One of the key
elements of the Just Third Way is monetary reform, to which is added essential
tax reforms. The problem is that very
few people understand money. Today we
take a look at three concepts about which many people have ideas that may not
be entirely accurate, monetization, fractional reserve banking, and the
Quantity Theory of Money.
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| Georg Friedrich Knapp |
Monetization. The standard definition of “monetization” in
most of today’s schools of economics is “to convert (a debt, especially the
national debt) into currency, especially by issuing government securities or
notes.” This definition is rooted in the
principles of Keynesian economics (especially the “State Theory of Money” of
Georg Friedrich Knapp that assumes only the State can create money) and
implicitly rejects Say’s Law of Markets.
The Just Third
Way understanding of monetization is the process of turning something of value
into the medium of exchange, i.e., into “money,” to facilitate economic
transactions. Anything that exists and
that has a measurable value can be turned into money, including promises to
produce marketable goods and services in the future.
To be just and
legitimate within the Just Third Way framework, the creators of money must have
ownership of that which is monetized, and it must have measurable value, even
if only among the parties to a specific transaction. Government debt fails to meet the Just Third
Way criteria for monetization on both counts, as it is backed by future tax
collections that the government does not yet own, and the present value of
future tax collections cannot be known with the necessary degree of certainty.
Thus, if two
parties agree between them to trade one good for another in a barter
transaction, monetization has occurred, even if the entire transaction has been
carried out without reference to any unit of currency. In an economy that has moved beyond barter
and uses currency (“current money” measured in terms of a generally recognized
unit of value), economic transactions are usually measured in terms of the recognized
unit of value (e.g., “dollar,” “pound,” “peso,” etc.), and
special institutions called commercial or mercantile banks regulated by a
central bank that links the commercial or mercantile banks together into a
network to maintain uniformity and stability function to turn existing and
future things of value into currency or the equivalent, such as demand deposits
(checking accounts).
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| Popular impression, but wildly innacurate |
Fractional
Reserve Banking. Bank reserves are
funds held in cash at a commercial bank (“vault cash”) or on deposit by a
commercial bank at a central bank to cover transactions demand for cash,
primarily any obligations of the bank that are presented for payment. Because it is unlikely that all of a bank’s
obligations will be presented for payment at one time, a bank need not hold all
of its financial assets in cash at the bank or on deposit at the central bank
(a check drawn on which being legally the same as cash), and may keep an amount
equal to a fraction of its outstanding obligations in the form of cash or on
deposit at the central bank.
With modern
communications and a central banking system, a legally imposed fractional
reserve requirement is an anachronism, as any commercial bank can either borrow
reserves on demand through the central bank, or sell some of its financial assets
for cash to the central bank immediately to meet any or all of its
obligations. Just Third Way monetary
reforms include a 100% reserve requirement, ensuring coverage of all of a commercial
bank’s obligations by selling all offsetting financial assets to the central
bank (commercial banks create money by accepting assets and issuing offsetting negotiable
claims against the assets), which issues cash or creates demand deposits at the
central bank to the full amount of the bank’s financial assets, and thus its obligations.
This allows loans
to be made based exclusively on the creditworthiness of the project itself, not
any arbitrary amount established by regulators or politicians. The erroneous belief that commercial banks make
loans out of reserves encourages banks to make bad or questionable loans when
there are “excess” fractional reserves, and prevents banks from making good
loans if extending credit even for the most creditworthy borrower would cause
the amount of the bank’s financial assets to exceed the fractional reserve
requirement.
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| Adam Smith, Banking Principle economist. |
Quantity
Theory of Money. The Quantity Theory
of Money is that the money supply and the price level in an economy are in
direct proportion to one another. In “Currency
Principle” schools of economics such as Keynesian, Monetarist/Chicago, and
Austrian, this means that when there is a change in the
supply of money, there is a proportional change in the price level and vice versa,
with the price level being affected by the “velocity” of money (the average
number of times each unit of currency is spent in a year) and the number of
transactions.
In “Banking Principle” schools of economics such as “Smithian”
classical economics and binary economics, the money supply is in direct
proportion to the price level, again with the price level being affected by the
velocity of money and the number of transactions, but the relationship of price
level to the money supply is not reciprocal, that is, absent artificial
manipulation of the money supply such as issuing currency backed by government
debt or altering or changing the standard of value, the price level, the
velocity of money, and the number of transactions determine the money supply,
the money supply does not determine the price level, the velocity of money, and
the number of transactions. This
relationship is expressed mathematically in both Currency Principle and Banking
Principle economics in the Quantity Theory of Money equation:
M
x V = P x Q
where M is the money supply, V is the
velocity of money, and Q is the number of transactions.
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