Twelfth Installment
What is the True Nature of Monetary Theory?
The lineage of the circular reasoning as a theory of money
For those of us in the generation who reached adulthood after the collapse of the bubble economy, the term "monetary theory" no doubt brings to mind the book of the same name by University of Tokyo Professor Katsuhito Iwai, published in 1993 by Chikuma Shobo. While invoking Marxist arguments, Professor Iwai stated that "money circulates as money because it is circulating as money" and that money is "something that survives circular reasoning."
For a scrap of paper that has no inherent utility value whatsoever to be regarded by all constituent members of a society as "exchangeable for goods and services equivalent to 10,000 yen," it must become a "10,000 yen note" with the equivalent value of 10,000 yen. This belief held by the constituent members of society - that this scrap of paper can be exchanged for goods and services equivalent to 10,000 yen in value - is a shared illusion of sorts, and this shared illusion establishes the value of money. This is Professor Iwai's circular reasoning as a theory of money.
Professor Iwai's argument faces a bit of a problem when applied to the legal tender issued by governments (or central banks), but this will be discussed later. Nonetheless, the phenomena of money spontaneously emerging have been observed across the world throughout history, with sea shells and precious stones fulfilling the role of money (i.e., as a medium of exchange for economic transactions) in primitive societies, and cigarettes, for instance, serving as money in prisoner-of-war camps and prisons. This spontaneous emergence of money can be explained by Professor Iwai's circular reasoning as a theory.
The groundbreaking theoretical studies of Nobuhiro Kiyotaki (now a professor at Princeton University) and Randall Wright (a professor at the University of Pennsylvania) in the 1980s blazed the trail in explaining the spontaneous emergence of money by the aforementioned circular reasoning as a theory, and their work has been continued by groups at the University of Pennsylvania and the University of Toronto among others.
These studies very meticulously modelled the exchange process between money and goods and, while one of the key objectives initially was to determine the source of money, an innovation was recently announced (in 2005) by Ricardo Lagos and Professor Wright; this Lagos-Wright Model has been used to develop theories also applicable to monetary policy analysis. These recent monetary theories have primarily analyzed outside money (seashells, precious stones, paper money and other objects whose utility value is zero but which have come to serve as mediums of exchange), but research analyzing inside money (i.e., scrip money or bank/corporate bonds that have come to serve as means of settlement) has also been pursued.
Scrip money - a spontaneously-emerging medium of exchange
Models that only take into account outside money, such as recent monetary theories developed along the lines of Lagos-Wright, tend to fall under the spell of the Friedman rule (the theoretical conclusion that a deflationary policy is the optimal monetary policy) discussed in the previous article. It has become increasingly understood, however, that the introduction of scrip money can create circumstances that would lead one to the conclusion that mild inflation is the optimal monetary policy (this does, though, require several strong theoretical presumptions).
This outcome is extremely suggestive. Monetary theory thus far has focused on outside money (paper currency, seashells, etc.) and thus accepted the unrealistic policy recommendations of the Friedman rule, but expanding the scope of analysis to include inside money (scrip money, deposit liabilities, etc.) may yet free us from the Friedman rule's spell.
The circular reasoning as a theory emphasized in Professor Iwai's writings and in the Kiyotaki-Wright model (that the circulation of money as money is attributable simply to the fact that the constituent members of society treat it as money) is by its nature only truly valid for issues pertaining to spontaneously emerging inside money and not with respect to outside money such as legal tender.
Let us first consider why explanations of outside money (especially legal tender issued by central banks) using the circular reasoning as a theory are problematic. The explanation that a 10,000-yen note has a value of 10,000 yen because everyone believes so is certainly true, but this alone is inadequate. If the only basis for value is people's expectation that others also believe that this scrap of paper has 10,000 yen of value and will accept it for transactions, then a collapse of this expectation would render the 10,000-yen note worthless. The reduction of paper currency to mere scraps of paper is termed hyperinflation, a phenomenon that actually occurred in post-WWI Germany and in the countries of Central Europe. Hyperinflation was halted in these countries and is not presently occurring in Japan by government guarantees of the value of money through the collection of taxes and of the general public's trust in the government's ability to collect taxes. As paper currency in a broad sense is a certificate of indebtedness issued by a government (central bank), it is the government's ability to secure revenue, i.e., the ability to collect taxes that guarantees its value. In other words, the value of legal tender is supported not simply by the circular reasoning as a theory of money but also by multifaceted governance capacities, including a government's fiscal administration and its ability to collect taxes.
By contrast, the short-term liabilities of a financial institution, etc. (actual short-term loans through deposits and repo transactions) function as money in a spontaneous manner, with the basis for these serving as money being essentially the circular reasoning as a theory of money. Faith in the financial soundness of the financial institution issuing these liabilities can be regarded as one source of support for the value of scrip money. It is clear that before the Lehman shock, though, that financial institutions lending and borrowing funds to/from each other had almost no knowledge at all of their counterparty's financial standing. Everyone in the real short-term financial market places their trust in each other's liabilities and engages in transactions without checking on the soundness of other parties. Accordingly, the fundamental logic underlying the value of scrip money is the fact that it is circulating as money, i.e., the circular reasoning as a theory of money.
If money is by nature a creation of circular reasoning, as Professor Iwai asserts, then spontaneously-emerging scrip money does indeed manifest the true essence of money.
* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the November 2, 2009 issue of Kinzai Financial Weekly
