Money 4 – Why does it matter?

The elimination of money from economics theory and teaching leads to major practical problems.

  1. Why did we have the financial crisis and the prolonged recession?

The Queen famously asked why economists failed to see the crisis and ensuing recession coming. What is less talked about is how they subsequently also failed to understand a) what was happening as it was occurring and b) the nature of the recovery. Once you appreciate that money and credit are central to a modern economy, and academic macroeconomists were using models without money or credit, this failure is much easier to understand.

Some policy makers did a better job of learning and adapting to the crisis. Ben Bernanke, at the US Fed, with his study of the 1930s depression years, was well placed to support the economy once the crisis was underway. The Bank of England was not so well led. Mervyn King appeared to believe in a banking model in which the lender of last resort need not exist. When this model failed to have any correspondence to reality, he acted as though reality was at fault, not his personal model.

The financial crisis and its aftermath was predicted and understood by some people however.
But they were likely to be eclectic economists, on the fringes of the mainstream, who did not exclude the views of Keynes and Minsky for their lack of “microfoundations”.

  1. Why did the enormous monetary stimulus not lead to a stronger recovery?

The answer is that the monetary stimulus was not so enormous. The numbers were large, but the transmission mechanism was very weak, and therefore the recovery has been slower than most predicted.

Another misunderstanding follows, since the recovery has been slower than expected, new ideas have been sought to explain it away, such as secular stagnation. But once you accept the idea that QE is eye-catching, but not very powerful for the economy (it may be more powerful for asset prices but that is a different matter) then the slow recovery is not so surprising.

  1. Why do we ever have unemployment at all?

The academic models we have been looking at, theoretically make the existence of unemployment impossible. Given that this is evidently not the case, the models must be augmented with ad-hoc frictions, to make them have some connection to observed reality.

If money is allowed in the model at the start then you do not run into such issues, and surely this is evidence that the theories with don’t include it, don’t make much sense.

Why do economists believe these myths?

If an economist is typical pressed on this, responses vary from claiming that the representation is broadly accurate (it is not!) or more likely that it does not matter (it does!). If the assumption does not matter, why choose such a strange one?

A more recent defence has been that the latest batch of sophisticated new Keynesian models incorporate money and credit and a banking sector. But if that is the case why not change all the teaching? Why is money tacked onto the end of a model rather than incorporated as a critical building block?

I think that they attempt to tack money onto the end of their model building because it is not possible to incorporate it at the start. The assumptions which exclude money are critically important to the complex mathematical models that the current breed of academic economists revel in building. The worry for me is that armed with them, they go on to lead to key policy and market implications. It would also be fair to say that pretty much everything I do in studying the macroeconomy would not be classed as macroeconomics by a current mainstream academic.

Modern academic economists believe that conversations about macroeconomics should be based upon General Equilibrium (GE) and rational expectations and have “microfoundations”. The most recent iteration is the Dynamic Stochastic General Equilibrium (DSGE) model. GE is a truly majestic piece of mathematics which describes an economic system based upon essentially perfect barter.

The concept of money is added as purely commodity money. Any asset can be arbitrarily chosen as the denominator in which to price all others, it is just the numeraire. This helps with the solution as it reduces the number of independent variables by one when solving a set of simultaneous equations.

The advantage of building models in this way is that you can translate many concepts used in micro economics and apply them to macroeconomic questions. This is known as “microfoundations” and many Noble Prizes have been won, tying the neat General Equilibrium theory up with clever mathematics.

After the financial crisis, it is obvious that money and credit had to be included, and so the most recent batch of Neo-Keynesian models attempt to do so. But this is an ad hoc tacking on of a couple of new variables that do not connect to the central mechanism of the model. I see these models as sophisticated in the same vein as the geocentric models used to argue against Galileo.

If we use Kuhn’s model of paradigms, then this looks like economists trying to bury “anomalies” during a period of “model drift” when their models are increasingly unable to answer the questions people think matter. The next stage is “model crisis”. Or perhaps we are already there.

Relationship to Politics and Free-market thinking

This model creates the illusion of a perfect economy in which everything works, with the practicalities of reality being termed “imperfections” such as imperfect competition or sticky wages. This links strongly to the ideology of free markets being the answer to all questions i.e. the idea is to make reality behave more like the model.

Economists of a more interventionist or left-wing persuasion can exist within this paradigm. But ad hoc elements such as asymmetric information have to be added, combined with some pretty inventive and tortuous modelling, eventually producing models which suggest intervention is the correct policy response.


Recent mathematical models cannot be held responsible for the birth of the myths of money and banking. In Classical economics the concept of value is separate from money and logically prior to it and so JS Mill told us that “There cannot, in short, be intrinsically a more insignificant thing, in the economy of society, than money”.

We have recently seen stirrings from eminent economists that all is not well with the profession,, but it is not yet filtering through to how the subject is being taught at grass roots.

Where we are left is a deeply divided set of disciplines. Practitioners, both in financial markets and many Central Bankers have a different approach to pure academics. But even academia is split between macroeconomists who study an economy without money and Finance professors who study a monetary system without an economy.

Both can be seen, to borrow a phrase from Keynes, as “an extraordinary example of how, starting with a mistake, a remorseless logician can end in bedlam”.

Money 3 Banking – a money creation myth

I will again use the bestselling undergraduate textbook “Macroeconomics” by Greg Mankiw as the source for this story.

How does money get created?

In the beginning, there were bank reserves……


  1. The Central Bank determine Bank Reserves – this is the money that the banks have on deposit with the Central Bank
  2. Banks, holding these reserves, then lend them out to customers, who then either put that money on deposit themselves or transfer the money to someone else who does. The mountain of customer deposits is generally many times larger than bank reserves. This is known as the “reserve-deposit ratio, rr”.
    It is an “exogenous variable” in other words “the model takes as given”.
  3. There is also the currency in circulation which the central bank also determines.
    This is known as the “currency-deposit ratio, cr”. It is also an “exogenous variable”.
  4. Combining these via “money multiplier”, gives you the Money Supply.

In this way, the Central Bank determines the level of reserves, and thus controls the money supply in a predictable way.

From bank reserves to money supply to inflation……

The next stage in this story is the “Quantity Theory of Money” which “remains the leading explanation for how money affects the economy in the long run.”
This starts with a key identity or equation:

Add a few assumptions….

P * Y is also nominal GDP, so if we assume that V (the income velocity of money) is constant (or “exogenous”), then a change in M leads to a change in nominal GDP.

Via a separate assumption, the level of output Y is determined by a production function which does not include money, therefore a change in M leads to a change in P i.e. changing the money supply causes inflation.

Economists are taught this key conclusion at university:
Thus, … the central bank, which controls the money supply, has ultimate control over the rate of inflation.”

Unfortunately, like many Creation Myths none of this is true.
As Mankiw says, this model “is simplified. That is not necessarily a problem.”
I agree, “all models are simplified”. But when causation is the wrong way around, this is a massive problem.

Banking – a personal perspective

When I left university, I became a trader at a bank, spending many years on a money markets desk. It is at the least glamorous end of trading, but I found it fascinating being at the centre of the banking system, funding the bank’s activities, and forming the link between the Central Bank and the markets. What was immediately striking was that bank operations were nothing like the models I had been taught at university.

In the story above, the driving force is the Central Bank adding reserves, causing banks to lend money. The mechanisms described are correct, just in the exact opposite order. The actual sequence goes something like this:

  1. Customer decides to buy something and uses credit card for the purchase.
  2. Transaction goes through. i.e. bank lends the customer money for the purchase.
  3. The money shows up as a credit entry on the shop’s bank account and a debit entry on the credit card.
  4. The banking system now has a debit and a credit. Banks move the money between them to square their accounts.
  5. It is important to note that the central bank wasn’t required to do anything in this process.

What if the customer takes out cash? Then the banking system is short of reserves.
This is not a problem as the central bank just adds or takes out reserves on a regular basis to make sure the banking system has exactly as much as it demands.

It is not the case that the Central Bank tells the bank funding desk it has more reserves, who then calls round the rest of the bank to tell them to do some more lending. In simple terms the central bank sets the rate of interest (Fed Funds in the US and the Base Rate in the UK) and then supplies money as demanded. The supply of money is determined completely by the demand for money.


Correlation of money supply with inflation

Milton Friedman and Anna Schwartz “wrote two treatises on monetary history that documented the sources and effects of changes in the quantity of money over the past century.” What they did was document that money supply and inflation are positively correlated. This is a most obvious prediction from either story of money, and so I have never seen an argument that it supports one over the other. As inflation rises, then more money will be demanded in the economy to facilitate transactions. The central bank accommodates this so we see a direct relationship between money and inflation. This tells us nothing about causation. Friedman’s attempts to show causation by econometric tricks with “long and variable lags” are completely bogus.

Stability of velocity of money

An argument for why one can assume V is a constant, is that historically, over short periods, it has been. Unfortunately, this again is a direct prediction from both stories. If the central bank always supplies as much money as is demanded then there is no reason for velocity to change.

Why did QE not lead to hyperinflation?

According to this monetary theory in the textbooks, the vast increase in reserves caused by Quantitative Easing should have led to an explosion in bank lending and a rapid rise in inflation.

This clearly hasn’t been the case, and in fact, the taught theories really struggle with reality here. They are forced to rely on ad hoc and non-quantitative explanations such as “animal spirits” or a reduction in confidence. Since this “confidence” is not directly predictable or even observable, it requires a leap of faith, equivalent to “magic”.

It’s a wonderful coincidence that a model which predicts a MASSIVE stimulus finds, in reality, an unseen counterbalancing force which is of EXACTLY the same magnitude. But still, I read that MV=PY holds and the miraculous drop in V to exactly offset the rise in M, was a bizarre coincidence and that once the velocity of money rises back to “normal”, inflation will come.

There is a much simpler explanation. The amount of loans created by banks was never constrained by reserves and so increasing reserves has no effect on the behaviour of banks or their clients.

What do central bankers say they are doing?

Central bankers involved in monetary policy and the oversight of the banking system must understand how banking works. What do they say is going on?
They agree with my model and say that “the reality of how money is created today differs from the description found in some economics textbooks” and describe the model that is taught as “some popular misconceptions”.


Money is simply not exogenous and does not cause inflation.

Amongst practitioners, including bankers and central bankers, this is obviously well understood. Bagehot famously described it perfectly in 1873. What is striking is the contrast to academic economists who persist with a very different mythical version of banking and continue to educate our bright, young minds with a story of pure fantasy. So why do they do it? I will speculate on that in the next post.

Money 2 – an alternative history

In the beginning, there were people….
People have social interactions which have very strong patterns. One of these patterns is the concept of Reciprocity. If someone gives you something you have a strong sense of obligation to give them something back. This forms the basis on many successful marketing strategies (see “Influence” by Robert Cialdini) but also sits at the heart of everyday social interactions.

For example, in the office someone makes coffee for you. This creates an implicit obligation which you will wish to later reciprocate, or perhaps “repay”. In fact, the word “pay” is said to come from Latin “pacare” meaning “to pacify” and later came to mean to settle a debt. You do not immediately barter, need to give something in return at that time. You have a social relationship and there is mutual trust that this obligation will be repaid. This obligation could be called a “debt” or a “liability”. The person who made the coffee now can be seen to be holding an “asset”.

Make it more useful by adding features….

This method of economic organisation works well for small items between tight-knit or homogenous groups. But it would be far more powerful if we could add some other features which allow us to expand it:

  1. Unit of measurement.
    It is handy to be able to quantify the economic value of the transaction so that more complex exchanges can be facilitated
  2. A method of recording ledger items.
    Just remembering that it is your turn to buy doughnuts for office is not sustainable for more complex economic transactions.
  3. Tradability to a 3rd party
    It would be great to be able to have the favour repaid by someone other than the recipient.

A voucher system….
So let’s start a voucher system. Every time you do me a favour such as babysit my kids I will give you a voucher. Every time I do a favour such as mow someone’s lawn I will be given a voucher. I can build up a stack of voucher from doing these jobs and then “spend” them by taking my family to a restaurant for dinner.

This system of money can be seen today in small areas. In the UK, there is the Lewes pound and the Brixton pound. Tight-knit communities can develop all sorts of formal and informal social conventions to regulate exchange. None of them require gold. These are the sorts of systems of money found in ancient, primitive societies. There is no strong archaeological evidence because this kind of money is not physical, however the earliest writing ever discovered was on tablets thought to represent ledger type records. Tokens in the form of Coins are in fact a later discovery and this has commonly been misunderstood as thinking that it was the tokens themselves that were the valuable item. In fact, it was and is the social obligation that matters, coins were simply a means of recording it.

Using a central authority to widen the usage….

But these local currencies or voucher systems have limitations. They rely on trust which is hard to foster with strangers. It would be much more powerful to have some authority or government to issue the money and guarantee its use across a broader area. This is when we see minted coins by a sovereign.

The unit of value can be solidified by collecting taxes in that unit. You will notice that you owe your taxes in US dollars in the US, and in pounds sterling in the UK. The benefit to society is huge, economic activity can be distributed and exchange facilitated on a grand scale. There is also a large benefit to the government, as issuer they get to earn seignorage.


The alternative story of money is still taught, but these days it is mainly in sociology, history or anthropology departments. This version has been eradicated from economics faculties and treated as “fake news”. Economics students are not taught arguments to support their story, it is simply assumed and most are even unaware there are other ideas.

Money 1 – A Creation Myth

In this piece, I take “Macroeconomics” by Greg Mankiw, the bestselling undergraduate textbook, as the source for this story.

A history of money

In the beginning, there was barter
and a rudimentary economy was based on it. This is extremely inefficient as you have to walk around all day carrying lots of goods, hoping you bump into someone who has something you need who at the same time wants something of yours and will trade you for it.

Efficiency demanded the use of commodities….
Given how poorly organised this world would have been, “it is not surprising that in any society, no matter how primitive, some form of commodity money arises to facilitate exchange”. “Most societies in the past have used a commodity with some intrinsic value for money”. We can see this because archaeologists have found lots of gold, silver and copper coins from previous civilisations.

A really nice example of recent commodity money is the use of cigarettes for currency in a POW camp in WW2. This is an excellent example of why commodity currencies existed and how they operate.

As society evolved thus did “fiat money”….
A modern development in the history of money is the development of “fiat money” which is “money that has no intrinsic value”. This occurs via a process of “evolution from commodity to fiat money”. The process by which this happens is rather mysterious but “in the end the use of money in exchange is a social convention: everyone values fiat money because they expect everyone else to value it.”

Modern money

Money is the stock of assets that can be readily used to make transactions” and it can be defined by its uses which are:

  1. Store of value
  2. Unit of account
  3. Medium of exchange

Between history and mythology

Unfortunately, as so often is the case with creation myths, none of this is actually true. Understanding what money is and why economists are taught its history in such a strange way is important. In fact, I would say it is central to understanding current economic policy and also how best to invest.

Myth #1 In the beginning there was barter

There is no evidence of any society has ever used barter as their primary means of exchange. This should be unsurprising as it would be horrifically inefficient.

Myth #2 Commodity money was the primary form of money for most of history

This myth is more serious and way more pervasive.
However the evidence from the existence of coins far from backs it up, I think it is good evidence of the opposite.

Imagine we are in ancient Rome and we have a Denarius coin in front of us
(Deni from Latin “containing ten” originally was the value of 10 asses)

It has a nice picture of Hadrian on it, “he” of the wall.
It was made of silver and so has an intrinsic value from its weight in silver
(there are examples of use of gold in coins too – the history is interchangeable)

Consider this, let:

A= intrinsic melt-down value of the coin

B= face value on the coin

Then scenarios are:

A > B the coin would not exist, it would be melted down.

A = B why mint it in first place? Why bother calling it a Denarius at all and put the Emperor’s face on it? It would be simpler just to weigh it. There is no benefit for the government to go to the trouble and expense of minting these things.

B > A Now there is a reason to mint it – a profit! The difference (B–A) is known as “seignorage”. We know this was a main source of income for monarchs for centuries from records. But if B>A then there is no strong link between the intrinsic value of the metal and the value of the money. It sets a lower limit but nothing more.
So what is the difference to fiat money? Not much. History indeed has little evidence for a prevalence of commodity money.

But what about the example of cigarettes in the POW camp?
I love this example because it is correct, and utterly misleading. There is an important reason why a commodity currency was used. It is because there was no way to enforce an obligation as the members of the economy were not in control of their society (see below for why this matters).

Myth #3 Money is an asset

Money is not a thing, or an asset like any other asset in the economy. It is much more special than that. It is a ledger item which always consists of an asset and a liability which come into existence at the same time. There is nothing else like it and it is central to the functioning of the economy. I will delve into this in the following posts.

A common error when struggling with such an abstract concept, it is often much easier and more natural to think in tangible terms. An analogy for this is units of measurement. It is now “obvious” that the concept of measurement is conceptually separate from any physical object. I can separate the concept of “1 metre” from the physical reality of a “piece of metal 1 metre long”. Although it is hard to imagine than this was not always obvious for humans, it was certainly not the case in ancient societies. In fact, it is striking how well these societies were able to operate, before the concept of number being separable from their physical objects, allowed formal arithmetic.

Myth #4 Money can be defined by its uses

This myth is again common but is a non-unique definition for money. There are many, many assets which could be used for the functions:

  1. Store of value
  2. Unit of account
  3. Medium of exchange

For example: dollars, gold, bitcoin, cigarettes, diamonds, canned food, oil etc.
In fact, anything non-perishable as bananas would not store well. The concept that in a mainstream economics they assume that anything can be used for money is important. Economic theories have developed from it, often containing the hidden assumption that money is not special and can largely be ignored. It is an asset like any other asset, is priced in the same way as any other asset. Therefore we should not be surprised that all the output from these models show no important role for money in the economy. I would have hoped the financial crisis would have exposed this as a myth.

Myth 5 Fiat money is a modern development

In fact, it is the oldest form of money.
I would prefer to say that “fiat money” means “money” and that “commodity money” is best defined simply as a “commodity”.


The story of money taught to economics students contains many a myth.
Next, I will tell an alternative story of money. The ideas I will present are not difficult.

But as Keynes said, “The difficulty lies not so much in developing new ideas as in escaping from old ones.”