In the past two weeks we took a bit of a diversion the case of so-called commodity money consisting of precious metal coins. We also briefly discussed the gold standard. I argued that even on a gold standard, the currency is really the government’s IOU backed by taxes. And that remains true even if the sovereign stamps the IOU on a gold coin. So those precious metal coins were really what is often derided as a “fiat money”. The typical dichotomy posed between “fiat money” that has “nothing” backing it versus a “hard money” or “commodity money” with gold or silver behind it is actually false. All “modern money” systems (which apply to those of the “past 4000 years at least” as Keynes put it) are state money systems in which the sovereign chooses a money of account and then imposes tax liabilities in that unit. It can then issue currency used to pay taxes.
In the introduction to this Primer I had promised not to delve too much into history—first because our main purpose is to explain how money works today; and second because the past is admittedly cloudy (“mists of time” as Keynes said). However, I felt it was necessary to explain how things worked on the gold standard and with metal coins (as best as we can determine) in order to argue that those who think that “fiat money” systems are something strange, unnatural, and of recent vintage, are confused. Governments of the past and present can choose to tie their hands, so to speak, by standing ready to convert their currencies to precious metal or foreign currencies. Fixed exchange rate systems stand at one extreme of the modern money continuum. They are a policy choice. There is nothing “natural” about them. They do, however greatly reduce fiscal policy space—in ways to be discussed more later in the primer. The US and other sovereign countries could choose to tie policy in that manner. But they would not thereby return to some mythical utopian past with a natural self-regulating commodity money. In truth, domestic fixed exchange rate systems usually bring on more problems than they resolve, and they are typically short-lived. And international fixed exchange rate systems—such as the sterling system or the Bretton Woods system fared no better.
This week we return to our analysis of the operation of today’s monetary system, examining the denomination of IOUs in the state money of account.
IOUs denominated in national currency: government. In earlier blog posts we have noted that assets and liabilities are denominated in a money of account, which is chosen by a national government and given force through the mechanism of taxation. On a floating exchange rate, the government’s own IOUs—currency—are nonconvertible in the sense that the government makes no promise to convert them to precious metal, to foreign currency, or to anything else. Instead, it promises only to accept its own IOUs in payments made to itself (mostly, tax payments, but also payments of fees and fines). This is the necessary and fundamental promise made: the issuer of an IOU must accept that IOU in payment. So long as government agrees to accept its own IOUs in tax payments, the government’s IOUs will be in demand (at least for tax payments, and probably for other uses as well).
On the other hand, when government promises to convert on demand (to foreign currency or precious metal), holders of the government’s liabilities have the option of demanding conversion. This might in some cases actually increase the acceptability of the government’s currency. At the same time, it commits government to conversion on demand—which as discussed earlier requires that it have accumulated reserves of the foreign currency or precious metal to which it promises to convert. Ironically, while it might be able to find more willingness to accept its currency since it is convertible, it also knows that increasing currency issue raises the possibility it will not be able to meet demand for conversion. For this reason, it knows it should limit its issue of a convertible currency. Should holders begin to doubt government will be able to convert on demand, the game is over unless government has sufficient access to foreign currency or precious metal reserves (either its hoards, or to loans of reserves). It can be forced to default on its promise to convert if it does not. Any hint that default is imminent will ensure a run on the currency. In that case, only 100% reserve backing (or access to lenders) will allow government to avoid default.
We repeat that convertibility is not necessary to ensure (at least some, perhaps limited) demand for the domestic currency. As discussed above so long as government can impose and collect taxes it can ensure at least some demand for a nonconvertible currency. All it needs to do is to insist that taxes be paid in its own currency. This “promise to accept in tax payment” is sufficient to create a demand for the currency: taxes drive money.
Private IOUs denominated in the domestic currency. Similarly, private issuers of IOUs also promise to accept their own liabilities. For example, if a household has a loan with its bank, it can always pay principle and interest on the loan by writing a check on its deposit account at the bank. Indeed, all modern banking systems operate a check clearing facility so that each bank accepts checks drawn on all other banks in the country. This allows anyone with a debt due to any bank in the country to present a check drawn on any other bank in the country for payment of the debt. The check clearing facility then operates to settle accounts among the banks. The important point is that banks accept their own liabilities (checks drawn on deposits) in payments on debts due to banks (the loans banks have made), just as governments accept their own liabilities (currency) in payments on debts due to government (tax liabilities).
Leveraging. There is one big difference between government and banks, however. Banks often do promise to convert their liabilities to something. You can present a check to your bank for payment in currency, what is normally called “cashing a check”, or you can simply withdraw cash at the Automatic Teller Machine (ATM) from one of your bank accounts. In either case, the bank IOU is converted to a government IOU. Banks normally promise to make these conversions either “on demand” (in the case of “demand deposits”, which are normal checking accounts) or after a specified time period (in the case of “time deposits”, including savings accounts and certificates of deposits, known as CDs—perhaps with a penalty for early withdrawal).
Banks hold a relatively small amount of currency in their vaults to handle these conversions; if they need more, they ask the central bank to send an armoured truck. Banks don’t want to keep a lot of cash on hand, nor do they need to so in normal circumstances. Lots of cash could increase the attractiveness to bank robbers, but the main reason for minimizing holdings is because it is costly to hold currency. The most obvious cost is the vault and the security guards, however, more important to banks is that holding reserves of currency does not earn profits. Banks would rather hold loans as assets, because debtors pay interest on these loans. For this reason, banks leverage their currency reserves, holding a very tiny fraction of their assets in the form of reserves against their deposit liabilities.
So long as only a small percentage of their depositors try to convert deposits to cash on any given day, this is not a problem. However, in the case of a bank run in which a large number of depositors tries to convert on the same day, the bank will have to obtain currency from the central bank. This can even lead to a lender of last resort action by the central bank that lends currency reserves to a bank facing a run. In such an intervention, the central bank lends its own IOUs to the banks in exchange for their IOU—the bank gets a reserve credit from the central bank (an asset for the bank) and the central bank holds the bank’s IOU as an asset. When cash is withdrawn from the bank, its reserves at the central bank are debited, and the bank debit’s the depositor’s account at the bank. The cash held by the depositor is the central bank’s liability, offset by the bank’s liability to the central bank.
Next week: we will begin with an analysis of how banks clear accounts among themselves, by using central bank reserves. This also leads to a discussion of “pyramiding”: in modern economies that leverage liabilities, it is common to make one’s own IOUs convertible to those higher in the debt pyramid. Ultimately, all roads lead back to the central bank.