Money Theory – A Primer on the Issues

The group organising the newly formed ‘Cafe Economique’ in Nottingham wanted an introduction to basic money theory for their first public event on Thursday 30th June and this article, written by Feasta member Brian Davey, was the result. The extended version of the talk, with notes on sources and for further reading, relates basic concepts to what is happening in the world right now, inclusive of the Greek financial crisis, and what should be done about it.

Note added July 10: You can hear an audio recording of this talk at


Money Theory – A Primer on the Issues

Functions of Money

(1) Unit of account – a measuring rod with units like pounds and pence or dollars and cents in which the other functions of money are expressed.

(2) Medium of exchange – money makes possible the greater flexibility inherent in a network of exchanges as compared to the one to one inflexibility of barter exchange.

Here the assumption is that when people sell (eg their labour power) they do so in order later to buy. So, they start with a commodity C, exchange it for money M, and then use the money to purchase one or more other commodities C.

This is expressed thus C – M – C.

(3) Store of value – money stores purchasing power and thereby makes for greater flexibility in the time management of purchasing and selling – I can delay purchasing and accumulate purchasing power through time to use it to acquire commodities later.

When money becomes a store of value another thing happens. Increasingly money becomes, not just a means to facilitate exchange, it becomes the end, or purpose of exchange. Rich people acquire money as an end in itself on the assumption that if they accumulate purchasing power they also accumulate other forms of power – including the power to purchase politicians, lobbyists, media empires, and an ability to do whatever they want.

Thus increasing proportions of transactions take this form

M – C – M’

Capitalists start with money, use it to purchase commodities, including human labour power, equipment and energy which is used to power the equipment and produce a product C which they then sell for a greater quantity of money.

(4) Money as a means to make money – including a medium for gambling

Indeed eventually many money transactions take this form on the financial capital markets

M – A – M’ (where A is a title to a money earning asset. Loans are later turned back into money on repayment )

Money is used to acquire ownership titles to income earning assets like company shares, tradable loans (bills and bonds) and to derivatives (which I will explain later). Indeed a huge proportion of the world’s transactions are the exchange of currencies which we can express thus.

M1 – M2 (where 1 and 2 are used to denote different currencies).

To get a sense of where things are nowadays consider the two lines below.

They are an approximate visual scale representation of firstly the size of global production in the “real economy” each day – transactions of goods and services. (The small line A).

The second, and much longer line, is a representation of daily global financial transactions on stock markets (B), global foreign currency exchange (C) and trade in financial securities, insurance and derivatives etc (D). Much of C and D is really financial gambling. It is described as ‘managing credit risks’ e.g. credit default swaps – and thus as a type of insurance but insurance is essentially gambling against things not happening and after a point this kind of activity pretty much becomes gambling pure and simple.


—¦——————————¦——————————————————————————- $5500 billion


When you see these lines you will notice that money is no longer predominantly a medium of exchange; it is a medium for making more money through financial transactions, most of which is really a kind of gambling.

In the current Greek financial crisis the big unknown is which institutions have taken bets (credit default swaps) on the Greeks not defaulting. There might be as much as $100 billion or even more such bets taken by US banks alone according to the Bank for International Settlements – and the unspoken terror in the financial markets is that these bets would have to be paid – by financial institutions without the money to honour their commitments. The fear is that this could create a domino reaction of failing institutions.

Money as a medium of exchange and money as a store of value may be conflicting functions

Meanwhile, back in the “real economy” (as opposed to the unreal one of the financial markets) we should note that the medium of exchange function and the store of value function have a somewhat contradictory relationship to each other. For example, if it is generally assumed that there are hard times ahead people may decide to hold onto more of the money that they have earned – to have a store of value ‘for a rainy day’. They decide to store value by holding onto their money rather than use it in exchange. One way of saying this is that their preference for “liquidity” increases – their preference for holding an increased proportion of their assets in money form.

When that happens money circulates more slowly – the velocity of circulation of money falls. Then sellers will find that the market for their products or services has declined.

Recessions as a breakdown of the medium of exchange as more money is used as a value store – self fulfilling expectations

This is a feature of recessions and we can see an element of self fulfilling prophecy here. If people think there will be difficult economic times they hold back from purchasing and that very holding back brings on the difficult times. Likewise companies hold back on investment purchases. As sales fall prices tend to fall too – as there is an attempt to sell unsold goods on markets by reducing their prices. People hold back on purchasing to wait for prices to fall further and this leads to a yet larger fall in sales and a speed up in the rate at which prices are falling. This collective psychology characterises downward deflationary spirals. Companies and individuals go bust, default on their loans which then creates turmoil back in the financial markets….of this more later.

History and the evolution of money forms

The earliest forms of money associated with simple commodity exchange were themselves commodities. Objects which were easily divisible, which were durable and thought to be useful by many people were particularly suitable. That’s why gold and silver, which could be used in jewellery and ornament, and were relatively easily turned into coins, came into use as money commodities. But there were other products too – e.g. durable foodstuffs like dates or grain.

The grain example is instructive. In ancient Egypt people stored the harvest in state grain stores and got a token to denote how much they had put in the store. These tokens then circulated instead of the grain itself.

Note that commodity money, like grain, was subject to an erosion in value – you had to pay for storage and there’s always a certain amount that rodents and other pests would get. Even coins made of precious metal would tend to decline in value – people clipped tiny amounts from them to make up their own gold or silver store and monarchs, who had the right to make coins, would reduce the precious metal content and make more coin. They cheated by taking coins back, debasing their precious metal content, and re-issuing a greater number of coins with less gold or silver in them.

So the value of tangible money tends to degrade over time or you paid for its storage or self keeping – it has a long run tendency to degrade in purchasing power values. A sort of negative interest rate called demurrage.

Development of the money sector of the economy – bank money

The first bank money was created by goldsmiths. People deposited their gold with goldsmiths for safe keeping and were given receipts. Soon the receipts for gold deposits circulated instead of the gold itself.

After a time goldsmiths noticed that it was very rare indeed that everyone wanted to convert receipts back into gold. So, not for the last time in the history of banking, they committed fraud. They issued more receipts than they had gold in the vaults and lent them at interest. Bank money was created. Of course, when word got around and people lost confidence there was a rush to take the notes back to the goldsmiths to claim the gold that they were supposed to represent. Some banks/goldsmiths went bust.

Nevertheless it became common and accepted practice to issue more notes than there was gold in the vaults and this was legalised. The goldsmiths had become so powerful and the creation of new cash for expanding commerce so strategic. This ability to commit fraud and get away with it because of the strategic role of money and political connections has continued. It characterised the last global financial crisis too.

The following is said to be a candid quote from a governor of the Bank of England, Sir Josiah Stamp, speaking in 1927. The reference to “iniquity and sin” was meant quite literally – as we have seen banking was born out of the fraud of goldsmiths and fraud as a recurrent feature of banking has continued.

“Banking was conceived in iniquity and was born in sin. The Bankers own the earth. Take it away from them, but leave them the power to create deposits, and with the flick of the pen they will create enough deposits to buy it back again…..if you wish to remain the slaves of Bankers and pay the cost of your own slavery, let them continue to create deposits.”

Basically then banks create the money that they lend – the rule of thumb that developed was that they were allowed to do this as long as they had enough liquid assets in their tills, and at the central bank, so that when customers wanted their money back they did not run out of cash. To make the system more stable bankers’ banks – national central banks – would step in and lend money so that commercial banks did not run out during bank runs. In exchange the banks were supposed to operate carefully and were subject to regulation. However, there has always been an issue about the extent to which central banks are there to represent the interests of society or there to serve the bankers.

Money lending and debt

The word “credit” derives from the Latin credere – to believe or trust – so things have gone backwards since then. Recent analyses of the banking system in the USA describe it as ‘criminogenic’ – encouraging of crime (incl. Fraud).

In pre-industrial times money lending against interest was universally regarded as a sin and socially corrosive. If the economy or production does not grow there is no extra production out of which interest can be paid so the long run effect of compound interest payments in a static economy is to transfer wealth and power from debtors to creditors. Debtors fell into debt slavery from which they and their offspring could not escape. What stopped moneylenders taking over were continual attempts to regulate money lending and when they failed – riots and driving the money lenders out of the town or country. You could say that something like this is being attempted on the streets of Greece. Some societies also had arrangements for periodic debt cancellation – the original meaning of a Jubilee. Nowadays when lenders on the bond markets the term “a haircut”, is used for an arrangement that adjusts in favour of borrowers.

An alternative is for national financial authorities arrange an inflation. What money will buy in purchasing power terms falls in favour of borrowers but the store of value function of money is eroded. The dirty secret is that when the debt burden on an economy is reduced this will often help an economy get going again – at the cost of all those whose savings are eroded in value. The postwar German economic miracle was largely based on radically cancelling debts.

In history other institutions made the money system more flexible – charity, alms, giving to the poor and the efforts of religious orders represented a social security system of sorts to provide so that people did not get into debt. The more unequal a society the more the poor are likely to be in debt.

In addition, for commercial purposes there were arrangements where people who financed trade shared the risks of a business venture – in Islamic finance capital users (like traders) and capital providers share risks in business ventures. The financial relationship is an ‘equity’ one. If the business venture is prosperous the money provider shares in the profit on an agreed basis. If the venture makes a loss they share in the loss.

Features of the usurious relationship

This is in contrast to a usury relationship or modern bank lending, or on the bond markets. In the usurious relationship ALL the risks are put on the debtor. Indeed if the debtor cannot pay up then they lose the collateral that is part of the arrangement – they lose an item of their property with a money value equal to the unpaid debt.

I should say here that it is not just individuals who are expected to surrender their property if they cannot pay their debts – nowadays the international bankers are so arrogant and powerful that states are supposed to do so too. If developing countries could not pay up on debts the IMF and World Bank expect them to privatise state assets at knock down prices so that local people then pay through the nose for essential services like water and roads that were formerly run in the interest of everyone as public services. That is currently expected of the Greeks too – you can read in the Financial Times interviews with officials of the European Central Bank which say that Greece is not insolvent – because it has plenty of public assets that it can sell off. Then overcharging from privatised public services ruin even more people and make the situation worse – but, hey, that means they have to sell off even more assets. The main aim of this game is to ensure that bankers never lose and that everyone else does. This is especially important when big finance houses fear having to pay up on credit default swap gambles that they made so lean on the central bankers and politicians behind the scenes.

Debt and Growth

For over 200 years since industrialisation lending has also taken place to finance investment in productive activity. Fossil and other energy has been applied to the productive process by powered machinery so that production has increased massively. Growth meant that a surplus existed that could be shared between producers and money lenders – or capital providers as they called themselves. Indeed, wage and salary owners could borrow manageably too if their incomes were sufficient and interest payments were serviceable for all whose real income was substantial and rising – up to a point. In loans for houses – mortgages – it became conventional to allow for a loan of not more than a certain multiple of annual income made to people who have saved a certain amount already.

Note an importance consequence: for debt to be serviceable there must be economic growth and rising incomes. Otherwise debt service becomes an increasing burden. But there is now a problem because we have reached the ecological limits to growth. We cannot keep on growing without wrecking the planet and we are in any case running out of the liquid fuels that have powered global transport growth.

In recent years energy and food prices have soared because of oil depletion and a plateau in world oil supplies. The energy cost of recovering more energy is rising. To grow requires more energy and as less is being discovered and developed oil prices have soared, as well as the prices of things made with the help of oil. That has transferred so much money to oil producers that they couldn’t spend it all – instead they lent it back to banks in oil consuming countries. So incomes were squeezed and debts rose – up to the point where many people could no longer service their debts – for example mortgages on their houses.

With banks lending less, money creation stalled and people’s income fell. States needed to bail out the banks to rescue the money system. What’s more they found taxation revenues falling and expenditure like unemployment and welfare benefits rising. So states got into deficit. Instead of states creating the money – which when they have their own currency they are entitled to do – they continued to borrow it – from the banks and the very same finance markets who have had to be bailed out.

The role of the land market and real estate in banking and money cycles

About 70% of the collateral underpinning modern bank lending is actually real estate in the UK – and a similar large proportion in many other industrial countries. The banking and financial sector is therefore closely tied to the real estate market. This is important because there is then a close relationship between the economic cycle in the real estate market and banking and financial crises. This is little explored by most mainstream economists with some honourable exceptions.

If you think about it then any form of economic development has a spatial dimension. It “takes PLACE”. Economic development involves the need for locations for factories, offices, roads, railways and housing. Some sites emerge as particularly favourable particularly when opened up by infrastructure investment – often paid for by taxes. The wonder of the market economy is claimed to be that if prices signal that something is profitable more of that thing will be created. But you cannot increase the amount of land. Location is always unique. So during economic development booms the land price tends to soar in specific locations (the capitalised rents for owning particular locations). Recognising which locations to get hold of is a way of making a lot of money if you can get the credit to buy up land and property and then persuade politicians to spend tax money on infrastructure to boost the value of your land. London’s extension of the Jubilee Tube Line to Canary Wharf cost £3.5billion but increased property values by an estimated £13 billion along the route. Capital gains like this, courtesy of the taxpayer, are taxed less than income tax too.

Property market cycles tend to be about 14 years in length. The long run rate of interest is about 5% and bearing in mind the rent that people pay affordable house prices are 14 years rent. If land, house and property prices are bid any higher then debts become unserviceable and the housing and property market grinds to a halt.

Bubble economics

Economic cycles tend to end in “bubbles”. The rising price of particular classes of assets like land or property creates a collective euphoria or mania. People borrow to buy this asset, or invest all their savings in it on the anticipation that they will make more money as its price continues to rise. Their credit inflated purchases chase up the price until the price of the asset and the servicing of debt become unsustainable. Confidence falters and the crash occurs. The big money is to be made by getting in a bubble early and getting out early. Banks are left with debtors who have lost money and cannot pay up.

International Money Arrangements

For many centuries precious metals have functioned as a de facto international currency – or currencies that could be converted into gold at a fixed rate of exchange under the so called Gold Standard. After world war two there was a sort of a gold standard in that the dollar was the major international currency, used in payment for foreign trade (eg of oil) and the dollar could be converted into gold at a fixed rate. Other currencies were then “pegged” to the dollar at fixed rates of exchange. This arrangement collapsed as a result of the costs of Vietnam war, the competitive decline of the US economy – and also because of the malevolent influence of the City of London – as explained below.

When a country imports it needs foreign currency to pay for the imports and must buy the appropriate foreign currency offering its own currency in exchange. When a country exports foreigners offer their own currency on the exchanges to buy the exporters currency so that exporting companies can be paid in their own currency. If imports exceed exports then, all other things being equal, the foreign currencies being offered to buy the local currency will be less than the local currency being offered to buy foreign currencies. The result will be a fall in the rate of exchange for the local currency.

All other things rarely are equal though. The interplay between the two processes of exporting and importing would determine the exchange rate. However there is a further complication – in that money flows through the exchanges between countries for investment and speculative purposes too, not just for trade. In recent years these flows have been on an enormous scale and are moved very fast moved through computer telecommunications by international banks. The speculative flows quite dwarf the amounts of currency trading that is needed for real trade in goods and services.

Under the fixed exchange rate system it was necessary for national money authorities to buy and sell the dollar (or another international reserve currency like sterling) with their own currency to hold the exchange rate for their own currency stable. What made these pegs possible were strict regulatory limits on the extent to which national banks could exchange foreign currencies for investment and speculation purposes. These regulations were undermined, largely by the City of London with the connivance of the Bank of England. Thus London’s role as an international finance centre was protected by offering a haven where the financial regulations of other countries were not imposed. This haven was supplemented by tax havens and secrecy jurisdictions around the world attached to London in places like the Channel Islands, the Cayman Islands and so on. The international mobility of money, facilitated by London has been important turning world financial markets into an unregulated and irresponsible force that dominates global politics.

The dominance of finance and the coming perfect storm

In the last few years, the convergence of a number of trends created the conditions for a perfect storm in the financial markets. Peak oil and rising energy prices transferring income to oil producers on a massive scale which were lent back into financial markets. Globalisation has made for flat or low wages so many consumers got deeper into debt to pay for the necessities of life – leading to a general financialisation of society.

Meanwhile the big money was made in the financial markets by speculation rather than in productive investment with an epidemic of control fraud that has run out of control. Politics has been increasingly dominated by the interests of the FIRE sector (finance, insurance and real estate) which takes perhaps 40% of US business profit and is so powerful it has to pay little or no tax.

A global network of tax havens and secrecy jurisdictions enables big money to avoid regulations and contribute nothing to the public purse. The debt and interest burden and the privatisation that transfers natural monopolies into private hands, act as a burden on wage earners and the real economy in favour of increasingly criminalised financial interests who have opted out of funding state budgets.

At the same time artificial currency constructs like the euro are unravelling, a bank credit fuelled bubble in China is about to burst, while the dollar is undermined by the declining power of the USA and its military expenditure abroad has become a drag on that economy….a huge debt melt down seems likely……..

In conclusion

In the coming financial, economic and socio-ecological storm it will be necessary to unite society around an appropriate programme including: (1) Investigation and prosecution of major financial criminals and fraud; (2) Root and branch reform of the finance sector taking away from the banks the right to create money against credit and returning the power to create money to the state and, at the local level with complementary currencies, to communities; reimpose controls on foreign currency capital controls;(3) Tax the things the rich cannot take to tax havens – namely the value of their land and the extraction of natural capital to promote material use efficiency; (4) use the sums raised to reduce taxes on labour and for public (and ecological) purposes, particularly the transformation of the energy sector; (5) Transform the finance sector to an intermediary role between savers and borrowers, impose regulation to prevent speculation, finance industrial and ecological investment through equity and through partnerships that share risks; (6) Encourage investment, economic recovery and adequate action on climate and energy by socially just policies to drive carbon out of the economy – e.g. cap and share.

Brian Davey June 2011

Sources, Resources and Notes….. hinting at yet further issues

Richard Douthwaite “The Ecology of Money” available for download online at

Bernard Lietaer – Currency Solutions for a Wiser World
See the TED video on the site – Lietaer points out that according to the World Bank there have been 96 Banking crises and 176 monetary crisis in the last 25 years due to structural causes –the current banking system lacks resilience because it lacks diversity and has too much interconnectivity so problems cascade through it in a reinforcing way.

Both Douthwaite and Lietaer argue the case for a diversity of currencies, including complementary currencies.

Karl Marx “Capital” Volume 1 Chapter 3 is the source of the c-m-c and m-c-m’ formulation. It was adopted by Keynes and later economists (eg Herman Daly and Joshua Farley in “Ecological Economics” Chpt 14)

Isaac Josua, „Krisen und wer dafuer bezhalt“ in Atlas der Globalisierung, Le Monde Diplomatique (German edition 2010 page 46-47). This is the source of the diagrams to show size comparative size of financial markets.

Ilargi “A Low Thunder Rolling Across the Plains” The Automatic Earth Blog, – is the source of background information about derivatives in a possible Greek default. The Automatic Earth Blog is one of the best multi dimensional sources on the financial crisis.

Michael Hudson, Regularly updated articles about financial politics e.g. about the crises in Greece, Iceland, the Baltic States etc Also theorises the FIRE sector and the role of land and capitalised rental incomes through the real estate sector as a way of accumulating untaxed wealth

Paul Grignon, “Money as Debt” YouTube cartoon in instalments which is basically correct – free earlier edition for instalment one…

Wikipedia Demurrage
Wikipedia Commodity Money

Islamic Finance Analyses the difference between the rhetoric and the reality.

Richard Douthwaite, The Supply of Money in an Energy Scarce World, chapter in “Fleeing Vesuvius. Overcoming the risks of economic and social collapse”, eds. Richard Douthwaite and Gillian Fallon, Feasta Books, 2010 – will eventually be downloadable for free from Describes energy money links and their consequences.

For articles on risk sharing and equity partnerships see articles by Chris Cook, James Pike and Oscar Kjellberg in Fleeing Vesuvius.

Phillip J Anderson, The Secret Life of Real Estate and Banking, Shepheard Walwyn, 2009. A look at over 200 years economic history in the USA detailing the close relationship between real estate booms and busts and the credit creation by the banking sector.

Fred Harrison, “Boom Bust” Shepheard Walwyn, examines role of land, rents, and finance in the British economic cycle.

Labour Land Value Campaign Describes example of land value bonanza at the expense of the taxpayer

Smart Tax Network –

University of Missouri-Kansas Department of Economics, Modern Monetary Theory Resources

Nicholas Shaxon, Treasure Islands: Tax Havens and the men who stole the world, The Bodley Head, 2011.

William K Black with Lars Schall. Interview: The Great Global Bank Robbery – Black argues that neo-classical economics has failed to develop a theory of fraud and of criminogenic environments – and hence cannot analyse the epidemics of accounting control fraud that characterise bubbles and cause markets to collapse.

Coming bust of Chinese credit fuelled property bubble and hence of Chinese banking crisis

Cap and Share.


Note: Feasta is a forum for exchanging ideas. By posting on its site Feasta agrees that the ideas expressed by authors are worthy of consideration. However, there is no one ‘Feasta line’. The views of the article do not necessarily represent the views of all Feasta members. 

2 Replies to “Money Theory – A Primer on the Issues”

  1. Brian,

    Thanks a million for your superb ‘primer’ & all your & Feasta’s efforts over the years, much appreciated!


  2. Thanks, I enjoyed the paper, and hope to remember some if it all.

    I was recently in Berlin, and participated in a “Third Reich” walking tour, with an excellent guide. He was doing a PhD in History, and his views were generally well informed. The tour included the Holocaust memorial.

    He argued that the origins of anti-Semitism lay in the early Christian (and later Muslim) belief in the sinfulness of usury. So, for example, it was not possible to be a good Christian Crusader, and to lend money. I am not sure whether it was sinful to borrow it, but I suspect not. Yet a trading society cannot effective function without moneylending, and Jewish culture did not have (and perhaps never has had) lending constraints. So, while they were excluded from more mainstream activities, the Jewish people tended to specialise in the area, and so became bankers to the more (notionally) scrupulous. Recovering loans is, even today, one of the less popular of professions.
    It makes some sense to me.

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