BIS’s Borio calls on economists to take money more seriously

Economists ought to take money more seriously in their thinking, the Bank for International Settlements’s Claudio Borio argues in a new paper, setting out a framework for thinking more clearly about the monetary system.

“Bar a few who have sailed into these waters, money has been allowed to sink by the macroeconomics profession. And with little or no regrets,” the head of the BIS monetary and economic department says. “Today, I would like to raise it from the seabed.”

In the paper, published today (January 11) but based on an earlier speech, Borio argues the academic literature has tended to treat money as separate from payment systems, losing some “valuable insights” in the process.

Furthermore, by assuming in many models that money cannot have a long-run impact on the real economy, economists may reach misleading results, Borio says.

Thinking about money and payments together highlights the importance of having an “elastic supply” of the means of payment, he writes. Bank customers’ transactions are settled on the banks’ books and then in turn finally settled at the central bank.

To keep the system functioning, the central bank needs to provide significant quantities of credit, “most visible in the huge amounts of intraday credit central banks supply to support real-time gross settlement systems”, Borio says.

Furthermore, as is widely understood at central banks but less so in the wider public, it is bank lending decisions and not the monetary base that determine the overall money supply. The “ultimate anchor” of the monetary system is therefore the interest rate, and not the monetary base, Borio says.

When banks lend, they create money, and this too is essential to the functioning of the monetary system, Borio argues. “Without it, the economy could not run smoothly,” he says, adding that “credit creation is all around us”.

Following this line of thought further, Borio notes money and credit are often thought of as much more distinct concepts than they are in reality. One can pay for goods and services with money, but one can also defer payment using credit and then settle later.

“On reflection, the distinction between money and debt is often overplayed,” Borio writes. “True, one difference is that money extinguishes obligations, as the ultimate settlement medium. But netting debt contracts is indeed a widespread form of settling transactions. Needless to say, bank deposits constitute by far the bulk of all means of payment and are a form of debt.”

Future of central banking

Far from the future seeing central banks replaced by a distributed form of money like a crypto asset, Borio argues his line of reasoning points to the essential role of the state in the monetary system. Crypto assets suffer from a lack of elastic supply, he points out, which is to blame for the extreme price gyrations seen in recent years. As a result, they are not widely trusted as money.

“The problem cannot easily be solved,” he says. “A fully unbacked currency in elastic supply will not succeed in gaining the necessary trust. Alternatively, seeking to tie it to the domestic currency would require some agent to arbitrage in possibly unlimited quantities between the two, just as when central banks seek to keep exchange rates stable.”

Another alternative, backing the crypto asset with sovereign money, rather defeats the point, Borio adds.

In protecting trust in the currency, central banks must defend both price and financial stability, he continues. In so doing, they maintain trust in both money and money-like instruments such as debt. By raising the threat of default, financial instability can bring the payment system to a halt; similarly, unstable prices undermine confidence in money.

But the link between money and debt, the importance of maintaining both price and financial stability highlights the problems with viewing inflation as a purely monetary phenomenon, Borio claims.

Since the interest rate is the true monetary anchor, and interest rates affect different sectors differently, surely monetary policy affects the real economy, he says. The concept implies monetary policy and financial stability need to pay close attention to one another, a common theme in Borio’s work.

Borio says the current monetary system, overseen by central banks and financial regulators, is far from perfect. “But the present system encapsulates many of the valuable lessons we have learnt during a long journey through history – a sometimes painful journey of trial and error, with setbacks and false starts. Those lessons should not be unlearnt.”