Money can be thought of as an IOU (“I owe you”), denominated in a nation’s money of account. The issuer of an IOU can buy goods or services from anybody who is willing to accept the IOU as payment.
In return, the issuer of the IOU promises to accept it back again in the future as payment for goods or services the issuer provides.
Anybody can attempt to issue an IOU. The difficulty, as the economist Hyman Minsky emphasized, is in getting it accepted.
For example, perhaps your neighbor offers to tend to your garden while you are away on holiday. You write “IOU $20” on a slip of paper and promise that you will accept the slip of paper back again in payment for a service to be performed on your return. Your neighbor knows and trusts you and so accepts this arrangement. On returning home, you wash your neighbor’s car and mend a fence, accepting back the IOU as payment.
Or, perhaps while you are away, your neighbor talks with a mutual friend who is a good math tutor. The friend agrees to tutor your neighbor’s child and accept your IOU as payment. This can work because the mutual friend knows and trusts you, the issuer, and also trusts that your neighbor would not try to pass off a fake (or counterfeit) IOU. When you return from holidays, the mutual friend asks you to babysit, and you agree to accept back your IOU as payment.
Of course, when dealing with friends or neighbors, we would not usually be so formal. There would be no need to issue physical slips of paper with “IOU” written on them. There would probably just be an understanding that friends or neighbors help each other out with no need for a slip of paper to change hands.
But the example illustrates the idea of money as an IOU. So long as there are people willing to accept the IOU, it can be issued. But the IOU will only circulate within its own circle of acceptance. Outside this circle, the IOU won’t be able to function.
A national currency is the IOU of its issuer. In monetarily sovereign nations, the issuer is government. When government uses the currency to purchase goods and services, it promises to accept back its IOU in payment of obligations to it. These obligations mostly take the form of taxes. Other examples are fees and fines.
A deposit is a bank’s IOU, denominated in a nation’s money of account. When a bank issues a loan by simultaneously creating a deposit for the borrower, it is promising to accept back its IOU in the form of loan repayments made from the borrower’s account.
For a nation, we can think of a hierarchy of money, with the most widely accepted IOUs at the top. The government’s currency ranks highest. A little lower are bank deposits, which are a bank’s promise to provide government currency to account holders. Since government usually guarantees deposits up to some limit, bank deposits are “as good as currency” for most purposes and widely accepted. A little below them are deposits held at other financial institutions. Much further down the list might be a chain store’s gift vouchers. These can be transferred from one person to another and are accepted by the chain store as payment for its goods. Still further down are personal IOUs.
In the next two parts of the series, we will look a little more closely at government and bank IOUs, and the relationship between them.
A little more detail on this topic and an academic citation can be found at the following link: