This part has been under pen for more than a year. This has given us time to reflect on and clarify our thoughts on money. The result is unconventional but has brought clarity to many issues for us. These will be explored in later essays on the Fed and quantitative easing (QE).
A Review of Currency As Represented By the Federal Reserve Note (FRN)
In Understanding Money: Part 4 – The Value of Money we established of the FRN:
- It is a debt instrument that may be redeemed at any time in “lawful money”.
- It is also lawful money and as such is completely fungible. It may be redeemed in terms of any other FRN of the same denomination or of FRNs and coins whose total value equals the value of the FRN to be redeemed.
- This leads to the fact it may be redeemed in terms of itself – self-redemption.
- It is a debt with zero maturity and we would add, zero interest. We will represent it as MZMc, meaning money with zero maturity, currency component.
- The FRN is backed by the assets on the Fed’s balance sheet. All the assets on the Fed’s balance sheet are debt instruments such as Treasuries, Federal Agency (GSE) Debt, mortgage-backed securities and gold certificates (note: not gold but debt instruments representing a claim on the US stockpile of gold).
- We have not discussed coin but the same arguments that apply to the FRN apply to coinage.
A Review of Fractional Reserve Banking (FRB) and Money Creation
In Understanding Money: Part 2 – Money Creation we established certain characteristics of FRB and add some new points:
- It begins with the deposit of currency in a savings or checking account. The deposit is in fact a loan to the bank and as such is actually a form of debt. The depositor is issued a receipt or note attesting to this loan.
- The deposit (loan) is equal in value to the currency deposited and is fully recognized and accepted as money. In effect the amount of money has doubled.
- The new money as a deposit is a debt held by the depositor and considered to have a zero maturity since it may be redeemer at any time (the bank is open) in an equivalent amount of MZMc.
- With the advent of electronic banking, ATMs, and debit cards, the deposit may be redeemed or withdrawn at virtually any moment of the depositor’s choice, constrained mainly by logistics (finding an ATM), withdrawal limits and possibly the time of day.
The Equivalence of Debt and Money
Now we get a little wild. We have established via the FRN that all (currency) money is debt. We have established via FRB that all deposit loans as debt are money. Now let us consider debt with a maturity greater than zero.
Most debt begins with money with zero maturity, as MZMc or an electronic transfer of money from an account whose assets have a zero maturity. For much of our discussion, while we use MZMc to represent currency in particular, including electronic forms of money makes no difference and we will not make the distinction. Continuing on, you may borrow two eggs from your neighbour and pay him back with two eggs. But this is an exception. We will say for the purposes of our argument that all debt begins with the conveyance of an asset with zero maturity – cash or cash equivalent – to a party who in return conveys a debt instrument of equivalent value in exchange. We are saying that this debt instrument is money. It represents a future obligation to replace it with MZMc.
Most debt also has other aspects such as a maturity date when it will be repaid in full, an interest rate or yield specified on the loan and a term structure that details how and when interest is to be paid and principal is to be repaid. We may then speak of the maturity of the debt. When the debt is repaid at its maturity and possibly at other points determined by its term structure, it is paid as MZMc. The creditor may be handed currency, or an electronic deposit (of money) may be made into a bank account of the creditor.
This is the principle of FRB generalized to all debt creation. The debt created, be it a mortgage loan, a car loan, a business loan between two companies, or whatever – the credit (debt) market is huge and diverse – is money, just as your bank deposit is money. The key difference between the debt represented by a loan as described above and a loan in the form of a bank deposit is in its maturity. The bank deposit is considered to be a loan with zero matuity whereas most other loans or forms of debt have a non-zero matuity and an associated term structure. Both however, are loans that bear interest.
As an example, suppose I can borrow $1000 of FRNs from bank B at no interest, repayable in one year (actual loans are more complicated but the principle is what we are interested in). The bank determines that I should be good to repay the amount and makes the loan. Bank B gives me $1000 of FRNs and in return, takes a note that I will return $1000 of FRNs to the bank in 1 year. Now the $1000 of FRNs that I hold has been in circulation since the Fed created it so it is old money. The $1000 note the bank hold is new money with a 1-year maturity that has just been created by the bank. It is not FRNs but will be in one year. Rather it will be redeemed as FRNs in one year. In the meantime, the bank does not distinguish it as an asset from ZMM.
The Maturity of Money
The monetary base has two components, one is currency in circulation (FRNs) and the other consists of the balances of depository institutions in reserve accounts with their Federal Reserve banks. Now the monetary base has some wonderful properties. It has a true zero maturity and it is self-redemptive or self-referential.
The FRN may be redeemed at any time subject to operational constraints. As a holder of an FRN you have the right to exchange it or redeem it in lawful money at any Fed branch or the Treasury department, but this takes time. So in this sense, the FRN has an indeterminate maturity that could range from seconds to never.
Here is a perfectly plausible scenario. You walk into a Federal Reserve bank and ask to redeem an FRN. They take the one you offer and hand you another one. You don’t like it so you ask to redeem it. They take it back and hand you another. The maturity of the the intermediate FRN was a few seconds. Here’s an interesting question. The second FRN handed you: is it different from the other two or is it the original handed back?
The self-redemptive property of FRNs, however, means that at any and every moment in time, an FRN can be considered to be redeemable by itself and to have been redeemed by itself. It in fact has a true zero maturity. As mentioned above, we will denote the FRN as MZMc to distinguish it from the Fed’s definition of money with zero maturity (MZM).
A bank deposit is considered to have a zero maturity also. However, it lacks the property of self-redemption. It has to be redeemed as either MZMc or as an electronic transfer of funds to another account. Such transactions take a finite amount of time. So bank deposits have a small maturity which for practical purpose is considered to be zero. We think ‘callable’ (as in callable bond) is a better term, however.
There is another argument for distinguishing a deposit from an FRN. Deposits are redeemable in FRNs but the inverse is not true. This goes back to the point we made in the last section: ALL debt begins and ends as MZMc, including the FRN.
We will talk more about debt as money when we talk about its term structure.
The Death of Money
In Understanding Money: Part 2 – Money Creation we discussed the birth or creation of money. Can money die? The answer is yes but the method depends on the type of money. Money – debt – that has a maturity, will be extinguished by conversion to currency either at its maturity or at a collection of points determined by its term structure.
Suppose you lend your brother-in-law $1000 cash, half to be repaid in 6 months and the balance to be repaid in 1 year and witnessed via a promissory note. The promissory note represents $1000 of newly created money, half of which will be cancelled, repaid or destroyed in 6 months and half in 1 year (assuming your brother-in-law is good for it). The effect of the entire transaction over its lifetime is to expand and then contract total credit market debt which we now consider to be the total money supply, by $1000.
A more prosaic level of money destruction involves your bank account. For a deposit of $100, FRB creates a matching $100 deposit record. You hold the deposit record and your bank holds the $100 in currency which as we have discussed, is no longer yours. If you want $100 in currency back, then the deposit record is destroyed and the bank completes the process by returning $100 in currency.
So you see, money, apart from being created every day, is being destroyed every day. It may be hard to accept this fact but we have explained the case as cleanly as we can. The larger leap has been to extend the idea of the destruction of deposit debt to debt with longer maturity.
But what of the FRN, the unit of currency? Apart from accidental destruction – in a moment of bravado, you decide to light your cigar with a C-note – FRNs remain in circulation until retired, usually because they have become damaged. In this case, they are returned to the Fed by your bank which is reimbursed by the Fed with new ones. The old ones are recorded and physically destroyed. But the same amount of currency remains in circulation.
To reduce the amount of currency or reserve deposits in circulation, the Fed sells assets to its primary dealers who pay for them in currency or reserve deposits. The Fed’s balance sheet is adjusted by reducing its assets by the amount of the transaction and its liabilities, notably either currency in circulation or excess reserves or both, by the same amount. The end result is the shrinking of the monetary base and possibly even the amount of currency in circulation. A study of the Fed’s balance sheet shows a fluctuation of the amount of currency in circulation both up and down, equivalent to the creation and destruction of currency.
Note that taking currency or destroying money in this way does not require the physical destruction of the currency but only for the currency to leave the hands of the public (primary dealers) and become locked in a Fed vault.
What Can You Do With Your Money?
Before we go on we want to make another point. We maintain that you can do one of two things with money; you can save it or you can spend it. Here again we have decided to be unconventional.
First of all we consider spending to be the exchange of MZMc for an asset. We note that the use of credit instruments is a variant that is discussed below. The asset may be a good, a service (we recognize that services are not usually considered to be assets because their persistence is too short a duration to be counted), or a financial debt instrument in the form of a loan (buying a Treasury is loaning your money to the government). In conventional terms, buying a Treasury bond or making a deposit in a bank is considered to be a form of saving. We consider it to be a form of spending whereby the owner of MZMc exchanges it for money of non-zero maturity.
Saving we then define narrowly as the retention of MZMc as a reserve. This is the cash you maintain on hand to allow you to transact business in the economy as well as provide for an emergency should one arise. This is the personal implementation of the idea of liquidity. What would normally be considered to be saving such as depositing money in a savings account or money market instrument we consider to be a form of spending.
Going further, if we have created the notion of a cash reserve held by every entity that transacts in the economy, where is the MZMc that is not in a reserve? The answer is that at any moment of time all MZMc is in someone’s reserve. So to return to the idea that we can only save or spend our MZMc, we sharpen the definition that our cash on hand consists of two parts, MZMc that we will try and retain as a true reserve and MZMc that we will spend under appropriate circumstances. At any point in time, all MZMc is in the possession of some entity. There is no grey area where MZMc belongs to no one.
This allows us to develop the idea of the velocity of money in a nice way which we do in a separate note: A Brief Note on the Velocity of Money. It also allows us to provide additional thinking to the role of gold as a currency in A Brief Note on Gold As a Currency.
Thoughts on Credit Instruments
This discussion applies to credit cards, lines of credit and similar instruments. These are discussed further in Portrait of the American Consumer.
With an ordinary loan, we receive MZMc of a specific amount for a specific term exactly once. We repay the loan according to its term structure (discussed below) and the loan is cancelled. In the process the creditor has determined that we are “good” or creditworthy for the amount of the loan. A credit instrument is a different kind of loan that may be withdrawn in stages such as a student loan, until the credit limit has been reached if at all. It’s term structure can be complex and this type of credit is called non-revolving.
The other kind of credit called revolving credit, can be extended on demand, effectively a loan of MZMc, but repaid and extended again, in whole or in part, any number of times.
The credit limit is the maximum size that a credit loan may take and is the maximum amount that the debtor has been approved to receive. Its maturity may be quite complex. Depending on how much and when the money was loaned, the maturity of it may be indefinite as long as a defined term structure (minimum monthly payments) is adhered to.
To understand how this is a form of money creation, suppose we want to open a line of credit or a credit card with a $1000 limit. The bank does the same background check and issues the credit. Now suppose we want to buy something for $500. Recall we have argued that all financial transactions are made with MZMc – cash or an electronic call on our bank account. The transaction proceeds because the vendor accepts the electronic call as equivalent to being handed $500 cash.
We argue that there was a point in the transaction – perhaps only momentary – where we effectively had possession of $500 of MZMc. And the vendor at the next moment effectively received $500 in MZMc. And there is a point in the transaction when our bank now recognizes a $500 debt obligation on our part and is in possession of $500 of new freshly created money of an indeterminate maturity (effectively a loan to us).
Normally, creditworthiness is established on a one-time basis for a loan. For credit instruments, credit worthiness is established up to a limit for an indefinite period of time and usage.
We are trying to finish this part more than a year after it was begun. To sum up some of the key points arrived at so far:
- All money is debt.
- Effectively all debt is money. Debt is created from money with zero maturity, specifically MZMc, and is destroyed by converting it back into or redeeming it as MZMc.
- More generally, virtually all financial transactions involve or can be reduced to an equivalent MZMc.
The Term Structure of Money
When we move from debt or money of zero maturity to forms of debt or money of longer maturity, we have to add two other components: interest and term structure. For a loan of a principal amount P, the term structure identifies a series of payments over time until the loan is repaid. It also specifies interest payments both by amount and frequency.
In making a loan, thereby creating money, we are exchanging MZMc in the present for a succession of repayments of MZMc in the future. Consider an example whereby you borrow $3000 from your bank today, July 22, 2013, at 10% annual interest on the outstanding balance to be paid in 3 equal annual payments. With interest, the three annual payments will be $1300, $1200 and $1100, each in MZMc, for a total of $3600. We will denote the money type of a component in the transaction by an appropriate subscript MZMc) to money amounts where appropriate.
The initial transaction creates a $3000 loan but a new $3600 of a special type of money with an interest rate and term structure that we will tag with the subscript Ms for money special. We can then represent Ms as a time series of MZMc components in a pairwise fashion:
($3600Ms, t0) = ($1300MZNc, t1) + ($1200MZNc, t2) + ($1100MZNc, t3)
Here, t0 = 20130722 represents today’s date, t1 = 20140722 the first anniversary payment date and so on. Let us look more closely at what happens to $3600Ms at time t1. In fact, ($3600Ms, t0) = ($2300Ms, t1) + ($1300MZNc, t1). That is $1300Ms has been destroyed or replaced by $1300MZNc leaving $2300Ms.
In short, the term structure of money with non-zero maturity allocates ownership of parts of the MZMc money supply at any point in the future.
The Term Structure of the Money Supply
In principle, the term structure of most monetary instruments is known. In particular are those that are identified with a CUSIP number such as Treasuries and Municipal bonds. One could imagine a system that collects the relevant data on individual term structures of all fixed debt and aggregates them over the total credit market.
The major exceptions are the various credit instruments and particularly revolving credit instruments, that have no identified repayment structure but have credit limits, fixed interest rates and minimum scheduled payment criteria. Given the large number of users of such instruments (e.g. credit cards), statistical methods may offer a reasonable approach to creating aggregate estimates allowing for an artificial term structure to be created.
Even of it is not practical or economically feasible to collect and compile the term structure of the total money supply, it does exist. The important point is that the leverage in the system must not be so great relative to the total MZMc supply that at each moment of time, there is sufficient to allow both maturing non-zero money to be collapsed into its MZMc equivalent and still allow enough liquidity for the daily operation of the economy.
If the limits to money creation cannot be calculate ed, they can be discovered empirically through a study of the behavior of the leverage of the money supply as we have done.
What we have developed in this essay is a wonderfully elegant way of looking at money as a structured continuum of all debt obligation. Standard monetary theory develops the start of the continuum through the different monetary aggregates such as M1, M2, etc. that cover debt or money of short maturity. We have simply extended the theory to include debt of all maturities.