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The Money Problem

Rethinking Financial Regulation

The University of Chicago Press

Taking the Money Market Seriously

Pure money ... is nothing else but the most perfect type of security. Bills of short maturity form the next grade, being not quite perfect money, but still very close substitutes for it. ... The rate of interest on these securities is a measure of their imperfection — of their imperfect "moneyness." — John Hicks, 1946

Are the instruments of the money market — the short-term debt instruments we have been calling cash equivalents — really money? The question seems to invite a semantic debate. It obviously depends on how one defines "money." Still, semantic debates can sometimes be useful; they can help to sharpen concepts. This is one of those cases.

Start with the textbook definition of money. That definition can be rehearsed by any student of introductory economics. Money is conventionally defined as the set of assets that can be readily used in transactions. In this regard the medium of exchange function of money is commonly said to be paramount. But cash equivalent instruments, unlike checkable bank deposits, generally do not function as a medium of exchange. Rather, they must be converted into the medium of exchange — by selling them or waiting for them to mature — before they can be used in transactions. In this respect, cash equivalents resemble other (nonmonetary) financial assets like stocks and longer-term bonds.

So, under the textbook definition, cash equivalents are not money. And some experts — perhaps many — favor sticking to this usage. Consider the following observations from a prominent macroeconomist regarding the Federal Reserve's (now discontinued) M3 monetary aggregate, which consisted of several important classes of cash equivalents: "Economists define 'money' as an asset that is used to pay for transactions. ... I have to confess that in a quarter century of teaching and research, I never had any occasion to make use of M3. It always seemed to me that this unambiguously failed the definition of an asset that is used to pay for transactions. If you're going to include such assets in your concept of 'money,' why stop there?"

Along the same lines, another well-known monetary economist recently had this to say about "money market": "I know that finance people and business people frequently use the words 'money market' to mean the market for short term bonds/loans. But when you are talking about models of monetary exchange, it is a really bad idea to use the words 'money market' in that way. What you really mean is 'bond market.'" This same economist has also said that "money market" is "just a weird slang name for the market in short-term bonds." And two other influential economists recently opined that referring to short-term debt as money is "an abuse of the word 'money.'" To all these experts we are dealing with a binary categorization. An instrument either is used in transactions or is not; it is either money or something else, such as a bond.

Other monetary theorists, however, have defined money rather differently. Milton Friedman and Anna Schwartz devoted part 1 of their 1970 book, Monetary Statistics of the United States, to the "Definition of Money." They remark that it is "tempting ... to try to separate 'money' from other assets on the basis of a priori considerations alone." They go on to note that "perhaps the most common" version of the a priori approach "takes as the 'essential' function of money its use as a 'medium of exchange.'" But Friedman and Schwartz decline to tie their definition of money to this function: "We see no compelling reason to regard the literal medium-of-exchange function as the 'essential' function of the items we wish to call 'money.'" They conclude instead that "the definition of money is an issue to be decided, not on grounds of principle as in the a priori approach, but on grounds of usefulness in organizing our knowledge of economic relationships." Friedman and Schwartz see varying degrees of what they call "moneyness" in different assets.

They are not alone. It has long been common, both within economics and in the broader financial and commercial world, to use "money" in reference to assets that are not a medium of exchange. Invariably such assets have consisted of various kinds of short-term debt. They are commonly seen as occupying a kind of intermediate status between cash and bonds. Hence economists sometimes call them "near money," a term that is roughly synonymous with cash equivalent or money market. Moreover, as we will see shortly, many nondeposit short-term debt instruments are commonly classified "as if" they were cash (and differently from stocks and longer-term bonds) in a variety of legal, accounting, and financial market contexts.

This broader usage stands in tension with the binary, textbook definition of money we saw above. The textbook definition does not admit of gradations; it does not envisage a spectrum of moneyness. Is this just a matter of loose terminology, or is something more at stake? This chapter suggests that this terminological ambiguity points toward something that is economically significant. For there is something special about cash equivalents; they have a property that distinguishes them from longer-term bonds and other financial instruments. This property can be usefully described as moneyness — but the challenge is to specify precisely what this means in functional terms.

So what does it mean to say that cash equivalents are "money," or that they are "moneylike," or that they have "moneyness," even though they are not a medium of exchange? A common answer is that these instruments are very liquid: they can be traded quickly and cheaply for the medium of exchange. But this can't be the whole story. All sorts of financial assets apart from cash equivalents are extremely liquid. Ten-year Treasury securities, many large-cap stocks, and interests in equity mutual funds all exhibit high liquidity. They can be exchanged for cash at a moment's notice and at negligible cost. Yet unlike cash equivalents, these other liquid instruments are not classified with cash in any of the myriad contexts alluded to above. So liquidity alone doesn't seem to be the answer.

Another common answer is that cash equivalents are safe. Now, this gets us into the right zone — or so this chapter will argue — but it is important to specify just what is meant by safe. This is not entirely obvious. After all, high-quality long-term bonds are often said to be "safe" assets, but they are not generally thought to be cash substitutes. At the same time, cash itself isn't necessarily "safe" over any given period; it may fall in value relative to other things.

This chapter offers a specific, functional explanation. It starts with the observation that economic agents generally find it desirable to hold an inventory of liquid assets to facilitate near-term transactions, which we will call a "transaction reserve." (Milton Friedman called it a "temporary abode of purchasing power.") And this chapter argues that, in a monetary economy where prices tend to be "sticky" in the short run, agents will generally want their transaction reserves to have a very stable value in relation to cash. Cash equivalents have this special property: unlike, say, longer-term Treasuries, they have practically no nominal price risk. For this reason they make particularly good transaction reserve assets. This leads to a seemingly paradoxical conclusion: the expectation of potential near-term transactions is one source of demand for cash equivalents, even though cash equivalents are not a medium of exchange.

I believe there is novelty in this argument, but the more important contribution of this chapter is something else. I aim to bring together various fragmentary pieces of theory and institutional practice into a coherent and integrated account of the role of short-term debt in the financial system. There is a remarkable lack of any unified treatment of these matters in the existing literature. Consequently, many discussions in this area are characterized by vagueness, inconsistent usage of terminology, and occasional confusion. The topics discussed here are a cornerstone for the rest of the book.

This chapter concludes that cash equivalents serve a function that can usefully be described as monetary: they satisfy an aspect of money demand. When drawing a line between money and bonds, it sometimes makes sense to place cash equivalents on the money side of the line. A corollary is that the moneyness property of short-term debt disappears on default. The latter point is straightforward enough, but this idea plays a crucial role in the next chapter, so it needs to be stated explicitly.

Bear in mind that the proposition that cash equivalents are moneylike has not been taken seriously in the actual design of our monetary institutions. We saw this in the introduction. Issuing deposits (the predominant medium of exchange) is a privileged activity. You need a special charter to do it, and chartered entities are surrounded by an elaborate institutional apparatus. Issuing cash equivalents, by contrast, is not a legal privilege but a legal right. Cash equivalents have no legal-institutional status as such; their issuance is a matter of property and contract. A key inquiry for this book's design project is whether there is a respectable policy rationale for the stark institutional dichotomy between deposits and (nondeposit) cash equivalents. This chapter begins the task of calling that dichotomy into question.

The Contemporary Monetary Landscape

We can start by looking at the universe of US dollar–denominated money-claims, a term that was defined in the introduction as, essentially, short-term debt instruments apart from trade credit. Figure 1.1 shows the evolution of this asset class over the past two decades. The top nine series (lighter shading) represent private money-claims, in that the issuer (obligor) is a private firm, not a public institution. The bottom four series (darker shading) are sovereign money-claims, meaning the federal government is either issuer or guarantor.

Some of these instruments are more familiar than others. Details about them are supplied in the appendix to this chapter, but the details are not important. All these instruments are quite simple. They are dollar-denominated short-term debt. (Whether currency in circulation is properly viewed as a form of "debt" is a subject of debate — a largely metaphysical one at that — but I include it here for completeness.) The maturity cutoff is one year. Note that the figure is underinclusive, inasmuch as several categories of private money-claims are absent because data are not available.

I should emphasize that the figure depicts gross quantities: every distinct instrument is counted. That is to say, the figure doesn't "net out" those money-claims that are held by issuers of money-claims. For example, the figure includes money market mutual fund (MMF) shares, even though MMF portfolios consist almost entirely of other types of instruments that appear in the figure. If the figure were presented on a net basis, it would include MMF shares but exclude instruments held by MMFs. Unfortunately, the data required to present each series on a net basis are not available. The figure therefore can't be compared apples to apples with standard measures of the money stock, which employ netting. While net quantities would be useful for certain purposes, gross quantities are instructive in their own right. The use of gross quantities should not be confused with "double counting." The figure counts each distinct instrument exactly once: this is single counting. The figure might be said to reflect double counting if any of the relevant issuers were mere pass-through entities, but this is not the case. MMFs, for example, issue demandable (zero maturity) claims, whereas the weighted average maturity of their assets may be as high as sixty days. Accordingly, their shares are distinct instruments and belong in a gross aggregate.

Figure 1.1 gives rise to a few immediate observations. First, the market for US dollar–denominated money-claims is huge, exceeding $25 trillion on a gross basis. (By way of comparison, total outstanding US mortgage debt is about $14 trillion.) Second, this market grew rapidly in the run-up to the financial crisis. The 9.3% annualized growth rate of this market from 1995 to 2007 far exceeded the 5.4% annualized growth rate of nominal GDP over the same period. Third, this is primarily an institutional market, not a retail one. Apart from deposits, MMF shares, and physical currency, very few of these instruments are held directly by individuals.

It is worthwhile to look separately at the private and sovereign components of this asset class. As shown in figures 1.2 and 1.3, from 1995 to 2007 private money-claims grew at an annualized rate of 12.2%, far outstripping the 3.9% growth rate of sovereign money-claims over the same period. This trend reversed itself with the government's intervention during the financial crisis. The private aggregate plunged after 2007, while the sovereign aggregate soared. Interestingly, most of the crisis-related growth in sovereign money-claims came not from the Federal Reserve's balance sheet expansion — indeed, the figures reveal the modest size of the Fed's balance sheet (the bottom two sovereign series) in relation to the overall market for money-claims — but rather from emergency increases in deposit insurance coverage. Still, as shown in figure 1.1, the postcrisis growth in sovereign money-claims was insufficient to offset the massive contraction in private money-claims over the same period.

During the years preceding the crisis, private money-claims came to represent a steadily increasing share of the total. Figure 1.4 illustrates this trend and its sudden reversal with the onset of the crisis. The increasing private share from 1995 to 2007 can be understood as an increasing privatization of the broad money supply in the precrisis years.

The figures above highlight an additional fact that is crucial from an institutional design perspective: for at least the past two decades, practically all money-claims have been issued by the financial sector and the government. That is to say, nonfinancial (commercial or industrial) issuers have been virtually nonexistent. In particular, only one series in figure 1.1 above — nonfinancial commercial paper — represents issuance by commercial or industrial firms. And that market is trivial — it is by far the smallest series in the figure. This fact comes as a surprise even to many financial specialists. It is commonly supposed that the money market consists largely of commercial paper issued by real-economy firms to finance their working capital. This could hardly be further from the truth.

But isn't commercial paper nonetheless an important source of financing for the nonfinancial sector? The answer is no. Figure 1.5 shows selected sources of financing for the twenty-five largest nonfinancial US public companies. It is apparent that commercial paper is not a significant source of financing for corporate America today. This will be important later in the book, when we discuss the practical implications of imposing legal restrictions on money-claim issuance.

Finally, the figures above raise an important conceptual point. It is typical to think of "money" as a neutral, default-free, uniform asset. But the figures show that the reality is more complicated. A large institution doesn't have the luxury of holding its entire cash balance in the form of insured deposits; the $250,000 cap on deposit insurance coverage makes this impracticable. And a large uninsured bank account presents unacceptable credit risk. The "cash and equivalents" line on the balance sheet of any large institution therefore consists of some combination of the instruments shown in figure 1.1. This is the institutional reality of money today.

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Excerpted from The Money Problem by Morgan Ricks. Copyright © 2016 The University of Chicago. Excerpted by permission of The University of Chicago Press.
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