Different Kinds of “Money”

Different Kinds of “Money”

September 2, 2007

A number of economists have had difficulty over the idea of “different kinds of money.” Certainly the Monetarists have followed this weedy path the farthest — at one point I think they went all the way up to M13. But probably all kinds of economists buy into this in some form or another. This is in part because of the history of banking, particularly the period 1850-1930 or so. This was a time when commercial banks were engaged both in credit creation and money creation, oftentimes in a single act. That would be confusing, no? Also, it was a time when people were transitioning from commerce in literal metal coins to paper money, and then to commerce in the form of bank transfers of various types as we do today with checking, debit cards, credit cards, wire transfers, and so forth. All of these innovations served as an alternative to conducting commerce in bullion coins. This confusion is what gave rise to the idea that credit creation is a type of money creation, and since we know that excessive money creation leads to a loss in monetary value, i.e., inflation, well, danger danger!

We can see today that credit, whether a long-term loan or a bank deposit, is merely a contract denominated in money, not money per se. A Certificate of Deposit that matures in March, promising delivery of money on that date, is really no different than a futures contract for cocoa that matures in March, promising delivery of cocoa. All have a contractual counterparty, which real money, i.e., base money, does not. Actual money is something like a manufactured good. Certainly a bullion coin is a manufactured good, no? Paper money is a manufactured good as well, although one with different qualities (no production cost) than gold or silver. It’s true that paper money may “break down” and lose value sometime in the future, but that is true of Chevy Suburbans as well — or silver, as was the case since the mid-1870s. All monetary transactions take place with base money, which is literally coins or bills, or bank reserves. (There is another point of confusion here in that a redeemable bill does have a counterparty, in the sense that the issuer is legally required to deliver bullion on demand. For our purposes, since there is little real difference between a redeemable bill and an unredeemable one as long as base money supply is being properly managed, we will consider them the same and both forms of base money.)

When banks pay each other, they actually transfer bank reserves via the Fed’s clearinghouse function. This is a type of base money. Although it seems like you can pay someone with “money in your bank account,” which is a type of credit contract with the bank, what the bank actually does is to redeem that credit contract for bank reserves (i.e., it pays back your loan to the bank), and then pays the receiving bank with those bank reserves. The receiving bank immediately borrows those bank reserves from the recipient, thus leaving the recipient with a loan to the bank (bank deposit), and the bank with the bank reserves. Complicated. But nobody actually uses a bank deposit as money. You don’t just transfer ownership of the deposit (the loan to the bank) to another person.If a person with an account at Bank A pays someone with an account at Bank B, the person with an account at Bank B does not get a note that says “you now own a deposit at Bank A.”

Imagine there were no banks, and all transactions were done in gold coins. Of course, you don’t want to sit on gold coins all the time, because you can earn interest if you loan that money to someone. So, while you’re saving up to buy a car, you accumulate Treasury bills, which are lending to the Federal Government instead of a bank. Now you have Treasury bills, accumulating interest, and you want a car. You don’t just walk into the car dealership and try to make a deal trading the Treasury bills for a car, a type of barter. No, you sell the Treasury bills for gold coins, and give the gold to the car dealer in return for the car. The car dealer may then take the gold and go buy Treasury bills himself, so that he can make interest income. This is basically what happens in a bank transaction, but instead of Treasury bills (loans to the Federal Government) you have bank deposits (loans to a bank), and instead of making a transaction in gold coins (a type of base money), the bank does it for you in the form of bank reserves (a type of base money).

This is an idealized case. In the case of a transfer between accounts in the same bank, this process becomes even more opaque as the bank in essence transfers base money within itself, which it doesn’t even bother to do in real terms, and just modifies its credit accounts. Between two banks, if Bank A is to pay Bank B $100m and Bank B is to pay Bank A $90m, then they net out the transaction and Bank A pays Bank B $10m in bank reserves. This is done at the Fed, which serves as a clearinghouse for banks. We have sure come a long way from transactions in full-weight metal coins. But you can see how the principles apply.

When we have this process clear in our heads, it is easy to see that the increase or decrease of credit is somewhat irrelevant to the monetary process, although it may be important to the economy as a whole. The main thing is to insure that the thing that the credit contracts are denominated in, money, remains stable in value. This clears up all the confusion as to whether certain forms of credit creation are a type of “money creation”, and whether that “money creation” is inflationary, et cetera.