Political economy of finance note #2
This post is part of a series of notes (which begins here) for a two-week intensive course on the political economy of finance that I taught at Al Akhawayn University in Ifrane, Morocco. Each note looks at a political-economic concept and an institutional structure. The notes are the skeleton of the course, fleshed out in the classroom with lectures, analytical techniques, discussions and supplementary texts.
Credit, a lender’s belief that a borrower will pay them back, has a major effect on economic activity. A lender’s expectation that debt will eventually be repaid pins down a certain vision of the future; with that imagined future in mind, the lender makes other economic plans accordingly. By connecting the past to the present to the future, credit relations give continuity to economic life from one day to the next, and from one year to the next.
The mechanics of settlement
This is not just a metaphor, it is a quite concrete description of how settlement works. To see this more clearly, we should focus on the mechanical aspects of settlement. Let us place exactly at the moment when a debt must be settled, at the precise time at which a borrower must fulfill the obligations of the promise they have made. What happens next?
The T accounts below show how banks create liabilities that serve as a settlement medium. Initially, a credit relationship exists between two entities, a borrower and a lender. Since we are imagining that the debt is now due, we can call it payable from the point of view of the borrower, and receivable from the point of view of the lender. This initial state of affairs is shown in row (1) of the balance sheets below:
To make the point as stark as possible, suppose further that the borrower doesn’t have money on hand. Then how can the debt be paid? The money must be borrowed. Banks specialize in lending money, and so a borrower who needs to pay might very reasonably turn to their bank in order to make a payment. In step (2), the borrower takes on a new liability, let’s say a bond, and sells it to the bank. The bank, in turn, creates a new deposit liability, which is an asset to the borrower. Note that two new credit relationships have been created: the borrower has issued a bond, which is a promise to pay the bank in the future; the bank has created a deposit, which is a promise to pay the borrower on demand.
Deposit money is the usual bank money that we transact with all the time. The borrower can transfer its new deposit to the lender, using the usual payment system. The lender accepts the money as payment of the outstanding debt, which is destroyed, as shown in step (3).
The meaning of settlement
What has happened? Step (4) shows the ending positions. This picture of settlement raises some questions. For one thing, the borrower still owes money: instead of a debt payable to its original lender, now it owes money on a bond, held by the bank. But the two debts are different—the payable was due today, while the bond is due in 30 days, or in five years, or in ten years. The borrower has bought some time—neither more nor less than that.
What about the lender? At the beginning, the lender held the borrower’s credit; at the end, the lender holds the bank’s credit—one debt has replaced another. But bank credit is different than other credit. The lender will have its own debts to pay, now or in the future, and it can use bank credit—bank deposits—to pay them. The lender accepts bank deposits as payment because it is confident that others will do the same. In short, the bank has good credit, so its liabilities can serve as the medium of settlement.
Hiding here is a bigger idea, one that will be important as we apply these small-scale ideas to bigger questions. Everyone who regards the bank as having good credit will accept its deposits as payment. Those deposits can therefore serve as a single, shared means of settlement among all of those entities. A group within which such settlement habitually occurs is a payment community.
A familiar, material example of a payment community is a currency area—the geographic extent over which a given variety of paper money is accepted. Within the boundaries of nation-states (or a larger currency area such as the Eurozone), this specific set of liabilities serves routinely to clear payments—everyone accepts them because everyone else accepts them. Outside of the payment area, these same liabilities are not money, they are foreign currency, and no good for settling debts.
The financial technique for today’s class is the symmetrical graph of the central bank’s balance sheet, see here for example.
Political economy of finance
Settlement (this post)