1.  Currency versus banking teachings. A frame of reference of lasting relevance to modern money systems

/8/ The expression New Currency Theory (NCT) makes reference to the historical British currency school of the first half of the 19th century. It was opposed by the banking school of the time.[1] The reference to these teachings does not intend to replicate them in the original form of their time, but wants to carve out the structural components which have continued to exist ever since.

The historical currency school emanated from earlier doctrines of mercantile bullionism, i.e. the idea that a nation's wealth depends on its stocks of gold and silver. Now that the metal age of money is over once and for all, the involved currency paradigm is supposed to be of no more relevance. This is an error. At the time, everybody was a 'metallist' in the sense of considering precious metals to be the base of paper money, money on account and additional monetary items built upon this base. The currency-school scholars or chartalists of the time―as represented by Ricardo, Thornton and Torrens―had no interest in gold as such. Torrens considered himself to be an anti-bullionist. They wanted to have a modern paper currency and credit system, albeit a stable one, avoiding scarcity as well as excess issue of credit and money, thus pre-empting deflation as well as inflation. They wanted to establish corresponding rules—some mechanism that would ensure control over the quantity of banknotes and credit.

Currency scholars as well as leading politicians of the time saw out-of-control issuance of private banknotes as the main cause of recurrent banking and economic crises. The analogy to banks' out-of-control credit and deposit creation of today is obvious. In response, the 1833 Bank Charter Act made central-bank notes legal tender (lawful money), and the 1844 Bank Charter Act determined the relative maximum of banknotes allowed by setting proportional reserve requirements in gold and silver to back them up. The British Bank Charter Acts were of general importance since they served as a model for similar measures across the then industrialising world. They marked the beginning of an end to the issuance of new private banknotes, phasing out old ones by substituting Bank of England notes for them, thus establishing /9/ the central-bank monopoly of banknotes such as it exists up to the present day.[2] The Act, as Whale put it, followed the currency-school 'theory that banking ought to be separated from the control of the currency'.[3] Money was thus re-established as a legal matter of the polity, ultimately as the sovereign prerogative which it normally has been throughout history.

In the years after 1844, however, the Act was repeatedly suspended on the request of the Bank of England, under pressure from the banks to print much more money in order to further fuel the railway boom of the time – which promptly discharged into the banking panics and financial crises of 1847 and 1857. The Act was a

nyway circumvented from the beginning, because what it did not take into account, in spite of discussion from currency and banking scholars, was the role of bank credit and demand deposits: the 'cheque system', as it was called later on. While the issue department of the Bank of England had to observe a 100% gold coverage of banknotes, the banking department was not subject to restrictions and could thus create any credit at discretion.  

In the course of the 19th century, demand deposits came to be used as a general means of payment in the bank-mediated clearing procedures among companies, government bodies, rich families and banks themselves. The monetary importance of this mechanism was fully recognised only from the 1890s, when the bank-credit theory of money was developed.[4] At that time the share of demand deposits had grown to about one third of M1 in advanced European countries. Today it has reached 80–90 per cent.

Nonetheless, currency-school teachings established as a matter of expe­rien­ce and empirical fact that modern money is fiat money which can freely be created. In the absence of proper regulation, free creation of bank money (banknotes, demand deposits) tends to procyclically overshoot, temporarily shrink, and be in final consequence without restraint. It thus results in an unstable and ultimately inflationary and asset-inflationary money supply which induces financial and economic crises.

Therefore, from a currency point of view it needs to be determined by law what shall be money in the sense of currency in general circulation, under whose control and responsibility modern fiat money shall be created, /10/ according to what procedures, and who shall benefit from the seigniorage, i.e. the special profit that accrues from creating new currency.

This gives rise to the question: what is the best economic anchor to tie the currency to. At the time discussed above – the late metal age of money, so to speak – gold was seen as that anchor, notwithstanding the backing of currency by government securities to a certain extent. Both currency and banking scholars also considered prices as a meaningful starting point. But they faced difficulties in documenting inflationary and deflationary tendencies, or depreciation and appreciation of the external value of the currency.

Later on, from around 1900, with the presumption of an 'intrinsic' value of money fading away and statistics largely improved, economists tried to replace gold with the average price of some basket of commodities— whether raw materials, initially including gold, or the prices of consumer goods and services, as standardised today in statistical consumer price indices. Important as these are, however, they are not suited as a master metre of the domestic and foreign value of a currency. Money buys commodities, but itself it is neither a commodity nor a basket of commodities.[5]

The quantum leap for the basket idea was to relate the existing stock of money to the entire national product, as formulated in similar ways by Fisher, Keynes and others (equations of exchange or equations of money circulation, respectively).[6] The value of money equals its purchasing power which is ultimately derived from productivity, i.e. the economic product as indicated today by GDP as a first proxy. So the productive potential of an economy at full capacity, i.e. the potential of the overall economic product, became the economic frame of reference for a commensurate money supply, relevant to both quantity policy and interest-rate policy.

The actual demand for money, it should be noted, includes demand from the informal and submerged economy as well as from the financial economy. The question of sound proportions between the real and the financial hemispheres of the economy is still largely ignored by orthodox economics.

/11/ With respect to such questions, the main representatives of the opposite banking school, Tooke and Fullarton, invoked the law of money reflux and what was known then as the 'real-bills doctrine' (real bills = bills of debt from credit­worthy originators, i.e. good IOUs).[7] The real-bills doctrine says that as long as bankers write out credit and print banknotes against 'real bills' at short notice, the money will surely be put to good use, and upon maturity of credits granted the money (mostly banknotes) will be taken out of circulation (reflux), making sure there is no more money than there is 'real' demand for. The quality of available real-bills collateral will regulate the quantity of credit and banknotes created thereupon. They thought of bankers as honourable merchants of im­pec­cab­le judgement. Interestingly, this is a moral and behavioural argument, not a functional one.

To banking-school scholars, inflation was a crucial aspect. In practice, though, bankers tend to be somewhat hypocritical in this respect. Towards the outside world they routinely speak out in favour of stable currencies, stable prices etc. In practice they not only don't care about it, but in fact they tend to fuel inflation and asset inflation by creating multiple credit leverage. This expands their balance sheet. It increases the nominal value of various bank assets, it raises interest rates and possibly interest margins, and it decreases banks' liabilities as much as those of any other debtor. Too much additional money at a time surely creates consumer or asset inflation. But the banks that create the additions derive from this an obviously irresistible first-user advantage. So, if inflation is not extremely runaway, banks luckily live with it, or to put it pointedly, they actually bank on it.

Torrens, as leader of the currency school, was himself basically a supporter of the real-bills doctrine. Over time, however, he became disappointed with the realities of 'real' bills and with bankers' actual practices. According to Thornton, himself a respected banker of the time, it is impossible to reliably know in advance which bills will be 'real' and which ones will turn out to be fictitious. Equally, banks discounted long-term bills almost as willingly as short-term bills. Unforeseen events can throw over any calculation. The banking business itself, he observed – including the Bank of England – had a tendency towards over-issuing credit and banknotes for pure self-interest, eventually triggering banking crises, the more so because bank­notes, to be accepted, had to be convertible (redeemable in silver coin or gold bullion).[8]

/12/ The banking school did not maintain a position along the lines of 'money doesn't matter', but their attitude was actually one of 'money doesn't matter that much'. According to Fullarton's law of reflux, inflation, credit bubbles and crises must have had reasons other than monetary ones, because banknotes were supposed to flow back to the banks on repayment of credit. Should there be signs of inflation, people would immediately exchange paper notes for coin, and so any overhang would be choked off. Sure enough, such money reflux is not documented ever to have happened— although it has often been attempted in bank runs, when long queues of people wait in vain in front of closed banks to get their money back.

As the currency school has stated, in real-world banking there is no limit on the amount of 'real bills' and bank money, except when the next crisis sets in and much of the good items go bad. Correspondingly, the currency school's response to the real-bills doctrine was the thesis of the real-bills fallacy: the belief in 'good bills', 'good uses', 'good bankers', 'perfect markets' and other features of ideal-world economics does not apply to real-world banking. To put it differently, the banking-school rationale is based on the axiomatic classical belief in the 'invisible hand' of markets, i.e. the medieval Scholastic theo­lo­gem of God's wise manus gubernatoris unfailingly creating a harmonia mundi unless distorted by evil machinations. In neoclassical economics, the latter are normally projected onto government interference.

Banking scholars demand that the government does not meddle in monetary and banking affairs, for money is seen as a means of exchange which is spontaneously—or market-endogenously, as it is called—created among traders. In the process, money itself becomes a commodity. The banking school's idea of money, and what is known today as the commodity theory of money, was later expounded in more detail by Menger in 1871 and the subsequent Austrian School. A commodity should be left to 'the markets'. With regard to money, this is but another way of saying it should be left to the big banks and financial actors of the time, while the government should limit itself to protecting property and enforcing private contracts. In this respect, banking theory again reflects the unreflecting idea of any orthodox economics that markets would have some sort of extra-territorial status, or absolutist private status beyond the state; something which dynamic market processes with far-reaching ramifications cannot have as a matter of fact.

That is certainly true of the legal foundations of monetary and financial order. The currency-school type of thinking entails as a basic assumption that 'money matters', as it was put in the monetarism of the young Friedman, maintaining the views of his Chicago school teachers Simons, Knight and Viner, who were behind the Chicago Plan of 100% reserve banking of the 1930s.

The monetary system is constitutive of the entire economy and comes with important consequences for state and society at large. Money governs finance, as finance governs the economy. This is certainly no linear causation. It entails feedback interdependencies. These, however, unfold around the systemic hierarchy of money, finance and the economy.[9] Who controls the issuance of money and the main pathways of money flows is in possession of the most powerful instrument of societal control besides law-based command powers backed by force.

The banking-school type of thinking, by contrast, tends to deny or belittle the power and importance of money. To bankers, the power of banks has always been a non-issue. Again, this is in line with classical economics, where money is seen as an ephemeral 'veil' on the economy, just mediating business and trade, not being constitutive of them. In neoclassical economics this corresponds to the theorem of neutrality of money, i.e. changes in the money supply may change price levels but are not supposed to result in final changes of investment, employment and growth (production/consumption).

Another element of banking teachings is to deny the necessity, even the possibility, of separating the control of the currency from the banks' credit business. Starting from their own business practices, bankers tend to identify money with credit. In modern banking, the act of issuing private banknotes and demand deposits in fact is an act of crediting. Who would disagree that credit and debt, assets and liabilities, are defining the banking business? From early modernity banks have operated on coin, bullion, credit letters, bills of debt, bills of exchange, credit claims and debt obligations of /14/ any kind, and have treated them as more or less interchangeable items, particularly if transferable and thus tradable, rather than being tied to a specific person or company. (The most recent development in this regard is the transferability and tradability of banks' loan and overdraft claims on customers). For banking teachings it has never been important to conclusively determine what money precisely is. In banking, this is actually not that important as long as depositors and other creditors of a bank hold still, debtors keep on paying and the value of assets is more or less preserved so that solvency and creditworthiness is maintained.

Even if the term 'real bills' is not used anymore, the real bills doctrine is a mainstay of any banking theory from the 18th century up until today. It is a core principle of central banking too (quality assets eligible for monetary policy operations). The banking doctrine today is hardly different from what it was 200 years ago: let banks freely create money (then banknotes, today digital money on account). Money and capital markets continually readjust and thus establish equilibrium so that under conditions of symmetric endowments, information and competition, banks cannot fail to create the optimum amount of credit (money) and financial markets cannot derail. No one ever asked how something like a self-limiting market equilibrium should ensue as long as there are no effective limits to commercial banks' creation of a disproportionately growing supply of money and financial assets, of credit and debt, as if defying the gravity of an economy's productive potential.

A prominent figure of banking-school teachings of the recent past was Fr. v. Hayek, who called for radical denationalisation of money, also known as free banking.[10] Fama's Efficient Market Hypothesis (EMH) can also be seen as a typical banking-school approach to money and finance of the recent past.[11] In this, financial markets were seen as near-perfect information-processing machines which relentlessly absorb and price in any relevant information. This is similar to the all-superior swarm intelligence which Hayek ascribed to markets (contrasting this to unknowing central planners and dull bureaucrats).

/15/ For sure, markets in good order are a mechanism of self-organisation and mutual readjust­ment. Many modern markets, though, are oligopolistic and corporatist power structures, and this certainly applies to contemporary big banking and finance. Apart from this, markets can fail, just as governments and the citizenry can—not normally, but often enough to create crises. For example, markets' judgement on risk and opportunity is often subject to serious mistakes. Markets normally do not foresee major events. Markets often follow rumours and vague moods, hypes and follies. They often rationalise afterwards what they are doing, rather than having had solid reasons for doing it. Markets quite often exaggerate over long periods of time and readjust only with great delay, when all of a sudden they go into breakneck reverse—as was the case with euro area bonds at untenably low interest rates and ever higher levels of government debt over many years up until 2010, as banks suddenly had to confront their own vulnerabilities, which they had swept aside for many years. This is typical of market behaviour in many cases, and it is obsessional rather than rational and efficient.

To conclude, the decisive difference between currency and banking teachings is not about a gold standard. It is about the question of who ought to be entitled to the prerogative of issuing and controlling a nation's money supply: whether the banking industry on a basis of private contracts (banking position) or a state authority, or a state-controlled institutional arrangement based upon public law (currency position); including the question of whether money is seen as a common good and a sovereign state's monetary prerogative of constitutional necessity, or whether money is seen as a private commodity under private control.

Today more than ever this is a policy issue of the utmost importance. From a currency point of view, the issue is as much a legal, constitutional concern of national monetary sovereignty as it is a question of financial stability and economic productivity. From a banking perspective it is a question of private law and financial profitability, giving lower priority to public finances and real-economic prosperity on the grounds that efficient markets could be expected to do the job automatically.

So 'currency vs banking' conveys a general frame of reference of lasting relevance to modern money systems. NCT and contemporary monetary reform initiatives clearly stand in the filiation of currency-school teachings /16/ and have a close relationship with 19th and 20th-century chartal theories of money. Likewise, they carry the (partially burdensome) legacy of monetary reform movements of the interwar years, such as the stamp scrip movement and the social credit movement, both of which aimed at full nationalisation of money.[12] An ancestry of academic origin can be traced through various approaches to 100% reserve banking of the 1930–40s.[13] NCT takes up the main structural components of previous currency-type teachings, and continues their legacy in up-to-date reformulations applying to today's still further modernised monetary and banking conditions.

MMT's positioning within the field of 'currency versus banking' is more complicated and actually contradictory. As explained in the following, it would be a mistake to portray MMT as a direct descendant of banking theory in the way that free banking is. MMT declares itself to be a theory of sovereign currency, building upon a state theory of money. So, at first glance, it looks rather like another currency-school type of theory. It then, however, builds upon a special version of the real-bills doctrine and treats the near-free creation of private bank money in the present system of fractional reserve as an indispensable centrepiece of a nation's sovereign-currency system—an unexpected combination, suitable for creating political confusion.


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[1] Cf. O'Brien 1994, Viner 1937.

[2] Ryan-Collins/Greenham/Werner/Jackson 2011 42–45.

[3] Whale 1944 109.

[4] As e.g. in Mcleod 1889, Withers 1909, Hawtrey 1919, Hahn 1920; remarkable passages also in Schumpeter 1911 (e.g. 110) and von Mises 1928 (e.g. 81).

[5] Wray 2012 264.

[6] Humphrey 1984. Fisher 1922 (1911), chap. II. Keynes 1923 77–83.

[7] Poitras 1998.

[8] Poitras 1998 pp481.

[9] Huber 2013 pp195.

[10] Hayek 1976, White 1989.

[11] Fama et al. 1969, Fama 1970.

[12] For stamp scrips cf. Gesell 1919, Fisher/Cohrssen 1934; for social credit Douglas 1920, 1924, Mairet 1934, Munson 1945, Hutchinson/Burkitt 1997.

[13] Soddy 1926, Currie 1934, Hart 1935, Fisher 1935, Simons 1948, Friedman 1948, 1959, 1969, Douglas et al 1939.