Introduction

Abstract

This book is a translation and adaption of the Dutch report ‘Geld en schuld. De publieke rol van banken’, published by the Netherlands Scientific Council for Government Policy (WRR). This report was the result of a formal request by the Dutch Minister of Finance for an advice on the functioning of the monetary system, as suggested in a motion adopted by the Dutch Parliament during a debate on money creation. In this introductory chapter, we first briefly introduce money and debt before discussing the role of trust and dynamism in the financial monetary system. The introduction ends with an overview of the book.

Money, as the saying goes, makes the world go round. Everybody uses it; our modern societies would not function without it. Credit is just as crucial, as borrowing allows businesses to invest and consumers to buy goods and services today against their income tomorrow. But although money and debt are central in our societies and to our welfare, how they actually function is not easily understood.

The financial crisis of 2007–2009 and its social, economic and political consequences have led to debates in many countries about fundamental reform of the financial-monetary system. Citizens’ initiatives – such as Positive Money in the United Kingdom – have pushed for a debate on a fundamentally different monetary system, called the sovereign money system. Along the same lines, Martin Wolf, one of the best-known columnists at the Financial Times, has called for an alternative monetary system. Economists at the International Monetary Fund (IMF) and the Bank of England (the UK central bank) are conducting research in this area. The Icelandic parliament has drawn up a proposal on this subject and in Switzerland a referendum was held in June 2018 on the similar Vollgeld initiative, in which 24% of voters supported it and 76% were opposed.¹

In the Netherlands, the citizens’ initiative Ons Geld (‘Our Money’) has placed monetary reform squarely on the public and political agenda. In 2015, the initiative – inspired by a popular theatre play that portrayed a financial system ridden by greed, elitism, instability and injustice – proposed placing money creation exclusively in public hands and gathered more than 120,000 signatures. In the ensuing Parliamentary debate in March 2016, a motion was adopted requesting the government to seek advice from the Netherlands Scientific Council for Government Policy (WRR) on the advantages and disadvantages of different monetary systems (see Box 1.1). The WRR published this report (in Dutch) in January 2019. This book is the translation of this report.

FormalPara Box 1.1 Motion Concerning a Request for Advice

“The House

having heard the deliberations,

noting that a deeper investigation into the role and functions of banks in money creation and other functions is necessary;

considering that there is a need for a banking system with fewer risks for savers and the taxpayer;

requests the government to seek an advice from the Netherlands Scientific Council for Government Policy (WRR) on the operation of the monetary system and all forms of money creation by banks and to include in any event the advantages and disadvantages of alternative systems of money creation and the extent of seigniorage,

and returns to the day’s agenda.

Omtzigt

Merkies”

The proposal for an alternative system casts light on a fact that will surprise many people, including many bank employees: most of our money is not created by governments or central banks, but by commercial banks. Banks create new money when they grant loans; while money is destroyed when loans are repaid (we explain this in Chap. 2). This means that the creation of money in our current system is inextricably linked to the creation of debt. Money and debt are in many ways two sides of the same coin. That means strong growth in debt – of concern to many international institutions and economists – cannot be seen in isolation from growth in the money supply.²

Before the financial crisis, many analysts paid scant attention to money and debt. Although by some measures the size of the financial sector had come to overshadow that of the real economy, many persisted to see money and debt as an insignificant ‘veil’ over economic activity, one without notable effects on the real economy. The financial sector generally did not feature in the macroeconomic models used for policy analyses (for example by the CPB, the Netherlands Bureau for Economic Policy Analysis). Economic models disregarding financial risks dominated education and policy discussions, while fundamental macroeconomic research devoted scant attention to the role of money and debt.³

Citizens’ initiatives are rightfully calling for greater attention to the role of money and debt in our societies which, as pillars of the financial system, have far-reaching effects. In what follows, we briefly introduce money and debt (Sects. 1.1 and 1.2) before discussing the role of trust (Sect. 1.3) and dynamism in the financial monetary system (Sect. 1.4). The introduction ends with an overview of the report (Sect. 1.5).

1.1 What Is Money?

There is no denying that views on money are as difficult to describe as shifting clouds (Schumpeter⁴)

What is money? Is it ‘the thing that makes the world go round’ or ‘the root of all evil’? Although money pervades our daily lives, it is much harder to define than we might expect. Even economists have difficulty identifying how and why money functions in capitalist economies.⁵

Money is first and foremost an (implicit) agreement between people and therefore a social construct.⁶ An asset can only serve as money when people are confident that others will accept it as such.⁷ The value of money is ultimately based not on the material of which it is made but on the confidence that it will be accepted by others.⁸ Over the course of history, money has therefore taken many different forms: coins, shells, salt, coral, banknotes, and strings of ones and zeros in computer systems.

We take trust in money for granted to such an extent that we do not question where this trust comes from. Although largely a question of habit, trust in money does not appear out of thin air; it must be generated and maintained.⁹ The mechanisms to do so depend on the system. In systems where money is made of materials that have value independent of their use as money – for example coins made of precious metals – these will include the verification of precious metal content, markings on coins attesting that they are genuine, and legal and statutory frameworks that for example criminalize counterfeiting. Such institutional frameworks are vital in systems such as ours where the material from which money is made has no value. For bank deposits, trust is generated by factors such as the deposit guarantee system, banking supervision and the availability of liquidity support for banks.

There are various theories on the origins of money.¹⁰ The leading explanation is that money originated as a response to the inefficiencies of barter trade.¹¹ But as persuasive as this argument sounds, it is not backed by historical evidence.¹² Others argue that money has its origins in debt relationships when promissory notes became dissociated from the issuer and recipient and began circulating as a means of payment for goods and services.¹³ Yet others emphasize the role of the state and religious authorities, with money originating from the taxes (or offerings) collected by these institutions.¹⁴

These historical accounts offer different perspectives on money, each with consequences for how money is understood. Those who see money as a response to the inefficiencies of bartering emphasize its spontaneous emergence; Carl Menger emphatically argued that ‘no one invented money’.¹⁵ When the emergence of money is attributed to debt, the emphasis falls on social relationships, particularly between creditors and debtors.¹⁶ Accounts that focus on the role of the state and religious authorities emphasize the role of these institutions in how money functions.

In economics, it is common to focus on the functions of money: as a means of payment, as a store of value, and as an accounting unit.¹⁷ Money is, first and foremost, what society accepts as a general means of payment. It can be used to purchase products and services, pay wages, settle debts, buy financial instruments such as shares, and to pay tax. Money is thus (undifferentiated) purchasing power. As a means of payment, it is crucial that money can be transferred from one person to the next without affecting its utility; that it is divisible and can be used to pay different amounts; and that its value is sufficiently stable. People will accept a means of payment only if it can be used later to purchase something of comparable value.

Value stability gives rise to money’s second function: as a means of saving (store of value). Since an asset can only serve as money if it largely retains its value over time, people may decide to keep money for a longer period. This in turn imposes another requirement on money: it must not be easily debased. While shares, bonds, jewellery or real estate can all serve as a means of saving, money is unique in that it can be used almost immediately as a means of payment. In the jargon, money is a highly ‘liquid’ means of saving, whereas jewellery is not. Saving by means of money also means more certainty – or at least running different risks – than by, for example, owning shares.

Third, money serves as a measuring or accounting unit, allowing comparisons between things that are completely different. Although a loaf of bread and an IPhone have little in common, their price can easily be compared. It also allows comparisons at the macro level, for example between countries’ gross domestic product. This is again associated with money’s first function: as a general means of payment, it is essential that services, products, property, financial instruments and taxes can be expressed in the same units.¹⁸

In this report, we consider money to be what is generally accepted as a means of payment.¹⁹ On the basis of this definition, money today mainly consists of cash (notes and coins) and the instantly available funds in bank payment and savings accounts. There are also forms of quasi-money (such as deposits fixed for longer periods) which may or may not count as money. Even more broadly, certain short-term debts sometimes count as money.

The statistics we refer to in this report are based on three different monetary aggregates.²⁰ M1 is the narrowest definition of the money supply: it includes all cash and demand deposits at banks. M2 and M3 are wider definitions that include savings and for example shares in money market funds (see Table 1.1). These broader definitions include financial instruments that are, strictly speaking, not a means of payment but which can be easily turned into a means of payment with no or hardly any loss in value.

Table 1.1 Monetary aggregates

The current broad monetary aggregate (M3) comprises 7% cash, 39% bank deposits that can be used to make payments (deposits in payment accounts) and 51% deposits with a maturity of less than two years or a notice period of less than three months (savings deposits). Other financial resources make up 3% of M3 (see Fig. 1.1).

Fig. 1.1

Composition of the money supply

September 2018, € billions

Source: DNB table 5.4

These official definitions of the money supply can differ from what actually functions as money. Innovations in the financial world can lead to new products that function as money or which can easily be converted into money. The boundaries around what constitutes money are thus fluid and far from clear-cut, as we see in the emergence of cryptocurrencies such as Bitcoin (see Box 1.2)

Box 1.2 Is Bitcoin Money?

So-called ‘cryptocurrencies’ – digital currencies generated by cryptography, the writing of computer codes – have recently attracted a great deal of attention. The best-known among them, Bitcoin, was launched in October 2008 just after the fall of Lehman Brothers. Bitcoin’s developers hoped it would become an alternative to dominant forms of money that depend on governments, central banks and commercial banks. Trust in Bitcoin would not depend on trust in these institutions but (so it was claimed) on objective, rational, incorruptible mathematical calculations in a decentralized, shared and publicly accessible accounting system.

Is Bitcoin money? As things stand now, it does not fulfil money’s three functions as outlined above. The ability to use Bitcoin as a means of payment remains extremely limited²¹; its value is volatile, having risen to over $20,000 in December 2017 before plunging to around $6,000 in the summer of 2018. This volatility makes Bitcoin unsuitable as a means of saving, although not as a means of speculation.²² Finally, it has limited use as an accounting unit as only a handful of products and services quote their prices in Bitcoins. Anyone who wants to use Bitcoins needs a real-time app to see how much they are worth in dollars or euros.

Cryptocurrencies remain in their infancy; we do not know what the future has in store. Nevertheless, the Bitcoin example reveals the difficulties of creating a stable currency. The limited number of Bitcoins that can enter into circulation and decentralized verification techniques do not guarantee a stable and reliable currency. Mathematical methods for generating trust currently have clear limits. Trust in a currency is largely based on its stability. The euro, the dollar and many other currencies are backed by institutions whose explicit purpose is to provide guarantees and maintain stability. The question is whether a cryptocurrency without such institutional backing can ever become an alternative to these forms of money.

1.2 What Is Debt?

Although the role of debt in the economy is frequently discussed, the precise meaning of the term is often far from clear. Discussions often become confused as debt is framed not only in economic but in moral terms.²³ This applies particularly to Dutch and German, where the word schuld is used both for an obligation to another party (debt) and for responsibility for culpable acts (guilt). Many religions view debt as pernicious for both lenders and borrowers. The Bible states: “Let love be your only debt” (Romans 13:8) and “The borrower is servant to the lender” (Proverbs 22:7). Islam prohibits interest, which in some interpretations is equated with usury.²⁴ In Europe, interest was considered pernicious for many centuries.

At the same time, investments facilitated by debt are crucial for economic development. According to Ferguson, credit and debt rival all other technological innovations in fuelling the development of our civilization.²⁵ Debt enables the borrower to anticipate future income from employment, goods or capital and to invest it or spend it on consumption. Someone can buy an ice-maker with the earnings he expects to generate in the future from selling ice creams. A farmer can borrow on the strength of a future harvest to buy fertilizer and pay wages. A loan can be used to pay for training to improve one’s employment prospects.

Debt is essentially a non-simultaneous exchange between two parties. Graeber describes debt as an exchange that has not been brought to completion.²⁶ It can be a social exchange, for example when you help someone to move house and expect that person to help you move house later. In a financial exchange, you borrow money that you will repay later, or buy a product that you will pay for later. Since one side of the exchange (granting the loan) takes place at a different time than the other side (repaying the loan), debt always runs the risk that something happens in the intervening period that prevents it from being repaid. The granting and drawing of a loan therefore require mutual trust and confidence in the future, captured by the word ‘creditor’ and its German equivalent Gläubiger.

The old saying holds. Owe your banker £1,000 and you are at his mercy; owe him £1 million and the position is reversed (Keynes²⁷)

Although debt is generally entered into voluntarily, there are exceptions. A debt to the tax office, for example, does not emerge from a voluntary agreement between two parties. But even when the debt is incurred voluntarily, the two parties often have unequal positions. Laws therefore protect households from usury; governments prescribe maximum interest rates. Such safeguards have been in place for centuries and remain in place today.²⁸

In principle, all debts must be repaid. But there are social, economic and practical reasons to place limits on this obligation. Although infamous debtors’ prisons such as Marshalsea in London, the setting for Charles Dickens’ Little Dorrit, no longer exist, debtors can still be temporarily detained if they fail to repay.²⁹ The Netherlands was the first country in Europe to decriminalize bankruptcy and to introduce a more or less orderly procedure for it. A Desolate Boedelkamer (office of the commissioners for bankruptcies) where bankruptcies could be settled – and debtors could make a fresh start – was created in Amsterdam City Hall in 1627.³⁰ This is how Rembrandt was able to start painting again, rather than landing in prison or seeking sanctuary in the free town of Vianen. There is thus a socially recognised limit to the repayability of debts, as the lender accepts some degree of risk.³¹

The Dutch word for debt, schuld, has multiple meanings, which sometimes causes confusion. The meanings range from a moral debt or an abstract obligation to a specific debt and a contract enforceable by law. The many different forms that debt can take also explain the confusion as to whether money is always debt (see Box 1.3).

Box 1.3 Is Money Always Debt?

A question that often arises when discussing alternative money creation systems is whether money is always debt. In the current system, money is created when a loan is granted. The bulk of our money (bank deposits) is actually debt owed by the bank to account holders. Money is therefore inseparably linked to debt. But although some authors have claimed that ‘all money is debt’³², this is not necessarily the case. Our cash – coins and banknotes – does not constitute debt; one cannot exchange this money at the central bank for gold or anything else.³³ Although central banks record cash in their accounts as debt, it is to a certain extent an arbitrary choice to record money as debt and not as equity, which also appears on the liabilities side of the balance sheet.

Debt can serve as money if it is sufficiently divisible and transferable. But not all debt serves as money and not all forms of money are debt. This does not alter the fact that money is always a claim on current and future production. As newly generated money increases this claim, the unlimited creation of money is not without consequences (due to the risk of higher inflation).

1.3 The Importance of Trust

We have already alluded to trust a number of times. Trust is crucial for the functioning of money and for the contracting of loans. The financial crisis, however, has shaken this trust.³⁴Ons Geld – the widely supported Dutch citizens’ initiative advocating for an alternative system – can be read as an expression of mistrust in the current system, as can the popularity of cryptocurrencies.

Dutch citizens have less trust in the banking system than in the country’s other institutions. Strikingly, highly educated people have less trust in the banking system than their less educated peers. This is unusual; the opposite generally applies to trust in institutions (see Fig. 1.2).

Fig. 1.2

Trust in institutions

Source: CBS (2017)

In a similar vein, a survey by the Dutch central bank (DNB) found that economists have less trust than the public at large in the stability of the financial system (see Fig. 1.3). Trust was correlated with the degree to which respondents believed regulations have been sufficiently tightened: respondents with less trust in the stability of the system were also more sceptical about the tightening of the rules.³⁵

Fig. 1.3

Trust in the stability of the Dutch financial system

Source: DNB (2016)

There has recently been much discussion about trust in the financial sector. The Dutch Banking Association (NVB) has launched a Banking Confidence Monitor,³⁶ universities have organized debates, and the finance minister has written a Letter to Parliament on trust in the financial sector.³⁷

Trust in the financial monetary system involves many interlinked forms of trust: trust in policymakers (politics, central bank), trust in banks and other financial institutions, trust in bankers, money and the future, and interpersonal trust. Trust in money crucially depends on institutions such as the central bank and the deposit guarantee system, and thus trust in these institutions. Financial crises not only reduce trust in financial institutions but are associated with the decline of interpersonal trust more generally.³⁸

Trust cannot be enforced; it must ultimately be given. Trust must be earned through proven reliability, by meeting justified expectations. Trust also depends on the ability to express and discuss dissatisfaction.³⁹ This report will consider these two aspects of trust, gauging the reliability of the system in terms of its economic contribution, stability and fairness. Influence and legitimacy are further factors to consider when addressing dissatisfaction.

1.4 The Dynamism of the Financial Monetary System

Money and debt are part of a larger and changing financial monetary system comprised of banks, the central bank, but also public authorities, pension funds, insurance companies and shadow banks⁴⁰ play a role in it. Just as the assets used as money change over time, the financial monetary system does not stand still. Industrialization and globalization have had major consequences for the operation of our current system (we describe this in Chap. 3), as have technological developments. The speed at which money can be moved around the world has increased enormously. Whereas gold coins and paper bills of exchange were once physically transported from place to place, a payment can now be sent from one side of the world to the other in milliseconds. It has become much easier to invest not only in the local bakery but also in businesses in Brazil or South Africa.

New technologies – containing potential that established parties have not always been able to exploit – have opened the way to cryptocurrencies such as Bitcoin (see Box 1.2 above) and other financial innovations. Central banks closely monitor the development of new technologies, which may support innovation and better financial services but also pose risks to public interests such as the stability of the financial system. Central banks are also interested in how they can harness new technologies; in many countries, they conduct research on, for example, the advantages and disadvantages of a central bank digital currency (CBDC). While the monetary system will continue to change, precisely how is impossible to predict (see Box 1.4). “The issue is shaping up to be every bit as vexed as those of robots and jobs,” says Andrew Haldane, Chief Economist of the Bank of England.⁴¹ “Passions around cashless societies run high. If nothing else, this tells us that money is, always has been and always will be much more than a cryptographic code; it is a social convention.”

Box 1.4 Fintech as a Revolution?

There is a lot of talk about “fintech”, but what exactly is it? The then Managing Director of the IMF, Christine Lagarde, described it as “the collection of new technologies whose applications may affect financial services, including artificial intelligence, big data, biometrics, and distributed ledger technologies such as blockchains”.⁴² In the discussion about fintech, two questions are central: (1) what will fintech mean for financial services? and (2) what will it mean for financial service providers? Although these questions are related, the discussion will be clearer if they are discussed separately.

Payments, savings, finance and insurance are seen as the four classic functions of the financial sector. IMF researchers have added a fifth: advice on these four functions. In all five areas, there are new initiatives and applications of new technologies.⁴³ Debates often cite the power of distributed ledger technologies (blockchain) which can be used, for example, to create more decentralized payment architectures. Other developments include the use of machine learning and algorithms to automate trade in financial products (high-frequency trading) and enable insurers to assess claims. It remains difficult to gauge the role of fintech and the potential of these new services.⁴⁴

What will these innovations mean for existing financial institutions? Small fintech players do not currently pose real threats to large banks, which enjoy strong market positions due to their banking licences, size, expertise, skills and implicit and explicit guarantees. But when they are acquired by large banks, fintech players can spur innovation by their new owners. The question is what will happen when ‘bigtech’ companies such as Amazon, Apple, Facebook and Google begin offering financial services.⁴⁵ While Amazon has launched Amazon Cash and Google offers Google Pay in many countries, these developments will not necessarily intensify competition. Existing banks may choose, for example, to set up partnerships with these major entrants into the financial market.⁴⁶

But the fact remains that today’s large banks cannot take their future relevance for granted. Will there be a transition to greater diversity and reduced scale, a consolidation of the existing giants, or their absorption into bigtech companies such as Facebook, Amazon and Apple?⁴⁷ In any case, developments will be driven by a wide range of factors, including laws and regulations. Continuous political oversight is therefore essential.

Current developments and uncertainties are not all due to fintech; we are in unfamiliar terrain in other ways too. Debt as a percentage of GDP has never been higher.⁴⁸ Monetary policy is in uncharted waters. The European Central Bank’s policy interest rate has been close to zero for many years and it has bought up unprecedented amounts of government and corporate bonds. How we would extricate ourselves from this unconventional monetary policy remains unclear – or, indeed, whether the current situation is the new normal which we have yet to grasp. Some companies and governments (including the Dutch government) can now issue bonds with negative interest rates. This means that the government and some companies actually receive interest from their lenders, illustrating in stark terms the uncertainty and uniqueness of the current situation. The current coronavirus crisis – which erupted after publication of the Dutch report and is therefore not discussed in this translation – only reinforces these uncertainties. In our complex and turbulent times, it is questionable whether existing solutions will work.

1.5 Overview of the Report

The Dutch government requested the WRR to issue an opinion on “the operation of the monetary system and all forms of money creation by banks and to include in any event the advantages and disadvantages of alternative systems of money creation and the extent of seigniorage”. The present report is the response to this request.

In our current system, money is inextricably linked to debt and the operation of banks. This means changes affecting the monetary system will also inevitably lead to changes in credit and the financial landscape. The concerns that underpin the citizens’ initiative Ons Geld (‘Our Money’) go further than simply safeguarding money and payments; they also concern the role of debt and banks in society. This report on money therefore also devotes attention to debt and the broader operations of the financial monetary system.

We first consider the mechanics of the current monetary system (Chap. 2), discussing how money is created and the main driving forces and constraints in money creation. While banks play an important role in our monetary system by creating new money when they lend, they do not do so in a vacuum: banks are influenced by the demand for loans, assessments of risks, financial regulation and monetary policy. In Chap. 3, we trace the development of the monetary system since the 19th century, examining the different forms money has taken over time and illustrating a constant dilemma between the need to maintain currency stability and the need for monetary flexibility.

In order to gauge the advantages and disadvantages of an alternative system of money creation, Chap. 4 focuses on key problems in the current system as they bear on four goals: economic contribution, stability, fairness and legitimacy. Chapter 5 then discusses an alternative monetary system which we refer to as the sovereign money system. This essentially involves a system in which money is directly or indirectly in public hands. Although more radical alternatives – such as abolishing national currencies or systems in which money is once again linked to a precious metal – have been proposed, these have remained largely undeveloped and insignificant in current debates. We thus focus on the sovereign money system and its variants. The potential advantages and disadvantages of this alternative system are analysed in Chap. 6.

The final part of the report focuses on avenues to address underlying problems, beginning with a discussion of the lessons drawn from the crisis and the main policy reforms in the current system (Chap. 7). The report ends with conclusions and recommendations (Chap. 8).