Upon reflecting on the history of monetary thought, Perry Mehrling, professor of economics at Barnard College in New York City, asserts that it is largely “a dialogue between two points of view, often distinguished as the Currency School versus the Banking School.” In one historical episode, it was the respective advocates of these competing schools of thought that butted heads in the controversy leading up to the English Bank Charter Act of 1844, an act that would give exclusive power of note-issuance to the Bank of England (BoE).

But, rather than being competing theories, it is perhaps best to see these schools of thought, or their respective principles of note issuance, as complementary. For both the currency principle and the banking principle illustrate aspects of currency issuance that goes to the heart of understanding money’s three basic functions: i) store of value; ii) medium of exchange; iii) and unit of account.

The Currency Principle

Advocates of the currency principle were motivated by the fear of the over-issuance of notes that they believed would surely accompany a paper currency as opposed to a metallic one. A legal tender paper currency was fine insofar as it was fully convertible to a metallic standard. Whereas the supply of paper notes depended only on the fancy of those supplying the notes, the supply of precious metals was regulated by real factors of production, which could not be arbitrarily increased.

By issuing notes at a rate that matched the increase in supply of the metallic standard, the scarcity, and thereby the value of money, could be protected. Over-issuance of notes violated the natural scarcity that accompanied precious metals, and would thus erode the value of money through inflation and consequently the people’s trust in the currency. (For more, see: Understand the Different Types of Inflation.)

To a certain extent, the advocates of the currency principle were right, but by overemphasizing the importance of scarcity, they were neglecting the fact that money needs to be flexible enough to meet the needs of trade and industry.

The Banking Principle

It is this point on the need for flexibility, or what economists call elasticity, that the advocates of the banking principle understood well. Full currency convertibility is unnecessary and even detrimental to economic growth as it restricts the primary means by which trade and industry carry out their daily business. An inelastic currency that fails to expand to the needs of trade will act as a headwind on economic activity.

In order to avoid this headwind, advocates of the banking principle argue that rather than note issuance being regulated by the physical supply of the metallic standard, it should be regulated by banks’ assessment of the needs of productive industries. By issuing notes for the use of productive economic activity the supply of money can increase concomitantly with real goods, thus avoiding the inflationary problem of too much money chasing too few goods.

As for maintaining the credibility of the notes, this could be achieved by at least guaranteeing the convertibility of notes into the metallic standard. Of course, the amount of the metallic standard would only be a fraction of the actual amount of notes issued as their supply is regulated by the needs of trade. Any over-issuance of notes above those needs would lead to the notes being redeemed for the metallic standard; so long as not all notes were thus redeemed the system could operate effectively.

The only problem was that, if for whatever reason the public lost confidence in the currency leading to a run on the banks, convertibility would have to be suspended for the simple fact that their would not be enough metal in the banks’ vaults for all notes to be redeemed. Such a scenario would reinforce the public’s distrust of the currency and have the currency principle advocates smugly stating, “we told you so.”

Monetary Lessons for a Fiat Currency World

While these separate schools of thought arose in the context of the gold standard, their respective emphases on scarcity and elasticity and the tension between them still exist in a fiat currency dominated world. That is because scarcity and elasticity are important features of any monetary system as they highlight some of money’s most important functions.

Firstly, taking money’s function as a store of value, it is understandable why the currency principle advocates wished to protect the scarcity of money by maintaining full convertibility. Issuing notes without any hard limit, they believed, would likely lead to a limitless increase in the currency and inflation would ensue. Inflation erodes the value of money, thus making it a poor store of value.

On the other hand, money must also function as a medium of exchange to facilitate economic transactions. An inelastic currency that fails to expand to the needs of trade does not facilitate transactions and could actually begin to hinder them. If the public begins to feel that the medium of exchange is becoming too scarce this can lead them to begin to hoard it, thus depressing economic activity even further. Deflation results as people no longer want to use the currency to make payments but as a way to store value. (For related reading, see: The Dangers of Deflation.)

As for a currency’s ability to fulfill the third function of money, as a unit of account, this will in part depend on how well it fulfills the other functions. Both inflation and deflation imply that the unit of account is constantly being adjusted. The faster the rate of price rises or declines, the more unstable the unit of account becomes in its ability to measure value. This of course, is why central banks tend to set price stability—usually translated as a low but stable inflation target—as their primary policy objective.

The Bottom Line

Far from being old arguments from a bygone gold standard era, the currency principle and banking principle highlight the importance of money’s core functions and what is required to maintain a stable monetary system. Becoming familiar with these schools of thought helps to understand the current challenges that face today’s monetary authorities.

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