BEE Partner, South Africa Economy Watch

In the older economy, the monetary system did provide a constraint, and this constraint helped stabilize the economy; changes in the value of reserves worked in conjunction with the price mechanism. By contrast, the modern monetary system offers no constraint, and, in fact, inflations and asset price booms are self-financing, since price rises increase the value of collateral, on the one hand, and raise the value of bank capital on the other. The modern monetary system also allows for a creative use of the central government’s budget. The shift in money from real to nominal, following the changes in technology, has brought a new role for the government. The government budget is both much larger and plays a stabilizing role in the way it affects the economy.

The Old System and the New

^{The money supply in a craft system — convertible paper and metal, with bank deposits convertible into either on demand — denotes a set of activities that arequite distinct from the demand for money. That is, to supply money, metal has to be coined or paper printed; worn out coins and paper are replaced. New coinage or new printing will be done in response to price incentives; if the value of money in circulation lies above or below the intrinsic value of the monetary standard, then money will be supplied or withdrawn. By contrast, in a mass production monetary system, bank deposits have no backing other than the power of the state, money is only supplied when demanded, and it is always supplied when effectively demanded (when there is adequate collateral). In the modern economy supply and demand for money are indistinguishable. Money is independently supplied and demanded in the monetary system of a craft economy; it is created and cancelled in the process of circulating the total of goods and services produced in a modern economy.}

^{In the craft economy, neither the central bank nor the government had much control over either the money supply or the interest rate. Rather, both were largely determined by market forces and the price mechanism. The money supply adjusted automatically to keep the value of money in circulation equal to the intrinsic value of the monetary standard. The rate of interest adjusted to keep the volume of credit advanced in line with the banking system’s reserves. Even if the central bank had some ability to influence interest rates, it still had to ‘lean against the wind,’ which meant moving more or less in step with the market. By contrast, in a mass production system, the money supply accommodates almost instantaneously to the demand for money, and the nominal (short-term) rate of interest can be set by the central bank; in some circumstances, it can also set the nominal long-term rate.}

^{Reserves in a craft system act as backing for money of an inferior grade. Metal backs paper, paper backs bank deposits. In each case, the reserves are fractional, since withdrawals will not be likely to require the full amount, except in the case of a run. The reason is simple: the inferior money is more easily handled and used. It is more efficient, but it lacks intrinsic value. Fractional reserves imply a money multiplier; that is, if the amount of metal in the system increases, the total amount of money will increase by a multiple of that original increase. By contrast, the reserves in a mass production monetary system provide no backing — they have no intrinsic value. Government guarantees (for example, deposit insurance, lender of last resort), provide for the safety of the currency. Holdings of gold and silver are historical relics; paper and deposits are backed by the state’s power to tax. Reserves are nothing but clearing balances, and once electronic funds are in place, they are hardly needed at all. There is no money multiplier.}

^{The rate of interest in a craft economy is set by supply and demand. That is, when aggregate demand is exceptionally high, more funds will be needed for circulation. This will require attracting additional reserves away from private hoards. Banks will have to bid for reserves by raising interest rates. By contrast, in a modern monetary system, reserves do not provide a constraint, and banks do not have to bid for them. The central bank cannot fail to provide them; it has to accommodate, although it may choose to impose penalties. These, however, are a matter of policy; they are not the result of a market process. But the central bank has to keep order in financial markets, which requires smoothing out of interest rates. It cannot allow volatility, so it must peg the rate of interest.}

^{The Government Budget in a Modern Economy}

^{To understand just what a government budget imbalance means, consider a world of three parts: the domestic private sector, the government sector, and the ‘foreign’ rest of the world. In this scheme, the government deficit is the domestic private sector’s surplus with the government; the government’s surplus is the domestic private sector’s deficit. The current account surplus is its surplus with the rest of the world. Now compare the country’s current account surplus with a private sector surplus (the government deficit). The two surpluses are exactly the same in nature and have the same effects. The current account surplus is generally considered a ‘good thing,’ since it represents an excess of sales over purchases; by the same token, the government deficit should be regarded as a ‘good thing’ for the private sector.}

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