Peter Praet: The role of money in a market economy
Speech by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at
the Bargeldsymposium, organised by the Deutsche Bundesbank, Frankfurt am Main,
10 October 2012.
* * *
I would like to thank Massimo Rostagno and Fédéric Holm-Hadulla for their contributions to the preparation of this
speech.
Ladies and Gentlemen,
It is a great pleasure for me to speak here today at the Bargeldsymposium of the Deutsche
Bundesbank. I would like to congratulate the organisers for devising a programme that
covers such a vast range of practical aspects involved in managing a currency.
My fellow speakers at this symposium have already shared their expertise on many of these
practical issues. I have nothing further to add to their insights and expert judgement. Instead,
I would like to take a step back and address some crucial conceptual questions that surround
the role of money in a modern market economy.
Let me start by briefly reviewing the key economic explanations for why the use of money
has been such a prevalent phenomenon in history. To this end, I will adopt the common
definition of money as being any object or token that is generally accepted as a means for
paying goods and services and for settling debts.
I will illustrate the evolution of money in form of a linear parable, which leads from a barter
economy to a system with commodities as a medium of exchange; and from there to a fiat
currency regime. However, it is important to point out that in fact, the history of mankind's
experimentations with money in its various incarnations has been far from linear. It is made
of sudden breakthroughs - often in response to wars, famines or fiscal crises - followed by
set-backs and regressions to earlier and less developed states of affairs.
Money and trust
Imagine a clever merchant who regularly loads his produce onto a cart and heads to the
market place where all merchants meet to exchange their goods. This market place is
impossibly complicated. Any merchant in need of a commodity that he does not produce
himself has to search endlessly. Much of his time is spent in trying to find a partner in a direct
barter "giving what was not wanted directly for that which was wanted" (as William Stanley
Jevons would have described the situation).1 Trading time could be protracted even longer,
as a lucky encounter would not necessarily mean that a trade is perfected: lengthy quality
verification might ensue, as both contracting individuals would have to be convinced that
equal value was being given up as it was received.
In this task they could be assisted by a pricing table indicating all possible pairs of rates at
which goods can be exchanged. If there are ten goods, the table already has forty-five
dimensions; if there are twenty goods, the table has one hundred ninety dimensions, and so
on. But in fact, the table would be a lot bigger and nearly impossible to consult: the
combinations of pairs of trades are for all practical purposes infinite, if one considers that
trades can either be made on the spot or by future delivery, and that any futures contract is
priced differently according to the time at which delivery is to be made.
This extreme inconvenience leads to an insightful observation. The clever merchant notes
that a certain commodity is more frequently exchanged. Why? Probably because it is easy to
carry and certainly because it is durable - it does not physically decay and maintenance
costs are low. Also, probably its verification costs are relatively small so most merchants,
even those who do not need the commodity for consumption, are happy to engage in trades
where this commodity features at least temporarily.2
These trades are multistage and sequential: market participants exchange their produce for
that particular commodity with the expectation to be able to exchange that commodity again
for the goods they desire. As this commodity has the highest subjective probability of trade, it
becomes almost generally acceptable.
By joining in the network of sequential barters involving that particular commodity as an
intervening vehicle of exchange, the clever merchant can minimise his market time,
maximise time for production or leisure, and specialise more.
The exceptional good that enters so many exchanges becomes the medium of exchange; it
becomes money. Money facilitates spot purchase-sale contracts because it minimises the
time spent transacting. Money also enhances inter-temporal trading, namely contracts
involving future delivery, because it provides a unit of account in which all such contracts can
be expressed and acts as a "record-keeping" device permitting enforcement of budget
constraints over time.3 Remember how infinitely complicated the pricing of promises
denominated in all possible commodities, quantities and future dates was. Now, with all
individuals agreeing to denominate inter-temporal contracts in the same commodity, the
pricing problem can be significantly simplified. A monetary economy is more productive and
more efficient in transferring consumption opportunities across time: money is a pre-condition
of an efficient credit and savings markets.4
Let me insert a side-remark here. If saving is nothing more than deferred consumption, and if
the currency is expected to be generally acceptable in exchange for consumption goods
today as well as across time, a medium of exchange is a natural store of value for setting
income aside in view of future consumption. Money does not earn interest, so it is dominated
by other forms of savings which contractually yield a return. But in the end, all forms of
savings have to be converted into money, if savings are ever to be converted into
2
Several contributions to the related literature invoke the costs of verifying the characteristics and attributes of a
good received in exchange (costs of inspection, measuring, property rights) as the prime reason for the
emergence of a dominant medium of exchange. See, for example, Brunner, K. and A.H. Meltzer (1971), "The
Uses of Money: Money in the Theory of an Exchange Economy", American Economic Review, 61(5),
pp. 784-805; and Alchian, A.A.(1977), "Why money?", Journal of Money, Credit and Banking, 9(1),
pp. 133-140. This insight has also been modelled in search theoretic frameworks; see Jones, R.A. (1976),
"The origin and development of media of exchange", Journal of Political Economy, 84(4), pp. 757-776; and
Oh, S. (1989), "A theory of a generally acceptable medium of exchange and barter", Journal of Monetary
Economics, 23(1), pp. 101-119.
3
Several authors have claimed that the unit of account function is not necessarily connected with money's
medium of exchange function; see Wicksell (1906), Lectures on Political Economy, London; and Niehans J.
The Theory of
(1978), Money, Baltimore. At the same time, the monetary asset will usually also serve as the
economy's unit of account - i.e., prices will be quoted in terms of money - since otherwise additional
accounting costs would be incurred.
4
In theory, one could imagine a pure credit, non-monetary economy where all credit contracts are denominated
in an abstract unit of account whose only function is to state prices. This is the world Eugene Fama describes
in his pure financial theory of money (see Fama E. (1980), "Banking in the theory of finance", Journal of
Monetary Economics, 6(1), pp. 39-57). However, in practice, people would only accept promises denominated
in something abstract if they were certain that they would be able to exchange these promises for the
commodity they desire. Hence, credit contracts need to be denominated in things that people value or are
certain that they would be easily converted into other commodities.
consumption. So, money is probably part of wealth and, in any case, any other form of
wealth will need to be retrieved at a later time in the form of money.
Another day, the clever merchant makes a second smart observation. If only the
extraordinary commodity acting as money could be replaced in trade by an IOU, a sight draft,
a representative claim on a given quantity of the same commodity! Society could retain the
exchange services of money while economising on the capital - say, gold or silver coins -
which is used up to embody the commodity medium of exchange. Bills convertible into the
commodity money would be circulating in lieu of - or at least in parallel to - gold or silver
coins. Hence, a fraction of the stock of those precious metals could be unfrozen from
circulation and diverted to other productive uses. Somebody will have to issue the bills, hold
a reserve of coins and stand ready to convert bills into species on sight. But the law of large
numbers will make sure that the precautionary reserve of species could be kept small in
relation to the overall value of bills in circulation, as only a fraction of money-holders will want
to convert at each point in time.
This new technology of money creation exploiting the law of large numbers is the
pre-condition for two salient features of today's economies: the emergence of private banks
and the emergence of inside money created by private issuers and circulating alongside
outside money issued by the financial authority.
The emergence of banks can be thought of in the following manner: in a trading environment
where people meet randomly, are unlikely to meet twice and each person's own trading
history is his own private information, people issuing bills or IOUs cannot be easily punished
if they ever fail to deliver on their promises. But then, it may become profitable for some
agents to make themselves easy to monitor and find ways to communicate, enforce and
protect a "reputation" for never reneging on their payment promises. Banks are born as those
agents whose paying histories become public information.5 Importantly, the emergence of
banks benefits not the banks themselves (which usually charge a higher rate on their lending
than they pay on their issuance of IOUs) but also society as a whole: the free negotiability of
the bank's liquid liability expands the market participants' trading opportunities. Thus, this
form of money creation is valuable and socially beneficial.
Inside money then naturally derives from the business of banks issuing IOUs, bank bills or
bank deposits, which are readily convertible into commodity currency and thus coexist with
outside money as a monetary counterpart in transactions.6 The difference between outside
and inside money is that the former is an asset for the economy as a whole, but it is nobody's
liability. Inside money, instead, is named this way because it is backed by private credit: it
would cancel out if all the claims held by banks on private creditors were to be settled. So, it
is one form of currency that is created - and can be destroyed - within the private economy.
As a consequence, reputation and trust in the ability of individual banks and the banking
system as a whole to redeem the bills, the IOUs or the deposits is essential in order for the
new fractional reserve system to function. Trust is the critical word. It becomes an intimate
attribute of money.
Returning once more to our parable, there is one more observation for the clever merchant to
make: the bills circulating in lieu of gold and silver coins provide an exchange service to the
society of merchants, which has a value per se. By virtue of its general acceptability the
medium of exchange provides a service to the user, namely it minimises the time and effort
needed to trade on a market. This exchange service implicit in the use of money can be
independently
valued of the value that gold and silver receive in their non-monetary uses.
Given certain conditions, that value would not be lost, even if convertibility were to be
abolished.
Yes, we have reached the stage of a fiat money regime, one where the monetary medium is
made of intrinsically worthless tokens of paper or some other inexpensive material. Regimes
of this sort have always existed in the history of monetary standards in the aftermaths of
wars or deep economic depressions. Since August 1971, however, - when President Nixon
delinked the US dollar from the backing of gold at a pre-specified parity7 - the entire world
has been operating under a fiat currency regime.
Pre-conditions for sound money
Of course, our parable is a very simplified caricature of the historical evolution towards a fiat
money regime. In particular, what is important to keep in mind, is that this evolution was not
without setbacks, that is, periods during which the trust in money was fundamentally
undermined.
Thus, it is interesting to ask ourselves: what are the conditions for a monetary system to
remain viable? I see three conditions.
First of all, an absolute pre-condition is trust on the side of the holder of such inconvertible
notes that the value of the medium of exchange with respect to the universe of goods
remains predictable and steady. If a currency cannot guarantee this, it loses general
acceptability in trade and loses attractiveness as a store of value: it ceases to be money.
public regulation
The second condition descends directly from the first: a fiat currency needs
and - in its pure form at least - cannot be manufactured by unfettered private issuers. It is
easy to understand why. Any unregulated private issuer would have the incentive to increase
note issuance well beyond the socially-optimal level. This is due to a failure of private issuers
to account for the negative externalities that increased production of currency, and the
concomitant erosion in its value, would have on those using it. In fact, unfettered private
issuers would produce currency up to the point where the value of the exchange services
provided by the last unit of currency produced is equal to the marginal cost of producing it.
But if issuing unconvertible notes is costless - or nearly costless - then an agent with the
right to issue notes would do so in infinite quantities, because only when the money stock
becomes infinite is the exchange service value of the last unit in terms of goods indeed
driven to zero.
Of course, one can think of incentives for banks to preserve their franchise, thus partly
counteracting their temptation to drive the last unit of their own currency to zero and reap the
entire exchange value that private traders assign to that unit. For example, the bank could
commit to buy back its notes whenever their value relative to a certain basket of goods
declines. But time inconsistency problems apparently make these arrangements prohibitively
costly to run, because there is - to my knowledge - no evidence in history of a fiat currency
regime, where all money is inside money and no money is contractually redeemable, at least
ex ante, into some real asset available in the bank's inventory.8 A currency that offers zero
exchange services at the margin is a currency without real value, a currency that supports an
infinite price level: in effect, a failed currency.
Third, public regulation has to be designed in such a way that any market failure resulting
from unfettered private issuance is not simply replaced by government failure: this essentially
requires that the right to issue currency be placed outside the remit of fiscal authorities and
instead be entrusted to an independent public agency, such as a central bank. This central
bank's task should then find a technology that forces money to be maintained in a certain
general
proportion to real income and to the real value of transactions and that ensures its
acceptability.9
Barring changes in the money multiplier - a concept to which I will return - if the nominal
money stock grows at the same pace as real income, the price level will be stable and
money will maintain its value in terms of goods and services across time.
Note that in such a fiat money environment, the outside/inside money distinction remains
valid and meaningful. The stock of fiat money can now be thought of as a claim of
consumers and investors vis-à-vis the public agency, which is outside the perimeter of the
private economy. So, from the standpoint of the private sector, it remains an external,
"outside" claim: it is outside money. Also, banks can issue deposits convertible into outside
money, which is now the monopolistic prerogative of the regulated public agency, the "central
bank". Indeed, in many - though not all - modern-day monetary systems, banks are
mandated to hold reserves in outside money in their accounts at the central bank, as a
statutory fraction of the total amount of their customers' deposit accounts. This places a
maximum limit on the total amount of loans that commercial banks are allowed to extend
through issuance of own liabilities and, by implication, on the volume of inside money that
they can legally create.
The ratio between the total amount of inside money and the quantity of outside money is the
reciprocal of the reserve ratio - the statutory reserve ratio plus the ratio of banks' desired
excess reserves over deposits - and is sometimes referred to as the money multiplier. As
long as banks are held accountable for discharging their obligations in terms of the fiat
outside currency at par, and as long as the quantity of the fiat outside currency is kept in
check by the public agency, the existence of a money multiplier - even a large one - does
not pose risks of over-supply for the overall stock of money, i.e. the sum of inside and
outside money. The money multiplier, as many other economic ratios, is not steady,
however. Its wild fluctuations in situations of economic duress can be very harmful for the
economy.
Monetary orthodoxy holds it that, in a fiat currency regime, what chiefly matters for
determining the value of the currency is the quantity of money injection. In modern central
bank operating practices, a central bank controls the quantity of money creation by
exercising a firm control over the real interest rate at which money is lent to the economy (in
lending operations), or over the price of the assets which the central bank purchases in
exchange for money (in outright transactions). Provided the real interest rate or the price at
which monetary injection occurs is decided by the central bank in all independence, and with
an exclusive view to maintaining a stable price level, it is less important, at least within
certain limits, whether the central bank lends against private or public collateral.
Does this imply that the distribution of central bank liquidity does not matter? The answer is
yes, but only to the extent that it does not undermine the incentives for private and public
agents to systematically violate their solvency conditions.10 By contrast, if these conditions
are violated, risks of fiscal and financial dominance could emerge. This calls for the central
bank to pay close attention not only to the quantity of its liabilities, notably outside money, but
also to the quality and composition of the assets that back money.
Institutional underpinnings of sound money
Depending on the institutional environment, the authorities with the right to issue money
could also face a strong inducement for overproduction. Suppose, for instance, that this right
lies with a fiscal authority, as has been the case over long stretches of history. The fiscal
authority could finance state expenditure by raising taxes; but this would require the
establishment of costly administrative structures. It could even finance spending via its
printing press. In a fiat money regime, at the margin, the cost attached to this operation
would be close to zero. The benefit, however, would be positive and equal to the value of the
new public undertaking multiplied by the opportunity cost of financing the new public function
with taxes. The pecuniary value of that benefit to the government issuing money is called
seigniorage.
Yet, from the perspective of society as a whole, the creation of additional money would entail
higher costs, as the currency would be debased as a store of value and its exchange
services in transactions would be degraded. Unpredictable changes in the value of money
would undermine its function as a means of exchange. In fact, if these changes are frequent
and large in scale, the monetary system may even degenerate into a barter economy.
As historical episodes of hyperinflation demonstrate, such fears are clearly of immediate
concern for economic life.
Therefore, society needs strong independent institutions to preserve the value of money.
There has to be a mechanism that removes the wedge between the authorities' perceived
cost of expanding the money supply and the costs felt by society at large. Only if this
mechanism is established will it be possible to effectively counteract the inducement for the
authorities to abuse their competence to issue money.
The emphasis on strong institutions as a pre-condition for sound money has deep intellectual
roots in Germany. The concept of "Ordnungspolitik" is often invoked as a recipe for success
in setting up institutions conducive to a stable and prosperous economy. It focuses on
providing a framework that fosters a level playing field for economic competition and avoids
excessive interference from other policy domains, and notably from monetary policy. To put it
in the words of Walter Eucken, a founding father of the ordo-liberal school of thought: „Alle
Bemühungen, eine Wettbewerbsordnung zu verwirklichen, sind umsonst, solange eine
gewisse Stabilität des Geldwertes nicht gesichert ist."11 To this end, Ordnungspolitik entails
stringent rules that restrict discretionary policy intervention and thereby provide a stable and
predictable environment for private savings, consumption and investment decisions.
The successful track record of this framework has also very profoundly inspired the design of
the institutional architecture of European Monetary Union (EMU). In particular, monetary
policy is entrusted to an independent central bank with a primary objective to ensure price
stability. An explicit price stability objective assigned to the central bank is a technology that
can ensure that - over the medium term - the supply of money is kept commensurate with
the real expansion of incomes and transactions, so that money maintains its value.
Since the introduction of the euro, this monetary policy framework has proven highly effective
in ensuring price stability. But it requires a stronger underpinning in the areas of fiscal,
financial and structural policy.
Money in crises
Even with strong institutions in place, no monetary system is fully immune to adverse shocks
that may temporarily upset economic and financial stability.
To see why, it is useful to recall the dual role of money as a medium of exchange and as a
store of value. A key challenge for those who have to manage a currency is that the intensity
with which either of these two functions prevails at a given point in time differs in crisis and
normal conditions. And, of course, a solid definition of "normal" versus "crisis" conditions is
necessary for the public entity in charge of monetary control to be able to switch from one
mode of currency management to another as the conditions evolve.
In normal times, the means of payment function is the prevailing motive to hold money.
Households and firms tend to invest in assets, which promise to remunerate creditors'
decision of parting from money and lending in exchange of an uncertain cash flow to be
received in the future. When the overall risk implicit in the discounting of these cash flows is
moderate, a small positive yield paid on fixed income assets is sufficient to compensate
creditors for their decision to forgo current consumption, and money is dominated by those
assets as store of wealth. Agents bear money not for its maturity value but for its exchange
value. Money holdings relative to the overall private wealth are kept at the minimum buffer
level necessary to finance expected transactions plus, probably, a small margin to face
unexpected expenses. These are times when the regularity which quantity theorists
emphasise - the close relationship between the growth of money supply and inflation -
becomes more intimate and evident in macroeconomic statistics, as the portion of money
balances motivated by pure transaction purposes is large and steady. The monetarist
prescription that money creation needs to respect a strict factor of proportionality relative to a
non-inflationary path of real income growth finds its most pertinent and compelling
application in these normal times.
But imagine a situation in which agents suddenly lose confidence in other assets which are
claims on private issuers. The cash flows to be expected of these claims are now discounted
by an abnormally large risk factor. All assets are promises of payoffs in terms of currency at
some future point in time. As the uncertainty around these payoffs increases, however,
agents scramble for currency in an attempt to short-circuit the credit cycle. Short-circuiting
the credit cycle means that the creditor attempts to compress the time interval that
contractually separates his purchase of a claim on a stream of future cash flows from the
time when cash is received. A scramble for currency is a collective - often desperate,
panicky - attempt to shorten this cycle.
But, collectively, this is not a possibility except at highly punitive discounts. Why is it not
possible for everybody to convert claims to currency into currency at once? Because a large
fraction of those claims - say, fixed income bonds or equity issued by companies - is backed
by the issuers' long-term investment projects. When starting those projects, firms and other
productive agents raised currency by issuing claims whose maturity was expected to match
the productive cycle of their underlying real investment. But the underlying real investment
cannot be liquidated instantly, except in fire-sales that are highly destructive of their realised
market value. In this process, where everybody seeks to convert non-monetary assets into
currency, the value of non-monetary assets is curtailed, the value of wealth itself falls, and
the fraction of money over wealth increases. Money is now primarily viewed as a store of
value.
What type of money increases most in these conditions? It depends on the extension and
ramifications of the collective loss of confidence. In a crisis of the kind which we experienced
in October 1987, a pure "stock market shock", investors become particularly worried about
the value of very long-term assets, equity stocks traded in the stock market. In 1987, as
stocks precipitously lost their value in a matter of few hours' trading, the market dynamics
involved investors trying to liquidate their stock positions against money, any type of money:
both outside currency and inside money balances or bank deposits. In those conditions, bank
liquid liabilities were considered secure enough to preserve investors' wealth.
But in banking crises of the proportions observed in 1930-1933 or following the collapse of
Lehman Brothers in September 2008, bank liquid liabilities - deposits, inside
money - appear as insecure as bank equity. Net redemption demands then become
unusually large, and banks - running low on cash reserves - are forced to raise additional
funds to avoid defaulting on their obligations.
A bank can raise funds from additional borrowings, possibly by borrowing from the money
market or by using lines of credit held with other banks. But under those conditions other
banks might be either equally strained and unable to provide credit, or unwilling to expose
themselves to a stressed bank. So raising funds may just mean selling assets, or calling in
short-term loans. Both operations destroy finance and inside money. These are the most
intractable financial shocks, as they potentially undermine the payments network on which a
monetary economy is so deeply dependent.
Under these conditions, the quantity theoretic relationship between money-growth and
inflation is suspended: the link between money and spending in the economy is blurred by
the hoarding of currency. The money multiplier drops, the inside money system is wounded
at its very root, and its beneficial social function is threatened. Combined with a collapse of
demand due to wealth effects and amplified by price and wage rigidities causing
unemployment and under-utilisation of productive resources, a financial cataclysm can turn
into a macroeconomic calamity.
What is the most appropriate response of a central bank mandated to price stability in these
conditions? The central bank has to promptly and decisively resist the shortage of liquidity,
the contraction of finance and the destruction of spendable purchasing power, which is partly
embodied in inside money. A central bank that is mandated to price stability has to
accommodate the increase in demand for currency. At the same time, it has to ensure that it
never becomes fiscally or financially dominated.
Yet would a strong expansion in central bank money not be inflationary? No, an expanded
central bank liquidity buffer is non-inflationary under these conditions. When it is used as a
store of value (not as a means of payment) and a security buffer for weak financial
institutions, money becomes temporarily disconnected from spending decisions. Under these
conditions, a large stock of base money is a sign of deflationary risks rather than a harbinger
of future inflation, as was observed in the 1930's.
The art and science of central banking will have to be implemented in the identification of the
time in which normalisation will mean a return of money to its traditional means of payments
function. At that time, when inside money will resume its traditional role in liquidity provision,
when the multiplier will start increasing, the central bank will have to be quick in re-absorbing
the excess outside currency created in the crisis times. Money will have to be put back along
the trajectory indicated by the quantity theoretic relation.
Conclusion
Let me conclude with a few words on how these considerations affect the ongoing debate on
putting EMU on a sounder footing.
An effective monetary policy is one which can resist inflationary pressures and stabilise
inflation at low and stable levels. For this, an independent central bank is an absolutely
necessary condition. But it is not sufficient. The fiscal counterpart needs to be disciplined and
the overall macroeconomic framework needs to foster stability.
In such a system, the central bank can concentrate on the determination of the interest rate
charged on its liquidity provision to the banks with a view to maintaining inflation at low and
stable levels. The fiscal authority for its part has to ensure that its fiscal policy stance remains
consistent with debt sustainability, at whatever real interest rate may be determined by the
central bank. Then households and firms can focus on their undertakings without having to
worry about sudden shifts in economic policy that change the calculus underlying their
decisions.
Judging against these ideals, we must acknowledge that the track record of EMU has been
mixed.
Despite the challenges that several countries in EMU are currently facing, it is important to
emphasise that the ECB has delivered on its price stability mandate, with CPI inflation
averaging around 2% per annum. Moreover, the ECB has contributed to averting acute
downside risk to inflation during the crisis, which would also have impacted adversely on
economic stability. To this end, the Governing Council forcefully reduced the main policy
rates and adopted several non-standard measures that preserve the transmission of
monetary policy signals to the economy. Its full operational independence and the clear
orientation of its price stability mandate have been crucial cornerstones in guiding these
interventions.
At the same time, our experiences since the start of EMU underscore the importance of other
policy domains for economic stability. In a benign economic environment before the crisis,
the institutional framework of EMU has not prevented the accumulation of fiscal imbalances,
losses in economic competitiveness and the build-up of excessive risks in the financial
sector. When the financial and economic crisis erupted, these vulnerabilities became a major
propagator of economic uncertainty and distress. In fact, the mutually reinforcing nature of
these vulnerabilities even led some observers to question the integrity of the currency as a
whole.
This clearly demonstrates that an independent central bank wit