See discussions, stats, and author profiles for this publication at: https://www.researchgate.

net/publication/264820202

The fundamental role of money and banking in macroeconomic analysis and

policymaking

Article  in  International Journal of Pluralism and Economics Education · January 2012

DOI: 10.1504/IJPEE.2012.051140

CITATIONS READS

0 5,319

1 author:

Sergio Rossi
Université de Fribourg
85 PUBLICATIONS   501 CITATIONS   

SEE PROFILE

All content following this page was uploaded by Sergio Rossi on 30 January 2015.

The user has requested enhancement of the downloaded file.

308 Int. J. Pluralism and Economics Education, Vol. 3, No. 3, 2012

The fundamental role of money and banking in

macroeconomic analysis and policymaking

Sergio Rossi
Macroeconomics and Monetary Economics,
Department of Economics,
University of Fribourg,
Boulevard de Pérolles 90,
CH-1700 Fribourg, Switzerland
E-mail: sergio.rossi@unifr.ch

Abstract: The crisis that burst in 2007 has revealed a number of conceptual
and methodological flaws of neoclassical economic analysis, based on rational
behaviour, representative agents, and microfounded macroeconomics, where
money and banking are considered as pertaining to the microeconomics of
goods and business activities. Macroeconomic analysis requires a systemic
approach to money and banking, both of which are essential for the working of
any economic system. In this perspective, the paper explains how both have to
be integrated into that analysis. It points out that macroeconomic analysis and
policy making require a deep knowledge of the history of monetary thinking.

Keywords: macroeconomics; methodology; money and banking; monetary

circuit.

Reference to this paper should be made as follows: Rossi, S. (2012) ‘The

fundamental role of money and banking in macroeconomic analysis and
policymaking’, Int. J. Pluralism and Economics Education, Vol. 3, No. 3,
pp.308–319.

Biographical notes: Sergio Rossi holds a PhD in Political Economy (1996)

from the University of Fribourg, Switzerland, and a PhD in Economics (2000)
from University College London. He is a Full Professor of Economics at the
University of Fribourg, where he holds the Chair of Macroeconomics and
Monetary Economics since 2005. His research interests are in the area of
monetary macroeconomics, where he has authored and edited many books,
contributed a number of chapters to books, and widely published in academic
journals.

1 Introduction

The financial and economic crisis that broke out in 2007 has revealed the importance of
money and banking in the working of any economic system. It is indeed plain that every
transaction implies money and involves one or more banks as settlement institutions. As a
matter of fact, contemporary economic systems are monetary economies of production
and exchange. This observation should be enough to question the relevance of so-called
‘Real Analysis’ [Schumpeter, (1954/1994), p.277], that is, the claim that “all the essential
phenomena of economic life are capable of being described in terms of goods and

Copyright © 2012 Inderscience Enterprises Ltd.

 The fundamental role of money and banking 309

services, of decisions about them, and of relations between them” (ibidem). In this view,
“[m]oney enters the picture only in the modest role of a technical device that has been
adopted in order to facilitate transactions. This device can no doubt get out of order, and
if it does it will indeed produce phenomena that are specifically attributable to its modus
operandi. But so long as it functions normally, it does not affect the economic process,
which behaves in the same way as it would in a barter economy: this is essentially what
the concept of Neutral Money implies” (ibidem). In fact, money cannot be neutral, since
its existence is the sine qua non condition for any transaction to be carried out, in order to
settle the relevant debt obligation between any two counterparties. There would be no
economic system without money, as the latter is the measurement unit for any economic
object that is produced and exchanged within the former.
These prolegomena are enough to show the importance of ‘Monetary Analysis’,
which “spells denial of the proposition that, with the exception of what may be called
monetary disorders, the element of money is of secondary importance in the explanation
of the economic process of reality” (ibidem). As Schumpeter (1954/1994, p.278) puts it,
“Monetary Analysis introduces the element of money on the very ground floor of our
analytic structure and abandons the idea that all essential features of economic life can be
represented by a barter-economy model.” This paper sets off from this perspective, in
order to argue that money, banking and finance require a macroeconomic understanding
in order to avoid another systemic crisis. The next section provides a critical appraisal of
neoclassical monetary economics, to show that it is flawed both conceptually and
methodologically. The third section presents a truly macroeconomic or ‘systemic’
approach to money and banking, explaining both of them with regard to the monetary
circuit that encompasses all transactions in every kind of market. The fourth section
elaborates on the proper role of monetary policy in such a framework. The last section
concludes briefly.

2 Neoclassical monetary economics: a critical appraisal

Considering money as an item (either in the form of a medium of exchange or as a store

of value) exchanged in the market place, the majority of authors adopt the neoclassical
approach that aims at analysing macroeconomic issues (such as production, inflation, or
financial stability) referring to their alleged ‘microfoundations’. This view implies that
the workings of an economic system can be reduced to a series of relationships between
agents as well as goods (in the spirit of Real Analysis as noted by Schumpeter). There
would thus be no solution of continuity between the micro and macroeconomic levels of
enquiry: “if microeconomic theory is true, then the nature of the macroview or the
aggregated view of the economy cannot be inconsistent with the microview” [Boland,
(1982), p.85]. This “is the view that all of macroeconomic analysis is methodologically
and perfectly analogous to microeconomic analysis” (p.84). As claimed by Hicks (1946,
p.245), this view “enables us to pass over, with scarcely any transition, from the little
problems involved in detailed study of the behaviour of a single firm, or single
individual, to the great issues of the prosperity or adversity, even life or death, of a whole
economic system. The transition is made by using the simple principle, already familiar
to us in statics, that the behaviour of a group of individuals, or group of firms, obeys the
same laws as the behaviour of a single unit.”
310 S. Rossi

To be true, one should note some recent mainstream attempts at abandoning the
‘representative agent’ assumption, to consider agents’ heterogeneity (Delli Gatti et al.,
2005; Markose et al., 2007). However, they focus on agents’ behaviour, neglecting
structural and indeed ‘systemic’ features that would allow us to have a truly
macroeconomic understanding of money and banking. Also, heterogeneity is reduced to
overlapping generations or informational asymmetries, not to the different possibilities to
get bank credit by different (macro) categories of agents, like firms and wage earners, as
pointed out by the monetary theory of production (see Graziani, 2003; Gnos, 2006).
In fact, the basics of money and banking are flawed in neoclassical economics: it is
actually wrong to claim that money is a good or an asset, and that banks are similar to
any other (financial or non-financial) business. National accountants are well aware that
no ‘monetary aggregate’ (considered to measure the ‘money supply’) pertains to the set
of produced output, thereby confirming Smith’s (1976, p.290) argument that one should
distinguish money from money’s worth. In particular, money is issued by banks through
a process that will have to be explained thoroughly, whilst money’s worth (a purchasing
power) is produced by firms (including banks) thanks to their wage earners. The role of
banks is essential, not because they are in a position to transfer to so-called ‘investors’ the
savings formed within the system (any non-bank financial institution can do so), but
because they can open credit lines to which no pre-existent savings correspond actually.
The focus, and emphasis, on market exchange by neoclassical economists is also
problematic. At the conceptual level, the traditional understanding of exchange refers to a
transaction involving two separate items that generally pre-exist their exchange, which
moves them across space in so far as their property rights are transferred, from sellers to
buyers, on product or financial markets. As regards services, including those provided by
wage earners on the labour market, the neoclassical view considers them to enter into an
exchange against money (or against some monetary good as captured by the quantity
theory of money), which would be both a medium of exchange and the object against
which the relevant services are exchanged. In any case, according to this paradigm, “the
elementary event is a transaction – an exchange in which one economic actor transfers
goods or services or securities to another actor and receives a transfer of money in return”
[Friedman, (1987), p.5].
This view supposes that agents have some initial endowments of goods, assets or
‘money’, which they might be willing to exchange among themselves in order for them to
increase their own ‘utility’. At the macroeconomic level, this representation of agents and
market exchange can explain neither the creative process of production nor how the
‘money’ units are issued by banks and endowed with a purchasing power objectively. It
is indeed plain that neither goods nor money units ‘fall from heaven’, or a helicopter, as
the former have to be produced and the latter have to be issued through a process that, in
fact, associates the former with the latter so as to measure output in economic terms and
to provide a ‘content’ to money units (see the next section for analytical elaboration).
In fact, if production is considered as an exchange on the factor market, between
those agents (such as workers) who possess the so-called ‘production factors’ and firms
looking to obtain these factors in exchange for money units, then one has to explain not
only how it is possible for firms to dispose of money, but also how it is possible that the
relevant output is net for the economic system as a whole. The neoclassical explanation,
as a matter of fact, assumes that money is ‘a creature of the market’ [see Menger, (1892),
pp.244–245], that is, it would emerge through a ‘discovery process’ that induces market
participants to select, by ‘trial and error’, the object whose ‘moneyness’, or ‘degree of
 The fundamental role of money and banking 311

saleableness’ (p.242), is the highest within the set of available objects. Also, production
would amount to a transformation (notably, a change of form) of matter and energy, but
without any possible net creation (so that economic growth could not occur according to
this paradigm). This view is shaped by physics. Indeed, neoclassical economics aims at
presenting the working of an economic system as if it were akin to physics, so much so as
some neoclassical authors are now working on so-called ‘econophysics’. Needless to say,
physical laws impede to have any net creations in the physical world, as the famous
Lavoisier principle recalls (to wit, within a closed system matter and energy can only be
transformed, as no net creation or net destruction can occur in physical terms).
To sum up, neoclassical monetary economics suffers from conceptual as well as
methodological flaws. At the conceptual level, it defines money as a physical numéraire
emerging from exchanges on the goods market, in which agents learn about the property
that best qualifies an item as a medium of exchange. Hence, there would be no essential
character of money distinguishing it from (non-money) goods, the degree of moneyness
varying over time and across space as a result of technical innovations (such as those in
payment systems) and juridictional laws (about the legal-tender feature of money that is
at centre stage in the so-called ‘State theory of money’; see, for instance, Wray, 2003). At
the methodological level, neoclassical monetary economics focuses on exchange and
considers it from a microeconomic perspective, whose surface phenomenon induces this
approach to assume that an exchange involves two agents and two separate items, which
change their position in space over time. There would thus be no essential role for banks
as well as no possibility to explain economic growth as every transaction would amount
to a transfer of any pre-existing items (including their physical transformation on factor
markets), between a seller and a purchaser, through the physical intermediation of some
medium of exchange, although the latter may be fully immaterial (in the form of entries
in a bank’s ledger).

3 The macroeconomics of money and banking: basic principles

Money and banking have a macroeconomic character essentially. This implies that both
need to be apprehended for their nature and role within the economic system as a whole.
As a matter of fact, the nature of money cannot be understood by looking at the material
that has been used to carry out money’s functions historically. The functional definition
of money, according to which “money is what money does” [Hicks, (1967), p.1], does
not provide any satisfactory answer in that regard. This definition is prone to circularity
and is therefore useless analytically: “If it is not clear what ‘money’ is, it is also not
possible to describe the functions of ‘money’” [Bofinger, (2001), p.4]. To understand
what money is, in fact, one needs to go beyond surface phenomena (such as the material
that is used, or the entries that are booked, to settle economic transactions). The task at
hand, indeed, is much easier now than it used to be in the distant past, when money was
reified into an array of different materials (gold or silver, for instance). Even the
advocates of the State theory of money agree today that money is issued by the banking
system (formed by the central bank and a variety of financial institutions that may bank
with it, particularly the traditional branch of commercial banks). To understand what
money is, therefore, one is best inspired if one begins by analysing how a payment is
carried out by a bank through which the payer discharges her debt obligation against the
312 S. Rossi

payee – who is paid finally as far as he has no further claims on the payer [Goodhart,
(1989), p.26].
Table 1 shows the result of a payment on the factor market, which is the market
where national income is formed as a result of production activities carried out by wage
earners within a variety of (financial or non-financial) businesses. Indeed, to understand
the nature and role of money, one has to investigate how a payment on the factor market
is possible starting from tabula rasa to avoid assuming that a bank deposit pre-exists the
payment that originates this deposit actually.
Table 1 The result of a payment on the factor market

Bank
Assets Liabilities
Loan to the payer (a firm) + x m.u. Deposit of the payee (wage earner) + x m.u.

As Moore (2001, p.12) points out, money is “credit-driven and demand-determined”. As

a matter of fact, firms need to obtain a credit line in order for them to pay their wage
bill for the relevant period. This is the reason why monetary circuit theorists refer to
‘credit-money’ (see, for instance, Graziani, 2003): money is issued via credit, although
one has always to distinguish money from credit analytically. “The supply of credit is the
supply of a positive amount of income and requires the existence of a bank deposit (a
stock), whereas the supply of money refers to the capacity of banks to convey payments
(flows) on behalf of their clients” [Cencini, (2001), p.7]. Indeed, the flow-versus-stock
distinction is appropriate in this regard, for it allows to understand that money differs
from deposits with banks. The former is a flow and exists within any payment, which is
instantaneous, since it takes an instant to carry it out, whilst the latter are a stock (of
purchasing power) and exist between any two payments.
The flow nature of money and payments should not lead us astray. Money is not a
stock that can be ‘at rest’ (in some bank deposit) or ‘on the wing’ (that is, circulating) as
imagined by Robertson (1937, p.29). Also, the fact that credit implies an income
that the relevant bank lends to its borrower does not mean that credit must rely
on some pre-existing deposits within the banking system necessarily. Indeed, as
endogenous-money theorists have remarked in the history of monetary thought (see, for
instance, Realfonzo, 1998), loans create deposits. This causal relationship means that the
first event is a loan, which a bank may grant to some (creditworthy) customer, in order
for the latter to pay a debt obligation. Now, as banks can issue money but cannot provide
it with a purchasing power, which the payer needs in order to settle the relevant debt
obligation to the payee, one has to explain how it is possible that a bank may open a
credit line to a client, which provides an income to the latter that the former did not
record in its books previously.
In fact, there is only one kind of payments that can give rise to the income that is
necessary to settle the underlying debt obligation: the payment of wages on the factor
market, as it associates the emission of a number (x) of money units (m.u.) with the
newly-produced output (see Table 1). Hence, money measures output numerically, and
ouput defines the real content of money [Cencini, (1995), p.15]. Thus, it is the income
formed as a result of the payment of wages, and which is saved by wage earners, that
nourishes the credit that the bank grants to the relevant business. Wage earners have a
credit to the bank as far as they hold a claim on a bank deposit: the credit that the bank
 The fundamental role of money and banking 313

grants to the firm, in order for the latter to pay out wages, is thus financed by wage
earners eventually. This is not circular reasoning, for every payment, not only the
payment of wages, implies a double entry in a bank’s books as a result of it: the income
deposited by the payee provides thus the necessary finance that, through the bank or the
banking system as a whole, the payer can borrow to settle their debt obligation. It would
indeed be supernatural if banks had a capacity (to create income out of nothing) that no
individual or institution has in the real world.
Once formed, as a result of production ‘monetized’ by banks, income can either be
saved or spent (on any kind of markets). The expenditure of income on the financial
market amounts to a transfer of purchasing power from buyers to sellers of any financial
assets. At the macroeconomic level, therefore, financial market activities are a zero-sum
game, because they neither increase nor decrease the amount of total income recorded in
the whole banking system. These activities, however, can lead to income generation in a
macroeconomic sense, when they induce banks to grant credit to some borrowers on the
financial market, which the latter uses to invest in the production process (whose results
are both a newly-produced output and the corresponding national income). Activities on
financial markets, however, can also originate a destruction of income within the whole
economic system, whenever they induce a bank failure and the ensuing cancellation of a
part (or the entirety) of deposits with this bank. This suffices to argue that banks have to
be regulated (as they are not simply a business like any other firm), and that all financial
market activities must be controlled, to avoid their potentially negative macroeconomic
effects. These regulations do not stem from ideology. They are not necessary because of
bankers’ or financial market participants’ forms of behaviour. Banking and finance have
a macroeconomic character, which does not depend on behaviour but stems indeed from
their nature and working within the monetary circuit. It pertains therefore to a monetary
authority that is in charge of economic and financial stability to design the proper ways
and means to address the various macroeconomic challenges raised by money, banking
and finance (see Rossi, 2012). Let us investigate this subject matter in the next section.

4 Redesigning monetary policy to guarantee macroeconomic stability

As the events leading to the bursting in 2007 of the financial crisis in the USA have
shown, price stability (as captured by any consumer price indices) is not enough to make
sure that macroeconomic stability prevails. In fact, the tasks of central banks must go
beyond price stability, to include also macroeconomic stability, which does not occur
necessarily when the general price level remains stable. In this respect, Milton Friedman
noted indeed, for one, that “[t]here is […] a positive and important task for the monetary
authority – to suggest improvements in the machine that will reduce the chances that it
will get out of order, and to use its own powers so as to keep the machine in good
working order” [Friedman, (1968), p.13]. In modern jargon, this means that central banks
should make sure that the monetary and financial system in which they operate remains
stable or, in other words, that ‘systemic’ stability is guaranteed – so that if one or more
banks or financial institutions go bankrupt, monetary and financial order is preserved in
the system as a whole.
At the time of writing, the relevant debate focuses mainly on the need to reform the
workings and instruments of financial supervisory authorities, as well as on the need to
314 S. Rossi

strengthen cooperation between central banks and financial supervisors. According to

several national and supranational authorities, the origins of the global financial crisis are
found in the so-called ‘leverage effect’ and large proprietary trading activities that banks
have been carrying out in a variety of financial markets around the world, as well as in
the procyclicality of existing financial regulations (such as ‘Basel II’), which magnify
both upturns and downturns on financial markets, and thereby aggravate rather than
contain financial instability of both banking and payment systems. Bank regulators and
supervisory authorities, however, should not waste time fine-tuning the forms of
behaviour of financial-market operators, introducing (and amending) all sorts of rules to
distinguish among banks and non-bank financial institutions as well as between large,
systemically important financial institutions (that are too big to fail, alone or as a group)
and other, minor institutions. The most effective regulations are, in fact, those affecting
the structures of the system through which all these actors play their role on domestic and
cross-border markets. As Rossi (2010) explains, the recent global financial crisis
originated in the current structure of payment and settlement systems. Hence, the
necessary solution to avert further systemic crises is plain: the banks’ book-keeping must
distinguish those payments that give rise to a new income (within the economic system as
a whole) from any other payments, which just transfer a pre-existent income from the
payer to the payee. As pointed out above, income-generating payments can only occur on
the factor market, when businesses pay out wages to their collaborators disposing of
those credit lines that banks opened to them. Logically, no financial-market transaction
can generate on its own a positive income in the economic system, as these transactions
do not concern production but the exchange of financial claims between any two market
participants. Logic as well as conceptual thinking lead us thus to the conclusion that the
regulatory changes needed to prevent further systemic crises in economic systems will
have to impact on the structure of contemporary payment and settlement systems. Let us
elaborate on this briefly.
Banks (that is, those financial-market institutions that can carry out any payment
without having pre-existent deposits with them) must record their transactions into two
separate book-keeping departments, analogously to those departments (named Issue and
Banking department respectively) that were introduced by the 1844 Bank Act, in order
for the Bank of England not to impair monetary stability of the domestic economy in the
gold-standard regime. As Bradley (2001, p.3) points out, “[t]he division [into two
departments, one for banking activities and the other for the emission of bank notes by
the Bank of England] adopted in 1844 failed to fulfil its objectives because it was based
on an exogenous conception of money.” Yet, considered in light of money endogeneity
as explained above, the separation of all banks (not just the central bank) into two
functionally distinct book-keeping departments remains relevant, as it allows to
distinguish explicitly the emission of money in income-producing payments from the
emission of money in all those payments that just transfer a pre-existent income on any
markets [see Schmitt, (1984), pp.192–209]. Reforming banks’ book-keeping structure to
introduce this distinction will thus enable banks, as well as their supervisors, to know at
any point of time the amount of income that banks’ clients deposit with them, beyond
which no financial-market operation should be allowed, because it would rely on a pure
creation of money to which no income corresponds originally.
Let us illustrate this monetary-structural reform with a stylised example. Suppose that
bank A has issued x units of money in payment for the wage bill of firm A, and that bank
B did the same for firm B but for a number of y units of money: income has thereby been
 The fundamental role of money and banking 315

formed for a total sum of x + y units of money within the economic system as a whole.
Table 2 records the results of these money emissions in the books of banks A and B.
Table 2 The results of the payment of wages through the banks’ two departments

Bank A
Issue department (I)
Assets Liabilities
(1) Credit to firm A +x m.u. Department II +x m.u.
(2) Credit to firm A –x m.u. Department II –x m.u.
(*) 0 0
Bank A
Banking department (II)
Assets Liabilities
(1’) Department I +x m.u. Deposit of workers A +x m.u.
(2’) Loan to firm A +x m.u. Department I +x m.u.
(*) Loan to firm A x m.u. Deposit of workers A x m.u.
Bank B
Issue department (I)
Assets Liabilities
(1) Credit to firm B +y m.u. Department II +y m.u.
(2) Credit to firm B –y m.u. Department II –y m.u.
(*) 0 0
Bank B
Banking department (II)
Assets Liabilities
(1’) Department I +y m.u. Deposit of workers B +y m.u.
(2’) Loan to firm B +y m.u. Department I +y m.u.
(*) Loan to firm B y m.u. Deposit of workers B y m.u.
Note: (*) is the balance of those entries that are recorded in the relevant department.
Entry (1) shows the emission of money by the bank to the benefit of the relevant firm,
which has to pay the wage bill to its wage earners, who are credited with a bank deposit
by entry (1’). As soon as this payment is carried out by the bank, the latter transforms the
monetary debit of the firm (entry 1) into a financial debt for it (entry 2’), on which
interests will accrue daily as this is standard practice in banking. The balance of all these
entries shows, in the end, that the firm has, indeed, a financial debt to the bank, which
in turn is financially indebted to this firm’s wage earners. So far, the results are no
different from today’s (single-department) banks’ book-keeping, which already records
both firms’ financial debts and wage-earners’ financial credits to the relevant bank as
shown in Table 1.
Now, when a given bank carries out financial-market transactions, which do not
generate a new income for the whole economic system, the two-department structure of
banks’ accounts will show the maximum amount (of income) that the bank will be
316 S. Rossi

able to spend for its own sake or for its clients’, without inducing financial instability. As
Table 2 shows, bank A may either lend or dispose on financial markets of no more than x
units of money income, as this is the total amount of purchasing power available in it.
Bank B may for its part do the same, for a maximum amount of y units of money income.
If one of these banks lends or spends on financial markets a greater amount of money
than it has in the form of deposits with it, it would have to record this transaction through
its two accounting departments, that is, create ex nihilo in its Issue department the
number of money units it needs to add to the income that is available in its Banking
department, thereby breaking the book-keeping rules of bank ‘departmentalization’ in a
transparent manner. This would lead thereby to some immediate sanction from banking
supervisors, providing thus a good incentive for any bank to abide by these rules in any
of its financial-market transactions.
If so, then leverage effects and proprietary trading by banks will not be possible,
unless the relevant bank either owns or borrows the necessary and pre-existent deposits,
which it will spend on either interbank or financial markets for any income-transferring
operations. In this case, bank A (for instance) will record the entries shown in Table 3.
Table 3 The result of a financial market transaction in the reformed banks’ book-keeping
structure

Bank A
Banking department (II)
Assets Liabilities
(*) Loan to firm A x m.u. Deposit of workers A x m.u.
(3’) Deposit (into bank B) +y m.u.
Securities (sold to workers B) –y m.u.
(4’) Deposit (into bank B) –y m.u.
Financial assets (bought from +y m.u.
a trader (a client of bank B))
(**) Loan to firm A x m.u. Deposit of workers A x m.u.
Trading book (memory item):
Securities (sold) –y m.u.
Financial assets (bought) +y m.u.

Bank B
Banking department (II)
Assets Liabilities
(*) Loan to firm B y m.u. Deposit of workers B y m.u.
(3’’) Deposit of workers B –y m.u.
Deposit of bank A +y m.u.
(4’’) Deposit of bank A –y m.u.
Deposit of trader +y m.u.
(**) Loan to firm B y m.u. Deposit of trader y m.u.
Notes: (*) initial balance; (**) final balance
Entry (3’) records the fact that bank A sells some securities (in its trading book) to firm
B’s workers (who have their relevant deposits with bank B): as a result of this operation
on the financial market, (the property right on) the deposit of y units of money recorded
 The fundamental role of money and banking 317

with bank B moves from firm B’s workers to bank A, as testified by entry (3’’). Entry
(4’) is, by contrast, the record of another financial-market transaction: bank A disposes of
its deposit with bank B to purchase some financial assets whose price is equal to y. Entry
(4’’) records therefore the transfer of (the property right on) the relevant deposit with
bank B, from bank A to the trader selling these assets to it. All in all, as the final balances
in Table 3 show in both bank A and bank B, the total sum of available deposits within the
whole banking system (x + y) corresponds to the loans that banks provided to the
non-financial business sector (firms A and B), in order for the latter businesses to
remunerate their workers on the labour market. As the actual object of both firms’ debt to
the banking system is a produced output, this ensures that the money-to-output
relationship established on the factor market through the payment of wages is left
unaffected by those financial-market operations that banks may carry out for their clients
or for their own sake at any time around the world.
If all operations that a bank carries out on financial markets have to be recorded, as
shown in Table 3, distinguishing between the Issue and the Banking department in its
own book-keeping, then no bank will have an interest in ‘off-loading’ (part of) its loans
into special-purpose (or structured investment) vehicles. Appropriate structural reforms
have therefore a positive influence on agents’ forms of behaviour, although the latter are
not constrained at all by the former: simply, what to date is a potentially destabilising
form of behaviour at the macroeconomic level will not be so, once the structural reform
of banks’ accounting has been carried out. Individual freedom and financial stability will
thus be preserved simultaneously, with a regulatory reform in banking that puts into
practice the distinction between money and credit, on which monetary circuit theory has
been developed in the history of economic thought [see Rossi, (2007), pp.9–31].

5 Conclusions

In this paper we argued that both money and banking are essential for the existence, and
working, of economic systems. Money is the means of final payment that banks provide
to measure the object of any transactions in economic terms and to ensure that the payee
has no further claim on the payer, once the relevant payment has been finalised by a
bank. Banks are special, since they are in a position to issue the number of money units
that are necessary for any payment to be carried out finally, even though they do not
dispose of pre-existent deposits with them. As a matter of fact, bank loans generate
deposits with the banking system. These deposits are the result of production whenever a
non-financial business draws on a credit line it has with a bank in order for it to pay its
production costs, that is to say, the total wage bill. The association of money and output
that occurs thereby gives rise to income, a purchasing power that exists in the form of a
bank deposit, until the latter is spent by its holder to buy output on sale on the product
market. Yet, banks can exploit their loans-make-deposits mechanism in order for them, or
their clients, to dispose of credit lines beyond the ‘needs of trade’, that is to say, on
financial markets. When this occurs, the total amount of bank deposits available within
the system exceeds the volume of saleable output, which elicits therefore an inflationary
pressure that remains unnoticed when ‘excessive deposits’ are spent to buy real and/or
financial assets whilst the relevant monetary authorities are focusing on consumer prices
in order to attain (or maintain) price stability within the economic system. The financial
318 S. Rossi

circulation of excessive bank deposits cannot but give rise to a series of asset bubbles,
which burst when the banks’ debtors become over-indebted and are not in a position to
repay their debts as they mature. Owing to banks’ interconnectedness and indebtedness
on the (domestic or cross-border) interbank market, the monetary-structural disorder in
banking has a disruptive potential to create global systemic crises eventually.
Financial crises have therefore a monetary-structural origin, as they are the result of a
discrepancy that exists between the nature and role of money, on one hand, and the actual
workings of payment and settlement systems in monetary production economies, on the
other hand. Financial regulations should therefore ensure that bank activities respect the
essential distinction between money and credit, which amounts to separating in banks’
book-keeping those payments that generate new income (on the factor market) from all
those payments that just dispose of pre-existent income (on financial markets): the latter
transactions should be booked and carried out in such a way to avert a bank issuing a
number of money units to which no available income corresponds, since this is
inflationary although it does not show up in an increase in those price indices that central
banks usually consider in their monetary-policy strategies and decision-making
processes. The separation of any banks’ book-keeping into an Issue department (where
the emission of money for all payments that generate income in the economic system is
recorded) and a Banking department (for all those payments that transfer a pre-existent
income between the payer and the payee) will avert any mismatch between money and
output in the market place. Within such a structurally-improved framework for banks’
book-keeping, banks’ and non-bank agents’ forms of behaviour will have no negative
systemic effects. Although a bank or non-bank agent will still be in a position to behave
so as to enter into excessive debt (when it borrows an income that it will not be able to
repay in due time), this individual financial fragility will not affect the workings of the
whole financial system. Indeed, if, at the individual level, any agent might still borrow
any amount of income that any other agent is willing to lend to it (after all, both agents
will be accountable for their individual choices), at the level of the economy as a whole
there will be always and everywhere an amount of total available income (notably in the
form of bank deposits) identically equivalent to the total sum of produced output on sale
in the market place. This identity will be the mechanical and truly unavoidable outcome
of modern payment systems, run by banks through their two book-keeping departments
that will align the practice of banking and finance with the modern theory of money.

Acknowledgements

The author is much grateful to the referees for their comments on a previous version of
this paper, whose first draft has been presented at the research seminar of the Centre for
Monetary and Financial Studies at the University of Burgundy in Dijon, France. The
author thanks seminar participants for their constructive remarks. The usual disclaimers
apply.

References
Bofinger, P. (2001) Monetary Policy: Goals, Institutions, Strategies, and Instruments, Oxford
University Press, Oxford.
 The fundamental role of money and banking 319

Boland, L.A. (1982) The Foundations of Economic Method, Allen and Unwin, London.
Bradley, X. (2001) ‘An experience in banking departmentalisation: the Bank Act of 1844’, Centre
for Banking Studies and Research Laboratory of Monetary Economics Working Papers, No. 5.
Cencini, A. (1995) Monetary Theory, National and International, Routledge, London and New
York.
Cencini, A. (2001) Monetary Macroeconomics: A New Approach, Routledge, London and New
York.
Delli Gatti, D., Di Guilmi, C., Gaffeo, E., Giulioni, G., Gallegati, M. and Palestrini, A. (2005) ‘A
new approach to business fluctuations: heterogeneous interacting agents, scaling laws,
and financial fragility’, Journal of Economic Behavior and Organization, Vol. 56, No. 4,
pp.489–512.
Friedman, M. (1968) ‘The role of monetary policy’, American Economic Review, Vol. 58, No. 1,
pp.1–17.
Friedman, M. (1987) ‘Quantity theory of money’, in Eatwell, J., Milgate, M. and Newman, P.
(Eds.): The New Palgrave: A Dictionary of Economics, Vol. 4, pp.3–20, Macmillan, London
and Basingstoke.
Gnos, C. (2006) ‘French circuit theory’, in Arestis, P. and Sawyer, M. (Eds.): A Handbook of
Alternative Monetary Economics, pp.87–104, Edward Elgar, Cheltenham and Northampton.
Goodhart, C.A.E. (1989) Money, Information and Uncertainty, 2nd ed. (first published 1975),
Macmillan, London and Basingstoke.
Graziani, A. (2003) The Monetary Theory of Production, Cambridge University Press, Cambridge.
Hicks, J.R. (1946) Value and Capital: An Inquiry into Some Fundamental Principles of Economic
Theory, 2nd ed. (first published 1939), Oxford University Press, Oxford.
Hicks, J.R. (1967) Critical Essays in Monetary Theory, Clarendon Press, Oxford.
Markose, S., Arifovic, J. and Sunder, S. (2007) ‘Advances in experimental and agent-based
modelling: asset markets, economic networks, computational mechanism design and
evolutionary game dynamics’, Journal of Economic Dynamics and Control, Vol. 31, No. 6,
pp.1801–1807.
Menger, K. (1892) ‘On the origin of money’, Economic Journal, Vol. 2, No. 6, pp.239–255.
Moore, B.J. (2001) ‘Some reflections on endogenous money’, in Rochon, L-P. and Vernengo, M.
(Eds.): Credit, Interest Rates and the Open Economy: Essays on Horizontalism, pp.11–33,
Edward Elgar, Cheltenham and Northampton.
Realfonzo, R. (1998) Money and Banking: Theory and Debate (1900–1940), Edward Elgar,
Cheltenham and Northampton.
Robertson, D.H. (1937) Money, Cambridge University Press, Cambridge (first published 1922).
Rossi, S. (2007) Money and Payments in Theory and Practice, Routledge, London and New York.
Rossi, S. (2010) ‘The 2007–9 financial crisis: an endogenous-money view’, Studi e Note di
Economia, Vol. 15, No. 3, pp.413–430.
Rossi, S. (2012) ‘Money, banking, and finance’, in United Nations Educational, Scientific and
Cultural Organization (Ed.): Encyclopedia of Life Support Systems, forthcoming, UNESCO,
Paris.
Schmitt, B. (1984) Inflation, chômage et malformations du capital, Economica and Castella, Paris
and Albeuve.
Schumpeter, J.A. (1954/1994) History of Economic Analysis, Routledge, London and New York.
Smith, A. (1976) An Inquiry into the Nature and Causes of the Wealth of Nations, Clarendon Press,
Oxford (first published 1776).
Wray, L.R. (2003) ‘The neo-chartalist approach to money’, in Bell, S.A. and Nell, E.J. (Eds.): The
State, the Market and the Euro: Chartalism versus Metallism in the Theory of Money,
pp.89–110, Edward Elgar, Cheltenham and Northampton.

View publication stats