Why is money difficult?

As regular readers know, I emphasize two central functions of monetary systems:  payments and market-making. These are the foundation pillars of what I call the “money view”.

In my teaching, I have come to appreciate a variety of barriers that people bring with them to the study of money, and to appreciate the necessity of bringing these barriers up to consciousness as part of the process of learning.  (I would hazard a guess that 90% of dispute about money has its origin in these unrecognized barriers, and hence is basically a waste of time.  But that’s a subject for another time.)

The first and largest barrier is what I call the “alchemy of banking”.  Banks make loans by creating deposits, expanding their balance sheets on both sides simultaneously.  This process apparently offends common sense understanding of what it means to make a loan—I can only lend you a bicycle if I already possess a bicycle.  Even more, it seems to go against a fundamental principle of elementary economics that “there ain’t no such thing as a free lunch”.   Against this resistance, I insist that the essence of banking is a swap of IOUs.

The second barrier is “essential hybridity”.  Money is part private (bank deposits) and part public (central bank currency), though in normal times we hardly notice because the two kinds of money trade at par.  Similarly, central banks are part private bankers’ bank and part public government bank, with the proportions shifting over time with financial development and with the exigencies of the state (such as war).  This fact of hybridity is however apparently hard to accept, mainly because it offends political sense.  Idealizations of pure public money attract the left (quoting Knapp), and idealizations of pure private money attract the right (quoting Menger), so that the actual system seems to everyone to be somehow polluted by illegitimate extension.

The third barrier is “inherent hierarchy”, which refers to the sense in which central bank money is better money than private bank money, even though they trade at par.  You and I use bank money to settle our promises to pay, but banks use central bank money, and central banks themselves use world reserve money.  The fact of hierarchy is apparently hard to accept mainly because it offends our sense of justice as between states—the Westphalian notion of equal sovereignty.  Importantly, for economists, it also offends our sense of justice as between participants in markets within states.  Hierarchy sounds like monopoly, or power, or other non-market mechanisms of allocation that trained economists instinctively abhor.

The fourth barrier is what Hawtrey called “the inherent instability of credit”.  Promises to pay are made and accepted today, but the future to which they refer inevitably turns out different than anyone imagined at inception, so some failure is to be expected.  More important, all credit (non-bank as well as bank credit) seems to be subject to a kind of positive feedback loop since, as more and more people come to have a common view of the possible future, promises to pay in that possible future get bid up in value and that makes it easy, indeed inevitable, to overpromise.

This fact of inherent instability is something we have an especially hard time confronting, since it goes to the heart of our existential dilemma.  We don’t know the future but we are nevertheless required to behave as though we do.  Indeed, the commitments we make to one another to perform in various ways in the future form the very fabric of the society in which we live.  Marriage is like that, and so is credit.  The fact of financial instability threatens that fabric, indeed constitutes a kind of unraveling of that fabric, as default on one set of promises undermines another set as well.  As economists, we cling to conceptions of equilibrium, including intertemporal equilibrium, which have the reassuring property of excluding instability, but the resulting psychological comfort is bought at the price of abstraction from a fundamental feature of the actual system in which we live.

These are the main four barriers to understanding, according to me.  The central problem we face is that the current institutional fact of financial globalization makes all four barriers especially hard to overcome.   So-called shadow banking—which I define as “money market funding of capital market lending” and consider to be the quintessential institutional form of banking for financial globalization—disorients our intuition which is based on the comfortable but outdated image of Jimmy Stewart community banking.  We pine for a former age when alchemy/hybridity/hierarchy/instability seemed to be under acceptable social control.   Just so, the “money multiplier” promised a fixed ratio between public and private money, but no longer.

Money is always difficult, and it is more difficult than ever today.  The main difficulty however is not with the complexity of the world, but rather with ourselves, and our inherited habits of thought.