Making Money Work: How to Rewrite the Rules of Our Financial System

Additional Praise

In this provocative and highly original book, Matt Sekerke and Steve H. Hanke provide a fascinating account of the origins, development and workings of the modern monetary economy. The authors debunk some of the leading assumptions underlying modern monetary economics and explain some leading paradoxes in recent experience. The writing is clear and concise, and the style is stimulating. The book is a major achievement in monetary economics.

—George S. Tavlas, Alternate to the Governor of the Bank of Greece on the ECB Governing Council and Distinguished Visiting Fellow, Hoover Institution, Stanford University

Making Money Work offers a daring and provocative solution to a perennial problem: how best to rewrite the rules of our financial system. Monetary and financial economists of all traditions will find much to take away from this highly original contribution to modern financial and monetary theory, which offers a novel policy conclusion – that the aim of monetary policy should be to make money as neutral as possible. This book deserves to be widely read.

—Kevin Dowd, Professor of Finance and Economics, Durham University Business School

This book offers a refreshing, illuminating, and sorely-needed rethink of monetary economics. Sekerke and Hanke lucidly explain who creates money, how this creates imbalances, and the role of a neutral monetary policy in taming those imbalances. I highly recommend studying this book carefully.

—Harald Uhlig, Bruce Allen and Barbara Ritzenthaler Professor in Economics. University of Chicago

An exciting and provocative book that goes far beyond traditional monetarism. Sekerke and Hanke mount a head on challenge to the mainstream macroeconomics which has been the only game in town for two decades, not to mention the source of multiple policy errors. Sekerke and Hanke’s novel and comprehensive analysis, which from start to finish has money and finance at its center, is a strong contender for a replacement.

—David Laidler, FRSC, Professor Emeritus, University of Western Ontario and author of Taking Money Seriously

Even the world’s most influential economists are puzzled about how the quantity of money affects output, employment and inflation. Making Money Work is a vital contribution to the public debate, not just in the USA, but around the world. The book is both necessary and ambitious, trying to clarify key issues in debates which go back centuries. It is of the utmost importance to understand what Sekerke and Hanke are saying.

—Tim Congdon, CBE, Founder of Lombard Street Research (now TS Lombard), Professor, University of Buckingham, and Chair of the Institute of International Monetary Research

This thought-provoking book strongly challenges received wisdom in the monetary field, not only on much current theory, but also on practice, both for regulation and policy setting. The authors make a strong case for their criticisms, and if they are right, then monetary theory and management have been badly misdirected in recent decades. Whatever your own preconceptions may be, the challenges laid down here are well considered, argued and presented. Their critiques in this book should be read, assessed and addressed.

—Charles Goodhart, CBE, FBA, Emeritus Professor of Banking and Finance, London School of Economics

The authors advocate a radical new approach to both monetary policy and regulation of the commercial banking sector. Highly recommended.

—Christopher Wood, Global Equity Strategist, Jefferies

Money and banks have been ignored for too long by both economic theory and monetary policy. It is a pleasure for a practitioner to discover this stimulating presentation, which puts them back in their proper place. It clearly explains how monetary policy and regulation should be designed—not to assist fiscal excesses, but to support investment and economic prosperity. A must!

—Philippe d’Arvisenet, former Head of Economic Research, BNP Paribas

Sekerke and Hanke’s book is perfectly timed for both economics and policy. It shows how to modernize monetary policy for faster growth and defense of the dollar, unlocking banking as a vital engine of growth. Sekerke and Hanke rewrite the theory of monetary policy to include the impact of bank regulation and fiscal policy alongside the actions of the central bank.

—David Malpass, former President of the World Bank Group and Under Secretary of the Treasury for International Affairs

Sekerke and Hanke have made an important and timely contribution to the debate over our monetary and financial system. Bringing together fiscal, monetary and regulatory aspects, the authors offer readers a unified and integrated approach unique to the literature. Highly recommended for both scholars and practitioners.

—Mark Calabria, former Director, the Federal Housing Finance Agency, and former Chief Economist to the Vice President

This writer dubbed Steve Hanke the Money Doctor for designing inflation-slaying monetary regimes in nations from Montenegro to Argentina. Hanke also won Fortune’s praise as virtually the first expert to predict that a post-Covid explosion in M2 had unleashed a sustained rash of runaway prices. Here, Sekerke and Hanke champion a new architecture that would recharge our commercial banks to fund the high-risk, big-potential projects essential to ensuring America’s future prosperity and wean our nation from a dangerous over-reliance on government funding.

—Shawn Tully, Senior Editor-at-Large, Fortune Magazine

In recent years, money supply has been disappearing from much macroeconomic research. Monetary policy without money is an oxymoron. The Sekerke and Hanke book is the antithesis of that paradoxical methodological direction.

—William A. Barnett, Oswald Distinguished Professor of Macroeconomics, University of Kansas; Director, Center of Financial Stability; and Editor, CUP journal, Macroeconomic Dynamics.

Sekerke and Hanke offer a uniquely comprehensive view of the US monetary system, showing how the Federal Reserve, the Treasury, and other regulatory agencies combine with banks and non-bank financial institutions to drive economy-wide trends and cycles in production, investment, and employment. They describe how this system broke during the financial crisis of 2008 and identify promising solutions to make it work again for the benefit of all Americans.

—Peter Ireland, Murray and Monti Professor of Economics, Boston College

The authors take us clearly through the institutional complexities of the modern financial system. They show why it is hard to be over-impressed with the basic fact of money creation by individual banks. They explore the consequences for monetary economics, for business cycles, and for our understanding of financial crises. More than most economic explorations, they leave us with new insights as to why and how money itself matters so fundamentally.

—Roger Sandilands, Emeritus Professor of Economics, University of Strathclyde

Making Money Work offers an insightful and compelling analysis of the modern financial landscape, challenging conventional views on banking, money creation, and monetary policy. Its unique approach—combining rigorous theory with practical reform proposals—makes it an essential read for anyone in finance and economics.

—Abderrahim Taamouti, Professor and Chair in Applied Econometrics, University of Liverpool, and Fellow of the Econometric Society

A must-read that combines the authors’ knowledge of financial markets with an in-depth analysis of monetary theory.

—Didier Cahen, Secretary-General of Eurofi

Economic theory too often abstracts from the details of money and finance. This book offers a brilliant new approach to economics, firmly grounded in the institutional realities of the financial system.

—Manuel Hinds, former Minister of Finance of El Salvador (1995–1999) and co-recipient of the Manhattan Institute’s Hayek Prize (2010)

Making Money Work

How to Rewrite the Rules of Our Financial System

Matt Sekerke

Steve H. Hanke

Copyright © 2025 by Matt Sekerke and Steve H. Hanke. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permission.

The manufacturer’s authorized representative according to the EU General Product Safety Regulation is Wiley-VCH GmbH, Boschstr. 12, 69469 Weinheim, Germany, e-mail: [email protected].

Trademarks: Wiley and the Wiley logo are trademarks or registered trademarks of John Wiley & Sons, Inc. and/or its affiliates in the United States and other countries and may not be used without written permission. All other trademarks are the property of their respective owners. John Wiley & Sons, Inc. is not associated with any product or vendor mentioned in this book.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Further, readers should be aware that websites listed in this work may have changed or disappeared between when this work was written and when it is read. Neither the publisher nor authors shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic formats. For more information about Wiley products, visit our web site at www.wiley.com.

Library of Congress Control Number applied for:

Cloth ISBN: 9781394257263

ePDF ISBN: 9781394257287

ePub ISBN: 9781394257270

Cover Design: Wiley

Cover Image: © tomertu/stock.adobe.com

Cien pasos equivocados en el camino correcto es mejor que mil pasos correctos en el camino equivocado

Foreword

This book must be read for the following reasons:

It offers a theoretical view on money and monetary policy that is often overlooked; indeed, the authors explain why economic thinking fails to grasp the nature of fiat money.

It stresses that monetary policy is heavily influenced by fiscal conditions. The monetary impact of the government budget is an essential factor behind monetary policy. If you combine a fiscal constraint factor (money must finance the deficit) and regulatory banking measures (banks have to buy the issued obligations), you completely condition monetary policy. We should see to it that bank regulation is more neutral.

What is worth praising in this properly extraordinary book is the combination of monetary theory and the business-related imperative of making money. I have never seen (except perhaps in reading Keynes) such a skillful association.

The authors look at central bank policy from the viewpoint of the quantity of money. Far from being an old-fashioned method, my experience has showed me that this relationship is essential to determine the adequate mix of fiscal and monetary policy.

The proposals for reform contained in the book are geared to achieve neutrality in the monetary system. I have been working and battling during all my career to promote the benefits of neutrality. This is the crux of the book.

The pathological character of real estate as the essential bankable project and absorber of savings is well analyzed.

If monetary policy creates distortions—which is abundantly the case—the allocation of savings to investments is, by definition, skewed. Is this the right way of using monetary policy for productive investment purposes?

Obviously, no.

We need, therefore, to improve the performance of the monetary system and make a better use of aggregate savings.

In order to achieve these aims, it is absolutely essential to enforce neutrality as the main objective of monetary policy. We have to stop believing that we (and central banks) know better than the markets. Markets, not public officials, fix the long-term interest rates.

* * *

To sum it up, the authors have illuminated a compelling path toward a basic objective which I share: a quantitatively based monetary framework.

—Jacques de Larosière

Jacques de Larosière is a member of the French Académie des Sciences Morales et Politiques. In the past, he served as the Managing Director of the International Monetary Fund (1978–1987), the Governor of the Banque de France (1987–1993), and the President of the European Bank for Reconstruction and Development (1993–1998).

Introduction

The Global Financial Crisis of 2007–2009 (GFC) precipitated a deep recession and a comprehensive reckoning with the risks taken by the world’s largest universal banks. Less obviously, the GFC introduced major disruptions to the conditions by which money is supplied to the wider economy. Commercial banks’ ability to create credit was restrained by new lending guidelines and increases in their capital and liquidity buffers, and the production of money-like instruments by financial intermediaries in the shadow banking sector was sharply curtailed. Governments stepped in with quantitative easing (QE), filling the gap with varying degrees of success. As the banking system of the developed world slowly recovered, the center of global credit creation shifted to China, a situation which has proven unsustainable.

Fifteen years later, we can evaluate the post-GFC policy measures which continue to define the landscape for banking, the capital markets, and monetary policy. With banks straining under the burden of their capital markets business and their accumulated exposures to real estate, credit growth is grinding to a halt. As a result, the global economy is leaning heavily on global savings to finance investment, just as capital investment needs are reaching a generational inflection point. Investments in electricity generation and electrification, decarbonization, the reconfiguration of global supply chains, and the renewal of public infrastructure and common pool resource assets will require investments in the hundreds of trillions over the coming decades. That we are leaning increasingly on government finance for this purpose is a worrying sign.

Our task in this book is to explain why the commercial banking system is central to the monetary economy. Motivating our analysis and results requires an ambitious itinerary. We must explain not only why banks are so essential for investment and the monetary system, but also why the received wisdom on money, banking, and monetary policy is wrong. We must explain how a fiat money system works and why the economic thinking underlying contemporary policy is inadequate to the task of fostering and regulating it.

We focus on the United States throughout, though we believe our analysis is valid for most of the developed world. To present data for all the major economies would quickly become overwhelming, which is not to mention the endless differences in the design of central banking institutions, bank regulation, and capital markets prevailing in different jurisdictions. We hope that others who are more knowledgeable about specific territories will approach their systems with the same orientation. We have also decided to cut off our reviews of empirical data at the end of 2023. Sacrificing some up-to-the-minute timeliness was necessary to avoid continuous revisions to our data analyses as we drafted the manuscript.

We have been following developments in money and banking for decades, as a consultant to universal banks, in post-GFC litigation, and in designing reforms to monetary systems. Tracing each insight back to its source sometimes eludes us. We hope that those whose work is under-represented in the bibliography will forgive us.

The best way to follow the complete argument is to proceed straight through, but in a book of this size the reader may want to skip around or at least skim certain sections. Chapter 2 will be most interesting for those who want to understand why cryptocurrencies and decentralized finance are not viable alternatives to the system of fiat money. Chapters 4 and 5 describe the micro-foundations of bank lending and financial intermediation, and how the presence of banks and financial markets complicates standard models of economic growth. Chapter 6 and Part Two are heavy on institutional details.

We would like to thank William A. (Bill) Barnett, Dean Buckner, Mark Calabria, Warren Coats, Peter Colwell, Tim Congdon, Kevin Dowd, Charles Goodhart, Manuel Hinds, Peter Ireland, Clark Johnson, David Laidler, Marco Macchiavelli, Ross McLeod, Roger Sandilands, Kurt Schuler, Abderrahim Taamouti, George Tavlas, Andrew Willans, and Zachary Zolnierz for helpful comments on an earlier draft of the book. Caleb Hofmann provided valuable help in preparing the final manuscript. We alone are responsible for any errors that may remain. We appreciate the efforts of Bill Falloon, Stacey Rivera, Purvi Patel, Katherine Cording, Delainey Henson, and the rest of the team at Wiley.

Correspondence about the book can be addressed to the authors at [email protected] and [email protected].

Matt Sekerke and Steve H. Hanke

March 2025

Part One

How Money Works: Institutions of the Monetary Economy

Chapter 1

Rethinking Monetary Economics

Money has disappeared from economic thinking, absorbed into Interest and Prices.1 Its essential role in the economy is as invisible to economic theory as water is to fish. This is not just a problem for theory. When the monetary system breaks, it is the job of economists to fix it, and theory is the economist’s sharpest tool.

The last great proponents of the view that money matters in the economy—monetarists like Milton Friedman, Karl Brunner, and Allan Meltzer—were humbled by the failure of Paul Volcker’s monetarist experiment at the Federal Reserve from 1979 to 1982.2 For the next 40 years, the Federal Reserve’s monetary policy drove interest rates downward until they could go no lower.3 We are now surrounded by the legacy of this policy: mountains of debt, insane real estate prices, eye-watering equity valuations, and Gilded Age levels of inequality. Perhaps the pathologies of an era that ignored the quantity of money as a factor in economic growth are a good reason to pay attention to the quantity of money once again.

Our goal is not to rehabilitate the old monetarism. Instead, we want to reexamine the role of money in the economy, taking the classic quantity theory of Irving Fisher and the Cambridge economists as a point of departure. We want to build a monetary economics that coheres with the current state of our financial architecture. The economic impact of money has not vanished from real life, even if we now carry less cash and the role of money has been abstracted away from economic theory. The quantity of money continues to affect growth, inflation, and asset prices. This book explains how.

Macroeconomics Without Money

The preferred tool of the vanguard in moneyless macroeconomic theory is dynamic stochastic general equilibrium (DSGE) modeling.4 The paradigmatic DSGE model is the real business cycle (RBC) model in which large-scale macroeconomic fluctuations are traceable to changes in productivity or household preferences.5 Random fluctuations or shocks affecting technology and tastes take center stage in contemporary macroeconomic analysis.

The RBC model supports a distinctive narrative about the macroeconomy. Developments in the economy are the result of technology-driven fluctuations in output and the efforts of households to optimize after observing them. Wages, interest rates, consumption, and investment adjust to the new state of technology through optimizing activity and quickly converge to their equilibrium values. All analysis can be carried out in terms of real variables, measured independently of their monetary values.

To achieve even a modicum of influence for money, some kind of external device is needed to extend the RBC model. Neo-Keynesian economists shoehorn an assumption about sticky wages or prices into a model that is otherwise largely identical to an RBC model.6 These stopgap theoretical devices, reverse-engineered to generate the short-term effect on inflation they are meant to explain, are defended with elaborate handwaving about why sticky prices are obvious to economists but imperceptible to economic actors.

Sticky-price models of the economy include a price level whose changes can be interpreted as inflation. The price level establishes a one-size-fits-all exchange rate between monetary values and real quantities like aggregate consumption, aggregate output, and the opportunity cost of leisure. As the inverse of the price level, in effect, money is a redundant variable and may be excluded from the model. The price level is influenced in the short term by changes in an interest rate, which is set by a central bank and taken to capture the stance of monetary policy. Everything one needs to know about money, it seems, is encapsulated in the interest rate (a price for consumption today versus consumption tomorrow) and the price level.7

Such grudging admission of an economic role for money via interest rates and the price level comes with the enormous caveat that changes in monetary conditions affect the economy only in the short run, as transitory responses experienced on the way to a new, long-run equilibrium in which money once again takes a back seat to shocks in tastes and technology.

Given this state of consensus in macroeconomic theory, current thinking on monetary economics consists of situating the rate of interest controlled by the central bank relative to an unobservable rate of interest called r-star, or the rate of interest that would prevail in capital market equilibrium. Monetary policy is tight or loose depending on whether the central bank’s policy rate is above or below r-star.

Unsurprisingly, RBC and Neo-Keynesian models have little useful to say about phenomena like proliferating debt, asset price inflation, growing inequality, the Global Financial Crisis (GFC) of 2007–2009, or the post-COVID episode of inflation. We can hardly look to current monetary economics to understand our current situation.

Broad Money and the Banking System

The old monetarism defined money too narrowly, focusing on the liabilities of the central bank as the decisive instruments of control for monetary policy. Much of contemporary economics repeats the same error, limiting money to cash and reserves supplied by the central bank. The relevant quantity of money for economic activity is much broader. Most of it is deposit money supplied by banks. Accordingly, much of this book is devoted to centering banks in a conception of the monetary economy.

Contrary to what is taught in basic economics courses, banks do not lend pre-existing funds. They do not intermediate funds between depositors and borrowers or multiply the reserve money supplied by the central bank. Banks create deposit funding out of nothing.8 Over the course of this book, we will justify this claim and refute the standard textbook stories.9

Banks create money when they make new loans. Deposit money is credited to a borrower on the books of the bank against the recognition of a loan asset. The deposit money created by the loan remains in circulation until the principal of the loan is repaid. Excess money balances can be exchanged for goods, services, or assets, but these transactions only transfer the ownership of the money balance. Society cannot collectively get rid of deposit money except by repaying loans.

The ability of banks to create their own funding in the form of deposit money has enormous consequences for economic analysis. It means that any investment that can be funded with bank credit need not draw on aggregate savings. Aggregate savings are costly because they can only be formed when someone in the economy reduces their consumption. Bank credit economizes aggregate savings. This was once well-known to economists like Walras, Fisher, Marshall, Wicksell, and the Keynes of the Treatise on Money. As the great Joseph Schumpeter wrote in his monumental History of Economic Analysis,

Banks do not, of course, create legal-tender money and still less do they create machines. They do, however, something … which, in its economic effects, comes pretty near to creating legal-tender money and which may lead to the creation of real capital that could not have been created without this practice. But this alters the analytic situation profoundly and makes it highly inadvisable to construe bank credit on the model of existing funds’ being withdrawn from previous uses by an entirely imaginary act of saving and then lent out by their owners. It is much more realistic to say that the banks create credit, that is, that they create deposits in their act of lending, than to say that they lend the deposits that have been entrusted to them. And the reason for insisting on this is that depositors should not be invested with the insignia of a role which they do not play. The theory to which economists clung so tenaciously makes them out to be savers when they neither save nor intend to do so; it attributes to them an influence on the supply of credit which they do not have. The theory of credit creation not only recognizes patent facts without obscuring them by artificial constructions; it also brings out the peculiar mechanism of saving and investment that is characteristic of full-fledged capitalist society and the true role of banks in capitalist evolution.10

The meaning of those patent facts for that peculiar mechanism of saving and investment is the axis on which this book turns.

The centrality of banks in the monetary system points to the credit- and claim-based nature of fiat money. Bank money is not backed by reserves, fractionally or otherwise. Instead, it is underwritten by credible claims to future economic surpluses. The same is true for money issued by the government: the government’s ability to redeem its debt and preserve the unit of account in terms of its monetary standard depends on the credibility of its claims to future tax revenues. We explore this and other aspects of fiat money systems at length in Chapters 2, 5, and 9.

Bringing out the role of banks in the contemporary economy is complicated by two main obstacles. First, academics tend to view banks through the same corporate finance lens as other firms, despite the special nature of banks’ funding and their distinct legal organization. Second, the corporations that first come to mind when we think of banks are in fact large financial holding companies in which the true banking business is just one subsidiary. The credit-creating banking business is attached to multiple capital markets businesses which are concerned with financial intermediation. Two very different economic functions with very different risk profiles live under the roof of a universal bank, competing with one another for business opportunities, capital, liquidity, and the attention of senior management. To make progress in monetary economics we must grapple with the peculiarities of the universal banking firm.

We separate the economic functions of universal banks into commercial banking and financial intermediation in Chapter 3 and trace the networks of claims that are characteristic of each. In Chapters 4 and 5, we distinguish the functions of financial intermediation and credit creation, digging into their microeconomic foundations and tracing their respective roles in financing investment and economic growth. We take particular care to explain why interest rates are not sufficient to determine equilibrium in either market. In Chapter 6, we consider the hybrid universal bank institution and its contribution to shadow bank activities.

If banks are central to the monetary system and live inside universal banks, then the regulation of universal banks is a matter of significant economic concern. Because universal bank regulation affects the volume of credit created by the banks and its allocation among different sectors of the economy, it is a powerful structural instrument of monetary policy. In Chapter 8, we explain how bank regulation affects monetary conditions.

A combination of competition, corporate governance, and regulation ensures that private firms perform their economic functions and maximize social welfare. In Chapter 12 we consider how well these forces have operated in the domain of universal banking. We ask whether any mix of competition, governance, and regulation can ensure that universal banks simultaneously and successfully perform their roles in the monetary system and the capital markets.

From Interest-rate Policy to Quantity-based Policy

In Part Two, we define monetary policy as the official mechanisms that govern the creation and destruction of the money supply. We think of monetary policy being much bigger than what the central bank does. Monetary policy is a complicated mix of bank regulation, fiscal policy, and central bank policy that conditions the production and distribution of money in the economy. It cannot be reduced to interest rates.

One’s first lessons in economics involve drawing supply and demand schedules and finding the equilibrium where they cross. Competitive equilibrium yields an equilibrium price and an equilibrium quantity. If we conjure an idea of a money market, applying the same tools will yield an equilibrium quantity of money at an equilibrium price: the interest rate. As a result, many economists see the interest rate and the quantity of money as two sides of the same coin: take care of the interest rate, and the quantity of money will take care of itself.

In Chapters 4 and 5, we explain why equilibrium in capital and credit markets is more complicated than these blackboard models would imply. Excess demands for equity and credit are a glaring, fundamental fact of economic life for all but the richest members of society. For example, economists like to think that people consume not based on their current income, but based on the permanent income they would earn over their lifetime. But to actually consume at this level, one would need to borrow against the entirety of one’s future earnings, pulling late-career income forward by some decades to the beginning of one’s working life. While consumer credit allows people to borrow against some of their future income, the volume of permitted borrowing is nowhere near the present value of one’s late-career excess earnings. Offering to pay a higher interest rate does nothing to change the situation; instead, we have an equilibrium with an excess demand for money. The interest rate does not clear the market, and credit is rationed by other mechanisms. Commercial credit demand is also pervasively rationed, with firms able to borrow far less than what their expected future earnings would support.11

Credit rationing ensures that interest rates alone do not determine the quantity of money. The same phenomenon in capital markets—equity rationing—ensures that interest rates do not determine equilibrium between savings and investment, either. To describe the set of investments that can be funded by savings or credit at a particular interest rate, we propose the notions of investable and bankable projects. Many potential investments may have a positive net present value at current interest rates, but additional qualifications are needed to make the project investable and match savings to the project. For an investable project to become bankable requires further qualifications. The set of investments that obtain financing in rationed equilibrium is, therefore, determined not only by interest rates but also by a complicated mix of institutional and contractual features and the informational endowments of banks and investors.

Savings can flow to investable projects, and money can be created by underwriting bankable projects. Bank regulation tilts the set of bankable projects by making certain types of lending more costly. Fiscal policy can put funds into projects regardless of whether they are investable or bankable. It can also make projects investable or bankable by letting investors and banks transfer their risks to the government. When banks, bank regulation, and fiscal policy have so much power to shape the quantity of money, the central bank’s field of action is relatively small by comparison. We consider their respective roles in monetary policy in Chapters 8, 9, and 10.

Neutral Monetary Policy

The money supply must be created and continually renewed by the banking system, the government, and nonbank financial institutions. The conditions of bankability that support the creation of deposit money are not evenly distributed in society. And while government money creation is zero in the aggregate, its net impact may be positive or negative for any given economic sector or stratum of the income distribution. As a result of credit rationing and fiscal policy, the money supply is not homogeneously distributed in society, and we do not expect money’s impact on growth, inflation, or asset prices to be uniform within the economy. The supply of money will privilege incomes and prices in certain sectors at the expense of others. Contrary to the received economic wisdom, money is not neutral in the short run or the long run.

The non-neutrality of money is not detectable using economic aggregates. Its effect is distributional, privileging certain economic actors and activities at the expense of others. Special instrumentation is needed to see it. In Chapter 7, we marshal available data to show the heterogeneity of monetary conditions across segments of the economy. In Chapter 8, we show how regulatory credit risk weights reinforce heterogeneity in private money supply, and in Chapter 9, we present evidence that imbalances in money supply are not completely rebalanced by the intermediation of funds between segments.

We believe that an important goal for the monetary system is to create conditions in which the money supply is more neutral, a notion we define more precisely in Chapter 11. The availability of credit should not determine whether economic actors participate in certain markets or change the intensity of their effort devoted to economic activities. We must also be concerned about the quality of money.12 When the money supply distorts the level and allocation of economic activity, productivity is lost, inferior investments are made, and concentrations of wealth accumulate. These are outcomes we should try to avoid.

Productive Capital Markets

If the obverse of credit rationing in credit markets is the non-neutrality of money, the obverse of equity rationing in capital markets is the proliferation of safe assets. Safe assets are the default option for aggregate savings whenever the supply of investable projects falls short. In lieu of risky projects with potential to produce excess economic returns, financial intermediaries must find or create safe assets to absorb surplus savings. Safe opportunities are found in the form of government debt. But they are also overwhelmingly made by plundering the supply of bankable projects, as we show in Chapters 7 and 13.

For the financial system at large, our overarching goal is to use the global supply of savings more efficiently by channeling more of it to risky investable projects. It is likely that global savings will be scarcer in the coming decades than they have been for the past 40 years. If so, it would be foolish to fund projects with scarce savings when they could be funded from bank credit instead. We argue that capital markets have extended their footprint deeply into bank business, cannibalizing bankable projects and channeling savings needlessly into funding low-risk projects and money substitutes. Global savings and the efforts of financial intermediaries would be better directed toward funding risky projects with greater growth potential.

In Chapter 14, we sketch our vision for a new monetary policy framework. This entails a novel central bank operating model, reforms to banking and bank regulation, and improvements to capital markets. We can only suggest a direction for reform. If we wanted to settle the details once and for all, we would fail to meet the moment. Hence our motto for the book: One hundred flawed steps in the right direction are better than one thousand correct steps in the wrong direction. Or as Keynes said: It is better to be approximately right than precisely wrong.

Notes

1. Woodford, M. (2003). Interest and Prices. Princeton University Press.

2. For a magisterial treatment of the development of monetarism in the United States, which involves much more than just the contribution of the three leaders mentioned, see Tavlas, G. (2023). The Monetarists: The Making of the Chicago Monetary Tradition, 1927–1960. University of Chicago Press.

3. Bianchi, F., Lettau, M., and Ludvigson, S.C. (2022). Monetary policy and asset valuation. Journal of Finance 77 (2): 967–1017.

4. See Laidler, D. (2024). Lucas (1972) a personal view from the wrong side of the subsequent fifty years. European Journal of the History of Economic Thought, doi: 10.1080/09672567.2024.2329045 for a discussion. The new approach rapidly conquered the field, to the point where a paper in macroeconomics without a DSGE model is almost unpublishable; see Colander, D. and Freedman, C. (2019). Where Economics Went Wrong: Chicago’s Abandonment of Classical Liberalism. Princeton University Press: 149–152. For critiques of the DSGE approach, see Romer, P. (2016). The Trouble with Macroeconomics. Manuscript and Stiglitz, J.E. (2018). Where modern macroeconomics went wrong. Oxford Review of Economic Policy 34 (1–2): 70–106.

5. The touchstones in this area are Kydland, F.E. and Prescott, E.C. (1982). Time to build and aggregate fluctuations. Econometrica 50 (6): 1345–1370, Long, J.B., Jr. and Plosser, C.I. (1983). Real business cycles. Journal of Political Economy 91 (1): 39–69, King, R.G., Plosser, C.I., and Rebelo, S.T. (1988a). Production, growth and business cycles: I. The basic neoclassical model. Journal of Monetary Economics 21: 195–232, and King, R.G., Plosser, C.I., and Rebelo, S.T. (1988b). Production, growth and business cycles: II. New directions. Journal of Monetary Economics 21: 309–341. Black, F. (2011). Exploring General Equilibrium. MIT Press memorably boils DSGE down to ‘technology and tastes.’

6. Gali, J. (2015). Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework and its Applications, 2e. Princeton University Press, Schmidt, S. and Wieland, V. (2013). The new Keynesian approach to dynamic general equilibrium modeling: Models, methods, and macroeconomic policy extensions. In: Handbook of Computable General Equilibrium Modeling (eds. P.B. Dixon and D.W. Jorgenson), 1439–1512. Elsevier.

7. It is common among some monetary theorists to speculate unironically about a moneyless limit in which money disappears from the economy completely. See Woodford, M. (1998). Doing without Money: Controlling inflation in a post-monetary world. Review of Economic Dynamics 1: 173–219 and Woodford, M. (2000). Monetary policy in a world without money. International Finance 3 (2): 229–260 for some early steps in this direction.

8. McLeay, M., Radia, A., and Thomas, R. (2014a). Money in the modern economy: An introduction. Bank of England Quarterly Bulletin 2014 Q1: 4–13 and McLeay, M., Radia, A., and Thomas, R. (2014b). Money creation in the modern economy. Bank of England Quarterly Bulletin 2014 Q1: 14–27.

9. See Chapters 3 and 5.

10. Schumpeter, J.A. (2006 [1954]). History of Economic Analysis. Routledge: 1080 (emphasis added).

11. Holmström, B. and Tirole, J. (2011). Inside and Outside Liquidity. MIT Press. Credit rationing is (almost) obvious when contrasted with the Arrow-Debreu complete markets benchmark in which claims to consumption in any future state of the world can be traded among agents, for a price.

12. Put differently, we are concerned with the credit counterparts of money. See Congdon, T. (2024). The Quantity Theory of Money: A New Restatement. Institute of Economic Affairs.

Chapter 2

Fiat Money Systems

Monetary economics concerns itself with the connections between money, banking, and economic activity. The failure of economists to respond coherently to the Global Financial Crisis (GFC) is a failure of monetary economics. In this chapter, we confront several fundamental reasons behind the poor track record of monetary economists. Several foundational precepts of economic theory obscure and diminish the importance of money and banking in market exchange. The deepest misunderstandings stem from a misunderstanding of the nature of money itself, which is incorrectly defined as anything acceptable in exchange and deemed neutral with respect to the underlying real economy.1

In contrast to this view, we argue that money is primarily a unit of account that is made determinate by collective action through the state. Money is constituted as a nexus of credit relations, which are unevenly distributed in society and possible only under limited circumstances. As a result,