What types of money exist and how are they created and destroyed? A description of how it is, not how it should be Presentation by John Hermann ... in an age of illusion and universal deceit, telling the truth is a revolutionary act. attributed to George Orwell Theories about the nature of money Debates about the nature and definition of money have been raging for more than 200 years between different schools of economic thought. The position adopted here is an amalgamation of several strands – the postKeynesian perspective, modern monetary theory (chartalism), monetary circuit theory, and horizontalism (endogeneity). I do not generally subscribe to neoclassical ideas, and in particular the quantity theory of money, nor the commodity theories of money (including the Austrian school). Definition of money Generally, money is something that serves as a medium of exchange, a unit of accounting, and a store of value 1. A medium of exchange must be widely accessible, and acceptable for the purpose of buying and selling assets, goods and services. 2. As a unit of accounting, money provides a simple device for identifying and communicating value. 3. As a store of value, money allows the rewards of labour or business to be stored in a convenient tool. Money used widely within a country must be recognised as money by a central monetary authority Otherwise commerce, government spending and taxing could not work together in a consistent and efficient manner. A number of entities which possess money-like properties are not recognised by central banks as being money. These include commodities, local currencies, banking lines of credit, and sovereign securities. Entities recognised by central banks as being money (or money equivalents) are included in their regularly published tables of monetary aggregates. Money does not need to have a tangible form Most of our money supply today takes the form of computer tokens known as bank credit money Commodity Money versus Token Money A true monetary economy is inconsistent with the presence of a commodity money, which is by definition a kind of money that any producer can produce for himself. But an economy using as money a commodity coming out of a regular process of production cannot be distinguished from a barter economy. A true monetary economy must therefore be using a token money. This necessitates having an issuer of currency. (Graziani, 1989) Modern Forms of Money 1. State Fiat Money Money created by a central authority (central bank and/or central government) and acceptable for the payment of taxes. The main forms being currency (coins & notes, which have been declared to be legal tender) and creditary banking reserves (exchange settlement funds). 2. Bank Credit Money Money created by commercial depositories (banking institutions) as retail deposits, and exchangeable with legal tender. Currency - the best known form of State Fiat Money We have a dual monetary system In our economy, banking reserves (state fiat money held by banks) and bank credit money tag along after each other. There are endless debates, both among economists and within the wider population, having their origins in an inadequate appreciation of the manner in which these two forms of money relate to each other and interact. However it is not necessary to operate a dual monetary system. A range of economic reformers have proposed alternative monetary systems in which all money used in the economy is created by a central monetary authority as fiat money (but not as reserves). Thus bank credit money and reserves are not essential for a workable monetary system. What is the Money Supply? The money supply is the conjunction of retail banking deposits and currency held by the private non-bank sector. The word banking refers to the activities of authorised depository institutions (ADIs) – commercial banks, credit unions and building societies. Retail banking refers to ADI business activity with the private non-bank sector. What is a deposit? A banking deposit is a store of bank credit money, and is usually regarded as being a claim on state fiat money. All central banks accept deposits as being part of the money supply. The money supply is divided into transaction money (M1, or narrow money) and nontransaction money (which usually returns interest). The sum of the two is known as broad money. Banking deposits are generally classified as being either demand deposits or investment deposits. A demand deposit may be withdrawn (exchanged for legal tender or for another deposit) at any time at the discretion of the depositor. An investment deposit returns interest, has a date of maturity, and early withdrawal incurs a financial penalty. A savings deposit occupies a half-way house between the above two definitions. Difference between a term deposit and a certificate of deposit (CD) These are similar forms of investment deposit, and the difference is that one can cash in a CD before the date of maturity subject to a (reduction in interest paid) penalty stated in the CD. A term (time) deposit usually cannot be withdrawn early but, being a sound and lowrisk financial asset, could be used as financial collateral for a gaining a loan until the cash became available. Bank certificates of deposit and term deposits return interest Banking reserve requirements The term Banking reserves refers to the stock of state fiat money held by ADIs as assets. Banking institutions are obliged for several reasons to maintain a minimal level of regulatory capital in relation to their financial assets (loans, investments and reserves), and a minimal level of banking reserves in relation to their deposits. The ratio of reserves to deposits is the reserve ratio. In some countries there is a substantial statutory minimum reserve ratio, while other countries - including Australia and NZ - have no (or almost no) statutory reserve requirement. Assets and Liabilities In regard to a bank loan (of bank credit money), the accounting convention is that: (a) The debt acquired is a liability of the borrower and an asset of the bank; (b) The money acquired is an asset of the borrower and a liability of the banking system. Difference between a deposit and a bank borrowing A deposit is an asset of the depositor and a liability of the depository. The liability of the depository is an obligation to pay the depositor legal tender if requested (subject to time or other constraints which might happen to apply). Accompanying a deposit are banking reserves, which are an asset of the depository. A borrowing by a depository has two components: that part which is an asset of the lender (a loan security), and that part which is an asset of the borrower (free reserves). The loan security is also a liability of the depository. More on deposits and bank borrowings A loan involves the reallocation of assets between lender and borrower for a period of time. Because deposits are associated with reserves (which are by definition bank assets), deposited money has some of the qualities of a loan. Moreover a loan has some of the qualities of a deposit. Despite this logical fuzziness, one may say that (a) anything accepted as being part of the money supply cannot be regarded as money loaned to a bank; (b) anything accepted as being money loaned to a bank cannot be regarded as part of the money supply. Complementarity principle A loan security is an asset of the lender and a liability of the borrower. Deposited money is an asset of the depositor and a liability of the depository. An entity which can be regarded as a loan security cannot at the same time be regarded as deposited money, and vice versa. Central banks are obliged to choose which position to adopt for a particular financial entity, according to the circumstances and the utility of doing so. Highly liquid (short term) government securities, although not part of the stock of reserves, behave in important ways like money and are an important part of every bank’s measure of liquidity. They are sometimes referred to as "near-money" or "near-reserves". Investment Deposits (sometimes called nontransaction deposits) There seems to be a mixed viewpoint amongst central bankers and Treasury officials around the world concerning the status of savings deposits, term deposits, and certificates of deposit manifested as the imposition of a range of reserve requirements on these financial entities. These requirements are generally less than the reserve requirement for demand deposits. If these financial entities were uniformly regarded as loans or investments, then one would expect a zero reserve requirement in every country. This is not the case, although it is significant that the general trend over the last few decades has been a gradual reduction in the reserve requirement on time deposits. Indicators of the recognition that these deposits have money-like features is the retention almost everywhere of the word "deposit" rather than the word "security", and also the practice of including savings deposits in the monetary aggregate M2 and time deposits in the monetary aggregates M3 and M4. It is not usual for these deposits to be bought and sold in the marketplace, although there are examples of securities formed from bundles of such deposits which have been marketed in a similar manner to mortgage-backed securities. The view of an investment manager Is a Time Deposit a Security or a Cash Item? by James W. Kaiser, CPA Partner, Investment Management Group Is a time deposit a security or a cash (money) item? The answer is both. There are very few short-term instruments that are treated as a cash item under the 40 Act. The SEC has long considered time deposits and various other money market instruments to be securities. Therefore, for the purposes of financial statement presentation, time deposits are indeed securities. Not surprisingly however, the IRS guidance available on this subject is inconsistent with the SEC. There are General Counsel Memorandums and Treasury Regulations that clearly include time deposits in the definition of a cash item. Therefore, for the purposes of the asset diversification test, one could reasonably treat time deposits as a cash item. Therefore, a time deposit is both a cash item and a security, depending on the purpose of the classification. Creation and destruction of bank credit money Commercial banks create credit money in the accounts of their customers when they make retail loans, engage in retail spending, purchase financial assets from the private sector, accept currency in exchange for a new deposit, and honour cheques drawn on the central bank. And consistent with what was said earlier, payment to a commercial bank (for any reason whatsoever) entails removal from the money supply of any bank credit money associated with that payment. Only the reserves (which tag along after deposits) are retained -- as free reserves. The idea that bank credit money is only created when banks advance loans This is a commonly held idea. However technically it is true to say that spending by a bank involves crediting an account of the payee with credit money which did not exist previously. The same is true of the creation of a deposit in exchange for currency and for a cheque drawn on the central bank. The source of this idea might be a particular interpretation of the word “credit” in the term “bank credit money”. The word credit has several meanings, and in the context of a deposit account it may be taken to mean an obligation of the depository to provide on demand legal tender (state fiat money accessible to the public) in exchange for a deposit. Creating a deposit of credit money in exchange for currency Upon receipt by the teller, the coins are transformed from ‘currency in circulation’ into bank reserves Creation and destruction of state fiat money Central banks create new state fiat money when they purchase securities (sovereign or otherwise) from the private sector and from depositories. Central banks destroy state fiat money when they sell securities to the private sector and to depositories. If over a financial year the central government happens to spend precisely what it collects from taxes and net borrowings, then there is no net change in the volume of state fiat money. From a technical and MMT perspective, central banks also create reserves when governments spend. Treasury’s central bank account Treasury’s receipts and expenditures are recorded in its general operating account with the central bank. A chartalist (MMT) view of the flow of money would be that: (a) bank credit money is removed from the money supply when central government collects revenue from taxes and borrowings, and is re-created when central government spends, and (b) banking reserves also are destroyed and re-created when government taxes/borrows and subsequently spends. Even if it is held that entries in Treasury's general operating account with the central bank constitutes a form of state fiat money (which is disputable), it is technically incorrect to describe these creditary entries as reserves. Restraints on money creation Banks are not free to create money willy-nilly. They are subject to restraints imposed by both the markets and regulators. But under current procedures, these restraints do not arise from a hard limit on the amount of banking reserves in the system. They arise from the cost of lending, which is conditioned by (a) the interest rate targeted by the central bank, (b) regulatory and market capital requirements and the market price for bank capital, (c) administrative and hedging costs of lending, and (d) the credit-worthiness and credit-hungriness of borrowers. Endogenous money Part of postKeynesian economics is the idea that money is created endogenously, driven by the requirements of the real economy and that banking reserves expand or contract as needed to accommodate loan demand at prevailing interest rates. The essential components of this theory are that (a) 'Loans create deposits', (b) a solvent bank is effectively never reserve-constrained, and (c) reserve requirements are only significant at an aggregate level.