Confusion about Money and Banking

Written by Derryl Hermanutz

Two recent articles posted by Bullion Vault authors on GEI attempt to explain how credit money, currency, and a banking system work. While I agree with Bullion Vault that the world’s money systems are in a very deep doodoo, and I agree that owning some gold might be a very good insurance policy against potentially extreme fiat money volatility right now, their diagnosis of the nature of the fiat money problem and their consequent prescription for a solution is based on a total misunderstanding of how fiat money systems actually work.

The first article was by Paul Tustain (January 16), “Can Banks Really Just Create Money?” The second was by Adrian Ash (February 3), “Fiat Money from Banks: An Argument for Gold“

Barter Economies

I normally criticize “sound money” Austrian school arguments for conflating money with value, an argument that swings back and forth between describing a barter economy where producers “exchange” their surplus outputs of economic goods with each other, and inexplicably importing features of a money economy where consumers “purchase” producer outputs with money.

In the barter scenario the producers themselves produce the medium of exchange, which is their surplus goods. The goods have “use value” to people, so they also have “exchange value”. I trade you a leather coat that I made for some tin pails that you made. In a barter economy people directly trade “goods values”.

Goods values can be denominated in terms of money: my coat is “worth” $10 and your pails are worth $5 each. But goods values are not money. We do not “buy” each other’s goods with money. Barter is the “direct” exchange of goods values without using the “medium” of money. Barter is done for the simple reason that none of the traders “has” any money. They only have goods.

In a barter economy Say’s Law holds true: supply creates its own demand. If we assume with Say that human needs and wants are unlimited so that there’s always vigorous demand for any supply that is produced, and if trade goods themselves function as the means of exchange, as the “money”, then the more trade goods that are produced, the more “money” the economy has to facilitate exchanges of everybody’s surplus supply to satiate unlimited demand.

My production of a surplus supply of leather coats functions as my “money” that I can trade for other people’s surplus goods. The trade goods are simple enough that anybody can produce them, so everybody is a producer of something or other. Pretty soon we will all be rich in leather coats and tin pails and other forms of “real wealth”. But we still won’t have any “money”.

The assumption of unlimited demand and 100% labor force participation ensures there can never be excess supply, so the more production the better for all. Flexible exchange values automatically adjust relative supply of and demand for the various goods and services that this barter market has on offer. The more productive we are, the more exchanges we can make, the richer in diverse goods we all become. What could possibly go wrong?

Barter vs. Money Economics

The economics of a barter economy is completely different than the economics of a money economy. Classical, neoclassical and Austrian economics all go wrong by mixing up the two kinds of systems as if the economic mechanics are interchangeable. In a barter economy the producers themselves produce the “money”, the exchange medium, by producing a tradable surplus supply of goods. In a money economy producers still produce surplus trade goods, but who creates the “money” with which to “buy” those goods, and how does the money get into the economic system?

My coat might be “worth” 2 of your pails. But there is no “money” involved in these exchanges, because neither of us has “produced” any money. So even if we agree that your pails are worth $5 each, I have no $5 of money to pay for them. I can only offer $10 “worth of” leather coats as a barter exchange for 2 of your pails. We have produced tradable goods that have use and exchange values, but we have produced no money. Classical, neoclassical and Austrian economics simply assume money into their barter economic models, as if the “value” of the goods that are being produced somehow causes “money” to be in our pockets. But reality doesn’t work like that.

Production of Money

In the case of a money economy the producers do not produce any “money” at all, unless they are counterfeiters. In a money economy the banking system exercises a monopoly over the issuance of money. Classical, neoclassical and Austrian economics do not know how the money gets from the banking system into our pockets. Historically these schools of economics have simply left the banking system out of their theories and models, as if banks don’t exist or have no effect on economics. If banking systems are acknowledged at all they are depicted as neutral “financial intermediaries” that accept deposits from savers and lend those deposits to borrowers.

These ‘banks as intermediaries’ models of a barter economy fail to tell us where the money that is deposited in banks came from in the first place. They tell us that money merely “represents value”. But we don’t deposit a truckload of fresh sawn timber in our bank and get a credit for a truckload “worth of” timber. Banks only accept “money” as deposits, and they don’t want our real economic “value”. You can park your truckload of timber outside the bank, but that won’t cause any money to be credited to your bank account. Or you can “lend” the timber to somebody who wants it, but that still won’t cause any money to be deposited in your bank account.

IOUs and Money

In Tustain’s article he begins with two people creating personal IOUs against each other. He calls these Ufs, “unreturned favors”. This is all fine and good. Godfrey and Brad can set up their own Uf accounting system to record how many Ufs each owes to the other. Nobody else on our fair blue planet will give them anything of value in exchange for one of their Ufs, but Godfrey and Brad have agreed to take each other’s IOUs as promises to return the favor later.

Godfrey does a favor for Brad, Brad signs over an Uf to Godfrey. If and when Brad returns the favor to Godfrey, Godfrey returns the Uf to Brad. The Uf functions as a “promissory note”. The signer of the note has issued a “debt security”. The receiver of the note holds it as his “credit” against the borrower.

Even if Brad writes on his promissory note, “Pay to the holder on demand one Uf of favors provided by Brad”, his Uf still will not enjoy general currency. Godfrey can’t “spend” the Uf by getting someone else to do him a favor, and paying for the new favor by transferring Brad’s promissory note to the new guy. Brad’s Uf is only worth anything to Godfrey, who knows Brad and has agreed to accept Brad’s Uf as Brad’s written promise to return the favor. The written promise, the Uf note, is the “security” that Brad has given to Godfrey. If Brad forgets he owes Godfrey a favor, Godfrey can pull out the note and say, “SEE! You still owe me.” If worse comes to worse Godfrey can present the printed and signed Uf as evidence in court that Brad “owes” him.

Godfrey and Brad have set up a two man credit and debt “monetary system”. When Brad hands over the Uf to Godfrey, he has paid Godfrey a form of credit money that Brad has issued against himself. The value of the money is Brad’s promise to do a favor for Godfrey in the future. When Brad follows through and does the favor, Godfrey gives him the ‘money’ back.