping to a money of account was a huge step for any society. Almost certainly involved authority. I’m pretty sure Vincent can provide some examples.
    Golfer: There actually is a universally recognized human right to work, in the UN charter on human rights. The USA has violated it for half a century. Crimes against humanity. In answer to your question: no, the majority of Americans cannot go to a bank and get an “entrepreneurship loan” and in any event as you probably know the vast majority of new business fails. This is a good path for those who already have plenty of wealth as a backstop. As the old adage goes: banks only lend to those who do not need money (the period from 2004-06 was a exceptional).

    • If you view the existence of unemployment as a violation of the UN’s right to work, then it is not only the US that has been violating it, and not only for 50 years. Europe has done much worse most of the time, and others as well. But in the US, everyone, even the unemployed, has the right to work. They can do whatever it is they have the skills for as an entrepreneur, rather than an employee. It involves risk, of course, and many new businesses do fail, even those with access to bank loans. There may be no guarantee of success as an entrepreneur, but there is no guarantee of success as an employee, either.

      I don’t know what the UN had in mind, but I have said repeatedly that it is the obligation of the monetary sovereign, as sponsor of the economic system, to alleviate the ill effects of the system, unemployment in particular (but also crime, fraud, etc.). JG is a moral obligation at the very least.

  10. Golfer: yes you are right, other nations violate that human right (and many of the others). We’ve written lots on this; the best source is Phil Harvey who also supports the JG (his version is somewhat different)–he’s a lawyer by training (and an economist) so knows the human rights literature well.
    But no, it is not enough to say you “have a right to work”, the UN charter makes it a government responsibility to ensure that right is achievable. There must be a job available for you. It goes further than that, in fact. You can look it up: Article 23.
    • (1) Everyone has the right to work, to free choice of employment, to just and favourable conditions of work and to protection against unemployment.
    • (2) Everyone, without any discrimination, has the right to equal pay for equal work.
    • (3) Everyone who works has the right to just and favourable remuneration ensuring for himself and his family an existence worthy of human dignity, and supplemented, if necessary, by other means of social protection.
    • (4) Everyone has the right to form and to join trade unions for the protection of his interests.
    The US and almost all other nations habitually violate this human right. The US govt goes on and on about human rights abuses abroad, but refuses to enforce this human right at home, with tens of millions of people suffering as a result.

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  13. Jack Lew: Debt Ceiling Will Be Hit Sometime In Late February Or Early March
    HUFFPO 12/19/13

    What a perfect MMT opportunity.
    Could be a total fish or cut-bait situation if played correctly, the death-knell for ignorant deficit hawks and a vast opportunity to educate everyone on the correctness of a couple of MMT’s tenets.
    Warren Mosler could sponsor a couple of the learned Doctors of the MMT school, maybe those here commenting, for instance, along with some of Warren’s oft-noted cadre of MMT supporters at Treasury – those who know that this (MMT) is exactly how things work in the real world, to visit Secretary Lew and a couple of Treasury lifers.
    They could explain exactly why there is no need to worry about the debt-ceiling or funding the deficit…..BECAUSE the government actually creates money when it spends by ”keystroking”.
    Thus, the government cannot default. Keystroking is the modern monetrary policy tool.
    Keystrokers are us.

    As a result of this magical ‘keystroking’ phenomena,Treasury does not need to have money in its account before it spends money, the Treasury can just hit the old keyboard and pump the ‘balances’ into existence. There is no need to issue more debt and to worry about the stupid ‘ceiling’ on public debt. That is so ‘gold-standard’ thinking.
    The ignorati at Treasury have given us the great opportunity to explain what a sovereign government can do with its fiat money system today. It would be wrong to waste such an opportunity to advance the Warren Mosler money school in light of all the potential problems we are now facing.
    Let’s just do it.
    Warren and company – bring Frank Newman, the Treasury guy who says anyone doubting MMT is stretching our understanding of how money works. Warren would not need to run for Congress or President anymore.
    What could possibly go wrong?

  14. Congratulations Vincent! Clear, comprehensive and well structured wrapper.

    I think global conceptual maps are essential to logical links to detail. Like a regional map shows thumbnails of divisional maps that lead to detailed localities. The more structure that emerges in MMT the better – it was the original hurdle I faced in coming to grips with the school.

  15. Why are for-profit, privately owned banks allowed to convert their liabilities directly into the liability of the state? If they were not allowed to do so, “loanable funds” theory would still be correct, although it has no bearing on the ability of the sovereign to spend, since the sovereign doesn’t have to borrow from the supply of money available to the private sector.

    • Why? The system was set up that way (100 years ago today) so that bank failures would not cause disasters for bank customers.

      • The current system was set up under a gold standard, not relevant under a fiat system.

        The current system places enormous power, power to create state money, in the hands of private, for-profit organizations with no accountability. Pure depositories can be created for people who wish to secure their money and those who wish to take risks can deposit their money with banks that lend out or invest part of the deposits. Pure depositories can nenver fail since they are simply warehouses (the state can insure the vault cash from fire, theft etc.) while bank depositors may lose part or all of their deposits if the bank fails and that is exactly how it should be.

        Banks should be able to create their own money, but not state money nor should they have any preferential access to the state money like Fed lending reserves.