thank you for this very useful metaphor, which I have been using in some of my contexts before but not in this clarity and depth.
You describe banks‘ superpower to "issue Layer 2 chips to borrowers, in exchange for a loan agreement in which the customer promises to return a larger amount of Layer 1 money to them in future than what the chips promise to them now (in a sense, the bank ‘buys’ a higher-value long-term promise by issuing lower-value short-term promises, but exposes itself to risk in the process)."
In this paragraph an important point is missing: In most cases, for any loan agreement / credit creation banks additionally request bankable securities, some form of non-monetary assets that back up their risk in case of a loan default. Layer 2 chips issued by the banking sector are therefore i.e. mostly asset backed tokens (merely pretending to be savers‘ money, as you correctly argue).
For Layer 3 Tokens, legal compliance regarding their actual backing varies broadly.
Thanks for the important addition here Ludwig. Yes, that collateral adds a whole bunch of new dynamics to the equation. Whether that makes the Layer 2 chips 'asset backed tokens' is a worthy topic to debate: for the person who holds them, they're not (aka. a person holding bank-issued chips doesn't get to claim the collateral), so it's more like the loan asset held by the bank is 'asset-backed'. Will meditate upon this some time!
Thanks for this, Brett. I was in Portland, Oregon recently and I noticed that several businesses had “cash-free establishment” signs in their windows. In some cases I thought these were like “driver carries no cash” (i.e. don’t rob us) signs, or that they were (more likely) “dollar bills are germ-delivery-systems, so we don’t touch those anymore” signs (mild pandemic virtue-signaling), but now I wonder: do banks offer incentives to small businesses to go cashless? Or maybe the pandemic has done that work for them.
Hi Ben - I write a lot about this topic elsewhere (plus you can find me speaking about it on many podcasts if you search etc), but the short answer is yes, banks, payments companies etc have many different strategies for pushing people away from the cash system, and one of the key targets is small businesses (which in turn spread the cultural meme of 'cashlessness' to their customers)
Cash is a receipt for a bank liability. In the UK a bank note is nothing more than a receipt for central bank created liabilities in the Issue Department of the Bank of England. That's it. The system is already cashless - it became that as soon as the ability to convert the notes into silver or gold coins was removed. Cash is really just a bank transfer to and from the Issue Department.
The Issue department of the Bank of England maintains balancing assets with the National Loans Fund - directly via the Ways and Means Account and Gilt issue and indirectly via the Bank of England Banking department which similarly holds Gilts as balancing assets.
The National Loans Fund has balancing item asset with the Consolidated Fund, and the Consolidated Fund holds the ultimate asset - the ability of Parliament to obtain tax from people in the denomination everybody is using. The whole of the Sterling system is a layered discounting of that power.
There's a layer 0, layer -1, and layer -2 before you reach the root of the system.
See "An Accounting Model of the UK Exchequer" for the gory details.
You may also want to explore why the liabilities in the layers are exchangeable 1-for-1 with the other layers for a particular denomination, but not between denominations. That's to do with the contractual basis of the relationship - in the UK's case the Sterling Monetary Framework which constrains a bank to behave in a particular way and subject itself to regulation, in return for the state guaranteeing that the liabilities they issue will be (largely) money good.
The banks, in effect, have become agents of the state in return for stopping the liabilities they issue from floating in value against each other.
I do have your 'An Accounting Model of the UK Exchequer' actually ;)
Thanks for the many subtle and important points you raise here. Bear in mind, however, that the point of this article is not to give a technical geeky account of how all the mechanics of state-issued money work, so yes, by default there are many things missing. What I'm trying to do here is to help people without technical knowledge to think more clearly, and I'm afraid to say that the vast majority of people are many many steps away from understanding what you just said in this comment, so it helps to have some simpler metaphoric ways to provide some stepping stones.
Also, while I understand you're trying to give a legal-institutional type take, for the vast majority of the public, the system is definitely not cashless. Cash may be a 'receipt', but without this receipt I have no asset
As of 2020, the Federal Reserve lowered reserve requirements to ZERO. And in Canada too. That means banks can now issue money without being required to back it by L1 money.
Those trillions “printed” and given out to people as PPP loans were originated by banks. But the loan forgiveness comes from where? Who pays the liabilities these banks have to each other?
Technically, the banks can simply cancel liabilities they have to each other. If Bank A issues a loan or credit card and it is redeemed for credits in Bank B, while Bank B does the same for bank A, then the banks can simply cancel out their debt to each other when they settle their balances periodically using the Automated Clearing House (ACH) system that is also run by the Federal Reserve.
So banks can issue a ton of money to spur economic activity, and then cancel the debts to each other and take it out of circulation.
Intercoin.org is about making an alternative to the banking system, allowing cities and other communities to issue their own currency (eg Berkshares, Bristol Pounds etc.), give it out as a UBI and then tax it back to remove money from circulation (fiscal policy). The fiscal policy can then be used to mitigate negative externalities like pollution etc. So the monetary and fiscal policies are managed by the people. The businesses are getting money from people spending money on things they actually want, rather thank bank underwriters trying to guess whether there will be a lot of demand for the business’s services 5 years later.
Sure - the 'multilateral net settlement' systems are the systems whereby the cross-bank chip movements are cancelled out against each other. This is why huge amounts of Layer 2 transactions can go on without it requiring the much movement in the Layer 1 system
Likewise, just a quick note to say that this REALLY helped me.
I started the article, got part way through, got a bit confused (by my own pre-existing misconceptions), went away, mulled it over, clarified and just finished reading with a far greater understanding. Thanks as ever.
Ok this is probably too complex to fully describe in a single response, but I'll make a few initial comments (I'd probably have to write a full piece to simplify this)
1) To fully understand the dynamics of this, you also have to understand the interbank payments system, which I only very briefly touched upon in this essay
2) When a typical bank first issues a loan, it's in digital chip form and will appear in the borrower's account (e.g. the account might suddenly say '£450,000')
3) But the person will then use that to buy whatever they were wanting to get. So, for example, in the case of a mortgage, the borrower will then transfer that to the owner of a house they want to buy. In that case, their account goes to 0, and the house-sellers account goes up to £450,000 in digital chips
4) If the house-seller banks at a different bank to the buyer, this will mean that the original bank will have to transfer Level 1 reserves to the second bank to compensate them for the fact that they now have a customer (the house-seller) with £450,000 in new Level 2 digital chips. This means, Bank A will lose a bunch of reserves as a result of issuing the loan (but they're compensated for this by the fact that in issuing the loan they got a future loan asset)
5) But Bank A isn't the only bank issuing new chips. For example, if Bank B has also created new chips via loan issuance to someone else in Bank B, that might end up creating a counterflow in which new digital chips might end up with a house-seller in Bank A. This might cancel out the reserves that would otherwise needed to be passed between the banks - i.e. the two banks collectively create £900,000 in new layer 2 chips, but then find themselves having to pass £450,000 in layer 1 reserves to each other as their borrowers initiate transfers, but those just offset each other (I.e. Bank A sends 450k to Bank B, and Bank B sends 450k to Bank A, which means, in effect, they don't send anything)
6) In a sense, the new chips the banks create end up in a different part of an interlinked interbank system. These new chips stay in play, so long as nobody ever actually goes to an ATM to 'leave the network of casinos'. If anybody in the system goes to an ATM though, one of the banks in the banking system will be forced to destroy/withdraw digital chips from circulation
7) Put slightly differently, all the banks are creating new digital chips through loan issuance, but those chips then get reassigned to different parts of an interconnected banking system via the interbank payments system. The only time these chips get retracted is when loans are being repayed (that's a whole other topic), or when people are withdrawing cash
So, to get to your question:
8) If a customer was to ask for a cash loan, the bank is still going to extract a loan asset, but it would be conceptually equivalent to the situation in which a) the bank creates new digital chips for the customer, who then b) immediately withdraws cash and thereby destroys the digital chips ('leaves the casino').
One of the key themes here is that in a modern highly advanced banking system there are systemic interlinkages between all the separate banks which 'deepens' the ability of the banks to issue credit - i.e. they begin to operate as a kind of collective, collectively issuing chips, and if they can get people to stay within that chip system they don't have to do very much passing of Layer 1 reserves between themselves at all.
When banks are not interlinked, the cash system becomes a way that a person hops from one bank to another (e.g. I get my loan, exit the banking system via the ATM, give to someone else, who may deposit it into a different bank and thereby 'enter the casino again'), but when they are strongly interlinked, they begin to create a kind of collective 'meta-casino' that will fight with the cash system.
Great metaphor and exposition! But how does it map to the M0-M3 taxonomy from college macroeconomics? All the explanations I've ever come across are so abstract I'm unsure.
It varies depending on country, but M0 maps onto what I'm calling Layer 1 here - or 'base money'. M1 traditionally refers to what I'm calling Layer 2 here. After that it tends to gets hazy, lumping different categories together etc, and depends on country
Mar 2, 2023·edited Mar 2, 2023Liked by Brett Scott
Hi Brett,
I like your casino-chip metaphor. The biggest reason that this layering framework does not get popularized, in my opinion, is that making the distinction (between layers) that truly exists raises the cost of understanding but do not yield immediately visible value for many people. In other words, incorrect understanding does not directly impact those people who misunderstand (somehow every person in the monetary system shares the aggregate cost of misunderstanding). So, even though i enjoy and agree about this layering framework, I strongly believe many people would still and continually treat those money from different layers simply as different forms of money.
Hi An-Tsu, yes I think you are right about this in general. I guess it's my job to try convince people that this matters! It's worth noting that this same phenomenon is a problem for anyone trying to raise awareness about big issues that are generally invisible to the public (e.g. data exploitation, electricity derived from fossil fuels etc)
Very interesting, and a useful metaphor. I tried in the past to explain everything with the general mechanism of loan/IOU. Banks and central banks are only special players among many, including consumers and corporations. But that's very abstract for many people.
Damn man, you can write like a motherfucker. Never felt like explanations of monetary policy have been totally on the level or fully made sense to me, this is the first time that I feel like i really grok what money systems are and how they function. Nice one!!
Thank you this is really useful. I'm wondering, could reserves be considered another, distinct layer (layer 0)?
Whenever I read about a country running out of dollars, I think why don't they just get an American bank to lend them dollars (since the bank can create them from nothing)? Is it because they need reserve dollars (layer 0), and banks can only lend them layer 1 or 2?
Sorry if it's a dumb question I'm not an economist
Here's a metaphor for this: Imagine if you want to promise a friend a massage. You can write it out on a piece of paper and hand it to them ('IOU a massage'). Alternatively, you could write it out on a computer next to their name, and show it to them. This isn't the most elegant metaphor, but to your friend, both the physical and the digital version of the promise still offer them the same thing.
So, for banks, cash and digital reserves are interchangeable - they can take cash they have, give it to the central bank, and ask for digital reserves instead, or they can take their digital reserves, and ask the central bank to give them cash instead. This is why, on bank balance sheets, you'll always see a line item that says 'cash and reserves', because the physical and digital versions of state issued money are basically interchangeable to them.
In terms of your second question, that's much bigger and I'm not an expert in all the nuances of that, but I think in many cases they actually do get American banks to lend to them, in which case the country ends up with Layer 2 dollar sitting in a US bank account. Alternatively, it may be the central bank giving credit lines to another central bank etc. Anyway, it's too big a topic to cover here. Remember, though, while banks can technically 'create from nothing', it's dangerous for banks to do that because it puts them on the line when they do that (the money they issue is a liability to them, not an asset). In the end, the commercial bank will be asking 'do we really want to create new Layer 2 money for this government, and what will we get in return'
Hi, thanks for the article, I have learned a lot!!
But there’s something I don’t understand in this paragraph: “Digital chips for borrowers: they issue Layer 2 chips to borrowers, in exchange for a loan agreement in which the customer promises to return a larger amount of Layer 1 money to them in future…”
Because what the customer does is to return a larger amount of layer 2 chips, isn’t it? Despite that later the bank balances it reserves…
Hey Brett,
thank you for this very useful metaphor, which I have been using in some of my contexts before but not in this clarity and depth.
You describe banks‘ superpower to "issue Layer 2 chips to borrowers, in exchange for a loan agreement in which the customer promises to return a larger amount of Layer 1 money to them in future than what the chips promise to them now (in a sense, the bank ‘buys’ a higher-value long-term promise by issuing lower-value short-term promises, but exposes itself to risk in the process)."
In this paragraph an important point is missing: In most cases, for any loan agreement / credit creation banks additionally request bankable securities, some form of non-monetary assets that back up their risk in case of a loan default. Layer 2 chips issued by the banking sector are therefore i.e. mostly asset backed tokens (merely pretending to be savers‘ money, as you correctly argue).
For Layer 3 Tokens, legal compliance regarding their actual backing varies broadly.
Thanks for the important addition here Ludwig. Yes, that collateral adds a whole bunch of new dynamics to the equation. Whether that makes the Layer 2 chips 'asset backed tokens' is a worthy topic to debate: for the person who holds them, they're not (aka. a person holding bank-issued chips doesn't get to claim the collateral), so it's more like the loan asset held by the bank is 'asset-backed'. Will meditate upon this some time!
That's a great point, because that gets into the power dynamics and implications of a bank having control over property, etc. in society writ large.
Thanks for this, Brett. I was in Portland, Oregon recently and I noticed that several businesses had “cash-free establishment” signs in their windows. In some cases I thought these were like “driver carries no cash” (i.e. don’t rob us) signs, or that they were (more likely) “dollar bills are germ-delivery-systems, so we don’t touch those anymore” signs (mild pandemic virtue-signaling), but now I wonder: do banks offer incentives to small businesses to go cashless? Or maybe the pandemic has done that work for them.
Hi Ben - I write a lot about this topic elsewhere (plus you can find me speaking about it on many podcasts if you search etc), but the short answer is yes, banks, payments companies etc have many different strategies for pushing people away from the cash system, and one of the key targets is small businesses (which in turn spread the cultural meme of 'cashlessness' to their customers)
There's a few things missing from this viewpoint.
Cash is a receipt for a bank liability. In the UK a bank note is nothing more than a receipt for central bank created liabilities in the Issue Department of the Bank of England. That's it. The system is already cashless - it became that as soon as the ability to convert the notes into silver or gold coins was removed. Cash is really just a bank transfer to and from the Issue Department.
The Issue department of the Bank of England maintains balancing assets with the National Loans Fund - directly via the Ways and Means Account and Gilt issue and indirectly via the Bank of England Banking department which similarly holds Gilts as balancing assets.
The National Loans Fund has balancing item asset with the Consolidated Fund, and the Consolidated Fund holds the ultimate asset - the ability of Parliament to obtain tax from people in the denomination everybody is using. The whole of the Sterling system is a layered discounting of that power.
There's a layer 0, layer -1, and layer -2 before you reach the root of the system.
See "An Accounting Model of the UK Exchequer" for the gory details.
You may also want to explore why the liabilities in the layers are exchangeable 1-for-1 with the other layers for a particular denomination, but not between denominations. That's to do with the contractual basis of the relationship - in the UK's case the Sterling Monetary Framework which constrains a bank to behave in a particular way and subject itself to regulation, in return for the state guaranteeing that the liabilities they issue will be (largely) money good.
The banks, in effect, have become agents of the state in return for stopping the liabilities they issue from floating in value against each other.
I do have your 'An Accounting Model of the UK Exchequer' actually ;)
Thanks for the many subtle and important points you raise here. Bear in mind, however, that the point of this article is not to give a technical geeky account of how all the mechanics of state-issued money work, so yes, by default there are many things missing. What I'm trying to do here is to help people without technical knowledge to think more clearly, and I'm afraid to say that the vast majority of people are many many steps away from understanding what you just said in this comment, so it helps to have some simpler metaphoric ways to provide some stepping stones.
Also, while I understand you're trying to give a legal-institutional type take, for the vast majority of the public, the system is definitely not cashless. Cash may be a 'receipt', but without this receipt I have no asset
As of 2020, the Federal Reserve lowered reserve requirements to ZERO. And in Canada too. That means banks can now issue money without being required to back it by L1 money.
Those trillions “printed” and given out to people as PPP loans were originated by banks. But the loan forgiveness comes from where? Who pays the liabilities these banks have to each other?
Technically, the banks can simply cancel liabilities they have to each other. If Bank A issues a loan or credit card and it is redeemed for credits in Bank B, while Bank B does the same for bank A, then the banks can simply cancel out their debt to each other when they settle their balances periodically using the Automated Clearing House (ACH) system that is also run by the Federal Reserve.
So banks can issue a ton of money to spur economic activity, and then cancel the debts to each other and take it out of circulation.
Intercoin.org is about making an alternative to the banking system, allowing cities and other communities to issue their own currency (eg Berkshares, Bristol Pounds etc.), give it out as a UBI and then tax it back to remove money from circulation (fiscal policy). The fiscal policy can then be used to mitigate negative externalities like pollution etc. So the monetary and fiscal policies are managed by the people. The businesses are getting money from people spending money on things they actually want, rather thank bank underwriters trying to guess whether there will be a lot of demand for the business’s services 5 years later.
Sure - the 'multilateral net settlement' systems are the systems whereby the cross-bank chip movements are cancelled out against each other. This is why huge amounts of Layer 2 transactions can go on without it requiring the much movement in the Layer 1 system
I'll check out Intercoin
Very illuminating and clear. Thanks Brett! Carne Ross
Really glad you found it useful Carne
Likewise, just a quick note to say that this REALLY helped me.
I started the article, got part way through, got a bit confused (by my own pre-existing misconceptions), went away, mulled it over, clarified and just finished reading with a far greater understanding. Thanks as ever.
Awesome - thanks Shaun
Do you assume that all kind of loans are digital? What about when a client ask for a cash loan? The money have to be back to its physical form again.
I live in Iraq, a cash dependent society. How your metaphor applies in this case?
Thanks for article, can't stop sharing it with my network.
Ok this is probably too complex to fully describe in a single response, but I'll make a few initial comments (I'd probably have to write a full piece to simplify this)
1) To fully understand the dynamics of this, you also have to understand the interbank payments system, which I only very briefly touched upon in this essay
2) When a typical bank first issues a loan, it's in digital chip form and will appear in the borrower's account (e.g. the account might suddenly say '£450,000')
3) But the person will then use that to buy whatever they were wanting to get. So, for example, in the case of a mortgage, the borrower will then transfer that to the owner of a house they want to buy. In that case, their account goes to 0, and the house-sellers account goes up to £450,000 in digital chips
4) If the house-seller banks at a different bank to the buyer, this will mean that the original bank will have to transfer Level 1 reserves to the second bank to compensate them for the fact that they now have a customer (the house-seller) with £450,000 in new Level 2 digital chips. This means, Bank A will lose a bunch of reserves as a result of issuing the loan (but they're compensated for this by the fact that in issuing the loan they got a future loan asset)
5) But Bank A isn't the only bank issuing new chips. For example, if Bank B has also created new chips via loan issuance to someone else in Bank B, that might end up creating a counterflow in which new digital chips might end up with a house-seller in Bank A. This might cancel out the reserves that would otherwise needed to be passed between the banks - i.e. the two banks collectively create £900,000 in new layer 2 chips, but then find themselves having to pass £450,000 in layer 1 reserves to each other as their borrowers initiate transfers, but those just offset each other (I.e. Bank A sends 450k to Bank B, and Bank B sends 450k to Bank A, which means, in effect, they don't send anything)
6) In a sense, the new chips the banks create end up in a different part of an interlinked interbank system. These new chips stay in play, so long as nobody ever actually goes to an ATM to 'leave the network of casinos'. If anybody in the system goes to an ATM though, one of the banks in the banking system will be forced to destroy/withdraw digital chips from circulation
7) Put slightly differently, all the banks are creating new digital chips through loan issuance, but those chips then get reassigned to different parts of an interconnected banking system via the interbank payments system. The only time these chips get retracted is when loans are being repayed (that's a whole other topic), or when people are withdrawing cash
So, to get to your question:
8) If a customer was to ask for a cash loan, the bank is still going to extract a loan asset, but it would be conceptually equivalent to the situation in which a) the bank creates new digital chips for the customer, who then b) immediately withdraws cash and thereby destroys the digital chips ('leaves the casino').
One of the key themes here is that in a modern highly advanced banking system there are systemic interlinkages between all the separate banks which 'deepens' the ability of the banks to issue credit - i.e. they begin to operate as a kind of collective, collectively issuing chips, and if they can get people to stay within that chip system they don't have to do very much passing of Layer 1 reserves between themselves at all.
When banks are not interlinked, the cash system becomes a way that a person hops from one bank to another (e.g. I get my loan, exit the banking system via the ATM, give to someone else, who may deposit it into a different bank and thereby 'enter the casino again'), but when they are strongly interlinked, they begin to create a kind of collective 'meta-casino' that will fight with the cash system.
Great metaphor and exposition! But how does it map to the M0-M3 taxonomy from college macroeconomics? All the explanations I've ever come across are so abstract I'm unsure.
It varies depending on country, but M0 maps onto what I'm calling Layer 1 here - or 'base money'. M1 traditionally refers to what I'm calling Layer 2 here. After that it tends to gets hazy, lumping different categories together etc, and depends on country
Thanks, enlightening as always!
Hi Brett,
I like your casino-chip metaphor. The biggest reason that this layering framework does not get popularized, in my opinion, is that making the distinction (between layers) that truly exists raises the cost of understanding but do not yield immediately visible value for many people. In other words, incorrect understanding does not directly impact those people who misunderstand (somehow every person in the monetary system shares the aggregate cost of misunderstanding). So, even though i enjoy and agree about this layering framework, I strongly believe many people would still and continually treat those money from different layers simply as different forms of money.
Hi An-Tsu, yes I think you are right about this in general. I guess it's my job to try convince people that this matters! It's worth noting that this same phenomenon is a problem for anyone trying to raise awareness about big issues that are generally invisible to the public (e.g. data exploitation, electricity derived from fossil fuels etc)
The implications need to be made clear, especially if different circumstances arise that cause issues.
Very interesting, and a useful metaphor. I tried in the past to explain everything with the general mechanism of loan/IOU. Banks and central banks are only special players among many, including consumers and corporations. But that's very abstract for many people.
Glad you find it useful
Damn man, you can write like a motherfucker. Never felt like explanations of monetary policy have been totally on the level or fully made sense to me, this is the first time that I feel like i really grok what money systems are and how they function. Nice one!!
Really glad to hear that Peter. Thanks for the support!
Hi Brett,
Thank you this is really useful. I'm wondering, could reserves be considered another, distinct layer (layer 0)?
Whenever I read about a country running out of dollars, I think why don't they just get an American bank to lend them dollars (since the bank can create them from nothing)? Is it because they need reserve dollars (layer 0), and banks can only lend them layer 1 or 2?
Sorry if it's a dumb question I'm not an economist
Hey Luke, Reserves are on the same level as cash.
Here's a metaphor for this: Imagine if you want to promise a friend a massage. You can write it out on a piece of paper and hand it to them ('IOU a massage'). Alternatively, you could write it out on a computer next to their name, and show it to them. This isn't the most elegant metaphor, but to your friend, both the physical and the digital version of the promise still offer them the same thing.
So, for banks, cash and digital reserves are interchangeable - they can take cash they have, give it to the central bank, and ask for digital reserves instead, or they can take their digital reserves, and ask the central bank to give them cash instead. This is why, on bank balance sheets, you'll always see a line item that says 'cash and reserves', because the physical and digital versions of state issued money are basically interchangeable to them.
In terms of your second question, that's much bigger and I'm not an expert in all the nuances of that, but I think in many cases they actually do get American banks to lend to them, in which case the country ends up with Layer 2 dollar sitting in a US bank account. Alternatively, it may be the central bank giving credit lines to another central bank etc. Anyway, it's too big a topic to cover here. Remember, though, while banks can technically 'create from nothing', it's dangerous for banks to do that because it puts them on the line when they do that (the money they issue is a liability to them, not an asset). In the end, the commercial bank will be asking 'do we really want to create new Layer 2 money for this government, and what will we get in return'
Hi, thanks for the article, I have learned a lot!!
But there’s something I don’t understand in this paragraph: “Digital chips for borrowers: they issue Layer 2 chips to borrowers, in exchange for a loan agreement in which the customer promises to return a larger amount of Layer 1 money to them in future…”
Because what the customer does is to return a larger amount of layer 2 chips, isn’t it? Despite that later the bank balances it reserves…
That you in advance for the clarification