What Is Money Today? Legal and Economic Perspectives

Rosa Lastra, Jason Grant Allen and Michael Kumhof


Money today is different to money even a decade ago. The use of cash is declining and many non-bank companies offer digital payment systems and ‘cryptocurriencies’ that are supposed to work as the new money. Facebook is the latest to join the bandwagon with its LIBRA proposal and access to a staggering 2.4 billion active social media accounts.


In our research project for Rebuilding Macroeconomics we ask what really is money? Is  money in one society different to another? Or does a universal and ahistorical core of properties of money that exist across place and time? More generally, what is the ontological grounding for how we deal with money? How does this differ between Economics and Law, and most importantly for this project, how can Economics and Law inform each other when dealing with the question of money?

The global financial crisis of 2008 has demonstrated that modelling monetary as well as goods flows should be central to economic analysis, and that monetary-financial stocks (balance sheets) can matter enormously. Monetary exchange is the lifeblood of modern economies. But what is allowed to serve as this lifeblood, and how do we realistically incorporate this into our models? This is not a question that can be settled by assumption; it must be grounded in reality. Here we may find that Law has a lot to offer to Economics.


The concept of money has been side-lined in many orthodox macroeconomic theories. The irrelevance of money is seen in the Arrow-Debreu model to real business cycle models, the majority of New Keynesian models and virtually all models of banking. These models are grounded in unrealistic abstractions, frequently lacking a real-world counterpart and entirely leave out the most important monetary exchange mechanism: the use of bank liabilities.


We often find at one extreme, non-monetary models that assume exchange of goods for goods (barter) or against private non-bank IOUs denominated in units of goods and ultimately repaid using goods. At the other extreme, we find the exchange of goods against exogenously supplied government cash, despite the fact that cash is of little and diminishing importance in modern economies, and its supply is almost entirely demand-determined.


The neglect of the financial sector in standard dynamic stochastic general equilibrium (DSGE) models prior to the Global Financial Crisis (GFC) is a well-known example of this problem. By assuming an economy with no money—essentially frictionless barter without the concept of default—the economic models used by many central bankers and most academic macroeconomists failed to foresee the sources of systemic instability or understand the crisis as it unfolded.


Following the GFC, modellers have started to incorporate the financial sector into DSGE models. But in the vast majority of cases banks are simply assumed to be yet another agent that manages flows of physical resources throughout the economy, rather than a monetary agent that manages both the creation and the flows of money.


A fundamental philosophical predisposition of mainstream economists is to assume observed phenomena reflect the solution of private efforts to optimally deal with constraints and frictions. An implicaton of this is that bank deposits serve as money because the private sector finds it to be optimal solution. We can refer to this as the market theory of money. But what if this assumption is wrong?


The alternative assumption, perhaps best called the legal theory of money, is that money is money because the law says so: money is a creature of legal convention. While the law does not currently define permissible forms of money very strictly, it always has the sovereign option to do so. A sovereign re-definition of what may serve as the lifeblood of the economy would obviously have massive implications.


We do not mean to imply that future changes in the law would necessarily be restrictive. A proper legal understanding of money may instead support the creation of new forms of money, and this would be the opposite of restrictive. The current debate concerning central bank digital currencies is a case in point.


The economic world is governed by the laws and other conventions of human communities. This points to the need, at a fundamental level in the philosophy of Economics, to explain the social construction of artefacts such as money. Because so many of the social behaviours and relations involved in “making money” are legal, Law has a foundational role to play in constituting well-grounded economic models.


Given the obvious implications of legal definitions of money for economic outcomes, Economics can inform Law concerning the question of which legal innovations would be useful or detrimental. The remit of our project is therefore not only a positive exercise to obtain a more accurate description of the existing economic and legal environment. It is also to some extent, a normative exercise about which future innovations may be beneficial.


The first theme of our research project is the development of the functional analysis of money. A useful rule of thumb when approaching the topic of money is that, for the most part, money is as money does. And whatever else you do with money, you certainly use it to pay for things. Conversely, whatever you use to pay for things would seem to have some claim to ‘money status’.

This seems a common-sense place to start, and is our point of departure –  and the point of departure taken by many contemporary approaches to the definition of money within macroeconomics, too. Our intention is to unpick the economic analysis of money’s functions and find out what a legally-inflected view can help to understand the topic.


Saying that ‘you use X to pay for things’ is the start, not the finish, of the enquiry. Payment is after all, a legal concept, not just an economic one, and can be achieved in different ways. From barter or countertrade, cancelling out debt, or changing the state of a ‘blockchain’ data structure.  All these entail different mechanisms that might help us to bottom-out what we mean by the function of payment.


Different social systems are implicated in each of these different payment systems, and that bears on the nature of the monetary system that emerges. Monetary systems embody political, even constitutional, values and these values inform the mechanisms of payment the system affords. In our view, it is essential that these politico-legal elements be incorporated into the micro foundations of macroeconomic models. Taking the time to develop a more integrated legal and economic conception of money will serve both disciplines and perhaps society better.

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