Monetary theory is a central element of economics. Its significance has risen since the monetarist counter-revolution led by Milton Friedman.
And yet, the theory is profoundly unsatisfactory as even a cursory reading of basic text books will suggest. Conventional monetary fails to define money unambiguously. Instead, elementary texts say money has three functions: as a medium of exchange, as a store of wealth and a means of measurement.
This is no definition. It is as if you were defining a motor vehicle by reference to its functions which might include acting as an expression of social status and a means of having fun as well as a mode of transport.
Money supply is measured with reference to various monetary aggregates assembled by central banking authorities. Its behaviour will therefore depend upon which aggregate is used, but is normally associated with interest rates and the activities of the banking industry, which through the fractional reserve system managed by central banks, makes the majority of what is deemed to be money in most advanced economies.
The demand for money is typically depicted as the result of the impact of the three functions; its role as a medium of exchange and store of wealth are the most significant.
The theory then connects the money economy with the real economy through interest rates and the exchange rate. It’s all very, very complicated.
The complexity of conventional models has defeated generations of students. As a consequence, monetary policy and its implications for markets for finance and real goods have been left in the hands of specialist technicians employed by universities and central banking authorities and quantitative analysts working for banks.
The theoretical and practical confusion monetary theory causes found its fullest expression during and after the 2008 financial crisis. It was reflected in the failure of the technicians in academia, central banks and the banking industry to foresee the biggest monetary shock since 1945 and their continuing struggle to reach satisfactory conclusions about how to prevent it recurring.
For Economics 2030, money and banking is a process supporting the interactive value-creation at the level of the individual at the heart of the service economy that dominates advanced economies. People creating value by creating interactively may or may not exchange money for the intangible commodities they produce. But when they do, money is definitively a process, a means by which mutual obligations are liquidated before, during and after a value-creating interaction
Money cannot credibly store intangible value, nor can it coherently measure it. So money in service economies is solely a medium of exchange, a payments mechanism.
This mechanism is like other mechanisms that support people involved with value-creation. These include electricity, the internet, roads and telecommunications.
There is no reason why this mechanism should be treated any differently to any other mechanism and there is no reason why the payments system should be controlled or even dominated by banks.
The majority use banks mainly to settle payments. But what’s been transferred is not cash or other financial instruments. It’s digital data.
This electronic mechanism could be more efficiently operated by non-banking businesses with experience of building and operating high-speed digital data systems. These include Google and other advanced IT companies.
Ideally, there should be a single electronic payments system that anyone and everyone can easily use. So long as the system’s security is sufficiently robust, there should be no reason for the system to be regulated. Payments are made through a system run by algorithms not people.
A comprehensive payments system would also encourage people to minimise their need for cash: something that can be easily stolen and relatively easily counterfeited. Ultimately, a cashless society where all payments are settled electronically may be optimal.
And it should be free at point of use. Costs could be covered through advertisement revenue in the way that Google and Facebook are funding their own operations.
What then is left of conventional monetary theory?
Not a lot.
Stripped of their original function as a safe place to keep cash, banks would be left to provide advice to corporate and individual customers about how to use their wealth efficiently. Since the payments system would be driven by an electronic network without human agency, there is no reason for them to be given special access to it. Bank deposits would become largely unnecessary. Most banks would die.
Central banks, stripped of their control over the money creation mechanism that banks allow, would be similarly pointless.
This conception appears radical, but growing interest in payments systems like Bitcoin that don’t need banks indicates that the future is already arriving. And the central banks of the world could be just one more financial shock away from redundancy.
For more about the theory of money see