The functions and form of money

Money plays so dominant a role in our daily lives that we tend to take it for granted. We often forget that money is a social institution subject to ongoing change. This complicates the task of defining what exactly constitutes money. In theory, anything can represent money, as long as it is widely accepted as such within its geographic sphere of circulation. This acceptance depends on its capacity to carry out several unique functions:

- Money is, above all, used as a medium of exchange in market transactions to pay for goods and services. It is able to do this as the socially accepted representative of purchasing power, giving its holders command in the marketplace.

- Money also acts as a unit of account which allows all marketed goods and services to be expressed on the basis of a common numerical standard, the money price.

- In addition, money functions as a store of value, thereby preserving purchasing power over time and allowing its holders to postpone their purchases until later. This enables money to be saved and lent out to someone else in the meantime, the foundation of our credit system.

- Finally, money also has to settle debts effectively when they come due. Here it functions as means of payment

When analyzing the historic evolution of money as a social institution, we must distinguish between two different types of money. One is commodity money in which the monetary unit (such as our dollar) is defined as a certain quantity of one or more precious metals. The Coinage Act of 1792 introduced a bimetallic standard in the United States based on gold and silver coins specie). This gave way to a gold standard in 1834. With the exception of temporary suspensions to help the government finance wars (e.g., 1862-78, 1914-19), we maintained that gold standard until its abolition during the Great Depression.

Under such a metallic standard, money holders could redeem their dollars in gold or silver at the officially fixed rate of exchange. They also had the unrestricted right to import and export those metals at that official rate. These characteristics of commodity money exerted an automatic discipline on the economy by linking the quantity of circulating money tightly to the nation's supply of precious metals. Always having to face the possibility of people trying to redeem their dollars and get gold, the government could not afford to issue dollars much in excess of its gold reserves without risking monetary instability.

On the international level, the gold standard established fixed exchange rates between different currencies (e.g., dollar, pound. franc. mark, yen), defined by their respective weights in gold. External imbalances in trade and capital flows were automatically corrected.

Countries with balance-of-payments surpluses ("surplus countries") experienced inflows of gold, followed soon by faster increases in money supply and credit, intensifying inflationary pressures, and consequently deteriorating trade performance. The exact opposite occurred in the cause of "deficit countries" where the deflationary effects of gold outflows let to lower imports and higher exports.

Despite its capacity for automatic self-regulation, such a gold standard was ultimately fraught with serious problems. Its international adjustment mechanism via specie flows between countries was actually based on inflationary (or deflationary) destabilization of entire national economics. At the same time, the domestic "gold coverage requirements for money and credit eliminated the scope for effective counter cyclical economic policy initiatives. More generally, the reliance on relatively fixed (ie., inelastic) supplies of precious metals imposed a rigid barrier on money creation and thus on economic growth.

To overcome this barrier, the banking system soon began to develop new instruments circulating as money (i.e., a medium of exchange) in our economy. Whether paper currency of the the form of money of the state's monetary authorities or notes and deposits of private banks, they all had one thing in common. Each of these monetary instruments was issued in the wake of credit extension and represented therefore credit-money. In other words, they were all created in direct response to borrowing by economic agents in need of additional liquidity . This credit-linked process of money creation lessened reliance inelastic supplies of commodity money

An early example of such credit-money, circulating widely after 1836, were notes issued by state-chartered banks whenever they lent funds to borrowing customers. These state bank notes apart from having limited geographic circulation and becoming obsolete when the issuing bank failed, suffered from a lack of homogeneity. 1 Consequently, the National Banking Acts of 1863/4 replaced them with safer and more uniform bank notes issued by federally chartered banks. Unable to compete with them national bank notes state banks could survive only by offering a new and more attractive form of credit-money. In the1880s they introduced demand deposits, which allowed borrowing customers to write checks on bank deposits payable on demand. These convenient checking accounts soon replaced bank notes as the dominant form of credit-money, a position they have maintained to date.

Apart from this private bank money, credit-money could also take the form of state issued paper currency. For example, during and after the Civil War (1862-78), the U.S. Treasury issued inconvertible "Greenbacks" which made up for disappearing specie reserves and helped to finance war-related budget deficits. In 1913 Congress established the Federal Reserve and empowered the new central bank to issue notes- today's dollar bills.

There return of the United States to a gold standard after World War I (1919) meant that the issue of Federal Reserve notes and demand deposits was still ultimately restricted by the nation's available specie reserves. This situation lasted until the unprecedented collapse of our banking system during the Great Depression. As part of a broader monetary reform, the Roosevelt Administration took our currency off the gold standard, under the Emergency Banking Act of 1933 and the Gold Reserve Act of 1934.

That step marked the climax of a gradual movement away from commodity money. It freed money creation from the metallic barrier of rigid gold coverage. The issue of credit-money, whether in the form, of private bank deposits or as state issued paper currency, could now respond directly to the liquidity needs of the economy by being tied directly to the lending activity of the banking system. In other words, we had finally established a flexible (i.e., "elastic") supply of currency.

The abolition of the gold standard in 1934 moved the United States to an inconvertible paper standard ; this provided for an elastic currency based on different forms of credit-money. These different forms represented money by simple declaration (or fiat) of the government Their effectiveness depended therefore on public confidence, which could be undermined by signs of monetary instability, especially the devaluation of money through inflation. But that new monetary standard had no automatic correction mechanism, such as the gold coverage requirements and specie-flow adjustments of commodity money. Consequently, it had to be a managed standard.

Central bank management of private bank money

This management of the inconvertible paper standard rests with the central bank and its manipulation of the money creation process, which is the domain of monetary policy. The Fed has direct control over part of the money supply, its own Federal Reserve notes. But how can it affect money creation by private banks? That depends on its control of the payments system, which transfers funds from one location to another for payment in transactions and settlement of debts. The Federal Reserve Act of 1913 authorized the central bank to operate a nationwide check-clearing system; this system was set up in 1918 and later expanded to include both wire transfers and electronic funds transfers. 2

This check-clearing mechanism forms the core of our payments system. It works by having participating banks keep a fixed portion of their deposits as reserves in accounts with the central bank (or as cash in their vaults). Checks can then be cleared by simply transferring an equivalent amount of reserves from the account of the bank on which the check was written to the account of the bank in which the check was deposited, with the Federal Reserve acting as bookkeeper.

Whenever customers deposit cash or checks in their accounts, the receiving bank gains an equivalent amount in reserves. Of those it has to keep only a small fraction as required reserves. The rest constitutes excess reserves, which can be loaned out in the form of new demand deposits. In other words, the ability of private banks to create new money in the process of such credit extension depends on their excess reserves. These in turn are under the direct control of the central bank. The Federal Reserve can manipulate total bank reserves by trading government securities ("open market operations") or lending to banks ("discount loans"). Its reserve requirements determine, then, which portion of that total represents excess reserves.

While each individual bank can extend credit and thereby issue new demand deposits only up to the amount of its excess reserves, the banking system as a whole can create a multiple of those in new money. This money multiplier comes into effect when borrowers spend their new demand deposits and thereby transfer reserves from one bank to another. The recipient bank has to keep a certain percentage of those newly gained reserves to cover its additional deposit liabilities, but can loan the rest as excess reserves. A third bank is now gaining those reserves, and so forth. At the end of this chain reaction all initial excess reserves are turned into required ones, and the money creation process will have been exhausted. 3

The operating targets of the Federal Reserve

How should the Federal Reserve use its monetary policy tools to manage the inconvertible paper standard most effectively? The answer to this question depends on one's view of the relationship between the money supply and economic activity. This issue is one of the most contentious in economics, with two dominant schools of thought in standard monetary theory "Monetarism" and "Keynesianism" battling each other.

- Monetarism, a modern variant of the age-old quantity theory of money, stresses the stable, long-run expansion of the money supply in line with the economy's natural growth capacity as a key prerequisite for full employment and price stability (see Harry Johnson, 1962; Milton Friedman, 1968). Consequently, followers of this approach want the central bank to focus on money-supply measures as its principal operating target. The most important of these monetary aggregates include M1, which consists of currency plus demand deposits (e.g., NOW accounts), M2 which is M1 plus various savings deposits (e.g., consumer CDs, money market funds), and M3 which adds to M2 yet another set of savings deposits (e.g., negotiable CDs, large Eurodollar accounts). It should also be noted that Monetarists tend to blame our economic problems on wrong policy. See, for example, the analysis of the Great Depression by Milton Friedman and Anne Schwartz (1963) as the result of Federal Reserve mistakes. 4

- Keynesianism, based on the writings of John Maynard Keynes (1930, 1936), takes a radically different view of central bank intervention in our economy. In contrast to the fixed policy rule of Monetarism, Keynesians believe in the importance of discretionary monetary policy as a short-run stabilization tool to counteract cyclical fluctuations in economic activity. In this context, they want the Fed to focus on interest rates and other credit conditions as its main operating targets. 5

The credit cycle of private banking

Apart from the relatively small portion of state-issued coins and notes, most credit-money is issued by private banks turning their non-earning excess reserves into income-yielding loan assets. Since money creation is thus linked to credit extension by banks, we cannot construct an accurate monetary theory without analyzing how they behave. Any reasonable model of bank behavior in turn has to account for the fact that the issue of credit-money depends on highly variable investment decisions of both lending banks and their borrowing customers.

Assuming the Fed allows sufficient expansion of (excess) reserves in the banking system, the creation of private bank money is ultimately determined by the profit motive. New money is created (in the act of credit extension) only if banks are willing to lend their excess reserves and debtors want to borrow the funds at mutually acceptable terms. This dependence on the profit motive confronts the banking sector as a difficult trade-off between safety and profitability. When banks opt for safety, they may decide to increase their capital flow, keep more reserves, and / or invest in safer assets. But these safety-oriented strategies come at the expense of more profitable investment opportunities, and vice versa.

Banks and our other financial institutions tend to manage this trade-off in an inherently unstable manner. During periods of recovery they share the public's optimistic expectations and eagerly seek to expand their assets in response to strong credit demand. In search for higher returns encourages them often to lend too much and to make investments that would have been rejected as too risky under less euphoric circumstances. Then expectations rapidly turn sour as debtors begin to face debt-servicing problems in the wake of declining income. Mounting losses and risks force lenders into a sudden emphasis on safety. If they insist ,on tougher credit terms and / or reduce their supplies of funds. This tightening comes at a time of , great vulnerability for many debtors and reinforces the spread of spending cutbacks. The result is general debt deflation and recession. Thus banks typically behave in procyclical fashion.

A second feature of private bank money is that the Federal Reserve does not have full control over the money supply. Its policy tools, whether reserve requirements, discount loans, or open-market operations, enable it to manipulate bank reserves. This management of (excess) reserves determines only do banks' ability to create money. It controls neither their willingness to lend nor the demand for bank loans from debtors, the other two determinants of money creation. These depend instead on the profit motives of lending banks and borrowing customers.

Financial instability and the "lender of last resort"

The credit cycle of the banking system makes our economy vulnerable to incidences of financial crisis. One historic lesson from the 1930s is that this kind of crisis, if not contained, is the economic equivalent of a heart attack. This is so for two interrelated reasons:

- Bank failures have a tendency to spread especially when they prompt worried depositors to withdraw funds from bank accounts. Given the practice of fractional-reserve banking, such runs on bank deposits have a tendency to sink even relatively healthy banks and thus may easily turn into a self-fulfilling prophecy. The more banks fail, the greater the panic runs. This process, a standard feature during the era of commodity money, reached a climax in the Great Depression. Over 9,000 banks failed within three years in the United States, and still-solvent banks had to shut down temporarily in order to prevent collapse.

- In addition, such spreading bank panics have a profoundly paralyzing effect an economic activity As a cause of chain bankruptcies in the banking system they wipe out savings, destroy much of the money supply, and reduce credit volume. Such disruptions may turn a normal cyclical downturn into a depression.

Given the negative repercussions of bank failures, it was only a question of time before the government was forced to find ways to cope with financial crises. One policy option widely used today is the intervention of government agencies as lender of last resort for cash-strapped and failing institutions. It should be noted that the introduction of t he Federal Reserve in 1913 was intended to do just that by giving reserve-deficient banks access to its discount window. But this mechanism failed to prevent the collapse of the domestic banking system between 1920 and 1933, because the Federal Reserve limited access to the discount window through excessively restrictive collateral requirements. This debacle was followed after 1933 by a major expansion of the lender of last resort, which succeeded in reducing the number of bank failures and containing instances of financial crisis. 6

The Glass-Steagall Banking Act of 1933 created the Federal Deposit Insurance Corporation (FDIC). Financed through annual insurance, premiums paid by member banks, the FDIC has two important functions. One is to insure bank deposits (currently up to $100,000 per account). This deposit insurance and to reassure otherwise worried depositors and thereby hunt the propensity for panic runs. The other is to organize the orderly removal of failing banks, either by providing financial assistance to merge them into healthy banks or through outright asset liquidation. Companion legislation set up the Federal Savings and Low Insurance Corporation (FSLIC) to do the same for thrifts. In addition, the Banking Act of 1935 broadened the lending authority of the, Federal Reserve by allowing banks lo pledge any asset (e.g., their own promissory notes, government securities) as collateral for discount loan rather than just commercial loans to business firms. 7

While clearly effective, this lender-of-last-resort assistance has also created a significant problem. Its assurance of government ball-outs erodes the disciplining force of market failure and may prompt banks to undertake riskier investments that, if success did, promise higher returns. This moral hazard can be overcome by such measures as imposing larger bank capital requirement on risky assets and limiting the size of banks given guaranteed protection. Furthermore, the monetary authorities try to counteract the risk-taking bias of banks by examining them on a regular bass and imposing special regulatory constraints an their behavior.

The first two decades of the postwar period were marked by a remarkable absence of financial crisis in the United States. Baring the occasional FDIC assistance for (mostly small) banks facing failure, no major lender-of-last-resort intervention was necessary until the first "credit crunch" in 1966. This excellent record was due to a variety of fortunate circumstances, including strong balance sheets (i.e., large savings, low debt burdens), of the private sector at the end of World War II and the unprecedented postwar boom. But this situation began to change in the mid-1960s. Since then the U.S. economy has suffered from increasingly severe recessions (in 1969-70,1974-75,1979-82,1990-92),each of which required more extensive lender-of-last-resort assistance. 8

Notes

1. By 1860 them were more than 1,600 different banks operating under the diverse laws of some 30 states, and each bank could issue a variety of notes. This heterogeneity also encouraged counterfeiting on a massive scale. For example, the "Bank Note Reporter and Counterfeit Detector" listed more than 1,000 counterfeit bank notes during that year.

2. Before 1918, checks were cleared by a "correspondent" banking network among thousands of individual banks. In general, large city banks handled payments services for the smaller, usually rural banks within a given area. That elaborate and cumbersome network caused high transfer costs and frequent delays. in addition, many banks redeemed out-of-town. checks at discount rather than at par.

3. The maximum size of this multiplier is the reciprocal of the required reserve ratio. In reality, however, the multiplier is made smaller by various leakages. Banks may keep excess reserves rather than loaning them out. The public may make cash withdrawals which disrupt the reserve transfer between banks in the check-cashing process. Moreover, the actual size of the multiplier is affected by shifts of funds among deposits with different reserve requirements. Jerry Jordan (1969) stressed that all these factors are subject to relatively stable behavioral pattern thus, allowing the Federal Reserve to predict the actual multiplier quite accurately.

4. Reagan's election victory in 1980 propelled supply-side economics to the forefront. While its neo -conservative protagonists share many of the Monetarist arguments they reject its prescription of stable money supply in the long run as too restrictive and difficult to attain. Instead, supply-siders such as Robert Mundell (19711 Victor Canto at al. (1983), and Marc Miles (1984) call for the return to some am of gold standard. Such a system they argue, would give the money supply an objective basis for adjusting automatically to price fluctuations (am our discussion of specie-flow adjustments above). In other words, they favor a "price rule" in lieu of the "quantity rule' of the Monetarists.

5. This ideal of counter cyclical monetary policy predates Keynes and the Great Depression. It emerged originally (as the "Banking School during the first half of the nineteenth century in Britain, as evidenced by do practices of the Bank of England and the debate with the -Currency School,- the predecessor of Monetarism, over-the Bank Act of 1844.

6. Between 1890 and 1920 bank failures averaged approximately 100 per year in the United Stow. That annual average row to about 600 in the 1920s with an astonishing 2,200 during the early 1930s. But the creation of more effective lender-of-last-resort mechanisms after 1933 succeeded in sharply reducing the number of bank failures, keeping them within an average range of four to nine per annum between 1942 and 1981.

7. In 1973 banks with strong cyclical fluctuations in- loans and deposits (e.g., farm banks) pined easier access to the discount window through a "seasonal borrowing privilege". At the same time the Federal Reserve restated its willingness to lend even to nonbank institutions and business firms in emergencies. And in 1980, discount loans became available to nonmember banks, thrifts, and credit unions.

8. Martin Wolfson (1994) provides an excellent analysis of the major lender-of-last-resort interventions over the past three decades, including the 1966 thrift crisis, the collapse of Perm Central and panic in the commercial paper market in 1970, the failure of Franklin National in 1974, the bailout of the Hunt Brothers in 1980, the defaults of Penn Square, Drysdale, and Mexico in 1992, the rescue of Continental Illinois in 1984, the stock market crash of 1997, and the collapse of the thrifts in the late 1980s.

Source: Robert Guttmann, "Reforming Money & Finance", 2ed. 1997.