December 23, 2015

Money and debt in six elementary steps

Comment on ‘Randall Wray attacks “debt-free-money cranks” based on sloppy arguments’

Blog-Reference and Blog-Reference

Money has taken various historical forms (token, coin, note, deposit, etc.) and the banking system in each country is the outcome of a murky historical process. Therefore, the first thing to do is to abstract from historical detail and to define a clear-cut analytical frame of reference. This frame has been called by Keynes the ‘monetary theory of production’ and it is as close as possible to the economy we happen to live in. The frame of reference consists of the elementary structure of the monetary economy.

(i) The pure consumption economy consists of the business and the household sector. The household sector provides the labor input to the business sector which consists initially of one firm. The output of the firm is sold to the household sector. Example: the wage income per period (e.g. year) is 100 [thousand/million/billion, euro/dollar/yen]. So, in a period of defined length, the households put in their work and the firm owes in total 100 monetary units to the household sector. For an overview how all fits together see here.

(ii) The firm issues IOUs and these are used in turn by the households to buy the output. For simplicity, the wage income of 100 monetary units is fully spent on the consumption good. Starting from zero at the beginning of each period IOUs are created by the firm and vanish completely until the end of the period. Clearly, IOUs are debt and they are used exclusively for the elementary transactions between the business and the household sector.

(iii) IOUs work fine with one firm but not with many firms. If the business sector consists of many firms the need for a general IOU arises. This general IOU is produced by the central bank and is called money. The central bank gives the firms money in the form of current deposits and the firms owe current overdrafts to the central bank. The firms pay the workers by transferring the deposits instead of IOUs. The workers spend their income and the deposits return to the business sector which reduces the overdrafts. At the end of the period, all deposits and overdrafts are again zero. So money is created out of nothing and vanishes into nothing until the end of each period. This process can continue in principle for all eternity no matter how big or small the economy is. There is no such thing as a fixed quantity of money.

(iv) Only deposits are money but, clearly, deposits are always exactly equal to overdrafts. Hence, money is the central bank’s half of what is essentially a credit relationship. Both sides of the central bank’s balance sheet are equal at any point in time by logical necessity. So Randall Wray is fundamentally right: initially, there is no such thing as debt-free money. But note that deposit/overdraft money as transaction medium is entirely different from credit for houses and cars or for financing real investment of the business sector or for financing public deficits. Not to keep these things properly apart is a recipe for guaranteed mental breakdown.

(v) The production/transfer of deposits and overdrafts is in principle not different from the production of bread or haircuts. The central bank pays wage income to its employees and recovers its costs by charging a transaction price. The transaction price is economically different from interest on credit. The sum of wage incomes of the consumption good producing firm and the central bank is fully spent by the household sector. There is neither saving nor dissaving of the household sector, and the profit of the firm and the central bank is zero throughout. This process can continue in in principle in all eternity. What we have is the most elementary version of a proper functioning monetary production economy (2014).

(vi) Things are different if the central bank does not charge a transaction price but interest on overdrafts, which in sum must again be equal to its wage bill. This is how things have developed historically. And this is how the creation of money as a means of transaction became linked to interest. As a matter of principle, these things should be kept institutionally apart. In a well-designed monetary economy the central bank finances the wage bill of the business sector whatever it is and charges a transaction price that covers exactly its costs. Problems of the monetary order do not arise because money is created out of nothing, or because money is one half of a debt relationship. Problems arise because the transaction function and the credit function are not properly kept apart.

Conclusion: Wray is right on insisting that debt-free money is a nonsensical concept. His banana and cloakroom examples, however, are idiotic. The advocates of ‘debt-free money’, on the other hand, have a valid point: the production of transaction money should be institutionally separated from the production/revolving of credit and not be paid for by interest but by a cost covering transaction price. For the inclusion of the store-of-value function and household-, business- and government sector debt see (2015a; 2015b).

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2014). Economics for Economists. SSRN Working Paper Series, 2517242: 1–29. URL
Kakarot-Handtke, E. (2015a). Essentials of Constructive Heterodoxy: Financial Markets. SSRN Working Paper Series, 2607032: 1–33. URL
Kakarot-Handtke, E. (2015b). Essentials of Constructive Heterodoxy: Money, Credit, Interest. SSRN Working Paper Series, 2569663: 1–19. URL

Immediately preceding post 'Money, cranks, and morons'.
Immediately following post 'Deficit spending, helicopter money, and profit'.