💰 Where does money come from?

Let’s do a little “D’Oh!” experiment in this joint post.1 Imagine a moment when you can’t access your bank—or any other money. A friend is prepared to sell you something you really want, now. You say “I’ll buy it, but I can’t get money at the moment.” You then write and sign a piece of paper that says “I owe you, my friend, XXX and promise to recompense you by ʏʏʏʏ-ᴍᴍ-ᴅᴅ” That is, definitively, a promissory note, enforceable under most sovereign laws. In the US or UK for example, one can sue for nonpayment.2

Now, let’s take our imagination a bit further. You’re also a sorta good guy in the community, well-known and trusted by all. So on the note, to make it more attractive to your friend, and at no extra cost to yourself at all, you simply add “and I will recompense anyone who holds this exact piece of paper and presents it to me.” Now it is a negotiable promissory note. Your friend can use it to buy something from someone else who knows and trusts you. Boom! Money. Cash. Moolah. Dough. Before the modern financial infrastructure, this sort of arrangement is pretty much the best that anyone could do. And would do. And did do. How did this work? Pretty much in the way described above.

There were then refinements. As our society still does now, some villagers would specialise. For example, some could promise to hold one’s savings safely. Maybe they had two or three big, loyal Rottweilers. “I’ll leave my valuables there. He only charges a small stipend to keep it safe.” And the specialist connects up with other village specialists elsewhere, eventually a global network. They all become pen pals, so to speak. OK, the post travels slowly and maybe irregularly. But we see close relationships born from mere written correspondence. Take Ibn Yiju and Madmun ibn Bandar. In the 12th century, Abraham bin Yiju (a Jewish merchant, manufacturer, and financier based in India) and Madmun ibn Bandar (the chief of the port of Aden, Yemen) ran an extensive credit, shipping, and moneylending network maintained through written correspondence possibly given for delivery to trusted sailors on and from the ships to Aden.

Here’s an alluring thought. You may be familiar with Dr Jo’s take on Science^⌘: we try to solve problems by creating provisional theories and testing them destructively. Are they properly joined up? Do they work in the real world? If either test fails, it’s back to building a better theory; otherwise, we can provisionally accept them as ‘true’, and use them in reality. We shoot our sharpest arrows at theories, and choose the survivor.

John, who lives in Switzerland, recalls visiting CERN the last time it was shut down. He was able to wander the tunnels and see the particle detector opened for inspection. A lovely experience. But his big takeaway? The proton stream ( a bunch of hydrogen atoms stripped of their electrons, circulating in a magnetic cylinder) shrinks in length as they all speed up.3 Wow. They are independent particles. But for relativistically stationary observers, or a beam coming in the opposite direction, the distance from front to back is seen to shrink! Just as it was predicted by Einstein, whose special relativity has withstood so much prodding.

In contrast, very little such brutal scientific examination has been applied to traditional economic theories. Instead economists tend to look for validation, display these examples as show ponies, and then award one another large prizes.

Can we take our thought experiment from the start, and use it to create a theory that (a) makes sense and (b) works? With money, there are several problems. Financial theories are tricky, and practice is even more difficult. To take just one example, on the board of Long Term Capital Management were Myron Scholes and Robert C Merton, both recipients of “The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel”. LTCM nearly tanked the World economy in 1998.^⌘ Predictive theories (and only predictive theories are of much use) are particularly difficult to test, and can fail rarely but spectacularly.4

So let’s start gently. Our first observation is that it may be bloody difficult to predict the future, but a theory must also work backwards in time. The problem with ‘retrodiction’ is that it’s just so easy to tweak our theory to fit the facts (‘hypothesising after the results are known’, or HARKing). This is a danger with all theory, so feel free to pick us up if we cross the line. We can however falsify—arguing that it didn’t even work before.

We also still need a foil, or standard theory. We’ll call this the Theory of Money. The idea—traceable back to Adam Smith, writing way back in 1776 in “Wealth of Nations”—is that initially, barter was used, but was clumsy and inconvenient. So things became more organised, resulting in cash, which in turn led to banks, which could then advance credit. Like this:

barter → cash → banks → credit

It’s easy to see though why barter is problematic. In 1883, William Stanley Jevons wrote a book Money & the Mechanism of Exchange about problems with the barter theory of money. What if one party doesn’t want any of the items offered up? No! Take your smelly fish elsewhere! Clumsy.

It’s even difficult to see how cash could happen through multiparty barter. How could three-way barter even arise, let alone a four- or five-way barter? Jevons used the term “coincidence of wants” for this specific requirement for successful barter, and pointed out just how incredibly unlikely such a coincidence would be. One doesn’t have to be an accomplished statistician to see that.

There’s another problem. The Theory of Money seems cognitively a bit dim-witted. We are a social species, and thus very attuned to mutual obligations. We instinctively pay attention to favours received and favours given. We hoard memories and remember obligations. Perhaps there’s a way we can build these ideas into a better theory? With due concerns about HARKing, let’s move on.

Proponents of the Theory of Money look at things, like the ‘coin’ from the Island of Yap in the picture at the start of our post, and sneer at the ‘primitive natives’ who were obviously silly enough to think that they could make two-metre-wide, 4,000 kg coins and use them for barter. Not exactly pocket change. They might add humour: “At least you can’t lose your cash down the back of the couch!” But perhaps they’ve got the wrong end of the stick? Have they considered what the ‘primitive natives’ were thinking?

That’s a great, big immovable stone, gopferteckel!5 The Theory of Money immediately fails, even in retrodiction. But here’s a different approach. Let’s call it our Theory of Credit.

credit → cash

Simply put, things start with an obligation: credit. And my debt to you is something—an asset—that you own and can immediately reuse, if it is negotiable. It’s even more useful if it’s fungible — it can be divided up into useful, smaller parts for other purchases. It’s cash.

A good place to start is with the observation that those same, cumbersome stones are physical representations of things of truly enormous value in the society that made them: memory, trust and social tradition. It is then but a short step to realise that they are also creditworthy—they can backstop promises! This giant ‘coin’ then transforms into a solid symbol that represents, and is, something you own a portion of and that you can pay from.

The “from” is important. You own part of this communal store of value. It’s part of the community treasury. Money only means something in the context of a community. Outside of a community, it has no value whatsoever. You can simply transfer a portion of your own part-ownership of that Rai stone, in writing or, before writing, just through solid oral tradition.6 This ownership portion can be transferred to pay off a debt, or just to buy something.

So let me ask you, M{s,r} Modern Person, how exactly is that different from you writing a cheque against your bank account? This works owing to memory (written records, bank income statements and balance sheets), trust (well, we trust our banks till we don’t!) and inanely normal social tradition.

And the physical aspects of payment can change, too. Cheques have now been entirely superseded by more modern methods of payment except, apparently, in the United States. But whether it’s a check in the US, or a scanned QR code in Switzerland, it does the same thing. A claim is transferred, recorded in social records, and settled, sometimes even, much later but nowadays, pretty quickly.7 The tech differs; but the social contract or social construct is the same!

Rai stones were mined and transported at some expense from overseas, as gold is nowadays in the West. According to one account, a stone was lost in a shipping incident. However, the community determined it was still there — despite being on the bottom of their ocean. So they simply decided it was still of value, and fungible, simply by virtue of the community declaring it to be so.

The discussion the community had in establishing this precedent is lost to history, but if it indeed happened, clearly the sunken stone was important enough to their economy at the time to be granted that special validity. It was an injection of wealth like “helicopter money” in modern day terms, and continued to be used as “money”. Still today, countries need injections of cash, from time to time, even if only in the form of negotiable, written notes of what is owed, or credits from other countries in their currencies or metallist stores of value like gold and silver. They also need retirement of cash to mitigate inflation. More on that later.

Let’s talk credit. Here’s Alfred Mitchell Innes writing back in 1913 and 1914, after Jevons’ critique of the barter theory two decades earlier:

Broadly speaking these doctrines [the evolutionary sequence of barter, money and then credit] may be said to rest on the word of Adam Smith, backed up by a few passages from Homer and Aristotle and the writings of travelers in primitive lands. But modern research in the domain of commercial history and numismatics, and especially recent discoveries in Babylonia, have brought to light a mass of evidence which was not available to the earlier economists, and in the light of which it may be positively stated that none of these theories rest on a solid basis of historical proof—that in fact they are false.
A. Mitchell Innes, The Banking Law Journal, May 1913. What Is Money?

… and in response to his detractors a year later he wrote:

The Credit Theory is this: that a sale and purchase is the exchange of a commodity for credit. From this main theory springs the sub-theory that the value of credit or money does not depend on the value of any metal or metals, but on the right which the creditor acquires to “payment,” that is to say, to satisfaction for the credit, and on the obligation of the debtor to “pay” his debt and conversely on the right of the debtor to release himself from his debt by the tender of an equivalent debt owed by the creditor, and the obligation of the creditor to accept this tender in satisfaction of his credit.
A Mitchell Innes, The Banking Law Journal, Vol 31 (1914), Dec/Jan, Pages 151–168. The Credit Theory of Money.

Our Theory of Credit seems to have legs, but can we stress-test it a bit more?

We can extend our exploration even further back—back to the first records and before—using an idea we’ve already hinted at. We have a problem here too, though. It’s difficult to determine what other societies were thinking.

We can however look at their behaviour, and at least try to interpret this reasonably. Many societies around the world seem not only to emphasise the importance of reciprocity, but also to act on these ideas, and build them into the fundamental rules that govern that society. Some of these may seem a bit strange: the Roman concept of pietas, the potlatch customs from the Pacific Northwest, Japanese bushido, European chivalry, and the still extant Māori koha, South African ubuntu and ubumuntu from Rwanda.8 There’s a powerful argument that a lot of similar ideas boil down to the practical aspects of game theory, for example the optimal strategy of the iterated prisoner’s dilemma.^⌘

Pharmaceutical companies know about our strong, deep instinct for reciprocity. They give small trinkets to doctors, or invite them to lavish, all-expenses paid conferences, and thereby establish a bond of reciprocity,^⌘ where the doctor subconsciously feels obligated to prescribe their product. And don’t get us started on political donations in the US.9

Giant carved stones in Pacific societies make sense as a backstop to credit. The inability of would-be robbers to easily abscond with the money, is a feature—not a bug! The buying and selling of rights was transitory, but the bedrock was there. Those who recited and kept the records became highly respected members of their societies. Oral tradition was a big deal. Storytellers earned respect. This brings up another explanatory detail.

As society grows, it becomes hard to hold everything in even the most eidetic head. And eidetic heads capriciously and inconveniently die from time to time. There’s also the matter that kings and high priests want all the details written down. So writing is invented. People die, but financial records live forever.

This is another test of Theories of Credit v Money! As Mitchell Innes has already pointed out, the first marks in clay concern the recording of debts.10 Which theory works better here?

Rai stones were effectively no different from the way wealthy Western people in the past would deposit their precious items with banks or moneylenders or even in temples, and then use negotiable ‘writs’, to transfer a societally enforceable claim on a part of that deposit.11 What value is such a writ if not enforceable?

Which brings us to the role of government. ‘Libertarians’ make great play about minimising the role (and strength) of government, but without a fair, powerful legal system, and without a potent enforcement arm, a writ can be ignored on the whim of a robber baron, as happens in modern kleptocracies!

However, once we have a powerful, stable, trusted and equitable system of government, it’s but a small step to sovereign money.12 The authority in charge designates what they will (and will not) accept as scrip to pay taxes. And there’s enforcement: if you don’t pay your debts, you become an outcast! As we said, we’ll get to taxes by and by.

It’s really interesting to observe that the UK still operates a hybrid system. Go draw money from a bank in Scotland or the Isle of Man or Guernsey, and you’ll get notes that don’t look like Bank of England (BoE) notes. Well, why not? Because they’re not. They are not printed by, nor backed by, the BoE (except indirectly through governmental laws and regulations. Did we mention enough that social enforcement of obligations was important? Like, really really!)

The notes above are a promise by the various issuing banks that they will honour a debt in £ should the note be presented. Yoiks! Not the BoE? But not Yoiks. The banks are tightly regulated and required to hold enough £ to pay out immediately the (likely) worst case where a large number of depositors want to withdraw on the same day. And most people surely trust the indirect backing of the BoE, right?13 Well it is backed in turn by the taxing authority of the UK Government. The government brings their whole house down if they default on these obligations. That’s a big, big crash!14

Previously, we blipped over a small detail. let’s look at those models again. First our loose characterisation of a ‘Theory of Money’:

barter → cash → banks → credit

… and now, our ‘Theory of Credit’.

credit → cash

But the arrows are causal. It’s important whether cash or credit comes first, because we live in a causal universe. The arrow of causality has implications for all real financial transactions.15 Strangely enough, despite the intense conservatism that is burnt into the thought processes of most economists, we can see a growing realisation that the theory of money is poorly predictive, and the credit theory simply works better. Credit immediately creates cash, if the writ is negotiable. They exist, side by side, immediately.

These insights allow us to firm up our definitions. Rather than waving our hands about possible historical origins of money, we can define these concepts, based on the arrow of causality.

We can examine these definitions in the real world. Take banking. Not everyone may be aware that every time an enthusiastic young family goes to their bank and gets a loan, the bank effectively just prints money! Let’s look at this. We’ll start simply.

You may be familiar with the term ‘Lies to Children’.^⌘ No, it’s not pejorative. The idea is that where a concept is complex or difficult, we start with something a lot simpler (a ‘Lie to Children’) to get the basics through to them. We might then move on. Rather than getting lost in the intricacies of Basel III banking regulations, we start much, much simpler.

Here’s some simple maths. Say the government requires the bank to hold back 20% of a deposit, so that ‘80%’ can go out the back door as a loan, probably in fact, directly into an account at another bank.16 That seems sensible, right? The bank needs money (cash) on hand to pay other depositors who can walk in at any time and demand to make a withdrawal. But there’s a catch. Someone receiving a loan can, and likely will, deposit the money from the loan in a bank, or whomever they pay will deposit it. In fact it likely simply went from one bank account to another before the receiver could spend it. Another 80% goes out the other bank’s door as a loan, and so on. Give it a little thought, and you can work out that effectively, the amount of new money circulating is a multiplier, five times the original deposit! This multiplier is just the inverse of the reserve margin; 1 divided by 20%.

Now have a look at Basel III, which emphasises backing each new risk-weighted asset with appropriate capital, a liquidity coverage ratio that demands enough high-quality liquid assets to survive a month of stress, and longer-term, illiquid assets funded by stable liabilities.

We can now discard our primitive multiplier. No more Lies to Children! The modern take from the BoE is explicit:

Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money … In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits. [our emphasis]

It’s not just that we’re increasingly clear about how money arose. Modern bankers now explicitly acknowledge the logic of money creation: that credit ⇒ cash just makes more sense than cash ⇒ credit. And that’s what they do. Which bleeds over into everything …

Here, we should stop and give credit (pun intended) where it’s due. The argument we’re examining—that money is just the other side of an obligation and a feature of social trust and state fiat—is not our invention. We’re standing on the shoulders of a long lineage that has finally gone mainstream.

It all started rather tentatively. Plato had a rudimentary glimmering in designating money as a “token” or “symbol of”, or “for”, exchange “νόμισμα ξύμβολον τῆς ἀλλαγῆς” (nomisma xymbolon tēs allagēs). But things started to really take off in the 1800’s. The earliest modern thinker to formulate a credit theory of money was Henry Dunning Macleod (1821–1902), with his work in the 19th century, most especially with his The Theory of Credit (1889) which seems to have inspired Mitchell Innes who we have already met. Georg Friedrich Knapp coined the term “Chartalism” in his State Theory of Money (1905 ) arguing that money is a creature of law and state decree—not a shiny metal—a direct rebuttal of metallism. In his Treatise on Money, Joseph Schumpeter explicitly argued for money’s origin as merely the mirror image of credit, and asserted the first to recognise this was Plato.

Then, in the late 20^th century, a band of economists—Warren Mosler (well, technically a bond trader), L. Randall Wray, Bill Mitchell, and Stephanie Kelton synthesised these early insights into what we now call Modern Monetary Theory (MMT). If our post seems closely adjacent to, and a big nod to their work, well, it is!

Now, is MMT ‘settled science’? That’s impossible. We know that no science is ever permanently ‘settled’. Critics point out that managing inflation with fiscal policy is a blunt instrument.17 Small open economies face currency constraints that the US or UK might not.18 Mainstream economists worry about the tragedy of the commons when deficit spending runs wild.19 These are serious objections that can’t summarily be dismissed. They can however be addressed, most importantly through the injunction that tax policy must not be distorted by ‘special influence’.

We have dug down to the foundation of ‘Modern Monetary Theory’. The concept that credit comes first is not just a historical curiosity: it’s how banks actually work. The implications are profound: causally, traditional barter-inclined economists have the arrow of causation squarely back-to-front.

For a sovereign fiat currency, net financial assets originate from government spending. Money—the stuff we use day to day—derived originally from government spending, goes into the economy, appears on balance sheets (or bank statements) and becomes onwardly spent. And thus the money circulates and facilitates commerce.20

There’s a bigger concept here. With ToM i.e. cash ⇒ credit, governments and institutions become fixated on questions like “How much do I have to spend?” Taxation is seen as a necessary evil, needed to provide the government with ‘money to spend’.

With ToC, it’s the other way around. Because we have credit ⇒ cash, the constraints on our spending are quite different. To improve our social credit, we must do two things right. The first thing we must do is spend appropriately on the right things. If we neglect important social constructs like making sure everyone has a roof to shelter under, good food on their table, quality education, decent health care and choice of work21 — then over decades, or sooner, our society will weaken and its long term credit will evaporate. Giving people the ability to create credit produces money, lubricating the economy. Sometimes, we need helicopter money to kick things off—a sunken but still creditworthy Rai stone. Or a microloan from the Grameen Bank.

The limiting factors here are (a) the generative ability of the society to meet the needs, and (b) something more politically problematic—the need to remove money from circulation, to control inflation.

Why is this ‘politically problematic’? Well, of course, the wealthy push back—hard—against giving up their excess wealth and, as we know, wealth can buy substantial political favours. Which brings us to the second thing we must do right: how we tax people!

Both theories agree that we must control the proliferation of money, or inflation inevitably results. But the most dramatic contrast between ToM and ToC surely concerns taxes. With the former, money comes first, so taxes are needed if the government is to spend. With ToC, taxation exists mostly, but not solely, to destroy money! The “mostly” is an important qualifier. What we tax, and how much, drives societal behaviours. This controls two things: inflation, and the balance of power. If we don’t tax the rich, they warp the fabric of society, resulting in spending on skewed things, frippery and political donations. In a particularly badly run society, they distort the running of the society itself by biasing politicians’ behaviour.

More generally, a powerful role of the state is to maintain the ‘commons’, which otherwise becomes degraded by the competing attempts of everyone to squeeze out as much as they can—damaging shared assets, and reneging on shared responsibilities.

Through the lens of ToC and MMT, it seems logical that failure of these mechanisms will sap the vitality of any society. Is this what we're seeing in the United States at present: the final result of over four decades of failure to invest in people and infrastructure? And if so, what is the antidote? There's no easy fix, as we need to immunise the political system and government from the influence of wealth. The logic of MMT suggests that taxing away the money spent on lobbying, campaign donations, and floating palaces cools inflation and starves the political influence that perpetuates inequality. Free from the need to chase donations, politicians might actually vote for what society needs. But this, of course, is theory ...

Theory is fine, but what about reality? Above, we’ve provided fairly convincing tests where ToM failed—retrodictively—and ToC is more explanatory. Critics on both sides may however plausibly advance the idea that both our ‘ToM’ and ‘ToC’ above are strawmen.22 Reality is messy, once we emerge from the cloister of theory into the real world, where the really smart people are making money and keeping very quiet.

The problem—even with prospective prediction—is naturally that we don’t know what would have happened in a counterfactual, parallel universe, if a different theory had been applied. One way around this is to stack up similar countries that handle things differently, and see how they compare.

But hey, we have even more arrows in our quiver. It may be a fool’s errand to try to predict the future of financial markets or entire economies, but we can still ask questions, and look at real-world people—in finance, and especially in politics—and listen to their justification for their actions. We can do this looking both back and forward. And Lo! We still often encounter statements along the lines of:

“There’s not enough money for …” (ToM)

This is often in the context of fairly rich countries with rather crap maintenance of infrastructure, and poor human outcomes. This demands more exploration, doesn’t it?

Next, you can start asking probing questions. Here are just a few:

1. What limits lending? Is it savings, or profitable borrowers and constraints on banks?

2. What confers long-term value on fiat money? Scarcity, or faith in social credit?

3. What actually constrains government spending? Is it “what the government takes in”, or do they issue credit first?

Which theory works well in reality? Perhaps the most important questions you can ask are “What are politicians claiming as the basis for their actions?” and “Did this work?” Allow them to to a bit of predicting, based on their theories.

We need to hold politicians accountable and hold them to their promises. If they make promises that their actions will “improve equity”, “improve growth” and “dampen inflation” and things then go the other way, it’s pretty clear that their grip on the situation is tenuous, plead as they might! ToC or ToM? If the IMF steps in and imposes austerity, and this does the opposite of what was predicted and intended, then what price the theory that powered this intervention? ToC or ToM?

We can learn from others’ mistakes, too. Consider the following graph …

This isn’t an accident, it’s a problem that demands explanation and resolution. Clearly, a good answer is simple “Bad government!” But how? Why? Presumably those 12,000+ official, registered lobbyists in Washington (on an average base salary of ~120k) are earning their keep from health care organisations, drug companies and device manufacturers. Not to mention a whole bunch of unofficial lobbyists. We’ve already mentioned the influence of political donations. At some point actions are needed. Firing politicians is an option that’s still available in some countries.23

A lot of this seems to boil down to common sense. What really counts for people is working together^⌘ to make a better world for us all. Don’t underestimate social credit here: money is perhaps best seen as a lubricant. In excess, it can make things too slippery to stand or—if local accumulations are unchecked—smother people.

Have you recently taken your pet theory for a walk in the bright light of day? Does it slip and stagger? And most important of all, does it work—and is it predictive? Do you have a quiver full of arrows, and where do they point?

We think the Theory of Credit has a lot to offer—starting with getting the arrow of causality right—but what do you think? Do you have a better theory? We’d like to hear it.

Our 2c, John & Dr Jo.

^{⌘ This ‘of interest’ symbol signals a post where the topic is explored in more detail: Dr Jo is usually to blame!}

This post was published simultaneously on our two sites. Here’s the cross link.