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Drawing the line (continued)

Following up on two posts ago, my own view is that the most important line to be drawn in discussing monetary aggregates is between the monetary base and everything else. The monetary base (M0) is the medium accepted for final payment within the domestic monetary system. In the United States and most other countries today, it comprises notes issued by the central bank, coins issued by the central bank, and demand deposits of commercial banks at the central bank. When held by commercial banks rather than the public, the notes and coins just mentioned count as part of their reserves, along with their demand deposits at the central bank.

In earlier posts I have stressed the importance of keeping in mind the difference between money in the sense of the monetary base on the one hand and broader measures of the money supply, which are various forms of credit, on the other hand. The public colloquially calls all of them money, and bank deposits, for instance, do serve as generalized media of exchange. The medium of exchange function is not all there is to money, though. Money as opposed to credit constitutes final payment for a good. When a Wells Fargo Bank customer writes a check to a Citibank customer, the transfer of deposit credit constitutes payment as far as they are concerned, but it is not final payment as far as their banks are concerned. Wells Fargo has to transfer reserves (monetary base) to Citibank to the extent that it lacks offsetting claims on Citibank.

There can be complications to the story. Under a gold standard operated by a central bank, for instance, the monetary base is final payment within the domestic monetary system but gold is final payment internationally. That is a wrinkle best left for another time.

Besides the distinction between final payment and less-than-final payment, another reason for distinguishing between the monetary base and the types of credit that constitute broader measures of the money supply is that historically, it has been the case often (much more often than not during the last century) that the monetary base is supplied monopolistically while the types of credit that constitute broader measures of the money supply are supplied basically competitively, though often subject to many distorting regulations such as minimum reserve requirements and government-imposed credit allocations. The credit aggregates are somewhat substitutable for one another in a way that they are not substitutable for the monetary base. One credit technology may entirely replace another, as checks and wire transfers have done to bills of exchange. A credit technology may reduce the demand for the monetary base, as interbank clearing has done, but it is does not eliminate demand for the monetary base unless trust is so perfect that banks are willing to hold one another’s IOUs perpetually instead of demand final settlement of debts outstanding.

My reading of the monetarists is that for them, the line between M0 and M1 or M2 is in practice less important than the line between M2 and M3—not neglected, just less important. They consider the statistical correlations between monetary aggregates and economic activity to be highly important, while for me they are less important than the underlying market process—or, in the case of a monopolistically supplied monetary base, the nonmarket process.

I also consider that the Divisia aggregates give a better sense of the substitutability among credit aggregates than making a strong distinction between some aggregates and others, as the monetarists have done, as Murray Rothbard did in America’s Great Depression, and as subsequent Austrian efforts inspired by his effort have done.

MISCELLANEOUS: Because of the interest my Bitcoin post aroused, I will collect my thoughts on the subject and write something substantial about it. I have also promised Mike Sproul a post or posts on the "backing" theory of money with right of rebuttal for him and will eventually get around to it. Finally, on the subject I discussed here, J.P. Koning's Moneyness blog has had a number of relevant posts and is worth reading for whatever else he writes as well.

ADDENDUM: In some countries, including the United States, coins today are issued by the treasury as notes were in the past. These details do not change the overall story. Also, the theory of free banking contends that for the monetary system to most nearly achieve equilibrium, the monetary base as well as the provision of credit based upon it should be competitive. I thought that on this particular blog, the point would be obvious, but apparently not so.


  1. I really appreciate your distinctions between what we might call money and a bunch of 'credit-substitutes'.
    I'm really not sure of the significance of the whole discussion here, though – why do we draw any line in the sand?

    The only part of the monetary base, or of money generally, that is actually issued by the sovereign into the money and banking system is the coins by Treasury (US).
    As both FRNs and bank-credit enter economic circulation through the private banking system, they are both really private bank money – though the FRNs are printed FOR the private bankers at cost by the government.
    As these coins represent a tiny fraction of one-percent of the overall money supply, it is safe to say that all money is issued into existence by the private bankers.
    But, again. So what?
    And what is the real significance of 'reserves' in the money system?
    To me, they are a throwback to gold reserves for the money system – there being no gold standard today, why are there reserves?
    What are reserves? A CB accounting construct.
    What they do today is to provide balance to the financial statements of the bankcorporations in their transactions with the Fed as national paying agent.
    Otherwise, they're useless.
    The future will undoubtedly see a move to sound money, though we may disagree about what that means.
    Reserves add nothing to soundness, as recent history has shown.
    It's past time to start thinking about non-reserve based currency systems.

    1. I disagree that only coins are issued by the sovereign in the United States. The Federal Reserve System is part of the government. So are other central banks around the world. Even though some have a degree of private ownership, control in every case rests with the government.

      1. But the legal structure provided by the Constitution is different than all other countries in the world, and therefore so is the legal relationship between the U.S. central bank and the Treasury. No doubt the privately-owned Fed provides important and vital services to the U.S. government, but when it comes to the money issuance/creation function, Congress and the Treasury alone hold power over creation of the "medium accepted from final payment" (M0), i.e., current coin, regardless of the metal type used.

        Also, let's not forget where the Fed gets its corporate charter, its very legal right to exist. Again, it's the peoples Congress and their Treasury Department, which entities are not motivated by private gain or rent-seeking.

        1. There are two theories under which the Federal Reserve Corp. could be allowed to issue the "medium accepted for final payment" (M0) or metallic coined money, and both would be treasonous in my view.

          First, one could argue that the power "to coin money" in Article 1, Section 8, Clause 5 generally means the power "to create" any kind of money, not necessarily metallic coinage.

          Second, one could argue that the power "to coin money" in Article 1, Section 8, Clause 5 is not an exclusive grant of power to Congress, and therefore the privately-owned Federal Reserve Corp. can also issue its own metallic coins.

  2. What's missing here is the idea of a permanent float of money that is never really paid off. In 1700, people called banknotes 'credit money', while only coin was 'base money', the argument being that every banknote was ultimately paid in coin. About 100 years later, people realized that there was a permanent float of banknotes that was never really paid off, and so banknotes were often 'final payment', and should be counted as part of the money supply. In 1840, people called checking account dollars 'credit money', while coins and banknotes were considered base money, the argument being that every checking account dollar was ultimately paid in notes or coin. By 1920, people recognized that there is a permanent float of checking account dollars that are never really paid off and are often used as final payment, and this permanent float of checking account dollars was recognized as money. Not as base money, but as M1, money nonetheless. Since 1950, people have excluded credit card dollars from any definition of the money supply, on the grounds that every credit card dollar is ultimately paid with a check, a note, or a coin. There is, as yet, no real recognition that there is s permanent float of credit card dollars, which is also money.

    In every case, people have been trying to draw the wrong lines in the wrong places. What matters is who issued the money and whose liability it is. Not how long the money happens to sit around before being spent.

  3. "The monetary base (M0) is the medium accepted for final payment within the domestic monetary system. In the United States and most other countries today, it comprises notes issued by the central bank, coins issued by the central bank, and demand deposits of commercial banks at the central bank."

    Kurt, for what it's worth, my research shows that Jefferson, Madison and other framers intended that only that metallic Treasury-direct coin would be "the medium accepted for final payment" (MO) in the U.S. This view is also reflected by the eight Legal Tender Cases (1869-1884). Granted, this would be easier to see if current coin were made of precious metals, but the legal effect is the same, even with our current cheap metal current coin.

    Also, I think you meant this, but our central bank (the Fed) merely distributes current U.S. coin as fiscal agent for Congress and the Treasury Department. The Fed does not issue or mint coins directly, as it has no such power.

    As Justice Field said in the final legal tender case, Juilliard v. Greenman (1884): "The promise of a thing (promissory notes) cannot be made equivalent to the thing itself (current coin)."

  4. Surely the main policy-related reason to focus on the monetary base is that it is under the control, in principle, of the central bank/issuing authority. Thus it seems to me that monetary base control is the only way to build a stable monetary regime under fiat money – assuming the issuing authority is constitutionally constrained to a growth rate for the base following a Friedmanite rule with minimal discretion; for story on this, see

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