Neo-chartalists rightly look to Georg Friedrich Knapp and Alfred Mitchell-Innes as brilliant forefathers of a state and credit theory of money. However, Knapp and Innes* of course wrote in a different time and had their hands full with explaining the fallacies of metallism and explaining why money is credit.

Now, however, the problems of metallism and the idea of money as credit, and in turn the functional finance implications, are well understood. Besides the contributions of Knapp and Innes to these areas, what did they think about private credit money creation? There is, given their focus on metallism and other issues of the time, relatively little on private money creation in their work. The past century, as mentioned, has seen the development of more or less a full understanding of the implications of the ideas of Knapp and Innes. However, there have been numerous relatively small crises in the past century (just since the 1980s: Savings & Loan in the US, the Japanese asset price bubble, LCTM, banking crises in Finland, Sweden, Asia, Russia, Argentina, Ecuador, Uruguay, and throughout Europe) and two massive economic crises (1929, 2008) that have had much or most of their basis in the private credit money creation realm of the economy. In other words, although a great deal of the suboptimal performance (sustained unemployment, lack of investment in infrastructure, education, and healthcare) has been due to a failure to understand and apply readily implementable state money & functional finance insights, there has also been another major source of economic suffering, resulting from the non-state-money side of the economy. The worldwide private credit money system has caused untold suffering and misery for millions. This side of the equation must be integrated into any functional finance insights that arose from Knapp, Innes, and others (the subject of my next post).

Although the answers to questions about state and private credit money stand or fall on their own merit, it is perhaps useful to note what Knapp and Innes thought about the private credit money side of the financial system.

Knapp does not focus on this area, perhaps in part why subsequent neo-chartalist developments did not either. The most interesting passage in Knapp on the subject may be the following:

  “It is a great favour to the banking world that the State permits the issue of [bank] notes. As is well known, other business men may not issue notes, or private till-warrants. Certainly the State also controls the business by law, for it rightly counts it of public utility. But it is nevertheless remarkable that the profits which are increased by this means, of a magnitude only explainable by the note issue, should flow exclusively to the owners of the capital. The State is giving to the holders of bank shares a means of increasing their profits which it absolutely denies to other businesses.” (Knapp 1924 [1905], 136-137)

It seems somewhat surprising that many (by no means all) of the others who built on Knapp’s work did not focus more on integrating this “remarkable” “great favour” of the state to “the owners of capital” and the social and systemic implications for a state theory of money (again, some have; I think not enough).

ON INNES

Innes, of course, wrote from within the Anglo-American financial milieu, and, it is important to remember, immediately after the creation of the Federal Reserve and under the gold standard.

In his two influential papers (1913, 1914) in The Banking Law Journal he develops the credit theory of money which Wray (Wray, working paper**) and others show is consistent with and reinforces Knapp’s state theory of money. Innes only turns his attention to private credit money at the end of the second paper (1914).

Innes, before considering private credit money, discusses a mechanism for inflation of state money under the gold standard. He then goes on to argue that the system where government money is leveraged by private credit money creation amplifies this inflation significantly, and that this is “by far the most important factor” in inflation. (Innes uses the common yet mistaken “fractional reserve” argument for how this leveraging occurs. Considering how common this mistake is, and that he was writing only 1 year after the creation of the Fed, this is understandable in his case).

In my opinion it is difficult to tell where Innes is laying the blame here (and he warns that he does not fully understand this area of money). He uses the term “redundant currencies” several times (all quotes from Innes are from Innes 1914, p. 166-167), which implies he thinks that this mixed system is somehow flawed. It seems, however, that in one case the “redundant currency” is private money, and in another use, it is state money.

Innes makes clear, (in his notes and several other places) that he views private money creation as a natural state of affairs, although he also seems to see the modern mixing of the two systems as possibly problematic (“in old days…it was easy to draw a sharp distinction between government money and bank money”). He also, however, implies that it is merely the way the system is being used (“ignorance of the principles of sound money”) that may be the problem.

As mentioned, Innes cites “this redundant currency” in a way that it seems he is referring to private credit money in the first use. But in the second use of “redundant currency” he seems to be referring to HPM (state money) – a “redundant currency operates to inflate bank loans in two ways, firstly, by serving as a ‘basis’ of loans” (Innes is assuming a loanable funds system).

At any rate, I do not want to make a claim that Innes was against either state (in favor of some kind of free banking) or private money (in favor of some kind of narrow banking system that would soon be in vogue – e.g., by Soddy, The Chicago Plan, Fisher etc.).

But it is clear that Innes saw the state/private hybrid system, as it was in his time, as deeply problematic and the root of inflation.

“Just as the inflation of government money leads to inflation of bank money, so, no doubt, the inflation of bank money leads to excessive indebtedness of private dealers, as between each other. The stream of debt widens more and more as it flows.

That such a situation must bring about a general decline in the value of money, few will be found to deny. But if we are asked to explain exactly how a general excess of debts and credits produces this result, we must admit that we cannot explain. ” (Innes 1914, 166)

I do not want to misrepresent Innes, so I include the entire passage below, with what I see as some of the more relevant parts in bold. I do want to make clear that I am not making, nor do I think Innes actually meant to make, an anti-Fractional Reserve argument, but rather, had he understood that loans create deposits and reserves are not of much importance, Innes would simply have stated his concerns as being about the relation of private to state money.

“Again in old days the financial straits of the governments were well known to the bankers and merchants, who knew too that every issue of tokens would before long be followed by an arbitrary reduction of their value. Under these circumstances no banker in his senses would take them at their full nominal value, and it was easy to draw a sharp distinction between government money and bank money. To-day, however, we are not aware that there is anything wrong with our currency. On the contrary, we have full confidence in it, and believe our system to be the only sound and perfect one, and there is thus no ground for discriminating against government issues. We are not aware that government money is government debt, and so far from our legislators realizing that the issue of additional money is an increase of an already inflated floating debt, Congress, by the new Federal Reserve Act, proposes to issue a large quantity of fresh obligations, in the belief that so long as they are redeemable in gold coin, there is nothing to fear.

But by far the most important factor in the situation is the law which provides that banks shall keep 15 or 20 or 25 per cent, (as the case may be) of their liabilities in government currency. The effect of this law has been to spread the idea that the banks can properly go on lending to any amount, provided that they keep this legal reserve, and thus the more the currency is inflated, the greater become the obligations of the banks. The, importance of this consideration cannot be too earnestly impressed on the public attention. The law which was presumably intended as a limitation of the lending power of the banks has, through ignorance of the principles of sound money, actually become the main cause of over-lending, the prime factor in the rise of prices. Each new inflation of the government debt induces an excess of banking loans four or five times as great as the government debt created. Millions of dollars worth of this redundant currency are daily used in the payment of bank balances; indeed millions of it are used for no other purpose. They lie in the vaults of the New York Clearing House, and the right to them is transferred by certificates. These certificates “font la navette” as the French say. They go to and fro, backwards and forwards from bank to bank, weaving the air.

The payment of clearing house balances in this way could not occur unless the currency were redundant: It is not really payment at all, it is a purely fictitious operation, the substitution of a debt due by the government for a debt due by a bank. Payment involves complete cancellation of two debts and two credits, and this cancellation is the only legitimate way of paying clearing house debts.

The existence, therefore, of a redundant currency operates to inflate bank loans in two ways, firstly, by serving as a “basis” of loans and secondly by serving as a means of paying clearing house balances. Over ten million dollars have been paid in one day by one bank by a transfer of government money in payment of an adverse clearing house balance inNew York.

Just as the inflation of government money leads to inflation of bank money, so, no doubt, the inflation of bank money leads to excessive indebtedness of private dealers, as between each other. The stream of debt widens more and more as it flows.

That such a situation must bring about a general decline in the value of money, few will be found to deny. But if we are asked to explain exactly how a general excess of debts and credits produces this result, we must admit that we cannot explain. (Innes, 1914, 166-167)

Again, I am not sure on how precisely to interpret Innes’ argument or intentions here. He clearly felt something was wrong with the system but, as he says, he is not entirely sure what. Had Innes lived to see the demise of the gold standard and other developments in the financial sector, one can’t help but wonder what he might have thought about state money, private bank credit money, inflation, and financial instability.

 ~~~

* Although it seems his correct name was Aflred Mitchell-Innes, references to him as both Mitchell-Innes and Mitchell Innes can be found. Innes’ original Banking Law Journal articles did not use a hyphen, and in them, Innes allows himself to be addressed in a letter as “Mr. Innes”, so I will use the shorter of the two.

** L. Randall Wray.  “The Credit money, state money, and endogenous money approaches: A survey and attempted integration.”

Knapp, Georg Friedrich. (1924 [1905]. The State Theory of Money. Clifton: Augustus M. Kelley.

Mitchell-Innes, Alfred (1914), ‘The credit theory of money’,  Banking Law Journal, (Dec/Jan.), 151-68.

(Next post – TOWARDS A PURE STATE THEORY OF MONEY)