“On money, debt, trust and central banking” – Claudio Borio

This paper by Claudi Borio (Head of the Monetary and Economic Department at the Bank for International Settlements) was published 2 years ago but is, I think, still worth reading. Borio states that the views are his (not BIS policy) but offers a central banking perspective on the qualities of a well functioning monetary system.

It covers a lot of familiar ground for anyone who has been reading about the nature and history of money but I found it useful for two reasons. One was the emphasis on the role of “Trust” in any effective monetary system and the institutional structure that underpins that trust. The other was the discussion of the role “elasticity of credit” plays in any well functioning monetary system and the related concepts of price and financial stability.

These issues (trust in the system and potential price instability) are ones that frequently come up in the current discussion of the role of crypto currency and stable coins. I am not yet ready to jump 100% onto the crypto bandwagon but do share the belief that there are legitimate concerns with the expansion of government debt that followed the Global Financial Crisis and has been exacerbated by the need to respond to COVID 19.

The paper is short and worth reading but the extracts copied below will also give you a flavour of its key messages.


This essay examines in detail the properties of a well functioning monetary system – defined as money plus the mechanisms to execute payments – in both the short and long run, drawing on both theory and the lessons from history. It stresses the importance of trust and of the institutions needed to secure it. Ensuring price and financial stability is critical to nurturing and maintaining that trust. In the process, the essay addresses several related questions, such as the relationship between money and debt, the viability of cryptocurrencies as money, money neutrality, and the nexus between monetary and financial stability. While the present monetary system, with central banks and a prudential apparatus at its core, can and must be improved, it still provides the best basis to build on.


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

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

My focus will be the on the monetary system, defined technically as money plus the transfer mechanisms to execute payments.3 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”, ie the extent to which the system allows credit to expand. 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 work in progress

I – Elements of a well functioning monetary system

At its most essential, a monetary system technically consists of (i) a unit of account, (ii) a means of payment (“settlement medium”) and (iii) 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.

Two points about this definition. 

For one, there is no explicit reference to the third well known function of money, ie 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. 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 (eg 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 (eg 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

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 decentralised 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). 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 … 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 (ie the value of money).

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

II – A well functioning monetary system: day-to-day operation

Two aspect of a well functioning monetary system in its day-to-day operation are worth highlighting. One is the need for an elastic supply of the means of payment; the other is the need for an elastic supply of bank money more generally. All this, in turn, points to the risk of overestimating the distinction between credit (debt) and money.

The central banks’ elastic supply of the means of payment is essential to ensure that (i) transactions are settled in the interbank market and (ii) the interest rate is controlled. The interbank market is a critical component of our two-tier monetary system, where bank customer transactions are settled on the banks’ books and then banks, in turn, finally settle on the central bank’s books. To smooth out interbank settlement, the provision of central bank credit is key. The need for an elastic supply to settle transactions is most visible in the huge amounts of intraday credit central banks supply to support real-time gross settlement systems – a key way of managing risks in those systems (Borio (1995)). But it also underpins the way central banks set interest rates – a process which is often misunderstood. It is worth considering this process in more detail, since it also sheds light on what is the ultimate anchor for credit creation.

There are two polar cases. In the first, the central bank satiates the market with bank excess reserves – the means of payment (scheme 2, right-hand panel). Then the demand for the means of payment becomes infinitely elastic at the rate paid on them, ie the rate on the central bank deposit facility: supply becomes irrelevant. In the second, the central bank meets exactly the demand for means of payment rather than satiating the market (scheme 1, left-hand panel). The key point here is that because the uncertainty regarding interbank settlement is minuscule and banks can count on the central bank to allow the system to settle by providing the necessary funds, the demand for bank reserves is, in effect, vertical at some frictional level, ie unresponsive to the interest rate. The central bank then simply sets the desired interest rate by signalling where it would like it to be. And it can do so because it is a monopoly supplier of the means of payment: it can credibly commit to provide funds as needed to clear the market …. What the example makes clear is that, at least under current institutional arrangements, there is no such thing as a well behaved demand for bank reserves, which falls gradually as the interest rate increases, ie which is downward-sloping.

But wait, one might argue: what about cash? Cash, too, is provided elastically, ie is purely demand-determined. In fact, the non-bank public would bring any excess to the banks; and the banks, in turn, would exchange any excess holdings for bank reserves. The central bank would have to oblige: this is what convertibility is all about.

This analysis is something any central banker responsible for implementation would find familiar. But it has not filtered through sufficiently to academia. When I first discovered it the mid-1990s, much to my disappointment I had to throw out of the window everything I had learnt in textbooks and at university on the topic.

Hence an implication that will play a bigger role later on. The monetary base – such a common concept in the literature – plays no significant causal role in the determination of the money supply (bank deposits with the non-bank public plus cash) or bank lending. … As has become increasingly recognised, the money multiplier – the ratio of money to the monetary base – is not a useful concept. In fact, in systems without reserve requirements the multiplier is, practically, infinite; and nothing calamitous has ever happened. Increasing bank reserves (the means of payment) beyond what markets want simply pushes interest rates to the deposit facility or, in its absence, to zero. It is like pushing on a string and could result in loss of control over interest rates (scheme 2). Bank lending reflects banks’ management of the risk-return trade-off they face, and bank transaction deposits the non-bank sector’s portfolio preferences.

Thus, the ultimate anchor of the monetary system is not the monetary base but the interest rate the central bank sets. Moreover, there is clearly an element of convention in how interest rates are set nowadays, ie in how one chooses the point along a de facto vertical demand curve for reserves

All this points to the critical role central banks play in ensuring the smooth functioning of the payment system, including as overseer (Borio (1995)). Indeed, historically the precursors of central banks were arguably the city-state chartered public banks established mostly in 1400–1600.18 They were set up to improve the efficiency of payment systems by providing a high-quality means of payment and centralising a number of clearing and settlement operations. Thus, they came into being well before central banks started acting as lenders of last resort under stress – commonly regarded as the beginning of the central banking era

Now, a high elasticity in the supply of the means of payment does not just apply to bank reserves, it is also essential for bank money. This money is created as a counterpart to the loans banks extend or assets they buy.20 Without it, the economy could not run smoothly. More generally, credit creation is all around us: some we see some we don’t (Borio (1995)). For instance, explicit credit extension is often needed to ensure that two legs of a transaction are executed at the same time so as to reduce counterparty risks (delivery versus payment in the case of securities, and payment versus payment in that of foreign exchange transactions): the party in question may need to borrow to bridge the gap. And implicit credit creation takes place when the two legs are not synchronised. Today’s economies are “credit-hungry”

In fact, the role of credit in monetary systems is commonly underestimated. Conceptually, exchanging money for a good or service is not the only way of solving the problem of the double coincidence of wants and overcoming barter. An equally, if not more convenient, option is to defer payment (extend credit) and then settle when a mutually agreeable good or service is available. In primitive systems or ancient civilisations as well as during the middle ages, this was quite common.21 For instance, in the feudal system a worker would receive a good from his landlord and pay later in kind, through his labour. It is easier to find such examples than cases of true barter

On reflection, the distinction between money and debt is often overplayed. True, one difference is that money extinguishes obligations, as the ultimate settlement medium. But netting debt contracts is indeed a widespread form of settling transactions. Needless to say, bank deposits constitute by far the bulk of all means of payment and are a form of debt. And even outside money, which is irredeemable, can be regarded as debt. This is so not just because the very instrument that counts as money is a liability (debt or “I Owe You” (IOU)) of the issuing agent. But also because, while not subject to legal default, like any form of money it is vulnerable to confidence crises – a flight to another currency – when the sovereign’s creditworthiness is in doubt. For all intents and purposes, this is equivalent to a deposit run and a default. It undermines the role of money as a unit of account and even as a means of payment – think, for instance, of dollarisation.

Borio argues that we can think of money as an especially trustworthy type of debt. Borio expands on this observation in a footnote which references Gorton’s and Holmström’s notion of debt as an information-insensitive asset, ie an asset whose (nominal) value is relatively insensitive to information about the condition of the issuer (see eg Holmström (2015) and references therein). . This argument sounds right to me (i.e. one could think of good money as an asset whose nominal value is highly (ideally perfectly) insensitive to information). Borio cites a number of factors that engineer this outcome to which I would add the preferred claim that bank deposits have on the assets in systems such as Australia (see here for a longer discussion of this point).

Put differently, we can think of money as an especially trustworthy type of debt. In the case of bank deposits, trust is supported by central bank liquidity, including as lender of last resort, by the regulatory and supervisory framework and varieties of deposit insurance; in that of central bank reserves and cash, by the sovereign’s power to tax; and in both cases, by legal arrangements, way beyond legal tender laws, and enshrined in market practice.

All this also suggests that the role of the state is critical.

At an even deeper level, money is debt in the form of an implicit contract between the individual and society. The individual provides something of value in return for a token he/she trusts to be able to use in the future to obtain something else of value. He/she has a credit vis-à-vis everyone and no one in particular (society owes a debt to him/her)

All this also suggests that the role of the state is critical. The state issues laws and is ultimately responsible for formalising society’s implicit contract. All well functioning currencies have ultimately been underpinned by a state, with the currency area often coinciding with a given political unit’s perimeter.26 Moreover, it is surely not by chance that dominant international currencies have represented an extension of powerful states – economically, financially and politically – from Byzantium’s solidus to today’s US dollar. That said, it is no secret that the relationship between the sovereign and the currency has been a chequered one, to say the least. The sovereign has often yielded to the temptation to abuse its power, undermining the monetary system and endangering both price and financial stability. This simply indicates that it is essential to put in place adequate safeguards. I will return to this point

III – A well functioning monetary system: the longer run

Price and financial instability amount to broken promises.

Having discussed the issues that arise concerning the need to generate trust in the day-to-day operation of the monetary system, it is now time to turn to those that arise in the longer run in the context of delivering price and financial stability

The previous analysis suggests that the concepts of price and financial stability are joined at the hip. They are simply two ways of ensuring trust in the monetary system. Inflation, deflation and price volatility induce instability in the value of money – and its close cousin, debt – in terms of goods and services, undermining its means-of-payment (and store-of-value). Financial instability effectively undermines it through the threat and materialisation of default, which can bring the payments system to a halt when bank deposits are involved. Price and financial instability amount to broken promises.

While, as concepts, price and financial stability are joined at the hip, the processes behind the two differ. Let’s look at this issue more closely

The process underpinning financial instability hinges on how “elastic” the monetary system is over longer horizons, way beyond its day-to-day operation. Inside credit creation is critical. At the heart of the process is the nexus between credit creation, risk-taking and asset prices, which interact in a self-reinforcing fashion generating possibly disruptive financial cycles (eg Borio (2014)). The challenge is to ensure that the system is not excessively elastic drawing on two monetary system anchors. One operates on prices – the interest rate and the central bank’s reaction function. … The other operates on quantities: bank regulatory requirements, such as those on capital or liquidity, and the supervisory apparatus that enforces them

The process underpinning price instability – as typically and, as I shall argue, somewhat misleadingly conceived – is best captured by the famous dictum: inflation is a monetary phenomenon. The process was described in very simple terms in the old days. An exogenous increase in the money supply would boost inflation. The view that “the price level is the inverse of the price of money” has probably given this purely monetary interpretation of inflation considerable intuitive appeal. Nowadays, the prevailing view is not fundamentally different, except that it is couched in terms of the impact of the interest rate the central bank sets.

This view of the inflation process has gone hand in hand with a stronger proposition: in the long run, money (monetary policy) is neutral, ie it affects only prices and no real variables. Again, in the classical tradition this was couched in terms of the money supply; today, it is in terms of interest rates.

But arguably, this literature, old and new, underestimates the role real factors play in the inflation process and overestimates the relevance of neutrality.

Now, no one can deny that monetary accommodation is necessary to sustain inflation. In this sense, just as with financial stability, credit creation and hence the expansion of the means of payment are relevant. Nor can anyone deny that, over time, more of a given effect of a change in the stance of monetary policy will be reflected in prices. The empirical evidence is convincing.

But arguably, this literature, old and new, underestimates the role real factors play in the inflation process and overestimates the relevance of neutrality. Let me mention just three analytical reasons and three pieces of empirical evidence, in that order

First, once we recognise that money is fundamentally endogenous, analytical thought experiments that assume an exogenous change and trace its impact are not that helpful, if not meaningless. They obscure, rather than illuminate, the mechanisms at work.

Second, once we recognise that the price of money in terms of the unit of account is unity, it makes little sense to think of the price level as the inverse of the price of money. This conflates the price of money with the value of money, in real terms: it is simply a succinct way of stating “what money can buy”. But any financial asset fixed in nominal terms41 has the same property.  As a result, thinking of inflation as a purely monetary phenomenon is less compelling. 

Finally, once we recognise that the interest rate is the monetary anchor, it becomes harder to argue that monetary policy is neutral, at least over relevant policy horizons. After all, the interest rate is bound to affect different sectors differently, resulting in different rates of capital accumulation and various forms of hysteresis. And for much the same reason, it is arguably not that helpful to make a sharp distinction between what affects relative prices and the aggregate price level. In practice, not least because prices move at different speeds and differ in their flexibility, changes in the overall price level and inflation result from a succession of relative price changes. It stands to reason that, at low inflation rates, the “pure” inflation component, pertaining to a generalised increase in prices, would be smaller, so that the distinction between relative and general price changes becomes rather porous. This, in turn, opens the door for real factors to play a bigger role than normally assumed. It may not be a coincidence that many central banks have been confounded by the behaviour of inflation for some time

Turning to the empirical evidence, this comes from recent decades as well as from back in history.

First, a growing body of work has found that the globalisation of the real economy (trade integration) has played an underappreciated role in exerting persistent downward pressure on inflation over the last 20 years or so …

Second, turning to monetary neutrality, recent research going back to the 1870s has found a pretty robust link between monetary regimes and the real interest rate over long horizons. By contrast, the “usual suspects” seen as driving saving and investment – all real variables – do not appear to have played any consistent role (Borio et al (2017)). Given the trends in the data, they work reasonably well from the early 1980s onwards, at least qualitatively, but the relationships do not hold before then. Over the longer sample, no systematic pattern emerges – a sign that the relationships in the more recent period may be spurious.

Finally, studies indicate that financial booms tend to misallocate resources, not least because too many resources go into sectors such as construction, which depresses productivity growth persistently once the boom turns to bust (Borio et al (2016) and references therein). Furthermore, a large amount of empirical work indicates that the financial busts that follow booms may depress output for a long period, if not permanently. It is hard to imagine that interest rates are simply innocent bystanders. At least for any policy relevant horizon, if not beyond, these observations suggest that monetary policy neutrality is questionable.

Given that the processes underlying price and financial stability differ, it is not surprising that there may be material tensions between the two objectives, at least in the near term. Indeed, since the early 1980s changes in the monetary system have arguably exacerbated such tensions by increasing the monetary system’s elasticity (eg Borio (2014)). This is so despite the undoubted benefits of these changes for the world economy. On the one hand, absent a sufficiently strong regulatory and supervisory apparatus – one of the two anchors – financial liberalisation, notably for banks, has provided more scope for outsize financial cycles. On the other hand, the establishment of successful monetary policy frameworks focused on near-term inflation control has meant that there was little reason to raise interest rates – the second anchor – since financial booms took hold as long as inflation remained subdued. And in the background, with the globalisation of the real side of the economy putting persistent downward pressure on inflation while at the same time raising growth expectations, there was fertile ground for financial imbalances to take root in.

While the near-term tensions are material, adjustments to the monetary system can help reconcile them over the longer term. Extending policy horizons is essential. Financial imbalances build up only gradually: they pertain to stocks (balance sheets) rather than flows. Typically, they grow over periods that are considerably longer than those associated with business cycles ….

Strong monetary system anchors are crucial. As argued in more detail elsewhere, putting them in place requires action on two fronts. It calls for effective regulation and supervision. This must be so both in relation to banks (and other financial institutions) assessed on a standalone basis (the so-called “micro-prudential” perspective) and with respect to the system as a whole (the so-called “macroprudential” perspective). And it calls for monetary policy regimes that secure long-term price stability while taking advantage of any room for manoeuvre to respond to financial stability threats

Still, all this would be to no avail unless the creditworthiness of the state was ensured. This is the ultimate linchpin of the monetary system. As history demonstrates, failing to ensure it would undermine both price and financial stability. Granted, central bank independence is precious and can provide a degree of insulation. And a strong and independent regulatory and supervisory apparatus can help too. But, even combined, they cannot suffice in the longer run: the monetary system would not be able to survive. The dam would simply be too fragile to hold back the rising water

Still, all this would be to no avail unless the creditworthiness of the state was ensured. Combining adequate monetary and regulatory anchors with the sustained creditworthiness of the state is what in BIS (2018) is referred to as a “macro-financial stability framework

It is sometimes argued that, assuming the sovereign remains creditworthy, the private sector could deploy sufficiently strong anchors; central banks and supervisory authorities could be dispensed with. By implication, there would be no need for a monetary policy to actively manage the currency. Fully functioning central banks did not spread until the second half of the 19th century, but there were long periods of relative price stability while financial crises were not necessarily more frequent or severe than they are now. Free banking is sometimes recalled with nostalgia.

I find this conclusion highly doubtful. In particular, the evaluation of free banking is overly rosy. For instance, some scholars have argued that even the Scottish experience is not well understood: according to them, the degree to which banks depended on London and the Bank of England has been underestimated (eg Goodhart (1988)). More to the point, I cannot imagine that a completely laissez-faire solution could meet today’s challenges. Our current financial system is several orders of magnitude larger and more complex. Competitive pressures are too fierce. Risk-taking incentives are too great. The role of the safety net in abating them is overestimated: to my mind, the experience suggests that during financial booms it is not so much the reassuring comfort of safety nets that is at work, but the temptation to believe that “this time is different”, to quote that felicitous expression (Reinhart and Rogoff (2009)). Banks, other financial institutions and businesses alike do not face sufficient discipline during financial expansions; rather, they enjoy indiscriminate and misplaced trust. And should a financial crisis erupt –sooner or later, one will – I simply cannot imagine it could be handled effectively without the central bank as lender of last resort. The private sector is not well placed to perform this function

Underline (red), TR:
Banks, other financial institutions and businesses alike do not face sufficient discipline during financial expansions; rather, they enjoy indiscriminate and misplaced trust.  And should a financial crisis erupt –sooner or later, one will – I simply cannot imagine it could be handled effectively without the central bank as lender of last resort. 

None of this means that the current system is perfect – far from it. Nor that what we have today is the final destination. But the present system encapsulates many of the valuable lessons we have learnt during a long journey through history – a sometimes painful journey of trial and error, with setbacks and false starts. Those lessons should not be unlearnt.

Underline (red), TR:
the present system encapsulates many of the valuable lessons we have learnt during a long journey through history – a sometimes painful journey of trial and error, with setbacks and false starts. Those lessons should not be unlearnt. 

The importance of a lender of last resort in a monetary system to help manage stress is obvious. This is consistent with the view that the function emerged to overcome the inadequacy of previous arrangements (eg Goodhart (1988)), with one well known example being the creation of the Federal Reserve in 1913, following the 1907 crisis, and the establishment of a special commission that drew on the European experience (see also Smith (1936)). This general view, however, has not gone unchallenged. For instance, Calomiris et al (2016) stress the role of political expediency. Bagehot (1873) himself was of the same opinion concerning the Bank of England; not surprisingly, he was a supporter of free banking. Interestingly, this contrasts with Thornton (1802), the other famous scholar of the lender of last resort function


The monetary system is the cornerstone of an economy. Not an outer facade, but its very foundation. The system hinges on trust. It cannot survive without it, just as we cannot survive without the oxygen we breathe. Building trust to ensure the system functions well is a daunting challenge. It requires sound and robust institutions. Lasting price and financial stability are the ultimate prize. The two concepts are inextricably linked, but because the underlying processes differ, in practice price and financial stability have often been more like uncomfortable bedfellows than perfect partners. The history of our monetary system is the history of the quest for that elusive prize. It is a journey with an uncertain destination. It takes time to gain trust, but a mere instant to lose it. The present system has central banks and a regulatory/supervisory apparatus at its core. It is by no means perfect. It can and must be improved. But cryptocurrencies, with their promise of fully decentralised trust, are not the answer.

Paraphrasing Churchill’s famous line about democracy, “the current monetary system is the worst, except for all those others that have been tried from time to time”.

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