by Lew Rockwell, Lew Rockwell:
Money is routinely defined by what it does, rather than what it is. That is unfortunate because its modern definition overlooks money’s important – but now forgotten – fourth function.
Aristotle observed that money is a medium of exchange, unit of account, and store of value. This definition omits the fourth function needed to explain money and currency in our modern economy.
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Money & Money-Substitutes
In ancient Greece, only silver and gold coin circulated in commerce. There were none of the currencies that are in circulation today. So Aristotle’s three functions of money were perceived differently during his time and subsequent centuries when precious metal coins were being used.
In fact the word ‘currency’ only came into existence in the late 1600s when a nascent banking industry began taking root in London and paper banknotes started circulating. Anyone who accepted a banknote knew that it was not money, namely, silver or gold coin, but rather, a money-substitute that was only a promise to pay money on demand. Thus, banknotes were recognised simply as currency from the Latin ‘currens’, meaning running or moving like the current of a river. Silver and gold money have existed since the dawn of civilisation, so compared to their track record, currency is a relatively modern term.
Although banknotes were not money, they gradually became accepted over time as banks put them into circulation. People who borrowed from banks received banknotes, not precious metal coins. It was a forced circulation, but banknotes did offer advantages. They were convenient to use, and society benefitted another way. Banknotes reduced government expenses by supplanting coins that remained in a vault, thereby avoiding the loss of weight from abrasion in their everyday use and from the illegal practice of clipping, the costs of which were borne by the Treasury.
As governments removed precious metal coin from circulation in the twentieth century, the distinct concepts of money and currency became conflated. It is an understandable result because money and currencies both convey purchasing power, thereby performing Aristotle’s three functions. Money-substitutes, however, come with risks not found in money, highlighting the importance of its overlooked fourth function – the payment needed to conclude a transaction.
Final Payment
Final payment is achieved when the obligation of the payer to the payee is extinguished, allowing no doubt or dispute that the transaction has been concluded, assuming no force or fraud. When any of today’s currencies are used to purchase a good or service, payment is not concluded at the time of purchase. Completion of the transaction is dependent upon a third party, namely a bank.
Regardless of whether the currency used in a payment is paper banknotes or bank deposits circulated by cheque, plastic cards, wire transfers, or online, all national currencies in circulation today are a liability of some bank. The bank owes you the purchasing power that you placed with it. When you purchase a good or service, your purchasing power is then conveyed to the merchant by the currency you use in the transaction.
Following the basic principle that goods and services pay for goods and services, final payment can only be achieved with an unencumbered asset. There is a fundamental difference between a payment made with a bank liability and one using a tangible asset like gold and silver coin, which have proven themselves over millennia to be the best assets to serve as money.
Payment by money is an immediate and final transfer of purchasing power from the payer to the payee. In contrast, national currency is conveyed in a three party transaction requiring clearing and settlement processed through the banking system, which introduces the counterparty risk that a bank may default. When a merchant accepts a national currency, payment is not complete until the merchant uses the currency received to purchase a good or service. Because of counterparty risk, this final payment sometimes does not go smoothly.
G-SIBs & the Fragility of Bank Payments
Banks have two functions – lending and payments. Lending is much riskier and gets most of the attention because it is the underlying cause of banking crises when loans do not get repaid, causing losses that erode a bank’s capital. However, payments are far more important, and this function is the reason that some banks are deemed ‘too big to fail’.
Thirty banks receive international attention by being labelled as Global Systemically Important Banks (G-SIBs) by the Financial Stability Board, an international body that monitors and makes recommendations about the global financial system. Their recommendations are put into practice by each nation’s financial regulators.
When a bank incurs losses because loans it made are not repaid, its shareholders suffer. When a bank teeters on insolvency because of these losses, the economy suffers if the payment system is disrupted by the bank’s troubles because banks are interlinked. They are bound to one another to clear and settle the countless transactions made by bank customers every day that are the lifeblood of the economy. This interlinked chain is only as strong as the weakest bank.
Daily clearing and settlement enable banks to bring their financial accounts into balance. Throughout the day, some banks have an outflow of deposits, while others have an inflow. At 3pm banks settle these differences. Banks that received deposits lend them to those banks that lost deposits. If this process were to stop because a bank declared bankruptcy, the disruption to transactions would impair economic activity, and the larger the bank the larger the disruption. So G-SIBs receive special ‘too big to fail’ protection.
