[tfolger08]

I recently had an exchange with someone who was criticizing Joe Salerno’s “True Money Supply” metric on the grounds that it conflates money and bank credit. I think he just misunderstood that the distinction wasn’t really relevant for the purposes of the metric, but it prompted a question in my own mind about the interplay between a money and a money substitute, particularly with fiat money. If I’m not mistaken, we typically consider bank credit to be a money substitute for redeemable physical dollars, and yet in my own life, I find myself conducting nearly all my exchanges with bank credit, I could almost not care less if I ever saw a physical dollar, there are a growing number of situations where cash is not accepted while bank credit is, and when I receive money proper, I get rid of it and convert it into bank credit almost immediately. It almost begins to seem to me that bank credit is the money and physical dollars, the money substitute for those places that will only accept cash (which they will nevertheless almost certainly convert into bank credit after receiving it).

With commodity money, it’s hard to imagine a money substitute overtaking the money proper, because while the money substitute has value only in exchange, the money proper has value in exchange plus its value as a commodity. But in the case of fiat money, neither has any value worth considering outside of its value as a medium of exchange. And so it seems to me that whichever is to become the preferred medium of exchange, and hence the money, is dependent entirely upon which is the more suitable for, and valued in, exchange, and that it’s therefore entirely possible, and maybe even likely, for this relationship between a money and a money substitute to reverse when the money substitute becomes more convenient. Is there a problem with this thinking?

[jmherbener]

Money itself is whatever people choose to use as the general medium of exchange. Money substitutes function as a medium of exchange in lieu of money itself because they are redemption claims to money that can be exercised on demand at par. People will choose whether to use money or money substitutes according to their judgment of the relative advantages and disadvantages as a medium of exchange in the circumstances of their trades.

A particular item can serve as a money substitute as long as it is a redemption claim to money that can be exercised on demand at par. If a bank, then, so redeemed customer deposits that are credit deposits, such as passbook saving accounts, then those deposits are money substitutes. In fact, checking accounts in our day and age are also legally credit deposits. The bank owns the funds in customers’ checking accounts (customers have lent the funds to the bank) and the bank owes the customers immediate payment.

Before the financial crisis starting in 2007 and the ensuing economics downturn, the split between money itself (i.e., Federal Reserve Notes) and checkable deposits was approximately 25% to 75%. During the economic downturn the split moved to 50% to 50% as people desired to hold more cash itself.

The general trend (accentuated by governments), however, has been toward minimizing the use of cash.

https://www.mises.org/library/joseph-salerno-war-cash

This trend toward using money substitutes instead of money does not depend on what money itself is. This trend was also strong under the gold standard. Near the end of the classical gold standard, most transactions were done in bank notes or bank deposits and not in gold and silver coins. Even under a genuine gold standard, people may choose (for convenience, safety, and so on) to conduct the bulk of their transactions in money substitutes.

No matter how far this trend goes, it does not result in the money substitute becoming money. Its use as a medium of exchange remains entirely depend on redemption on-demand and at-par for money itself and thus, on the continuing existence of money. In order for the item used as a money substitute to become money, the government must either initiate legal disabilities against money itself or legal privileges for money substitutes.

Take a look at Rothbard on the history of switching monetary regimes.

https://mises.org/library/what-has-government-done-our-money

[tfolger08]

How do we demonstrate that the use of the thing we’re calling a money substitute, as a medium of exchange, is actually dependent on its redeemability for the thing we’re calling the money proper? This is easy to see for commodity monies, and for fiat monies when a money substitute is first introduced, but once you have a money substitute for a fiat money that’s accepted as readily or more readily than the money itself, it’s not clear to me why its value should any longer depend on the fiat money at all, since the only value either one has is its value in exchange. There doesn’t seem to be a reason to prefer one or the other, as long as it can suitably perform this function.

Now I’m not saying that this is empirically the case in the US. As far as the suitability as a medium of exchange is concerned, physical dollars still have the important advantage of being able to be held independent of any bank. Maybe the answer that I’m looking for is that a thing only ever becomes a money substitute if it lacks some important characteristic of the money proper? If it really were as suitable or more suitable, it wouldn’t become a money substitute, but simply a competing money. There wouldn’t really be any point in using gold as a money substitute for gold, or in using some other paper certificate as a money substitute for fiat dollars.

Thank you for your time in replying by the way.

[jmherbener]

There are items that people use as media of exchange themselves, like Federal Reserve Notes, bitcoins, and so on. And then there are items that people use as media of exchange that are redemption claims to money, like checkable deposits, passbook saving accounts, and so on.

The evidence that money substitutes require redemption as a condition of their continuing use as a medium of exchange is the fact of continuing redemption by the issuer of the money substitute. Banks could quit offering on-demand, at-par redemption for their checking accounts, etc. and, faced with such a prospect, people at large may or may not continue to accept such account balances in lieu of accepting money or money substitutes issued by non-bank institutions, but the fact of continuing redemption makes these deposits money substitutes and not money itself.

A money substitute has an objective definition that depends only on the fact of redemption and not on how people subjectively value the item. Whether or not people use some particular item as money or a money substitute depends on their subjective valuations, but the categories of money and money substitutes do not. They are definitions.

[tfolger08]

Feel free to end the discussion if I begin to take up too much of your time.

Pushing the question further though, when we see someone appearing to redeem one item for another, how do we determine whether what they’re doing is redeeming a money substitute for money proper, or if they’re converting money proper into a money substitute to facilitate some exchange. If we see someone withdrawing physical dollars from their bank account for the purpose of frequenting a cash only establishment, how is that we can assert that he’s redeeming bank credit (money substitute) for physical dollars (money proper), instead of converting bank credit (money proper) into physical dollars (money substitute) to facilitate his transaction?

Your last paragraph, if I’m understanding it right, seems to suggest that the answer is that we would infer how he regards the item by context – that in the example I’ve given, if the person views their bank credit as “their money,” and physical cash is merely a form their money must take to facilitate a particular transaction, then for them, the bank credit is, in fact the money, and the physical dollars, the money substitute. Whereas by contrast, if someone were withdrawing physical dollars in order to hold them, we might say that for him, it appears the physical dollars are money, and the bank credit, merely a form their money must take to facilitate particular transactions. If this is true though, what would prevent the possibility of the relationship between a money and a money proper reversing. And perhaps my original framing of the question confused things. I don’t mean a reversal in a categorical sense, but just an empirical situation in which physical dollars, previously viewed as the money, begin to be regarded as merely a form that money must sometimes take to facilitate transactions, and where people instead view their checking account balances as their money. And if such a situation did appear to maintain, wouldn’t economists have to change to treating bank credit as money, and cash as a money substitute?

[jmherbener]

It is the issuer of the money substitute who guarantees redemption. It is this objective fact that is a precondition for the bank customer to consider his checkable account funds as a money substitute. He has a reasonable expectation that merchants at large will accept his checking account funds in lieu of cash.

In similar fashion, certificates of deposit issued by banks are credit instruments, banks guarantee repayment of principle and interest, that do not function as a medium of exchange. When customers take money into and out of their CDs this doesn’t alter the objective fact that the CDs are credit instruments. Likewise when customers take cash into and out of their checking accounts this does not change the objective character of either cash or checkable deposits.

Banks guarantee redemption of checkable deposits into cash in order to increase the value to customers of such deposits by establishing the preconditions for such deposits to be a medium of exchange. Banks do not need to make any guarantees regarding cash itself to grant cash status as a medium of exchange.

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