LeoGlossary: Monetary System
A monetary system is a set of institutions along with procedures that facilitate monetary exchange. This includes both money and payment systems. It details how money is created, distributed, used and regulated within the economy.
Money is a crucial component of economic activity and a barometer on a nation's financial health.
Over time, with advancements in technology, money changed. This led to the altering of the monetary system. It is the evolution of these systems that allow for the growth rates we see economically. Ultimately, it leads to greater wealth generation as it facilitates more business and commercial activity.
Components To A Monetary System
A monetary system has two basic components. They are:
- accounting
- communications
Regardless of the form of money that is used, this is the basis of any monetary system. It covers all exchange, trades, and settlements.
Accounting
Another word for accounting is ledger.
When it comes to a monetary system, the ledger is crucial. One of the core functions of such a system it to maintain all the transactions and balances related to the money being used.
For example, when one sends fiat currency such as USD from to another account, the ledger is updated, removing the money from the balance of the sender and putting it into the account of the receiver. Of course, in our central banking system, there are also ledgers that maintain the settlements between the individual banks.
Another key role for the accounting mechanism is ensuring there is no double spending. A monetary system that allows the same money to be spent more than once in a transaction obviously would collapse rather quickly. Ledgers ensure that once money leaves an account, the debit is made to reflect that. Thus, if the person tries to spend it again, the system would come back with an invalid transaction (non-sufficient funds).
Under fractional reserve banking, which most of the global economy presently operates, we see how accounting is crucial. Most of the money we use is commercial bank money, or the digital version of the banknotes from the central banks. Under this scenario, the money supply is expanded through the creation of loans. This is an accounting function as a credit is added to the account of the borrower. This expands the money supply. Of course, due to double entry accounting, the asset is immediately offset by a liability, in this instance the note on the mortgage or whatever the debt is.
This is what is often referred to as a debt based monetary system since the money is created through liabilities.
Communications
Most people overlook the fact that much of our monetary system revolves around communications. For years, these were electronic networks interconnected by the various parties. Today, these moved into the digital realm, resembling computer networks.
The importance of communications cannot be stressed enough. With our global monetary system, we have a variety of networks put together by the various financial institutions, all running their own ledgers.
Communications is so important that when the West wants to sanction a country, one of the first things they threaten is to have their banks removed from the SWIFT network. This is an indication of what our monetary system is since this is not a settlement service. Instead, it is a messenger system that notifies the different financial services entities of what is taking place.
Without that, an institution will be left in the dark regarding transactions that are occurring. To keep a ledger up to date, one needs the data. This is transmitted around the world via these networks.
Get kicked off the network and basically the monetary system, or at least part of it, is cut off.
The global economy is such that we have tens of trillions of dollars in transactions occurring each day. In payments alone there are an estimates 2 billion made on a daily basis. Much of the monetary and economic advancement that was made the last half century is due to the improvements in the global communication systems that we utilize.
Types of Money
People typically like to break up money into commodity, commodity based, and fiat money. However, this is lacking in how we truly operate today. However, from a historical perspective, let's define them.
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Commodity - here the money is a commodity, usually a precious metal such as gold or silver. Under this system, the money has intrinsic value even if it was not used as a medium of exchange.
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Commodity-Based - the money is based upon a commodity yet is not used as the medium of exchange. Instead, there is some form of paper or specie that is used in its place. Essentially the commodity is the measure of value.
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Fiat Currency - this is where coins or paper is issued without a backing (reserve) and given the status by a government of legal tender. This means everyone under that jurisdiction is required to accept the money as payment on debts. Governments will also accept it for taxes.
All of these utilize the components of a monetary system. In dealing with physical money, the accounting is simply the amount one has in his or her possession. As for the communication, it happens in person, and in real time, when the money is handed over.
Under this scenario, settlement is obviously done as soon as the receiver has cash in hand. The accounting would show a debit on the payer's balance sheet where the receiver had a credit.
Things have gotten a bit more complicated since the days of solely physical currency.
- Commercial Bank Money - this is the digital version of a currency, created through loans
- Central Bank Money - these are banknotes, coinage, and reserves on the balance sheets of commercial banks
- Eurodollar System Money - assets that have liquidity, tradeable, and can be used as collateral. They are typically tied to the balance sheets of the banks.
Here we can see that we are dealing with 3 different forms of money utilized by the same financial institutions. Many are operating in each of the arenas requiring the communication with many different networks and the accounting of different ledgers.
The key to all of these systems is the ledgers are centralized.
Cryptocurrency
Cryptocurrency and other digital assets are starting to garner attention as decentralized money. This is nothing new as we can see with Commercial Bank Money. Here we have thousands of institutions around the world creating money. Cryptocurrency simply removes the banks from the equation.
In terms of monetary system, it is blockchain that is the center point. This is a digital accounting and communication system in one. The blockchain utilizes distributed ledger technology meaning that keeps track of all transactions on the network. Where this differs is the nodes maintaining the data are unrelated, resulting in decentralization.
The breakthrough came with the emergence of Bitcoin. Again, while most look at the monetary aspect of the coin, the true advancement was the solving of the double-spend problem without the use of a centralized entity. By using the Proof-of-Work (PoW) consensus mechanism, the system is able to ensure that all balances are available to be spent only once. Anything that disagrees with consensus is disregarded and rejected by the network.
Since these systems are decentralized, wallet utilizing private keys are created. This is similar to an account with a financial institution except there is no company or entity behind it. Hence, the counterparty risk is eliminated since the blockchain is on the other side. As long as the block producers keep validating transactions, and one has the private key, all funds are accessible.
Blockchains are global in nature. Since they are permissionless, anyone is free to join. The infrastructure tends to be run by people all over the world while the users require only an Internet connection. These are monetary systems that are considered inclusive. Many theorize they will eventually eliminate the unbanked and underbanked.
As a monetary system, blockchain is still in its infancy. It does follow the concept of global networks. Like the Eurodollar System, there is a chance these will end up being outside the reach of governments and central banks. Cryptocurrency could end up being a form of money that does penetrate all parts of the world.
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