The essence of modern money

Sashi Sivramkrishna

Just a few days ago, the Reserve Bank of India (RBI) decided to close the issue of 7.75 percent Government of India (GOI) bonds, probably on account of the surge in demand for this virtually risk-free asset. Why are we so keen to hold financial liabilities of the government? Aren’t GOI bonds the other side of the much-dreaded public debt or accumulated financial liabilities of the government?

Before answering these questions, it is important to understand how these bonds are purchased. Suppose I had bought Rs 2,000 worth of bonds in cash, I would have given a Rs 2,000 currency note in exchange for the bond. Isn’t this actually a swap of one liability of the State (i.e. of the RBI) for another (a GOI bond)?

If I was to purchase the bond through my account at a commercial bank, the bank would ultimately settle the transaction by allowing its reserve account at the RBI to be debited (reduced) or in other words, the RBI swaps its liability (reserve accounts of commercial banks at the RBI) for the liability of the GOI, i.e. bonds, which I will be the owner of. Meanwhile, the reduction in the bank’s assets (reserves at the RBI) would be compensated by an equal reduction in its liabilities (my deposit account at the bank), keeping its balance sheet balanced.

In a modern money economy, when we speak of money we are really speaking of exchanges of financial liabilities. Unfortunately, mainstream macroeconomics textbooks inculcate the idea of money as an asset. This asset could have been a commodity such as gold or silver in the not-so-distant past. Presently, they argue, it is paper currency with no intrinsic value.

While it is true that money is an asset to the holder, the essence of modern money is overlooked; it is a financial asset which must therefore appear in some other entity’s books of accounts as a financial liability. This is not true of a gold or silver coin, which is a physical asset that does not appear in anyone else’s books of account as a liability.

To delve deeper into the idea of money as a financial liability, it is useful to begin with (paper) currency. We are often intrigued by the sentence printed on a currency note, ‘I promise to pay the bearer the sum of one hundred rupees’ (or any other denomination), signed by the RBI Governor. Clearly, this is a promissory note, an IOU (I owe you). However, what is it that the central bank is promising to pay? At a time when the rupee was on a silver standard, it meant the promise by the issuer of notes to exchange Rs 100 for a hundred silver rupees, each rupee being a measure of weight and purity of silver (approximately 11.4 grams of 96 percent purity). Given that the rupee is now fiat currency and not backed by the promise to convert it into anything, it means that the if I were to ask the RBI to exchange the note for a hundred rupees, I could get two Rs 50 notes instead.

These IOUs or financial liabilities are, however, used widely to settle claims that arise in exchanges.

When I buy a newspaper from a vendor, I can settle the claim that arises from this sale with currency, a promissory note, a liability of the RBI. In a modern money economy most claims that arise in such exchanges are not settled with the promissory notes of the State. Instead, we use promises to pay of commercial banks or what is commonly referred to as bank deposits. The money held by an entity in a bank deposit is the bank’s promise to pay the sum of money deposited. The bank also promises to swap its deposit for the State’s liability (cash or notes) at par. I can settle the claim of the newspaper vendor by a cheque or by a transfer of the deposit, which is essentially the bank’s promise to pay or financial liability of the sum involved.

The non-bank private sector can and also does issue promissory notes to temporarily settle claims. However, ultimately, these claims have to be settled with liabilities of commercial banks, and in times of deep crisis if and when bank closures were to become widespread, with those of the State only. I could for instance, purchase provisions from a neighbourhood store on credit, a promise to settle the claim later. After that period, I would have to issue a cheque or pay cash.

Corporate bond issues are also a swap of financial liabilities. A company exchanges your deposit (bank liabilities) for its own (the bond). Once again, in times of a crisis, there could be a rush for a reverse-swap, i.e. getting back your bank deposit for the bond. The NBFC (non-bank financial company) crisis that arose in the ongoing COVID-19 pandemic illustrates disruptions that arise in such swaps of financial liabilities.

When fund houses couldn’t get bank deposits in exchange for bonds (assets of NBFC) which they held, meant that they were unable to settle claims of investors who wanted their bonds (liability of NBFC) to be swapped back for bank deposits. Banks were then expected to come to their rescue. They could exchange the bonds (assets of the NBFC) for deposits so that the NBFC could pay off investors.

When we understand money as a financial liability it is obvious that all liabilities are not equally secure. A hierarchy of money exists with household and individual IOUs at the base, corporate and NBFC liabilities above it, bank deposits higher up and finally, those of the State (central government and RBI).

The question arises as to why are government liabilities the most secure? While all other financial liabilities are ultimately backed by physical assets, which always entails risk, State liabilities are not; they are backed by the fact that the State is the monopoly issuer of legal tender, i.e. liabilities that are accepted in settlement of obligations to the State — primarily taxes. In a modern economy the State, by design, also accepts bank deposits in settlement of tax obligations making use of bank money widespread; however, security of bank deposits is limited by an insurance ceiling (Rs 5 lakh).

This answers the question we posed at the beginning; why 7.75 percent GOI bonds were so much in demand in the ongoing crisis. At the same time, it highlights why the GOI must run a deficit and accumulate debt so that private sector desire for secure and risk-free savings can be met. A reluctance to accommodate this desire could raise the private sector’s marginal propensity to save, induce a contraction in the economy through the paradox of thrift and thereby force the fiscal deficit to widen. The economy could be drawn into a vicious whirlpool of austerity policies.

Sashi Sivramkrishna is a modern money theory researcher and author of Maximum Government, Maximum Governance: Reframing India’s Macroeconomics Discourse. Twitter: @sashi31363. Views are personal.