Money was used from ancient times in the form of barter system. First money was called Tea Money. Tea leaves were used as money in Russia, Tibet, and China. ‘Tea bricks’ which are blocks of whole or finely ground tea leaves, were used for trade, since they were easy to carry. After Tea Money, Tobacco money came into existence. Tobacco was used as a money in and around the American colonies of Virginia, Maryland, and North Carolina for nearly 200 years. Nearly all business transactions in Maryland were carried out with tobacco being used as money. Money had taken various forms. In New Zealand Maori warriors used crayfish while raffia cloth was used as methods of payment in Angola & Zaire. A piece of camwood, used for large scale payments in Central Africa, while Kina pearl shells from Papua New Guinea used in 1950’s to make payments. From Simbos used in Belgian Congo to Feather money in Santa Cruz Islands, money had taken many forms. Finally, it came to coins like bronze coins used in China to coins with lion’s head from Lydia.
Money has changed form again, from coins it has come into bullions, assets, liabilities and so many other forms. Today money is mostly created. One of the main underlying causes is money creation, and yet this significant cause is rarely put forward, let alone how it contributes. The story is surprisingly simple: banks create money (= bank deposits) by extending loans. Bank loans are obviously extended if there is a demand for loans, and the bank considers the consumer creditworthy / project viable. Underlying the demand for new loans is additional economic activity being financed – consumption (C) or investment (I), and these are the two components of the domestic demand for goods and services, called gross domestic expenditure (GDE). It drives economic (called gross domestic product – GDP) growth and impacts on company profits and therefore on share prices, and so on. To complete the “big picture” (the macroeconomy) we need to add net external / foreign demand: exports (X = foreign demand for domestic goods) less imports (M = domestic demand for foreign goods) which make up the trade account balance (TAB). Therefore, the big picture is:
C + I = GDE; GDE + (X – M) = GDP
The story of money creation is so astonishing and the system so fine that it must be told in an uncomplicated manner. This text is an endeavour to achieve this ideal. One of the thrusts of these texts is that new bank lending does not begin with a new bank deposit. In fact, the exact reverse applies: a new bank deposit (= money) is the consequence of new bank lending, and this is so because we all accept bank deposits as the main means of payments (= the definition of money). In the genesis of banking days, the bankers, the goldsmiths, who transmuted into bankers, certainly had to take in deposits of precious metal coins before they could lend. However, they soon learned that they could lend money without taking deposits. The second thrust of these texts is to refute the notion that money creation revolves around the so-called reserve requirement (RR) of banks (also called the cash reserve requirement). The perceived dominance of the RR in money creation also has its genesis in the past: in the convertibility of bank notes into gold. However, this “standard” (of money creation management) left the world economic stage in the first half of the twentieth century. It was followed by the requirement that banks hold reserves with the central bank equal to a prescribed percentage of their deposits (the RR ratio). You will understand that this standard imposes a quantitative relationship between banks’ reserves with the central bank and bank deposits, and therefore constitutes a powerful money creation management tool. This tool meant that the central bank had total control over money creation – just by managing the amount of bank reserves with itself. This standard did not last for long because with a quantitative control tool the price of money (= the interest rate) had to be left to its own volition. The consequences in terms of interest rate volatility were quite profound. This standard gave way to one where interest rates are targeted, i.e. are not left to find their own level, and where the RR became a derivative of the system and not the driving force. Thus, instead of the RR being the kernel of the money creation process, in reality it is only one of many factors that affect bank liquidity. This standard gave way to one where interest rates are targeted, i.e. are not left to find their own level, and where the RR became a derivative of the system and not the driving force. Thus, instead of the RR being the kernel of the money creation process, in reality it is only one of many factors that affect bank liquidity. And bank liquidity is completely under the control of the central bank; because of this the central bank is able to manipulate bank lending rates to whatever level it deems propitious in terms of the desired growth rate in bank lending / money creation.
We saw above that:
C + I = GDE; GDE + TAB = GDP
Of the two components of GDP, GDE is the largest by a long margin in most countries. And of the two components of GDE, C is the largest by a long margin in most countries. Thus, C can be seen to be the chief driver of GDP growth. This gives rise to the adage the consumer is king. Alfred Marshall, a celebrated economist of the past, spoke of the sovereignty of the consumer. For example, in the US consumption expenditure makes up roughly 80% of GDP.
There is a celebrated identity in economics relating to the role of money (a product of the fine mind of Irving Fisher in the early twentieth century) referred to as the quantity theory of money:
MV = PT.
Put simply, over a period (say, a year) a change (D) in the money stock, DM, times the change in its velocity of circulation, DV (which generally is a stable number), is equal to the change in prices, DP (i.e. inflation), times the change in the total of economic transactions adjusted for inflation, DT (i.e. DGDP). Thus, assuming V to be stable, an increase in M will give rise to an increase in nominal GDP. Nominal GDP = actual GDP as measured at current prices, that is, not adjusted for inflation (real GDP × inflation = nominal GDP). If there is no inflation it means that the increase in M is fully translated into an increase in GDP. Basically, this says that M growth plays a major role in driving additional economic output and the welfare of the country and its people.
It is an elegant and beautiful feature of the modern monetary system – because it means that funds are always available for new consumption and business projects (C + I). Money creation provides the fuel for economic growth. However, and this is critical, it is only elegant if money creation growth is carefully managed, and this is the formidable task of the central bank. If it is not prudently managed, it transmutes into a monster in the form of inflation, which can be a destructive force in terms of economic growth and employment. Thus in terms of the identity MV = PT, a small increase in M can lead to an equivalent increase in real GDP, while a massive increase in M can lead to an equivalent change in P, or even to a larger increase in P and a decline in real GDP.
What happens when M increases at a high level? As we know, underlying an increase in the demand for loans is an increase in the demand for goods and services. If demand is high, and local industry cannot meet supply, local prices will rise (DP+), and the exchange rate will fall. Foreign goods will become cheaper / local goods will become expensive, imports will rise, exports will fall, and the TAB will deteriorate. If M rises further and extensively, the vicious circle will be exacerbated.
If money creation is left unchecked and is a consequence of a government debt trap (when government borrows from the banking sector to pay interest), and if it borrows from the central bank, the consequences are profound.
The worst inflation monster the world has experienced is 7 000 000 000 000 000 000 000% pa (7 sextillions % pa) in Zimbabwe in 2008. The previous record was 41 900 000 000 000 000% pa in Hungary in 1946. In the Zimbabwean case GDP growth during the hyper-inflation period was negative every year and the unemployment rate grew to over 90%. The cause was massively excessive money creation. The largest denomination bank notes in the history of the world, for 100 quintillion pengo, was issued in Hungary in 1946. The largest denomination bank notes with zeros printed on its face is the Zimbabwean 100 trillion dollar note issued in 2009. Prior to the issue of this note, thirteen zeros had been lopped off the bank notes. Following the issue of this note another twelve zeros were lopped off, making it equal to 100 Zimbabwe dollars. The monster side of money was also seen by the developed world in 2008 / early 2009, when the “credit / banking / sub-prime crisis” was at its peak. To a large degree this crisis had its genesis in the excessive creation of money by the credit granted to the many US sub-prime borrowers by the US banks, which led to an artificial and unsustainable boom. It also clearly demonstrated the fact that banks are inherently unstable, and therefore require rigorous regulation by government authorities. It may come as a revelation to young readers that the bank failures seen in this period is not a new phenomenon; history is littered with banking / credit crises and bank failures.
Money has a name: dollar, pound, rupee, franc, rand and so on. One of these or another name is the name of your country’s currency or, more formally, the monetary unit of your country; this will be set down in some statute of your country. The unit (say one dollar) will most likely be made up of sub-units or parts (say 100 cents). This enables prices in your country to be in multiples of one cent.
A glance at a bank note will reveal that it is issued by your central bank; so, it is a liability of the central bank. If you are in the UK and you have a fifty pound note it will say: I promise to pay to the bearer on demand the sum of fifty pounds. In some cases, the note will state: This note is legal tender for the payment of the amount stated thereon or This note is legal tender for all debts, public and private (USD notes). Your note may even state both these phrases. What do these lofty phrases mean? The first one means nothing more than the central bank will exchange your weather-beaten bank note for a crispy new one. In days past it meant something more significant; we will discuss this issue in more detail later. The legal tender covenant means that a creditor (think: a creditor provides credit and is therefore owed an amount of money) is legally obliged to accept payment from a debtor (think: a debtor makes a debt and therefore owes money) in the form of bank notes (and coins – although not stated on the coins) to the value specified on the note. If the payment of legal tender money is refused the debt is extinguished. The question arises: does a country only have one currency that is designated legal tender by statute? The answer is yes (usually). This means that only the currency of a country may be used to pay for goods and services in that country (and from abroad after exchanging the local currency for a foreign one). However, in extreme circumstances (as in hyper-inflationary times) in a few countries, other currencies have been declared legal tender. For example, in Zimbabwe in 2009, the Zimbabwe dollar lost all its money attributes / roles (see below) and the South African rand (ZAR) and the US dollar (USD) were declared legal tender. The Zimbabwe dollar went into hibernation for its severe financial winter.
Money’s primary role is to serve as a means of payment / medium of exchange. The other roles of money will be obvious: unit of account (also known as standard of value) and store of value. Unit of account means that records (accounting records in the modern age) can be kept of assets and liabilities in one standard, and that comparisons can be made between the assets and liabilities of different entities and at different times. Store of value means that the medium of exchange maintains its purchasing value, that is, you can keep the money tucked away (under mattresses in the olden days and in the bank today) and spend it later when it will at least buy the same amount of goods and services as when you received the money.
In other words, we pay for most goods and services we buy by the transfer of bank deposits, which makes it money. Notes and coins, the other component of money, are also used to make payments, but bank deposits are overwhelmingly used in this modern age. A new bank deposit is new money created, and it springs from bank credit / loan extension. So, now we know that money (M) is comprised of bank deposits (BD) which are immediately available or available soon and bank notes and coins (let us call these N&C):
M = BD + N&C.
Another example may be useful: Company A (Co A) which produces goods and wants to sell them, and Company B (Co B) which wants to trade in the goods produced by Co A. Co B does not have the money to do so and approaches Bank A (let’s assume that it is the only bank) for a loan of LCC 100 million. It is in the business of lending money and grants the loan in the form of a credit to Co B’s bank account in its books. Co B’s balance sheet changes. Bank A’s balance sheet is the converse of Co B’s balance sheet. It will be noted that the deposits of Co B, a member of the non-bank private sector (NBPS) of the economy, have increased, that is, the amount of money (M) in circulation has increased, by LCC 100 million. The increase in M has a balance sheet cause of change (BSCoC): the credit extended to the NBPS. The actual cause is the approach by Co B to the bank and the bank accommodating it, i.e. the demand for loans / credit. Let us take the transaction a little further. Co B clearly borrowed the money in order to buy goods from Co A. In addition, there is a strong financial reason: the interest rate on his new deposit is lower that the bank’s lending rate (reflecting the bank’s margin). Co B will do an EFT payment to Co A via the internet, show Co A the proof of payment (pop), and take delivery of LCC 100 million worth of goods. The final balance sheet changes.
An alternative to the above is that Co B obtains an overdraft facility of LCC 100 million from the bank. This is more likely in real life, but the outcome is the same. In terms of the money-component identity, M = BD + N&C, we have:
DM = +LCC 100 million = DBD = +LCC 100 million.
It should be apparent that we also have an identity from Bank A’s balance sheet: DM = Dcredit to NBPS:
DM = +LCC 100 million = D loan to NBPS = +LCC 100 million.
Money was created by accounting entries by a bank. This shatters the notion that a bank must receive a deposit before it can provide credit; the path of causation is a bank creates new deposits by providing new credit. The belief system that money creation rests on something tangible, like silver or gold, should now lie in ruins. This also indicates that banking is a good business; it is, and it is so because we, the public, generally accept bank deposits as a means of payment. This simple reality makes it money.
A significant question now arises: does this not mean that the banks are able to create loans and its counterpart, money, ad infinitum? The answer is a yes, but it is a qualified yes. Because of the phenomenon of banks being able to create money by accounting entries, a policy on money, that is, a monetary policy, is required. Also required is exacting bank regulation and robust supervision because, inter alia, the phenomenon of money creation makes banks inherently unstable.
You will have heard of the central bank of your country. You will have read or heard about your central bank’s key interest rate (KIR – called by different names such as repo rate, discount rate, bank rate, base rate, but we call it by this generic name from here on). Central banks “control” money creation by the banks through its KIR, and in many cases are responsible for the supervision of banks.
Bank notes are the notes of the central bank, and we know that because they are issued by the central bank, they are part of its liabilities. Coins in many countries are also issued by the central bank; where this is not the case, they are issued by a government department (usually Treasury or the Department of Finance). We will assume they are issued by the central bank for the sake of simplicity. We will call them bank notes and coins or just N&C, with the background knowledge that N&C are liabilities of the central bank. N&C are held by the domestic non-bank private sector (NBPS) and by the banks in their vaults, teller drawers and ATMs. Only the former (N&C held by the NBPS) is regarded as being part of the money stock.
Bank deposit (BD) money is a wide term. The foreign sector, government and banks also bank with banks (the latter is called the interbank deposit or loan market).
Generally, the deposit part of the money stock is taken to include only the deposits the NBPS. Thus, we have:
M = BD + N&C (both in the “hands” of the NBPS).
Money exists and is created in the money market. The money market is a financial market and it is one of the financial markets. The financial markets make up the financial system. Therefore, if you are to understand money and money creation clearly, you need to see it as part of the financial system. This is followed by a definition of the money market, an exposition on money market interest rates (because they are the operational variable of monetary policy) and the interbank market/s.
The financial system of any country is divided into 6 parts:
i. First: lenders (surplus economic units) and borrowers (deficit economic units), i.e. the non-financial-intermediary economic units that undertake lending and borrowing. They may also be called the ultimate lenders and borrowers (to differentiate them from the financial intermediaries who do both). Lenders try and earn the maximum on their surplus money and borrowers try and pay the minimum for money borrowed.
ii. Second: financial intermediaries, which intermediate the lending and borrowing process; they interpose themselves between the ultimate lenders and borrowers and endeavour to maximise profits from the differential between what they pay for liabilities (borrowings) and earn on assets (overwhelmingly loans). In the case of the banks this is called the bank margin. Obviously, they endeavour to pay the least on deposits and earn the most on loans.
iii. Third: financial instruments, which are created to satisfy the financial requirements of the various participants. These instruments may be marketable (e.g. treasury bills) or non-marketable (e.g. a utilised bank overdraft facility).
iv. Fourth: the creation of money when demanded. As you know banks (collectively) have the unique ability to create their own deposits (= money) because we the public generally accept their deposits as a means of payment.
v. Fifth: financial markets, i.e. the institutional arrangements and conventions that exist for the issue and trading (dealing) of the financial instruments.
vi. Sixth: price discovery, i.e. the price of shares and the price of debt (the rate of interest) are “discovered”, i.e. made and determined, in the financial markets. Prices have an allocation of funds function.
Lenders and borrowers: The first element are lenders and borrowers. They can be categorised into the four groups or “sectors” of the economy:
i. Household sector (= individuals).
ii. Corporate sector (= companies – private and government owned).
iii. Government sector (= all levels of government – local, provincial, central).
iv. Foreign sector (= any foreign entity – corporate sector, financial intermediaries such as retirement funds).
The members of these sectors may be either lenders or borrowers or both at the same time. For example, a member of the household sector may have a mortgage bond (= borrower by the issue of a non-marketable debt instrument) and at the same time hold a balance on your accounts at the bank (= a lender; a holder of money).
Financial intermediaries: The second element is financial intermediaries. As seen in Figure 1, lending and borrowing takes place either directly between ultimate lenders and borrowers [e.g. when an individual buys a share (also called equity or stock) issued by a company], or indirectly via financial intermediaries. Financial intermediaries essentially solve the differences (or conflicts) that exist between ultimate lenders and borrowers in terms of their requirements: size, risk, return, term of loan, etc. An example: your friend Johnny (a member of household sector) has LCC 10 000 he would like to lend out (= invest) for 30 days at low risk. You (a member of household sector) would like to borrow LCC 20 000 for 365 days to buy a car. You do not mind who you borrow from, because you represent the risk, not the lender. Your and Johnny’s requirements do not match at all; direct financing will not work. He places his LCC 10 000 on deposit with a prime bank for 30 days and you borrow LCC 20 000 from the bank for 365 days. You and Johnny are both in high spirits; the bank satisfied your different requirements. Financial intermediaries exist not only because of the divergence of requirements of lenders and borrowers, but for the specialised services they provide, such as insurance policies (insurance companies), retirement fund products (retirement funds), investment products (securities unit trusts, exchange traded funds), overdraft and deposit facilities (banks), and so on. The banks also provide a payments system, the system we do not see but rely much on. The main financial intermediaries that exist in most countries and their relationships with one another. Note that the non-deposit intermediaries may also be seen as investment vehicles. Their products (= their liabilities), which can be called participation interests (PIs), are designed as investments for the household sector (and in some cases other financial intermediaries).
Financial instruments: The third element is financial instruments. They are also called securities, borrowers issue securities. They are therefore evidences of debt or shares. They also represent claims on the issuers / borrowers.
Ultimate lenders exchange money (deposits) for securities and ultimate borrowers exchange (issue new) securities for money. Financial intermediaries issue their own securities (e.g. deposits) and hold the securities of the ultimate borrowers (e.g. treasury bills). As you know, the banks have a special and unique role in this market for money in that they are able to create money (bank deposits) by making new loans (buying new securities). Securities offer a return that is fixed (fixed-interest debt) or variable (variable-rate debt and share dividends). The capital amount of shares and debt is paid back after a period (bonds and preference shares) or not ever (perpetual bonds and shares). Securities are also either marketable of non-marketable. This is discussed in more detail in the next section.
There are two categories of financial instruments:
a) Debt (and deposits).
b) Shares.
The instruments of debt and shares and their issuers are as follows:
The household sector issues:
a) Non-marketable debt (NMD) securities
b) - Examples: overdraft loan from a bank; mortgage loan from a bank.
The corporate sector issues:
a) Share securities (marketable = listed & non-marketable = non-listed)
b) Ordinary shares (aka common shares).
c) - Preference shares (aka preferred shares).
d) Debt securities
e) Non-marketable debt (NMD).
f) Marketable debt (MD)
g) Examples: corporate bonds, commercial paper (CP), bankers’ acceptances (BAs), promissory notes (PNs).
The government sector issues:
i. Marketable debt (MD) securities
ii. Treasury bills (aka TBs and T-bills).
iii. - Bonds (aka T-bonds).
The foreign sector issues (into the local markets):
i. Foreign share securities (inward listings).
ii. Foreign debt securities (inward listings).
The deposit financial intermediaries (central and private sector banks) issue:
1. Deposit securities
2. Central bank
3. Non-negotiable certificates of deposit (NNCDs).
4. Notes and coins.
5. Central bank securities.
6. Private sector banks
7. Non-negotiable certificates of deposit (NNCDs).
8. Negotiable certificates of deposit (NCDs).
The quasi-financial intermediaries’ issue:
1. Debt securities
2. Non-marketable debt (NMD)
3. Marketable debt (MD)
Financial markets: The fourth element of the financial system is financial markets. Financial markets are categorised according to the securities issued by ultimate borrowers and financial intermediaries. It was noted above that financial securities are either marketable of non-marketable. Examples are non-negotiable certificates of deposit (NNCDs) (= an ordinary deposit receipt) and negotiable certificates of deposit (NCDs) issued by the private sector banks. There are two market types or forms primary market and secondary market. All securities are issued in their primary markets and the marketable ones are traded in the secondary markets. In the primary market the issuer receives the money paid by the lender / buyer. In the secondary market the seller receives the money paid by the buyer. There are a number of markets for financial instruments: the market for life policies (a primary market only), the market for PIs (also called units) of securities unit trusts (a primary market and a partial secondary market: the units are saleable to the issuer), the market for PIs in retirement funds (strictly a primary market), the deposit market (primary market for NNCDs and a secondary market for NCDs), the bond market (secondary market), and so on. The money market should be defined as the short-term debt market (STDM = marketable and non-marketable debt), while the bond market is the marketable arm of the long-term debt market (LTDM). The money market (STDM) and the LTDM together make up the debt market (also known as the interest-bearing market and the fixed-interest market). The terms interest-bearing and fixed-interest oppose the debt market from the share market because the returns on shares are dividends and dividends are not fixed – they depend on the performance of companies. The LTDM and the share market is called the capital market.
The foreign exchange market is not a financial market, because lending and borrowing do not take place in this market. Rather, it is a conduit for foreign investors into local financial markets and for local investors into foreign financial markets. In addition to these cash or spot markets [where the settlement of deals takes place a few days after transaction date (T+0)] we have the so-called derivative markets. They are comprised of instruments (forwards, futures, swaps, options, and “others” such as weather derivatives) that are derived from and get their value from the spot financial markets. Whereas cash markets settle as soon as possible, derivative markets settle at some stage in the future. Secondary markets are either over-the-counter (OTC), also called “informal markets” (such as the foreign exchange and the money markets) because there is no exchange involved, and exchange (or formal) markets, such as the share (or stock) exchange. The financial markets do not intermediate the financial lending and borrowing process as do financial intermediaries such as banks; they merely facilitate the primary and secondary markets.
Money creation: The fifth element is creation of money. When banks make new loans / provide new credit (= buy NMD, MD and shares), they create NBPS deposits (= money). The referee in this game is the central bank which controls the growth rate in money creation (= new bank deposits resulting from new bank loans) by means that differ from country to country (which are elucidated later). The principal method is the interest rate on banks’ loans (= bank assets) via the central bank’s KIR interest rate, which influences the cost of bank liabilities (i.e. via the bank margin).
Price discovery: The sixth element is price discovery. Primary and secondary markets are important for several reasons, the most important of which is price discovery, i.e. the establishment of interest rates for various terms and the prices of shares. Interest rates, as we will see, have an important role to play in the pricing of all assets. The central bank plays a significant role in the establishment of interest rates. These significant issues are addressed later.
As far as debt instruments are concerned, the money market encompasses:
1. Primary market: the issue of all forms of short-term instruments of borrowing, that is, the short-term debt of ultimate borrowers and certain QFIs, and short-term deposit instruments. Deposit instruments are the NNCDs and NCDs of banks and certain instruments of the central bank, the important ones of which are notes and coins (= part of money) and central bank securities (= a form of deposit, and an instrument of monetary policy).
2. Secondary market: the exchange of existing marketable short-term debt instruments.
Hidden from the public’s view, however, is an integral part of the money market: the interbank market. These markets play a significant role in money creation and monetary policy.
Thus, once you understand the operations of financial market I have described above, in your country, you will get a clear idea on how to spend your money wisely. Besides if you do have any questions give me a call: https://clarity.fm/joy-brotonath
