Towards a Trias Pecuniae

This article presents the idea of a trias pecuniae as a synthesis of the commodity and credit theories of money. The margins of error provided by the rigidities of a classical gold standard and the flexibilities of a purely fiat standard as grounded in the commodity and credit theories of money have historically proven insufficiently robust to prevent episodes of inflation, financial excess and wealth inequalities. In conclusion, it is argued how through checks and balances, societies are able to grant citizens an unalienable right to the freedom of wealth with an effective and simple check. This article puts forward an analytical framework derived from approaches in philosophy (i.e. two theories of causality), law (through a so-called monetary matrix) and political theory (i.e. Montesquieu’s trias politica) to consistently untangle the elements that characterize the two money theories and the three theories of banking attached to them. In conclusion, the trias politica is applied to all wealth, allowing the discernment of three wealth powers: the fiscal power, the monetary power, and the credit power. The checks necessary to serve societies to remain in balance can be implemented by making the relations between the people and each of these institutional powers reciprocal. Essentially, when future income is removed from the equation of eligible collateral on the basis of which each of the wealth powers is able to enter into arrangements of credit, a society tackles all sources of inflation and financial excess. Through these checks, societies are able to eliminate the tendency of income and wealth disparities to become ever greater, not by top-down measures and interventions, but by means of laws that apply equally to all persons, natural and legal, thus leveling the playing field for the management of all wealth in a bottom-up fashion.

(Foreword Towards A Trias Pecuniae: here)


This article presents three different approaches to the topics of money, credit and gold that all lie outside the domain of economics. They have their origins in the domains of philosophy, law and political theory. When money and credit are discussed, the focus more often than not is on quantitative effects in the various monetary aggregates that follow from changes in interest rates. The focus in this article is of another order. Instead of focusing on market and price dynamics, the focus is on questions of causality. The objective is to provide a perspective that seeks to explain the causal relationships of any currency in circulation. Throughout this article, these three approaches of (1) the use of metaphysics in economic theories, (2) a monetary matrix, which is a simple elementary overview of five functions of money and five teleological attributes of a currency, and (3) Monetesquieu’s trias politica. All these approaches connect to each other, even if this may not seem to be the case at the start and only becomes readily apparent in part 3 of this article. Beside these three approaches, there are three themes that return at different stages of this article. These themes are recurring topics in economics, namely: (1) the emergence of financial excess; (2) inflation; and (3) a growing disparity in the distribution of wealth. As a collection of themes however, and a figurative backlight for a trias pecuniae, these three relate to the quality of public management of both public funding and private wealth. Viewed from this angle, one could frame these three economic phenomena within a politico-theoretical view of free market capitalism and democracy as being inseparably intertwined. One could say free market capitalism and democracy go hand in hand; when either one is traded in for something different, society will eventually lose the other as well.

In regard to the distribution of wealth in societies, there are studies and statistics for many mature economies, but available data is mostly restricted to incomes and comes in the form of GINI-coefficients. Data on net equity positions (that is all assets minus debt owned by private households) are only sporadically available. With some regularity headlines inform us of CEO salaries being raised using compensation schemes in stock options in the many millions. Compared to the bottom lines of the lowest paid employees, this compensation has been growing over the decades. Figure 1 is a way to graphically visualize the idea of a growing disparity in the distribution of wealth. The idea behind the two opposites in wealth distributions is very similar to that of perfectly competitive markets and monopolies. Free market capitalism is about driving down all profits. Were a market to be perfectly competitive, markets would clear at the marginal costs of production. This is important for three reasons. First, all profits logically are excess income (income minus costs > 0). Second, purchasing power of customers cannot be optimized any further when they buy at marginal costs. Third, all profits result due to reasons of market failure. The imperfections of our reality are plentiful, and the question of profitability (read: excess income) is therefore about reasons why markets fail to clear at the marginal cost of production. Some causes of market failure are natural, others are artificial 1. Likewise, an unequal distribution of wealth can only happen when causal factors push the distribution of wealth to become ever more unequal. In this manner the arrows in the above image can be understood, because under a strictly capitalist regime, based on the principles of level playing fields, the distribution of wealth can never become perfectly equal. It can only ever be optimal: it will tend toward equality without ever realizing it. If wealth distribution starts trending the other way, towards inequality, it means that playing fields have become unlevelled. The question is: how so exactly?

Essentially, the question of an optimally equal distribution of wealth starts with the attributes that feature the financial equation that underlies each and every society. In other words, in which ways are money and credit arrangements treated under the law? The economic literature 2, in short, provides two basic answers to the question of what money is: money is either considered credit, or in the opposite, money is a particular commodity and by historical preference, this particular commodity is gold. The first answer is grounded in the credit theory of money whereas the latter features the commodity theory of money. Every theory of money can be placed on a spectrum between the extreme pure forms of these two theories. A commonality of all money theories is that the validity of its thesis is argued by carefully examining monetary history for confirmation of key features, and most importantly, a formalized methodological exposé and understanding of banking. In general it can be said that when depositors withdraw their funds en masse, a bank that solely lent conservatively to solid investments, can – under extreme circumstances – become illiquid and and may be forced to sell off assets at fire sale prices and declared bankrupt as a result. The question of what a bank must be able to do in order to remain in business as a bank can be summed up in two rules: (1) it needs to remain solvent and (2) it needs to be able to satisfy the liquidity preferences of its clientèle. The inherent risks of banking have been a returning feature in every financial crisis of the past, yet in theoretical terms, banking still remains a mysterious matter. This article attempts to put forward a perspective that may contribute to a detailed appreciation of the many intricacies and nuances of banking.

Structure of this article

In structure, firstly, two different theories of causality are discussed in order to reflect on the use of metaphysics in economics by examining the philosophical foundations of economic thinking. The two theories of causality that are discussed return in part 2 where they are related to theories of banking. Also in part 1, a monetary matrix is presented that is nothing more than an elementary overview of five functions to money and five teleological attributes of any currency. Admittedly, this matrix started as a personal study aid while reading the money literature. In its elementary application, it helps clarify theories of banking, as well as conceptually covering most questions of money (if not all). Part 2 reviews three theories of banking (i.e. full and fractional reserve banking, and free banking) based on (1) theories of causality and (2) the monetary matrix from which an important conclusion is drawn. This conclusion forms the material basis to condense the money literature in a synthesis of both the credit and the commodity theory of money in part 3. The key question in part 2 and 3 in this respect is: On what collateral basis is credit created? Part 3 answers this question through the application of Montesquieu’s trias politica to all wealth in society. In so doing, it helps answer this most profound question: How can a society codify the freedom of wealth in its institutional constellation so as to achieve the optimal distribution of wealth?

Part 1 – A question of philosophy: economics or catallactics?

It is useful to reflect on the essence of the economic science, as it can be summed up by two competing words that aspire to capture the topics that economists study. Namely, economics and catallatics. The etymological origin of the adjective economic is Greek, and its meaning can be summed up in just a few lines 3:

“pertaining to management of a household,” perhaps shortened from economical, or else from French économique or directly from Latin oeconomicus “of domestic economy,” from Greek oikonomikos “practiced in the management of a household or family” (also the name of a treatise by Xenophon on the duties of domestic life), hence, “frugal, thrifty,” from oikonomia “household management” (see economy (n.)). Meaning “relating to the science of economics” is from 1835 and now is the main sense, economical retaining the older one of “characterized by thrift.”

In contrast, based on Richard Whately’s “Introductory Lectures on Political Economy” (1831) 4, Mises and Hayek argued to use the term catallactics instead:

It is with a view to put you on your guard against prejudices thus created, (and you will meet probably with many instances of persons influenced by them) that I have stated my objections to the name of Political-Economy. It is now, I conceive, too late to think of changing it. A. Smith, indeed, has designated his work a treatise on the “Wealth of Nations;” but this supplies a name only for the subject-matter, not for the science itself. The name I should have preferred as the most descriptive, and on the whole least objectionable, is that of CATALLACTICS, or the “Science of Exchanges.”

It is only natural to indulge a preference if one were asked to choose between them, but in a way, both these two words capture what economic scholars and related social scientists study: on the one hand, we study exchange and the terms of trade. On the other, economists study mutations on individual balance sheets, or, the management of households (be it a household of an entrepreneurial, private or public nature). But an entity’s profit and loss account, finally, deserves explicit inclusion too, as it ultimately causes balance sheets to mutate.

1.1 systems-thinking and process-thinking

In the social sciences, there are two different theories of causality by which one might understand and explain reality. These two theories are systems-thinking in the tradition of Immanuel Kant, and process-thinking in the tradition of Wilhelm Hegel (Stacey, 2003). With reality being the same framework of reference, these two theories explain the functioning principles of reality by contrasting logic. One could say they are two radically different ways of thinking. For the domain of economics, these two theories of causality are of relevance in that almost all economic theories apply systems-thinking without any formal acknowledgment of it, or further inquiry. Process-thinking in contrast, has not yet been introduced.

In short, systems-thinking applies a dual theory of causality, whereas process-thinking applies a singular theory of causality. In the methodological application, systems-thinking uses two levels of analysis: agents are at the micro level whereas the system or a whole is at the macro level of analysis. Agents are considered rational in their actions and as such rational causality applies. For the functioning of the whole however, the causality is formative in that developments move from one stage of maturity to a next. In contrast, process-thinking is conducted on a singular level of analysis (i.e. there is no micro-macro paradigm) with the unit of analysis focusing on the interactions of individuals. The causality is rather paradoxical because in interactions, the experience of individuals are formed and are forming each other at the same time. On the basis of professor Ralph Stacey’s “Strategic Management and Organisational Dynamics5 the main points of these two theories can be summed up. In regard to causality in general, the following can be said:

One way of thinking about the relationship between cause and effect in Western culture is linear and unidirectional. There is some variable Y whose behaviour is to be explained. It is regarded as dependent and other ‘independent’ variables, X1, X2, … , are sought that are causing it. Linear relationships mean that if there is more of a cause then there will be proportionally more of the effect (Stacey 2003, p. 10)”.

The manner in which causality is understood is relevant for the way we experience choices, because the choices we make result in actions. As the saying goes, actions have consequences. In this regard, four distinctive choices can be discerned: a dichotomy, a dilemma, a dualism and a paradox. A dichotomy is a choice of either this, or that. For example, students may have a choice between studying or going to a party. A dilemma is a choice between two equally unattractive alternatives. For example, market circumstances may necessitate cutting costs and laying off personnel or increasing prices and risking production levels and revenues. With a dualism, a choice is unified. For example, think global, act local. With a paradox, two opposing ideas are true at the same time and cannot exclude each other (Stacey, 2003). In economics one could think of any transaction as a paradox. In every transaction, supply and demand come together and cannot exclude each other. Rather, as opposing ideas, they can only hold true at the same time.

In regards to systems-thinking and the causality of mechanisms and organisms, Stacey has timeless insights to offer:

A mechanism can be understood in terms of it being a pre-designed system in which the parts derive their function from the functioning of the whole. In order to develop the parts the whole must be thought of in front. The whole is therefore required before the parts have a function. As such, the clock is formulated before the parts can be designed (Stacey, 2003, p. 21-22).”

“An organism can be defined in terms of being not designed up front and then assembled into the unity of an organism. They, arise as the result of interactions within the developing organism. The parts emerge, as parts, not by prior design but as a result of internal interactions within the plant itself in a self-generating, self-organising dynamic in a particular environmental context. The parts do not come before the whole but emerge in the interaction of spontaneously generated differences that give rise to the parts within unity (Goodwin, 1994; Goodwin & Webster, 1996). …In terms of systems-thinking Kant was introducing a causality that was teleological and formative rather than simple, linear, efficient (if-then) causality assumed in the mechanistic scientific way of understanding nature. The causality is formative while it is in the self-organising interaction of the parts that those parts and the whole emerge. It is as if the system, whole, has a purpose, namely to move to a final state that is already given as a mature form of itself. In other words, nature is unfolding already enfolded forms and causality might be referred to as formative causality (Stacey, Griffin and Shaw, 2001) in which the dominant form of causality is the formative process of development (Stacey, 2003, p. 22).”

When systems-thinking is applied, markets are thought of as abstract places outside personal experience where all suppliers and all consumers gather. However abstract this thought of gathering might be, when economic markets are discussed, certain forms of competition can be recognized from which a type of market can be assessed. It may resemble a perfectly competitive market, or due to reasons of market failing, they may resemble oligopolistic or monopolistic markets where suppliers are able to sell their products at a premium above their marginal costs of production. Irrespective of these dynamics and the type of competition, all agents part of a market can be assumed to act in their best self-interest. For sellers it is only rational to want to make a profit whereas in contrast, consumers want to buy at the lowest possible price. For the functioning of the market as a whole however, formative causality applies in that the interacting parts give emergence to a whole that at a higher level, feeds back into the causal loop as a formative cause. It is argued that supply and demand communicate through prices and the business context of price formation influences the behavior of all participants in that they are subject to the dynamics and disciplining principles of markets. The dual character of the theory of causality thereby is rational causality for consumers and sellers, and formative causality for the whole of markets. A market, an industry, a sector, a national economy, they are approached as systems with many subsystems, always precisely defined and confined to certain boundaries accordingly. Hereby, individual actions are explained from the micro level and the functioning of the whole at the macro level.

For process-thinking, Stacey refers to the late sociologist Norbert Elias:

“…Elias argued that social evolution could not be understood in terms of social forces, cultural systems, supra-individuals, supra-systems, spirit or any kind of whole outside experience. Instead he argued for a way of understanding that stayed with the experience of interaction between people. He suggested a kind of circular, paradoxical causality in which individuals form the social while being formed by it at the same time and he acknowledged the link between this view and the philosophy of Hegel. Elias held that there is no nothing mysterious about the simultaneous evolution of social order and individual personality structures (Stacey, 2003, p. 300).”

To sum up the main difference between systems- and process-thinking:

Process and systems-thinking ways of thinking differ because they are based on completely different notions of theories of causality. Systems-thinking assumes a dual causality: the rational causality of the autonomous individual applies to the human observer or designer of the system and human thinking about the system, while formative causality applies to the operation of the system. The system unfolds what is enfolded in it so that the future is in a sense already there. The systems that humans produce in their interaction emerge as a higher level than the individuals and those higher levels have their own causative powers. The system produced in interaction acts back on that interaction as formative cause. For example human interaction is said to produce social structures or cultural systems that then cause the actions of individuals. Novelty cannot be explained in systemic terms, only in individual centred terms. In process-thinking the theory of causality is unitary and transformative in that patterns of interaction emerge as continuity and potential transformation in the iteration of interaction itself. The future is thus under perpetual construction in the interaction between people and it is the process of interaction between differences that amplifies these differences into novelty. The explanation of novelty lies in the properties of the processes of interaction. The individual and the social are at the same level. There is nothing above it, below, behind or in front of interaction exercising any causal power on it. Instead of thinking in terms of dualism, process-thinking is conducted in terms of paradox and dialectic (Stacey, 2003, p. 313)”.

When process-thinking is applied, the approach does not part from personal experience. Abstract ideas that exist beyond or lie outside personal experience – and factually do not exist – are not readily assumed. In this sense, markets are not assumed. However, when product markets are considered there is of course a certain competitive process we can observe much like the way any football match during a season unfolds, but a market where all suppliers and all buyers gather is understood in different terms. The causality through which prices emerge is considered singular; a paradoxical process whereby supply and demand are formed and forming each other in each transaction that are taking place continuously. Each transaction legitimizes supply in demand and vice versa. With the purchase of goods or services, a final trade is settled according to the terms of exchange a supplier and buyer agreed to. In economic geography, we tend to think about prices as widely heterogeneous. Prices cannot be considered homogeneous as mathematical representations in books on microeconomics do. Prices differentiate depending on where transactions take place. In different locations and contexts, markets function differently. In the resulting patterns of iterating transactions, transformation can be observed in the sense that patterns of transaction are continuously changing. Hereby, transformation is enfolded in the changing attributes of the contextual environment and the changing properties in terms of trade. Transformation of markets, or entire economies is thus under perpetual construction through iterating transactions whereby all participants are at the same level of analysis. Everything economic is related through interactions. From this perspective, a market or an economy is nothing short of an immense collection of transactions. With process-thinking, thinking in terms of paradox, causality is of a nonlinear nature.

Use of metaphysics in economic literature

In economic literature, systems-thinking is applied rather implicitly, hidden for an unsuspecting reader yet always present with a well-established and distinguished vocabulary. Take, for example, the greatest of all economic questions: if one were to enter a query in the search engine of any university library and search for economic growth, it would yield thousands of results, pointing one to publications that argue over whether economic growth should be understood as exogenous or, alternatively, as endogenous to the economy. The implicit assumption of an economy being a whole outside of direct personal experience has given cause to assume the economy is a system. This is followed by a question that frames growth as a question that can only be explained for reasons endogenous to the system, that are internal, or in contrast, maintains growth comes from outside the system and is exogenous. Mostly, endogenous growth is argued for by means of educational policies and stimulating an innovative and competitive business environment. In contrast, arguments in favor of exogenous growth emphasize a variety of policy instruments and the application of various fiscal and/or monetary stimuli. This very same line of thinking underlies the idea that the economy is always moving towards a new equilibrium. In terms of formative causation, its movement is thought of as a developmental process into a more mature form of itself. This idea, too, can be traced back to the assumption that the economy is a system that can only be understood through the dualism of systems-thinking. In this regard, economists study micro- and macroeconomic variables and research how phenomena actually work, so that remedies can be prescribed for how phases of disequilibrium can be better handled and managed6. In this respect, macroeconomic indicators are suggested to have a causal relationship. However, empirically speaking, all economic correlations are dynamic themselves; there are no constants.

From the perspective of process-thinking, economic growth is approached differently because the focus remains on personal experience. When wage increases are excluded, if one considers economic growth, one can only experience this through a material increase in purchasing power in the monetary unit. Essentially, it is the only way in which greater prosperity is experienced immediately. The same holds true for a decrease in purchasing power of the monetary unit. Whereas macroeconomic indicators may provide many insights in a particular statistical cohesion between macroeconomic variables during certain phases of economic cycles, the complexity driving these dynamics is thought of in terms of non-linearity. The assumption of a formative causality leads to a quest to find forms of economic determinism within the precisely defined boundaries of an economic system. These assumptions may occasionally help a greater understanding, but when left undiscussed, they may also confuse matters needlessly. With process-thinking, the continuously changing patterns of iterating transactions are foregrounded and conceptualized in terms of non-linearity and through an emphasis on understanding the dynamic interplay itself.

1.2 Introducing a monetary matrix

The monetary matrix is an elementary approach to the concept of money. For any money, five functions are discerned whereas for each currency five teleological7 attributes are considered. These attributes may be considered teleological in that they are of an essential relevance to any currency in circulation. Even when an attribute is absent, then too its relevance is self-evident8.

Teleological attributes

The history of money shows a great variety of different tangibles that have been used as a money. From silver and gold coins to the fiat paper moneys of today, but also salt, tobacco, and even stones have been resorted to as a money. Without going into details for each of these, from the perspective of the commodity theory of money, one is inclined to discern between tangibles and intangibles in that under a precious metals standard, be it a gold standard or a regime of bimetallism with silver, the convertibility of paper money in precious metals warrants a distinction between tangible currency and an intangible fiduciary paper claim on an intrinsically more valuable underlying asset. However, from the perspective of the credit theory of money, the emergence of tally sticks is an example that there is no automatic necessity for precious metals to be included in an exchange. David Graeber in his phenomenal anthropological approach to money, “Debt, the first 5,000 years“, sums it up as follows: “Tally sticks emerged in England as private contracts in the form of a hazel wood twig, on which the amount due was notched, and then split in half. The creditor would keep one half, called the stock and the debtor kept the other, called the stub (Graeber, 2011; paraphrased from p. 48)9. Both theories of money can be explained with this matrix albeit it only agnostically. It does not prove the credit or commodity theories necessarily right or wrong.

A currency comes in different nominal values in coins and notes or coupures. In their raison d’être, the varying denominations simplify transactions. Whereas coins mostly break down the unit of account in smaller fractions, mostly in cents and multiples thereof, notes commonly vary in multiples of 5, 10, 20, 50, 100, and some notes have a higher notional value. Any price can be transacted by standardized coins and notes. Each of these fractions and multiples of the unit of account are fungible so that their circulation facilitates continuous settlement of exchanges. The measurable nature of any currency is not strictly limited to its nominal features because from the perspective of the commodity theory of money, when coinage comes in the form of precious metals, its weight and purity is of practical importance for the assessment of its valuation. Clipping, diluted coinage and the phenomenon of Gresham’s Law – “bad money drives out good money out of circulation” – feature many stories in monetary history in this respect.

The difference between the attributes of a currency being scarce, or relatively abundant10 and its attribute as catallactic is due to a nuanced difference in the manner in which the effective purchasing power of a currency is manifested. Scarcity drives the value of the currency in reasonably objective terms since its total notional amount in circulation can always be assessed11. Every participant is able to assess the relative value of a currency in reference of his past experience of prices for goods and services. However, the effective purchasing power of a currency also follows from the spendthrift of individuals engaging in transactions. The catallactic attribute accounts for the subjective perception of individuals using their money to make purchases. For example, works of arts are more valuable for some than others. As the Dutch saying goes, (shoulders shrugging) “what a mad man is willing to pay”. The attribute of catallactic is a currency attribute that emphasizes the sentiments of buyers (and sellers). Both these factors determine the purchasing power of a currency, albeit in different ways. Whereas the total supply of money in circulation allows for reasonably objective calculations for its purchasing power, the catallactic attribute accounts for discrepancies above as well as below more or less objective prices, by means of consumer (and seller) perceptions. There is a reason why product marketing or brand advertisement can prove itself a great way to increase turnover and profitability. Perception matters. A last attribute of any currency is that it circulates in an environment of rules. The set of laws and regulations that govern the contractual relationships among all economic actors stipulate the fiduciary obligations of all parties engaging in exchange and in contracts of credit. In modern monetary frameworks with central banks of issuance, the currency is brought into circulation as legal tender. Legally, any currency is defined as a means in settlement of debts. Also, the law specifies standards of contract, and this is of utmost importance to arrangements of credit.

Functions of money

In regard to money, two functions have been added to the three functions of money that feature in all economic text books. Beside the three well-known functions of a medium of exchange, unit of account and a medium of hoarding, the two additional functions are a medium of direct transfer and a means of indirect transfer. When for example, children receive a weekly allowance from their parents, money is used as a direct medium of transfer. Money is transferred to allow others to spend it. This same principle applies when taxes are paid because taxes do not necessarily require that there be a direct relationship of exchange. In principle, a transfer occurs whenever money is transferred from one party to another without there being a material direct exchange. In this regard, theft (which is punishable under the law), inheritances, and donations are other examples where money is used as direct medium of transfer. Simply put, ownership of financial means is transferred without a possession of equal value returning in direct exchange.

By considering this fourth function to money, one is also able to discern between hoarding – or saving in modern parlance – and investing. Saving money literally is no different from hoarding money under one’s mattress or storing it in a vault. When money is put in a deposit account with a bank however, money is transferred to a bank as a loan or credit to the bank. The legal title of ownership is not transferred, it is amended by the transfer of possession and the right to use it. The owner of money receives a claim on a bank, whereas the bank receives liquid funds which it uses to enable its lending operations. Money is therefore not hoarded at a bank, in deposit, it is invested. A last function of money is that of an indirect means of transfer. This function of money can be observed when the value of what a monetary unit buys, decreases. This effect generally occurs as a consequence of an increase of the total amount of money instruments and is known as inflation. The causality of inflation is however a rather complex matter. Although it is always under constant management by central banks of issuance, one can consider the monetary phenomenon of inflation somewhat of a Hydra of Lerna because there are always several factors in play. Only together, they can be held responsible for causing inflation, yet their coherence as causal factors is incredibly complex. In general though, and from a theoretical point of view, real economic factors tend to cause price deflation, though not necessarily so. Whereas rising productivity and increased competitiveness give rise to lower prices and effectively to an increase in purchasing power of the monetary unit, a failed harvest or increasing factor costs of production cause prices to increase and result in a decrease in the purchasing power of the monetary unit. Causes of inflation of this nature are not considered part of this function of money. The loss of purchasing power of the monetary unit – excluding real economic factors – can only be explained because money has been used as a means of indirect transfer. The monetary unit loses purchasing power as a consequence of an illegitimate quantitative expansion in money balances. The question of monetary inflation in this respect is one of causality: how so exactly? Can inflation as a monetary phenomenon best be thought of in terms of linear, formative, or non-linear causality?

Part 2 – Three theories of banking, causality & money functions

Broadly speaking, there are three different theories of banking and they differ on the manner in which banking institutions are conceived to extend and create credit facilities: full reserve banking, fractional reserve banking and free banking. Full reserve and fractional reserve banking see savings held in bank accounts as the source from which loans are financed. These two theories can be considered examples of interloanable funds theory. All three alternative views differ from each other in both positive analysis (how things truly work) and in normative analysis (how things ideally ought to work). Moreover, the credit and commodity theories of money are closely connected to the way banking is understood, although they are applied in variations in each money theory so one cannot say the commodity or credit theory of money prescribes a theory of banking. Tradition has it, this varies from author to author in both camps of the money doctrine.

Interloanable funds theories

With fractional reserve banking and full reserve banking, (time) deposits are viewed as the fundamental basis on which credit is extended. Both theories can be considered interloanable funds theories, though they differ in respect to the amount of reserves that banks are required to hold in reserve for loans they extend. With full reserve banking, emphasis is given to the distinction between sight deposits and time deposits. Sight deposits may be withdrawn at any point in time and proponents of full reserve banking argue that these funds ought to be held in full reserve at banks. As this constitutes a service to a customer, a bank will offer this service at a fee. Time deposits on the other hand, can only be withdrawn after expiration, as specified in the loan contract, so that these funds can be lent by a bank. The bank compensates depositors with a fee for their trust in the bank’s ability to lend their money in prudent investments, and with a precise time structure so that a bank technically is not transforming the maturity of its loan book. Maturity transformation would require banks to borrow short at lower rates, and lend long-term at higher rates. Proponents of full-reserve banking argue, loans and deposits are matched at corresponding maturities ensuring real-economic stability. With fractional reserve banking there is less emphasis on sight and time deposits and this follows from the fungible character of a currency. Only a fraction of deposits is needed as a reserve for withdrawals because more often than not, people are comfortable leaving their liquid funds in the care of a bank. Because loans flow back as deposits into the banking system, the banking system is able to expand its loan book step by step. Theoretically, it is argued that the fractional reserve basis of lending, implies banks can only loan up a multiple of its deposit according to the set fractional reserve ratio. Hereby, a central bank is considered to play a facilitating as well as a constraining role. For example, a central bank can facilitate banking institutions by means of injecting liquid funds, and constrain banks by raising its lending rate for reserves, or by exerting control over the money supply depending on the instruments employed. From the perspective of fractional reserve banking, banks are able to transform the maturities at which they attract deposits and extend loans. This feature is important to emphasize because when, for example, short term deposits are withdrawn, and a bank needs to attract funds, banks may need to access a central bank’s liquidity facility if and when they are unable to borrow liquid funds with other banks (i.e. on interbank markets). From the perspective of fractional reserve banking, a key feature of banks is that they naturally are in the business of maturity transformation. It is argued, the benefits from increased liquidity risks are positive for long term economic growth on a net basis. Hence, central banks are seen as the lender of last resort to quell liquidity crises and ensure financial stability.

Free banking

Free banking has a very different take on the manner in which banks are able to extend loans. In principle, banks are left free to extend credit regardless of deposits they hold in reserve. Essentially, a credit facility is created out of thin air for which reserves are only an operational consideration, and not by any means a constraint. An integral part of this view is that the risks banks create should be left to banks creating and taking them. Proponents of free banking can be found in both credit and commodity theory of money, as the reserves that banks hold can be held in gold, or otherwise a fiduciary currency. In the strictest sense, free banking argues against a central bank acting as a lender of last resort. It would give banks incentives to take more risks. Free banking emphasizes that banks are naturally inclined to refrain from excessive risk taking because when they create too much credit, banks risk decreasing their profitability, and possibly jeopardize their solvency and long-term survival. The backstop of central bank intervention therefore stimulates excessive risk taking and interventions would redistribute credit risks in that they are transferred from the parties creating them, to central banks or in the alternative, to their respective governments. This argument lies at the heart of a centuries old debate on crises of liquidity and solvency: if a bank becomes illiquid and is forced to sell off assets at fire sale prices, chances of this bank becoming insolvent materialize due to dynamics of panics. A self-fulfilling prophecy may unfold, irrespective of whether a bank is solvent, or not. So if and when a central bank quells a liquidity crisis by injecting liquid funds into a bank or the banking sector, it is able to mitigate the risks of a liquidity crisis becoming a solvency crisis for a single bank or a few banks. But once it does, it risks flooding the financial system with liquidity effectively hiding an insolvency crisis. The margins of error in a strict legal management of all houses of credit have always existed, and most likely always will. And the same goes for the ongoing debate on central banks and their actions being lender of last resort. But then again: can these questions not be resolved from a different perspective?

Historical origins of interloanable funds theory

The origins of the theory of fractional reserve banking is found with the banking school as it emerged in the United Kingdom (Humphrey, 1987)12. By considering deposits as the foundation or basis on which loans are extended by banks, it appears that a logical explanation was found that explains how banks are limited in the total amount of loans they extend. The amount of deposits in the whole of the banking system can increase, though it is restricted by the reserve-deposit ratio. Or, so it was thought: the origin of this idea was a banker’s rule of thumb. Banks considered such rules a prudent means to an end. Yet, according to increasing and decreasing business confidence, the reserve ratio fluctuated. From Robert Torrens (1837), Humphrey (1987; p. 17-18) quotes:

In his theoretical analysis, Torrens treated the multiplier as a potentially variable magnitude, fluctuating in value from a high of twenty to a low of five depending on the state of business confidence and its impact on bankers’ desired deposit/reserve ratios. As he put it, these ratios ..will necessarily vary with the variations of commercial confidence. When trade is prosperous, when few failures are occurring, and when commercial bills are promptly paid as they fall due, bankers might consider it safe to continue to re-issue, upon securities, the cash returning upon them as deposits, until the proportion between their deposits and their cash, became as fifteen to one, or even as twenty to one. In periods of commercial pressure, on the other hand, bankers would be disposed to contract their liabilities, until the deposits. . . bore to their cash a proportion, not exceeding seven to one, or even five to one”.

For the explanation how banks are able to expand their loan book, deposits were considered as the means by which banks were able to lengthen their balance sheets. A loan was not created out of nothing, it found its basis in the deposits already held by the bank in reserves. The algebraic formulas that attempted to capture this causal application of the reserve requirement in practice were refined over decades by different authors who built on each others work (see Humphrey (1987) for how this quantitative theory of credit expansion was mathematically refined). The theory of fractional reserve lending seemed to explain the quantitative restrictions on the total amount of loans. With full-reserve lending13, banks are required to maintain a direct linear relation between the money they borrow from depositors, and the money they lend to borrowers (i.e. not to lend more money than they have). With fractional reserve lending, this causation can be understood in terms of formative causality as deposits can be multiplied through the intermediary interaction of banks with depositors and borrowers allowing a theoretical maximum amount of loans. The normative analysis of full reserve banking addresses problems of inflation and financial excesses by ensuring money cannot be used as an indirect means of transfer, which fixes the total amount of money since it cannot be multiplied by means of lending. With fractional reserve lending however, the monetary expansion through the multiplier effect necessarily requires a functional use of funds to be used as an indirect means of transfer. The amount of credit of borrowers grows during some time intervals (and falls during others) and depending on the growth rate in loans outstanding, this gives rise to inflationary dynamics of a monetary order. In its formative development however, fractional reserve lending does not necessarily require a dangerous rate of monetary inflation because in the long run, the banking community can only create so much credit after all. From this perspective, adjustments in the deposit-reserve requirement and central bank interventions can be considered exogenous factors that explain the emergence of monetary induced inflation. In theory at least. And in practice? So long it does not exceed 2% annually, inflation is considered a harmless good.

The credit theory of money

In contrast to reserve theories of bank lending, free banking does not recognize deposits as the basis of loans. Instead, in this view, all credit emerges as a result of lengthening a bank’s balance sheet whereby a bank takes on a claim on a borrower on its asset side of the balance sheet, and creates a credit facility on its liability side.

Jakab and Kumhof, in a working paper for the Bank of England, “Banks are not intermediaries of loanable funds — and why this matters14, formulate this as follows. From the summary (page II, III), (editorial comments in [brackets] for purposes of clarification):

The fundamental reason for these differences is that savings in the ILF [interloanable funds] model of banking need to be accumulated through a process of either producing additional goods or foregoing consumption of existing goods, a physical process that by its very nature is slow and continuous. On the other hand, FMC [financing through money creation] banks that create purchasing power can technically do so instantaneously and discontinuously, because the process does not involve physical goods, but rather the creation of money through the simultaneous expansion of both sides of banks’ balance sheets. While money is essential to facilitating purchases and sales of real resources outside the banking system, it is not itself a physical resource, and can be created at near zero cost. In other words, the ILF model is fundamentally a model of banks as barter institutions, while the FMC model is fundamentally a model of banks as monetary institutions.

The fact that banks technically face no limits to increasing the stocks of loans and deposits instantaneously and discontinuously does not, of course, mean that they do not face other limits to doing so. But the most important limit, especially during the boom periods of financial cycles when all banks simultaneously decide to lend more, is their own assessment of the implications of new lending for their profitability and solvency, rather than external constraints such as loanable funds, or the availability of central bank reserves”.

Richard Werner’s excellent article “A lost century in economics: Three theories of banking and the conclusive evidence” (2016)15 details a century worth of theoretical struggles and obfuscations on banking theories. In an earlier article, Werner (2014)16 detailed a way to assert that the credit theory of money can be tested empirically by looking at the accounting software banks use to account for extending a mortgage loan, as well as calling a deposit into existence. In Werner’s words (p. 16):

It was examined whether in the process of making money available to the borrower the bank transfers these funds from other accounts (within or outside the bank). In the process of making loaned money available in the borrower’s bank account, it was found that the bank did not transfer the money away from other internal or external accounts, resulting in a rejection of both the fractional reserve theory and the financial intermediation theory. Instead, it was found that the bank newly ‘invented’ the funds by crediting the borrower’s account with a deposit, although no such deposit had taken place. This is in line with the claims of the credit creation theory. Thus it can now be said with confidence for the first time – possibly in the 5000 years’ history of banking – that it has been empirically demonstrated that each individual bank creates credit and money out of nothing, when it extends what is called a ‘bank loan’. The bank does not loan any existing money, but instead creates new money. The money supply is created as ‘fairy dust’ produced by the banks out of thin air. [32] The implications are far-reaching”.

Implications aside for the moment, an important clarification on Werner’s thesis is made by Murau (2018)17. Murau correctly includes the balance sheet of borrowers in the explanation of the credit theory of money for who Innes (1914) was one of its main originators. Murau writes (p. 9):

[..] In terms of balance sheet mechanics, when a bank hands out a loan, it expands its balance sheet on both sides and swaps IOUs of different maturities (cf. Figure 1). The short-term IOUs, if they are tradable on a secondary market, function as money that can be used by the receiver of the loan. Conceptually, money creation thus literally occurs out of nothing, it is merely an exchange of two promises to pay.”

If credit money created today essentially is nothing but a promise to pay credit money tomorrow, we seem to be approaching analytical difficulties. What is the payment of ultimate money supposed to be? A traditional argument is that it must be a money form with ‘actual value’. This is why until the 20th century, the majority of monetary theorists, who ultimately adhered to a ‘monetary theory of credit’ in one way or another, believed that it was not possible to decouple monetary systems from a scarce commodity such as gold (cf. Arnon 2011). A counter-argument comes from Mitchell-Innes (1914), one of the ‘founders’ of a modern credit theory of money, who postulates that we only need the highest money as an ‘idea’—as a ‘unit of account’. “The eye”, he argues, “has never seen, nor the hand touched a dollar. All that we can touch or see is a promise to pay or satisfy a debt due for an amount called a dollar” (Mitchell-Innes 1914: 155)[18]. This paper, in its analysis of the dollar-based international monetary system, will follow Mitchell-Innes’s argument”.

The important point to make here is the following. From an accounting perspective, the creation of a credit facility involves four balance sheet additions. Two balance sheets are lengthened: the banking institution takes on collateral on its asset side (+1) and creates a deposit that shows up at its liability side (+1), whereas simultaneously, any borrower takes on deposit on its asset side (+1) and a loan obligation on the liability side of his balance sheet (+1). In other words, credit is not created out of nothing by a credit institution as popular parlance suggests it is, it is created based on the collateral of a borrower’s balance sheet. A bank requires collateral of a counterparty before it extends a credit. In this respect, it is useful to emphasize an important and often repeated theme of free banking. Although seemingly, banks create a credit facility out of nothing, banks are nevertheless constrained in profitability. When banks make loans on the basis of collateral of inferior quality, they risk their profitability by increasing the amount of credit risks in their loan portfolio, which may lead them to incur losses. The key question in this regard is therefore what the quality of the collateral banks take in is. What do banks take in as collateral?

Collateral basis of credit

In regard to the present banking framework with money being a fiduciary contract, it should be noted that available data on credit aggregates show that since the 1970s, credit aggregates have grown at an almost perfect exponential rate. The closure of the gold window by President Richard Nixon on August 15, 1971 is seen as the main culprit mostly by observers from the commodity theory of money. However, this fact alone cannot explain the exponential growth of debt securities in and by itself. It is also noteworthy to mention that the number of pages in banking regulations over this period has increased dramatically too (see Penikas19 (2015) for an excellent overview of bank regulation documentation from 1975-2014). For any single (central) banker, researcher or economic scholar, it is almost impossible to track these changes in bank regulations. However, to explain the exponential growth in credit aggregates, one does not necessarily have to pinpoint the exact article or paragraph that regulates credit risk, market risk, operational risk or liquidity risk. To come to an understanding that explains this almost perfect exponential growth in outstanding credit (that is, until the global financial crisis of 2008), the only question one really needs to ask is what valuation technique is used by banks for collateral on the basis of which they create loans? From a purely theoretical or economic perspective there are two fundamental bases on which any loan can be created. The question is (1) what is the legal reach of the collateral that banks take in, and (2) what valuation technique underlies the amount of credit they extend? Then there is the one important follow-up question: (3) how are credit risks attributed?

If one takes a mortgage as example, there are two possible objects of collateral: (1) a legal title on a home that is purchased by the loan and (2) the income stream of a borrower. A first important difference is that the former is a balance sheet item that can be readily liquidated whereas the latter is a theoretical calculation of the net present value (NPV) of future proceeds from a borrower’s profit & loss account. Anyone’s future income can be calculated this way, and likewise a portion to which a mortgage lays a claim on. Most conventionally, banks have prospective numbers of your salary growth integrated in their standardized spreadsheets when they make you an offer for a mortgage (in case you wondered). In theory, and in practice, this value does not necessarily discount for instances when one is hit by a stroke of bad luck. A second difference is that the net present value of an income stream is easily much (and substantially) higher than the liquidation value of a home. But even more important is that third question: the most fundamental difference is that a balance-sheet item allows mutual risk-sharing by both credit institutions and borrowers, whereas an extrapolation of future income necessitates credit institutions to shift off credit risks they create. The only question is to whom?

As became apparent in the aftermath of the 2008 financial crisis, banks had legal and financial motives for escalating the losses of individual mortgagees, instead of limiting these losses to a minimum. The problem of an overvalued collateral basis of credit only becomes evident after a default occurs. Problems with indebtedness usually follow from situations where due to circumstances (i.e. divorce, loss of a job, illness) a borrower’s income falls short, and the sale of a mortgaged home is insufficient to compensate for the loan. Only then, a residual debt emerges. Depending on the legal framework of the jurisdiction where this happens, the question is who bears the losses? In this respect there is a myriad of subtle differences across jurisdictions. All over the world. Although the causality of how credit is created is the same everywhere; how credit risks are attributed under law is a different matter. For example, in the Netherlands, in case of an under water mortgage, a borrower’s default comes at the cost of mandatory participation in a three to seven year debt restructuring program20. This legal procedure puts someone under a mandatory regime in which all his excess income above a pre-set minimum income is seized by creditors (or his agent) to pay off as much as possible. In other jurisdictions, this period is limited to one year whereas in the United States, some states allow borrowers to walk away from their debt. The myriad legal differences across jurisdictions are what they are as a consequence of being historically and culturally embedded in the evolution of legal traditions21. It is best to leave questions of a legal nature to legal experts, but the point here is simple and straightforward. The valuation technique used to assess the value of any collateral on the basis of which a credit facility is created, matters for how residual losses in individual cases emerge, and how taken together, they give rise to systemic risks.

Mutual risk-sharing

When privately created credit risks are shared in reciprocity, and the principle of free banking applies – all created risks must be borne privately by the parties creating them – then excessive credit creation is prevented because it would be self-defeating. To illustrate the incentive of the risk-sharing principle with a mortgage example, let us see what happens. The following example along with numbers are from Luigi Zingales’ brilliant “Plan B” (2008)22. The amounts in the table below find their origins in the real world, but it should be noted that recovery rates on mortgages vary across jurisdictions and may be higher than 50 cents on the euro. During a housing bust house prices can easily fall 30% as we have seen during the 2008 financial crisis. When this happens, a house purchased for €400,000 with a down payment, or positive equity, of only €20,000 means mortgagees find themselves in a position of negative equity of -€100,000. If a bank chooses to foreclose a house, and auction it off, it could expect to recover only €140,000 of a €380,000 mortgage. Now, in the case of the US, in the context of which Zingales presents his plan, in most states, mortgagees can walk away from their mortgage by simply handing over the keys to their bank (and move to another state for practical, legal reasons). In the Netherlands, mortgagees cannot walk away from the loan they signed for. Dutch risk their whole livelihoods. Were this only be restricted to their houses, then a bank would have the incentive not only to be more prudent in extending new loans, but also to limit their losses by opting for a debt-for-equity swap. Zingales explains the merit as follows:

Foreclosing is costly for both the borrower and the lender. The mortgage holder gains only half of what is lost by the homeowners, due to what we economists call underinvestment: the failure to maintain the house. In the old days, when the mortgage was granted by your local bank, there was a simple solution to this tremendous inefficiency. The bank forgave part of your mortgage; let’s say 30%. This creates a small positive equity value — an incentive — for you to stay. Since you stay and maintain the house, the bank get its $266,000 dollars of the new debt back which trumpt the $140,000 that it was getting through foreclosure. […] In exchange, however, the mortgage holder will receive some of the equity value of the house at the time it is sold. Until then, the homeowners will behave as if they own 100% of it. It is only at the time of sale that 50% of the difference between the selling price and the new value of the mortgage will be paid back to the mortgage holder. […] The reason for this sharing of the benefits is twofold. One the one hand, it makes the renegotiation less appealing to the homeowners, making it unattractive to those not in need of it. For example, homeowners with very large equity in their house (who do not need any restructuring because they are not at risk of default) will find it very costly to use this option because they wil have to give up 50% of the value of their equity. Second, it reduces the cost of renegotiation for the lending institutions, which minimizes the problems in the financial system”.

In table 1 below, the numbers summarize what happens in case of a default, and in the alternative, what happens with a debt-for-equity swap. One can readily see that banks are able to limit their losses by entering a debt-for-equity swap whereas in the case they do not, they escalate losses.

Table 1: Mortgage defaults, residual debt & debt-for-equity swap

Housing boom

Housing bust (-30%)

Purchase price / appraisal value






Liquidation value (50c on 1)



Positive equity borrower


– €100,000

Loss to the bank


Debt-for-equity swap

Restructured mortgage


New positive equity


Loss to the bank


When banks adhere to a common sense rule of mutual risk-sharing, a bank creates credit on the basis of the liquidation value of the collateralized asset it takes in; not on the basis of a theoretical net present value of an income stream. A bank can only lose money if and when the borrower’s positive equity is insufficient to compensate for the loan in full. In case of a default, a home can always be sold off. Then, when due to circumstances this house is sold for less than it was bought for and the positive equity of a borrower proves insufficient, only then a bank must record a loss. And even then, a bank has an incentive to limit its losses by opting for a debt-for-equity swap as a means to protect its profitability, its reputation, and its long term survival. Whenever excessive credit creation becomes part of the equation, prices tend to overshoot and what applies to a boom, applies to a bust as well. Debt-for-equity swaps are essentially shock absorbers that help mitigate losses, in mutual benefit.

One of the key features of credit markets today is that credit creating institutions are shielded from incentives to limit losses they create. If the analysis until here is considered correct, then it holds true that under all monetary regimes, all credit emerges from the balance sheet of borrowers. When the valuation basis of collateral is the liquidation value of a balance sheet asset, then risk-sharing is necessarily mutual. Borrowers risk their positive equity and credit institutions their profit and loss account. The risk they created together in a loan contract is dealt with in reciprocity. As the crisis of 2008 illustrated, during the boom that led to financial excess, instead of being exposed to the incentive to prevent losses, or otherwise, a fall in profitability, banks had legal instruments and regulatory and financial incentives to increase the amount of money they lent even to those who couldn’t afford to borrow the amounts involved, with a booming economy as a result. At the same time, banks were enabled to shift risks onto (unsuspecting) third parties in several ways. For example, when banks started to securitize mortgages, and were able to sell mortgages in specific tranches (for purposes of differentiating in risk/returns for investors). Banks shifted credit risks off their balance sheets. Another example is the legal protection creditors enjoy under Dutch law for example; banks seize mortgagees’ incomes. Another way to supposedly mitigate inherent credit risks is through insurance derivatives. Seemingly, these instruments insure and limit risks, but essentially, they redistribute risks from originators to (not so savvy) investors. Also, as is the case in the Netherlands, mortgages can be guaranteed through a collective insurance scheme. Of course, like other schemes, this scheme is essentially underfunded with a quasi-government guarantee to provide public funds as a backstop.

Generic effects of inflated collateral valuations

Excessive credit creation can only happen when collateral valuations are inflated. Essentially, when collateral assets are appraised, a bank will require borrowers to risk positive equity too. Based on the best available estimates of the liquidation values of collateralized assets, a bank uses borrowers’ positive equity as a buffer against losses. However, when banks are able to shield themselves against excessive credit risks through various means, banks are enabled to profit excessively in the short run while shifting long term losses onto third parties, be they unsuspecting investors or taxpayers. Without a requirement of positive equity, without a requirement for borrowers to gradually retire their loans (and the emergence of interest-only mortgages), but foremost, without a reciprocal loss-bearing agreement between creditors and debtors, financial excesses are systematically baked into society’s financial cake. These protections make banks enjoy all of the upsides so long a boom continues. When markets bust however, or in the period running up to it, there is a historical tendency in banks proving to be creative and resourceful in shifting any downsides onto others. Too big to fail, so they say. Historically, credit expansions have proved notoriously pro-cyclical, even if the liquidation value of collateral limits the amount of credit banks can extend. But when this basis becomes impaired to the extent that effectively, collateral valuations become inflated, the pro-cyclical nature of a credit boom becomes even more self-reinforcing. When it comes to housing markets, especially, the ensuing dynamic not only increases the pool of borrowers, it also allows borrowers to take on more sizable loans. With larger loans, people are enabled to enter into bidding wars against each other so that house prices can increase dramatically. There simply is no technical limit to the amount of credit banks are able to extent. Whereas the collateral basis of the liquidation value of any asset is neutral in that it distributes any losses between the parties creating them, valuations based on income streams lead to excessive credit that under a worst case scenario, gives emergence to credit losses that neither party is able to bear and that can only be absorbed through either bail-ins or bail-outs. The origin of all systemic risks is inherent to all credit arrangements that inflate the valuation of an asset above its liquidation value.

Another insidious problem following from self-reinforcing dynamics of pro-cyclical credit expansions is something Jakab and Kumhoff also point to in their paper23. Indeed, since there are no technical restrictions for banks to create a credit facility instantaneously, and because banks have been able to shift off excessive credit risks, this gives rise to competition between different sorts of collateral. Not all collateral is born equal. A form of collateral discrimination is introduced to markets as a consequence of which the level playing field is tilted favoring certain kinds of collateral over others. For example, during the 2008 crisis small and medium sized enterprise (SMEs) proved to have inferior collateral. Irrespective of jurisdiction, when SMEs fail and their legal entity ends, there is no more income stream to lay claim on. Yet, with businesses there are almost always multiple creditors lining up wanting to seize assets in compensation for their outstanding credit. Among them are suppliers, banks and other creditors, and not unimportantly, a tax authority that usually has a senior claim over other creditors. Besides, business loans are more expensive to securitize, and more difficult to transfer off balance sheets. So when the boom turned to bust, bank lending turned out to be instantaneously discontinuous for SMEs. Small businesses were the first group of borrowers that found themselves shut off from credit facilities. Even if their business was doing sufficiently well, and despite many being formally eligible for funding. Banks, however, had bigger problems elsewhere and turned risk averse, and stopped or squeezed their loan books to SMEs. Even though SMEs are considered essential for a prospering economy as the vast majority of employment is generated by them, their collateral is rendered inferior once the valuation technique for credit shifts from the liquidation value of collateralized assets, to an inflationary one.

A final point concerns the growth in the total amount of loans over time. When we consider statistics of credit aggregates over the past decades, we can see right away that the amount of outstanding credit has grown exponentially. As Jakab and Kumhof also emphasize, there are no technical limits to increasing the stock of loans, but this does not mean banks can create credit without repercussions to their profitability and solvency. This point only holds true so long as banks are subjugated to a mutual risk-sharing principle. The important point here is that the exponential path of credit aggregates, as can be seen from 1971 onwards, can only be explained because there is no theoretical limit to the total amount of credit when future income becomes its basis. This basis is necessarily excessive and it comes with massive hidden costs to society. If not through inflation and outright losses, then society bears losses in terms of opportunity costs. The short term gains are confined to a few institutions and their agents, whereas long term burdens and losses are distributed amongst all.

Collateral requirements for credit-arrangements

The economic or catallactic science is not an exact science. Whatever is tried to find constants, there simply are no mechanistic laws to be found, or valuations that can be fixed. What is argued for here necessitates the law to enforce an impartial application of rules that renders all creditor-debtor relations reciprocal. When debtors are granted a sanctimonious right to always walk away from their positive equity on the basis of which credit was extended to them, only then will the playing field for all creditors be a level one (we will return to this feature in part 3). The question of what valuation technique is exact or robust enough is of a secondary order because there simply are no solutions that can prevent defaults. Defaults tend to occur every now and then. The point is this: if and when housing markets are booming, and a bank extends credit at 80% of the appraised value of a home, with 20% positive equity, there is simply no way to assess whether this is excessive. A housing bust with house prices falling over 30% creates losses. The same applies to examples where borrowers take out a mortgage with more or even less positive equity. Any quantitative requirement in this regard would be arbitrary. For this reason, it is far more effective to expose banks to incentives that hurt their bottom line. By granting all debtors the right to walk away from their positive equity and the collateral co-financed by a creditor, creditors are incentivized to conduct their business with prudence of a self-regulating order. Extending credit over and above the liquidation value of assets that are collateralized, is simply self-defeating, and possibly grounds for criminal prosecution.

Theories of causality & monetary matrix

Especially with fractional and full reserve banking, money and credit are thought of as forming a closed circuit in which deposits form the basis for loans. Hereby, full reserve banking applies a linear causation, mechanistically with a strict if-then application of action (deposits) and equal reaction (loans). Fractional reserve banking applies a formative causality in which the interacting parts enable the credit system as a whole to multiply deposits into loans. Still, this is in terms of an ‘if this, then that’ rule, with the reserve requirement being a constraint that stops banks extending more loans than their reserves allow. Both views draw the conclusion that the total amount of credit cannot exceed what reserves allow based on the deposit reserve ratio. If and when the amount of outstanding credit increases, only external factors can be pointed at as an explanation for the growth in outstanding loans. This can be caused by central bank intervention (i.e. liquidity injections) or changing regulations (i.e. lowering reserve requirements). When the dual theory of causality of systems-thinking is applied to money and credit, then two different forms of causation come into play. On one hand there is the rationale for both banks and borrowers to enter into a loan contract. On the other hand, formative causality applies to the system as a whole. The rate of interest is seen to play an important role in this regard because the supply of funding and the demand for loans communicate through interest rates. As an explanatory factor, a falling or rising interest rate (in relation to the rate of inflation), helps explain the developmental stages through which an economy is moving. Considering the economic literature, at the macro level of analysis, the relationships between the main variables such as the interest rate, inflation and unemployment are analyzed and used to illustrate the observed dynamics that are considered the driving forces behind movements of the economy. Hereby, a certain understanding of the intermediary function of banking institutions is chosen. Accordingly, a view and understanding of the role of central banks and fiscal authorities is added to the narrative too; these are considered external to the credit system. In this regard, authors or different schools of thought (i.e. (neo-)classicals, Keynesians, monetarists, Austrians, the evolutionary approaches) relate these topics differently, even if these schools share the perceived duality in terms of the causality of the system. To explain change, agents who are tasked to oversee the smooth functioning of the system are looked at as exogenous reasons. In contrast, all private parties are considered endogenous factors.

When process-thinking is applied, individual transactions are put at the center of things. Every loan agreement gives birth to a transaction. With the application of the singular causality, a credit facility is understood as a paradox, creating both a creditor and a debtor at the same time: all credit emerges from the balance sheet of a borrower. The loan agreement specifies the conditions and obligations within the context of the legal framework of a jurisdiction. This legal environment prescribes protocols and consequences in case either party is in breach of contract. For the collection of loan agreements, it can be said that the transactions they relate to in real-economic terms, give emergence to patterns in which economic change can be observed. Because each credit facility has its foundation in an object of real-economic value, credit facilities are a driving force in the emergence of economic patterns and asset valuations. Mutual risk-sharing would define the relation between creditors and debtors reciprocal, but once this relationship becomes asymmetrical, borrowers are confronted with a unleveled playing field. Like in oligopolistic markets, consumers of credit facilities are price takers. Or more universal, they are contract takers. People can sign a loan contract or decide not to, but they cannot negotiate the law. When creditors are legally protected and favored over debtors and when creditors are shielded from burdens of credit risks they help to create themselves, then an inflated valuation technique gives rise to financial excess. Inflation follows from the creation and extension of credit facilities and this can only result from inflated collateral valuations. When credit is extended on the basis of liquidation values of assets that credit institutions take in as collateral, then no credit facility can create inflation. Only when positive equity balances of borrowers are insufficient to absorb accidental credit losses do inflationary consequences become inescapable. These consequences of insufficient equity on the side of the borrower can take on several forms: (1) a rise in risk premia and interest rates,; (2) bail-ins; or (3) top-down interventions that go at the expense of the public (i.e. bail-outs and/or laxer monetary policies). The valuation of collateral and the reciprocity with which losses are shared is elementary to the question of the phenomenon of inflation.

When systems-thinking is applied, it suffices to explain money with three functions. As a medium of exchange it allows indirect barter through the intermediation of money. As a unit of account, all monetary aggregates can be quantified so as to distinguish between different money instruments. Within the collection of different money instruments, their moneyness is conceptualized as a question of hierarchy, with base money topping this hierarchy, and risk-bearing money instruments under it24. Financial securities usually can be sold off instantly and transformed into bank credit, and withdrawn as base money. As a medium of saving, money is thereby understood as the funding source for all loans. This way, the banking system is assumed to be a closed system with central banks and governments in their roles of overseers, being responsible for its smooth functioning.

With process-thinking money is approached differently. When money is used as a medium of exchange in any transaction, then money has a simple linear ‘if this, then that‘ relationship because its function is to finalize a trade. It facilitates an exchange of something for something. However, in its function as the unit of account, it does not have such a linear causality. Rather, in its capacity as unit of account, money can be thought of as a single standard with which an infinite number of private balance sheets can be measured. As a unit of account, money helps to quantify all private balance sheets. To illustrate the non-linear nature, when the FIFA World Cup starts, the generic application of broadcasting allows a particular match to be watched by any amount of people. If it had been a match in a national competition it might have been viewed by millions perhaps, but with the World Cup, matches are seen by over a billion people. With the functional application of a money of account, something similar happens. In its capacity as unit of account, a monetary unit denominates all balance sheets within (at least) its jurisdiction. As a unit of account, money doesn’t only measure our positive balances in deposit accounts or quantify our financial obligations (i.e. debt). Thinking of deposits as the source of loanable funds obfuscates this understanding. As a unit of account, money is better understood to have a nonlinear causality. Money denominates and quantifies all balance sheets without a theoretical restriction to the number of balance sheets, or the total amount of wealth.

The liquidity preference of people to hold cash at their disposal – in their wallets – is the only manner in which money can be hoarded, or saved. Most liquid funds however are held in the form of credit to banks in deposit accounts. Banking institutions of course, refer to their services of deposit accounts as a means for people to ‘save’ money, but technically this is untrue. The title of ownership is amended to the extent possession is transferred. The fact that the legal right to use it is transferred, tells us this money is invested. The difference between money being a means of direct transfer and a means of indirect transfer is a nuanced one. So long as all credit is created on the basis of the liquidation value of balance sheet items, all credit facilities find their origins in a possession that has a real-economic valuation that can potentially compensate for losses automatically. Inflation emerges as a result of granting credit that is based on inflated collateral valuations. Once a credit facility is based on a valuation that lies higher than the liquidation value of the collateralized asset, inflation is an automatic consequence. If and when the mechanism of mutual risk-sharing between debtor and creditor becomes impaired, there is nothing that shields any third party from the ensuing inflationary effects.

Inflation caused by means of excess credit creation is however but one source of inflation. To account for other sources of monetary inflation, we now turn to part 3.

Part 3 – A Trias Pecuniae

In part 2, one conclusion was drawn: when credit is created based on the positive equity of a borrower and is constrained by the liquidation value of what is taken in as collateral, all credit facilities necessarily are non-inflationary. Once collateral valuations become inflated, credit institutions have an interest in shifting any (and all) negative externalities onto third parties. This way, banks can profit from financial excess in the short run at the expense of future losses to unsuspecting third parties. In part 3, the focus of this analysis shifts to the merit of the two money theories that frame money as either credit or gold, as either public or private. History informs us that the margins of error provided by the rigidities of a classical gold standard as grounded in the commodity theory of money, and the flexibilities of a fiat standard as grounded in the credit theory of money, prove insufficiently robust to prevent episodes of financial excess and inflation. And consequently, structural inflation can be considered to cause growing disparities in wealth. To come to an understanding of why this is so, the money question can best be framed from a different perspective. The commodity theory would argue money is essentially private and therefor markets – if allowed – would choose a commodity like gold. The credit theory on the other hand argues money is essentially public and therefor, it is the nation-state that ensures its purchasing power. In this context, the choice seems to be about gold or fiat, private or public. But how can money as a social contract be ensured to be a strictly impartial contract instead?

A tripartite division of wealth powers

It was Montesquieu’s exposition of a trias politica in the eighteenth century that inspired now-democratic societies all over the world to adhere to principles of checks and balances, meaning that a society is able to separate and limit the executive power, the legislative power and the judicial power in order to maintain a sufficiently robust democratic order. If one thinks of all wealth and the financial equation that underlies each society in these terms, then one could say all wealth is influenced by three similar powers. One could speak of a trias pecuniae with a tripartite division of powers consisting of the fiscal power, the credit power, and the monetary power. The fiscal power is found within the administration of governments, specifically with the Treasury. As part of the executive power, the fiscal power is mandated to collect taxes so that government is able to finance public services. The credit power is represented by all institutions that manage third parties’ moneys, in particular those institutions that are licensed to create and extend credit. In their representative capacity of all private wealth, they can be seen as the equivalent of the legislative power. They act in mutually beneficial, financial interests of all private citizens in a fiduciary, representative manner. The monetary power is identified with central banks that are tasked to issue money and oversee and manage matters of liquidity vis-à-vis financial markets, and in particular, credit institutions. A central bank can best be seen as the equivalent of the judicial power in that their decision-making is independent from government. Their decisions are grounded on the legal foundations that give them a mandated authority to manage all money and credit in circulation, and which delegates the task to rule over matters of liquidity, and delegate matters of insolvency – if and when they deem it warranted – to bankruptcy courts. Each of these institutional authorities has a mandate, which grants it an instrument by means of which it is able to transfer money. The Treasury levies and collects taxes, credit institutions loan credit into existence and a central bank issues money. As concluded in part 2, so long as credit creation by credit institutions does not exceed the liquidation value of assets taken in as collateral, credit institutions cannot transfer money by indirect means. Put differently, they cannot exploit the private version of seigniorage25 and profit from excessive credit creation. Similarly, the question of whether money is used in its capacity as a direct or indirect means of transfer relates to the fiscal and monetary powers too. From a causality perspective, the question of inflation seems always to have been framed in terms of it having a linear or formative causality. But what if the causality of process-thinking is applied here too: isn’t inflation a non-linear phenomenon, paradoxically enclosed in each and every single created credit facility? Is this not where the abuse of money by means of indirect transfer is found?

The fiscal power

In respect to governments and their administrative control over fiscal affairs, money is used as a means of direct transfer if and when taxes are used to balance the budget. Once a government runs a budget deficit because it spends more than it takes in through revenues (i.e. the sum total of all taxes, levies, license fees, possibly through the sales of natural resources, rents from land, real estate and other public infrastructures, etc. etc.) then things can get tricky. Not necessarily, however. A budget deficit does not automatically lead to inflation, although this is rather the rule than the exception. Government debts prove a rather constant feature in the history of financial excess and play a central role in the extreme cases of all known episodes of hyperinflation26. If history is a lesson for today, the necessary nuance is the following: when governments start issuing bonds to finance their deficits there is no immediate risk of inflation so long as public bonds are collateralized by assets that can readily be liquidated. Government administrations are naturally inclined to promise the world to electorates and creditors alike, and can decide to roll over accumulated budget deficits by bending the rules in favor of their eagerness to spend their way to popularity. For example, governments nowadays treat their debt as unquestionably pristine, and therefore political consensus has led financial regulations to define government bonds as risk-free assets. This favors public bonds over other credit securities to be held for liquidity purposes, because in repurchasing agreements, sovereign bonds can be substituted for liquidity reserves without a discount, whereas other instruments do imply such a risk. Effectively, government can borrow more cheaply.

Money, in terms of its purchasing power can only be indirectly transferred from private citizens by their government when a fiscal power starts collateralizing future tax revenues. The way to differentiate between money being used as a direct means of transfer and funds only indirectly serving such a purpose, is by determining the collateral basis of government bonds. Once tax revenues are insufficient to balance a public budget (regardless of any hierarchy in government level), and a representative government finds itself in a position to auction a bond, then the question must be answered as to the collateral basis on which this public bond is issued. So long as a bond finances an investment of public interest and results in an asset that can readily be liquidated, and from which the electorate can choose to walk away, there is no reason why inflation should necessarily result.

To illustrate this, I will provide an example. The beautiful town of Valkenburg where I grew up as a child is nowadays part of the town of Katwijk. Katwijk is located on the Dutch North Sea coast, in the province of South-Holland. Because the Dutch shoreline needed reinforcements in an integrated fashion to protect the whole of Holland against rising sea-levels and seasonal storm fronts, it was decided by the Department of Infrastructure to build a concrete dike at the spot where the line of natural dunes that has protected Holland’s coast since time immemorial was thinnest, that is to say, at Katwijk. After this dike was constructed, the dunes would return by covering the concrete in sand. When the local council and representatives in Katwijk discussed the opportunity of building a parking garage alongside this new concrete dike, the majority vote was in favor of making the investment. From what I gather, Katwijk had funds in reserve, but had Katwijk not had sufficient funds, and needed to finance this project by auctioning a municipal bond, then its example might have been used to illustrate the nuanced difference between money being used as a direct and indirect means of transfer: the investment resulted in a modern, much needed and appreciated parking garage right at the coast and is an object of real estate with a permanent income stream. The point about public bonds is simple: so long as a bond is created on the basis of the liquidation value of a (new) collateral asset, the issuance of such a bond is non-inflationary. When future tax proceeds are the collateral basis, the issuance of said bond is necessarily inflationary. Its inflationary extent is unclear, with undetermined quantitative effects, as it depends on how great a shortfall there is on the invested funds, and on how great an amount of tax revenue will be needed to compensate for this shortfall as a consequence. If an income stream from any investment becomes lower than what is needed to service and retire an outstanding loan, then the credit financed investment causes inflation automatically. An insufficiently large income stream can only be compensated for through seizing a portion of available tax revenues that would otherwise have been used to pay for public services. In case of a shortfall, they can’t be. This is exactly where inflation emerges. When investments are not scrutinized on the basis of their financial prospects, default included, and large-scale public investments are initiated with the understanding that losses are of no consequence because of public backstops, then how can excesses be ruled out? All efforts to mitigate adverse effects are reduced to forms of symptom treating, leaving the root causes untouched.

Slowly and gradually, a permanent deficit becomes an inescapable, self-perpetuating feature of public and bureaucratic life. The key element to understand is that there is no theoretical limit to the amount of credit that can be created once future income is used as its collateral basis. When taxes are not used to cover a budget, but are simultaneously used as collateral to increase public spending, then a society is put on a road for which the necessary economic growth rate defies what is possible in a world of finite resources. The exponential function is simple: whatever grows continuously, grows exponentially. It always is only a matter of time. Whatever is growing exponentially always collapses under the weight of its own growth. Once tax revenues (and other public sources of income) are not solely used to balance public budgets, and instead, are also used as collateral for the issuance of, and for the rolling over of, public debts, there is nothing that can prevent a government from bankrupting itself and likewise, the whole of the society it is supposed to serve.

If, and so long as, there is no mandatory rule that serves as a check to maintain balanced public budgets, the freedom of wealth of all private citizens is impaired. Citizens are rendered defenseless against political opportunism of whatever nature. Irrespective of how political opportunism advertises itself ideologically, it is a common theme for all repressive orders. The ultimate budget right lies not with Kings, Presidents, or parliaments and senates, or any local council. The ultimate budget right lies with the people. Electorates can only remain in control so long as the budget right resides with them. The only way to do this, is to remove future income from the collateral basis of public bonds. Still, public authorities are able to issue bonds, however only on basis of (new) assets as collateral. This nuance is an acquired taste or understanding and so it must be legally acknowledged, for inflation caused by fiscal profligacy can be tackled without impairing the public’s ability to invest in projects of a common public interest. All it requires is a legal ban on future income as a collateral basis on which credit, public bonds included, can be extended.

The monetary power

For all money that is issued by a central bank, there is one essential accounting truth: all money emerges as a result of creating extra money that lengthens the liability side of a central bank’s balance sheet. In regard to money issuance by central banks, the key question concerns the asset side of the balance sheet from which money derives its value. Here too, the central issue is the collateral basis for the issuance of money. When a central bank issues base money, then it is a necessary accounting principle that it needs to lengthen its asset side too. In short, for all sorts of theoretical and practical reasons, this cannot be anything other than gold that central banks own outright. It is of the utmost importance to note here that money can still be issued in an unconstrained fashion by a central bank, and that when a central bank uses its gold reserve as its collateral base (no matter how much gold a central bank needs for this; it can be 1 kilo), then it is not required to fix the gold price. On the contrary, when the gold price floats, the gold price effectively increases when the money stock is expanded, regardless of the quantity that is hold in reserve27. For example, when a central bank doesn’t buy gold with the newly created money (based on its floating parity) but buys loan portfolios from banks as a means to satisfy liquidity needs instead, then this way, a central bank is flexible in its open market operations vis-a-vis financial institutions because a floating gold price allows both gold market participants and foreign exchange markets to evaluate all market conditions. Another important point here is about the relationship between central banks and all private parties. A central bank and private citizens have a social contract with each other. In terms of purchasing power, this contract is made impartial and reciprocal only if the gold price floats. Said differently, a floating gold price takes away the privilege of seigniorage from a central bank. This is of utmost importance because a central bank externalizes the proceeds from monetary expansion. A central bank can increase its money issuance for various reasons, to satisfy seasonal changes in cash preferences, to stop a banking panic and a run on solvent credit institution for example, but when a central bank intervenes for these purposes, all private parties are able to hedge their balance sheets, and/or currency exposures by means of owning gold. When it comes to a citizen’s pension this is especially important because gold is the one asset that absorbs all inflation. Citizens can choose for themselves whether to own gold that surely yields nothing at all, perhaps costing them an annual premium for gathering dust in a vault of a commercial third party. Some say it is a matter of conviction, others point to thousands years of monetary history. Irrespective of one’s own investment preferences, the point is the people can protect their wealth this way. It is their own choice to do so, or not. So long as a central bank issues money in a direct pricing arrangement with gold as its collateral basis, a central bank can no longer indirectly transfer wealth with impunity28 29.

Money issuance is a central bank liability that, in theory – and unfortunately in practice too – can derive its value from other financial liabilities held in collateral, such as government bonds. Outright ownership of gold comes without any liability attached to it. To be independent from all government interference, a central bank defines the money it issues as an impartial contract when it accounts all its issuance of money against one asset that is nobody’s liability. Here too, when future income is legally excluded from the collateral basis on which money can be created, then money cannot be used as an indirect means of transfer. A central bank’s balance sheet with government bonds as the collateral basis on which it issues money, turns the currency into a contract between a central bank and its government. In contrast to a classical gold standard, the basic idea is to let a central bank share the externalities of its monetary operations continuously. If a central bank issues a new stock of money without acquiring gold, this new issuance of money would result (ceteris paribus) in a rising gold price as a benefit to all (or, in the opposite case, a burden to those owning gold, as the gold price can fall, too when cash balances decrease). There are several points to make. Firstly, no asset is worth its price whenever it is bought for reasons of speculation. Caveat emptor applies (“buyer beware”). When gold is owned for reasons of self-conservation, the ultimate freedom is that no matter which unrelated third party defaults on the fiduciary obligations attached to a financial contract, anyone is able to shield oneself for from losses caused by the misdoings of others. Another point is this: under a classical gold standard, the gold price was fixed and formally, the Treasury was the mandated authority to approve a devaluation or a revaluation. The gold price was a political decree, not a free market price. When money is fixed as a weight of gold, then all gold owners are rendered price-takers. Essentially, it is a way to implement capital controls. It increases the exploitative privilege of seigniorage with legal impunity. A classical gold standard would reintroduce the very problem it tries to solve. A final point to make is that a floating gold price provides a reference rate for all foreign currencies. If, and when gold is used as a floating reference rate in terms of being a benchmark for all exchange rates, the international flows of goods and services are cleared through the dynamics of floating exchange rates and a floating gold price. The international settlement of trade imbalances does not necessarily require central banks to hold large gold reserves; rather, it requires them to account for imbalances by quoting the floating free market price of allocated gold. When the gold price is used as a collateral basis for all base money in a floating fashion, then gold is set free in its functional capacity as the common denominator of all wealth. In its practical application, this way, it can be utilized as a means of final settlement by which international imbalances can be cleared: if not in quantity then by its price. Gold, in its price fluctuations, simply absorbs all imbalances that continuously emerge in patterns of international flows of people, capital, goods and services, as well as migrating people with their belongings. As free market prices tend to be, the gold price would be responsive, and wouldn’t put anyone at an unfair disadvantage, indiscriminate for all.

The credit power

As discussed in part 2, the collateral basis on which credit is created is the key variable that determines whether credit creation is non-inflationary or necessarily inflationary: whether money is being used as a means of direct or indirect transfer. In summary, the fundamental problem of inflating collateral valuations for any credit facility is that its theoretical valuation lies much higher than the practical means by which any income stream is generated. Thus, the capital goods that produce an income stream, such as land, machines and buildings can only be liquidated below the outstanding nominal loan. To mention the remaining factor cost of production – labor – there is another important reason to remove future income as collateral basis for credit. The fruits of one’s labor are the most valuable possessions of all30. Once the valuation basis of credit includes the proceeds from future income, financial excess is created in disregard of considerations of sustainability. It goes to expense of all unrelated third parties. In the most extreme end of the spectrum of inflated collateral valuations, without discounting for failure (or a lower income than expectations implied), an income stream is arithmetically calculated as an asset with a net present value that always lies much higher than the liquidation value of the assets generating that income stream. In case of failure, when the proceeds from liquidating the collateralized assets do not compensate for the nominal loan, a residual loss emerges. These losses are part of any business. The associated costs are always a part of the equation. With banks, this always will be priced in higher risk premiums for borrowers, or as a loss in return on investments of shareholders. A default can always happen for any reason but once credit is created above the valuation of real-economic assets that can compensate for losses, a loss to society is already real. Essentially, with its creation, the integrity of money as a social and impartial contract is impaired, either through the emergence of the real-economic consequences of inflation, or alternatively in the form of an expensive loss to society in terms of lost opportunity costs and a gross misallocation of private resources. Whether a debt is serviced without disturbances or gets in disarray, the excessive basis of credit creation immediately leads to a boom and inflation will manifest itself. If not in consumer prices, then in asset valuations. This process may transpire over years, and even decades. A continuous expansion reinforces the pro-cyclical nature because not only asset prices inflate, all spending becomes based on excess, boosting businesses, borrowers and governments. Societies can easily be seduced by the short term gains, but it always comes at the price of long term instability, structural imbalances and socialized losses. If one were to investigate who benefits during booms, and who suffers in busts, one would not be surprised to learn that as an upshot, disparities in wealth generally increase. The rich become richer and the poor more impoverished. The generic growth rate necessary to service ever larger, exponentially growing debts, gives rise to systemic risks that essentially can only be borne by the people31. This can only happen in a financial context of privileged interests and a political vacuum that would rather double down on deceit and a status quo than admit being part of the cause of a tragedy that is slowly unfolding.

Besides reasons of a social-political order there is another important reason to have credit institutions adhering to a strict application of mutual risk-sharing. This argument is of an economic nature. Credit institutions are able to create and extend credit by taking in collateral with a known value in real-economic terms at technically zero costs. Of course, there are expenses, but a credit facility in itself can be created at zero cost. When credit is extended by banks on the basis of an excessive valuation, then — it follows logically — the level playing field for lending and borrowing is no more. Pension funds, insurers, brokerage firms, basically all businesses that manage other people’s moneys are put at a disadvantage in comparison to banks. They too manage funds of positive equity. As soon as banks are able to extend credit based on excessive collateral valuations, asset prices become distorted as an automatic consequence. More importantly, banks’ ability to create credit out of nothing, on top off the liquidation values of collateralized assets, decreases the credit power of all other liquid funds. Available private funds, formed by the slow and gradual accumulation of positive equity, must compete with credit that can be created instantaneously, and technically, at no cost. If, and when, collateral valuations become inflated, then it follows that these credit excesses undermine all private wealth. Another detrimental consequence is that because human resources and talents are competed for, and because this competition tends to be conducted on the basis of financial compensation, the best and brightest will always gravitate to the institutions that carry off the spoils that come with financial excess. On top of a widening discrepancy in wages and a more unequal distribution of wealth, this too comes at the expense of everyone in society.

One last point concerning collateral in credit arrangements remains to be made. The most important cause of private indebtedness is the fact that the law protects and favors creditors over debtors. For example, a late payment may be considered a breach of contract, giving a creditor a right to exercise a contractual stipulation to increase the interest rate it charges, unilaterally. The history of usury is a very ugly one. All legal regulations that result in an escalation in the amount of credit due, can be dismissed all together by simply granting all debtors the right to walk away from a contract of credit, at all times. The only requirement is to transfer ownership over the property taken in as collateral, as well as the positive equity a borrower risked. An impartial application of this collateral requirement in credit facilities should suffice as a means to prevent excessive credit risks. In case they do emerge, and banks become insolvent, depositors should understand they did not “save” money with the bank, they invested and risked it. It is only natural for people who deposited money with banks to seek legal protection against delinquencies caused in bad faith. It is exactly for this reason, too, that a legal requirement to restrict the collateral basis, such that it can to only include an object that can readily be liquidated, should be implemented. This should provide sufficient protection to deter forms of all bad faith actions indiscriminately. Ultimately, a collateral requirement would serve as a robust backstop to prevent excesses. As a first-line of defense in law, it surely breeds best practice. The incentive for any creditor to bear the consequences of their own imprudence and risk-taking must be maintained because in the alternative, it entails requiring society to regulate the extent by which loan-sharking is legally permissible. After all, the right to pick the fruits of one’s labor is the most valuable possessions of all. When someone’s income can be seized by creditors, elements of slavery are materially introduced in law. However, by implementing a collateral requirement of mutual risk-sharing, all credit facilities become essentially self-liquidating. There are no quantitative methods to manage houses of credit that can accomplish what one simple qualitative check is able to ensure. Instead of a top-down management by use of quantitative instruments, a bottom-up approach would be far more effective and efficient.

Checks and balances: a simple matter of reciprocity

For a functional separation of wealth powers there is only one, and one very essential thing to get right: remove future income from the legal equation on the basis of which credit can be extended and created. It is the sole element that can account for causing all monetary induced inflation. Be it through government, a central bank, or banking institutions. Or, through all of them simultaneously. By eliminating future income from the financial equation that underlies the foundations of society, a tripartite division of wealth powers can be balanced to ensure societies are robustly protected against the forces that aspire for short-term, immediate gains yet that always end up hurting everyone in the long term. Collateralizing future tax proceeds as collateral basis for the issuance of public bonds by the fiscal power should be banned, and likewise the creation of credit facilities by institutions with credit power, and the creation of a new stock of money by the monetary power, because using future income as collateral is necessarily inflationary.

If future income is eliminated as a legal collateral for loans, firstly, the Treasury (and the executive power that controls it) is effectively subjugated to a mandatory balanced budget. Taxation is fine so long as the budget right resides with the electorate. A constitutional ban on the issuance of government bonds may seem like an ultimate backstop for political opportunism of whatever nature, but society is best served when public authorities are able to invest in public goods such as infrastructure, so long as future tax revenues are not collateralized. Secondly, a central bank can only externalize economic effects from its monetary policy operations by letting a currency zone’s monetary basis float. As gold is nobody’s liability, it has historically served as an internal and external reference rate that allows any imbalance to be dealt with: either voluntarily, by settling international balance of payments imbalances in a quantity of gold, or in the alternative, by accounting for a shortfall in real capital exports in terms of a higher price for gold (because accumulated foreign exchange reserves can always be used to buy gold outright, instead). Thirdly, by limiting the legal eligibility of assets to serve as collateral to just those that can readily be liquidated in case of default, credit institutions are stripped of the privilege of profiting from exploiting debtors while shifting credit risks onto others. If and when credit creation is limited by the liquidation value of assets, all private wealth under management competes to finance investments on a level playing field.

A democratic order is best served when the balance of power is maintained and power is prevented from being concentrated in the hands of the executive power, which has a natural tendency to change laws in its own favor, going as far as to subsume completely both the monetary and the credit power. Once society is put on a road of continuous monetary expansion and economic growth, advertised from whatever ideological angle, then all that is accomplished, is a privileged class that keeps spending future incomes as if there is no tomorrow. That is, until inevitable consequences materialize. By defining money as a reciprocal contract between private citizens and each of these wealth powers however, a society is effectively protecting its best values, maintaining its democratic order by strengthening its resilience to all undemocratic forces. Could a democracy not have a higher objective than granting its citizens an unalienable right to live a life in freedom of wealth? Are not all people born equal as a people of positive equity?


As a graduate student of international economics and economic geography, I would like to make a final point. In Geography students are taught to always keep their eyes on the horizon. In reflection on the two theories of causality, the description of human nature as rational has traditionally yielded fierce debates: what exactly is rational? Ultimately, it is arbitrary. From a more agnostic point of view, one could ask: But, is not human behavior not almost always self-referential? To put it more academically, why not describe humans as satisficing agents? In more modern parlance, one could increase the contrast – admittedly, with joyful cynicism – by taking rational human beings on one side and cheating primates on the other. Even if humanity aspires to ideals of equal justice and common good, and rightfully so, there is no point in denying, the lowest common denominator of humanity’s moral character is a perpetual reason for societies to always remain wary of those who are figuring out ways to game the system and to benefit at the expense of others. In the same parlance, the objective of formulating checks and balances for a trias pecuniae is to make insightful for what elementary reasons societies – anywhere, at any point in time – are able to prevent the system gaming the people. Those who seek power and privileges, deserve none. For society to break down all power relations, it simply is most effective to define all relations as reciprocal. A functioning trias pecuniae would do just that.


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1 See: Schipper, J.C.A. (2009), “Capitalism, Free Markets and Patents: Grounds For A Major Policy Revision”. Permalink:

2 See: Ingham, G. (2004), “The nature of money”, for an excellent and critical literary overview of the credit and commodity theories of money from the perspective of Sociology.

3 As found on

4 Whately, R. (1831), “Introductory Lecture on Political Economy”. This quote can be found in Lecture 1, page 6; (or online, page 28 of this retrieved pdf copy):

5 Stacey, Ralph (2003), “Strategic management and organisational dynamics: the challenge of complexity”. Fourth Edition, Pearson Education Limited, Glasgow.

6 One could say economists nowadays conform themselves to write the same conclusion. All studies (1) prove this or that school of thought right; (2) policy-makers are able to draw the following lessons; and (3) more research is needed to further our understanding. The commonality of this cultivated three-pronged conclusion is that it suits one’s own carreer: (1) peers are created; (2) financers are rewarded with policy advices, and (3) a next study needs approval.

7 Teleology is the term used in Philosophy for the study of the finality of things.

8 Crypto-tokens for example. They exist in a digital realm but can never be held as physical cash in one’s wallet to settle an exchange with. That crypto-tokens can never become tangible is an essential fact for it requires electricity and several electric appliances before it can be used in exchange. In absence of being tangible, it will be priced accordingly.

9 Graeber, David (2011), “Debt, the first 5,000 years”. Melville House Publishing, New York.

10 Throughout his insightful work, professor Antal Fekete eloquantly phrases the question on the supply of money in terms of its relative abundance.

11 Only a few mouse clicks away, one can always find the total notional amount of money in circulation on the weekly financial statement of a central bank.

12 See: Humphrey, T. M. (1987), “The Theory of Multiple Expansion of Deposits: What It Is and Whence It Came”, in: Economic Quarterly (Federal Reserve Bank of Richmond), March-April 1987, Vol. 73. Excellent overview.

13 See: Huerta de Soto, J. (1998), “Money, Bank Credit, and Economic Cycles”, for an expose of full reserve banking from the perspective of the commodity theory of money. This body of thought is also known as the Salamanca school of banking and part of the Austrian School of thought.

14 Jakab, Z. & M. Kumhoff, (2015), “Banks are not intermediaries of loanable funds — and why this matters”. Bank of England, Working Paper No. 529. Permalink:

15 Werner, Richard (2016), “A lost century in economics: Three theories of banking and the conclusive evidence”, in: International Review of Financial Analysis, Volume 46, July 2016, Pages 361-379.

16 Werner, Richard (2014), “Can banks individually create money out of nothing? — The theories and the empirical evidence”, in: International Review of Financial Analysis 36 (2014), pages 1–19.

17 See: Murau, S., (2018). “Offshore Dollar Creation and the Emergence of the post-2008 International, Monetary System”, IASS Discussion Paper, DOI: 10.2312/iass.2018.009, June 2018. Permalink:

Murau’s other discussion paper, co-authored, is also well worth mentioning: Murau, S., Rini, J. & A. Haas, (2018). “The Future of Offshore Dollar Creation: Four Scenarios for the International Monetary System by 2040”, IASS Discussion Paper, DOI: 10.2312/iass.2018.008, June 2018. Permalink:

18 Innes, M. A. (1914), “The Credit Theory of Money”, in: The Banking Law Journal, Vol. 31 (1914), Dec./Jan., Pages 151-168. See also: Mitchell-Innes, A. (1913), “What is money?”, in: The Banking Law Journal, May 1913.

19 Penikas, H. I. (2015), “History of banking regulation as developed by the Basel Committee on banking supervision in 1974 – 2014 (brief overview)”. In: Financial Stability Journal. 2015. Vol. 28. No. 5. P. 9-47. Penikas indexed 453 documents for five different bank regulation regimes from 1974 to 2014, totalling 16,230 pages of Basel related banking regulations.

20 In the Netherlands, mortgagees can apply for a collective insurance scheme (so-called nationale hypotheekgarantie, or NHG) when they buy a home through a mortgage. This is a fee-based insurance scheme, capped at a certain price level for houses, and which comes at a fee and at a few basispoints in interest payments a month for borrowers. However, the discount banks give borrowers, compensates for this transfer in risks. Ultimately however, this insurance scheme is effectively backstopped by taxpayers since the controlling institution Waarborgfonds Eigen Woning (WEW) is quasi-government guaranteed, yet WEW only holds 0.5% of total outstanding mortgages it insured in reserves. When house prices collapsed in the aftermath of the 2008 credit crisis of 2008, WEW became underfunded and it was only thanks to government intervention and re-inflated house prices preventing this scheme to go bust. It has survived for the time being. But, its reserves are still no more than 0.5% of what is insured. The Dutch “borrow from the future” to serve “today’s needs”. Our government’s has made it the only financial paradigm.

21 Most legal frameworks, albeit in different legal traditions, make an elementary and legal distinction between possession and ownership. For an elaborate overview on European legal traditions, see for example: Zwalve, W.J. & E. Koops (eds) (2006), “The past and future of money”. Boom Juridische uitgevers (2008), Den Haag.

22 See: Zingales, L. (2008), “Plan B”. Permalink:

23 Jakab, Z. & M. Kumhoff, “Banks are not intermediaries of loanable funds — and why this matters”, (2015). Bank of England, Working Paper No. 529:

24 See John Exter’s inverse pyramid.

25 From Wikipedia: “Seigniorage /ˈseɪnjərɪdʒ/, also spelled seignorage or seigneurage (from Old French seigneuriage “right of the lord (seigneur) to mint money”), is the difference between the value of money and the cost to produce and distribute it.”

26 See for example Bernholz (2015), “Monetary Regimes and Inflation. History, Econonomic and Political Relationships”; and, Reinhart & Rogoff (2009), “This time is different. Eight hundred years of financial folly”.

27 One caveat here: to what extent the gold price responds is in reflection of both bullish and bearish considerations. Improved business conditions and production levels may warrant monetary expansions, and tolerate an appreciating ‘parity’. In contrast, if expansions are considered monetization schemes, a depreciation is only logical. For purposes of brevity it is best to leave questions of purchasing power dynamics, monetary aggregates and price fluctuations in the gold price, for a later paper to address. For here, the point is simply that the gold price must float.

28 Though there is no academic literature to refer to for the ideas from the freegold perspective, there is a rich and extensive body of thought circulating on the Internet that promotes this perspective. See: FOFOA (Friend of a Friend of Another). At Fofoa’s blog, one can also find the source materials written by Another and FOA (1997-2001), with whom the idea of “freegold” originated. With all the benefit of hindsight, I wish I had learned about this at university.

29 See also: “International Charlemagne Prize of Aachen for 2002 – the Acceptance speech by Dr. Willem F. Duisenberg, President of the European Central Bank, Aachen, 9 May 2002”. Online permalink:

30 Arithmetically, the net present value of one’s future income lies much higher than mostly is thought. Compare this principle with stock prices. Cyclically, stocks are traded during booms at a premium in a multitude of price/earnings because of more favorable earning prospects. During busts, this premium vanishes.

31 Public risks are a misnomer: they are always and everywhere privately borne.

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