ON MONEY, DEBT, TRUST, AND CENTRAL BANKING.

• Author: Borio, Claudio

Few issues in economics have generated such heated debates as the nature of money and its role in the economy. What is money? How is it related to debt? How does it influence economic activity? The recent mainstream economic literature is an unfortunate exception. Bar a few who have sailed into these waters, money has been allowed to sink by the macroeconomics profession. And with little or no regrets.

Today, I would like to raise it from the seabed. To do so, I will look to an older intellectual tradition in which I grew up. I would thus like to revisit the basics of monetary economics and draw lessons that concern the relationship between money, debt, trust, and central banking. (1)

I approach the topic with some trepidation. So much has been written by scholars much better equipped than me, including a number in the audience. Still, I hope to shed some new light on some old questions. A number of the points I will be making are well known and generally accepted; others more speculative and controversial.

My focus will be on the monetary system, defined technically as money plus the transfer mechanisms to execute payments. (2) Logically, it makes little sense to talk about one without the other. But payments have too often been taken for granted in the academic literature, old and new. In the process, we have lost some valuable insights.

Let me highlight three takeaways.

First, two properties underpin a well-functioning monetary system. One, rather technical, is the coincidence of the means of payment with the unit of account. The other, more intangible and fundamental, is trust. In fact, a precondition for the system to work at all is trust that the object functioning as money will be generally accepted and that payments will be executed. But a well-functioning system also requires trust that it will deliver price and financial stability. Ensuring trust is difficult and calls for strong institutions--an appropriate "institutional technology." Central banks have evolved to become key pillars of the whole edifice alongside banking regulatory and supervisory authorities--often central banks themselves.

Second, a key concept for understanding how the monetary system works is the "elasticity of credit"--that is, the extent to which the system allows credit to expand. (3) A high elasticity is essential for the system's day-to-day operation, but too high an elasticity ("excess elasticity") can cause serious economic damage in the longer run. In today's economy, generally blessed with price stability, the most likely cause of damage is financial instability. This form of instability can generate serious macroeconomic costs even well short of banking crises. And when banking crises take place, it threatens to undermine the payments system itself.

Third, price and financial stability are inexorably linked. As concepts, they are joined at the hip: both embody the trust that sustains the monetary system. But the underlying processes differ, so that there can be material tensions in the short run. These tensions can disappear in the longer run provided the appropriate monetary and financial arrangements are in place. Resolving these tensions is far from trivial and is a work in progress.

Along the way, I will touch on a number of subthemes. Examples are the risk of overestimating the difference between money and debt (or credit); the unviability of cryptocurrencies as money; and whether it is appropriate to think of the price level as the inverse of the price of money, to make a sharp distinction between relative and absolute price changes, and to regard money (or monetary policy) as neutral in the long run.

The structure of the speech is as follows. I will first discuss the elements of a well-functioning monetary system. I will then turn to some of the key mechanisms to ensure trust in its day-to-day operation. Finally, I will explore ways to secure trust in price and financial stability in the longer run.

Elements of a Well-Functioning Monetary System

At its most essential, a monetary system technically consists of (1) a unit of account, (2) a means of payment ("settlement medium"), and (3) mechanisms to transfer the means of payment and settle transactions (execute payments). The unit of account measures the value of all goods, services, and financial assets. It is a purely abstract, immutable unit of measurement--like, say, the unit of distance. The means of payment is a generally accepted instrument that settles (extinguishes) obligations. (4)

Two points about this definition.

For one, there is no explicit reference to the third well-known function of money--that is, being a store of value. This is not because it is unimportant. Far from it, the function is essential: stability in the value of money will play a key role in what follows. The point is simply that it is not a distinguishing feature of money. (5) Any asset, financial and real, is a store of value. Moreover, and more importantly, a viable means of payment must also be a store of value. So, there is no need to refer to this function explicitly.

In addition, compared with the traditional focus on money as an object, the definition crucially extends the analysis to the payment mechanisms. In the literature, there has been a tendency to abstract from them and assume they operate smoothly in the background. I believe this is one reason why money is often said to be a convention (Lewis 1969), much like choosing which hand to shake hands with: why do people coordinate on a particular "object" as money? But money is much more than a convention; it is a social institution (Giannini 2011). It is far from self-sustaining. Society needs an institutional infrastructure to ensure that money is widely accepted, transactions take place, contracts are fulfilled and, above all, agents can count on that happening. Even the most primitive communities require generally agreed on, if informal, norms and forms of enforcement. Putting in place the corresponding supporting institutions--or institutional technology--in a way that ensures trust is a major challenge. And the challenge naturally becomes more complex as societies develop. (6) I will return to this point in due course.

The sheer volume of payments in our modern economies highlights their importance. The volume exceeds GDP many times over, thousands of times in fact (Figure 1). To a large extent, this is because most of the payments correspond to financial transactions and their volume dwarfs "real" economic activity. Hence, also the common, largely efficiency-driven, distinction between wholesale payment systems, designed to deal with large-sized transactions, and retail ones, that deal with small-sized ones.

At the very least, a well-functioning monetary system has two properties.

First, technically, it will exploit the benefits of unifying the means of payment with the unit of account. The main benefit of a means of payment is that it allows any economy to function at all. In a decentralized exchange system, it underpins the quid pro quo process of exchange. And more specifically, it is a highly efficient means of "erasing" any residual relationship between transacting parties: they can thus get on with their business without concerns about monitoring and managing what would be a long chain of counterparties (and counterparties of counterparties). (7) The benefit of a unit of account is that it provides the simplest and most effective way of measuring relative prices, as it greatly reduces the number of relative prices that need to be known. (8) Unifying the two signifies that, by convention, the price of money relative to the unit of account is fixed at one. The benefit is that this greatly reduces the uncertainty about the amount of resources the means of payment can "buy." The residual uncertainty is that which surrounds changes in the prices of goods and services relative to the means of payment (i.e., the value of money).

Historically, we have seen cases where the unit of account and the means of payment have not coincided. But arguably this has generally reflected limitations of the monetary system. Think, for instance, of the coexistence of a multiplicity of settlement media in underdeveloped economic systems (e.g., in some ancient civilizations or in the early Middle Ages) or in fragmented monetary areas (e.g., in the Middle Ages and the Renaissance, notably in Italian city-states (Einaudi 1936; Cipolla 1956; Eichengreen and Sussman 2000). This strikes me as inefficient. Not surprisingly, it has been superseded over time. And in single currency systems, the two functions tend to become decoupled spontaneously only at very high inflation rates--a clear symptom of a dysfunctional monetary system (Heymann and Leijonhufvud 1995). (9) To me, all this indicates that the coincidence of the two functions is highly desirable. Thus, I don't agree with proposals to split the two. (10)

Second, and more fundamentally, a well-functioning monetary system will enjoy the solid trust of participants. To be sure, trust that people will accept the corresponding instrument as a means of payment and that the transfer will be effective are absolutely necessary for the system to function at all. But a well-functioning system requires more. It requires trust that the value of the instrument will be stable in terms of goods and services, as fluctuations generate uncertainty, and trust that its value will not change strongly in one direction or the other. What I have in mind here is not just inflation, which erodes the value of the means of payment, or deflation, which increases the value of the debts generated in the monetary system, but also outright defaults, notably on bank deposits (inside money). The role of trust is especially evident when the means of payment is irredeemable ("fiat money"), so that the issuer simply commits to "settle" the IOUs by issuing an equivalent amount of them. (11)

Naturally, ensuring...