A Classical-Inspired, Modern Framework for Understanding Money and Its Substitutes, by Prof. John McCallie

In the wee hours of the morning, Prof. Smith decided to give it one last roll at Caezar’s House. He was, after all, playing with “House money” after a nice run at the tables earlier. He “deposited” a small pad of “Benjamins” on the table. It was promptly converted into several tall stacks of colored chips. He couldn’t help but muse that he had just converted all his cash into something with the intrinsic value of a chunk of clay. While waiting for his turn to roll the bones, a short shoulder rub was sweet after a torturous day of economic seminars. Being cashless, he presented the masseuse with a chip. She was quite pleased when she saw that it was a black chip. A cocktail waitress soon returned with his favorite brand. She, too, was grateful when he slid a few reds on her tray as a tip. However, the table was “cold,” and he pocketed his remaining chips, grabbed his drink, and went to cash out. On his way to the cashier, he spotted a gentleman enjoying a Montecristo. To Prof. Smith’s delight, the gentleman was willing to exchange one of his creampuffs for some of his chips. The chips were generally accepted as money in the economy of Caezar’s House, even if they were just a piece of clay. The cashier converted his remaining chips back into cash, except for one of the purple chips, which the professor had pocketed as a memorabilia piece. The “House” was not disturbed with patrons walking out with such chips- it, in fact, improved its bottom line. Taking a dreamy draw from his Montecristo on his way out, Prof. Smith faintly smirked to himself when it struck him that he had just exchanged his “chunk of clay” for something with the intrinsic value of rag paper and ink. 

The Casino Chip Analogy: Understanding Money Substitutes

Like clay chips in a casino, bank products such as demand deposits, traveler’s checks, and other negotiable credit instruments have proven useful substitutes for cash or currency. As substitutes, these bank products represent claims on money and function essentially as IOUs, or more specifically, I-Owe-You-Money instruments. Traditionally, however, the prevailing view in economics is that these products are not merely treated as substitutes for money but are considered money itself and are included in the money supply. Although this conventional stance is longstanding and deeply entrenched, this paper demonstrates and explains why it is more precise and theoretically more fruitful to acknowledge that these products are money substitutes and not money in themselves, akin to casino chips. While these credit instruments certainly perform like money, they possess unique attributes that distinguish them from physical currency.

A cardinal virtue of acknowledging that such bank products are simply money substitutes is that it clarifies what is identified as real money in the economy. In this respect, money serves as a steadfast anchor for all these various substitutes. Furthermore, as the paper will illustrate, this perspective on money and banking provides a straightforward understanding of how various monetary entities arise and operate within a market society, thereby eliminating the confusion often associated with the study of money and banking. Moreover, this straightforward perspective has profound political and ethical implications regarding the production and use of both money and its substitutes in a free society, as will be discussed in the paper.

For generations, the typical economic textbook on money and banking has inculcated the idea that banks possess a unique power to “create money out of thin air.” This notion stems from the fact that banks can increase deposits simply with a “stroke of a pen,” as often stated. As noted, these issued deposits are viewed as actual money. Therefore, when banks issue deposits to make loans rather than lending out cash reserves directly, it is taught that “lending effectively creates new money” (e.g., Ammous, 2023, p. 289). This method of making loans is typically described as “fractional reserve banking,” since it indeed results in only a “fraction” of the deposits being backed by bank money reserves. Again, by equating deposits with actual money, this outcome is referred to as a “money multiplier effect,” since these typical bank lending practices result in deposits exceeding money reserves several times (e.g., Mishkin, 2019).

In contrast to the traditional view on money and banking, this paper clearly demonstrates how money substitutes function as a practical alternative to physical currency, thereby substantially reducing the need for money in trade. Rather than the notion of a money multiplier effect, the use of money substitutes economizes on the use of money. The concept of a “money multiplier effect” overlooks the fact that, given the use of credible money substitutes, transactions can occur in terms of money rather than with money itself. As further discussed in the paper, this discernible insight helps grasp the pivotal role these substitutes, along with the associated clearing systems, play in an innovative financial strategy that aims to attract real savings to be invested in interest-earning assets.

Notably, as will be demonstrated, when bank customers purchase bank products, such as demand deposits, they exchange cash or income for redeemable credit instruments or IOUs. This is similar to when casino patrons “purchase” chips, which also represent redeemable claims to cash. The resulting cash or money reserves essentially reflect preserved purchasing power. It is worth noting that the recognition of a pool of “preserved purchasing power” is predicated on the understanding that valued goods and services will continue to be produced by others to sustain it. The extent to which a bank can exploit this extra pool of “savings” is strictly limited by the amount it can muster by providing a reliable substitute for money that people will want to hold, while also bearing the associated risk. The financial innovation of this strategy thus relies on a bank’s ability to use this extra source of saved purchasing power prudently to finance investments.

Real savings, in this case, are represented by actual money that is at least temporarily not being used, hence available for investment. Given this perspective, the introduction of these inventive and practical bank products enables us to tap into a source of real savings that would otherwise be challenging to exploit. The financial goal of securing savings or capital to invest is a common objective across various financial products offered on the market. In this respect, bank products that are freely convertible into money, such as demand deposits, essentially function like other bank products that lack free convertibility, such as savings accounts or time deposits. All these financial products can thus be treated equally in economics as a means of investing savings.

The utilization of money substitutes is therefore a purely financial operation, meaning that it is not one of “creating” or “multiplying” money but rather one of using money more effectively. Nor is it a means of conjuring up savings out of nothing or “out of thin air,” as commonly stated or implied. Instead, this innovative financial strategy involves lending actual money that is essentially being saved. While indeed facilitating trade as a convenient alternative to cash — like clay chips in a casino — these products also play a central role in financing trade. It also means that money is a monetary entity that exists independently of financial institutions, such as banks. Indeed, these institutions intensely compete to harness this entity for investment purposes. The rest is simply finance.

The Rationale Behind the Conventional View

As will be discussed in the paper, the prevailing dominant view has roots in an age-old popular idea that spending levels have a significant influence on economic activity. Total spending levels are indeed interpreted in this prevailing framework as the “aggregate demand” for goods and services. Furthermore, money in some form is assumed to exchange hands in nearly every market transaction. Thus, the “money supply” is seen as playing a crucial role in determining spending levels. Understandably, this interpretive framework concludes that imbalances in the money supply can significantly contribute to adverse monetary disturbances, including inflation and recessions. For example, an inadequate money supply can restrict economic activity and result in a recession. Conversely, an excessive supply of money can overstimulate economic activity, leading to inflation.

Given that bank-issued money substitutes are widely used to facilitate transactions, this interpretive framework must equate these products with actual money to give it more plausibility and to make it more practical. From the standpoint of scientific nomenclature, this necessitated a redefinition of money, departing from its earlier definition that made a distinction between money and its substitutes, thereby allowing these products to be considered a component of the money supply. The dissemination and widespread popularity of this view can largely be attributed to the iconic works and personages of John Maynard Keynes and Milton Friedman (1969).

The paper further explains that the interpretive framework of these iconic figures, which posits that “banks create new money,” provides a “scientific” justification for centralized control over the banking system. This rationale supported the political agenda that emerged around the turn of the 20th century, which heavily favored increased centralization of economic control. Since banks are responsible for the majority of the money supply, it is easy to see why this framework advocates for centralized management of the “money supply” and the monopoly on currency issuance. The prevailing belief is that the health of the economy greatly depends on the control and oversight of the banking system by monetary authorities. Predictably, this agenda and monetary policy quickly became the uncontestable conventional view.

The conventional view’s fixation on spending levels inevitably leads to a heavy emphasis on desirable levels of consumption, as it accounts for the vast majority of total expenditures according to national income accounting methods. Notably, this perspective reverses the earlier economic emphasis on savings. The earlier argument was that savings served as the engine of economic growth through investments. This earlier perspective grasped that there was necessarily a direct trade-off between consumption and savings levels. This paper has such classical leanings and aims to challenge the prevailing stance on monetary theory and policy by acknowledging that money substitutes are not money in themselves; instead, they are dependent on what is truly money, which is the specific currency that underpins the financial instruments that substitute for it.

The Classical Leanings

This perspective in this paper aligns with the interpretive framework and terminology that prevailed before the current conventional view gained popularity around the turn of the 20th century. As is well understood in economics, this earlier view formally identified these credit instruments as “money substitutes” rather than actual money. Accordingly, the financial arrangements utilizing money substitutes were characterized as credit, not as money. The earlier perspective is dubbed the “classical view,” while the current dominant perspective is called the “modern view,” insinuating a shift from an antiquated or outdated mindset to a more sophisticated understanding.

Instead of the focus on spending, the ultimate “driving force” within the classical framework is the ends or goals pursued by individuals. This concept is understood within the framework of a market system, where producers freely trade with one another. In the context of individual rights and what is just, such pursuits are considered inviolate; however, these are merely labeled as “wants” in economics. Typically, on the first page of Economic Principles, “wants” are stated as axiomatically given. Moreover, they are considered “unlimited,” with the only limitation to achieving such ends being the means to fulfill them. This framework prompts the study of “wealth creation” to focus on how such ends can be maximized given the available means. Notably, as will be discussed, this study is necessarily guided by an underlying premise, which is also regarded as axiomatic, that the use of any particular “mean” to achieve an “end” precludes its use in achieving other ends, as captured in the phrase, “there is no free lunch.” Regardless, there is widespread agreement in economics today that said maximization is best achieved through a market system where individual rights are protected and where participants produce and trade freely.

The “means,” as expressed above, undoubtedly include a medium of exchange as a tool to facilitate the exchange of nonmonetary goods and services, albeit indirectly. Again, in an advanced economy, the supply of a medium of exchange consists of the asset, money, plus its various substitutes. As discussed later, actual money exists independently of banks and is referred to as “base money” in economics. In contrast, money substitutes are typically bank-issued IOUs and can be referred to as “bank money.” Both of these monetary entities are marketable goods in themselves and, undoubtedly, valuable tools for market participants to achieve their goals. However, these two types of media clearly exhibit distinct attributes and functions in the market, as highlighted in this paper.

The classical view argued that a competitive banking system, not unduly restricted or regulated, had the will and ability to meet the demand for a means of payment when it was rationally possible to do so. Consequently, the free-market supply of a medium of exchange responds rationally to the economic fundamentals of the market, thereby unlikely to hinder market participants from achieving their ends. The act of “spending” in this case is a given; it is merely the byproduct of market participants striving to profit from the exchange of goods in general, resourcefully using all the possible means. Hence, a classical perspective results in dismissing the ever-popular idea that spending in itself plays a causal role in determining economic outcomes.

A layman uninitiated in economics may wonder whether this lack of concern about spending shortchanges what seems to be the necessity of having sufficient demand for the goods that are produced or the will to spend. This concern about the sufficiency of demand, however, is unwarranted in the context of a free market. It results from a misunderstanding of what is meant by demand and what generates demand in the first place. As discussed in the paper, the demand for goods is typically illustrated in textbooks as an independent or isolated factor from that of the supply of goods. Rather than being independent factors, the concepts of demand and supply are necessarily connected.

From a classical perspective, demand is ultimately spurred by wants, which are, again, regarded as unlimited. In this sense, the issue is not with the urge to spend, which is generally boundless, but with the ability to spend, which is indeed subject to constraints. The ability to spend ultimately stems from the production of goods and services that others are willing to purchase. This affords the seller the means to demand other goods. Given that the ability to create value for others is constrained by the limited availability of means, as implied above, the only limiting factor in generating demand for other goods is the production of value that others are willing to pay for. This may beg the question of whether the market is willing and able to provide an adequate supply of a medium of exchange, which is a valuable good in itself. As demonstrated in the paper, there is little doubt that the industry responsible for providing this supply will respond effectively, just as any other sector is expected to do in a free and competitive market.

Notably, this classical-leaning understanding illustrates why a free and competitive banking system effectively meets the community’s monetary and financial needs without the necessity of top-down directives or centralized control, all while reducing the risks of inflation and recessions. Additionally, the framework presented in this paper acknowledges the emergence of new forms of money substitutes, which are continually being created and introduced to the market. These substitutes may also originate outside traditional banking systems, such as digital currencies or gift cards. Thus, the concept of “bank money” can be generalized to include these additional forms of money substitutes.

The Model of MCT and Its Value

The paper introduces a conceptual model, called the “Market of Concurrent Trading” (MCT), to clarify why the issuance of money substitutes, such as demand deposits, does not constitute the creation of additional money but instead utilizes money more resourcefully. This model clearly demonstrates how financial innovation, by using credit-based money substitutes, can create substantial benefits by reducing reliance on the existing supply of actual money. Using physical cash or currency in trade can indeed be costly and inconvenient. By utilizing substitutes, we can increase convenience and significantly enhance the efficiency of payment systems. In fact, most trades are conducted in terms of money rather than with physical currency, which challenges the common theoretical assumption that money changes hands in trade. Payment systems can conceivably evolve to the point where little or no cash (i.e., base money) is needed for transactions.

The view of an “economizing effect” from banking operations, as demonstrated by MCT, sharply contrasts with the conventional notion of a “money multiplier effect.” The concept of a money multiplier effect gained traction due to the popularity of the quantity-theoretic framework, which is discussed later in the paper. This traditional view redefines the concept of demand from the perspective of how it was understood from a classical standpoint. This reformulated idea of demand leads to centering on spending levels as a key determinant of outcomes, fundamentally reversing the classical view of it.

The contrasting effects, as noted above, go beyond a simple semantic debate about whether money substitutes are classified as money. It reflects a fundamentally different understanding of the causes and effects related to the financial operations of banks and their role in the economy. In short, the modern view conflates the concepts of money and credit, necessitating a redefinition of money to include money substitutes to render it plausible. The emphasis on spending levels behind its quantity-theoretic framework tends to embrace government monopoly issuance of currency and centralized control of the “money supply.” The political agenda aimed at establishing centralized control, which began around the turn of the 20th century, has regrettably evolved to the point where such control is now viewed as incontestable conventional wisdom.

Notably, the “economizing effect” demonstrated by MCT enables banks to access a unique method of what can be considered an elusive source of savings or capital. While money substitutes allow for cash withdrawals at any time, their financial arrangements are fundamentally similar to those of accounts that do not offer this feature. Just like savings accounts or time deposits, which have withdrawal restrictions, freely convertible money substitutes, such as demand deposits, also enable banks to lend out deposited funds that depict unused or unspent money. This explanation significantly clarifies how money and banking operate, removing much of the mystery surrounding the subject.

The paper discusses why this accumulated pool of unused or unspent money constitutes actual savings. This signifies that it represents unused or available resources which are produced and can potentially be used for investments. As previously mentioned, money deposited in banks reflects saved purchasing power, regardless of whether it is contractually or designated as savings. In this context, any deposit account at a bank facilitates the transfer of savings into investments, irrespective of whether it allows for immediate withdrawal. While certain bank products can perform as a medium of exchange, their issuance and use are purely financial operations that effectively utilize the existing supply of actual money. Therefore, contrary to the conventional theory’s characterization, these financial arrangements do not create or multiply money. This perspective can also be extended to encompass all financial institutions that provide credible substitutes for money.

A critical factor to consider is that a payment system using money substitutes, like demand deposits, is built on a foundation of trust. Such transactions necessarily involve a third party, such as a banker. Financial products of this nature would hardly be possible without confidence in banks and their credit instruments. In contrast, transactions made with cash or actual money do not require a third party; thus, a high confidence level in a third party’s medium is not required with cash or actual money trades. These are often described as “peer-to-peer” transactions. The property of requiring a high level of trust in the credibility of a third party’s medium is unique to money substitutes. It distinguishes them from the entity of money itself. Nonetheless, it is worth noting that the acceptance of cash or actual money implies an underlying trust that others will fulfill their roles in producing goods and services, which ensures that the currency retains its value for trade.

The “House Money” of Banks: Bank Money vs Base Money

The term “bank money” is used in economics to distinguish bank products that function like money from actual money, such as cash or currency. It will often be used in this paper synonymously with the term money substitutes. The term will also encompass other forms of money substitutes, such as cryptocurrencies and gift cards, that arise outside the traditional banking system and which function similarly. This paper’s perspective can be applied to all financial institutions that provide credible alternatives to money, enabling them to garner funds that can be leveraged into investments. To simplify the terminology without compromising clarity, the term “bank” is used throughout this paper to refer to these relevant financial institutions in general.

The term “bank money” is admittedly used informally in this paper. Unlike its typical use currently in economics, its use here is not intended to imply that it is actual money. Just as “House money” in a gambling setting does not denote actual money, neither does “bank money.” In the same informal sense, bank money can be viewed as “the House money of banks.” Like casino chips, “the House money of banks” is not actual money, but it is a useful substitute for money.

To be clear, money is the entity for which these substitutes have a claim and for which these are converted when “cashed out.” Furthermore, this medium of exchange exists apart from and independently of banks. Again, it is specifically referred to as “base money” in economics. Thus, the monetary aggregate of base money is denoted explicitly by the concept of money. In contrast, “bank money” represents a claim on said money. Although bank money can effectively function as a medium of exchange, it is a substitute for money, akin to casino chips, which are not considered money in their own right. Granted, the various substitutes for money are commonly referred to as money in everyday language. Nonetheless, as posited in this paper, distinguishing between money and its substitutes is critical in understanding how markets work.

Why It Matters

A common refrain is that the issue here is merely a matter of semantics; that, for all practical or theoretical purposes, all that matters is whether an entity performs as a “generally accepted medium of exchange.” This curt dismissal of the issue understandably follows from what is already ingrained in the modern view. However, conceptual clarity in this context holds profound moral and economic implications. In short, moral considerations pertain to the issues of property rights, freedom of contract, and personal responsibility. These principles in a free society apply to both the production and use of money (i.e., base money) as well as to the issuance and use of its substitutes (i.e., bank money), since the exchange of produced property is involved in both cases.

In terms of economic considerations, a “classical” approach emphasizes the importance of distinguishing between money and its substitutes. This distinction is essential for seamlessly integrating two currently separate interpretive frameworks: microeconomics and macroeconomics. In this integrated approach, the value of money, or its role as a unit of account, is determined by market forces, much like the value of other goods is established. Additionally, the prices and supply of substitutes, which are also influenced by market dynamics, play a pivotal role in shaping saving and investment behaviors in the financial sphere of the economy. These market processes are crucial for achieving a welfare-enhancing allocation of resources.

Starting with Carl Menger in the 1870s, who was recognized as the founder of the Austrian School of Economics and a key figure in classical liberalism, money is understood as a commodity that naturally emerges from the voluntary actions of individuals seeking to improve their lives. It is not a product of deliberate human design nor a creation of the state. Instead, it is a product of natural market forces. Similarly, the institution of bank money, along with its extension of credit, emerged as an unintended consequence of freely trading producers. Thus, the value and supply of base money, as well as bank money, result from the voluntary decisions made by all market participants. The information held by these decision-makers is condensed into monetary values. Trust and confidence in the value of this condensed information are essential for a well-functioning economy.

Money plays a leading role in coordinating an efficient allocation of resources over time and across the globe. It serves as the North Star for various products that can credibly substitute for money. The integrity of an economy indeed relies on the trustworthiness of its currency. In the context of a free-market society with well-defined and enforced property rights, market-driven forces are understood to be the most effective and least arbitrary means of obtaining an honest and objective value for goods and services. This certainly applies to the value and supply of bank money, which are “derived” from their interaction with base money, but it also pertains to the value and supply of base money, or money itself. The free-market processes that determine these economic parameters are those that establish non-arbitrary interest rates or define a non-arbitrary price of capital. Economic growth and stability in the global economy depend on such a market-driven price.

The value of money is fundamentally tied to the goods and services produced by individuals striving to improve their lives. The value of labor is exchanged for that of money, representing an equivalent worth to their work. From a moral perspective, the exchange of goods and services for money embodies an implicit code of honor characterized by the principle of “honest work for honest money.” Thus, money is expected to serve as a reliable means of measurement and a trustworthy store of value, particularly over time. When money was gold, the value of money was represented by a specific weight of that commodity. It functioned well in this capacity. Under the current fiat standard, base money, or what is actual money, is determined by fiat; this means that the monetary authorities dictate what is accepted as money as well as controlling its supply. Unlike a market-driven standard, the value of currency under the current fiat standard is not clearly defined. Instead, its value, or purchasing power, is stated to be defined merely by what can be bought with it—that is, whatever value the monetary authorities ultimately establish for the currency.

The dismal track record of price and financial stability under centralized control over money and its substitutes has raised concerns about the integrity and effectiveness of this system. Centralized control and forced monopolization of the money supply have predictably resulted in arbitrary decision-making and immense power, which many argue are inappropriate for a free society. Not only has it been significantly destabilizing and economically problematic, but it is also highly questionable from a moral perspective. The contention here is that the interpretative framework of the “modern view” and its expedient redefinition of money to include its various substitutes were key factors in justifying and endorsing centralized control of the money supply and interest rates. This agenda was aligned with the Progressive movement of the early 20th century, which aimed to expand government influence and control over the economy.

As mentioned earlier, the characterization of money and banking discussed in this paper aligns with the common understanding of these concepts in the early days of economics. This conceptual understanding held throughout much of the 19th century. During that period, base money, which consisted of the monetary use of gold or specie, was considered money, while bank money was designated as a substitute for money, and its issue and use were characterized as credit, rather than the creation of new money. This was the commonsense view of the framers of the U.S. Constitution, who sought to establish standards for the currency. Just as a specific length defines an inch, the dollar was defined by a specific weight in gold or silver. Having such a standard is the recipe for what is regarded as “honest money.”

The position of this paper is that a classical characterization of money and banking offers a more coherent explanation of monetary phenomena. It advocates a market-driven supply of money and its substitutes within a free market society. Under the classical perspective, there is a clear distinction between money and credit; however, in the modern view, these concepts are conflated and become intertwined, which has inevitably spurred boundless debates on their role in the economy. The current conventional view gained popularity around the turn of the 20th century and played a crucial role in establishing heavy-handed centralized control over the money supply.

By examining the shift in economic thought on this historic development, we can gain a deeper understanding of the nature and composition of these monetary entities. Although it is common in everyday language to refer to functional substitutes for money as money, this colloquial language is inconsequential. This paper argues that the terminology and perspective of the modern view lack precision and misrepresent the function of these monetary entities, which inevitably have consequential effects.

Other Considerations

The contractual agreement between a bank and a depositor establishes that the bank’s money substitutes are redeemable upon demand. This agreement serves as a “promise” to pay money when requested. It is important to note that a “promise” to pay has a specific meaning in commerce and does not impose the same obligations as a “guarantee.” Additionally, the agreement does not imply that money substitutes are 100% backed by actual cash, nor is it intended to convey that message.

Bank customers generally understand that banks “put their money to work” in the community to help finance the various activities of fellow citizens. They also recognize that if banks did not use deposited funds in this way, they would likely have to pay banks for the service of safeguarding their money rather than receive it for free. In certain situations, banks may offer interest on deposits due to the competitive nature of the market for capital. The fact that such deposits can earn interest highlights the financial nature of these arrangements.

The conventional view treats money substitutes as equivalent to money and interprets these contractual agreements as guarantees rather than promises. This perspective has become widely accepted across various schools of economic thought and has significantly influenced monetary policy. It explains the strong efforts by legislators and monetary authorities to ensure that this “promise to pay” is guaranteed, even if it means relying on taxpayer backing.

However, this common viewpoint often neglects the financial nature of these products and the critical role these substitutes play in attracting and lending actual money. While banks can usually redeem these claims on demand, this “promise to pay” is subject to certain contingencies inherent in financial operations. These issues can arise even in the most prudent and reputable banks. Without state intervention, this promise essentially represents a contractual agreement that must be appropriately qualified for such contingencies.

Other Perspectives That Align with This Paper

This paper’s characterization of money and banking also aligns with the widely accepted “Intermediary” theory. This theory holds that banks do not “create money out of thin air.” Instead, banks are considered financial intermediaries that lend out accumulated savings, rather than magically conjuring up savings out of nothing. This theory will be further discussed and cited below. This widely accepted understanding comports with the contention in this paper that the financial innovation of issuing bank money is a financial strategy to harness a source of savings that can be leveraged into investments. This financial operation is integral to the bank’s primary function of “loaning other people’s money.” The importance of this insight lies in its implications for the relationship between actual savings and investments, where money is not created but used more resourcefully, as highlighted in this paper.

The interpretive framework presented in this paper, which is centered on the MCT model, also aligns with recent developments in monetary theory, known as the “free-banking view.” These momentous advancements cogently explain why a free and competitive supply of what is termed “bank money” in this paper adheres to the unyielding but harmonizing forces of the market. As a result, its supply is driven by the dynamic forces of the market to levels that are “optimal.” Importantly, this means that the market-driven supply of such monetary entities is neither inflationary nor recessionary. Furthermore, its in-depth historical analysis indicates that notable episodes of financial instability in the past were not due to an inherently unstable competitive banking system but were instead prompted by misguided policies or other government interventions. In contrast to the conventional view, which strongly supports the monopoly-issuance of currency and centralized control of the money supply, the free-banking view endorses a competitive, decentralized supply of bank money. This view will be further discussed and referenced later.

The recognition that these bank products serve as a helpful substitute for money reinforces the interpretive framework of the free-banking view. Its framework establishes the economic Laws upon which the price and supply of these substitutes are derived. The market processes are integrally tied to the value and supply of base money. In essence, the constant force of arbitrage keeps their price at or close to par, while their supply hinges on the demand for these instruments. Thereby, bank money can be viewed as a financial derivative, given that its price and supply are derived from that of base money.

As derivatives of base money, their price and supply are endogenous variables, meaning that they are rationally determined within the system as an effect of economic conditions. Therefore, in contrast to the conventional view, their issuance and utilization are not influential factors or stochastic forces in determining economic conditions, apart from some autonomous positive or destructive force, such as the positive impact of a financial innovation. The initial effect of such forces is nevertheless quickly and rationally factored in within the system. The market for these “derivatives” is integral to the nexus between savings and investments, playing a vital role in determining interest rates and allocating resources over time. Moreover, the parameters for these derivatives and market processes involved depend on and are anchored by what is identified as money in this paper, which is referred to as “base money” in economics.

This paper also closely aligns with the monetary theory developed by Ludwig von Mises (1949), a prominent 20th-century economist and a significant contributor to the Austrian School of Economic Thought. Mises emphasized the necessity of distinguishing between base money and bank money, which is aptly referred to as “fiduciary money.” Base money, on the other hand, is defined as having the characteristics of a commodity. It is referred to as “proper money” in his famous tome on economics, Human Action (pp. 432-448). By applying the individual decision-making methodology that the Austrian School was known for, Mises laid the micro foundation for a general macro perspective that seamlessly integrates money and its substitutes. His work on this subject was published as early as 1912, yet it was ignored by mainstream economics, which was engrossed by the thought of centralized banking at the time. To his credit, Mises firmly rejected the ever-popular notion that “aggregate spending levels” are in themselves a causal factor in wealth creation.

This perspective in this paper is also aligned with Ayn Rand’s views on money and its role in the economy, as expressed in her philosophical works called Objectivism. Though not an economist, Rand grasped that “[m]oney cannot function as money, i.e., as a medium of exchange, unless it is backed by actual, unconsumed goods.” This understanding accords with the proposition posited in this paper that the generated pool of funds that ensues from issuing money substitutes reflects real savings with varying durations, thus representing claims on said “unconsumed goods.” Furthermore, she viewed money as a physical commodity that a free market utilized as a medium of exchange, advocating for gold as its form. Moreover, she grasped that “wealth creation” was not a matter of a deft hand at making bookkeeping entries, alluding to the popular prevailing view in economics that a solution to a stagnant economy was speeding up the issuance of bank money.

While covering all the theoretical aspects that explain the various market forces involved in these processes is impractical, the recent advancements of the free-banking view noted earlier have substantially enhanced our economic understanding of the equilibrating forces at play. This paper is indebted to these advancements. However, this paper presents a different perspective on how to think about “money and banking,” where money is not created but utilized more resourcefully by banks. This paper demonstrates that the financial innovation of using reliable substitutes for money has developed into a method for accessing an additional source of savings for investments. This makes the process primarily a financial operation. Base money indeed serves as an anchor for these financial arrangements, as it does in all financial arrangements. Given these considerations, base money is the only entity that can truly be identified as money in the commonsense understanding of the word.

Although money substitutes are continually being introduced and evolving, the price and supply of these substitutes are closely linked to that of (base) money. Again, this perspective has significant economic implications. For instance, it means that, in free societies, the value of any market-driven (base) money reflects the “democratic” forces of all market participants worldwide. As explained by the well-known Purchasing Power Parity Principle in economics, (base) money tends to flow to where it has the highest value, just as other resources or commodities tend to do. As a corollary of the Law of One Price, this process brings about a uniform “price” or purchasing value of money throughout the world. The price and supply of money substitutes respond logically to the market’s assessment of this anchor. In contrast to the conventional view, money substitutes are not money but an inventive device to facilitate a financial strategy that captures and transforms savings into investments.

Historical Perspective on Money and Banking

To repeat, throughout much of the 19th century, classical economics defined base money as actual money, while bank money was considered a substitute for money. The issuance of bank money was characterized as a form of credit. Additionally, classical economics proposed that the supply of these monetary instruments was influenced by the same market forces that regulate the supply of goods in other sectors of the economy. As is well understood in economics, these relentless equilibrating forces in the context of a free and competitive market tend to generate optimal, welfare-enhancing levels of not too much or not too little.

Optimal levels are known to fluctuate due to changing conditions; however, the processes that restore equilibrium are quick and effective at self-correcting, independent of legal restrictions. As a result, the classical view rejects the widely held belief that recessions are caused by insufficient spending stemming from a lack of a medium of exchange. David Glasner (1989, p. 63) explores the classical perspective in his insightful book on monetary reform. He discusses J. B. Say’s well-known argument against the common view that economic recessions are caused by an insufficient money supply. Glasner clarifies the terminology associated with the classical viewpoint, as quoted in his work:

“In [Say’s] usage, only coin or specie was actual money; banknotes and other credit instruments that performed as a medium of exchange he called money-substitutes. But semantic differences do not alter his basic point that a competitive banking system would never allow an unsatisfied demand for money to turn into a general oversupply of all real goods.”

From a classical perspective, economic recessions are more likely caused by an unexpected destruction of value. It is understood that this level of destruction must be significant enough to trigger an economy-wide recession. Therefore, recessions were seen as more likely to be caused by one or more poorly conceived government policies that destroyed value. A significant decline in bank deposits and overall economic activity is expected due to this destruction. It reflected a restorative effect until the necessary adjustments were made, and normalcy returned. At the time, there was high confidence in the competitive financial system operating under the gold standard. Consequently, this earlier perspective was notably famous for essentially dismissing the possibility of negative monetary disturbances.

The concept of money in the classical sense is defined and understood as a market-driven good or commodity widely accepted as a medium of exchange (see Jevons, 1875). Money serves as the foundation that rationally connects all the various money substitutes available around the world. Under the existing gold standard, the money supply was understood as the amount of gold or specie used for monetary purposes rather than its many non-monetary uses. To clarify, the money supply included the gold or specie that circulated outside banks and the reserves held by banks. This monetary aggregate is known in economics as “base money.” Due to arbitrage, money flows to where it holds the greatest value, equalizing its worth globally.

By the turn of the 20th century, however, the classical view began to lose popularity in favor of the “modern view.” This view was a revision of the ever-popular idea that recessions were caused by insufficient spending. The modern view offered a more sophisticated way of showing that recessions, inflation, or episodes of financial instability are largely blamed on “monetary disturbances” of either “too little money” or “too much money” by influencing spending levels. Thus, the “money supply” is considered a dominant causal factor via spending levels in determining levels of output and prices, including the price of capital or interest rates.

As previously mentioned, the theoretical interpretive framework of this revision of the ever-popular view presumes that money is exchanged in virtually every transaction. It was thus expedient to equate bank money to actual money to square this stance with what is seen and testable. Subsequently, bank money or anything close to the liquidity of bank money is potentially included in the money supply for theoretical and monetary policy purposes. Unsurprisingly, the modern view strongly embraces centralized control over this manufactured “money supply” by banks, given its theoretical importance in controlling levels of employment and prices. The theoretical assumptions underlying modern and classical views will be discussed in the latter half of the paper to clarify the reasons for the sharp contrast between these two perspectives.

In the modern view, money is merely a useful tool for central authorities to steer the economy. The sanctity of private property and freedom of contract in the production and use of money and its substitutes have either taken a back seat or been neglected altogether. Consequently, over time, the gold standard was supplanted by a fiat standard, in which base money consists of the liabilities of the central bank, the Federal Reserve System. The Fed’s liabilities comprise two components. One component is the monopoly issuance of fiat currency (Federal Reserve Notes and token coins) that circulate or exchange hands outside banks. The other component is bank reserves. Bank reserves, in this case, consist of a deposit or a bookkeeping credit at the central bank (although banks hold some fiat currency in reserve for redemption).

Central bank liabilities are ultimately backed by the faith and trust that taxpayers will honor these debt obligations if necessary. In contrast to a market-driven commodity, as under a gold standard, base money is fiat-driven, where legal tender laws abet the “general acceptance” of its currency. Interestingly, under a fiat standard, base money, or what is actual money, as argued in this paper, is entirely based on credit, or on the faith and trust in the monetary authorities to establish a reliable store of value and a steadfast anchor for its substitutes. That is, nothing backs it other than the faith and trust in the monetary authorities and the ability of taxpayers to remedy any shortfalls. This point is well understood even at the outset of its establishment.

Other Dissenters of the Modern View

Despite the dominant stature of the modern view, there were some notable dissenters. For instance, Dale K. Osborne (1985) published an in-depth article entitled “What is Money Today,” which cogently argued that base money is the only monetary aggregate that logically satisfies all the required conditions to be identified as money. In addition, Ludwig von Mises, a prominent 20th-century economist, highlighted the same distinction between base money and bank money, referring to these as “proper money” and “fiduciary money,” respectively. An entire section in his famous tome on economics, Human Action” (1949), is devoted to “The Money-Substitutes” (pp. 432-434). The attribute of being “the most marketable commodity,” which distinguishes money from its substitutes, is a permanent feature in his definition of money. Indeed, he indeed cautions against the common practice of referring to credit instruments as “money” merely because they can provide the same services as money does. Unsurprisingly, these arguments were ignored by academia. No matter, Mise’s primary concern with the popular terminology of equating bank money to actual money is still relevant and noted below:

“The first purpose of a scientific terminology is to facilitate the analysis of the problems involved. The task of the catallactic theory of money—as differentiated from the legal theory and from the technical disciplines of bank management and accountancy—is the study of the problems of the determination of prices and interest rates. This task requires a sharp distinction between money-certificates and fiduciary media.”  

The “sharp distinction” between “money certificates” and “fiduciary media” highlighted above is the distinction made in this paper between base money and bank money, respectively. To clarify, “money-certificates” were contractually fully backed by gold reserves. Consequently, these can indeed be considered as theoretically equivalent to actual money in their use, since the reserves these represent are, by contractual agreement, not leveraged into investments. Fiduciary media, on the other hand, is associated with the phenomenon of fractional reserve banking, where only a “fraction” of the issued media is backed by actual money, and other bank assets back the rest. Since this media is built on trust in the issuer, bank money can be aptly described as a fiduciary substitute for money.

In this respect, both base money and bank money thus fall under a broader economic category of monetary phenomena commonly described as “a generally accepted medium of exchange” (or the widely used acronym, GAMOE); that is, GAMOE specifies the essential attribute, or genus, of this broader category. However, the genus, understandably, does not distinguish between base money and bank money, or between a medium of exchange that does not require the trust of a third party, and one that does. From a classical perspective, base money constitutes actual money, whereas bank money, which relies on the trust of a third party, is classified as a “money substitute.” This distinction is imperative for understanding the different impacts these two monetary entities have on the economy. The classical perspective, therefore, includes the defining attribute of being a market-driven good or commodity in its definition of what money is for conceptual clarity.

The modern perspective, however, was pressed to scrub this differentia of being a market-driven commodity from the definition of money. This terminology approach was convenient for equating bank money with actual money, thereby justifying its theoretical framework and the popular agenda for centralized control over the banking system. The distinguishing attribute being dropped, the concept of money is simply defined as GAMOE. In other words, its theoretical framework necessarily requires equating money substitutes, or even “near monies,” with actual money. Thus, GAMOE serves as the benchmark for determining whether a particular monetary entity qualifies as money. Predictably, this approach generated a massive body of literature that wrestles with the question of what the appropriate money supply is for economic analysis and predictive purposes under this interpretive framework. Theoretical aspects underlying this agenda are discussed later in the paper.

As noted, economics is greatly indebted to recent developments in monetary theory, known as the “free-banking view.” This prodigious body of work emerged after the enigmatic episode of stagflation in the 1970s and the seminal work of F. A. Hayek (1977) on the competitive, decentralized issuance of currency. Hayek theorized that decentralization could serve as a cure for recurring bouts of inflation and monetary instability. The free-banking view aligns with the classical view in that both theorize that a free and competitive banking industry, like other industries, responds to the equilibrating forces of the market to supply an optimal level of its product, bank money. The notion that the industry would fail to provide an optimal level is considered unlikely. Its extensive historical studies also show that most, if not all, past episodes of financial instability and maladies resulted from legal restrictions or misguided policies, rather than the industry being inherently unreliable in supplying an optimal level of media.

Notably, George Selgin (2024), a prominent figure in the free-banking school of thought, has recently touted the Intermediary theory in a working paper. The Intermediary theory holds that banks do not have a special power to “create money out of thin air” or to conjure up savings for investments out of nothing. Selgin concludes that the Intermediary theory of banking reflects the functioning of banking systems more accurately than the idea of “creating money out of air.” In making the case for the Intermediary theory, Selgin (p. 12) necessarily invokes the critical distinction between “base money” and what is referred to as “bank money” in this paper, as indicated in this quote:

“Although it has long been standard to regard such deposits, and current account balances in particular, as “money,” there was a time when they were instead considered money “substitutes,” and when the unqualified term “money” was reserved for the stuff banks promised to pay holders of their liabilities if asked. Once upon a time, that stuff consisted of precious metal coins. Today it means fiat paper money or deposits at a central bank, also known as “base” money. The modern view is a natural counterpart of the definition of “money” as any “generally accepted medium of exchange.” Yet there are times when it’s worth recalling the old-fashioned distinction between bank liabilities that serve as such and “real” (“base”) money, one of which is when trying to understand how modern payments are accomplished.”

As mentioned above, understanding that bank money is linked to and leveraged on base money is crucial to grasping the intermediary role of banks, regardless of whether the “stuff” that bank money is linked to is gold or fiat. Furthermore, given the recognition that banks are financial intermediaries and do not create money, it follows that the financial strategy of using “bank money” does not reflect a supply of money apart from what already exists outside banks (i.e., base money), thus validating the “old-fashioned” classical view of characterizing the financial arrangement of bank money as credit and not as money. Again, as will be shown and explained, the financial arrangement of bank money merely reflects an innovative means of leveraging actual money or real savings into investments; that is, banks essentially loan out money that exists independently of banks and that which is unspent or saved.

Creating Credit and Not Money

The paper introduces a practical conceptual model, referred to as a “market of concurrent trading” (MCT), that clearly illustrates how the issuance of bank money significantly reduces reliance on (base) money. This perspective highlights an “economizing effect,” which stands in stark contrast to the modern view of a “money-multiplying effect.” While there are well-defined natural limits to this effect, its potential for economic efficiency can be truly remarkable and beneficial. This “economizing effect” is a key component of an inventive approach that helps banks garner what can be viewed as an additional source of savings or capital. As a result, a bank’s competitive success in economizing money influences its ability to attract these savings. This innovative financial strategy allows the bank to enhance its bottom line by converting these savings into interest-earning assets or investments.

The financial operation of lending out money that is saved or unspent obviously does not constitute the creation of new money. Instead, it generates credit by leveraging such unspent funds into investments. As a result, even though money substitutes allow cash withdrawals at will, the accounts created through this financial strategy are fundamentally similar to those without this feature, such as savings accounts or time deposits. This holds true despite differences in liquidity and interest rate risks. Similar to accounts with withdrawal restrictions, accounts that allow cash withdrawals reflect credit rather than actual money. While banks have undoubtedly improved trade and finance through the introduction of bank money, this paper argues that the idea that these significant benefits stem from the creation of new money misrepresents this phenomenon.

Alternatively, this paper demonstrates and explains that the “economizing effect” entailed in “gathering” money substitutes creates an additional source of savings that can be leveraged into investments. This understanding, again, is indebted to the advancements made in monetary theory by the free-banking view discussed earlier. These recent developments in monetary theory suggest that market-clearing equilibrium in the supply of bank money tends to be optimal. In other words, the free and competitive issuance of bank money promotes financial stability and mitigates the risks of inflation and economic downturns, also known as recessions. Conversely, arbitrary centralized control is considered a significant source of instability. In contrast to the traditional view, the free-banking perspective advocates a competitive and decentralized supply of currency. Currency, in this context, refers to bank money —specifically, private banknotes rather than Federal Reserve Notes or central bank notes. For clarity, central bank notes are a component of base money within the framework of central banking. Notably, however, “bank money” also encompasses many other forms of issued money substitutes, such as cryptocurrencies and gift cards.

In contrast, the prevailing conventional view supports arbitrary centralized control over the “supply of currency” because it views the supply of bank money as an unreliable causal factor rather than a rational response to economic conditions. Thus, economists wrangled incessantly for decades over what “money supply” should be controlled. Virtually every school of thought had its own version of what constituted this appropriate “money supply.” Unsurprisingly, this hopeless task, primarily due to ever-changing financial innovations, was finally abandoned by the 1970s. These disputes over which monetary aggregates to control have now shifted to heated debates over the control of interest rates. Viewing the money supply as a critical causal factor leads to a strong inclination to control either money or credit. This agenda is misplaced and potentially harmful if market-driven levels of bank money tend to reflect economic conditions rationally. In this case, arbitrary intervention distorts market decision-making.

Another notable implication from this alternative characterization of bank money is that it establishes the microeconomic foundation for a macro view of the economy. Unlike the disconnected theoretical framework between micro- and macroeconomics in the current curriculum, this alternative perspective creates a seamless transition from the micro to the macro landscape, leading to a unified general theory of the economy. This is discussed in the latter part of the paper, where it also examines the philosophical underpinnings and presuppositions of the modern view, which led to this interpretive framework equating the “House money of banks” with money. It is also helpful in understanding the economic implications of inevitable changes in financial innovations, such as gift cards and cryptocurrency accounts, which serve as money substitutes and are closely tied to base money. The paper concludes by briefly “prospecting” for a viable entity that can serve as both a medium of exchange and a reliable anchor for its various substitutes.

^{_{Capturing and Leveraging Money}}

The Market of Concurrent Trading and the Economization of Money

A practical conceptual model, referred to as a “market of concurrent trading” (MCT), is first introduced to illustrate how the innovation of using bank money portrays a mechanism for economizing the use of (base) money. Hence, the innovation depicts an economizing effect rather than a “money-multiplying effect” or the creation of money as taught by the typical prevailing stance. As further explained in the next section, the advent of this financial innovation in economizing the use of money is what created a novel means of capturing yet another source of “savings” for banks that can be leveraged into investments.

Conceptual models carry substantial explanatory power in economics. A conceptual model can arguably provide a higher level of understanding of how markets work than mathematical or graphical presentations can. For example, the Law of Comparative Advantage is still widely regarded as one of the most robust principles in economics. It was decisively substantiated by the conceptual model advanced over two centuries ago by David Ricardo. The pedagogical advantage of a conceptual model over a mathematical model lies in its practical ability to illustrate cause-and-effect relationships. By their nature, this ability is absent in mathematical models or equations.

A good example of this is Carl Menger’s (1976) conceptual model of the Law of One Price, advanced over 150 years ago. His conceptual presentation emphasizes the importance of bid-asked prices, which are necessarily overlooked in mathematical or graphical depictions of this Law. The graphical depiction of two lines intersecting reveals little beyond the logic of what is already understood about this depiction. The logic underlying what is conceptually understood about the Law paints a clear picture of what is known as the principle of “consumer sovereignty” in economics. This logic emphasizes the importance of understanding costs in terms of the satisfaction or utility given up, commonly referred to as “opportunity costs.” Otherwise, this principle or understanding is not fully appreciated in mathematical or graphical presentations of the Law.

The conceptual “model of concurrent trading” (MCT) effectively simulates how a financial innovation, using a reliable substitute for money, can economize financial resources and eliminate the need for actual money to change hands during transactions. The discernible aspects of the model clearly distinguish between the entities involved and the processes that utilize these entities, removing any ambiguity regarding whether money is created by these market processes. Essentially, the logic underlying MCT patently demonstrates the economizing effect of utilizing money substitutes and shows that these processes do not generate additional money. The key insights from this model will be valuable throughout the paper.

For clarity, first consider a market of concurrent trading with only three vendors. Fungible clay chips are used as money, and these alone perform as a medium of exchange in the model. Banking, thus bank money, is absent in the model, so there is no question about what money is in the model. Barter is also ruled out, as the focus here is on indirect exchange, or the use of money as a tool in the exchange of goods. Each vendor in this scenario produces a different good to sell daily to one of the other vendors. Again, for conceptual clarity, the same daily exchanges are assumed to continue indefinitely as in a continual “steady state.” The different goods tendered by the vendors are all priced equally at one chip. A scenario of such a three-vendor market that rules out both barter and banking is depicted below:

Market of Three Vendors

A produces a but wants only b

B produces b but wants only c

C produces c but wants only a

Given a money supply of three chips where each of the three vendors possessed a chip, the desired outcome of daily purchases could obviously occur, as illustrated in Diagram 1. The three daily trades could occur at almost any time or place during the day and in no specific order.

However, it would still be possible to achieve the same desired daily outcome if only one vendor possessed a chip. In this case, the money supply would consist of only one chip. For instance, if A was the only vendor to own a chip, then A could pay B for “b.” This would provide B the means to pay C for “c.” To continue, then C would have the means to pay A for “a.” This is shown in Diagram 2. Thus, a money supply of only one chip, rather than three, would suffice to consummate all three daily transactions.

As shown above, this outcome, achieved with only one chip, requires a specific order in the sequence of the three daily trades, starting with the vendor who owns the chip. This requirement could be appreciably inconvenient or troublesome, depending on the normal routine or locality of the vendors. To mitigate this potential inconvenience, the three vendors could agree to gather daily at a specified time and place to make the appropriate sequence of trades in short order (or concurrently). This gathering strategy thus enables the desired outcome of trades to be consummated expeditiously with a money supply of only one chip.

Although the voluntary gathering strategy described above is a hypothetical situation, it closely resembles the common observation that buyers and sellers often seek the benefit of convening at a “village square” or marketplace to facilitate trade. This concept is also well illustrated by the account of the islanders on Yap Island, as discussed by S. Ammous (2018, pp. 11-13) in his exceptional book on a Bitcoin standard for money. In this real-life example, extremely heavy Rai stones were used as a form of currency. The islanders gathered at the location of the custodian of the stones to declare ownership of specific stones acquired through trade. What is relevant here is that money did not physically change hands under these arrangements. Only the ownership of the stones changed. The stones remained with the custodian due to their enormous size and weight. Trust existed within this group because the islanders were familiar with one another; therefore, transferring ownership of money required only a verbal “order to pay.”

To further develop the model, the proposed “gathering strategy” of concurrent trading can be applied to a market with more than three vendors. For example, a community of ten vendors could also agree to this mutually beneficial gathering arrangement. As before, each vendor produces a different type of product, all priced at one chip. This scenario, which requires indirect exchange, is illustrated here, with producers identified by caps and their products represented by lowercase letters.

Market of 10 Vendors

A produces a but wants b                   B produces b but wants c
C produces c but wants d                   D produces d but wants e
E produces e but wants f                    F produces f but wants g
G produces g but wants h                   H produces h but wants i
I produces i but wants j                       J produces j but wants a

If all ten vendors each possessed a chip, that would indicate a total money supply of ten chips. In this scenario, all ten daily trades could be executed at any time and place throughout the day. However, again, all ten trades could still be completed efficiently through a coordinated trading arrangement, even if only one vendor had a chip, as illustrated in Diagram 3.

Compared to the alternative of no gathering, this gathering arrangement of concurrent trading suggests that the need for chips could be reduced from ten to possibly as few as one chip, thereby requiring a money supply as little as one-tenth of that of the alternative.

Despite the added complexity, it is reasonable to conclude that a money supply of only one chip is required for a community of a hundred or more vendors to achieve the same desired daily outcome under such a gathering arrangement of concurrent trading. Again, this suggests an even greater economization of money. This greater economization of money can be expressed as a reduced need or demand for money. The money supply could conceivably be one-hundredth or less in the absence of such a “gathering” arrangement.

To illustrate the remarkable effectiveness of MCT in economizing money, consider this: if this same desired daily outcome described above occurs repeatedly, a money supply consisting of just one chip could facilitate an indefinite number of transactions over an extended period. Given this daily gathering strategy for concurrent trading, individuals within a large market economy could fulfill their economic goals indefinitely with just one chip of money. This remarkable possibility of utilizing such a gathering strategy creates enormous benefits for the community. For sure, it dramatically reduces the need or demand for money to just a “fraction” of what would otherwise be required to accomplish the same desired ends. For example, in the ten-vendor scenario, the necessary supply of money to achieve this continuous beneficial outcome for the community could be reduced to one-tenth of what might otherwise be required. Additionally, the economization of money reduces the risk and cost of possessing and transporting it, which can be an appreciable amount.

As a matter of pondering further implications of MCT, suppose this “economization” process were “taken to the limit,” as in a mathematical sense. In that case, a money supply of only one chip is sufficient to satisfy this perpetual achievement for an infinite number of vendors under the arrangement of “concurrent trading.” It is even conceivable that no money at all is needed in an immutable and “perfect” world of trust. Still, this incredible possibility is not realistic, nor is it even desirable. Even if it is “mathematically” conceivable, this would understandably depend on an implausible set of circumstances, apart from a horrid force of law. Indeed, as referenced below, the described economization of money above is constrained by rational economic limits and can only be stretched so far.

While not delving too deeply into future implications, it’s important to understand the concept of bank money within the framework of monetary theory. Outside of legal restrictions, such as required reserve ratios, there are inherent limits regarding the efficient use of money. These limits are known as “The Principle of Adverse Clearings” (see Selgin, 1988, pp. 40-42) or “The Law of Reflux” (see Glasner, 1989, pp. 64-66). In summary, these natural constraints necessitate that banks maintain a sufficient buffer of money reserves and capital as a precautionary measure. Understandably, as will be explicated later, these acts of precaution by banks chip away at their ability to maximize profits, but the benefits of lower risk are understood to outweigh the costs.

To summarize, due to the economization effect of MCT, fewer chips of money are needed to consummate a day’s worth of transactions, plus this desirable daily outcome can occur continuously with just a “fraction” of the money otherwise needed. Moreover, the same number of chips could support an increase in transactions due to a growing community. Since there is no ambiguity about what money or the money supply is in this model, the perpetual desirable outcome cannot possibly be construed as resulting from “the creation” of chips or a “chip multiplier effect.”

It is essential to emphasize a crucial aspect of the daily outcomes made possible by the “economizing effect” of the market of concurrent trading (MCT) before discussing this gathering strategy in relation to bank money. Once all the trades have been finalized and expectations met upon gathering, the outcome for all participants at the end of each trading day depicts an improvement in their lives. If this were not the case, the participants would not engage in such an arrangement. We can say that this daily outcome is “profitable” in the eyes of the participants. Realistically, factors constantly change, and these processes may not always yield a profitable outcome. Nevertheless, unprofitable outcomes that inevitably happen immediately lead to individual actions aimed at restoring profitability. These actions are effectively guided by well-understood natural forces of the market.

Consequently, this daily outcome reflects an allocation of resources that tends to benefit all participants, even though only a fraction of the money is needed to facilitate this continuous and beneficial outcome compared to what would be required without MCT. This positive outcome is shown in the exhibits above, where MCT is demonstrated with three or more vendors in the market. It is crucial to keep in mind that this perpetual daily outcome reflects a profitable allocation of resources that is not strictly dependent on the supply of (base) money, as it can be achieved through a more effective use of the money supply due to the “economizing effect” of MCT. This observation will be applied to banking in the following section.

The Gathering Strategy of Bank Money

The “gathering” strategy of the concurrent-trading model suitably simulates how the financial strategy of using bank money works to economize the use of money. For example, every transaction that uses bank money as a means of payment creates a “document of payment” or “an order to pay.” These documents that reflect a means of credit can take many forms, such as checks or digital tokens. Whatever design these “documents” are fashioned, they specify which individual accounts are debited and which are equally credited.

These payment documents are gathered daily at a designated time and place for clearing and settlement, whether physically or digitally. This clearing process typically occurs in a “clearinghouse.” Thus, the daily “gathering” at a specific time and place in the MCT framework aptly simulates the daily gathering of these payment documents at the clearinghouse, usually but not necessarily at the end of the day. Again, these payment documents reflect a type of credit device or IOUs that, at least temporarily, serve as a reliable stand-in for actual money. Then, upon gathering, the clearing and settlement of such payments, using the effective means of bookkeeping adjustments to settle accounts, is simulated by the “expeditious sequential trading” of concurrent trading in the model. Importantly, only upon clearing and settlement are the transactions finally consummated.

MCT makes a clear distinction between the entity money and the processes entailed in its use. Thereby, the discernible aspects of the model demystify the processes by which the gathering strategy economizes the use of the entity money. The difference in the settlement mechanisms or in the level of expediency between the model and banking are immaterial concerning this issue of economization, nor does it matter if the documents of payment are tangible or digital; nor is it relevant whether a transaction is cleared at a particular time during the day, just as it is irrelevant when chips at a casino are cashed out or redeemed. Furthermore, it is irrelevant if payments are settled instantaneously as with direct debits. Technological advances, in fact, only improve the economization of money. As an interesting extraneous observation, however, the “gathering strategy” of banking has a significant advantage over the gathering strategy of concurrent trading by allowing daily commerce to be conducted in its normal or preferred routine rather than the daily necessity of traders having to gather at a proposed trading site or marketplace to conduct trades.

Bank money undoubtedly performs as a medium of exchange, but it also serves as an effective stand-in for money until it is cleared or “cashed out.” The daily “gathering” of these money substitutes at the clearinghouse enables trades made with bank money to be settled or consummated through efficient bookkeeping adjustments. Hence, the gathering strategy using credible money substitutes eliminates the need for exchanging physical money or cash in a vast number of daily transactions. Like the gathering strategy of concurrent trading, the gathering strategy utilizing bank money makes it possible for the community to achieve its desired ends perpetually with just a fraction of (base) money that would have otherwise been required. And, just as the discernible mechanics in the concurrent-trading market cannot possibly be construed as the creation of chips or a chip-multiplier effect, the favorable outcome facilitated by the innovation of bank money cannot possibly be construed as a money-multiplier effect nor as a marvel of “creating money out of thin air.”

The exceptional advantages of using bank money rather than actual money certainly explain the widespread use and high demand for it –as long as it is creditworthy and reliable. Using bank money certainly lowers the risk and cost of holding or transporting (base) money, but it also understandably creates great utility as a means of payment. As is well understood, the innovation of bank money, within said limits, greatly reduces the need or demand for (base) money, other things equal. In other words, the need or demand for a medium of exchange can largely be met with trusted bank money.

The financial innovation of bank money reduces the need to exchange physical currency for everyday transactions. However, it also minimizes the costly movement of base money between banks due to advanced and innovative clearing mechanisms. These transfers of reserves between banks are known as “interbank payments.” While a detailed explanation of why interbank payments are relatively small is beyond the scope of this text, in brief, the debt obligations between banks generally offset each other by the end of the day. This occurs when the “gathered” payment documents are settled during the clearing process. Banks have a clear profit incentive to carefully manage the issuance of their bank money to achieve this balanced outcome. As a result, the movement of base money between banks is greatly minimized or eliminated entirely.

Due to the remarkable innovation of bank money, the exchange of actual money by both the community and banks can be reduced to just a small fraction of the total value of daily commerce. MCT enables a more efficient use of money by allowing trades to occur without using cash or money. Again, this daily outcome is achieved through the use of money substitutes, such as demand deposits or digital tokens, which act like “chips” in a casino. Nonetheless, these substitutes are always anchored to base money, meaning they can be exchanged for cash at any time. Therefore, their value is strictly tied to that of base money due to the relentless force of arbitrage.

As will be explained further in the paper, understanding the MCT perspective helps grasp how the banking system can meet the demand for a medium of exchange without being strictly limited by a fixed supply of base money. In the prevailing dominant view, each transaction requires a specific amount of money, creating a direct correlation between the number of transactions and the amount of money needed. As a result, a given money supply constrains the potential number of desirable transactions. Therefore, the optimal number of transactions hinges on an adequate money supply, taking into account its turnover rate, which is often deemed capricious and unreliable.

This traditional perspective fuels the argument for arbitrary centralized control of money. In contrast, the MCT framework suggests that economic agents can facilitate numerous transactions through coordination, trust, and technology without being limited by a money supply inconsistent with the number of optimal transactions. Essentially, MCT emphasizes how financial innovations can optimize the use of money, ensuring that the physical availability of cash or base money does not negatively impact economic activities while remaining consistent with the underlying fundamentals of the economy. This framework promotes a banking system that is not overly regulated and allows for market self-regulation through competitive forces and arbitrage, challenging the traditional view that centralized intervention or control is needed.

From the MCT perspective, it is evident that upon clearing, the community’s resources have been reallocated from hands that value them less to hands that value them more. This means that resources are distributed in a way that aligns with individual interests, thereby improving the overall situation for the community. Thanks to the innovations associated with MCT and its advanced clearing systems, this favorable outcome can be achieved with minimal cash or money involved, while bank reserves remain relatively stable. The significance of this perspective lies in the fact that economic conditions or the underlying fundamentals of the economy ultimately dictate what the banking or financial systems can provide as a medium of exchange. In other words, the market supply of a medium of exchange depends on the market’s ability to create legitimate claims to resources. This insight helps address the issue of what the balances of bank money constitute if not money. This is addressed in the next section.

Extracting and Exploiting a Rather Elusive Source of Savings

The modern view, again, considers it expedient to equate bank money to actual money to satisfy the logic of its theoretical framework. It thus views the multiple expansion of bank money as equivalent to an expansion of the money supply. If the multiple expansion of bank money does not reflect the expansion or creation of money as posited in this paper, then it begs the question of what the expansion of bank money reflects. What is explained and stipulated here is that the innovation of bank money engenders an inventive means of garnering a source of funds that can be considered savings, and that the multiple expansion of bank money balances reflects the issue of credit in exploiting this source of savings.

When discussing savings, it is essential to have a clear understanding of the concept for effective economic analysis and meaningful conversations about monetary issues. In modern economics, savings are typically defined as the portion of income that remains after expenditures on consumption. However, a broader interpretation of savings refers to the real-life situations where value has been produced but not yet consumed, allowing for potential future use.

This definition aligns with the classical understanding of savings as “the excess of production over consumption,” where production is precisely defined as the “creation of value” and consumption is understood as the “extinction of value.” This fundamental understanding of savings is universally applicable, even in contexts where money and spending are absent. A classic example illustrating this concept is the practice of reserving “seed corn” for future planting rather than consuming it as food. This demonstrates how produced value can be preserved for future use rather than being used up immediately.

In the context of banking, the act of saving is clearly evident when money is placed in savings accounts or time deposits. These bank products, as well as many others, are contractually designed to harness money that is not being spent for a specific period. The fierce competition for this unspent money results in a competitive rate of interest being paid on such balances. Again, it is essential to recall that the deposited money in the case is an implicit claim on the produced value it represents in the context of freely trading producers.

Additionally, these products have withdrawal restrictions to instill confidence in the duration of bank liabilities. This contrasts with bank money products, like demand deposits, which impose no limitations on withdrawals or convertibility. However, the pool of reserves generated from the issuance of bank money can still be viewed as a collection of unused or unspent money, as described in this section. This pool of unspent money implicitly represents a form of savings, similar to what is generated from selling bank products such as savings accounts or time deposits. However, in this case, the pool of savings was not the result of a contractual arrangement intended to attract and access funds for investment purposes. Instead, it occurred despite the absence of such an intention. Given the lack of withdrawal restrictions on these products, it is reasonable to conclude that the confidence in the duration of these funds is lower compared to those that do have withdrawal constraints.

Again, money reflects an implicit claim on value that has been produced. This implicit claim can be exercised immediately or “stored” for later use. As long as it remains unspent, it reflects the value that was produced and exchanged for money. This implicit value can be thought of as unclaimed resources that are accessible at the time. Granted, the ownership of these claims within this pool of savings frequently changes hands—similar to the “pool” of Rai stones managed by the custodian on Yap Island, as previously mentioned. However, despite all the daily churning of ownership, the issue of who own such claims is immaterial for theoretical purposes. What is particularly important for bank management is that the level of this pool of savings remains relatively stable and predictable, allowing these funds to be loaned out, irrespective of who is credited with these claims.

The innovative settlement and clearing mechanism plays a crucial role in this process. For instance, by utilizing a reliable stand-in or substitute for money, daily trades can be consummated “at the end of the day” by highly efficient clearing mechanisms. The bank can then assess the overall impact of all these daily trades on its pool of savings. Although the ownership of these implicit claims within the pool is constantly changing, these changes are made simply through bookkeeping adjustments. Again, what matters for bank management is the net effect on money reserves, regardless of these shifts in ownership. While the multitude of transactions creates value, the key concern is the net effect on the value that remains unspent, as indicated by changes in the bank’s total money reserves. This is again reflected in how trades affect the pool of money reserves. Therefore, the clearing and settlement mechanism provides a novel means of determining the net effect of an entire day’s worth of transactions on this particular source of savings.

If the funds generated from the issuance and use of bank money are considered an additional source of savings or capital, then the innovation of bank money led to an inventive means of accessing an extra source of capital that can often be difficult to harness. This can indeed be considered an unintended consequence of this innovation, as this beneficial effect was not the initial purpose of this product. Despite its redeemable-on-demand feature, the financial arrangement involving bank money operates similarly to arrangements with withdrawal constraints, such as savings accounts. In this scenario, banks do not create money; rather, they essentially lend out money deposited by individuals. This understanding aligns with both the classical economic viewpoint and the “Intermediary Theory” previously mentioned.

As a practical example of this bank-money “gathering” strategy and how it harnesses a unique source of savings to facilitate financial needs in the community, consider a Montana rancher who sells alfalfa in the summer for 10 gold coins. The rancher plans to buy 50 brood cows in the winter with the 10 gold coins. These coins, kept by the rancher for several months, represent savings, which again is defined as the creation of value that remains unused. At the same time, a nearby farmer needs a temporary loan of ten coins to acquire a combine for a fall wheat harvest. Borrowing the coins from the rancher is a possibility, but personal loans can be problematic for various reasons. The strategic advantage of the bank-money “gathering strategy” is that the payment for alfalfa can be deposited directly into the rancher’s bank-money account. This affords the banker the means of making a short-term loan to the farmer to finance his need for a combine. Consequently, the responsibility for conducting due diligence on a loan lies with the banker, not the rancher. However, the bank assigns a bank-money account from which the farmer can draw rather than loaning out the actual gold coins directly. Therefore, the innovation of the bank-money strategy significantly reduces the risk and cost of holding and transporting actual money, which in this case is gold. This is a win-win-win outcome for the depositor, the banker, and the borrower. Notably, all three participants benefit from this bank-money strategy. The collection of such accounts within the community creates a more dependable and consistent pool of funds to address the financial needs of everyone.

Despite the cash-out-at-will feature of bank money, when individuals or businesses choose to deposit money with a bank in exchange for bank money, a pool of money is generated at the bank. Although a vast number of transactions occur daily using bank money, these transactions typically have little effect on the level of this pool of money reserves. In short, this is because the instructions, as directed by the bank money instruments, for withdrawing money from the reserves are generally offset by instructions to add money to the reserves. As is well understood, this stable outcome can be primarily attributed to the “Law of Large Numbers.” Nonetheless, as noted earlier, banks have a profit-maximizing incentive to manage their business in a manner that achieves this outcome. Consequently, under careful bank management, a steady pool of money reserves can be expected to persist indefinitely.

For example, clay chips serve as a substitute for money in the economy of a casino, and when patrons exchange their cash for chips, a pool of money reserves is established. This pool of cash can be expected to persist indefinitely, even though such chips are typically used for numerous transactions and can be cashed out at any time. Based on extensive experience, the “House” can generally expect that when chips are cashed out, the cash reserves will be replenished by patrons buying chips. Such offsetting transactions thus tend to keep the cash reserves at suitable levels under careful management. While it is impractical to address all the potential incongruities that could negatively affect these expectations, these issues are well understood and discussed in standard textbooks on money and banking. Nonetheless, these considerations are irrelevant regarding the central proposition in this paper.

Importantly, the steady pool of money reserves garnered at banks reflects bank money that remains uncashed out or unredeemed just as the steady pool of cash reserves at the “House” reflects chips that remain uncashed out. Additionally, bank money that is held indefinitely or rarely cashed out provides the bank with a source of reserves for an indefinite duration. For that matter, as intimated in the preamble, where casino patrons walk out with chips for whatever purpose, bank money that is never used or cashed out provides the bank with a timeless source of money reserves. The significant relationship between the level of money reserves and the level of unused bank money was recognized long ago by John Fullarton (1845, pp. 64-65), a preeminent monetary economist of the 19th century. This is evident in his observation that “banknotes which are not in use are the same as if they are not in existence.” Indeed, this insight suggests that at the end of the day, the amount of money reserves reflects the extent to which bank money holdings remain unredeemed.    

In a market with freely trading producers, acquiring either base money or bank money requires the production of tradable value. Even with a gift or handout, tradable value had to be produced at some earlier point to afford the means of offering a gift or handout of either base or bank money. Consequently, a bank’s stable pool of money reserves reflects unredeemed bank money, which corresponds to the tradable value that was created to obtain that money in the first place. Recall the earlier illustration with the rancher who grew alfalfa to trade for brood cows, for instance. As a result of trading this value, the gold coins she possesses reflect an implicit claim on the produced value of the alfalfa. Her willingness to accept coins hinges on the presumption that these will be useful in acquiring brood cows in the future. The postponement of exercising such claims is, by definition, saving. As evident in this example, the act of saving is not necessarily an explicit contractual proposition or something that establishes explicit data. Again, broadly speaking, saving is the act of postponing the consumption of produced value.

When cash or income generated from the production of marketable goods is deposited into a bank, the resulting money balances represent savings. The consistent pool of money reserves accumulated through these bank deposits serves as a source of savings or capital that the bank can utilize. If the community collectively deposits a steady stream of income, the bank can leverage these deposits into investments. Investments in this case can be considered as enhancing the management of a household or a business. This process plays a substantial role in the allocation of resources through time.     

Traveler’s checks, which were once popular and still viewed as a component of the money supply, are also instructive in this regard. The issuance of traveler’s checks is comparable to the idea of cash being converted into casino chips (or traveler’s checks) that are generally accepted as a means of payment in the economy of the “House” (or in the commercial world of the issuer). Even though the chips (or checks) can be cashed out at will, a relatively stable pool of cash is nevertheless garnered at the “House” (or by the issuer). This steady pool of cash indicates that there is always a certain amount of uncashed chips or checks available. This represents a pool of unspent cash or an unused store of value, which can be seen as a collection of savings that have been accumulated. These garnered savings afford the issuer the potential of investing them into appropriate interest-earning assets. Hence, the issuance of traveler’s checks does not constitute the creation of money. Instead, it illustrates an effective strategy of using credit as a substitute for money, which creates the means of exploiting an additional source of “savings”.  

Credit card usage is also worthy of consideration. Like the credit instruments of bank money, credit cards also perform as an effective means of payment in lieu of cash. Notably, however, the economization of actual money with credit card usage is even greater than that with bank-money usage. Like a “concurrent-trading market” on steroids, the documents of purchases of credit card payments are generally “gathered” and reconciled monthly rather than daily. Thereby, the innovation of credit card usage takes stock and reconciles a month’s worth of commerce rather than merely a day’s worth, yielding a much greater reduction in the need or demand for actual money. Despite technical differences, the extension of credit by both credit card and bank money usage hinges on similar financial considerations. For instance, the credit limits assigned to customers/borrowers on how much they can potentially draw from these accounts hinge on a credit analysis of their ability to meet their debt obligations. That said, an overwhelming number of transactions are made with credit cards, and unsurprisingly, this has spurred disputes among economists on whether credit card usage should be included in the money supply, such as including the sum of the authorized credit limits. Such quandaries are common in economics due to the interpretive framework of the modern view. Nonetheless, the financial arrangement of credit card usage is unequivocally characterized as credit and not money, and there is an understandable restraint in economics to include it in the money supply. However, as further explained in the next section, if there is a restraint in this case, then there should be a similar restraint to include the assigned balances of bank money in the money supply for the same reasons.

The Bank-Money Strategy of Loaning Out Garnered Savings  

As demonstrated and explicated above, the emergence of reliable money substitutes, along with their efficient clearing and settlement mechanisms, resulted in a remarkable development in finance: the ability to access and utilize a significant wellspring of existing savings that is otherwise challenging for the market to capitalize on fully. It is one of the most remarkable market innovations since the discovery of money itself, and it has indeed proven to be an enormous boon to economic growth and prosperity. The innovation of issuing a reliable money substitute that provides a more convenient way to conduct trades evolved into a financial operation that loans out the accumulated savings that ensue from the innovation. In contrast to the conventional view, however, this financial operation does not create new money; rather, it represents a more efficient use of the existing money supply.

The conventional view suggests that when banks lend money to customers or borrowers by assigning them a bank balance (such as a demand deposit), these additional balances are seen as new money created by the banks. This perspective is understandable due to its theoretical foundations and interpretive framework, which will be discussed later. However, as explained in this paper, the stable pool of base money (i.e., money reserves held by banks) that is garnered from the use of bank money actually represents a constant pool of savings. The assignment of these additional bank balances to customers or borrowers is a method of leveraging these savings into interest-earning investments. Essentially, this means that banks are loaning out base money that is being saved or not spent. Therefore, this operation is purely financial and does not constitute the creation of money.

This innovative means of loaning out garnered savings is often cryptically described as putting “idle” money to work. Still, this description misrepresents the critical property of money as a store of value. For one reason, in a market society, every cent of the entire supply of actual money is owned by some group or individual, whether it is possessed or consigned to others. It is wrongheaded to think that any of it is “idle” and not working at any given time. Money is always working, even if it is “hoarded.” As von Mises (1949, p. 402) pointed out long ago, “Hoarded money is still money and it serves in the hoards the same purposes which it serves in cash holdings called normal.” Not to suggest that “hoarding” cash presents a potential threat to economic prosperity, but when cash or income is converted into bank money, it becomes integrated into a strategic arrangement that allows banks to capture and utilize an additional source of savings, as explained earlier.

The well-known means of leveraging this additional pool of “savings” entails the issuance of a loan in terms of a bank-money balance that can be drawn on, rather than disbursing cash directly to borrowers from bank reserves. Notably, this bank procedure can be described as providing an assigned limit on how much can be drawn from this pool of garnered savings, similar to the assigned limits for credit card holders. In short order, the level of this pool of “savings” can be expected to diminish by the amount of these “assigned limits.” Hence, the money is loaned out indirectly to exercise its claim on produced value for the duration of the loan. It is in this sense that this particular money, which reflects savings, is put to work.

This process of leveraging such savings applies to all banks. Any reserves withdrawn from a particular bank as a result of leveraging its pool of savings are merely redistributed among other banks or financial institutions. This redistribution is positively driven by the intense competition to gain reserves (i.e., savings or capital) for their own use. The profit-maximizing endpoint in the competition to obtain and utilize such savings occurs when the benefits from further efforts to exploit these savings no longer outweigh the additional costs involved. At this stage, any further profit opportunities have been eliminated, and the specific source of savings in the economy has been fully utilized within its limits. This well-understood equilibrium point maximizes profits with the minimum risk, given the ever-present balance between safety and profits.

The extent to which cash or income remains converted into bank money is the extent to which this particular source of savings remains accessible to the banking system. This is manifested by the total amount of bank reserves in the system. Again, upon clearing, at the end of the day, these money reserves represent an equal sum of bank money that remains unspent or uncashed out. This, in turn, reflects implicit claims on resources that remain unexercised. The “savings” garnered in this case is the prospect that this pool of unexercised claims on resources will persist for some duration, rather than a matter of what is contractually designated as savings. This indeed places the bank in a position to capitalize on such savings by making suitable investments that align with the financial nature of these savings. To be precise, this process of exploitation is based on the expected level of this pool of reserves/savings and not just on the level that exists at a particular time.

The fact that the level of money reserves in the banking system manifests just a “fraction” of the level of bank-money balances as a result of banks investing this extracted pool of extra savings does not mean that money has been created or multiplied. It merely indicates that a significant portion of this pool of actual savings has been invested within said limits. Barring any outside influences that distort such free-market processes, such as legal restrictions or misguided monetary policy, the additional pool of loanable funds represents real savings of produced and unused resources that are accessible for investments.

Upon clearing and reconciliation, the total supply of bank reserves in the system remains constant, despite the multiple increases in bank money balances. In other words, the banking system, by utilizing the extra savings that result from the innovation of bank money, has financed the use of these said resources. It is important to note that the fact that total money reserves in the system remain constant indicates that, at the end of the day, a reallocation of resources has taken place; nonetheless, the level of money saved or unspent regarding this new set of circumstances remains steady, even though the bank money balances have inevitably changed hands. Thus, the unchanging supply of total money reserves reflects the same unchanging supply of produced but saved resources that remain potentially available for investment. Again, these savings can potentially be leveraged into investments while allowing for risks. As will be emphasized later, as long as this trend remains generally profitable, such as in normal times, this daily outcome can theoretically continue indefinitely.

Granted, the number of transactions is likely to increase due to banks extending credit by assigning additional bank money balances to borrowers. Nonetheless, these additional transactions are facilitated by utilizing bank money, leaving the needed supply of base money the same by economizing on its use. Thus, the increase in the number of transactions can be achieved with the existing supply of base money due to the increased efficiency of using bank money, as demonstrated by the MCT model. However, it is crucial to recognize that, in this case, trades are made in terms of money rather than with it. Again, this is advantageous since the use of cash or currency can be inconvenient or costly. Hence, by incorporating the substantial benefits of using trustworthy substitutes for money, economic conditions at the end of each day manifest a new reallocation of resources with the same amount of base money.

In the context of a steady ongoing process, this daily outcome described above represents one iteration in a continuous series of similar iterations. Again, each daily iteration entails a new reallocation of resources. The daily reallocation of resources leverages the positive influence of using the innovation of bank money to convert an elusive source of savings into investments, a key factor in wealth creation. As long as these claims to goods and services remain in the form of bank money, their value can be exploited by the banking system for investment purposes. This typically results in a positive effect on economic growth, albeit with certain risks. Each consecutive daily iteration, in this case, can be viewed as gradually improving economic conditions and the overall wealth of the community. Thanks to the innovation of bank money, this remarkable ongoing process can take place without the necessity of an increase in the overall supply of base money, i.e., actual money.

With that said, it is essential to recognize that the success of this ongoing series of iterations hinges on the effective management of this daily resource allocation and its overall profitability. Again, when banks issue bank-money balances to borrowers, these potential claims to existing resources are transferred to those who can utilize them. Since credit is involved, debt obligations are created in this process. For the financial strategy of using bank money to remain viable and avoid bankruptcy, these debt obligations must be met for the most part; thus, the ongoing reallocation of resources must be at least generally profitable for the bank’s community. This is typically expected in a free market economy, where both banks and their customers aim to profit from their actions. No matter, market forces will effectively correct any anomalies that occur when plans do not go as expected, a principle well understood in economics.

The model of MCT helps visualize the proposition above. Given the dynamics of MCT, the strategy of gathering at the same place and trading simultaneously results in a daily, mutually beneficial exchange of goods or, in other words, a beneficial reallocation of goods. Each daily outcome is expected to be “profitable” for the participants; otherwise, they would refrain from engaging in the arrangement. Notably, as previously demonstrated, the model clarifies how this gathering strategy results in a more efficient and beneficial use of the entity that serves as money, in this case, “chips.” For sure, this daily gathering arrangement leads to a continuous series of daily profitable outcomes, requiring only a “fraction” of the amount of money that might be needed otherwise to achieve this perpetual series of transactions. Since only physical money exists in this case, it is demonstratively clear what money is and the role it plays in this scenario. As stressed earlier, it is therefore impossible to misconstrue this beneficial daily outcome as being facilitated by the creation or multiplication of money.

The insight drawn from MCT is equally relevant for an advanced banking system, utilizing money substitutes, despite any added complexities. Similarly, the use of trustworthy money substitutes provides the market with a method for conducting daily transactions, using the entity that serves as money more efficiently. As demonstrated by the MCT, the “daily gathering arrangement,” utilizing bank money along with its efficient clearing mechanisms, makes it possible to consummate a vast number of daily transactions with just a fraction of the supply of (base) money that would otherwise be needed. Thus, in the same manner, this gathering arrangement leads to a continuous series in the daily reallocation of goods, while economizing on the use of (base) money.

For emphasis, each daily clearing event involving bank money represents a new reallocation of resources. Similarly, this ongoing process is expected to be mutually beneficial or profitable for all parties involved, thus promoting economic growth and prosperity. As noted before, in cases of unforeseen anomalies, market forces will nevertheless quickly work to restore profitability. Each daily reallocation marks a step in a continuous series of such iterations. Each step thus represents a new reallocation of resources, primarily conducted in terms of money rather than with the direct exchange of money. Instead of using physical currency, these profitable reallocations are achieved by utilizing bank money to conduct trades, thereby requiring a significantly smaller amount of base money compared to what would otherwise be necessary. From this perspective, there is no ambiguity regarding the economization of money.

This last point is particularly significant for monetary theory. It indicates that this continuous process is fundamentally a financial development. Notably, it requires little or no physical exchange of money, despite the vast number of transactions that are generally conducted. The MCT framework of concurrent trading helps clarify how this is accomplished. It demonstrates how bank money serves as an effective “tool” in economizing money. As a market-driven “tool,” its supply is contingent on and in response to the demand for it based on economic conditions. A competitive banking system amply supplies this tool, but it is also strictly limited by natural constraints, as discussed previously. These natural limits, in the case of bank money, involve the level of savings made available in this process. While it is pedagogically useful to present this process in terms of a series of “at the end of the day” clearing events for easier understanding and modelling purposes, it is nonetheless more realistic to view it as a continuous process that unfolds throughout the day and over time, without losing any relevance.

In consideration of MCT, the expansion in trade that results from exploiting the additional savings that ensue from the innovation of bank money is equally facilitated by using a credible substitute for money, bank money. Hence, the expansion in trade is achieved with a more effective use of money and does not depend on an increase in its supply. In other words, the issuance of bank money serves as a significant financial tool that competes for capital in the form of base money that can be used to purchase interest-earning assets. Base money obtained by “selling” bank money—such as demand deposits or gift cards—potentially represents actual savings that can be capitalized on through investment. Indeed, the level of generated savings is what circumscribes the level of these investments. Thus, in contrast to the traditional view that money is created, the main argument of this paper is that this wondrous financial strategy essentially lends out base money that exists independently of banks and that is, in fact, being saved or not spent.

The extent to which banks can exploit this extra source of savings can indeed be quite remarkable. Historically, banks have considered it safe enough to hold less than five percent of their money reserves relative to their bank-money balances. In other words, it was prudent to leverage 95% or more of this garnered pool of capital into interest-earning assets with suitable duration and liquidity. Previously noted as something conceivable but not likely, this economization can be “taken to the limit” to where the reserve ratio approaches zero. At this point, the community approaches what is referred to as a “cashless society,” where little or no money (e.g., cash) is exchanged in commerce. However, as noted before, it is well-established in monetary theory that natural constraints exist in the market that strictly limit the extent of this exploitation.

In a competitive free market, banks that are not unduly regulated or restricted usually take careful measures to manage the inherent risks associated with banking, particularly when dealing with freely convertible money substitutes. In the contemporary theoretical framework that emphasizes spending levels as a key factor in economic well-being, these precautionary measures are often viewed unfavorably as obstacles to extending additional credit, thereby dampening spending levels. However, this so-called “friction” plays a crucial role in curbing reckless behavior and encouraging important objectives like maintaining adequate reserves and capital. While policies aimed at stimulating spending often seek to reduce this “friction”—such as government bailouts, deposit insurance, and “Fed puts”—they can dangerously undermine its positive impact. Notably, by weakening these natural safeguards against imprudent behavior, such policies promote the enactment of additional heavy-handed regulations to address the negative influences on bank management behavior.

Finally, the useful cash-out-at-will feature of bank money is certainly a fruitful inducement to augment the demand for the bank product. However, as it would be for any business model that featured an “all-you-can-eat” inducement for its product, it exposes the bank to the risk of an undue “binge” on cash. Presumably, any “all-you-can-eat” feature is supported by a preponderance of evidence that the risk of “undue bingeing” is minimal. Though the risk is small, prudent banking in earlier times contractually included “option clauses” that provided temporary relief from rare cases of “undue bingeing.” Even though such precautionary “clauses” are reasonable, they were outlawed long ago (e.g., see Dowd, 1996, ch. 3). Nonetheless, these earlier qualifications on convertibility further demonstrate the distinction between bank money and base money.

An unrestricted cash-out-at-will feature understandably alters the level of calculated liquidity risk and time duration of funds garnered by issuing bank money relative to that of other bank products that have constraints on withdrawals, such as savings accounts and time deposits. Regardless, these considerations are merely contractual and managerial issues and do not affect the fundamental nature of these products in loaning out other people’s money. The financial arrangement of bank money, again, functions as an integral part of a bank’s primary role as a financial intermediary. That being said, the duration of the pool of garnered savings that ensues from the financial arrangement of bank money certainly falls within a broad spectrum of varying time durations of bank liabilities. To remain viable and competitive, prudent bank management matches this continuum in the duration of its liabilities with that of its assets to address the issues of liquidity and interest-rate risks, given the ever-present balance between safety and profits.

The Requisite of Profitability

 In both facilitating and financing trade, the institution of bank money is wholly built on credit. Consequently, its viability and existence depend on the profitability of using bank money. It must be generally profitable for the bank’s community as well as for the bank. Otherwise, the bank would be subject to a withering demand for its money substitute, resulting in shrinking reserves and possibly “bank failure.” The requirement of profitability underscores the distinction between money and its fiduciary substitutes. Unprofitable conditions, such as an economic recession, do not threaten the viability of actual money. On the contrary, such conditions would likely enhance the demand for actual money relative to bank money.

To illustrate, the requisite of profitability likewise applies to a gambling House’s casino-chip strategy. If the strategy of using chips as a cash substitute was not generally profitable for the House, then “at the end of the day,” the level of cashing out would exceed that of cashing in, resulting in depleted cash reserves and ultimately “House failure.” However, profitability is virtually guaranteed in the case of a gambling casino since the odds are purposely crafted in favor of the House. Certain activities, such as “card counting,” are even internally “policed” since these might adversely impinge on profitability. Additionally, the cash reserves generated from the chip strategy must be scrupulously managed. If a casino, for instance, persisted in imprudently “investing” appreciable amounts of its cash reserves on the “Wheel” of a casino next door, in all probability, the squandered cash reserves would again end in “House failure.”As for the viability of the strategy, the frequency with which chips change hands, or their “velocity,” is irrelevant as long as the strategy remains profitable for the House. Granted, gambling activities are in general a losing proposition for the patrons, but as long as patrons are satisfied with the House’s activities, the demand for the House’s cash substitute remains sufficiently strong. Otherwise, customers can simply patronize a competitor or abstain altogether.

Banks, unlike casinos, cannot fix the odds in their favor. Instead, they primarily depend on thorough due diligence and liens to enhance the profitability of their banking strategies. Similar to casinos, banks may implement contractual restrictions on certain activities or behaviors that could negatively impact their profits. Unlike the zero-sum nature of gambling, where either the House or the gambler wins at the other’s expense, the bank-money strategy functions differently. As mentioned earlier, bank lending practices are built on a win-win-win proposition for the depositor, borrower, and the bank. Banks have a vested interest in the overall financial well-being of their customers. A “healthy” constituency procures a stronger demand for their money-substitute and thus a heightened pool of savings or capital for the bank to leverage. As long as the demand for bank money remains sufficiently strong and profitable, the strategy remains viable. Like the casino-chip strategy, the churning or turnover rate of bank money is of little concern relative to profitability. Again, this “churning” or market activity tends to be profitable or wealth-creating in a market society where individual rights are protected, given the natural inclination to “profit” from one’s actions.

The requirement for profitability is closely tied to the daily clearing and settlement event at the clearinghouse, which represents a significant financial development stemming from the introduction of bank money. This daily event provides a composite snapshot of how the day’s trades impact the well-being of the bank’s community. It can be thought of as a daily temperature check on the overall health of the strategy. This daily “health checkup” reveals any concerns that need attention. As long as the strategy’s overall health remains robust, its prospects remain strong. Otherwise, there is a risk of bank failure. Moreover, since this event primarily involves bookkeeping adjustments, it takes place with a reduced need to use actual money, as inferred by the concurrent trading model (MCT).

For emphasis, the viability of a bank-money “gathering strategy” necessarily hinges on the attributes of credit, such as trust and confidence. Any consignment of cash or income to a bank for a deposit depends on the utmost confidence that it will be safeguarded or managed appropriately. Since bank products that perform as a medium of exchange are indeed credit instruments, any such bank products that are not trusted or creditworthy would, of course, be unacceptable or discounted in a free market as a means of payment. Furthermore, credit is manifested in the time duration between purchase and clearing, even if it is just momentary. Such considerations are absent with cash or currency payments (given the assurance that the cash or currency is authentic). Cash payments have a unique characteristic known as “finality.” This means that once a cash payment is made, no further debt obligations are created or exist. Diversely, transactions conducted with bank money involve some level of liability until it is cashed out or cleared, precisely because bank money is necessarily a claim on base money. Indeed, the creation and well-being of bank money significantly rely on a widespread culture of integrity and trustworthiness. This notion was recognized long ago by Adam Smith as essential for a functional free-market economy. Otherwise, in the absence of trust, bank money would hardly be possible, and the community would be saddled with cash payments or barter.

Part 2: The Impetus Behind the “Modern View”

The Endogenous Nature of Money and Its Fiduciary Substitutes    

The supply of bank money certainly augments the bank’s primary role as a financial intermediary in linking savings with investments. Per the classical view, the supply of such bank products that garner savings or capital to loan out is understood to comply with the economic “Laws” of a competitive market, like products in other lines of business. In economic jargon, these optimal levels in supply are endogenous variables, that is, determined within the system as an effect. These equilibrium levels are generally considered optimal and welfare-enhancing, given the conditions at any given time.

On the other hand, the causal agents are understood to be the ever-changing exogenous factors, which are encompassed within the concepts of wants, resources, and technology. In a free market, aside from changes in these external factors–such as technological advances and innovations in banking–the supply of money and its fiduciary substitutes are an effect. Therefore, they do not exert any causal influence on economic conditions beyond what has already been accounted for. In other words, all other things equal, the free-market production levels of these bank products reflect the existing conditions and tend to gravitate to optimal levels.

The modern perspective critiques the classical view by arguing that the free market often fails to provide a stable and welfare-enhancing medium of exchange. It attributes recessions and recurring financial instability to inefficient money supply. Unlike the classical view, the modern perspective highlights the significant role that the supply of a medium of exchange in general play in shaping economic conditions through spending levels. Consequently, this framework has led to a rationale for centralized control of the money supply.  

Notably, economics is indebted to recent developments in monetary theory proposed by the “free-banking view,” as mentioned earlier. Again, this school of thought emerged after the enigmatic 1970s episode of “stagflation” and F. A. Hayek’s (1977) pivotal work that addressed such phenomena. This immense body of work in both monetary theory and history has spurred a profound change in how to think about money and banking phenomena (it is unreasonable to cite all the literature here but begin with Selgin, 1988; White, 1989; Dowd, 1996; Glasner, 1989). In many respects, the interpretive framework of the free-banking view substantiates and greatly amplifies the classical view.

Again, per the classical view, the free-banking view holds that a free and competitive issuance of what is referred to here as bank money rationally complies with the equilibrating forces of the market to establish an “optimal,” welfare-enhancing level, thereby avoiding adverse monetary disturbances such as inflation or recessions. Also, in opposition to the modern view, its extensive and in-depth historical analysis has shown that most, if not all, of the past episodes of financial instability, including the depth of the Great Depression, have resulted from misguided policies or legal restrictions. As a result of these momentous developments in monetary theory, it is now acknowledged that the classical view had an elevated grasp of monetary theory compared to what was initially thought (see Glasner, 1989). But more importantly, this interpretive framework supports the view that the free-market supply of bank money is an endogenous variable; that is, the supply of bank money is derived from economic conditions as an effect and not a cause.

As previously explicated, the endogenous nature of the supply of bank money reflects a business of garnering and loaning out savings. All bank deposits, including those of bank money, are just one of three major sources of savings or capital for banks. The other two are borrowings and equity (or contributions made by owners). In the grand scheme of financial ventures in banking, a bank’s total investment portfolio, including infrastructure and overhead, is strictly limited by its ability to secure these three sources of liabilities. The totality of these liabilities is assumed to be invested in assets expected to maximize the rate of return on owners’ equity with a minimum amount of risk. For that matter, the same objectives apply to all financial intermediaries in general.

Regardless of which of these three sources above is used to garner savings or capital, the financial venture of banks does not depict a business of creating or multiplying money but one of leveraging these various sources of savings or capital into investments. Thus, in addition to the marginally profitable service of a convenient means of payment, the innovative bank-money strategy adds another source of profits in terms of financing trade. As noted, this beneficial service of financial intermediation using a credit instrument as a money substitute explains why the classical view characterized the issuance of bank money as credit and not as money. Again, in his recent working paper, Selgin (2024, p. 7) emphasizes the importance of viewing banks as financial intermediaries:

“The Intermediary theory maintains, in contrast, that ordinary banks’ lending capacity is generally constrained by their need to tap into real savings—savings that they are unable to create, either individually or collectively, out of thin air…Rather than being a matter of semantics, the disagreement between them is substantive. It is a disagreement concerning what real resources banks do or do not require in order to make loans, and make them profitably. It is substantive, and it is also important, for as I hope will become clear, whether or not banks are intermediaries has important implications for both monetary and bank regulatory policy.”

The endogenous nature of bank money in both its price and quantity supplied makes it clear that these variables of bank money are strictly tied to that of base money; that is, its price and quantity supplied, outside any legal force, are derived from those of base money as a result of well-understood market forces. Thus, the processes entailed in the price and quantity supplied of bank money are, in fact, much like those of a financial derivative linked to an underlying asset. The underlying asset here is the entity that identifies as actual money (or base money). Again, the redeemability-on-demand feature of bank money is an inextricable part of the process that links its price to that of (base) money through arbitrage. Nonetheless, the modern view posits that this inextricable process must entail exchanging actual money in trade. This theoretically imposed requirement, in turn, compels the modern view to characterize the “house money of banks” as actual money and not credit.

The “Real Side” of Money

The Presuppositions of the Modern View

It is understandable why the modern view equates bank money to actual money, given its presuppositions and theoretical foundations. Notably, it is wedded to the venerable old “Quantity Theory of Money” (QTM), which emerged as early as the 16^th century. Its basic idea is influenced by a common observation that economic activity correlates well with spending levels. For sure, economic activity is typically higher when spending levels are higher, and conversely, it tends to be depressed when spending levels are low. Given this positive correlation, spending levels are postulated to be the primary “driving force” in the level of economic activity or output. Since spending involves the use of money in some fashion, the money supply is perceived to play a predominant role in the level of economic activity. The presumption behind this emphasis on spending is that money changes hands whenever trades occur. Hence, the modern view considers it practical for theoretical reasons to adopt the idea that a payment utilizing bank money is equivalent to a payment made with cash or base money.

Indeed, the thesis of this view was popular in the early days of economics when it was asserted that a “general glut of goods” or what is referred to as an economic recession, was caused by “too little money.” This popular view was, of course, famously rebutted by the classical view, which argued that it was unlikely that “too little money” was the cause of a “general glut” in the context of a free and robust banking industry, which will always generate a sufficient supply of a means of payment when it is rational to do so. This will be expounded on later in the discussion on the presuppositions of the classical view.

It is worth mentioning that this ever-popular theory, which posits that spending is a dominant factor or “driving force” in the level of economic conditions or wealth creation, turns the classical theory on its head, regarding theoretical aspects of cause and effect. Despite the common observation that spending levels and economic activity correlate well, “correlation does not imply causation,” as it is commonly said.

Notably, the conventional theory holds that the impact of spending on economic conditions is equally effective, regardless of the purpose of the spending. Even government spending is ranked equally. In contrast to the classical view, consumption spending is therefore viewed favorably and highlighted, since it is calculated to make up the vast majority of total spending. Since saving is seen as the absence of spending and as a “leakage” from the total spending levels, it is conversely viewed apprehensively as an “ever-present danger” to economic well-being. Moreover, exports are viewed favorably, while the classical view contends that the real gains in foreign trade for a country lie in its imports due to its focus on the allocation of resources and the value received relative to the value given up.

As an appendage of QTM, the modern view embraces the famous Fisher “Equation of Exchange” or (M)(V) = (P)(T), where

The Equation itself is understood to be merely a concession in accounting that total spending [or (M)(V)] necessarily equals what is spent on total output [or (P)(T)]. Thus, the tautological nature of the “Equation” adds little to economic understanding, absent a theory on cause and effect. The tautological aspect of the equation is clearly manifested when only base money, e.g., commodity money, exists and bank money is absent. For example, in the model of concurrent trading with only three vendors, total spending [i.e., (M)(V)] equals the total “chip” value spent on the three goods [or (P)(T) = (1)(3)], regardless of whether it was three chips changing hands once [(3)(1) = (1)(3)] or one chip changing hands 3 times [(1)(3) = (1)(3)]. For sure, the theoretical challenge here is in determining what ultimately causes what in this arrangement. However, if the vendors decide that they do not want anything from others, the market obviously comes to a halt.

However, with the advent of bank money, the variables (M) and (V) in the “Equation” are no longer straightforward. For one thing, the turnover rate of money, i.e., velocity (V), is not even data that can be observed and analyzed. Its level has to be imputed from what is determined for the other variables in the “Equation.” This makes the findings circular and self-inducing. Thus, the “Equation” loses a lot of its relevance.

From a classical perspective, in comparison, the variable (M) in this famous equation denotes base money. Consequently, the variable (V) necessarily reflects the economizing effect achieved by using money substitutes, as demonstrated earlier. Again, this economizing effect inherently requires credit, and the supply of these substitutes is necessarily the result of the financial operations involved in the extension of credit in leveraging the actual savings that ensue from this economization in the use of base money, as explained earlier.

These financial operations are nonetheless closely linked to base money by the relentless forces of arbitrage. Thus, from a classical perspective, the price and supply of both base money and bank money in a free market are the effect of the equilibrating forces of the market. To be precise, the market-driven supply of a medium of exchange, broadly speaking and including both base money and bank money, is considered an endogenous variable, being derived from the natural forces of the market. Thereby, the product of (M)(V), or total expenditures, is the effect of economic conditions and not the cause or “driving force” of such conditions. The natural forces of the market are understood to be ultimately driven by the wants and aspirations of the participants in the market.

Understanding the distinction between endogenous and exogenous aspects of the market is crucial for grasping the relationship between cause and effect within a specific theoretical framework. For instance, the classical perspective recognizes that exogenous factors can influence the levels of either (M) or (V) beyond what is deemed endogenous in the market. These exogenous factors are all encompassed under the concepts of “Wants, Resources, and Technology.” A significant, unexpected gold discovery, for instance, is considered an exogenous change in “resources,” and this would impact the level of (M). The advent and advancements in financial innovations, such as bank money, are understood to be an exogenous change in “technology.” These changes are likely to have a favorable effect on the level of (V). Centralized monetary policy and banking legislation are external factors that can significantly change the levels of both (base) money supply (M) and velocity (economization) of money (V). These external changes can greatly affect economic conditions, either positively or negatively. However, the market has demonstrated a strong ability to adapt to such changes without relying on government intervention. More will be said about this later.

With that said, the famous “Equation” nonetheless comports well with the QTM playscript of the modern view, where the level of “spending” plays a critical causal role in the level of total output and prices. Again, total spending [or (M)(V)] is interpreted to be the primary “driving force” in the money value of total output [or (P)(T)]. Thus, from this quantity-theoretic framework, the “Equation” fosters the notion that virtually every transaction entails the exchange of actual money. Again, this assumption helps make the theory plausible. The classical theoretical framework, where the exchange of money is bypassed in a vast number of transactions through financial arrangements, using various credible substitutes for money, does not align with the modern view that relies on a QTM framework. Furthermore, the “Equation” accentuates what is already ingrained in the modern view: the notion that the “money supply” can be treated as an arbitrary or external causal agent rather than an optimizing endogenous variable shaped by market dynamics. It is important to note that these “external forces” are typically viewed as being disconnected from the welfare-enhancing processes of the market.

The presupposition that spending in itself drives economic activity understandably leads to the belief that the economic maladies of recessions or inflation stem from suboptimal spending levels, specifically nonoptimal combinations of money (M) and its velocity (V). Consequently, these nonoptimal spending levels are mostly blamed on “adverse monetary disturbances” of either “too little” or “too much money” that can arise in a free market economy. This cause-and-effect framework indeed promotes a policy agenda of centralized control. To address or prevent such issues, centralized government supervision and control over the money supply is thought to be necessary to maintain appropriate levels of the money supply (M).

To govern money, however, the monetary authorities must identify what monetary aggregates qualify as candidates for (M) to control. Since most spending is conducted with credit devices or money substitutes, it makes sense that monetary aggregates that resemble or come close to resembling a “generally accepted medium of exchange” (GAMOE) qualify as candidates. GAMOE, again, is the essential attribute or genus of the broader concept of a medium of exchange. This identification approach, therefore, classifies money substitutes as money. The modern view thus dropped the differentia from the definition of money that distinguishes it from its fiduciary substitutes to make it work for the theory. It is worth mentioning that this manner of identifying entities and the method of nomenclature lean on the dubious philosophical approach of nominalism. This approach focuses on identifying entities based primarily on their resemblance to the essential attribute as described in the definition, while dismissing other relevant attributes or properties. Disregarding pertinent nonessential attributes can, of course, result in misrepresenting entities and their function.

As noted, scrubbing the differentia was to square the facts of reality with the QTM interpretive framework of the modern view, where money (M) is presumed to be exchanged in virtually every transaction (T) of the “Equation.” Identifying money substitutes as money is thus necessary to make this presumption reasonable. Therefore, an entity resembling GAMOE qualifies as money (M). For instance, although bank checks are credit instruments and are technically classified as “orders to pay” (base) money, demand deposits still qualify as money because check payments are viewed as equivalent to cash payments. In this case, the reasoning behind this perception is that the fiduciary aspects of these payments are irrelevant, as checks are regarded as being backed by actual money.

Initially, the monetary authorities sought to control and optimize (M) to achieve the desirable economic goals of price stability and low unemployment. For decades, this objective led to an earnest but futile effort to find the right (M) to control. By the 1990s, these search and control efforts were abandoned and replaced with determined efforts to control and optimize interest rates. Despite this required shift in policy, the modern view, which is now accepted as uncontestable conventional wisdom, still embraces the monopoly-issuance of currency and strict centralized control of the “money supply.”

The Presuppositions of the Classical View

The classical view, on the other hand, supported a free and robust banking system, which was indeed experienced in the early days of economics. Given the existence of a competitive banking system, the classical view, for example, decidedly rejected the ever-popular “too little money” theory as the cause of recessions. In the famous economic passage known as Say’s Law, where the “too little money” theory was disputed, J. B. Say remarks that “merchants know well enough how to find substitutes for the product serving as a medium of exchange or money” (1880/1971 p. 134). To repeat, the terminology and monetary theory of the classical view is clarified by David Glasner (1989, p. 63):

“In [Say’s] usage, only coin or specie was actual money; banknotes and other credit instruments that performed as a medium of exchange he called money-substitutes. But semantic differences do not alter his basic point that a competitive banking system would never allow an unsatisfied demand for money to turn into a general oversupply of all real goods.”

The most significant presupposition of the classical view that helps explain the quoted proposition above and why the classical view often clashes with the modern perspective is referred to as the “primacy of production premise” (PPP). [See Salsman, 2021, pp. 115-168, for an in-depth description of PPP.] This premise stems from the recognition that for value to be consumed, it must first be created–that practically everything we consume must be produced, that “not much grows on trees.” A key implication of the PPP is the assumption that once value is consumed, it is gone forever. This point is inferred in the phrase “eating your seed corn.” The significance of this implication is not diminished by pinheaded objections that some values like state parks can be enjoyed without being consumed, which demonstrates a misunderstanding of what is meant by consumption in economics. The distinction between the economic concepts of consuming, saving, and investing is the difference between burning a tank of fuel to take the family to the beach or foregoing the trip and using the gas to grow the corn crop instead.

The classical view considers PPP axiomatic for economics, which is described as the science of wealth creation. It is axiomatic in that it does not need to be proved; it holds regardless. The recognition of PPP leads to a fundamentally different approach to economics compared to the modern view, which is heavily influenced by the philosophical approach of “positivism.” Adherence to PPP leads the classical perspective toward an emphasis on market processes that are intent on optimizing the responsible management of scarce resources, rather than the preoccupation with spending or demand.

Again, in the classical view, the willingness and ability to spend are a given in a free economy when value is produced. “Spending is easy when value exists,” as William Hutt exhorted in defense of the classical view. The cardinal virtue of the straightforward recognition of PPP is that it helps expose illogical conclusions and theoretical contradictions. Consequently, the convoluted ideas of mercantilism were rejected in the classical era. While PPP may seem commonsensical, it is not always honored in economic thought. The source of conflicting theories on cause and effect can often be traced back to the extent of commitment to PPP.

Furthermore, the concepts of “wealth creation” and “optimality” are understood in the broader sense of maximizing personal happiness or satisfaction rather than in some narrow material sense. The “God-given” or natural right to the pursuit of happiness of individuals constituted the “ends” or, in Aristotelian terms, the “prime mover” in economics. Whereas the accessible resources at any given time, including labor and know-how, constituted the “means” or, in Aristotelian terms, the “material cause.”

Accordingly, commodity money and its fiduciary substitutes were understood to be an integral part of the means in the pursuit of those ends. As depicted by the famous “Invisible Hand” metaphor, the “ends” in this case are generally best served by freely trading producers wholly reliant on their faculties and capital. The classical view on “wealth creation” no doubt complemented the developing political thought at the time that a free society is morally superior to a centrally controlled or enslaved society.

In alignment with the presupposition of PPP, the “classical” concept of demand is fundamentally different from that of the modern perspective. The classical idea of demand necessarily infers the production and supply of value for trade or exchange. Therefore, the supply of goods is what constitutes the demand for non-competing goods. In short, demand does not ensue from hungry mouths (wants) but from happy hands (production).

Hence, the so-called “driver” in the classical interpretive framework is the “production of value,” which is the genesis of demand. As Salsman notes, “What drives a robust economy is not ‘consumers’ per se but savers, investors, innovators, and producers.” In contrast, the contemporary view has evolved to where the market is divided into two separate and disconnected factors of supply and demand, which is commonly illustrated by two intersecting lines. This helps explain why the modern view stresses the importance of spending levels, particularly spending on consumption, in stark contrast to the classical view.

In the classical view, “spending” sits in the back seat as an effect. For that matter, the desire to spend is only limited by “wants,” and “wants” are correctly and axiomatically stated in economics as being “unlimited.” Thus, in the context of a competitive and robust banking system, the only constraint on spending is the supply of value that initially creates the ability (or income) to trade value for value in the first place. Once again, the implications of PPP play a decisive role in dispelling convoluted theories that suggest “demand” can be created from nothing, such as the idea that “printing money” or government spending augments demand.

Moreover, a severed link or “leakage” between savings and investments would suggest that a viable profit opportunity has been left unexploited. This contradicts the inviolable profit-maximizing principle in economics. Leaving a profit opportunity unexploited is hard to even imagine in a free and robust economy. Regardless of how produced value is saved, an unimpeded profit-maximizing market will find a way to exploit it if rationally possible. Even a quirky bent to “hoard” money (or its substitutes) and not to “cash out” on the implied created value of these claims only means more existing value in terms of assessable resources for others to exploit. The unusual preference of never “cashing out” money on the implied created value certainly does not warrant a dire “warning” or disapproval from economists. “In the field of monetary policies too there is no such thing as a scientific ought” (von Mises, 1949, p. 422).  

The industry responsible for the production of a medium of exchange, including the production of (base) money (e.g., mining and coinage) and the production of fiduciary substitutes (i.e., the issuance of bank money), is an integral part of the whole economy. It is just as “real” as any other industrial production line. Most importantly, the total supply of such products is endogenously determined; that is, the supply of commodity money plus its fiduciary substitutes is subject to the relentless Laws of economics. And, as in other production lines, such forces are understood to supply a welfare-enhancing optimal level in the context of a competitive and unimpeded market. Outside of some unusual major autonomous event, any “adverse monetary disturbances” were considered unlikely, if not implausible. In such an event, for instance, a gold discovery or the advent of a financial innovation, the market’s equilibrating forces engage immediately in establishing a new welfare-enhancing equilibrium. This is achieved as expeditiously as possible, given the “means.”

The classical view presents a unified and general theory of wealth creation, wherein the supply and demand for a means of payment are fully integrated within the system. One of the most significant insights in science is that a welfare-enhancing equilibrium incorporates and reflects a completely integrated combination of knowledge and judgments from every individual who freely participates in the system. The underlying understanding of this insight is that everything relies on the sanctity of private property rights and the freedom of contract. This also relates to the supply of a medium of exchange. In other words, the optimal levels of nearly all products, including the medium of exchange, are determined internally by the market. As such, a free and competitive market was not bifurcated into a market-behaving “real side” and then an unruly “money side” that requires control. 

The classical perspective on classifying base money as actual money led to one of the most salient principles in economics: the “purchasing power parity principle.” This principle states that a unit of the market-driven commodity recognized as money will flow to where it holds the highest value. As a result, a unit of money maintains the same value (or parity) everywhere within its universal sphere, due to the relentless forces of arbitrage. In this case, a unit of money represents an objective measure of its purchasing power, based on the collective knowledge of all market participants. The distinction between money and its fiduciary substitutes clarifies this principle; without this distinction, the principle becomes murkier.

The bifurcated view of the economy between the “real side” and the “money side” can partly be attributed to the methodology of the classical view that punctuated the “real side” and treated the “money side” as less relevant, given the efficiency of a free and competitive banking system, where producers can generally find a way to trade their goods. In time, the money side was seen as merely a tool for “keeping score” and keeping the “machine well oiled.” The unflattering “veil of money” metaphor describing the classical view of the “money side” suggested its view had virtually dismissed the issue of adverse monetary disturbances.

By the turn of the 20th century, the “money side” was merely viewed as raw material that the central authorities could manage and control to ensure optimality in what is considered “real” in the economy (e.g., low unemployment and stable prices). The respect for the inviolable sanctity of private property rights and contractual freedom in the production of a medium of exchange was practically ignored. Consequently, a long-desired political agenda of monopolizing the issuance of currency and instituting a fiat standard was accomplished.

In a very “real” sense, the free-market production and supply of both money and its fiduciary substitutes potentially create enormous utility and value for the community. Notably, however, the two entities, base money and bank money, depict two different “animals” in the economic kingdom. As is well understood, the two entities differ in both attributes and function. For certain, their value and quantity supplied are determined by distinctly different market phenomena. They may appear to live in symbiosis with one another, but the life and value of base money, or what is actual money, do not depend on the existence of bank money. It can and has lived without bank money. The same cannot be said about the bank money. It is strictly dependent on the existence of money; its life and value are indeed “derived” from it.

Prospecting for Money

As shown and explained in this paper, the story of the significant advancements made by the advent of “bank money” is best told from a classical perspective, where the IOUs that perform like money are recognized as credible substitutes for the entity that serves as money. The concurrent trading model patently demonstrates that the mechanics of using a money substitute manifest a financial strategy that greatly economizes on the use of money. Like clay chips in a casino, these financial instruments are not money in themselves but functional substitutes that reduce the need to use actual money. Indeed, the supply and demand for (base) money can be reduced to just a small fraction of what would otherwise be required for trade.

The financial innovation of using a stand-in for money that can be “gathered” and reconciled “at the end of the day” takes advantage of innovative settlement mechanisms that promote even greater levels of efficiency in making trades. Advancements in technology are constantly improving the efficiency of these settlement mechanisms. These features alone create enormous benefits in terms of costs and convenience. Notably, however, the innovation of bank money led to a new way of tapping into a previously hard-to-reach source of additional savings for investment. This has indeed accelerated economic growth where such innovations are applied.

As a result of investing the savings that accrue from using bank money, the money reserves of banks represent just a fraction of the balances held in terms of money substitutes. This aspect of a bank’s portfolio does not reflect a “money-multiplier effect,” as depicted by the traditional view. Despite the on-demand feature and particular liquidity risk, the financial operation using bank money resembles savings accounts and time deposits, where money is loaned out rather than generated. The business of loaning out other people’s money is purely financial and banked on the attributes of credit, namely trust and confidence. Using bank money thus greatly facilitates both trade and finance by utilizing outside money more effectively. Hence, money is not created under these arrangements.

As noted in the paper, the modern and classical views clash on theory and policy due to different presuppositions that underpin their respective theories. As a result, the contemporary view posits that the money supply is a primary causal factor or “driving force” in economic outcomes via spending levels. This view was popular even in pre-classical times. The mechanistic framework of this view presumes that transactions necessarily entail the physical exchange of money. Thus, it is expedient to include money substitutes in the money supply to make the theory plausible.

Since this quantity-theoretic framework assumes that transactions must entail the physical exchange of money, the number of transactions is constrained by the existing money supply (M) and its turnover rate (V). The product of these two monetary factors, (M)(V), is considered an independent development from the market’s equilibrating forces. Consequently, it can be misaligned with what is optimal, leading to either too little or too much “money.” Clearly, this interpretive framework is devoted to the idea of monopolizing currency issuance and maintaining centralized control over the money supply.

In contrast, the classical view regards spending levels as an effect, meaning that spending levels respond rationally to the market’s reaction to anticipated real economic factors. The “money supply,” or, more precisely, the supply of a medium of exchange, adjusts accordingly to reflect actual conditions due to the market’s equilibrating forces. Given that the issuance of money substitutes is entirely a financial operation, their supply is strictly limited by the amount of real savings that can be mobilized through these activities. On the other hand, where value exists, there is no reason to think that a competitive financial system will not exploit all profit opportunities to meet the demand for a medium of exchange. That is, the equilibrating forces of a free and competitive banking system tend to produce an adequate supply of a medium of exchange but not a dollar more.

Thus, the classical view considers it unlikely that undesirable outcomes, such as inflation or recessions, are caused by monetary problems arising from a free and competitive issuance of currency, as well as a variety of other substitutes for money. Contrary to the conventional view, the classical view argues that such economic maladies are more likely the result of misguided policies that are destructive to value or wealth creation. The remedy, in this case, involves addressing such destructive policies. When property rights are clearly defined and enforced, and the market’s beneficial forces are not misguided by political motives, the coordinating forces of the market tend to achieve financial stability and effectively tackle challenges such as inflation and recessions.

While this paper does not delve deeply into monetary theory, economics is indebted to the monumental contributions made by the Free Banking School of Thought in both theoretical advancements and historical analysis. Several of these excellent works are referenced below for further enlightenment. These developments represent a transformative shift in monetary theory. The Free Banking School reinforces and amplifies the classical perspective on the advantages of a free and competitive banking system. As such, the free-banking view aligns with the classical view and strongly advocates for a free and decentralized issuance of currency. Currency in the form of private banknotes would be another consideration for bank money.

The theoretical framework of the free-banking view is essential in fully grasping how the equilibrating forces of the market tend to drive the supply of bank money to optimal levels, helping avoid or mitigate inflation and recessions. The free-banking view understandably adheres to the existing terminology used for monetary entities, although it recognizes that bank money is tethered to base money. Additionally, it aligns with the Intermediary Theory, which holds that banks do not create money out of thin air nor conjure up savings out of nothing, in line with the propositions outlined in this paper. Given that banks are understood not to create money, the proposition in this paper is that this understanding implies money is the monetary entity that exists independently of banks.

As explicated in this paper, a key inference from the straightforward recognition that bank money is a money substitute is that base money is what identifies as real money. The existence and usefulness of bank money outside the force of law depend on the trust that it can be converted to base money if and when desired. Additionally, the value and supply of bank money are inextricably linked to and derived from that of base money. Base money is at the heart of economic affairs. It serves as a fundamental measure of value in trade and financial affairs. As a reliable anchor in financial matters, it plays a crucial role in effectively coordinating global market activities. The coordination of these activities is pivotal in the allocation of resources throughout the world and through time.

When base money was a market-driven commodity under the gold standard, its value and supply were endogenously determined, meaning that its value and supply were the effects of market-driven actions. Such actions are driven by the collective knowledge and decisions of all market participants. The processes are about as democratic as these can be. Furthermore, these processes proved mostly reliable and stabilizing when not unduly regulated and property rights are clearly defined and enforced. An evaluation of these processes certainly has economic implications, but even more so, it holds ethical and political concerns. In a free society, the moral question of whether real money is market-driven or fiat-driven is profoundly significant. These critical issues are addressed by Professor Judy Shelton (2024, p. 35) in her most recent publication and summarized below:

The magnificent mechanism of free-market interactions, so compatible with our belief in individual freedom and economic liberty, should cause us to question why we permit central banks to distort the signaling mechanism that so efficiently conveys value. It goes against founding values and common sense to utilize central planning to tweak the validity of the money unit – deliberately making it more plentiful (through monetary stimulus), or less available (through restrictive interest rates) to alter economic outcomes in pursuit of government-directed objectives.… Substituting the perspicacity of designated monetary authorities, for the shared acumen of hundreds of millions of people carrying out voluntary transactions to facilitate their daily needs and future dreams is akin to selecting the path to serfdom.

In summary, it is worthwhile to prospect for a commodity or combination of goods that could potentially serve as money in a free-market economy. As previously noted, money was the monetary use of gold or specie under a gold standard in earlier times. The gold standard possessed the paramount property of being independent or greatly shielded from bank manipulation and political influence. Granted, the integrity of such a system relies on a culture of honoring and protecting property rights, preferably on a global scale. The establishment of the Federal Reserve System (the U.S. Central Bank) in 1913 defied this culture. However, it was sold to the public as a “system” that could yield the paramount property of being independent of political and banking influence. Given the perpetual debasement of the currency and the dismal record of financial stability since its inception, confidence in central banks or a fiat-driven monetary system has been severely shaken.

The shattered confidence in central banks was a primary impetus in the development of Bitcoin. Being an “internet money,” its unassailable property of independence, plus its lightning-speed efficiency, make Bitcoin one of the most promising prospects for money ever “mined” by the market. Its unique digital signature provides secure authentication and ownership, and the “decentralization” of its supply and holdings is an invaluable attribute in establishing a truly independent and reliable money supply. For sure, its supply is strictly limited and structurally impervious to almost any attempt to encroach on its independence. Given a free and competitive banking industry, the optimizing supply of freely convertible bank money mutes any arguments of an insufficient supply of a medium of exchange. Nonetheless, Bitcoin presently lacks the necessary properties of “general acceptance” and “unit of account” to serve as a possible candidate for money, although this situation can certainly change.

On the other hand, the gold standard has already demonstrated its value as a form of sound money, particularly when property rights are respected and enforced by governments. Additionally, its supply is adequate and sufficiently responsive to changes in demand, taking into account both its production and its interchangeability with nonmonetary uses. Coupled with the innovation of bank money, this ensures that there is an optimal response to any demand for a medium of exchange where value is recognized.

Moreover, there is something noticeably special about a tangible asset with the characteristics of gold. Born and dispersed throughout the universe from the wedlock of supernova stars, this precious substance is impervious to the elements and will stick with us forever. Its atomic number, 79, allows for precise authentication and makes it impossible to counterfeit, even in the most sophisticated laboratories. These attributes establish the basis for a sound financial system when one is desired.

With that said, the gold standard may rise above other competing standards for a financial system. However, regardless of what the market eventually favors among competing options, it warrants a “judgment-free zone” in economics.

No matter whether money consists of gold, Bitcoin, or some other market-driven good, a “cashless society” is certainly plausible where nearly all payments are made digitally, biometrically, or with some other alternative substitute for money. An entire life could conceivably be spent without ever encountering the entity, money. Even so, the relentless forces of arbitrage due to unimpeded convertibility will keep the value of all the various forms of “bank money” strictly tied to that of money.

References:

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Kevin Dowd, 1996, “Laissez-faire Banking”: Laissez-Faire Banking by Kevin Dowd – Routledge​(Routledge).

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George Selgin, 2024, “Banks are Intermediaries of Loanable Funds”: This reference is a working paper, and it may not yet be publicly available online. You can check for it on the Cato Institute’s website or research publication portals.

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L. H. White, 1989, “Competition and Currency”: Competition and Currency – NYU Press