Ethereum, cryptoeconomics, governance
We’ve been arguing on the internet lately about whether commercial banks can create money, what constitutes money creation, how an inflationary vs deflationary base money impacts credit markets, among other closely related questions.
In trying to get to the bottom of these issues, it can feel like we’re entangled in semantic debates. I am writing this to at least keep myself to a consistent set of definitions, and will endeavor to avoid using these terms in more general ways.
I used to say ‘VOLT is money’ – but that’s not right. VOLT is a yield bearing claim on money, which holders expect to be able to redeem for money at minimal cost on demand.
For our purpose we will use a very simple definition: money is the generally accepted medium of exchange. Other supposed functions like store of value and unit of account are secondary, as money can function as an exchange medium even without being a reliable store of value or having standard units of account.
Something can be money in one place and time but not another. The thing that is the best money or most money-like is that which is the most widely accepted in exchange both in space and time. In our crypto jargon, whatever has the most liquidity is the best money.
In recent historical memory, this meant metallic money. A piece of copper, gold, or silver has intrinsic value regardless of which king has stamped it, and so can be widely circulated beyond the point of issuance.
Today, it means the debt of sovereign states, especially the United States. In this system, Treasuries analogize roughly to bars of gold.
If gold is money, a gold coin of standard weight is currency. This is what we usually mean when we say ‘unit of account’.
Here we can accept roughly the Wikipedia definition:
A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans.
We must however make the addendum that even if the institution primarily does something other than make loans, for example invest in yield bearing government or corproate securities, it can still be seen as a bank. In this definition, mutual funds, stablecoin issuers, and even Starbucks are banks. In fact, Starbucks is in the top 15% of banks in the United States by deposits, and pays out 0% interest.
So, a bank is a financial institution that accepts deposits and creates a demand deposit while simultaneously allocating capital in pursuit of yield.
What is key to emphasize about banks is that they are intermediaries, receiving deposits or credit from external parties and allocating these according to their risk appetite in loans or other instruments. They cannot create new money. It can be convoluted tracing these relationships to the base cause and effect in our developed modern economy. Below, we will start simple and work our way up.
Consider the most basic lending relationship without intermediaries first of all. I have some silver, I lend it to my neighbor at some interest rate so he can buy a new plowhorse. It is clear that in this situation, no new money is created, and my lending to my neighbor does not decrease the general price of silver (cause inflation) any more than me spending my silver in the market would. Though passive hoarding would indeed have a deflationary effect compared to the former, this is unappealing compared to earning yield or increasing consumption.
The next step would be that I receive a deposit from one neighbor (in other words, a loan without a definite term), and I in turn lend to a second neighbor so that he can expand his farm. There is still no sense in which inflation has occurred or new money been created, versus the alternative in which Neighbor A spent his silver on consumption goods or invested it into improving his own farm.
The next step would be that I have a counterpart the next county over engaged in much the same business. We agree to extend each other credit such that if someone has a check or note written by one of us, they can cash it in with the other on demand. At regular intervals we will clear and settle balances, exchanging physical gold while our customers benefit from the convenience of notes.
I might extend a loan to Neighbor A, and he travel to the adjacent county to buy a new farm machine on credit. With my notes locally redeemable, a merchant there will accept it and later deposit with my local counterpart.
In this case, the merchant has accepted my banknote as a money substitute. If any doubt were cast on my ability or willingness to redeem deposits on demand, banknotes I issue would quickly lose acceptability as money substitutes.
From the above we can clearly see that even though I could hypothetically issue more in banknotes than I actually have money, or lend out more than I have in deposits, this is not money creation. Reminder, money is the generally accepted medium of exchange. While Chase Bank payments over VISA are indeed widely accepted as money substitutes, VISA conducts daily settlements and if Chase were insolvent, it would be rapidly deplatformed. The only way that a bank could create money would be if it could issue additional loans without facing adverse clearings. At this point, it’s issuances would actually be money, not money substitutes.
That’s where the central bank and the state come in. Unlike a normal borrowing relationship, there is no clearing, as the source of the state’s ‘credit’ is its ability to forcibly extract value from the citizenry, not consensual market relationships. This makes the debt of the state the most liquid financial instrument and a natural base money. The central bank then mints this base money into currency.
Within a state’s borders its dominance is sufficiently great that only the most atrocious monetary policies can push the people to rebel against the fiat money and convert to alternative system, as in Argentina or other nations with large dollar black markets.
Internationally, a notion of adverse clearings returns in the form of balances of trade and interest rate parity. Most countries’ debt is not monetized beyond their borders, so while they can forcibly borrow from their citizenry, they can go no further. In this sense, Country A hyperinflating its money cannot cause inflation in the money of Country B, any more than Bank A extending too much in loans can cause a depreciation of the money held in Bank B.
There is currently no shared global money. The closest thing is the debt of the United States government, the most liquid asset in the world. Expansion or contraction of the liquid supply of US government debt thus has far reaching economic effects, causing inflation or deflation all over the world and often with ‘leveraged’ outcomes in emerging markets.
With this, I hope the reader is satisfied that:
1) Any money operates in a certain space and time
2) Normal credit relationships are not money creation
3) The real base money in the fiat regime is government debt
4) Minting dollars against state debt is like issuing banknotes against gold reserves, not like mining new gold (currency creation, not money creation)