Eco-Economy: Bank Money Isn’t Legal Tender

Bank Money Isn’t Legal Tender - Says Dr. Arthur Grimes

The following fascinating piece of correspondence between New Zealand Banking Reform Group’s Deidre Kent and prominent banker and economist Arthur Grimes was recently published on the New Zealand Banking Reform YahooGroup message list.

It is commended to all Eco-Economy readers as a great, thought provoking read, and hopefully an apt introduction to a great debate.

Finlay Thompson
New Zealand Banking Reform
July 18th 2001

Correspondence on money creation and banks’ role between Dr Arthur Grimes and Deirdre Kent, deirdrek@paradise.net.nz from 4 July to 19 July 2001. Dr Grimes is Director, Institute of Policy Studies,Victoria University of Wellington, Wellington, New Zealand

Who is Dr Arthur Grimes?

Who is Dr Arthur Grimes? From a websearch we find he has a BSoc Sci in Economics from Waikato University, a PhD and MSc (Distinction) in Economics from the London School of Economics where he won the Sayers Prize for Distinguished Thesis in Monetary Economics and many other prestigious awards. He was Chief Economist at the National Bank of New Zealand. Posts at the Reserve Bank include Chief Economist and Chief Manager, Financial Markets Department. He is now Director, Institute for Policy Studies, Victoria University of Wellington, an institute ‘which promotes study, research and discussion of current issues of public policy (both domestic and international). It is a link between academic resarch and public policy, providing a neutral forum for the study of important issues in New Zealand’. His CV says he was responsible for the design and implentation of New Zealand monetary policy, inluding design of the Reserve Bank Act 1989.

4/7/01
Dear Arthur Grimes

You may remember me as someone interested in the topic of money.

I am now chairperson of an organisation called NZ Banking Reform and in that capacity ( you know Finlay Thompson our spokesperson) I would like to invite you to be part of a debate on the general topic of 'whose perogative is money creation?' (we have a statement but right now I can't find it and time is passing). Our visitor is Michael Rowbotham author of The Grip of Death and Goodbye America.

We want two people on both sides of the debate one that the private banks should create the country's money supply and the other denying this. We invite you to be with Michael Reddell of the Reserve Bank representing the affirmative.

We are inviting Brian Gould to be with Michael Rowbotham and if he can’t come it will be either Finlay or me.

The date is Mon Aug 27th at the university and the chairperson is Grant Gillon, as the visit has been sponsored by the NZ Democrats.

I look forward to your reply.

Deirdre Kent

5/7/01
Deidre

I'm afraid I won't be available for this. The only people still even wondering about this topic, in my experience, are so far into the lunatic fringe that it is not worth the bother.

Regards

Arthur

5/7/01
Arthur

In that case we would be very interested to have from you a statement as to why you believe the commercial banks should create the bulk of the country's money supply.

Deirdre

9/7/01
Deidre

Only the Reserve Bank can create legal tender. You and I (and banks) can create other assets and liabilities but not legal tender.

Arthur

9/7/01

Arthur
Hey but that doesn't give a reason why banks should create 98% of the country's money supply as interest bearing debt. This "liability" immediately becomes legal tender.

Deirdre

10/7/01
Deidre

It is not legal tender (see the RBNZ Act 1989 - only the RBNZ can create legal tender).

Arthur

10/7/01

Arthur,

Does this mean when the bank lends me money to build a house and I pay my builder with by writing a cheque, I am not paying with legal tender?

Deirdre

10/7/01
Deidre

You are correct. A cheque is not legal tender. Two parties can agree to use it, but the contract is not finally settled until your bank pays the builder's bank with legal tender (i.e. with Reserve Bank liabilities). No-one can be forced to accept a cheque as payment - just as no-one can be forced to accept my IOU as payment.

Arthur

11/7/01
Arthur

When banks settle cheques with each other, you are suggesting that they are settling with non-legal tender? I understand only what they can't settle between themselves, which is a minority, is balanced up using the Reserve Bank liabilities.

So are you suggesting a very large part of the "money" circulating in the economy is non-legal tender?

Deirdre

They used to only have to settle the net amounts between themselves, through their settlement accounts at the Reserve Bank, which are legal tender (they are very small relative to wider definitions of the "money supply"). Now, large transactions are settled on a real-time basis which increases the amounts of legal tender banks hold. The Reserve Bank will have the details on this (it has changed since I worked there). The key point is that all final settlement is always through legal tender issued by the Reserve Bank. No other body can issue legal tender. Any person or company can, however, create other assets and liabilities which may or may not be used as a voluntarily agreed means of exchange (but not of final settlement).

Arthur

14/7/01
Arthur

All banks are surely under legal obligations to provide legal tender in exchange for bank credit? If the ANZ credited $20,000 to my account, I could surely go there and demand legal tender for this.

If there is an obligation on banks to provide legal tender in exchange for their liabilities, I would ask you what this implies as to the legal status of those liabilities? If bank liabilities are interchangeable on demand for legal tender, banks are creating (if not legal tender) a legal claim to legal tender - which is surely the same thing?

Would you agree that the status of bank liabilities is that they are a legal claim to legal tender?

If so, why should commercial banks be allowed to create this legal claim to legal tender?

It depends on what you define as money. If money is defined as base money(M0), then it is all legal tender (i.e. Reserve Bank liabilities). If it is defined as M3 then most is bank liabilities other than Reserve Bank liabilities. If it is defined to include trade credit then it includes a large amount of company (non-bank) liabilities. You can define money however you wish to get the answer you wish.

But who cares if you or I or the ANZ creates a liability. The ANZ's liability has no particular legal status that makes it any different to my son's liability when he borrows off me.

Arthur

15/7/01
Deirdre

The point is that if I have a contract with you then it is the same as if I have a contract with a bank - we both have to meet our contract. Banks are no different to any other corporate or individual in this respect. There is nothing special about banks.

Arthur

15/7/01
Arthur

Oh dear I find this rather frustrating. It seems to me you don't answer my questions.

If we define money as the M3 (whether some parts of it are 'legal tender' or not is not the issue, it is money which is accepted by the community), can I return again to my original question.

Why do you believe the banks should create almost all New Zealand's M3?

I believe there are three basic ways money is created.

1. As credit without interest. eg notes and coins
2. As debt without interest eg an IOU in a mutual barter agreement.
3. As debt with interest eg by banks when they loan mortgages into existence.

These forms of money have different effects and the third form has the effect of fuelling constant growth, among other effects.

The bulk of the M3 comprises mostly the third type and I wonder why you would argue that this should continue to be the best way of supplying our economy with money.

Deirdre

17/7/01

Deirdre

I really don't have time to go through this I'm afraid. These questions have been sorted out decades ago. Hence the almost complete disinterest in them throughout the world. I wish you luck in your discussions with the RBNZ.

Regards

Arthur

ENDS

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