Essays in Monetary Theory and Policy: On the Nature of Money (3)

By Jack Wendland*

Neoclassical economics has largely relegated money to the role of neutral medium of exchange.  A closer, more historical look at money reveals that, from the beginning, money has always been credit offset by debt, not a medium of exchange.  Although the acceptability of money follows a clear-cut hierarchy, the process by which money is created remains the same for all parties.  Running contrary to the mainstream narrative, this vision of money as credit has important implications for the fiscal policy of any state that issues its own currency.

The majority of introductory macroeconomic textbooks, at least those subscribing to the neoclassical school of thought, enumerate three functions of money: unit of account, store of value, and medium of exchange. To a certain degree, the definitions of the three functions seem, on the face of it, self-evident.  Not to be presumptuous, each will be explained in brief.  The space afforded to each function is commensurate with the attention it garners from neoclassical economics.  Much like a meter functions as a unit of measurement, money functions as a unit of account.  Without money, there would be no accounting for the economic value of variegated goods and services.  In addition to its role measuring value, money also functions as a store of value.  Absent inflation, money retains its value over time.  Accordingly, economic agents that wish to forego consumption in the present in lieu of consumption in the future can rest assured that their savings will not depreciate in value.

Although definitions of the first two functions of money can be dispensed quite quickly, the third requires a bit more exposition.  This necessity is due to the elevated standing the medium-of-exchange function receives in neoclassical economics.  As a medium of exchange, money facilitates the exchange of goods and services.  Again, this definition is, like the preceding, fairly self-evident.  But for reasons that will later be apparent, this narrative must be explored further.  According to neoclassical economics, money arose due to the inefficiencies of barter.  Prior the emergence of money, the exchange of goods and services was possible only in the presence of a double coincidence of wants.  The butcher and the baker could only exchange goods if the baker were in need of meat and the butcher in need of bread.  If the butcher found himself in need of bread, but the baker, a vegetarian, had no need for meat, no trade could occur between the two parties.  Enter money, medium of exchange.  Now, the butcher can gorge on bread until the cows come home (to be promptly slaughtered) so long as he has enough money.  And no longer a slave to that burdensome double coincidence of wants, the baker can take the money paid to him by the butcher and buy whatever utility-maximizing commodities he so chooses.

To be certain, the earliest money was rather primitive.  The butcher and baker did not arrive immediately at fiat money.  In the early days, all sorts of commodities auditioned to serve as money: salt, sugar, sea shells.  Eventually, these faulty commodity moneys were replaced by more practical precious metals.  Soon, these metals, gold and silver, were minted into coins of universal weight by all-powerful kings.  Further down the road, paper money enters the picture.[1]  Originally convertible to gold, modern money, fiat money, is now backed by nothing but trust, specifically, the trust that some other fool will accept what amounts to worthless paper in payment for his goods or services.

Though the cast of characters changes ever so slightly, the conundrum faced by the butcher and baker with uncoincidental wants has been retold countless times, all the way back to Adam Smith, father of classical economics.  It was Smith who first propagated the story of money emerging to extricate man from the burden of double coincidence of wants, citing the use of nails as media of exchange in Scotland and dried cod in Newfoundland as sufficient examples.[2]  Interestingly enough, both examples have since been revealed to be examples of something entirely different.  Just what these nails and dried cod were will be explained shortly.

But even overlooking the historical fallacies upon which this story rests, the neoclassical narrative can still be shown to be erroneous through use of reason alone.  In short, it seems highly unlikely that money would be predated by division of labor.  Nonetheless, this is precisely what neoclassical economics suggests.  The butcher and baker always come before money.  Spotting a lacuna in logic, David Levine poses a thoughtful question: “why do, and how can, producers orient themselves towards producing for a market when money does not exist?”[3]  The presumption that some primitive society would only realize the inefficiencies of barter after optimally organizing itself along the lines of a modern monetary production economy, each individual filling some specialized niche of labor, is a bold one.  It seems just as likely that the frame to a fixed-gear bicycle would have been produced before the wheel.  And the stipulation that this division of labor only gradually emerged out of subsistence agriculture is not sufficient.  The addition of subsistence as a precursor to specialization is pseudo-historic.  No amount of hasty caveats can erase the fact that the pre-money society conceptualized by neoclassical economics is nothing more than a hypothetical.

A better understanding of money must be historical.  There is no need to erase from our cerebral cortices the three traditional functions of money.  No doubt, these three functions will be featured in innumerable textbooks to come.  It must simply be recognized that these three functions of money are just that: functions.  All identify some particular usage of money, but none impart an adequate understanding of money.

Money is credit.  This statement applies to all incarnations of money, even the nails and dried cod of Adam Smith.  The creation of money requires two parties: debtor and creditor.  As such, it would be equally accurate to say that money is debt, as David Graeber, multi-hyphenate author of Debt: The First 5000 Years, does.  Given the recent success of Graeber, it may come in vogue to refer to money as debt.  But carrying on in the tradition of Alfred Mitchell-Innes, whose seminal article “What is Money?” predates Graeber’s Debt by nearly 100 years, here, credit is the preferred moniker.  For one, debt carries a pejorative connotation.  Furthermore, it is the aim of all individuals to accumulate credit, not debt.  In any event, without debt, credit would not exist, and vice versa.  Debt and credit are two sides of the same coin (more on coinage later).

Terminological asides out of the way, let us repeat: money is credit.  “By buying we become debtors and by selling we become creditors, and being all both buyers and sellers, we are all debtors and creditors.”[4]  The underpinnings for this assertion are unequivocally historical, not hypothetical.  But before examining this historical evidence, we must first return to the butcher and baker.  This time, however, our observation of the exchange between butcher and baker is outside the neoclassical viewpoint.  Here, the butcher and baker enter a social relationship.  When the butcher buys bread from the baker, he assumes the role of debtor, and when the baker sells bread to the baker, he assumes the role of creditor.  It is important to note that, although the debt may be extinguished immediately – as is the norm for most day-to-day, modern transactions – it can also be extinguished at some later date.  “The value of a credit depends… solely on the ‘solvency’ of the debtor, and that depends solely on whether, when the debt becomes due, he in his turn has sufficient credits on others to set off against his debts.”[5]  To accumulate the credits needed to retire his debt with the baker, the butcher must sell his meat to others.  “This is the primitive law of commerce.  The constant creation of credits and debts, and their extinction by being cancelled against one another, forms the whole mechanism of commerce and it is so simple that there is no one who cannot understand it.”[6]  Because the notion of money as credit is novel to most, it seems likely that, despite Mitchell-Innes’s assurances to the contrary, not everyone will fully understand this “primitive law of commerce” at first blush.

In diverging from the medium-of-exchange vision of money, it is important to develop some theoretical foundation for an alternative credit-debt paradigm.  But dealing in abstractions can only take you so far.  Eventually, concrete examples are needed.  This credit-debt paradigm is especially apparent in the case of the tally stick.  Throughout medieval Europe, creditors and debtors – sellers and purchasers, respectively – made records of their transactions on rectangular hazel-wood sticks.[7]  Tallies were cut across the stick to indicate the amount of debt.  Additionally, the name of the debtor and date of the transaction were inscribed on opposite sides of the stick.  The creditor and debtor would then split the stick down the middle.  The half taken by the creditor was known as the “stock” – from which the term “stockholder” derives – and the half taken by the debtor was known as the “stub.”[8]  The tally stick as described above was largely limited to medieval Europe.  Still, archaeologists have uncovered other tallies – not made on degradable hazel-wood sticks, but recordings of credits and debts nonetheless – throughout the world.[9]  One notable analogue to the tally stick is the contract tablet.  Used in ancient Babylonia, contact tablets, like tally sticks, recorded the amount of debt, the name of the debtor, and the date of the transaction.  These clay tablets were enclosed in clay cases and held by the creditor.  When the debtor retired his debt, the case and tablet were broken by the creditor.[10]  As with the tally stick in medieval Europe, the contract tablet was “the common instrument of commerce” in ancient Babylonia.[11]  Likewise, both the tally stick and contract tablet – specifically the credit each denoted – were transferrable.  That is, credit derived from a later transaction could retire debt from an earlier transaction.[12]  This transferability of credit is what Mitchell-Innes called “the primitive law of commerce.”

The designation of the tally as “the common instrument of commerce” in no way overlooks the coin.  In the neoclassical narrative, coins are upheld as the quintessential medium of exchange – durable, divisible, and, by nature of being crafted from precious metals, possessing some inherent worth.  But, as already stated, the import neoclassical economics attaches to money as a medium of exchange is widely overstated.  Medium of exchange is merely a function of money.  At its core, money is credit.  Again, the historical record supports the credit-debt paradigm of money.  “There is no question but that credit is far older than cash.”[13]  Indeed, the contract tablets of Babylon, which date back to 3,000 B.C., easily predate the first coins.[14]  Where coins did circulate, they played a subsidiary role to tallies.  Though the significance of coinage may have abated somewhat, at the time of Mitchell-Innes’s writing, he felt it safe to say, “In olden days coins played a far smaller part in commerce than they do to-day.”[15]  The statement is, in all likelihood, as true in 2013 as it was in 1913.  During the “olden days” referenced by Mitchell-Innes, coins could be removed from circulation entirely – as was the case when kings found it necessary to re-mint all existing coinage, not a rare occurrence – without affecting commerce.[16]  Today, any attempt to remove all coinage from circulation would likely result in revolt.

Note that this is the first mention of the state, what Max Weber defined as “a human community that (successfully) claims the monopoly of the legitimate use of physical force within a given territory.”[17]  Although this definition could be expounded upon, to do so would be outside the purview of this paper.  In any event, in both the neoclassical narrative of money as a medium of exchange and the alternative account of money as credit, money emerged independently of the state.  The butcher and baker created money of their own volition.  Only once the matter of the king calling in his coinage to be re-minted was raised did the state rear its head.  Seeing as to how abhorred the state is by neoclassical economics, it is rather ironic that talk of coinage necessitated talk of government.  This sudden appearance of the state may seem to obfuscate the question of who is responsible for the creation of money.

The truth is, anyone can create money.  We have already seen that a transaction between two parties creates money by putting one party, the purchaser, in debt, and the other, the seller, in credit.  Though examples thus far have been limited to medieval Europe and ancient Babylon, the same process can play out just as easily today.  Consider the case of two neighbors.  When one finds himself in need of a cup of sugar, rather than commute to the nearest grocery store, he simply walks across the hall – or yard or street – and kindly asks his neighbor if he can borrow a cup.  The second neighbor obliges and the first promises to return the same quantity at some later date.  Oftentimes, the first will even present the second with a note, some recording of the transaction: “IOU one cup of sugar.”  The creation of an IOU, an event that takes place every day, is no different than the splitting of a tally stick.  Both create a credit and a debt, in other words, money.  Still, the sanctity of an IOU between two neighbors – for a lowly cup of sugar, no less – may be legitimately called into question.  But fear not.  Other contemporary examples more formally designating credit and debt can be found.  Consider a small-business owner who walks into his local bank to secure a short-term loan necessary to expand his retail store from one to two locations.  If, after doing the requisite underwriting, the bank loan officer deems the small-business owner creditworthy, he will be extended a loan, one that must be paid back with interest.  As in the case of the IOU created between two neighbors, the loan created between the bank (the creditor) and the small-business owner (the debtor) is money.  Someone unfamiliar with the process by which banks extend loans might reasonably counter that no money has been created; the bank simply transferred money accrued from other depositors to the small-business owner, this line of reasoning follows.  But in actuality, this common perception of bank lending is inaccurate.  When a bank extends a loan, no one is sent into the vaults to make sure the amount being lent is on hand.  Paperwork is drawn up, keystrokes are struck, and, voila, money is created.  Technological advances aside, the basics underlying this loan are no different from those that underlay Babylonian contract tablets of five millennia prior.

Money created in this fashion – within the system, by bank loans – is known as endogenous money.  Because neoclassical economics has been blamed for disseminating a faulty understanding of money, it should be noted that not all branches of neoclassical economics dispute the notion that money is created endogenously.  In fact, endogenous money is one of the key tenets of real business cycle theory, one of many neoclassical progeny.  This realization is probably owing to the fact that real business cycle theory purports to delineate an economic model more real than those of preceding neoclassical schools of thought.  Still, real business cycle theory should not be given too much credit as several of its other stylized facts do not align as closely with reality.  Furthermore, the conclusions reached by real business cycle theory are far from agreeable.  This mention of real business cycle theory is meant only to demonstrate that, having penetrated the neoclassical fortress, endogenous money has rightly garnered some support outside of the more heterodox camp.

As previously stated, anyone can create money.  The rub lies in creating money that will be accepted by others.  So long as the two of you are on good terms, any person should be able to acquire a cup of sugar from his neighbor by issuing him an IOU.  But in all likelihood, scrawling the same three letters on a note and handing it to the cashier at the grocery-store checkout will earn you nothing but laughs.  This variation in the acceptability of IOUs hints at the hierarchy of debt, which can visually be imagined as a debt pyramid.

Not all money is created equal.  Duncan Foley’s debt hierarchy places private producers at the bottom, banks in the middle, and the state at the peak.[18]  Minor changes can be made to Foley’s original hierarchy – private producers split up into households and firms, for example – but the basic message remains: debt issued by those at the top is more acceptable than debt issued by those at the bottom.[19]  Without giving it much thought, the notion of hierarchical debt – the debt of private producers less acceptable than that of the state – seems fairly straightforward.  For whatever reason, this concept has some commonsense appeal.  But in all fairness, the concept of money as a medium of exchange possesses a similar appeal.  For this reason, the hierarchy of debt, specifically the state’s role atop the pyramid, must be examined more closely.

The state is accorded certain rights outside the reach of the private individual.  Whether or not this reality is fair is another issue entirely.  It has already been noted that one of the privileges taken by the state is the “monopoly of the legitimate use of physical force within a given territory.”[20]  Although factions outside the state might attempt to make use of physical force from time to time, their doing so is illegitimate.  When illegitimate use of force carries on too long, the state is said to have failed.  In addition to its monopoly on the use of legitimate force, the state also enjoys a monopoly on the issuance of sovereign currency.  Other currency may enter the circulation, as evidenced by the current Bitcoin phenomenon, but sovereign currency – the American dollar, the British pound, the Chinese renminbi – can be issued by the state alone.  All these sovereign currencies are money in the same sense that a contract tablet or tally stick or neighborly IOU is money, a point that will soon be revisited.  Nonetheless, sovereign currency is usually the first thing to spring to mind when the word “money” is mentioned.

Sovereign currency sits atop the debt pyramid because taxation creates a demand for it.  The case of colonial Africa provides arguably the greatest supporting evidence for this assertion.  When imperialist European powers began laying claim to stakes of the African continent, they faced a dilemma regarding how to monetize largely subsistence-based economies.  In short, the colonizers needed to create a demand for their currencies – which had no inherent worth for the indigenous peoples, who had been getting on just fine without the help of their unwelcomed visitors for quite some time.  It soon became apparent to the colonizers that the only way to create such a demand for their currencies was by levying a tax on their subjects.  Importantly, the taxes levied by the European overlords were always direct (a “poll tax, hut tax, wife tax”), as levying an income tax gave the locals no incentive to leave their familiar subsistence modes of living.[21]  In imposing these direct taxes, the colonizers were also able to select what work the Africans could and could not do to earn their colonial currencies.  More often than not, the autochthonous peoples were put to work harvesting cash crops or mining precious metals, pursuits that benefited only Europe.[22]  Clearly, these colonizers were not the most scrupulous individuals.  This example is intended only to demonstrate how taxes drive demand for currency, in this case, colonial currency.  Note that African currencies not acceptable in the payment of colonial taxes, such as cowrie, predated the Europeans’ arrival by centuries at least.[23]

It must be explicitly stated that the process by which the state creates money does not falter from the process described above.  This fact may be obscured by the unfortunate bias ingrained in our collective conscious towards viewing money as a medium of exchange, but if we step back two centuries, it should be made clear that state money follows the same credit-debt formula.  In medieval England, tally sticks were used not only to record the credits and debts of private producers, but also the credits and debts of the state.  In fact, tally sticks were used by the state until 1826.[24]  Following an expenditure, the state would issue a tally stick to the provider of the corresponding good or service as a record of its debt.[25]  And as explained above, the debt of one party is the credit of another, making the debt of the state the credit of the private producer.  The only difference between debt of the state and debt of the private producer is that the state extinguishes its debt by levying taxes, whereas the private producer extinguishes his debt by selling goods and services.  As seen in the case of colonial Africa, taxation by the state is all that is needed to create a demand for its debt.  In England, private producers accepted tally sticks as payment from the state based solely on the assumption that the state would accept the same sticks in payment of taxes to itself.  When taxation is abandoned, demand for the instrument of state debt – whether that be hazel-wood tally sticks or paper notes – collapses.  The cessation of taxes creates all sorts of problems for the state, as evidenced by the hyperinflations of the Confederate South and the Weimar Republic, both of which were brought on in large part due to neither state taxing its subjects.[26]

These realizations belie the mainstream narrative on state debt.  Although money can be created between two individuals as an informal IOU or between an individual and a bank as a more formal loan, most money creation is done by the state.  Also, IOUs and loans are almost always denominated in the money of the state.  The supremacy of state money is largely driven by the ability of the state to create a demand for its money through its power of taxation.  Furthermore, the state faces no constraint on how much debt it may issue.  The same cannot be said of banks and private producers.  Although the very business of banking involves taking on very large quantities of debt, known as leveraging, and private producers often take on debt as well, though not indefinitely as banks do, only the state has access to the printing press needed to print the sovereign currency.  This fact is widely understood by economists but largely kept hidden from the general public.  A litany of quotes could be called on to demonstrate economists’ understanding of this condition, but just one should suffice.  In 2011, speaking on Meet the Press, former US Federal Reserve Chairman Alan Greenspan declared, “The United States can pay any debt it has because we can always print money to do that.  So there is zero probability of default.”[27]  It should be noted that, in reality, state money more often than not takes the form of an electronic bank entry.  That is, money need not be physically printed.  Also, note that states that belong to a common currency area like the Eurozone do not possess the same power.  Still, Greenspan’s underlying message is true.  The United States, and any other sovereign currency issuer, cannot run out of money.  There is no limit on how much debt the state can accumulate.  Making taxes payable in state debt will always create a demand for state debt.  Additionally, taxation enables the state to retire its debt by accepting its debt – coming from private producers as credit, again, two sides of the same coin – in payment to itself.  The myth propagated by media members and politicians that state debt is unsustainable is simply not true.

Recognizing that the debt of the state is the credit of the private producer leads to the conclusion that the value of state expenditures should be greater than the value of state taxes.  Such a condition is commonly known as a government deficit, often a source of anxiety for proponents of the mainstream myth.  Nonetheless, in a two-sector economy consisting of the state and private producers, surplus for the private sector can only be brought about by deficit of the public sector, the state.  If the private sector is to accumulate any wealth, the public sector, as the monopoly issuer of the sovereign currency, must issue it more credit (in the form of state expenditures) than debts (in the form of state taxes).  There is no need for the state to balance its budget, setting expenditures equal to taxes.  In fact, doing so would be undesirable.  A state budget that is in balance leads only to a static private sector, one whose wealth is neither increasing nor decreasing.  Even less desirable than a state whose budget is in balance is a state whose budget is in surplus.  In fact, for the state, it is not budget deficits that are unsustainable, but budget surpluses.  No doubt, the public sector can run a surplus in the short run.  But doing so necessarily puts the private sector in deficit, effectively robbing private producers of their wealth by issuing them more debt than credit.  As expected, the most recent US public-sector surpluses – reported in fiscal years 1998, 1999 and 2000 – did not end well.  Because the private sector cannot indefinitely dip into savings, the public sector’s stinginess eventually led to recession.

Although the addition of a foreign sector allows for more policy space, in the case of the US, the preceding conclusions remain the same.  In short, running a foreign-sector surplus, specifically a current-account surplus, eliminates the need to run a public-sector deficit.  Both foreign-sector surplus and public-sector deficit accomplish the same task: transferring more credit than debt to the private sector.

Rejecting the notion that state debt is unsustainable opens up a panoply of policy proposals, including the promising prospect of the state acting as an employer of last resort, in other words, a job-guarantee program.  As its name suggests, such a program would guarantee a job to anyone willing to work, thereby eliminating involuntary unemployment, one of the greatest shortcoming of capitalism.  Importantly, a job-guarantee program should not compete with the private sector.  Because the sustainability of its debt is not a concern, the state could afford to offer those enrolled in the program a living wage, one greater than the minimum wage, but offering such a wage would be to the detriment of the private sector.  A job-guarantee program is designed to promote the public purpose, something that would not be accomplished by damaging the private sector.  In the spirit of promoting the public purpose, such a program should be administered at the local level, where officials are more in tune to the needs of their communities.  Any successful job-guarantee program should be countercyclical, expanding as the economy contracts and vice versa.  Estimates on the size of a US program show 8 million would be employed during boom times, 12 million during the inevitable bust.[28]  For skeptics, the number of those potentially employed by the program is likely far more intimidating than its estimated cost: one percent of gross domestic product.[29]  The Argentine state established a similar employer-of-last-resort program known as Plan Jefes y Jefas which peaked at one percent of GDP, employing two million.[30]  The US has never run a job-guarantee program per se, but the state did employ 13 million people during the Great Depression.  Although efforts have been made to discredit these job-creation efforts, New-Deal programs like the Works Progress Administration must be considered a success. The WPA alone, which employed 8.5 million people, was responsible for the construction of 650,000 miles of roads and 125,000 buildings.[31]

Medium of exchange is merely a function of money.  This oft-repeated phrase fails to answer what money really is.  By abandoning the neoclassical approach to money based on hypotheticals and adopting an alternative approach more reliant on history, money is shown to be credit, offset by debt.