This chapter introduces the system of accounts of the main sectors of the economy (households; non-financial corporations, the government; banks, and the central bank), describing how these sectors are interrelated through financial claims and liabilities. A financial system, consisting of commercial banks and the central bank, manages flows of funds originating from households, without these flows causing a need for the real sectors to liquidate illiquid real assets. The basic types of assets and liabilities are: real goods, gold, banknotes, deposits, bonds, loans, and equity. We explain how the shortcomings of both IOU and commodity-money based financial systems can be solved via establishing a central bank. A central bank is defined here by its balance sheet and central bank money is the central bank’s basic liability. Both monetary policy implementation and lender of last resort issues relate to liquidity flows within balance sheets. Understanding the logic of basic financial flows is therefore the basis for understanding central banking.

1.1 Real Economic Sectors and Basic Types of Transactions

The first economic sector is the household. According to the United Nations (UN and EC 2009), a household is a group of persons who share the same living accommodation, who pool some, or all, of their income and wealth and who consume certain types of goods and services collectively, mainly housing and food. We can characterise this household in terms of its holdings in the n real assets of the economy. Assets are resources controlled by an entity as a result of past events and from which future economic benefits or service potential are expected to flow to the entity (EC 2011). Assets can be represented by a vector X’ = {x1, x2, …xn}, in which gold coins are the n-th asset, i.e. xn. For example, the household owns: X = {x1 chicken, x2 cows, … xn gold coins}. To express the aggregate wealth of the household a unit of account is necessary.

In principle every pair of goods has one relative price, namely a price in terms of the other good. For example, say p(Chicken, Cow) is the number of Chickens needed to buy one cow. Obviously p(cow, chicken) = 1/p(chicken, cow). Also p(chicken, cow) = p(gold coin, cow)/p(gold coin, chicken). Assume now that we chose the n-th good, a well-specified gold coin (like the Florentine ducat with a fine gold content of 3.44 grams), as unit of account. Let’s simplify our notation, writing the relative price P(Gold coin, chicken) simply as p1 and P(Gold coin, cow) as p2, etc. In this case we have used gold as a numeraire.

A numeraire is a commodity whose price is used as unit of account. Dividing the price of the n goods by the price of the numeraire we obtain n − 1 independent prices, while the price of the numeraire in terms of itself is by definition one. We can represent all these prices by a vector of prices P’ = {p1, p2, … 1} in which each good is expressed in terms of the n-th good, in this case gold. The total value of the households’ assets is then P’X and we can represent the balance sheet of the household as in Table 1.1.

The left of the balance sheet contains the assets of the household, and the right its liabilities, which actually consist only in the household’s own equity.

Table 1.1 The household’s balance sheet
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One heroic implicit assumption in the above approach (but common in economics) is that of universal and immediately executable prices. Reality differs from this ideal for two main reasons.

The first is illiquidity. Some assets are rarely traded, and to purchase a certain asset in a relatively short period of time (within a minute, within a day, etc.), one will normally have to pay (significantly) more than if there were a lot of time to purchase it. Similarly, or often even worse, to sell the good in a short period of time, one will have to accept a significant price reduction, relative to the price that could have been achieved with more time. Immediacy of execution has a price, measurable, for example, in the form of bid-ask spreads, offered by dealers, namely the difference between the price the dealer requires for buying a stock and the price at which the dealer sells the same stock. For this reason, one says that the dealer offers “immediacy services”. As everyone can easily verify, in many used good markets (antiques, cars and other consumer durables), dealer bid-ask quotes are around 30–50%. In the most efficient parts of financial markets, e.g. US Government “on the run” bonds, bid-ask spreads are below 1 basis point (0.01%). Most other markets are somewhere in between.

The second main reason is asset specificity. A machine may have been tailor-made to exactly fit into the production process of a unique factory. Therefore, the value of the machine for the factory is much higher than for any other use, even with an unlimited time to sell. For instance, a very expensive and sophisticated machine used to test aerodynamics in the aerospace industry could also be used in the car industry, but with a more limited scope, as a much less sophisticated and expensive machine could fulfil the same function. A car manufacturer would buy such a machine only for the price of a machine fulfilling the functions it needs, as it does not need the most sophisticated functions used in the aerospace industry. Also human capital may be specific, as an employee may be an expert in a certain unique production process, or a manager in terms of knowing and being able to manage the psychological idiosyncrasies of the members of a specific team. The crucial role of asset specificity for economic organisation was worked out, in particular, by Williamson (1985).

Both distinct matters will play a key role in Chapters 5 and 6.

We now introduce two other sectors which we treat most of the time as one: corporates and the government. In the definition of the United Nations (UN and EC 2009), corporations are “legal or social entities […] whose existence is recognized by law or society independently of the persons, or other entities, that may own or control it. Such units are responsible and accountable for the economic decisions or actions they take, although their autonomy may be constrained to some extent by other institutional units; for example, corporations are ultimately controlled by their shareholders”. The simplified financial accounts of an economy with a corporate and government sector are shown in Table 1.2. The corporate sector will hold real assets, and as counterpart financial liabilities, representing the means through which the corporates have been funded. There is one major difference between the corporate and the government sector: in the case of the corporate sector, equity is also a financial liability, i.e. the equity is owned by e.g. households. In the case of the government, equity is a genuine own equity and not an external capital owned by another party (like household equity).

Table 1.2 A financial accounts system with the three real sectors
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Why is there a separate corporate sector, separated from households? Economic production and therefore welfare has been spectacularly expanded by the establishment “capitalist” firms, which have as liability both debt and equity (held by investors), and that as counterpart own a part of the real assets of the economy.

The reason for the existence of “capitalist” firms is discussed in Coase (1937) and Williamson (1985). Alternatives to pool ownership for larger scale industrial endeavours would be, for instance, the labour-owned firm (cooperative) or state-owned enterprises (SOEs). Both alternatives work to some extent, but up to now the capitalist firm has overshadowed its alternatives in efficiency for a large part of productive activity.

We can disregard growth, and assume that the amount of real assets in the economy does not change (except if asset value is destroyed through disorderly asset liquidation). A part of the real assets moves into the ownership of the corporate sector, and the household is compensated by receiving financial claims such that neither the net wealth nor the balance sheet length of the household changes. Of course, over time the creation of the corporate sector will make a difference: (i) it leads to a higher productivity and therefore to a steeper growth trend of the real assets held by the corporate sector (and hence the total amount of real assets of society); (ii) individual households will have different individual exposures to real assets, to equity and to debt, and therefore also their wealth will evolve over time differently, depending on how they positioned themselves.

The corporate sector’s need for real assets is obvious as far as traditional industries are concerned. For example, nineteenth century growth industries like mining, canal transportation, railways, clothing, breweries, etc. all obviously had needs to heavily invest into real assets. In the financial accounts, we assume for the sake of simplicity that these real assets are transferred from households to the corporate sector. In reality, most of these assets are actually produced over time by the corporate sector itself. In the case of sectors like IT or services, the financing needs arise for the purpose of establishing intellectual assets or the necessary brand name capital. Significant work is needed before the assets obtain value (e.g. thousands of programming hours before a complex software runs smoothly and can be deployed to clients). In these cases, it is not physically existing real assets that are transferred from the household to the corporate. Instead, the firm uses its funds to rent “real” human capital and to transform it into intellectual assets.

The raison-d’être of the government, and how to design it, are the subjects of Public Economics. Generally speaking, the government should provide “public goods”, i.e. goods with natural monopoly properties in which economies of scale in production are positive without limits, such as for security and defence, the legal system, the core of the monetary system, and some parts of the infrastructure. Moreover, the state may regulate market failures (externalities in production and consumption) and address acknowledged irrationality in human behaviour (e.g. enforce education and prohibit drugs). All this requires a stock of assets and employees. While the feudal state can really be considered as one enormous rich and powerful household, democracies could be considered being “owned” in a non-financial sense by the people. In the definition of the United Nations (UN and EC 2009, 62): “Government units are unique kinds of legal entities established by political processes that have legislative, judicial or executive authority over other institutional units within a given area. The principal functions of government are to assume responsibility for the provision of goods and services to the community or to individual households and to finance their provision out of taxation or other incomes; to redistribute income and wealth by means of transfers; and to engage in non-market production.” The financial accounts of the government are less obvious than those of the corporate sector, as many of the assets of the government are intangibles, and its equity is not really measurable. Moreover, the government is often composed of various heterogenous entities (central government, regional government, local utilities run by municipalities, etc.).

1.2 The Financial Sector and Financial Transactions

We now introduce banks into the financial accounts. What do banks do? They undertake various activities, as summarised in the following list. Some banks were specialized to a subset of these activities, while others cover many of them (“universal banks”). The historical origins of banks and of the various banking functions are explained, for example, in Kindleberger (1984, 71–152).

The United Nations (UN and EC 2009, 76) uses for banks in our sense the term “Deposit-taking corporations except the central bank” and defines those as entities with “financial intermediation as their principal activity. To this end, they have liabilities in the form of deposits or financial instruments (such as short-term certificates of deposit) that are close substitutes for deposits. The liabilities of deposit-taking corporations are typically included in measures of money broadly defined.”

Table 1.3 introduces a deposit and a note issuing bank into the financial accounts, which however only holds the gold in custody (i.e. this bank offers payment and security services). The two liabilities are identical in terms of financial accounts representation—they are only distinct in terms of technicalities of transfer and earmarking of bank liabilities to the claim holders (for deposits, a central ledger is maintained and the bank can see who holds what amount of bank deposits; for banknotes, there is no central ledger can be maintained). Such a bank would have to finance its running costs through fees it imposes on its clients.

Table 1.3 A financial account systems with a full reserve deposit bank
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In Table 1.4, banks can use the assets obtained through deposit and banknote issuance to finance investments. Assume here for the moment that (i) banks only lend to corporates and the state, and not back to households; (ii) banks still hold gold at a certain ratio α of their total assets, essentially as a self-chosen or imposed liquidity reserve; (iii) corporates and the state do not hold deposits. Assume moreover that the gained ability of the banks to provide credit creates new opportunity for the corporate balance sheet to expand, say because bank credit can finance projects that direct financing from the household can not because of the insufficient monitoring expertise of households. In Table 1.4 the corporate uses the fresh bank credit to partially acquire more real asset from the household.

Table 1.4 A financial account system with a fractional reserve bank
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1.2.1 Commodity Money, Financial Assets and IOU Economy

To understand the origins of central banking, it is worth recalling the merits of money in general and of financial money, in particular from the perspective of contemporaneous authors. Already Aristotle (1998, book I chapter IX) had noted that the inefficiencies of a barter economy can be overcome to some extent by the designation of one real asset as the medium of exchange—typically coined silver or gold. In the early eighteenth century, this was described for instance by John Law (1705, chap. 1) as follows:

Before the use of money was known, goods were exchanged by barter, or contract; and contracts were made payable in goods. This state of barter was inconvenient, and disadvantageous… In this state of barter there was little trade, and few arts-men…. Silver as a metal had a value in barter, as other goods; from the uses it was then applied to. … … What is meant by being used as money, is, that silver in bullion was the measure by which goods were valued: the value by which goods were exchanged: and in which contracts were made payable. He who had more goods than he had use for, would choose to barter them for silver… Silver being capable of a stamp, princes, for the greater convenience of the people, set up mints to bring it to a standard, and stamp it; whereby its weight and finesse was known, without the trouble of weighting or fining…. As money increased, the disadvantages and inconveniences of barter were removed; the poor and idle were employed, more of the land was laboured, the product increased, manufactures and trade improved, the landed-men lived better, and the people with less dependence on them.

As there is little evidence of societies really being based on barter, or in which money evolved from barter (Humphrey 1985; Graeber 2012, chap. 2), this should not be seen as a historical account, but rather as a reason why mankind developed other means to make trade possible. The use of a precious metal as money solved the problem of enforcement, but had various efficiency limitations, in particular for larger scale payments: structural and cyclical scarcity of the precious metal, heterogeneity due to imperfect coinage and usage, fragmentation of units used, weight, risk of theft and therefore cost of storage and transport. Therefore, credit instruments were soon developed to support trade. A financial asset is a claim of one economic subject towards another, for whom it is a financial liability. Financial contracts typically refer to unconditional or conditional cash flows to be paid in the future, whereby “cash flow” meant in the past settlement with species. The most basic financial asset is an “IOU” for “I owe you”—i.e. a promise to pay, which can be expressed in a numeraire good or any other specific good. IOUs can help to partially address the inefficiency of both a barter and of a species-based economy. In the words of Thornton (1802a, 75) the benefits of credit are many:

“The day on which it suits the British merchant to purchase and send away a large quantity of goods may not be that on which he finds it convenient to pay for them.” Without credit, “he must always have in his hands a very large stock of money; and for the expense of keeping this fund (an expense consisting chiefly in the loss of interest) he must be repaid in the price of the commodities in which he deals.” Credit sets him “at liberty in his speculations: his judgement as to the propriety of buying or not buying, or of selling or not selling… may be more freely exercised”.

The problems of an IOU-financial system with many agents and therefore multiple claims and liabilities lengthening agents’ balance sheet are: (i) Complexity to keep a record of all the claims and liabilities; (ii) Credit risk and costs to monitor all claims; (iii) Possible contagion in case of late payments or credit events. This raises the question of netting claims, and/or eventually settling them in money. Two steps have to be distinguished: financial claims netting without any increases of exposures to specific names and financial claims with “novation”, namely the possibility to transfer a claim on one debtor from one creditor to another creditor, which implies such increases of claims to specific debtors. The potentials of netting without and with novation have been described for example by Kindleberger (1984, 440) in the specific context of the European Payments Union (EPU) but apply universally to any multilateral netting and settlement issue. Multilateral netting is in any case a complex practical issue, and it is unlikely that many agents can spontaneously coordinate on it in a pre-modern environment. Netting through novation moreover requires that agents are willing to accept changes to the identity of their debtors—which will only be the case if the new debtors are systematically better than the old ones. If there is enough species to settle transactions, then of course such a situation would not arise. But merchants may have insufficient species reserves or transferring species as a means of payment may be very costly.

A way to avoid both the problems of species payments and of an IOU system, is to create financial liquidity through a single high credit quality, multiple-unit IOU which is accepted by all as means of payment and store of value, and which therefore plays the same role as species in achieving settlement finality of bilateral trades, without however any of its inconveniences. If this IOU has the highest possible credit quality, then novating financial claims towards it is always an improvement, i.e., can be regarded as “settlement” of the claim. Issuing these universal prime IOUs can be done in various ways, the only constraint being that the issuer must be considered to be of the highest achievable credit quality (such that novation is always accepted). The status of having the highest possible credit quality can be supported by a credible commitment of convertibility into species (i.e. into a real good), and this was considered necessary throughout most of the early history of central banking. The issuer of this universal prime IOU may be the state, a public bank, or possibly a state-sponsored private bank. In the words of Aglietta and Mojon (2014, 432–33):

Because debts have to be settled in other forms of debts, there is a hierarchy of debts and, indeed, of the institutions that issue them. The central bank is the bank that issues the debt in which all other debts are settled. … the ultimate liquidity in a payment system can be a commodity minted by the sovereign (or a foreign currency), or it can be the liability of a financial institution empowered by society as a whole or by its highest political authority—the sovereign. This institution is a central bank.

To illustrate the mechanics of central financial money creation, Table 1.5 shows a simple economy with m households (or m “merchants”), each of which initially have equity A and real asset holdings A. Assume the households initially do not have a suitable medium of exchange, which limits their ability to trade with each other. The central bank is a 100% reserve bank, i.e. all its assets are in the form of precious metal coins.

Table 1.5 A full reserve central bank
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While this scheme may improve the convenience of payments, it does not solve the issue of netting and settling the multiple cross household IOUs if the amount of precious metals in the economy is structurally insufficient or subject to cyclical fluctuations. The availability of medium of exchange to ensure efficient payment and settlement is only increased if the central bank extends its balance sheet further by adding non-money assets, be they real or financial, i.e. by mixing into its assets elements of the previous schemes. The scheme shown in Table 1.6 assumes that the central bank in addition purchases some government securities (amounting to S per household) and by providing some collateralised credit to each household (C).

Table 1.6 A central bank diversifying its assets into government bonds and credit
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The asset mix and total amount of assets will have to respect the need of the central bank to remain solvent and liquid, implying that the share of liquid assets should be sufficiently large (i.e. nothing is as liquid in this context as gold species, as this is what the central bank commits to pay out to its creditors any time) and that the credit riskiness of the portfolio should be contained—through an adequate average quality of non-gold assets, and sufficient diversification.