Money Matters

Economics with Justice Lecture, 9th March 2013

Richard Glover

In the recent Annual Economics Lecture Dr Peter Bowman spoke of Justice and how we may get hints of it in society. He suggested when a nation responds as one to an event or situation, justice may be close by; we may have got a taste of this during last year’s Jubilee and both of the Olympics events. On the other hand, where an event divides the nation, perhaps injustice lies hidden. Examples could be the differing responses of savers and borrowers when interest rates change, or perhaps other groups when house prices are on the move. It is the sense of what is good for the whole of society rather than for some at the expense of others that will be used as a guide here.

In series of presentations on Progress with Prosperity Ian Mason refers to the conceptual model of the economy as an aggregated household and aggregated firm which has prevailed for many decades. The focus of economic policy has been on the well being of the firm as this has been seen to be the means to greater prosperity. The lecture series argues that progress with prosperity rather than poverty will only come about through re-focussing policy towards the well being of households. After all, this is where real people live. This sense of people really matter will also be used as a guide.

This brief exploration of money will cover just a few topics of significance. Starting with the nature of money, its facility as a medium of exchange will be emphasised and some important consequences noted. Moving on to money creation, this much misunderstood matter has resulted in very large, perhaps excessive quantities of money, and yet most of us are still short of the stuff. Next in line are some key considerations about investment, a concept which overshadows so much of our understanding of money. To help our return to justice and prosperity, two recent publications will be used for clues before a general summary and conclusion.

Nature of Money

The three standard definitions of money are:

  • medium of exchange
  • unit of account
  • store of value

It is hoped to emphasise the importance of the first at the expense of the others.

We all know of money as a medium of exchange as it passes into and out of our grasp with some velocity; we all readily accept it in the belief or trust that others will do the same. How many of us would accept our pocket money, pay or pension in the form of money if nobody else would for those things we really wanted?

To set the scene, please imagine …..

A £10 note is found on the floor of a pub. The manager picks it up and sets it to one side for safe keeping; his wife uses it to buy bread; the baker uses it to buy fish, the fishmonger pays a newspaper bill. The newsagent books a restaurant table and the restaurant owner uses it for a pub lunch where the manager’s wife used it to replace the one used to buy bread. This £10 note came almost from nowhere and yet facilitated all of these exchanges.

Each participant in this micro economy was happy to accept money in exchange for what they had given in the belief that anyone else in the community would do likewise. Each believed they would get something more valuable to them than what was being handed over. Everyone gained; the community thrived.

This gives several clues about both trade and the use of money. But we will just consider some aspects of how much money. With a money supply of just £10, some patience is needed. Increasing the money supply to £1000 may induce some price rises. Somewhere in between will be an amount in circulation that suits the community and maintains price stability.

To get another clue as to what money actually is, it would help to imagine a little more …..

Soon afterwards, one of the regulars rushed into the pub anxiously asking if a £10 note had been found earlier. By coincidence and unbeknown to anyone, it was that very same £10 note that the manager handed over. Strangely, the regular held it up to the light and carefully examined it. And then with a great sigh of relief he tore it into pieces and threw it away. To the astonished onlookers he explained that his mislaid £10 note was in fact a fake and he had been very concerned it did not get into circulation and cause trouble!

And so this piece of paper had appeared as though “out of thin air”, worked its magic by sprinkling trust throughout the community, and then disappeared when no longer needed. During all this, it had absolutely no intrinsic value. Hence it is argued that money is a token of trust, and this trust is held by the community.

Where there is no trust, neither trade nor money is possible and we all become subsistence farmers; for today’s population this would be a significant challenge. With trust all can make the best use of the variety of talents and tastes exhibited in a community, and life becomes much easier. Where there is complete trust, trade and money are unnecessary as what is needed is freely given, as in a healthy family environment. Where there is a measure of trust both trade and money are possible and very beneficial.

For many of us, money arrives in our bank account after giving a month’s credit or trusting effort to our employer. We accept the money as a complete settlement of the employer’s debt to us, but only because we know others will do likewise when we buy the food, clothing, shelter and services wanted. The complete exchange is of a person giving of their ingenuity and effort and receiving nourishment and so forth in return through the ingenuity and effort of others. This illustrates money as merely the medium of exchange; it is only wanted as a means to those things we do want.

Money can be seen to represent our claim on wealth or more accurately two claims on wealth; those services rendered and services wanted in return. Hence money always represents both credit and debt. Merely debt-based or credit-based money are suspect concepts as credit and debt are inseparable twins; they are both very much natural aspects of trade and are both aspects of trust.

Note: For simplicity, only earned money was included in the analysis. Borrowing earned money introduces a new credit-debt relationship between borrower and lender. The community still owes goods and services to match the earnings. Spending the borrowed money requires the borrower to earn money from the community to repay, and then the lender can buy goods and services from the community. Equity is maintained.

Money makes trade very much easier. A credit­-debt relationship between two parties is transformed with money. Newspapers have been delivered for a week and result in a credit-debt relationship between newsagent and fishmonger. In settling the bill with money, this credit-debt relationship dissolves. The money represents what has been done to get it and what the community will do to take it away again. So the fishmonger hands over the community debt of services to the newsagent. This may be seen as money allowing the whole community to be present in each exchange.

At this point it would be helpful to briefly touch with those other definitions of money. As a unit of account, money is a common measure of value; we could easily determine how many bananas will exchange for a house or satisfy the national debt although would be hard pushed to supply them. However, it is suggested this is a natural consequence of money being a generally accepted medium of exchange.

The concept of money as a store of value can bring trouble. Value can only really be held by human beings. Our monthly pay only gradually leaves our account and can be said to be a store of value, but this is no different to the normal operation of credit and debt. So is it money that stores value?

And again, how can the whole community save money? For each of us it is received for what we give and given for what others give us; saving upsets this natural balance. Some can save, but not everyone. Typically, those who save lend the money to others who spend it back into circulation. It is the credit-debt relationship between lender and borrower that retains the value, not the money saved.

To conclude the consideration of money’s nature, the sense of money and a generally accepted medium of exchange is emphasised. Each money transaction involves goods and services in exchange for money. In the human economy, each complete transaction involves goods and services in exchange for goods and services, with money greatly facilitating the process.

Creation of Money

Money is obviously very useful, but where does it come from? Recently there has been much discussion about this, partly due to the financial crisis but also because the economics textbooks have been so misleading. There are three main concepts:

  • Money is created by banks through a mechanism known as the money-multiplier, backed by real money, formerly gold but now issued by the central bank.
  • Money we borrow from the banks is merely other people’s savings. Hence the encouragement of savings, as these can then be borrowed for investment in economic growth.
  • Money is created by the banks “out of thin air”.

It is suggested that all of these have an element of truth about them, but none of them present a complete picture. So how much is there?

The Bank of England publishes monthly statistics of money in the UK economy. The money total is presented in various ways of which probably the most useful to us is M4Lx; this is cash and coin, and all money held in deposit accounts. The L stands for what financial institutions have “lent” and the “X” excludes some money locked up in financial institutions.

M4Lx is about £1,846,549 million or about £1.8 trillion (Jan 2013). 3.5% is touchable as notes and coin, £64,246 million; this £1000 for each inhabitant must be well hidden if my wallet is anything to go by. All other money is electronic; 81.5% of money was created by the commercial banks and about 15% created by the Bank of England, mainly through the QE programme. Before the crisis, commercial bank money was over 97% of the total.

Any commercial bank money creation occurs during the process of extending what we call “loans”. Although this money is destroyed as the “loans” are repaid, new “loan” agreements are always being made and the balance is more or less is sustained.

Each of these so-called “loans” is actually an agreement between bank and borrower. The bank can only create the money when the borrower has agreed to repay it. In creating its electronic money, this instantly becomes a liability to the bank as you could spend it at any time. However, this liability is balanced by the bank’s new asset, your promise to repay the money. So the “out of thin air” is more accurately “out for the promise to repay”.

Often there is collateral involved on the sidelines; although this can only be called on in the case of default, it does indicate imbalance in relative negotiating positions. However, I would like to defer consideration of injustices till later.

All of the banks work together to provide an integrated banking system. Anyone with an account can pay someone at another bank without hesitation and trade between both parties is greatly facilitated. However, not all is as harmonious as it would seem.

Although each bank would seem free to create new numbers in its electronic accounting system, these are liabilities as another bank will not readily accept mere numbers. One bank’s numbers cannot be directly exchangeable with another bank’s numbers. This is similar to your having to pay cash to someone who does not have a bank account. Cash is readily acceptable to everyone in the nation, but even this cannot easily go beyond the border. Each bank creates a different flavour of money. Banks can only trade with each other through a mutually acceptable flavour of money, the high-powered money created by the banks bank, the Bank of England or the equivalent central bank of another nation. Every bank has to bank at the central bank and holds a deposit account. This enables banks to pay each other, and this is necessary when we pay someone for goods who uses a different bank to our own. The diagram will give a clue as to how this works.

All the banks aim to make their individual flavours of money as close to the national money, notes and coin, as they can. They undertake to swap balances with other banks so that our payments to persons banking elsewhere appear seamless. Even drawing out cash, where our bank has to have purchased it from the Bank of England using their deposit, the appearance is of our bank’s money flavour being 100% interchangeable with cash and coin and all other bank money flavours as well.

All of this effort by the bank makes us happy to use bank money. Collectively we as a community pay the banks through interest charges and fees for the use of money. As an indication of how much this is, consider 3% interest for the commercially created money; it represents some £4.5 billion each year. Banks face real costs in providing the nation’s money supply and payments system, and these must be paid for; but are the charges made reasonable? As money is a token for the community’s trust, and this trust is conveyed by rather than created by banks, can they justify these charges?

For now the subject of justice and bank charges will be left as our focus moves on to the subject of investment.


The concept of investment seems to dominate economic thinking and warrants examination. There are several prevailing ideas, some of which we will recognise and others may seem to be self evident.

  • Savings provide the wherewithal for investment. In John Maynard Keynes’ analysis, savings leak out of the active economy, but can be injected as investments.
  • Any new venture requires capital investment. Without investment, an economy will soon stagnate or falter.
  • Banks need to extend credit to bridge the gap between the expenses incurred and the eventual reward; they need to be encouraged to extend more credit to productive industry.
  • It is investment that will raise the living standards of our most impoverished.

If all the above is true, why do we not simply print some new money, or perhaps just type larger numbers into every entrepreneur’s bank account; then wouldn’t life would be better for all of us?

Perhaps we need to put our feet firmly back on the ground. Nature has a law that can be expressed as “sowing comes before reaping”. Despite Keynes famous “burying banknotes deep underground to stimulate the economy”, sowing coins in the soil does not produce fruit. In fact, we all create the goods and services we all need; they only come about through human effort applied to the gifts of nature. Obviously efficiencies of effort are greatly increased through physical capital, from simple spades to sophisticated systems. Obviously, this is made much more possible with a sound money supply. Nevertheless, it does not take an Einstein to see that ultimately all physical capital is the result of human ingenuity and effort applied to the gifts of nature. At this time, we can hopefully walk past the serious questions of fossil fuel use and sustainability.

So what is this physical capital? Let us imagine again ….. this time a proposed bridge to serve the needs of an agricultural community. They could be faced with the prospect of 10% of the community taking one year out from growing food to build the bridge. No matter what money systems are in place, if the same amount of food is desired, the community as a whole they will have to work harder to supply food and build the bridge. Once built life becomes easier, typically reflected in more reward for less effort. This is real investment, and of a completely different order to the kind that seeks rental income or capital gain.

To embark on such a vision a significant level of trust is necessary, but no new money is required. Money must flow in different ways through the community so that the bridge builders are able to buy food, and this most certainly necessitates coordination either through public or private enterprise. However it is provocatively suggested that there is no money gap to be bridged through new money for capital projects. This can be seen reflected in the simple fact that the same amount of food is needed before, during and after the bridge building project. Food and other life essentials have to be continually produced and continually consumed.

In a monetized market environment it is certainly necessary to divert significant flows of money towards large infrastructure projects, but unless the community is growing, why does the money supply need to grow?

Perhaps the bridge builders show particular talent for such work and continue in capital projects for some time; this could yield a stream of greater benefits for the community to share. Keeping our consideration at the level of the whole community, we avoid the question of who wins and who loses and can see the fundamentals of intelligent human effort and reward. Reward could be through a combination of more and finer goods and services with less human effort, and hopefully less impact on our environment.

This may appear to be rather idealistic and remote from reality. Perhaps it is, but is our present reality benefitting the whole community? If we wanted to build a bridge we would have to find someone with perhaps £20 million, and it may not be a reluctant bank but someone who has amassed lots of money, an investor, perhaps an investment company.

There has been an explosion in new money over the past few decades, well above inflation indicators of RPI or CPI. It is proposed here that new money is not necessary for a stable community, no matter what proportion are dedicated to real capital improvement. If the community is growing, it would be sensible for the money supply to grow likewise. The other reason that money may have to grow is with increasing exchanges of things outside of the real economy of human tastes and talents. The biggest encouragement for this by far has been the rising land prices, possibly accounting for 80% of the new money of the period since the “Big Bank”.

To take this subject further we need to take up the subjects of Justice and Prosperity.

Justice and Prosperity

Last August two International Monetary Fund researchers had an interesting paper published, “The Chicago Plan Revisited”[1]. It caused rather a stir.

The Chicago Plan was a proposed reform of the US money system in the wake of the Great Crash. Championed by the economist Irving Fisher and others, the inspiration came from a Nobel Prize winning chemist Frederick Soddy who had turned his attention to the problem of money. For us, their adaptation of the sophisticated “DSGE”[2] economic computer model is significant. This model is widely used and yet completely failed to foresee the 2008 crash. Such models are based on the concept of the aggregated household and aggregated firm previously mentioned.

This model shows how households supply all factors of production to firms, and receive all products. Money flows facilitate the transactions involved. The model can be simplified considering just the money; this allows us to ignore such complexities as human effort and the goods and services that humans enjoy. Relegating human beings to a cost of production allows the last trace of humanity to be removed. Such is the state of much economic thought, which is why we need to refocus on households, where real people live.

These researchers made a significant alteration to the DSGE model by splitting the aggregated household into two. The “unconstrained household” has spare money and assets that can be loaned to others; the “constrained household” is forced to borrow off others. Their modelling demonstrated financial instability with such a division in the community. They went on to show stability was restored when control of the money supply was returned to the central bank.

For expediency and a little emotional edge, perhaps we would use two other terms to distinguish these households, the “haves” and “have-nots”.

The other 2012 paper we could learn from is titled “Incorporating the Rentier Sectors into a Financial Model”[3]. Its authors present a similar message but in terms of rent-seeking activities that are strangling the real human economy. It expands the view from just blaming banks and their control of the money supply to include many aspects of what is termed the FIRE economy (finance, insurance and real-estate).

In fairly conventional economic terms, both papers illustrate the deep flaws in our present arrangements assumptions of free competition bringing about the most efficient allocation of resources to best meet the needs of the world human peoples, without destroying the planet.

Banks are in a position of some privilege in supplying the nation’s money supply. Money really is no more than a token representing credit for what has been given to the community and debt for what the community has yet to give in return. However, the availability of a sound money supply is of immense value to the community as a whole. Thus the banks find themselves able to charge the community “the most it can afford”, reflected in the exorbitant interest rates and fees we see.

Around this building in the West End of London are great landed estates that also enjoy such privilege. The community wants to shop here and yet leased retail outlets are squeezed through upwards-only rent agreements.

The solid surface of the planet is utterly essential for human beings to even exist, let alone create and enjoy. Making access to it conditional on the payment of rent opens the door to the potential for inequitable economic relations. Real-estate is often a prime target for financial investment due to this simple fact.

By far most of the new money over the past few decades has arisen through mortgages and this new money passes to the former owner, whilst the new owners have to work as hard as they can to meet the repayments and charges involved.

All such unrestrained privilege in a monetised community leads to pools of excess money, and this excess can be used to purchase additional revenue streams. Lending to governments buys a share of future tax revenue; buying equities secures a share of company earnings; buying real estate secures more rental income. All of this represents a claim on the efforts of those actually producing the wealth. Hence the rich get richer and the poor get poorer.

Our hallmark of a just society was in what benefitted the whole of the community, rather than some at the expense of others. Need any more be said?

It is suggested that rather than ascribing all of our difficulties to banks and their money creation, it would be better to look towards those areas where privileges are enjoyed without corresponding responsibilities being met.

With landed privilege it is possible to retain the economic rent of land that is generated by the community; justice demands its return to the community in some way, leaving everyone to enjoy an equitable share in rewards from the community’s collective ingenuity and effort.

With the privilege of supplying the nation’s money, rather than retain the value generated by the community, it could be returned through some form of annual licence or perhaps an interest charge. Alternatively, as suggested by the Chicago Plan, the privilege itself could be returned to the central bank.

It is hoped that money can be seen to really belong to the community rather than to banks. Money tokens can be issued by banks in appropriate quantities as a service to be paid for, but it does not belong to them.

It is hoped that investment can be seen to really be about human efforts directed towards establishing a better world than we perhaps find ourselves in. Somehow the community needs to support such efforts and diverting money flows is a very necessary mechanism. Money itself is not what is being invested.

It is hoped that more light is cast on the hidden forces behind many of our rich-getting-richer and poor-getting-poorer problems, and that these can usefully be explained in terms of economic rent. Where privilege allows community created wealth to be enjoyed by a few, justice and prosperity both slip away from our grasp.

Money is of great benefit to the community as a whole. However, where there are injustices of unrestrained privilege, money can also be of great benefit to those enjoyers at the expense of the less fortunate.

Dig deep for fundamental economic justice, and prosperity will be enjoyed by the whole community.

[1] IMF Working Paper WP/12/202; Jaromir Benes and Michael Kumhof

[2] DSGE – Dynamic Stochastic General Equilibrium

[3] World Economic Review Vol 1: 1-12 2012; Michael Hudson and Dirk Bezemer