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The process by which banks create money is so simple
that the mind is repelled.
- John Kenneth Galbraith The Federal Reserve's job is to take away the punch bowl just when the party gets going.
- William McChesney Martin [Federal Reserve Chairman,
1951-70] |
Thus far we have investigated capitalism and the market system
without looking specifically at money. But capitalism could not
proceed very far without concurrently developing an appropriate
form of money. The money supply must be able to grow as business
opportunities expand. In fact, the Federal Reserve System, which
is the central bank of the U.S., was created in part to assure
an "elastic" supply of money. This chapter, then, traces
the evolution of money from bartered commodities to the modern
banking system. It also examines the critical roles of central
banks as lenders of last resort and in controlling the flow of
money through the economy. In this chapter you will learn how
central banks control the flow of money. The question of what
type of monetary policy the central bank should follow will be
taken up in later chapters.
Before searching for the origins of modern money, we might well delve into a few basic questions about the nature of the money we use today. What do we use money for? What do we use for money? What gives modern money value?
The first question may seem trivially easy. We exchange money for goods and services and exchange goods and services for money. Money is a medium of exchange - we may essentially be trading our labor for goods and services, but the use of money for both selling our labor and buying our consumption goods vastly simplifies the transactions. Imagine trying to find a job that pays in exactly the types of goods and services you want! But there are other roles of money that are not so readily apparent.
You might put away some of the money that you received by exchanging your labor in order to use it later. Your 'saved' money is serving as a store of value, even while it is just sitting around. One of the reasons that societies often fear rapid inflation is that their money no longer serves this function very well. If we spent our money the moment we received it inflation would be of less consequence.
We also use money in a third way. We think in money when
we want to make certain types of comparisons. How many hours
will you have to work to pay one quarter of college tuition?
How long will you have to save your overtime checks to have enough
for a down payment on a condo? How many flu shots could the government
dispense if it bought one less aircraft carrier? So we are often
using money in its unit of account or standard of value
role even when we are not directly spending it or saving it.
Today's Money
Anything that can serve the three functions of medium of exchange, store of value and unit of account could be used as money. What is actually used as money will depend on law, convention, business practices and even the technology of money. In today's world, the major types of money are currency (and coins) issued by governments and bank deposits. Of course there are many types of bank deposits. The money that you expect to spend between now and your next payday - money serving as a medium of exchange - is probably deposited in some form of checking account that pays little or no interest but is easily spent by writing checks. The money you are saving for a down-payment on a house - money as a store of value - is likely to be in an account that pays more interest but does not offer as much accessibility as your checking account.
Let us briefly consider some of the things that are not money. You might use a credit card to make many expenditures, but the credit card is still not money. When you sign a credit card receipt to pay for a restaurant meal, the restaurant gets paid by a check (or its electronic equivalent) drawn on the bank that holds your credit account. You, in turn, will pay the bank with a check drawn on your checking account. You might buy government or corporate bonds if you consider them to be a better store of value than a savings account. While the bond is certainly part of your wealth, it is not money: before you can use it as a medium of exchange you would have to sell it.
It is most useful to view money as a spectrum, running from the most liquid (easily spendable) form to the less liquid forms that better serve as stores of value. Economists and central bankers have found that no one definition of money serves all purposes, so we have developed a number of them. The two definitions that are most often used (in the U.S.) are:
Since money is the normal standard of value we need to ask what gives money its value. To even consider the value of money, we must measure money itself against some other standard. One oft-used standard is the Consumer Price Index. It allows us to measure how rapidly money is losing or gaining value against an index of prices of goods and services that average families buy. Note that the Consumer Price Index only measures changes in the value of money. Another standard is used when we price our currency in terms of other currencies. The Yen and Deutschemark are common standards for this type of comparison.
In the most fundamental sense, money has value because others are willing to accept it in exchange for the goods and services we want to purchase. Our currency carries the statement: "This Note is Legal Tender for all Debts Public and Private." That means (within the United States) that no one to whom you owe money can legally refuse payment in currency. When you open a checking account, the bank agrees to honor your withdrawals and pay you with currency if you so request, so your checking account balance can be converted to currency at any time.
But it is not really the government edict or the bank's promise
that gives money its specific value. Rather it is the capacity
of an economy to produce the goods and services that the holders
of its money want to purchase. One way to understand this is
to reflect on the times and places where monetary systems have
broken down into hyperinflation. Hyperinflation has most typically
occurred in countries that had been (or were about to be) defeated
in war. With most of their productive capacity destroyed but
still having bills to pay, these governments continued to issue
money which was not "backed" by sufficient production
of goods and services. When we are pondering the great question
of the value of money, it is important to keep in mind that in
a market economy money normally enters circulation along with
the production of the very goods and services that it will be
used to purchase.
The Origins of Money
Modern money, like modern capitalism, is the result of a long evolutionary process. As markets began to play a bigger role in peoples' material life, money began to play a bigger role in markets.
It is possible to have trade without anything that serves as a money. Goods can be directly exchanged for other goods. The type of limited trade that takes place among neighboring clans of hunters and gatherers is often a form of direct exchange. However, direct barter has many limitations. You must find someone who has what you want and wants what you have. Additionally, prices can get quite complex. Even if only ten different goods are traded, traders would have to know the value of each good in terms of each of the other nine goods.
Note that direct barter in pre-market economies is quite different from modern barter. It is not unusual in our modern economy to find cases such as a roofer fixing a dentist's roof in exchange for the dentist fixing the roofer's kids' teeth. By - illegally - keeping the transaction off the books, both can avoid paying taxes on their earnings. But they are still using money as a unit of account; their exchange of services will be based on the market values of dentistry and roofing services. It is very unlikely that they will simply agree to trade one hour of dentistry for one hour of roofing.
As trade becomes more complex and involves a greater number of goods, a monetary commodity usually emerges. One of the traded goods will come to be used as a unit of account. Perhaps there are ten goods being traded in one region, and one of them is hammocks. Hammocks might become the common denominator in all prices: prices of all the other goods will be quoted in hammocks. Then hammocks might take on the additional role of a medium of exchange. If I have pots which I want to trade for a pig, but can't find anyone with a pig who wants pots, perhaps I can exchange four pots for two hammocks then exchange the two hammocks for one pig. The pig seller didn't really need hammocks, but figures that someone else will accept the hammocks in trade for the fish-traps that he does want. Or, perhaps the pig seller doesn't want anything right now. He can store the hammocks and use them for future purchases. Thus the hammocks come to serve all three functions of money.
Many items have been used as monetary commodities. Cattle, tobacco, rice, salt, pigs, coconuts and many other items have served as money. It was often a society's export commodity that took on the monetary role. Dried fish was Iceland's major export in the 15th century and also served as money within Iceland. You could have purchased a horseshoe for 1 dried fish, a pair of women's shoes for 3 fish, a barrel of wine for 100 fish or a cask of butter for 120 fish. [1 Source]
Some commodities were more convenient to use for money than others. Making small change when live cattle are used as money may be impossible. It might take two canoes full of coconut-cash to purchase a few small household items. And must we also consider the health of the cow or the size of the coconut?
Metal became the monetary commodity in many cultures because it had many advantages over other commodities. Its purity could be tested and it could be weighed. Its relative scarcity meant a small amount could have a large value. And if 5 ounces of brass could purchase two hammocks, then 2.5 ounces could purchase one hammock.
Ingots of silver alloyed with antimony served as a major form of money in China as late as the 1700s. Standard equipment for merchants and even small-scale peddlers included a set of steel scissors capable of cutting the silver ingots and a precision balance which could accurately weigh even tiny slices of silver as they were cut off the ingot. [2 Source]
Metal commodity money would be even more convenient if we didn't have to weigh it and test its purity. So the next step of monetary evolution was to form the metal into pieces of standard weight and stamp them with some symbol which would indicate that a metalsmith (or a government mint) had verified the weight and purity. Note that it was the amount and purity of the metal they contained that gave early coins their value. Modern coins are quite different: they are tokens issued by governments. In 1970, the U.S. replaced the silver in many coins with copper sandwiched between a copper/nickel alloy. This did not in any way affect the value of these coins.
Early Chinese coins (about 900 BC) were small replicas, cast in bronze, of shovels and other tools that had apparently been used earlier as monetary commodities. Some African societies formed their copper money into bracelets of a standard weight. Coins may well have been the first form of mass media: subjects of the Roman Empire could see an idealized portrait of their emperor right on the faces of the coins they used.
Since it was the amount of metal that gave a coin its value, exchange rates did not present a problem. A Dutch coin containing one ounce of silver would have the twice the value of a Spanish coin containing one half ounce of silver. The Dutch Parliament simplified the circulation of foreign coins in 1606 by issuing a manual for money changers which listed the weight and purity of 341 silver coins and 505 gold coins. [3 Source] For a small fee, a merchant could take foreign coins to the mint and have them melted down and recast into locally known coins.
As trade expanded across Europe in the late middle ages, many merchants found it more convenient - and certainly safer - to leave their gold and silver with a goldsmith or money changer. The goldsmith might issue paper certificates of a set denomination which the depositor could spend. The paper would be accepted because of the goldsmith's promise to redeem it in gold or silver. This practice was common in Amsterdam, for example, by the late 1500s. Or the merchant might send a note to the money changer asking him to transfer a certain amount of gold or silver from his account to the account of another merchant, very much as we use checking accounts today. This practice was common in parts of Italy in the 1500s. The Italian money changers did much of their business on a bench - banca in Italian - and thus gave us a name for these new institutions.
So far we have traced the evolution of money from commodity barter
through a series of steps which made trade more convenient. But
even the paper certificates issued by Amsterdam banks before 1600
were still a form of commodity money. They stood for a set amount
of gold. And if the amount of gold and silver was not increasing
rapidly enough to provide the money needed to support growing
commerce, commerce itself would suffer for a lack of money and
credit. Investment in a capitalist economy is a future-oriented
activity: investment this year will enable production to increase
next year. But a monetary system based on mined metals is past-oriented.
The amount of money in circulation depends on the amount of metal
mined in the past. It was the next step, the invention of bank
money, that was critical for the development of capitalism.
Bank Money
The goldsmiths and money changers described in the last section were not quite banks. They took deposits, but did not make loans. There were other forms of credit at the time. One merchant might borrow money from another. But such transactions left the lender temporarily without the use of the amount of money that had been loaned.
Sometime before 1600, probably starting in Italy but possibly in Holland, the money changers and goldsmiths took the vital step that turned them into banks. They started making loans from the customers' deposits and thereby increased the amount of money in circulation. A bank loan is very different from a person-to-person loan. If you loan $1,000 to a friend, your friend has the use of the money but you do not. However, if you deposit your $1,000 in a bank, and the bank loans the money to your friend, you both have the use of the money.
Such a system meets one of the fundamental needs of a growing capitalist economy. Let us return to Venice about 1600. A textile merchant comes to the banker with a plan. He wants to purchase raw wool in Britain, have it spun by cottagers in the countryside near Venice, woven by skilled weavers in Venice and dyed in Florence. The finished cloth will then be sold in Madrid where the demand is strong. Note that by arranging these factors of production goods will be produced which would not have been produced otherwise. So our merchant/capitalist needs money. His friends (also merchants) can't loan him the money because their money is tied up in other enterprises. But the bank can. The bank's depositors have deposited gold in their accounts, but spend their gold by writing checks. The banker notices that only a small portion of the gold actually circulates since Venice merchants accept checks drawn on the bank. By loaning the merchant 100 ounces of gold, the banker has exchanged one asset (the gold) for another asset (the merchant's IOU). Since the original depositor can still write checks on the bank, the banker has actually created new money with the stroke of a pen. Unlike the gold, the merchant's IOU is an interest-earning asset to boot. If the merchant's enterprise had been completely within Venice, the banker wouldn't even need to move any gold. He would credit the borrowing merchant's account with 100 ounces of gold (the books are still balanced because of the IOU) and the merchant would make purchases by writing checks.
Of course there were risks to such a monetary system. Many merchants still held to the quaint idea that only gold and silver were "real" money. Paper money issued by banks or checking account balances were just conveniences that would be acceptable as long as the paper or account balances could be immediately traded for real money. Yet once the banks started making loans, they no longer had an ounce of gold on hand for every ounce promised to the depositors or holders of paper. All it would take was a rumor that a bank might be in trouble to send the depositors scurrying for their gold. This would set off a liquidity crisis as only the first few through the door got their gold and the others were shown a stack of merchants' IOUs. The IOUs may have been good, but they were not liquid (easily spendable) as was the gold or silver.
Another sort of difficulty arose if the banker - through bad luck or bad judgment - was unable to collect on some of the loans. If too many IOUs became worthless, the banker's debts (the amount he owed his depositors) would be greater than his assets (the remaining gold and sound IOUs). This solvency crisis could quickly spread. As soon as one banker was discovered to be insolvent, depositors would touch off a liquidity crisis as they rushed to withdraw their accounts from other banks.
A third type of problem with such a monetary system is that it
might create too much money for the good of the economy. If the
loans made by banks are used for real investment then society's
capacity to produce increases along with the amount of money in
circulation. But if loans are used for speculation instead
of investment, money is being created without the corresponding
creation of actual goods and services.
Central Banks
The next step then was to find a way to utilize a banking system that could meet capitalism's need for an expanding supply of money yet at the same time control it so as to avoid the crises to which it was prone. The institution which partially accomplished this was the central bank. Early central banks generally held large reserves of gold and/or other metals and issued paper currency which they promised to redeem in gold. Private banks could then hold their reserves in the form of paper currency or other IOUs issued by the central bank. The Bank of Sweden, chartered in 1664, was the first central bank. Its banknotes were soon circulating throughout Sweden, in part because the metallic standard in Sweden at that time was copper - which was quite heavy relative to its value. Sweden's largest coin weighed over 43 pounds. The Bank of England was chartered in 1694. It was funded with a government loan and acted as the government's banker. These banks were at least partially under government control, if not always under direct government ownership.
The End of Gold The gold quickly became a minor part of the system. A central bank might get its currency into circulation by buying gold from private banks or from the public. But it might also create currency when it buys bonds from the government or other assets from private banks. So there will soon be far more central bank currency in circulation than the gold that supposedly "backs" it. The private banks will expand the money supply further as they make loans. Once such a system was in place and trusted by the public, gold was no longer necessary. By the mid-1930s most of the world's central banks no longer redeemed their currency with gold; there was no longer even a pretense that money was somehow "backed" by any particular commodity. Gold continued to play a minor role in the settlement of international accounts until 1971. While most central banks still own some gold, no major country today redeems its currency in gold or any other metal.
The power both to print money directly and to regulate the creation of money by private banks carries a great deal of responsibility. In some countries, the fear of abuse of such power has led to the evolution of governance structures for central banks which distance them from day-to-day politics. Both the United States and Germany have central banks with a certain amount of 'independence' from the executive and legislative branches of government. Other countries, most notably Great Britain, put the central bank under the direct control of the treasury minister.
Structure of the Federal Reserve The Federal Reserve has a particularly complicated governance structure. Many of its functions are carried out by the 12 regional Federal Reserve Banks. Each of these 12 FRBs is - in theory anyway -'owned' by the private banks in its region. Each is run by a President who is appointed by the regional FRB's Board of Directors. Note that this governance structure is much like that of any large private bank. Of the 9 directors on the board of each regional FRB, 6 are elected by the private banks with the larger banks having greater voting power. But the other 3 directors are appointed by the Board of Governors of the Federal Reserve System.
The Board of Governors is composed of 7 members. Each is appointed by the President of the United States - subject to confirmation by the Senate - for a 14-year term. One of the 7 is appointed Chair of the Board of Governors, again by the President of the United States, for a 4-year term. Aside from resignations and deaths, there will be one vacancy every 2 years. So even the President cannot quickly change the direction of monetary policy.
The Fed's critical decisions are made at meetings of the Federal Open Market Committee, which meets about every six weeks. These meetings are attended by the 7 Governors and the 12 FR Bank Presidents. When actual votes need to be taken, the Governors and the President of the New York FR Bank always have a vote. The other 11 FR Bank Presidents vote according to a complicated rotation scheme in which only 4 of the 11 can vote at any meeting.
The Mystique of Central Banking Yet the Fed still must be careful in the exercise of its autonomy. It is not written into the U.S. Constitution. It was created by vote of Congress and can be modified or even abolished by another vote of Congress. Still, the complex governance structure, combined with the fact that so few people understand what it does, gives the Fed an air of mystery which often allows it to escape the public - and congressional - scrutiny given to more ordinary government agencies. One former Fed official compared the Federal Reserve System to the Catholic Church:
The System is just like the Church. That's probably why I feel so comfortable with it. It's got a pope, the chairman; and a college of cardinals, the governors and bank presidents; and a curia, the senior staff. The equivalent of the laity is the commercial banks. If you're a naughty parishioner in the Catholic Church, you come to confession. In this system, if you're naughty, you come to the Discount window for a loan. We even have different orders of religious thought like Jesuits and Franciscans and Dominicans only we call them pragmatists and monetarists and neo-Keynesians. [4 Source]
The air of mystery soon permeates most of the Governors. Nancy Teeters, a liberal Keynesian appointed to the Board of Governors of the Fed by Carter in 1978 (the first woman appointed to that board) recalled:
At a dinner party in 1978, Arthur Burns [then chairman, a Nixon appointee] was talking to me, asking me questions and it sounded like a job interview. I said, "Arthur, you don't want someone like me on the Board of Governors with my liberal background." Arthur said, 'Don't worry, Nancy. Within six months you will think just like a central banker.'Arthur was right. I think I'm very much a central banker now. You're in a position where your views on money, credit and banking are not really a reflection of your political party or your positions on economic issues. It's not really a political job. I understand the milieu of what we are doing, the continuous decisions, the mystique of central banking. [5 Source]
More recently, President Clinton appointed Alan Blinder, a Keynesian regarded as 'soft on inflation' as vice-chairman of the Federal Reserve. But Blinder never emerged as a spokesman for easier money and credit. When asked if he had changed his views, Blinder responded:
No. What did change in me is that as long as I sit in this job I have a special responsibility that as a professor and magazine columnist I didn't have. As a Federal Reserve governor, you are sitting here as the only bulwark against inflation. You need to take that seriously, and I always have. [6 Source]
Although the Bank of England was chartered in 1694, it took several centuries to develop the institutional arrangements which could partially tame the banking system. The United States did not even establish its central bank, the Federal Reserve, until 1913. The Great Depression found most of the world's central banks either unwilling or unable to prevent the global banking system from crashing. The Federal Reserve was exceptionally pathetic during that crisis. However, central banks continued to evolve: at present their major responsibilities are to prevent banking crises and to control the flow of money though the economy.
The primary function of a central bank is to prevent liquidity crises. If there is a run on a bank, the central bank can provide the threatened bank with sufficient currency to accommodate the depositors. The central bank can hold the private bank's IOUs as security for sufficient cash to weather the crisis. If the IOUs turn out to be bad, so be it. The losses incurred by the central bank are minor compared to the economic disruption that would occur if depositors lost faith in the banking system. The central bank is acting as lender of last resort.
When there was a run on Continental Illinois Bank in 1984, the Federal Reserve started making emergency loans that quickly ran up to $8 billion, an amount equal to more than one third of Continental's deposits. The bank turned out to have held so many bad loans that it was taken over by the FDIC. Paul Volcker, then Chairman of the Board of Governors of the Federal Reserve, defended the Fed's emergency actions before a senate committee:
The operation is the most basic function of the Federal Reserve. It was why it was founded, to serve as a lender of last resort in times of liquidity pressures of this sort, so they don't spread through the rest of the system to innocent parties. . . . That's what a central bank is all about, to provide liquidity in those circumstances. We are just carrying out the most classic function of a central bank. [7 Source]
The central banks' other major role is to control the flow of money through the economy. One of the ways they do this is by requiring banks to hold part of their deposits as required reserves. The higher the required reserves, the less money banks can create by making loans. If a central bank were to set required reserves at 20% of deposits, and $1,000,000 found its way into the banking system as new deposits, banks could initially make loans totaling $800,000. The other $200,000 would be held as reserves. But the $800,000 in new loans would also become bank deposits. Then with $800,000 in additional deposits, the banks would be able to make $640,000 more in loans. Since the loaned amounts will continue to add to bank deposits, the banks will be able to make another $512,000 in loans out of the extra $640,000 in deposits. And on and on it goes, until the original $1,000,000 has multiplied itself into $5,000,000. If the reserve requirement were lower, 10% for example, banks could loan even more money (90%) at every step of the process, and the $1,000,000 could eventually become $10,000,000.
The Money Multiplier So a central bank can increase the reserve requirement to slow down the growth of the money supply or decrease the reserve requirement to speed it up. But changing the reserve requirement is often regarded as too large a move. The reserve requirement establishes the leverage that deposits entering or leaving the banking system can have on the entire monetary system. The money multiplier can be calculated by dividing 1 by the reserve requirement. A reserve requirement of 10% (0.1) gives us a money multiplier of 10. That would mean that any new deposits getting into the banking system could multiply themselves 10-fold through the process of banks making loans which themselves become deposits, as noted in the paragraph above. [8 Note] Instead of changing the reserve requirement - which is done rarely - the central bank normally affects the money supply by injecting money into or draining money from the banking system.
If the banking system has made too many loans and does not hold sufficient reserves, the central bank might loan money to banks to bring their reserves up to the required levels. By increasing or decreasing the interest rate charged for these loans (called the discount rate in the United States and the bank rate in Great Britain) the central bank can either discourage or encourage the lending activities of banks.
Open Market Operations Central banks can also get money into the banking system or drain money from the banking system by purchasing or selling financial assets. When a central bank buys financial assets it pays in an (electronic) check. This check is in fact newly created money - it didn't exist before the central bank deposited it in a private bank - and it allows the private banks to make more loans to the public and expand the money supply further as described above. When the central bank sells financial assets, the buyer writes a check (drawn on a private bank) to the central bank. This money then disappears from the banking system; the banking system will have fewer deposits and will have to contract its loan-making activities, which will further reduce the amount of money in the banking system. The Federal Reserve gets money in and out of the banking system by buying or selling U.S. Treasury bills, notes and bonds. [9 Note] These purchases and sales are carried out through a small number of Wall Street bond brokers and are called Open Market Operations.
In the United States, the usual practice is for banks to borrow
money from other banks before borrowing from the Federal Reserve.
At the end of the banking day, a bank that has insufficient reserves
to meet its Federal Reserve obligations will usually borrow from
a bank that has excess reserves. It will borrow the money overnight
and repay the loan in the morning. The interest rate on these
overnight loans is called the Federal Funds Rate. If there
are more potential borrowers than lenders in this market, the
Federal Funds Rate can quickly increase. This rate acts as a
barometer for Federal Reserve officials. If it rises too quickly
they will "inject" more money into the banking system
by purchasing financial securities; if it falls too quickly they
will remove money from the banking system by selling financial
securities.
The Logic of Capitalist Money
Our modern monetary system is vital to the growth process of a capitalist economy. If banks could not make loans, but could only accept deposits, the circulation system of capitalism could still function. Your boss could pay you with a check, you could write a check to your landlord, etc. You might even save money and loan it to your boss so she could expand the business. But such a system could not expand the money supply. When banks can create money by making loans, productive resources that might otherwise be underutilized can be brought into play. A bank loan creates the very money that a business will use to expand and thus create new goods and services. Or a bank loan can create the money that you use to purchase a new car and thereby allow the auto industry to utilize production facilities (and labor) that might otherwise be idle.
The central bank provides the critical missing link by protecting the banking system from liquidity and solvency crises. It also can stem inflationary pressures by slowing the growth of the money supply. Yet one fundamental weakness remains. The basic idea is to allow the money supply to increase as our productive capacity increases. If bank loans are used to create new productive capacity - loaning money to business or government for new factories or roads - then both money supply and productive capacity are growing together. But if banks create money that is used to speculate on land or silver or even tulip bulbs -as occurred in Holland in the 1630s - then new money enters circulation but no new productive capacity is built. This can set the stage for an inflationary surge followed by an economic crisis as bank loans have to be written off when the speculative bubble finally bursts.
Unfortunately, neither private bankers
nor central bankers have yet been able to establish a set of lending
rules that can effectively distinguish between the financing of
productive activities and the financing of purely speculative
activities. In 1979, Federal Reserve Chairman Paul Volcker warned
bankers:
The Board of Governors has particularly stressed its own concern that, in a time of limited resources, banks should take care to avoid financing essentially speculative activity in commodity, gold and foreign-exchange markets. . . . This is hardly the time to search out exotic new lending areas or to finance speculative or purely financial activities that have little to do with the performance of the American economy. [10 Source]
There is no evidence that Volcker's warning had any effect. In 1994, Federal Reserve Chairman Alan Greenspan raised short-term interest rates in order to stem 'speculative' purchases of stocks. This action temporarily knocked stock values back to more realistic levels, but it also led to significant increases in long-term interest rates which could quickly slow house building and might very well have slowed investment spending.
Money will, of course, continue to evolve. As electronic transactions become more commonplace, we will have to revise our monetary concepts. The ability to convert checking account balances to cash via an ATM in the middle of the night is blurring the distinction between currency and bank money. In many ways, bank money is already more liquid than cash. We can make electronic fund transfers instantly with no respect for distance. Cash could never do that.
Federal Reserve officials and staff are currently pondering the
implications of new forms of money. Fed Vice-Chairman Alan Blinder
recently alerted Congress to some of their concerns. Electronic
cash in the form of "smart cards" or "stored-value
cards" are on the horizon. Will they be a private form of
money - electronic travelers' checks? What if they are issued
by institutions other than banks that do not fall under Federal
Reserve regulations? Perhaps the Federal Reserve should issue
them - as a true electronic currency. While Blinder said it was
too early to formulate regulatory policy in this area, he noted
that "new electronic technologies may challenge both traditional
definitions of 'banking services' and the ability to enforce existing
laws." Certainly, Blinder asserted, - given the ease with
which these new forms of money hop over borders - any regulatory
policy with respect to electronic money will require a high degree
of international coordination. [11 Source]
Summary
Capitalism and its monetary system evolved together. With economic growth, there was a greater need for money. As more aspects of material life were penetrated by the market, the need for money increased ever more rapidly. No monetary system based on rare metals could meet this need. Business expansion requires an elastic money supply.
The invention of modern banking met part of this need. As long as the public accepted bank-issued notes or checks as money, banks could create money by making loans. Businesses expanded their capacity to produce goods and services. At the same time, banks expanded the supply of money.
The central bank evolved as the primary regulatory institution. Once its role was established, the central bank's own notes - Federal Reserve Notes in the United States - became the accepted form of currency. Checks drawn on bank accounts would be acceptable as long the bank agreed to redeem them in currency. For some time, the central banks also agreed to redeem their banknotes in gold or, in some cases, silver. But the gold held by central banks was only a small proportion of the currency they had issued; and the currency issued by central banks was only a small proportion of the amount of money held in bank accounts. Governments often attempted to limit the issuance of currency to some predetermined "safe" multiple of the amount of gold on hand, but this defeated the very purpose of such a monetary system. Finally, under the financial stress of the Great Depression, the relationship between gold and money was severed.
The major role of a modern central bank is to serve as lender of last resort. Bank failures are contagious. If a bank fails and depositors find their accounts worthless, the public rushes to convert their bank money into currency. Forget the depression photos of hundreds of terrified people lined up in front of the bank. Now we have electronic bank runs, as large depositors, sometimes halfway around the world, pull out their deposits. In the 1984 collapse of Continental Illinois, depositors withdrew over $8 billion in one week! Only a rapid and sufficient response by the Federal Reserve could have stopped this from spreading to other banks.
Central banks also control the flow of money through the economy. They do this by getting money in and out of the banking system through purchase or sale of financial securities. They can also loan money to private banks. Central banks also control the ability of private banks to create money through the loan-making process.
The modern monetary system is not without risk. Central banks
have yet to discover a method of assuring that money can be created
for productive purposes but not for speculative purposes. New
forms of money are constantly being created and some of these
may not be easy to regulate. Additionally, there is the challenge
faced by many of our current economic institutions: our regulatory
institutions - central banks included - are merely national while
corporations, banks and financial markets are increasingly global.
Notes
1. Could a capitalist economy grow if we continued to use only gold and silver as money?
2. What are the essential differences between modern money and commodity-based moneys?
3. If you were the head of a central bank, how could you design a set of rules for private banks which would allow unlimited lending for productive purposes but eliminate lending for speculative purposes?
4. Will cash eventually disappear?
Terms Introduced in this Chapter
Bank Money
Central Bank
Commodity Money
Discount Rate
Federal Funds Rate
Federal Reserve System
Lender of Last Resort
M1
M2
Medium of Exchange
Monetary Commodity
Money Multiplier
Open Market Operations
Required Reserves
Store of Value
Unit of Account
Parallel Readings
Economic Theory - Economics Explained, Chapter 10, "What Money Is," Chapter 11, "How Money Works," Appendix, "How the Banking System Works."
Economic History of the Western World - Economic
Development of the North Atlantic Community, Chapter 9.
Further Reading
Cassidy, John, "Fleeing the Fed," The
New Yorker, February 19, 1996. The frustrations of a Keynesian
(Alan Blinder) appointed to the Board of Governors of the Federal
Reserve. A good article on the power of the board chairman.
Galbraith, John Kenneth, Money: Whence It Came, Where It Went,
Houghton Mifflin, 1975. An engaging history of money, banking
and monetary policy.
Gleick, James, "Dead as a Dollar," The New York
Times Magazine, June 16, 1996. Credit card companies,
online services and banks are rushing toward a replacement for
cash. How will all of this be regulated?
Greider, William, Secrets of the Temple: How the Federal Reserve
Runs the Country, Simon and Schuster, 1987. An 800 page book
on money and the Federal Reserve! It reads like a novel. Put
it on your summer reading list.
"Woodrow" at http://woodrow.mpls.frb.fed.us/index.html
is the Web Site of the Minneapolis Federal Reserve Bank
and is currently the best of the Federal Reserve sites. You can
find the latest assessments of the economy, the "Beige Book,"
by the Fed, information on Fed officials, recent speeches by Fed
officials, and even a brief history of money. From Woodrow, there
are links to other Federal Reserve Banks: the New York Fed is
worth a visit.
Visit the U.S. Treasury at http://www.ustreas.gov/treasury/Welcome.html
where you can even find a brief history of (U.S.) paper money.
Net Notes