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. After all, he was 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 offered the masseuse a chip. She was quite pleased when she saw that it was black. A cocktail waitress soon returned with his favorite brand. She, too, was grateful when he dropped 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 okay with patrons walking out with such chips. This indeed 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 helpful substitutes for cash or currency. These are indeed recognized as IOUs, specifically I-Owe-You-Money instruments. These financial products are understood to represent claims to what is actual money. However, the prevailing and longstanding view in economics is that such products are identified as actual money. Subsequently, these are included and treated as a component of the money supply. This paper argues that, despite the deeply rooted perception that these financial products are viewed as money, it is more precise and theoretically more fruitful to acknowledge that these products identify as substitutes for what is actual money, much like clay chips are in a casino.

The straightforward recognition that these products are money substitutes rather than money themselves provides a more coherent economic understanding of the role that these credit instruments play in the economy, which is distinctly different from that of actual money. More specifically, this straightforward recognition highlights the significant financial role that these substitutes play in the economy, anchored to what constitutes money by free convertibility. This has significant policy and ethical implications. From a theoretical perspective, this understanding focuses on the economy’s productive capacity rather than the heavy emphasis on spending levels in the dominant conventional view. Ethical and policy implications, in short, pertain to property rights in the exchange of such products in a free society.

As discussed in the paper, the conventional view of equating such products to actual money relies on a theoretical framework that assumes money, in some form, must be physically exchanged in market transactions. Since transactions are greatly facilitated by utilizing bank products that are freely convertible into money, it is understandable why the conventional interpretation resorted to classifying these products as actual money. To make this perspective more convincing, the concept of money was necessarily redefined from its earlier commonsense understanding, thereby allowing these products to be theoretically included in the money supply.

Since these bank products are created, as it is commonly stated, with merely a “stroke of a pen,” economic textbooks have for generations promoted the idea that banks possess a unique power to “create money out of thin air” and, thereby, “multiply the supply of money.” This phenomenon is described as a “money multiplier effect” (e.g., see Mishkin, 2019). Referring to such products as money is certainly not uncommon in everyday language. Colloquial references to money substitutes as money are harmless; however, identifying money substitutes as actual money lacks the necessary precision in economics and misrepresents their role in the economy.

The view presented in this paper is that reliable substitutes for money can be utilized to facilitate transactions, thereby reducing or eliminating the need for actual money to be used in trade. The traditional view that banks create or multiply money overlooks the fact that transactions can occur in terms of money, rather than necessarily involving the physical exchange of money in trade. Although functioning like money, these credit instruments are not money in a formal sense. Instead, these products are again “claims” to whatever entity serves as actual money. By acknowledging that trades can occur in terms of money by utilizing credible money substitutes, this paper demonstrates how these products play a crucial role in an innovative financial strategy designed to attract savings that can be invested in interest-earning assets. The financial goal of attracting savings to invest is common among financial products in general; thus, in this respect, bank products that are freely convertible with money, such as demand deposits, essentially function like other bank products that cannot be cashed out on demand, such as savings accounts or time deposits.

As demonstratively explained in the paper, 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. Notably, the observation 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 such purchasing power. 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 while allowing for the applicable risk. Thereby, the financial innovation of this strategy lies in the ability to utilize saved purchasing power for financing investments.

The innovation of utilizing money substitutes is thus a purely financial operation. Being strictly financial, the operation is not one of “creating” or “multiplying” money. Nor is it one of conjuring up savings “out of thin air.” The innovative strategy merely involves loaning out money that is not being spent, as demonstrated in the paper. While certainly facilitating trade as a convenient alternative to using money, just as clay chips are in a casino, these products also play a central role in financing trade. In short, money is a monetary entity that is supplied and exists independently of financial institutions, such as banks. It is what these institutions intensely compete to harness for investment purposes. The rest is simply finance.

This perspective, as presented in this paper, has profound implications for both monetary theory and policy. The prevailing conventional view that banks produce “money” is responsible for the promotion and enactment of centralized control over the “money supply” and the banking system. Its interpretive framework highlights aggregate spending levels as the primary “driving force” in the level of economic activity. Hence, spending levels play a pivotal role in shaping economic outcomes, particularly in terms of employment and price levels. As previously noted, this interpretive framework assumes that money, in some form, changes hands in trade. Therefore, the level of total spending is interpreted as being heavily influenced by the level of the “money supply.” For instance, economic activity can be constrained by an inadequate supply of money in the market, resulting in an economic recession. Conversely, an overabundant supply can excessively stimulate economic activity, leading to inflation.

A theoretical fixation on spending levels inevitably leads to a perspective that imbalances in the “money supply” are a significant source of financial instability or “adverse monetary disturbances,” such as inflation or recessions. Granted, this type of interpretive framework is hardly new and was even popular centuries ago in the early days of economics. Since money substitutes are considered equivalent to money in the conventional view, banks are viewed as being responsible for most of the “money supply.” Furthermore, a free-market banking system is deemed unreliable in rendering a balanced supply that prevents or mitigates against negative monetary disturbances. It is thus understandable why this mindset calls for the monopoly issuance of currency and strict centralized control of the “money supply.” The dissemination and popularity of this view can largely be attributed to the iconic works and personages of John Maynard Keynes and Milton Friedman (1969).

In contrast, the perspective presented in this paper — that banks are merely financial institutions and do not create money but instead use it more effectively — implies a reversal in causation between spending levels and economic outcomes. In stark contrast to the conventional view, the free market’s supply of a medium of exchange, including money substitutes, is in response to and the effect of economic conditions, apart from autonomous or exogenous monetary factors that may occur. As discussed in the paper, the supply and demand for a medium of exchange in general is the effect of economic conditions rather than a cause. To be clear, a medium of exchange is a means of payment that can consist of either the asset, money, which exists independently of banks, or the various bank products that effectively substitute for money. As a result of supply and demand, spending levels are thus the effect of these factors rather than being the cause of economic conditions.

This perspective above aligns with the interpretive framework and terminology that were prevalent before the current 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 current dominant perspective is called the “modern view.” The earlier perspective is, however, dubbed the “classical view,” insinuating a shift from an antiquated or outdated mindset to a more sophisticated understanding.

Rather than the focus on spending, the ultimate “driving force” in the classical view is the goals or ends that participants in the market wish to pursue. These “ends” or goals are subsumed under the concept of “wants” in economics. In economics, wants are axiomatically a given and considered “unlimited,” with the only limitation on such pursuits being the availability of resources or the means to fulfill them. Thus, a resourceful use of such means is advantageous in maximizing these wants. There is widespread agreement in economics that such maximization is best achieved by a market system of protected property rights where participants produce and trade freely.

Such means undoubtedly include a supply of a medium of exchange as a tool to help facilitate the indirect exchange of nonmonetary goods and services. Again, in an advanced economy, the supply of a medium of exchange consists of both the asset, money, plus its various substitutes. As noted later, the supply of actual money that exists independently of banks is referred to as “base money” in economics. In contrast, money substitutes or issued IOUs are at times referred to as “bank money.” Both of these monetary entities are indeed valuable tools in achieving the goals of market participants; however, they clearly exhibit different attributes and functions in the market.

As discussed in the 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. Consequently, the market supply of a means of payment cannot possibly be a hindrance in achieving the ends of market participants; that is, the supply of a medium of exchange responds to economic conditions. Spending is merely the byproduct of market participants striving to achieve their ends. Thus, a classical perspective dismisses the ever-popular idea that spending in itself plays a causal role in determining economic outcomes.

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 paper introduces a novel model referred to as the “Market of Concurrent Trading” (MCT) to help clarify why the issuance of money substitutes, like demand deposits, does not constitute the creation of additional money but utilizes money more resourcefully. This model clearly demonstrates how the financial innovation of utilizing money substitutes based on credit can create substantial benefits by reducing the reliance on an 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 idea of a money multiplier effect gained traction due to the popularity of a quantity-theoretic framework, which is discussed later in the paper. This popular framework reformulates the concept of demand from the perspective of how it was understood from a classical standpoint. The reformulated idea of demand, in this case, has the propensity to accentuate spending levels as a key factor in determining outcomes, fundamentally reversing the classical view’s understanding of it.

The contrasting effects 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 the quantity-theoretic framework tends to embrace government monopoly issuance of currency and centralized control of the “money supply.” This movement to embrace centralized control is now considered unquestionable 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 that 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.

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 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 role 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 bank money serves as a helpful substitute for money reinforces the interpretive framework of the free-banking view. This framework establishes the economic Laws upon which the price and supply of these substitutes are derived. The market processes are integrally tied to the price 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 any initial positive impact of a financial innovation, which is quickly 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 views on money and banking expressed by Ludwig von Mises (1949), a prominent 20th-century economist and a significant contributor to the Austrian School of Economic Thought. The Austrian School consistently applied an individual decision-making methodology, which uniquely establishes a micro foundation for a general, macro perspective. In his tome on economics, Human Action (pp. 432-448), von Mises differentiates between base money, which he refers to as “proper money,” and bank money, which he refers to as “fiduciary money.” Notably, von Mises never accepted the “modern view” that “aggregate spending levels” in a free-market system were a causal factor in wealth creation. The theoretical implications of this paper are consistent with his monetary theory.

Furthermore, the concept of money discussed here is also compatible with Ayn Rand’s philosophy of Objectivism and her views on money. Rand grasped that money was the physical commodity used as a medium of exchange, advocating for gold as its form. Echoing the financial principles outlined in this paper, Rand acknowledged in her Ayn Rand Letter that “[m]oney cannot function as money, i.e., as a medium of exchange, unless it is backed by actual, unconsumed goods.” This accords with the contention 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.” Though not an economist, she understood that “wealth creation” was not a matter of a deft hand at making bookkeeping entries, alluding to the popular Keynesian theory that the solution to a stagnant economy was a matter of speeding up the creation of money produced by banks.

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 have significantly enhanced our economic understanding of the equilibrating forces at play. This paper is indebted to this understanding. 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. As demonstrated in this paper, base money is the entity that is identified as actual money. It is the anchor for financial arrangements that utilize money substitutes. Again, these substitutes are merely “claims” on money.

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 a free world society, 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, commodity money flows 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, however, money substitutes are not money in themselves but serve to facilitate a financial strategy that captures and transforms savings into investments.

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, it is the medium of exchange that exists apart from and independently of banks. This entity is specifically referred to as “base money” in economics. Thus, the monetary aggregate of base money is what is denoted by the concept of money. In contrast, “bank money” expresses a claim on base money. Although bank money can function well 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, the distinction between money and its substitutes is critical to the science of economics, as demonstrated in this paper.

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 crucial role in coordinating the efficient allocation of resources over time and across the globe. It serves as a reliable foundation for the various products that can substitute for money. Thus, the integrity of the entire economic system relies on the trustworthiness of its currency. In the context of a free market 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 also pertains to the commodity of money. It additionally applies to the price and supply of bank money, which are “derived” from its interaction with actual money. The market processes that determine these economic parameters are those that determine non-arbitrary interest rates, or the price of capital. These rates, of course, play a crucial role in the growth and stability of the global economy.

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. In contrast, today’s unit of money under a fiat standard is not sharply defined by the monetary authorities; instead, it is simply stated that its value is whatever can be purchased with it.

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, the monetary use of gold or specie was considered money, while bank money was recognized as a substitute for it. Accordingly, its issuance was characterized as credit and not as money. This was the commonsense view of the framers of the U.S. Constitution when they established standards for defining the dollar in terms of a specific weight in gold and silver. Being market-driven and thus shielded from political influence, it comes closest to “honest money” among other alternatives.

A classical perspective on money and banking provides a more coherent explanation of monetary phenomena. Additionally, it supports 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 become intertwined, leading to ongoing queries that are futile. The current conventional view gained popularity around the turn of the 20th century and played a crucial role in establishing 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.

An 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 being more likely to be caused by one or more poorly conceived government policies that resulted in the destruction of 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 a high level of confidence in the competitive financial system that operated under the gold standard. Consequently, this earlier perspective was notably famous for largely 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 viewed as a useful tool for central authorities to help steer the economy. The sanctity of private property and freedom of contract in the production and use of money and its substitutes either take a back seat or are neglected altogether. Consequently, in time, the gold standard was supplanted with a fiat standard, where base money consists of the liabilities of the Federal Reserve System or the central bank. The liabilities of the Fed comprised 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 (albeit banks hold some fiat currency in reserve for redemption purposes). These 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 the gold standard, base money is fiat-driven, where its “general acceptance” is abetted by legal tender laws.

Despite the dominating acceptance of the modern view, there were some notable dissenters. For instance, Dale K. Osborne (1985) also published an amazingly in-depth article entitled “What is Money Today,” which cogently argued that base money is the only monetary aggregate that logically satisfies all the requirements to be identified as money. 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. A section in his famous tome on economics, Human Action” (1949), is devoted to “The Money-Substitutes” (pp. 432-434). He also careful to include the differentia in his definition of money being “the most marketable commodity.” He 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, von Mise’s primary concern with the popular terminology of equating bank money to actual money given below is still relevant:

“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 and thus theoretically equivalent to actual money. These reserves, by contractual agreement, are not leveraged into investments. Fiduciary media, on the other hand, is associated with fractional reserve banking, where only a “fraction” of the issued fiduciary media is backed by actual money. Other bank assets back the rest. Since it is built on the trust of the issuer, bank money can be described as a fiduciary substitute for money.

Base money and bank money both fall under the broader category known as “a generally accepted medium of exchange” (or the commonly used acronym, GAMOE). This term specifies the essential characteristic, or genus, of this broader category in economics. However, it does not distinguish 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.” The distinction is significant for monetary theory. Therefore, for conceptual clarity, the classical view includes the differentiating attribute of being a market-driven good or commodity in the definition of money.

The modern view was compelled to scrub the differentia of being a market-driven commodity from the definition of money, as it was expedient to equate bank money with actual money to justify its theoretical framework and desire for central banking. The theoretical aspects of this agenda will be discussed in greater detail later in the paper. Being scrubbed, money is simply defined as GAMOE. Thus, GAMOE serves as the benchmark by which to determine whether a particular monetary entity qualifies as money; that is, its theoretical framework necessitates equating money substitutes, or even “near monies,” with actual money. Needless to say, this interpretation of monetary phenomena has generated a massive body of literature focused on what constitutes money for economic analysis and predictive purposes.

As noted, economics is currently indebted by more 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 is aligned with the classical view in that both theorize that a free and competitive banking industry, like other industries, complies with the equilibrating forces of the market to supply an optimal level of its product, bank money. Consequently, the notion that the industry would fail to supply 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, touts the Intermediary theory in a recent 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.

The Creation of Credit and Not Money

The paper introduces a practical conceptual model, referred to as a “market of concurrent trading,” or MCT, that clearly illustrates how the issuance of bank money significantly reduces the 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 to gathering what can be seen as an additional source of savings or capital for banks. 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 saved or unspent money does not create additional money; rather, it generates credit by leveraging unspent funds into investments. As a result, even though money substitutes allow for cash withdrawal at will, the accounts created through this financial strategy are fundamentally similar to those without such a feature, like 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 certainly enhanced trade and finance with the introduction of bank money, it is a common misconception that these significant benefits to communities have resulted in the creation of new money.

This paper argues that the “economizing effect” of “gathering” money substitutes can provide an additional source of savings. This perspective is indebted to the advancements made in monetary theory by the free-banking view discussed earlier. Recent developments in monetary theory suggest that market-clearing equilibrium in the supply of bank money tends to be optimal. In other words, free and competitive issuance of bank money promotes financial stability and mitigates incidents of inflation or recessions. In contrast to the traditional view, the free-banking perspective advocates for a competitive and decentralized supply of currency. Centralized control is seen as a significant source of instability. In this context, the term “bank money” refers to the supply of currency discussed in the paper, which mainly includes demand deposits and private banknotes. However, “bank money” also encompasses all 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” as a consequence of viewing the supply of bank money as an unreliable causal factor, rather than as a rational response to economic conditions. Thus, economists wrangled incessantly for decades over the appropriate “money supply” to control. Virtually every school of thought had its own version of what monetary aggregates were included in the “appropriate money supply.” Unsurprisingly, this hopeless task was finally abandoned by the 1970s, primarily due to ever-changing financial innovations. These disputes over which monetary aggregates to control have now shifted to heated debates over how to control 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 actually reflect conditions. The agenda thus ends up distorting market decision-making adversely.

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 reflects 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 significant explanatory power in economics. A conceptual model can arguably provide a level of precision in understanding market forces that mathematical or graphical presentations are unable to do. 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 ability to clearly and concisely illustrate cause-and-effect relationships. By their nature, mathematical models or equations can be problematic in showing cause and effect.

For instance, Carl Menger’s (1976) conceptual model of the Law of One Price, advanced over 150 years ago, 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 satisfaction 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, economizes money and eliminates the need for actual money to change hands in trade. The discernible aspects of the model clearly distinguish between the entities and the processes that utilize these entities. This removes any ambiguity about whether the entity, money, is created or not by these market processes; that is, the logic underlying MCT essentially proves the economizing effect of utilizing money substitutes and that such processes create no 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 designated as money, the only entities that perform as a medium of exchange in the MCT. 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 exchanging 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.

Notably, however, if only one vendor possessed a chip, and the money supply thus consisted of only one chip, it would still be possible to achieve the same desired daily outcome. For instance, if A was the only vendor to own a chip, then A could pay B for “b,” giving B the means to pay C for “c,” then C could pay A for “a,” as shown in Diagram 2. Thus, a money supply of one chip, rather than three, would suffice to consummate all three daily transactions.

As shown above, a specific order in the sequence of the three daily trades is required if the money supply is only one chip, 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). The gathering strategy thus makes it possible for the desired outcome of trades to be consummated expeditiously with a money supply of only one chip rather than three.

Even though this gathering arrangement above is a hypothetical strategy for illustration purposes, this voluntary “gathering” arrangement is certainly relatable to the common observation of buyers and sellers seeking the advantage of gathering at the “village square” or marketplace to facilitate trading. It also relates well to the famous account of the islanders on Yap Island, as discussed by S. Ammous (pp. 11-13) in his outstanding book on a Bitcoin standard for money. In this actual account, extremely heavy Rai stones were used as money. The islanders gathered at the custodian’s location to declare ownership of specific stones acquired through trade. What is relevant here is that money did not physically change hands under these arrangements. The stones remained with the custodian due to their enormous size and weight. Only the ownership of the stones changed. Trust was inherent in this group because the islanders knew one another well; thus, transferring ownership of money required only a verbal “order to pay.”

The proposed “gathering strategy” of concurrent trading can be considered for a market of more than three vendors. For example, a community of ten vendors could similarly agree to such a beneficial gathering arrangement. As before, each vendor produces a different vendible good, priced equally at one chip. Such a scenario that, again, requires indirect exchange is depicted here, with producers designated with caps and their products with 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

Again, if all ten vendors possessed a chip, equating to a money supply of ten chips, then again, all ten daily trades could be consummated at any time or place during the day. But even if only one vendor possessed a chip, all ten trades could still be consummated expeditiously with the aforementioned gathering arrangement of concurrent trading, such as that shown in Diagram 3:

Compared to the alternative of no gathering, this gathering arrangement of concurrent trading indicates that the need for chips could be reduced from ten chips to possibly as little as one chip, thus 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 or an increased reduction in the need or demand for money. The money supply could conceivably be one-hundredth or less in contrast to that of no “gathering.”

Furthermore, to illustrate how remarkable the efficiency of money can be, consider this: if the same desired daily outcome is achievable repeatedly, a money supply consisting of just one chip could facilitate an unlimited 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 only one chip of money. This remarkable possibility of utilizing such a gathering strategy creates enormous benefits for the community. It substantially lowers the risk and cost of possessing and transporting money. It also dramatically reduces the need for money to a fraction of what would otherwise be required to accomplish the same desired ends. In this case, the necessary supply of money to complete the daily trades could be reduced to one-tenth of what might otherwise be required.

Suppose this “economization” process were “taken to the limit” in a mathematical sense. In that case, one chip under the arrangement of “concurrent trading” is sufficient to satisfy this perpetual achievement for an infinite number of vendors. It is even conceivable that no chips (or money) are needed in an immutable and “perfect” world of trust. Still, this incredible outcome is neither realistic nor desirable. Even if it is “mathematically” possible, 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.

Not to venture too far ahead but in the context of bank money, outside legal limits (e.g., required reserve ratios), these natural limits concerning the economization of money are well understood in monetary theory. These are referred to as “The Principle of Adverse Clearings” (see Selgin, 1988, pp., 40-42) or “The Law of Reflux” (see Glasner, 1989, pp., 64-66). In short, these natural limits, that must be heeded or dealt with, is what explains why banks consider it necessary to hold a sufficient cushion of money reserves and capital as a precaution. 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 case, the perpetual outcome cannot possibly be construed as “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. After all the trades have been settled upon gathering and all expectations have been met, the outcome for all participants at the end of each trading day depicts an improvement in everyone’s life. If this were not the case, the participants would not engage in such a process. We can say that this daily outcome tends to be “profitable” from the participants’ viewpoint. Realistically, factors constantly change, and these processes may not always end up profitable. However, the equilibrating forces of the market are well understood, and unprofitable events immediately lead to actions to restore profitability.

Consequently, this daily outcome reflects an allocation of resources that benefits 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, since it occurs with a more effective use of the money supply due to the “economizing effect” of MCT. This observation will be applied to banking below.

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.” These documents that reflect a means of credit can take many forms, such as checks or digital tokens. Whatever design these “documents” are fashioned, these specify which individual accounts are debited and which are equally credited.

These documents are gathered daily at a designated time and place for clearing and settlement, whether physically or digitally. This clearing process generally takes place in what is called a “clearinghouse.” Thus, the daily “gathering” at a specific time and place in the MCT framework aptly simulates the daily gathering of the 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, substitute 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.

Bank money undoubtedly performs as a medium of exchange, but it also serves as an effectual stand-in for money until it is cleared or “cashed out.” The daily “gathering” of these money-substitutes at the clearinghouse allows trades made with bank money to be settled or consummated by using bookkeeping adjustments. Hence, the gathering strategy using credible money substitutes averts the necessity of 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 their 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 great 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 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 minimized is beyond the scope of this text, in brief, the debt obligations between banks typically offset each other at the end of each day when they settle the “gathered” payment documents during the clearing process. Banks have a strong and well-understood profit incentive to manage the issuance of their bank money in a way that supports this outcome. As a result, the movement of base money between banks is greatly minimized or can even be eliminated.

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 commerce conducted. MCT allows for a more efficient use of money by enabling 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 traditional views, 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 condition of the community. Thanks to the innovations brought by 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.

The two different monetary aggregates, base money and bank money, are subsumed under the broader category of a medium of exchange. Again, as is well understood in economics, the demand for a medium of exchange can be exercised in terms of either base money (e.g., cash) or bank money (e.g., checks) each having a different effect. Although understood in economics, the demand and use of bank money reflect an inventive way to economize the use of actual money from the perspective of current trading, and that it does not reflect a phenomenon of money creation. If banks are understood not to create money, then again this begs the question of what the balances of bank money constitute. As addressed in the next section, the contention here is that, per the classical view, bank-money balances reflect credit just as the balances of savings accounts and time deposits reflect credit and not money.

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, thus it 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.

Savings is typically defined in economics as the portion of income that remains after spending on consumption. More broadly, savings refer to value produced but not yet consumed, which applies universally even where money and spending are absent. A classic example of the concept of savings is “seed corn,” or the amount of corn produced and not consumed/eaten. In banking, the act of saving is evident when unspent money is placed in savings accounts or time deposits. Such bank products are contractually designed to harness unspent money to invest by paying interest on their balances. Additionally, these products have withdrawal constraints to gain confidence in the duration of these bank liabilities. Although bank-money products such as demand deposits do not have withdrawal constraints, the aforementioned pool of money reserves that ensues from the issuance of bank money is nevertheless a pool of unused or unspent money. While this is not a contractual arrangement to access savings, this pool of unused or unspent money implicitly signifies a collection of savings. Given that there are no withdrawal constraints with these products, the confidence level is lower on the duration of these funds for investment purposes.

Again, money reflects an implicit claim on produced value. 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 continue to exist. It is immaterial who owns these implicit claims on resources within this pool of money, which frequently changes hands—similar to the “pool” of Rai stones managed by the custodian on Yap Island, as previously mentioned. Despite the churning of ownership in the pool of savings, what is critical for bank management is that the level of this pool of savings remains stable or relatively predictable at the end of the day for lending purposes, 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 then assesses the overall impact of all these daily trades on its pool of savings. Ownership of these implicit claims within the pool is constantly changing. These changes are efficiently made with bookkeeping adjustments. Regardless of these shifts in ownership, what matters for bank management is the net effect on money reserves. While the multitude of transactions creates value, the key concern is the net effect on the value that remains unspent or saved, as indicated by changes in the bank’s money reserves. This, again, is 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 that are generated from the issuance and use of bank money are considered an extra source of savings or capital, then it turned out that, as an unintended consequence, the innovation of bank money led to the development of new techniques for identifying additional sources of savings. In that case, we can see bank money as an innovative means of accessing a source of savings that can often be difficult to exploit. Thus, despite its redeemable-on-demand feature, the financial arrangement involving bank money operates similarly to arrangements with withdrawal constraints, like savings accounts. In this scenario, banks are not creating money; rather, they are essentially lending out the funds 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, reflect savings, defined in economics 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 coins from the rancher is a possibility, but personal loans can be problematic for various reasons. The strategic advantage of the “gathering strategy” of bank money 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. Thereby, the innovation of the bank-money strategy significantly reduces the risk and cost of holding and transporting actual money, which is gold in this case. Notably, it is a win-win-win outcome for the depositor, banker, and borrower. 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 consistent pool of base 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 the bank’s money reserves by the end of the day. This is mainly because the instructions for withdrawing money from reserves, as directed by bank money transactions, are generally balanced out by instructions to add money back to reserves. Consequently, the steady pool of money reserves is expected to persist indefinitely, partly due to the “Law of Large Numbers” and also because of the profit-maximizing incentives banks have to manage these outcomes effectively.

For example, a steady pool of money is created at a casino when patrons exchange their cash for chips. In the casino’s economy, chips serve as a substitute for money. Although these chips can be cashed out at any time and are typically used for numerous transactions, a stable pool of cash reserves is still maintained. Based on extensive experience, the casino (the “House”) can generally expect that the cash withdrawn when chips are cashed out will be balanced by the cash inflow from patrons converting their cash into chips. These offsetting transactions tend to keep the cash reserves at appropriate levels. 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. However, these considerations do not impact the main argument of 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, for any reason and rarely cashed out, provides the bank with a source of reserves for an indefinite duration. For that matter, as intimated in the preamble where a casino patron walks out with a chip as memorabilia, bank money that is never used or cashed out provides the bank with a timeless source of money reserves. John Fullarton (1845, pp. 64-65), a preeminent monetary economist of the 19th century, recognized long ago the significant relationship between the level of money reserves and the level of unused bank money when he wrote that “banknotes which are not in use are the same as if they are not in existence.” Fullarton’s noteworthy observation suggests that at the end of the day the amount of money reserves indicates the extent of unredeemed bank money holdings, highlighting the critical relationship between these two factors.   

In a market with freely trading producers, acquiring either base money or bank money requires the production of tradable value. Even the case of 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. [The introduction of new money, such as mining gold or printing fiat currency, is ignored here. It is worth noting that mining gold is part of the equilibrating forces of the market to produce an optimal outcome between the supply and demand for money, whereas the introduction of fiat currency can be disequilibrating.] 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. For example, recall the production of alfalfa by the rancher. As a result of trading this value, the property of gold coins in her possession reflects an implicit claim on her produced value. 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 always an explicit contractual statement or a recordable data point that designates the act of saving. Again, saving is the act of postponing the consumption of the value that has been created.

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:

Ammous, Saifedean, 2018, “The Bitcoin Standard”: The Bitcoin Standard- Wiley

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

Irving Fisher, 1911, “The Purchasing Power of Money”: The Purchasing Power of Money

Milton Friedman, 1969, “The Optimum Quantity of Money and Other Essays”: The Optimum Quantity of Money

John Fullarton, 1845, “On the Regulation of Currencies”: On the Regulation of Currencies

David Glasner, 1989, “Free Banking and Monetary Reform”: Free Banking and Monetary Reform – Cambridge University Press

F. A. Hayek, 1977, “Denationalisation of Money”: Denationalisation of Money – Institute of Economic Affairs

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George Selgin, 1988, “The Theory of Free Banking”: The Theory of Free Banking – Mises Institute

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.

Shelton, Judy, 2024, “Good as Gold”: Good as Gold – Independent Institute

L. H. White, 1984, “Free Banking in Britain: Theory, Experience and Debate”: Free Banking in Britain – Cambridge University Press

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