FM on Money (8) Narrow Banking

Felix Martin describes a proposal for 100% Money made by the American Economist Irving Fisher in the 1930s. He calls it simple and radical.

Fishers proposal was to require that any deposit that could be withdrawn or used to make a payment on demand be backed by sovereign money – and banks which offered such deposits be permitted to do no other business. “The checking deposit department of the bank”, Fisher wrote, “would become a mere storage warehouse for bearer money belonging to its depositors and would be given a separate corporate existence as a Check Bank. As for the rest of what banks now do – whether client facing or not, whether wholesale business or retail – these things would be treated like all other capital market activities, and the institutions that undertake them would neither enjoy special sovereign support, nor suffer special sovereign supervision.

The market would decide what products would be offered, and what institutions would offer them. Outside the realm of “Check Banks”, even the dodgy promise of liquidity transformation would be permitted. If investors wanted to gamble on an intermediary’s ability to synchronise payments in and out of its balance sheet, they would be quite at liberty to do so – because there would no longer be any illusion on any side that such investors would be bailed out if the promise was not met.

Fisher's proposal was taken up into the 1930s by economists at the University of Chicago, after which it became popularly known as the “Chicago Plan”. Today under the banner of “Narrow Banking", it is being advocated once again by some the world leading regulatory economists. It has been the subject of a new study by the International Monetary Fund, which found that test its consequence suing a forma mathematical model strongly corroborates Fisher’s argument that it would lead to great macroeconomic and financial stability.

Fisher’s plan to separate money transactions from debt and credit is a valid one. Felix Martin believes that governments might do it, but they will not, because they want to keep the benefits they get from inflating the currency. I describe a better way in sound banking system. I describe them as transaction banks.

FM on Money (7) Equity

Felix Martin says that money is a social technology which depends on people. This is a good insight, but I have a problem with his view that money is debt. He argues that and notes are a circulated IOU and that money was originally created by the sovereign going into debt and issuing paper debt instruments. People were will to accept these notes as a settlement if debts, because the assume that the sovereign is creditworthy and that others will trust them to back their debt.

The argument that money is created by a debtor issuing debt gets things the wrong way round. Money is not created by a debtor. Money is validated by a person selling something in a half completed transaction. They have given up something, but have not received anything back yet. They are willing to accept the money (whether cash or bank record) because they trust the people in the community that they live in to honour it.

The person accepting money gives the community credit. They believe that someone in the community will give them goods or serviced in exchange for their money. Money is created by a community respecting money claims.

If I sell something for $10.00, I do accept it because I trust the bank, or think that the government will give me something. I trust my community to honour it.

Taking money as payment gives the person holding it equity in the output of the community. They can’t guarantee what they will get, but they will get a share of what is available in the immediate future. I have an equity in the goods that will be made available by them in the next period of time. I explains this in Trade.

Sovereigns do not decide the value of money. Businesses decide the value of money when they set the prices of goods and services offered for sale. The community decides the value of money when they agree to buy goods and services. The government does not decide the value of money.

FM on Money (6) State

The problem I have with Felix Martin is that he assumes a role for the state in money.

What matters is only that there are issuers whom the public considers creditworthy, and a wide belief that their obligations will accepted by third parties.

He claims that the sovereign is the only viable issuer of money, because only the sovereign can be trusted to always meet its obligations.

The sovereign’s credit worthiness rests on the strength of its authority and on the sovereign’s willingness to deploy it to accumulate credit from its subjects via taxation. More than its dominant size in the market, it is the sovereign’s dominant power outside the market that makes its IOUs effective as money. So long as the state is held to be legitimate, its money enjoys the trust no only on command or legal ground, but on ideological and even spiritual grounds (p.74).

This is a bit odd. We trust the money issued by a sovereign, because he has the power to tax us to back up his money if it fails.

The problem with this view is that the sovereign was not creditworthy. Kings were always fighting wars that they could not afford. They were always running up huge debts to fight stupid wars. When their debts got unbearable, they would default on them and the people who trusted them would lose out. Sovereigns were well known for defaulting on their debt, so it is unlikely that their debts would be trusted.

FM on Money (5) Origins

Felix Martin gets into a debate about the origins of money. The original idea that is expounded by economists is that money was originally a commodity. God or silver were the most common, because they were portable and divisible into coins. The first banknotes were receipts from bullion warehouses for gold and silver in storage. It was often easier to exchange the paper receipt than to exchange the gold or silver. According to this theory, proper money got under way when governments took over this role by holding gold and silver and issuing bank notes.

The other theory is that money began as debt issued by kings. When the king borrowed from his citizens, the person making the loan would get a written IOU from the King. These began to circulate as paper money.

Felix Martin prefers the latter explanation. He argues that the commodity money theory held back the development of monetary policy. He blames John Locke for this development.

I don’t think it matters too much which explanation is correct. I suspect that both occurred, and it is not clear which came first. It probably does not matter.

The debt theory is interesting because it shows that money is a social phenomenon.

At the centre of this alternative view of money- its primary concept, if you like – is credit. Money is not a commodity medium of exchange, but a social technology composed of three fundamental elements. The fist is an abstract unit of value in which money is denominated. The second is a system of accounts, which keeps track of individuals’, or the institutions’ credit or debt balances as they engage in trade with one another. The third is the possibility that the original creditor in a relationship can transfer their debtor’s obligation to a third party in settlement of some unrelated debt.

The third element is vital. Whiles all money is credit, not all credit is money and it is the possibility of transfer that makes the difference. An IOU which remains for ever a contract between two parties is nothing more than a loan. It is credit, but it is not money. It is when that IOU can be passed on to a third parry, when it is able to be “negotiated” or “endorsed”, in the financial jargon – that credit comes to life and starts to serve as money. Money, in other words is not just credit – but transferable credit.

This is good stuff. I have described a system of money that can meet these elements that does not need gold and silver or the intervention of the sovereign in Bank Deposits and Loans.

FM on Money (4) Banks on Strike

Felix Martin tells the story of a strike by the bank officials union that shut down Irish banks for more than six months.

Business carried on without too much disruption, while the banks were closed. Most bigger payments were made by cheques, although it was impossible to clear them at a bank. It seems that the owners of pubs and shops knew the people whose credit could be trusted. Businesses knew which business, they trusted, and accepted their cheques. Businesses would buy cash from large retailers, to make up their payrolls.

When the banks finally opened, it took them three months to clear all the cheques.

While they Irish banks were closed, the Irish made their own money.

FM on Money (3) Tally Sticks

Felix Martin records some interesting stories about the history of money to support his theory that the conventional view of money is wrong. The Exchequer tally sticks were an interesting portable means for recording receipts and payments.

For more than six hundred years, from the twelfth to the late eighteenth century, the operation of the public finances of England rested on a simple ingenious piece of accounting technology: The Exchequer tally. A tally was a wooden stick – usually harvested from the willows that grew along the Thames near the palace of Westminster. On the stick were inscribed, always with notches in the wood and sometimes in writing, details of payments made to or from the Exchequer. Some were receipts for tax payments made by landowners to the Crown. Others referred to transactions in the opposite direction, recording the sums due on loans by the sovereign to prominent subjects. Even bribes seem to have been recorded on Exchequer tallies.

Once the details of the payment had been recorded on the tally stick, it was split down the middle from end to end so that each party to the transaction could keep a record. The creditors half was called the stock and the debtors the foil, hence the English use of the term “stocks” for Treasury bonds, which survives to this day. The unique grain of the willow wood meant that a convincing forgery was virtually impossible, while the record of the account was portable, rather than just inscribed in the Treasury account books at Westminster. Exchequer credits could be passed from the original holder to a third payment in payment of some unrelated debt. Tallies were what are called: bearer securities” in the modern jargon.

Historians agree that the vast majority of fiscal operations in medieval England must have been carried out using tally sticks; and they suppose that a great deal of monetary exchange was transacted using them as well.

Although millions of tallies must have been manufactured over the centuries, and we know for sure that many thousand survived in the Exchequer archives up until the early nineteenth century, only a handful specimens exist today. The ultimate culprit for this unfortunate situation is the famous zeal of England’s nineteenth century advocates of administrative reform.

By late eighteenth century if was felt that it was time to dispense with it. An Act of Parliament of 1782 officially abolished tally sticks as the main means of account keeping at the Exchequer , though because certain sinecures still operated on the old systems, the Act had to wait for another half-century, until 1826, to come into effect. However, in 1834, the ancient institution of the Receipt of Exchequer was finally abolished, and the last exchequer stick was replaced by a paper note.

The irony is that when the redundant tally sticks were being burnt in a stove in the House of Lords during 1834, the intense heat set wood panelling alight and the houses of Parliaments were burned to the ground and had to be rebuilt.

Felix Martin on Money (1)

I have just finished reading Money: The Unauthorised Biography by Felix Martin. He has an interesting comment about the disconnect between the disciplines of economics and finance.

From the moneyless economics of the classical school, there evolved modern orthodox macroeconomics: the science of monetary society taught in universities and deployed by central banks.

From the practitioner’s economics of Bagehot, meanwhile there evolved the academic discipline of finance, the tools of the trade taught in business schools, used by bankers and bond traders.

One was an intellectual framework for understanding the economy without money, banks, and finance. The other was a framework for understanding money, without the rest of the economy. The result of this intellectual apartheid was that when in 2008, a crisis in the financial sector caused the biggest macro-economic crash in history, and when the economy failed to recover afterwards, because the banking sector was broken, neither modern macroeconomics nor modern finance could make head nor tail of it.

The answer to the Queen’s question - why did no one of the economist see it coming - is simple. Their framework for understanding the macro economy did not include money.

And by the same token, the question that many were keen to put to the bankers and their regulators – why didn’t they realise that what they were doing was so risky – also turned out to be simple. These frameworks for understanding finance did not include the macro economy.

It would have been comical, had it not ended in such a cataclysmic disaster (pp.225-256).