Monetary Theory for a Cashless Society

When the "money supply" does not matter

A couple of weeks ago, I was driving my thirty-something daughter to the airport for an overseas trip. “Oops,” she said. “I have less than $20 in my wallet.”

I can remember when that would have caused a panic, possibly even aborting the trip. Back when my wife and I took our first overseas trip together, a few days before departure we went to the bank to obtain foreign currency. I also remember sitting in the bank signing the top of American Express Travelers’ Cheques, which were treated like money in foreign countries. They were a safer way to bring large amounts of money overseas, because in order to use them someone had to sign the bottom in the same handwriting. Plus, American Express guaranteed replacement “if they are lost or stolen.”

But in 2023, my daughter with the empty wallet said casually, “That’s ok. Everybody takes credit cards. Worst case, I’ll find an ATM.”

In a cashless society, you do not need cash in order to make payments. What you need is something less tangible than cash. You need “access to the payments system.” Think of the payments system as a set of ledgers or accounts kept on computers.

I don’t claim that we live in a cashless society today. But the term “cash-optional” society seems reasonable. And that ought to lead economists to rethink monetary theory.

Imagine that we had never relied on cash in order to trade. Instead suppose that we had always used computerized ledgers as the payments system. If we had always lived in a cash-optional or cashless society, then classical monetary theory would never have occurred to any economist. What sort of monetary theory would have emerged instead?

Classical economic theory says that relative prices—how much a hamburger trades for a haircut—are determined by supply and demand in the relevant markets. But money prices—the dollars charged for hamburgers and haircuts—are determined by the supply of money. Suppose that with today’s money supply a hamburger costs $4 and a haircut costs $20. If the government doubles the money supply, then the price of a hamburger will go to $8 and the price of a haircut will go to $40.

In a cashless society, what determines whether we are in the world of $4 hamburgers and $20 haircuts or the alternative world of $8 hamburgers and $40 haircuts? For students of economics who have come to expect a simple, mathematical formula to answer this question, I am afraid that I can only offer an answer that will prove vague. But better to offer an explanation that is vaguely right than exactly wrong.

I think that dollar prices are mostly set habitually. Businesses will keep prices steady as long as that is appropriate. They will make changes in a process of trial and error.

I am inclined to think that overall dollar prices of goods and services are roughly proportional to households’ perceived level of wealth. If wealth were to suddenly jump by 10 percent, then after some period of time (say, ten years), spending will have been 10 percent higher than it would have been otherwise. Assuming that the actual path of goods and services produced is the same as what it would have been without the increase in perceived wealth, 10 percent more spending will translate into 10 percent higher prices than would have been experienced otherwise.

Perceived wealth depends on how households value their assets and how liquid they believe their assets to be. We own land, houses, and commercial buildings. We own businesses and shares of businesses. We own debt instruments, including bonds, shares in money market funds, and bank deposits (For the most part, these debt instruments net out—you have a corporate bond as an asset, but that bond is the corporation’s liability). We have our human capital, which is intangible wealth.

We may not have a precise estimate of the value of our assets. But we are bound to have at least some vague idea of what they are worth.

We are likely to feel more free to spend to the extent that our assets are liquid. Some of our assets are less liquid than others. A young doctor’s human capital is ultimately worth millions, but she cannot use it to buy millions of dollars worth of goods right away. Instead, she has to gradually trade human capital for liquid wealth by earning a salary.

“Liquid wealth” sounds like cash money. But in a cashless society, it is not easy to decide what counts as liquid wealth. You cannot immediately trade your $200,000 house for hamburgers and haircuts, but you can take out a $25,000 loan backed by your home equity and then buy stuff. The day you take out your loan, it looks like your house is giving you $25,000 of liquid wealth. But what about the day before you took out your loan? Your house might not have provided you with $25,000 of liquid wealth, but you knew that it gave you some potential to spend. And suppose you took out $25,000 but the bank was willing to lend $50,000? Does that mean your house’s liquid value is $50,000?

The liquidity of assets depends on banks’ willingness to lend against them. Sometimes they are in a generous mood to lend against home equity, and sometimes they are not. Sometimes the bank will not charge for overdrafts (giving you a free loan), sometimes they will charge a huge penalty (making the loan expensive), and sometimes the bank will refuse to make the payment.

So that’s the best I can do to explain dollar prices. They are influenced by the value that households estimate for their assets and on what households believe about those assets’ liquidity or lack thereof.

Deficit spending and the Fed

In our hypothetical cashless society, prices will be affected by government deficits and by the Fed. When the government spends another $100 without paying taxes, someone receives the $100 (“money”) that the government hands out or spends. The Treasury typically will simultaneously obtain this “money” from another person, who gives $100 to the government in exchange for a debt instrument (an IOU) from the government. That debt instrument promises to pay $100, plus interest.

In principle, there is a third person who will ultimately be responsible for repaying the $100 in the form of higher taxes. But that person does not know who he is. And he may not even have been born yet.

When I lend $100 to an individual, their IOU is an asset to me but a liability to that individual. What I am saying about government debt is that when I lend the government $100, its IOU is an asset to me, but the $100 liability does not appear on any household’s balance sheet. So there is a gain in perceived wealth.

Government has the unique ability to get people to accept liabilities that are anonymous in the sense that they are not tied to any individual. But governments can lose that ability, because they can experience a sudden loss of trust. Fifteen years ago, Ken Rogoff and Karmen Reinhart published an entire book, This Time is Different, on the history of government defaults.

Government accordingly has the ability to increase perceived wealth and cause inflation by running deficits. But the effect of the artificial wealth that they create may be spread over a number of years. Deficits may have to be quite large to show up in short-run inflation.

When the pandemic hit, output of goods and services went down, because people were staying home. But the government sent out checks to everyone, and those checks increased perceived wealth. If perceived wealth goes up and output goes down, the difference is bound to show up sooner or later in prices.

What about the Fed? I will argue here that the Fed has no magical dial it can turn to control inflation. My views go against orthodoxy. But I don’t see how in a cash-optional society that the orthodoxy can be correct.

In a cash-optional society, access to the payment system is not determined by the quantity of money. But the Fed has other means to influence the economy.

Banks perform a function of liability transformation. Risky, long-term liabilities, such as home mortgages or commercial loans, enter banks. They come out of banks as (apparently) riskless, short-term liabilities, such as deposits.

The Fed affects liability transformation in two ways. First, it does its own liability transformation. Second, it regulates the way that banks perform liability transformation.

What the Fed can do is intervene in financial markets, buying and selling. For example, it can borrow short and lend long. Lately, it does this using “reverse repurchase agreements.” That means holding long-term bonds financed the way a dealer would finance them, by using them as collateral for very short-term loans.

I am not certain what the overall effect of this should be, but the thinking is that the net effect would be to increase the value of long-term bonds as the Fed takes some of the supply off the market. Higher values for long-term bonds would increase perceive wealth for bondholders, spending and inflation to rise.

Traditionally, the Fed’s interventions in financial markets have been called “open market operations.” Textbooks describe open market operations as exchanging money for bonds. But given the way that the Fed has operated, especially since 2008, the textbook description is oversimplified and distorted. Most of the open-market operations undertaken nowadays do not inject or withdraw “money” from the economy.

The Fed also can regulate. It can make it relatively attractive for banks to buy bonds from the government and relatively unattractive to make loans. That would make household assets less liquid and thereby reduce spending and inflation.

There were dramatic regulatory changes in the early 1980s. Legal ceilings on interest various interest rates were lifted. These changes allowed interest rates to rise. In the short run, this decreased perceived wealth, which contributed to a recession. But eventually, financial deregulation was better for the economy. Over the next several decades output growth kept up with the increases in perceived wealth, allowing for a slowdown in inflation.

On net, I think that by far the biggest effect of government on overall prices comes through deficits. The next biggest effect comes from Fed regulation. There is some effect from Fed market interventions, but I suspect that it is minor. Given my (heterodox) views, I neither blame the Fed for the recent high inflation nor credit the Fed for the slight deceleration of inflation in recent months. As you know, I think that going forward the government needs to use inflation as the only means to deal with its mountain of debt. I expect that the Fed will have no power to stop this inflation.

I am sure that my description of a cash-optional society will not be readily understood and accepted. It will probably require several essays to get it across. The main point that I hope you will consider is the possibility that in a cash-optional society access to the payment system is not controlled by raising or lowering the quantity of any particular asset that you can define as money.

This essay is part of a series on human interdependence.