Is the title of an interesting paper by Claudio Borio (Head of the Monetary and Economic Department at the BIS). This link will take you to the paper but my post offers a short summary of what I took away from it.
Overview of the paper
Borio’s examination of the properties of a well functioning monetary system:
- stresses the importance of the role trust plays in this system and of the institutions needed to secure that trust.
- explores in detail the ways in which these institutions help to ensure the price and financial stability that is critical to nurturing and maintaining that trust.
- focuses not just on money but also the transfer mechanisms to execute payments (i.e. the “monetary system”)
“My focus will be the on the monetary system, defined technically as money plus the transfer mechanisms to execute payments. 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.”Borio: Page 1
In the process, he 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.
Borio highlights three key points he wants you to take away from his paper
First, is the fundamental way in which the monetary system relies on trust and equally importantly the role that institutions, the central bank in particular, play in ensuring there is trust in the system. At the technical level, people need to trust that the object functioning as money will be generally accepted and that payments will be executed but it also requires trust that the system will deliver price and financial stability in the long run.
Second, he draws attention to the “elasticity of credit” (i.e. the extent to which the system allows credit to expand) as a key concept for understanding how the monetary system works. It is well understood that allowing too much credit expansion can cause serious economic damage in the long run but elasticity of credit, he argues, is essential for the day to day operations of the payment system.
Third, the need to understand the ways in which price and financial stability are different but inexorably linked. As concepts, they are joined at the hip: both embody the trust that sustains the monetary system. But the underlying processes required to achieve these outcomes differ, so that there can be material tensions in the short run.
These are not necessarily new insights to anyone who has being paying attention to the questions Borio poses above, but the paper does offer a good, relatively short, overview of the issues.
I particularly liked the way Borio
- presented the role elasticity of credit plays in both the short and long term functioning of the economy and how the tension between the short and long term is managed,
- covered the relationship between money, debt and trust (“we can think of money as an especially trustworthy type of debt”), and
- outlined how and why the monetary system should be seen, not as an “outer facade” but rather as a “cornerstone of an economy”
The rest of this post contains more detailed notes on some, but not all, of the issues covered in the paper.
Elements of a well functioning monetary system
The standard definition of money is based on its functions as
1) Unit of account
2) Means of payment
3) Store of value
Borio expands the focus to encompass the “monetary system”as a whole, introducing two additional elements. Firstly the need to consider the mechanisms the system uses to transfer the means of payment and settle transactions. Secondly, the ways in which the integrity of the chosen form of money as a store of value is protected.
” 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 …. 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”Borio: Page 3
The day to day operation of the monetary system
Borio highlights two aspects of the day to day operations of the monetary system.
- The need for an elastic supply of the means of payment
- The need for an elastic supply of bank money more generally
In highlighting the importance of the elasticity of credit, he also draws attention 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.
“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)).”Borio: Page 5
“…we can think of money as an especially trustworthy type of debt”
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.Borio: Page 9
Once you understand the extent to which our system of money depends on credit relationship you understand the extent to which trust is a core feature which should not be taken for granted. The users of the monetary system are relying on some implied promises that underpin their trust in it.
“Price and financial instability amount to broken promises.”Borio: Page 11
While the elasticity of money creation oils the wheels of the payment system on a day to day basis, it can be problematic over long run scenarios where too much elasticity can lead to financial instability. Some degree of elasticity is important to keep the wheels of the economy turning but too much can be a problem because the marginal credit growth starts to be used for less productive or outright speculative investment.
The relationship between price and financial stability
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
Borio: Page 12
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.
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.Borio: Page 16
Borio concludes that the monetary system we have is far from perfect but it is better than the alternatives
Borio concludes that the status quo, while far from perfect, is worth persisting with. He rejects the cryptocurrency path but does not explicitly discuss other radical options such as the one proposed by Mervyn King, in his book “The End of Alchemy”. The fact that he believes “… the distinction between money and debt is often overplayed” could be interpreted as an indirect rejection of the variations on the Chicago Plan that have recently reentered public debate. It would have been interesting to see him address these alternative monetary system models more directly.
In Borio’s own words ….
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.55 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”. Page 18
The topic is not for everyone, but I found the paper well worth reading.