Why Money Matters

By L. Randall Wray*

Our Mission Oriented Finance conference explores how to direct funding toward what Hyman Minsky called “the capital development of the economy”, broadly defined to include private investment, public infrastructure, and human development. (See more here.)

But to understand how, we need to understand what money is and why it matters. After all, finance is the process of getting money into the hands of those who will spend it.

The dominant narrative is that money “greases” the wheels of commerce. Sure, you could run the commercial machine without money, but it runs better with lubricant.

lrw1 lrw2lrw3

In that story, money was created as a medium of exchange: instead of trading your banana for her fish, you agree to use cowry shells to intermediate trade. Over time, money’s evolution increased efficiency by selecting in succession unworked precious metals, stamped precious metal coins, precious metal-backed paper money, and, finally, fiat money comprised of base metal coins, paper notes, and electronic entries.

However, that never changed the nature of money, which facilitates trade in goods and services. As Milton Friedman famously proclaimed, in spite of the complexity of our modern economy, all of the important economic processes are revealed in the simple Robinson Crusoe barter-based economy.

lrw4 lrw5 lrw6

Money is a “veil” that obscures the simple reality; in the conventional lexicon, money can be ignored as “neutral”. (For those well-versed in economics, we need only refer to the Modigliani-Miller theorem and the efficient markets hypothesis that proved finance doesn’t matter.)

We only worry about money when there’s too much of it: Friedman’s other famous claim is that “inflation is always and everywhere a monetary phenomenon”—too much money causes prices to rise. Hence, all the worry about the Fed’s Quantitative Easing, which has quadrupled the “Fed money” (reserves) and by all rights should be causing massive inflation.

This post will provide a different narrative, drawing on Joseph Schumpeter’s notion that the banker is the ephor of capitalism.

Looking at money from the perspective of exchange is highly misleading for understanding capitalism.

In the Robinson Crusoe story, I’ve got a banana and you’ve got a fish. But how did we get them? In the real world, bananas and fish have to be produced—production that has to be financed.

Production begins with money to purchase inputs, which creates monetary income used to buy outputs.

As mom insisted, “money doesn’t grow on trees”. How did producers get money in the first place? Maybe by selling output? Logically, that is an infinite regress argument—a chicken and egg problem. The first dollar spent (by producer or consumer) had to come from somewhere.

lrw7There’s another problem. Even if we could imagine that humanity inherited “manna from heaven” to get the monetary economy going—say, an initial endowment of a million dollars—how do we explain profits, interest, and growth?

If I’m a producer who inherited $1000 of manna, spending it on inputs, I’m not going to be happy if sales are only $1000. I want a return—maybe 20%, so I need  $1200. If I’m a money lender, I lend $1000 but want $1200, too. And all of us want a growing pie. How can that initial million manna do double and triple duty?

Here’s where Schumpeter’s “ephor” comes in. An ephor is “one who oversees”, and Schumpeter applied this term to the banker. We do not need to imagine money as manna, but rather as the creation of purchasing power controlled by the banker.

A producer wanting to hire resources submits a prospectus to the banker. While the banker looks at past performance as well as wealth pledged as collateral, most important is the likelihood that the producer’s prospects are good–called “underwriting”. If so, the ephor advances a loan.

More technically, the banker accepts the IOU of the producer and makes payments to resource suppliers (including labor) by crediting their deposit accounts. The producer’s IOU is the banker’s asset; the bank’s deposits are its liabilities but are the assets of the deposit holders (resource suppliers).

This is how “money” really gets into the economy—not via manna from heaven nor Friedman’s “helicopter drops” by central bankers.

When depositors spend (perhaps on consumption goods, perhaps to purchase inputs for their own production processes), their accounts are debited, and the accounts of recipients are credited.

lrw8Today, most “money” consists of keystroked electronic entries on bank balance sheets.

Because we live in a many bank environment, payments often involve at least two banks. Banks clear accounts by debiting claims against one another; or by using deposits in correspondent banks. However, net clearing among banks is usually done on the central bank’s balance sheet.




Like any banker, the Fed or the Bank of England “keystrokes” money into existence. Central bank money takes the form of reserves or notes, created to make payments for customers (banks or the national treasury) or to make purchases for its own account (treasury securities or mortgage backed securities).

Bank and central bank money creation is limited by rules of thumb, underwriting standards, capital ratios and other imposed constraints. After abandoning the gold standard, there are no physical limits to money creation. We cannot run out of keystroke entries on bank balance sheets

lrw10This recognition is fundamental to issues surrounding finance. It is also scary.

The good thing about Schumpeter’s ephor is that sufficient finance can always be supplied to fully utilize all available resources to support the capital development of the economy. We can keystroke our way to full employment.

The bad thing about Schumpeter’s ephor is that we can create more funding than we can reasonably use. Further, our ephors might make bad choices about which activities ought to get keystroked finance.

It is difficult to find examples of excessive money creation to finance productive uses. Rather, the main problem is that much or even most finance created to fuel asset price bubbles. And that includes finance created both by our private banking ephors and our central banking ephors.

The biggest challenge facing us today is not the lack of finance, but rather how to push finance to promote both the private and the public interest—through the capital development of our country.

That is the main topic of our Mission Oriented Finance conference.

*Cross posted from FT’s Alphaville

25 responses to “Why Money Matters

  1. But, but, but, taxpayers fund the federal government.

    Dispelling this notion is a monumental task. It’s all well and good to present the logic of how our “money” comes into existence but those who accept your logic on money creation also cling to the notion of “taxpayer funded—this or that” suffering from cognitive denial when told that tax dollars are destroyed and don’t pay for anything.

    I think you may want to complete the circle of money creation, spending and taxation, a la J.D. Alt’s “Diagrams and Dollars.”

    • Actually, it will never do anyone any good to close the money creation circle a la MMT-speak, UNLESS y’all can convince the Treasury people, who think that banks create all the money used in national commerce, that you know what the hell you’re talking about.
      Warren is always saying how his colleagues at Treasury know all ‘this stuff’ is true, so get a little public finance administration support….that will go a long way.

  2. If the logic of “tax payer” money does not exist in a fiat system, why incur the wrath of IMF/World Bank austerity that eventually leads to human waste when Africa, Asia, L America etc can easily create money to finance their domestic developmental imperatives? Why have all nations remained welded to the notion that tax payer? And why the mind numbing endless debates in congress? Most importantly, why are the celebrity economists like Krugman, Stiglitz, Summers, etc not so vocal on a simple economic truth, but appear to support a pre-1971 system?

    I think you may want to inform the generally unaware American voter about this, not through academic debates, but through well publicized open public debates.

    Dare I say that the so called US/Africa summit should have rather focused on the usual international trade issues than the so called infrastructure development, which money can be created within these sovereign nations for their infrastructure needs- save for inputs that they can’t produce locally?

  3. Erick Borling

    But inflation! (Just kidding.) This kind of post is what I’m really grateful about with the MMT instructors who frequently return to the fundamentals when writing about economics. Mike Hudson is great but he’s so… meta it’s tricky to follow him. Anyway myths about the creation of money cause policymakers to enact policies that destroy lives, not to mention preventing fulfillment of potentials. I wonder why the Monopoly game is never used as an example of how the monetary system works, at least at the beginning of the game. At that time, money is simply handed out although there is no tally of the money issued by the central banker. That tally of money issued would be “the debt,” but who cares. Under the consolidation theory it would be the same as real life wouldn’t it? If there were a Federal Reserve in the Monopoly game, this layperson thinks that means that players put their money back in the central bank by buying T-bills (bonds?). The next questions after the inflation bogeyman are typically about the role of the Fed aren’t they. …’Cuz that’s the loop in the water hose. The water comes out the same. Yeah but there’s a loppy part in the hose. Still, the amount of water coming out is unchanged. But don’t forget the loop in the hose! (That’s the kind of back-and-forth that has economists arguing about MMT, isn’t it?)

  4. Banks put money in the economy short term but long term they remove money from the economy. LRW states it clearly in his article where he states: “If I’m a money lender, I lend $1000 but want $1200, too. ” The result of the bank loan was the removal of 200.00 from the economy. Some entity has to replace that 200.00 that was removed and the only entity that can do that is the central bank and they do it by buying government debt. That is why the Fed states clearly in their materials that a national debt is necessary for the operation of the central bank. The national debt forms the “payroll fund” for the nations banks.

    • Implicit assumption in that is that nothing is done with the 200 profit.
      Is that fair ?

      • A part of it will go for expenses and dividends to investors, true, but part will become the wealth of the bank. And look about you, hasn’t that happened?

      • Every attempt to minimize the debt-service cost of debt (future resource extraction to exchange for money-rent) is drawn to the red-herring question of where that extra $200 goes, and whether paperclips are bought or rent is paid with that debt-service rent money into the real economy.
        This is not the question that the debt-based money contract presents.
        The real question is limited to “from where/whom does that rent money come”, having nothing to with from where it goes.
        A bank is in many ways like any other commerce, so it receives income and pays rents, just like the rest of us.
        The question has to do with the source of interest-payment ‘money’…….and the answer is that the lack of creation/issuance of money to pay the interest on “that” (any) loan means that the rent money must come from some other loan that is ultimately not created for the purpose of paying debt-service interest that ends up as the bank’s rent money.
        This result axiomatically creates a deficit in the money supply that can only be maintained by constant increases in debt levels.
        Yes, all debt-based money issuance requires more debt-based money issuance to pay the debt-service costs of the debt-contract associated with the initial loan.
        What happens with that money received from that debt-contract by the bank has zero impact on debt-service money’s mal-construct.
        Any bank making any payments for any goods or services acquired is no different from any other business or household using its income for that purpose.
        The only ‘banking’ difference is that the bank creates its interest-earning asset, and money-system deficit, out of whole cloth in its lending operation.
        The principal amount is created and destroyed during the term of the loan.
        The bank’s interest income is never created/issued, though it is gained via contract, thus implementing the growth paradigm of modern capitalism………… and the paradox that debt-based money never works well in reverse.

    • Well, two things.

      First, if a bank lends $1000, then that money is created by the loan. If the loan is repaid, that $1000 is destroyed. What should really trouble you about this situation is that, in a “circuitist” worldview where all money is produced by bank lending, then growth can only come from ever-increasing leverage of future profits. This is the sort of situation that makes a single bad harvest turn a farmer into an indentured servant. In this sense, the “reason” to have government money is that it’s not really leverage at all, but just an asset that’s also called a liability for bookkeeping purposes.

      As far as the bank’s $200, you’re forgetting that a bank in the real world has investors and operating costs. That $200 will only be retained if there’s some special reason it should be; more likely, it’ll pay the wages of the tellers, or pay the utility bill, or be paid as dividends to a shareholder.

      • Very true, Sean and I did not forget that but the fact remains some part of that 200.00 will be retained by the bank; either that or the bank will be guilty of giving away money or loaning at less that 0%! And I believe banks are very innocent of that “crime”.

      • That $200 will only be retained if there’s some special reason it should be; more likely, it’ll pay the wages of the tellers, or pay the utility bill, or be paid as dividends to a shareholder.

        The $200 is destroyed. It ceases to exist. Not at the bank TO which it was paid, whose regular expenses you’re bringing up. But at the bank FROM which it was paid. That bank lost a reserve and extinguished a deposit. The payee bank obtained only a reserve. Writing a check to a bank leaves aggregate deposits diminished, aggregate reserves unchanged.

        Clearest example: the $10 monthly fee banks tend to charge on business checking accounts. Upon charging it, the bank doesn’t have $10 more; it owes its customer $10 less. Certainly the bank’s equity position improves, as its real estate, artwork and securities are less encumbered by debt. But our medium of exchange is money, not equity. With that $10 fee, deposit currency (M1), is diminished, and no money aggregate is augmented to offset it.

        Coins do not have this debt deflation attribute. Coins are assets to whoever lawfully possesses them, and all money aggregates remain unchanged when a payment is made in coin. Thus: positive money actually is a thing (which is not an argument for its universal deployment.)

        • Coins are a totally separate monetary system from currency/Fed Notes. Coins are spent directly into the economy by the govt although you have to look hard to find that fact on the balance sheets.

        • David Chester

          The writer is saying that there are two kinds of money. Hard cash which is a material substance (paper and coin) and circulates between purchasers and sellers of goods, services and valuable legal documents, and deficit money as promises in terms of post-dated checks, electronic impulses, etc, which are borrowed from the banks. When these are returned there is not a destruction of the money, as the writer claims, because it allows the banks (whose amount of deficit money is somewhat limited) to issue some more. Thus although the banks can create money out of thin air, the amount that is borrowed in this way is limited and a degree of governmental control is still maintained.

    • 1. The math is wrong. Not all of the $200 is removed, much of it is recycled. This is important because it means it is not correct that the growth rate must exceed the interest rate, or else the system implodes.
      2. Retained earnings of banks have no different macroeconomic effect than retained earnings of other companies, or savings by individuals, or net imports: all are leakages of money from the economy, and must be – will be, as a mathematical certainty – offset by the government deficit.

      • Golfer, your bottom line is correct except you left out one step. Government spending deficits place the needed funds into the economy WHEN the central bank buys that debt. And my math is correct and it is really rather simple and the conclusion is quite obvious if you consider the system I assumed.

  5. Rob Rawlings

    In the banking model described lending takes place purely based on expectations of future production with no reference to current savings. While I can see how such a system could evolve over time as money and banking get more sophisticated I struggle to see how it could get boot-strapped.

    Take an example of a community of subsistence farmers. One of them has an idea for a tool that will increase productivity. To produce it he needs to stop farming for a period. If the idea is to be implemented then one way or another he has to find a way to fund the production period. One way would be to borrow food from the other farmers with the promise of a greater return of food later when he starts renting out his new tool. Banking would facilitate and improve this process by making the borrowing process easier and standardizing the loan into a unit of account (likely based on a suitable commodity – and avoiding the need for the loan to be physical food units) , and then paying an agreed interest on the loans.

    In the credit money model described however the bank doesn’t need to borrow – its just issues IOU to the farmer to spend. What is the incentive of the other farmers to take these IOUs ? Even if they did wouldn’t it (initially) be inflationary ?

    Are there standard answers to these question of how banking using credit money got started ?

    • Bank lending per se can never be inflationary because they always take back more than they loaned…simple math.

      • Based on how confident you seem with your replies on this page, I suggest you brush up on your understanding of stocks vs. flows, the circulation of money in the economy vs. leakages & injections, and banking operations / balance sheets.

        Commercial bank lending is performing a basic service, for which they charge a price. Just like a mechanic who provides a service for a price. With their earnings from that service, they can either spend it back into the economy, or save it as their wealth which is a leakage out of the economy’s circulation. That’s both the bank *and* the mechanic, and anyone else who makes a monetary income: they can “remove it from the economy” as you say, or they can spend it back in.

        The bank’s service they provide in lending is really that they agree to swap IOUs with the borrower, for a price over time (a flow that we call interest, but isn’t special like you’re making it out to be). Check out Minsky on this aspect (“The fundamental banking activity is accepting, that is, guaranteeing that some party is creditworthy”). ‘Borrowers’ do this because the bank’s IOU is more acceptable to other people than their own IOU is, and thus the bank is offering a valuable service for which they expect to be paid (just like the mechanic).

        Can bank lending be inflationary? Of course it could. At any given moment, there is a stock of bank debt being used as money in the economy, matched against current loans, and that stock of money is increasing the economy-wide aggregate demand. Now say tomorrow, the stock of existing ‘bank money’ from loans is increased 100 fold, from some combination of massive uptick in borrowers looking for loans, reduced interest rates offered, lowered bank underwriting standards, reduced regulatory capital requirements, whatever. Despite the fact that there still exist flows for loan origination & loan repayment at any given point in the future, there can still be a massive increase in the stock of bank money created that translates to much higher effective demand without time (or ability) to be matched by increased output.

        Just saying that you should be way less certain in your proclamations about banking in the long-run and how that translates to some kind of laws like “bank lending per se can never be inflationary” or “banks remove money from the economy”.

        • With full and complete respect, it is not an issue that can be understood nor analyzed with words; it is a math problem and it is rather simple. You do need to understand and recognize an exponential but that is the highest level of math involved. Assume two blocks; a bank and an economy with lines with arrows between them showing loans, loan repayments and bank expenditures into the economy to pay for their existence. Now for a simple but illustrative case assume the bank makes a policy to make loans at a fixed rate of interest and for a fixed term and the same amount of loans each month. Assume an initial amount of money in the economy at the start point. Now, plot the amount of money in the economy vs time. It increases in a linear fashion until the end of the loan period at which time the money in the economy begins to fall at a rate proportional to the profit made by the bank, again at a linear rate. It will continue to fall until all of the money is held by the bank and none is in the economy. That is math. And it shows the policy of having a fixed loan rate is not good policy. So assume now the bank decided to maintain a fixed level of money in the economy. In order to do that the bank needs to loan back into the economy exactly the same amount of money it received in loan repayments while bearing in mind it does not have to loan back what it spent for expenses. This policy will produce a constant amount of money in the economy but the loan amount each month becomes an exponential! Eventually (and it is easy to calculate when) the loan amount will equal the total amount of money in the economy, a very unstable point. The lesson from this analysis is that banks cannot work in a stable fashion without another entity to furnish money to the economy and we know there are two entities that can furnish this needed additional money; a central bank or a sovereign government spending money directly into the economy in excess of tax receipts plus borrowed funds and at present the US govt does not do this except for coins. The central bank performs this needed function by buying the national debt which is why the Fed states and has stated a national debt is necessary to operate the monetary system.

  6. “The good thing about Schumpeter’s ephor is that sufficient finance can always be supplied to fully utilize all available resources to support the capital development of the economy. We can keystroke our way to full employment.”

    What defines when ‘all available resources to support capital development’ are in use? What I’m trying to figure out is that if the constraint for the amount of money creation is inflation, which derives from not being able to meet all demand, since the production capacity / all resources are already in use. But how do you define when all resources are in use / what do you refer to as ‘resources’? Or which capacity is in question? The workers, the machinery, or something else? And in what kind of timeframe? If there would still be demand for a certain product/service, should you simply create money to fund the investment of increasing the capacity?

    Concerning full employment.. are there some restictions to the type of jobs which could be funded by printing money, without this causing inflation? I’m thinking about this linked somehow to the capacity… Is the key question to always only fund things that are productive? If so, how do you determine whether a job/person/company is productive or not? Let’s say you’d fund to create jobs for all the unemployed teachers… Is this doable, or what are the constraints?

    Also, is a situation where a state’s public sector is not been financed by tax payers’ money possible only in case of sovereign money? In the euro (EMU) countries, the public sector is (in my understanding) either funded by taxes or by the state taking in foreign debt. Both have limitations. The foreign debt/interest eventually has its collectors (coupled with the looming pressure incurring from rating agency decisions) which will limit the amount of debt a country can take. Taxing the private sector on the other hand will slow/hamper the economy. Thus, in the current system, there’s constant shuffling of how to afford all the public sector jobs/spending.

    How does this situation play out in the case of a single currency area of multiple nations such as EMU?

    • “Or which capacity is in question? The workers, the machinery, or something else? And in what kind of timeframe? If there would still be demand for a certain product/service, should you simply create money to fund the investment of increasing the capacity?”

      I don’t know if this part of “mainstream” economics is in dispute here, but its story is that the definition of the “short run” is a time in which resources are fixed. If you need a machine, it’s the time it takes to build the machine. If you need an engineer, it’s the time it takes until some more engineers graduate. In the “long run”, the existence of excess demand will cause producers to employ more resources to satisfy it, and the assumption is that those resources will be available, by growth of population, or productivity, or technology, or shifting of resources from other uses that are not so much in demand.

      Specific resource shortages can cause the price of a resources to rise, but unless more money is created to accommodate the higher price, the demand for other resources will fall, or else the higher price will cause demand for the scarce resource to fall, or both. That is not inflation, it’s just a change in relative prices.

      A few resources: land, energy, and human labor; are inputs to virtually every production process. Increases in their prices will feed increases throughout the economy, raising the general price level. JG would tend to stabilize the price of unskilled labor, and energy will fluctuate absent action by monopolists to maintain prices by restricting production. I’m not sure there is a way to prevent a continuing increase in land price, when population is increasing. I think that may be the reason we still have inflation despite sharp declines in oil prices, from time to time, increases in productivity in excess of increases in wages over a period of decades, and periodic recessions that reduce demand for everything.

      Policy-wise, I think the best we can do is to target the size of the JG workforce. In the short run, specific shortages may cause changes in relative prices, but general inflation can only accelerate due to things beyond control of economic policy (population growth and monopolist actions) or a general labor shortage. When “nobody” wants to work at JG, because they all have better offers in the private sector, it is time to raise taxes. When too many are rushing into JG, it’s time to cut taxes. (“Discretionary” spending should be dictated by public policy objectives, not economic policy. Taxes are the only correct lever of economic policy.)

  7. Enough with the “ephors”!

  8. Pingback: Randy Wray: Why Money Matters | naked capitalism

  9. “In the real world, bananas and fish have to be produced—production that has to be financed.”

    In the modern world, it may be true that production has to be financed, at least production of some significant magnitude. I started my company without financing, only a small amount of equity. But I never grossed more than $300K a year.

    In the Crusoe example, no financing is needed. Bananas and fish simply needed to be harvested, the only input was labor and natural resources, no capital and no financing. Thus the “dominant narrative” could be correct as to the origins of commerce, using this example or others that start with subsistence agrarian societies. At least some of the primitive societies in North America never did develop money, but they did trade with each other, using barter. I think you need a better narrative of the origins, perhaps a larger society with no formal government, but a way of keeping track of debts between individuals (tally sticks?) or else just start with a monetary economy, and forget the origins. You don’t want people to be able to reject your entire thesis because of such a simple and, really, irrelevant flaw in your presentation.

  10. The ephor is an interesting concept. They create credits which we use for transactions. They also destroy credit, but only credits they created. So if a banker ephor creates and lends credits in the amount of $1000, he expects the return of $1200, principal and interest. Upon return, the $1000 is cancelled and the remaining $200 lives on in the economy. The banking ephor did not create the $200, so can’t cancel it. Later, after many transactions, the $200 is paid in taxes and used to reduce the deficit, and it’s creator, the Fed ephor, lowers the deficit and cancels it.

    The constraint on capital comes in the form of rent-seeking by excess savings which competes for yield against (productive) investment capital, resulting in impaired growth. Well distributed capital can enhance growth while capital concentration can impair growth by impairing the clearing of markets. This implies that there is a limit to key stroking to full employment unless impairing investment is curtailed as well as capital concentration (capital congestion). One way to limit impairing investment (or it’s impact) is to lower interest rates.