My Ph.D. in economics from the University of Chicago dealt with a monetary policy issue. My five years as an Assistant Professor of Economics at the University of Virginia allowed me to lecture extensively about monetary policy and my 26 years at the International Monetary Fund were largely devoted to providing technical assistance to member (primarily post conflict) county central banks (including Afghanistan, Bosnia, Croatia, Egypt, Iraq Israel, Kazakhstan, Kenya, Kosovo, Kyrgyzstan, Moldova, Serbia, South Sudan, Turkey, West Bank and Gaza, and Zimbabwe). In case you didn’t know, central banks issue the currency (money) of their respective countries. So, I know a lot about “money” and like talking about it.
And it’s not that I haven’t already written a lot about the subject. For a few examples see: “Econ 101-the Value of Money” “Money” “A Libertarian Money”
A lot of interesting things are happening these days in the monetary area, but they pertain to payments (transferring money from one person to another via PayPal, Venmo, Zelle, Visa, etc.) rather than money itself. I want to talk to you about “money” (not payments) as I might with my granddaughter. Money is what is transferred in payment.
Money exists because none of us are self-sufficient and must trade what we produce with others who produce the other things we want. I will skip the presumably well-known story of barter trade and its challenge of the double coincidence of wants (you have what I want, and I have what you want so we trade). Giving you a commonly accepted asset, that you can hold until you want to buy something from someone else and can “pay” for it by passing that asset on to the next seller is the essence of money. In addition, it becomes the unit of account (the unit for stating prices). Thus, money is a unit of account, means of payment and store of value.
But now dear granddaughter, lets dig deeper to discuss where this money comes from and its key features in today’s modern electronic (digital) world. First of all, I can’t pay you with any old asset equal in value to your sale price (the barter problem). I must pay you with “money,” an asset universally accepted within the country. To cut to the bottom line, money is the asset issued by our central bank (any of our twelve Federal Reserve Banks) or creditable claims on the Fed’s monetary liability—the U.S. dollar. Until 1933 these dollars could be redeemed for gold at $20.67 per once. Now the U.S. government accepts them in payment of our taxes denominated in dollars, which insures their ultimate value.
Federal Reserve notes (dollar bills) are the most direct manifestation of our money. But almost 90% of our money (the asset with which we can pay for things) is in the form of deposits at American banks, and credit unions. These figures can be a bit misleading because over 60% of our currency is held abroad.
When you pay someone with cash, they receive a direct claim on the Federal Reserve. When you pay with your bank deposit, your bank’s deposit with (claim on) a Federal Reserve bank is transferred to the payee’s bank, which credits the payee’s bank account with the designated amount. The asset paid and received is still ultimately a claim on the Fed.
But our demand deposits with our banks amount to 15.9 trillion dollars, while the reserves that our banks keep with the Federal Reserve Banks amount to only $3.3 trillion reflecting our “fractional reserve” system. What is going on here? How did banks create more of our money (ultimate claims on the central bank) than it backs with its reserves at the Fed?
When teaching money and bank at the U. of Virginia I loved walking the class through the money/banking multiplier that resulted from our fractional reserve backing system. It has become fashionable for some to claim that banks create deposits (money) by making loans. When you received a mortgage loan from your bank, they say it creates the deposits placed in our deposit account. This is sort of true and sort of not true. Your bank actually pays your mortgage loan to the account of the person selling their home and their account is almost surely in another bank. That means that your bank must have sufficient reserve balances at the Fed to transfer to the seller’s bank.
I will leave the details of the bank money multiplier to the Money and Banking class you will hopefully take when you go to college, but the fact that your deposits are only partially backed with reserves at the Fed (the rest of the backing being the bank’s loans and other financial assets, is what lies behind the occasional bank runs we saw in the movies before deposit insurance was introduced to assure depositors that they could get the money back even if their bank failed. If enough bank borrowers default on their loans, the bank could become insolvent. Only the first to withdraw their deposits will be able to get their money back. The potential risk of such runs on a bank only partial backing your deposits with reserves at the central bank motivated the Chicago Plan of 100% reserve banking. “Protecting Bank Deposits”
If bank deposits of US dollars are money, what about cybercurrencies? What are they ultimately claims on? Bitcoin, as you hopefully know, is not a claim on anytime. They can’t be redeemed for anything. It is not unit of account or means of payment for hardly anything—it is not money. It is a speculative “asset” for those who like to speculate (gamble). “Cryptocurrencies-the bitcoin phenomena” “The future of bitcoin exchanges” “Bitcoin-Cybercurrencies and Blockchain” “The difference between bitcoin and FTX”
But there is a class of cryptocurrencies that claim to be redeemable for money, such as US dollars—so called stable coins. The validity of this claim, as with your bank re your deposits there, depend on the details of its contract and the faithfulness of its adherence to that contract. Tether and USD Coin are the most popular US dollar stable coins.
But to use a stable coin for making payments, the person or firm you are paying must have the software or card reader needed to use the cryptocurrency you want to use. You might remember (probably not you, dear granddaughter) when not so many stores could accept visa, or MasterCard (or the Shell Oil, or Texico gas cards). Payment technology has continued to evolve and improve, but if it is not transferring money (US dollars in our case)—i.e. an asset ultimately redeemable for the Federal Reserve’s liability, it will not get you very far.
Other than handing someone cash, paying with your bank account requires a messaging and authorization system. Do you still write checks occasionally—so sorry. A check both indicates the amount to be paid and authorizes its transfer. Almost all payment instructions and authorizations are made electronically these days. Many central banks are considering introducing digital cash in place of or along side their currency notes (Central Bank Digital Currency). When offered through a bank, a CBDC would have the advantage of 100% reserve backing (it would be a direct claim on the Fed). On the other hand, modern electronic means of payment leave little room for further improvement as might be offered by CBDCs. “Econ 101-Retail Central Bank Digital Currency-CBDCs”
To make payments, or send money, abroad, your money must be exchanged for the money of the recipient. I regularly send dollars to Afghanistan, which are received as Afghani. A massive foreign exchange market in which the exchange rate of one currency for another is determined exists for that purpose. Such payments can be made more quickly and cheaply if both parties are willing to use the same currency. Thus, the US dollar is rather widely accepted for cross border payments. “The Dollar Again” The Special Drawing Right (SDR) of the International Monetary Fund serves this purpose for governments but is not widely used. “What are SDRs?” Stable coins redeemable for gold provide another promising potential unit given golds historical importances. The best existing example is e-gold by Global Standard (to which I am an advisor).
But not all monies behave the same. The behavior of the value of each (its inflation rate) depends on how its issuing central bank manages its supply. Some central bank’s supply whatever their government needs, generally resulting in high inflation rates. Some, such as our Federal Reserve, regulate its money’s supply in an attempt to maintain an inflation target (in the US the target is 2%). Others follow currency board rules that leave to the market the determination of a supply that keeps the currency’s value consistent with that of another currency (The Euro in the case of the Bosnian dinar or the Bulgaria lev). So dear granddaughter there are many interesting things to study about money.
Why don’t you pop over and let’s discuss it more over lunch? Oh, I forgot that you are in the West Coast Washington (state) while I am near the East Coast Washington (DC). Well at least we can meet on FaceTime or Zoom (or even the old fashion telephone). But I would love to meet one way or the other.
P.S. In 2002 as Patrick Honohan and I were finishing up the Bank-Fund Financial Stability Assessment of Egypt (Patrick led the World Bank team and I led the IMF team) I said in an email “Patrick, why don’t you just come across the street and discuss this over tea?” Patrick replied: “Warren, I am in Dublin. I moved here several months ago.” He later became the Governor of the Central Bank of Ireland.
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