Money Interpreted as an IOU

One way to conceive of money is as an IOU (“I owe you”) that is deemed acceptable by somebody other than its issuer. Anyone can attempt to issue an IOU. The difficulty, as the economist Hyman Minsky emphasized, is in getting it accepted.

Suppose you turn up at a supermarket, fill a shopping cart and proceed to the checkout. Rather than pulling cash or a credit card out of your pocket, you hand to the cashier a piece of paper on which you have jotted the words, “I owe you”. You declare confidently that it is your own personal IOU. Chances are you will receive a frown or a chuckle. If you persist, a manager might be called over to explain that your personal IOU is not accepted as money in this particular supermarket chain.

The manager might mention that they do issue gift vouchers and accept these in payment. These are the supermarket chain’s IOU. But, as it turns out, you don’t have any of these.

Fortunately you do have some dollar bills handy, which the manager would be pleased to accept. Dollar bills are an example of ‘government money’. Or maybe you offer to write a check or use EFTPOS. If so, you are agreeing to transfer an amount from your bank account to that of the supermarket chain. The deposit in your account is an example of ‘deposit money’. This would be equally acceptable to the manager.

Evidently there are all kinds of different monies (different kinds of IOUs), but some are more widely accepted than others. Your trusted neighbor might be willing to trade with you in personal IOUs; strangers, not so much.

What is it about the money of government or a bank that makes it more widely accepted in the community? To answer that, we need to look a little more closely at each in turn.

 
Government Money

A national government is well placed to ensure acceptance of its own money. Governments that choose to issue their own money are typically able to give it a central role, domestically, as the national currency. Prominent examples include the Chinese Yuan, US Dollar, Japanese Yen, British Pound, Brazilian Real and Russian Ruble.

The key to ensuring acceptance of a national currency is in the state’s power to tax. By specifying that taxes and other obligations to the state must be settled in government money, the government creates a need for individuals and businesses to obtain the currency.

It may be wondered in what sense government money is an IOU. What, in other words, is the government’s obligation or promise when it issues the currency? Among its obligations is the promise to accept its own money (IOU) back again in payment of taxes.

By way of analogy, suppose that your neighbor mows your lawn while you are away on holiday and you pay with a personal IOU. What you are doing is agreeing to accept back, in the future, your own IOU as payment for a service you will perform for your neighbor. Perhaps in the future you will wash your neighbor’s car and allow your neighbor to pay with the IOU you previously issued. So your promise, in issuing an IOU, is to accept it back at some later date in payment for services you agree to perform.

Similarly, the government pays for various services with its money (IOU). It uses its money to pay teachers, medical practitioners, police officers and many other types of workers for their labor services. It also uses its money to pay businesses for various goods and services. These labor services and business activities are performed for the benefit of the community. The government undertakes to accept its own money (IOU) back from the community as payment for the provision of these goods and services.

It is the imposition and enforcement of the tax obligation that enables government to spend its money into the economy. Some people will be willing to work for the government in the public sector to obtain the currency. Businesses will be willing to supply goods and services to the government in exchange for the currency. Others with tax obligations will be willing to transact with public servants and businesses or work in the private sector to obtain the currency.

The tax obligation is far from the only reason that we are prepared to accept the national currency. But it is the basis of our need to obtain it. Once this basic need is created, even people who pay no taxes will be willing to accept the currency, because of the established demand for it. And, for convenience, we will use the currency for much more than just paying our taxes. Once a demand for the currency is established, it is safe and convenient for buying and selling as well as for saving.

 
Commercial Bank Money

Banks also create their own money. This is in the form of deposits. A deposit is a bank’s IOU to convert bank money into currency (government money) at a deposit holder’s request, either on demand or after some duration of time. Most definitions of money include checking accounts, sometimes called demand deposits. These are bank deposits that can be converted into government money whenever the account holder demands it. When we use EFTPOS to direct a bank to transfer funds from our account to the account of a business in exchange for goods and services, we are making use of deposit money.

Banks are in a special relationship with government. They are required to convert deposits to government money in the form of hard currency (notes and coins) at par. In most countries, demand deposits are guaranteed through government provision of deposit insurance. It is possible for government to provide such a guarantee because of the central bank’s unlimited capacity to act as lender of last resort. Whenever banks find themselves short of currency, they can always borrow it from the central bank on terms specified by the central bank.

The requirement to convert at par in combination with the protection to account holders provided by deposit insurance ensures that $1 of deposit money is in most respects equivalent to $1 of government money. Since we have a need for government money, and bank money is “as good as currency”, we will readily accept bank money as well.

There is another important aspect of the relationship between commercial banks and government. Banks are required to hold accounts with the central bank (the government’s monetary agent). These accounts hold a special kind of government money called reserves. The accounts themselves are referred to as reserve accounts. The general public (referred to as the non-bank public) has no direct access to reserves. Only banks do. Banks can only use them for transactions among themselves and with the central bank.

Reserve balances play a key role in the monetary system because they are required for final settlement of transactions, including our transactions with government. Although we usually pay taxes and buy goods and services with bank money, final settlement only occurs once the central bank has adjusted reserve accounts to eliminate claims of banks on each other. At the end of any given day, some banks will owe others as a result of transactions occurring during the day. The central bank will need to delete reserves from the accounts of some banks and mark up the reserve accounts of other banks.

Since final settlement of transactions must occur in government money (reserves), banks must have access to sufficient reserve balances on our behalf. The banks need reserves for settlement purposes and we need the banks because the government gives them access to reserves.

 
Hierarchy of Money

We can begin to understand that there is a hierarchy to money. The most widely accepted IOUs are at the top of the hierarchy. The least commonly accepted IOUs are at the bottom.

Hierarchy of Money

 
Scholarly Treatment of the Topic

A more advanced treatment of the topic is provided by:

Stephanie Bell (Kelton) (2001), ‘The role of the state and the hierarchy of money’, Cambridge Journal of Economics, 25, 149-163.
 

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8 thoughts on “Money Interpreted as an IOU

  1. “You declare confidently that it is your own personal IOU. Chances are you will receive a frown or a chuckle. If you persist, a manager might be called over to explain that your personal IOU is not accepted as money in this particular supermarket chain.”

    What’s funny of course is that in the ‘good old days’ before supermarkets when you had a local grocery store it was perfectly normal for the store to grant you credit on account.

    In small communities, people built up debts with each other and then swapped them around to discharge them.

    As communities grow that gets a bit complicated so you come up with a clearing house called a ‘bank’.

    Then as communities get more intertwined the banks end up with the same swapping problem and you end up with another clearing house called a ‘central bank’.

    But overall it is the same process: Debts we owe can be discharged with Debts we own.

  2. Great piece Peter.

    One thing I’d like to see regularly added to the MMT narrative about what the Govt owes you. Its not just a tax credit, Govt’s also promise delivery of vital public services in exchange for their IOUs. For example, the only place to get a passport (a necessary condition to travel internationally) in the USA is with the govt. There are many examples like this, so we should add to the narrative that the Govt doesnt just owe you tax credits, they are owe you critical govt services. I know its relatively minor, but it helps to cement in people’s mind that the Govt does indeed provide invaluable services and it owes you those services in exchange for its IOU.

  3. That’s true, Neil. Some years ago I moved to a small rural town and went to buy something at the local hardware store. I pulled out my wallet at the register but the clerk (owner’s wife) said to me, “Oh, you live here, You automatically have an account here, payable in 30 days. We’ll send out a bill.”

    She wasn’t asking me whether I wanted to charge the purchase. She was telling me that this is how it works.

    So I smiled and said fine. Once a month, it cost me a stamp to send the check, even thought the store was a block away.

    But “that’s how it is done here.”

    This is a big deal in traditional communities.

    That is gone now. The hardware store closed not long after a Walmart opened in an adjacent larger town.

    That hardware store was all that was left of a vibrant community that had three car dealerships, a tractor dealership, a movie theater, several restaurants, several banks, assorted farm goods firms, two lumber yards, etc., in the Fifties. Nothing left. All the small farms have been replaced by agribusiness.

  4. In India, in the town that my aunt lives, the grocery store will send a man to collect the monthly dues (in cash). Before the cash changes hand, receipts are matched, errors if any are corrected, and then the cash changes hands.

    Of course for this to happen, you cannot be a stranger to the grocer!

  5. Hi Peter, trust you are well and thriving.

    Worthy of note is the documentary series Earth from Space running on SBS this week. It goes for 1h:30m but the lessons it holds of the real Law of Economy and Law of Attraction are mind-boggling. From the tiny little quotients of ‘energy’ that hold protons together and electrons in their orbit, cause the disassociation and distribution of the atoms, their vibratory rhythms, heterogeneity, inherent rotary activity, vibration, adaption, repulsion, friction – to their chemical affinity, magnetism, radiation, gravitation and progress to sex, colour, affinity and unity in every life form up to and including whole solar systems within the universe itself – it is a compelling story. Human social systems are so primitive in comparison. The combination of satellite data and planetary photography and animation are incredible – please take some time out to watch it. This is where our real choices are when it comes to living on this planet into the future.

    If the magnetosphere collapsed, we are vapour (like mind), toast – so quickly we wouldn’t even know it. And yet the whole system is designed to sustain and evolve life. It’s a beautiful depiction of the real environment we live in, and should be burnt into the spongy brain matter of every politician and economist on the planet.

    On another note, and while I am here, just wanted to link to TPRF’s video for International Peace Day on 21st Sept. this year 2015 (#PeaceDay): – it’s just 1m: 24sec and depicts through dance and words, letting go of all of the concepts that bind, by deploying Your Secret Weapon – which surprisingly enough also is …..

  6. I really like this piece.

    Do you understand the concept of how borrowing creates money?

    I think I get it, but what I don’t get, is that once the money is paid back, doesn’t that create its own kind of inflation, since hard cash is back in the system?

    P

  7. Hi Paul.

    Yes, a bank loan creates a deposit. The deposit can be regarded as bank money. It is a liability of the bank and an asset of the borrower.

    Offsetting the deposit is the loan, which is an asset of the bank and liability of the borrower.

    For the private sector as a whole, this nets to zero.

    When the loan is repaid, there is the elimination of both the loan and the deposit. The bank no longer has the asset (loan) and liability (deposit). Likewise, the borrower no longer has the asset (deposit) and liability (loan).

    The bank of course has accrued interest over the term of the loan.

    What is left for the borrower is whatever asset (e.g. car) was purchased with the loan amount and the income stream (e.g. wage or salary from a job) that s/he previously drew upon to repay the loan. It’s true that this income will be freed now for other uses.

    At the same time, though, the bank will probably be initiating other loans.

    In any period, there will be new loans issued and old loans repaid — bank money created and destroyed.

    The sum effect of all this lending and borrowing activity can be inflationary (or disinflationary), depending on the capacity of the economy to respond to higher demand for goods and services at current prices.

    It can also feed into asset inflation or disinflation.

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