Knapp: what makes bank money state money?

[Mathew Forstater <forstate@xxxxxxxx>]

Knapp and the State Theory of Money

Georg Friedrich Knapp put forward a state theory of money, similar to, but
more general than, what is now known as the Chartalist approach. This
approach is opposed to the Metallist view, according to which the value of
money derives from the value of the metal standard (eg, gold or silver)
adopted. More generally, according to Knapp, Metallists try to "deduce"
the monetary system "without the idea of a State". This, he believes, is
"absurd" for "the money of a state" is that which is "accepted at the
public pay offices". (Knapp 1924: vii-viii) It is thus impossible to
separate the theory of money from the theory of the state. Knapp's
exposition is quite complex and required the creation of a classificatory
scheme with hundreds of terms. We will try to keep our summary quite
simple; to some extent we will have to paraphrase rather than use
extensive quotes for otherwise we would have to define the numerous terms
he created.

Knapp noted that his approach was shaped by the view that "the use of
paper money was based on credit". (Knapp 1924:vi) As such, he was
concerned initially with debts, means of payment, and units of value. The
means of payment was defined as "a movable thing which has the legal
property of being the bearer of units of value" (Knapp 1924:7), while the
"unit of value is nothing but the unit in which the amount of the payment
is expressed" (Knapp 1924:8). Debts are expressed in units of value and
discharged with means of payment. What, then, determines which things will
act as means of payment to discharge debts? Knapp noticed that means of
payment are occasionally changed; sometimes one type of material (say,
weighed or coined gold) has been accepted but "suddenly" another (say,
weighed or coined silver) takes its place. Therefore, while the means of
payment may be a definite material, it is not bound to any particular
material for it may be changed. (Knapp 1924: 8-25) "A proclamation is made
that a piece of such and such a description shall be valid as so many
units of value." (Knapp 1924:30) "Validity by proclamation is not bound to
any material. It can occur with the most precious or the basest metals,
and in all cases where payments are not pensatory [that is, where the
value of the money material is not calculated by weighing it], i.e. in all
modern monetary systems." (Knapp 1924:30) The fundamental insight was his
recognition that these transitions always require that the State announce
a conversion rate (say, so many ounces of gold for so many ounces of
silver). This proves that the debts were always nominal and were never
actually "metallic": all debts are converted to the new metal, which
proves that all units of account must be nominal. Hence, the Chartalist,
and more specifically, State theory of money, since the proclamation is
made by the State.

Knapp examined the transition from use of weights of gold, to stamped
coins that are weighed to determine value, to stamped coins that are
accepted at face value, and finally to paper money; he found that the
State played the major role in much of this transformation--but we shall
skip this historical evolution. We will begin with the modern system,
where Chartal money has developed.

"When we give up our coats in the cloak-room of a theatre, we receive a
tin disc of a given size bearing a sign, perhaps a number. There is
nothing more on it, but this ticket or mark has legal significance; it is
a proof that I am entitled to demand the return of my coat. When we send
letters, we affix a stamp or a ticket which proves that we have by payment
of postage obtained the right to get the letter carried. The "ticket" is
then a good expression....for a movable, shaped object bearing signs, to
which legal ordinance gives a use independent of its material. Our means
of payment, then, whether coins or warrants, possess the above-named
qualities: they are pay-tokens, or tickets used as means of payment....
Perhaps the Latin word 'Charta' can bear the sense of ticket or token, and
we can form a new but intelligible adjective--'Chartal.' Our means of
payment have this token, or Chartal, form. Among civilized peoples in our
day, payments can only be made with pay-tickets or Chartal pieces." (Knapp
1924:31-32)

Note that like the tin disc issued by the cloakroom, the material used to
manufacture the Chartal pieces is wholly irrelevant--it can be gold,
silver, or common metal; it can be paper.

"It is, therefore, impossible to tell from the pieces themselves whether
they are Chartal or not. This is at once evident in the case of warrants.
As to coins, we must always refer to the Acts and Statutes, which alone
can give information.... if the pieces gain their validity through
proclamation, they are Chartal. Chartality, then, is simply the use in
accordance with proclamation of certain means of payment having a visible
shape." (Knapp 1924:34-35) Finally, "Money always signifies a Chartal
means of payment. Every means of payment we call money. The definition of
money is therefore 'a Chartal means of payment'". (Knapp 1924:38)

Knapp's explanation may appear to be nothing more than the claim that
legal tender laws determine that which must be accepted as means of
payment, and as well determine the value of the means of payment. However,
his analysis went further.

"The State as guardian of the law declares that the property of being the
means of payment should be inherent in certain stamped pieces as such, and
not in the material of the pieces. In this case also juridical reflection
goes to work and creates the concept of the pay-token or ticket, not from
caprice but because it must accommodate itself to the altered
situation.... The State, not the jurist, creates it." (Knapp 1924:39)
"If we have already declared in the beginning that money is a creation of
law, this is not to be interpreted in the narrower sense that it is a
creation of jurisprudence, but in the larger sense that it is a creation
of the legislative activity of the State, a creation of legislative
policy." (Knapp 1924:40)

And what is the nature of this "legislative activity" that determines what
will be the Chartalist money accepted within the jurisdiction of the
State?

"What forms part of the monetary system of the State and what does not? We
must not make our definition too narrow. The criterion cannot be that the
money is issued by the State, for that would exclude kinds of money which
are of the highest importance; I refer to bank-notes: they are not issued
by the State, but they form a part of its monetary system. Nor can legal
tender be taken as the test, for in monetary systems there are very
frequently kinds of money which are not legal tender... We keep most
closely to the facts if we take as our test, that the money is accepted in
payments made to the State's offices. Then all means by which a payment
can be made to the State form part of the monetary system. On this basis
it is not the issue, but the acceptation, as we call it, which is
decisive.. State acceptation delimits the monetary system. By the
expression 'State-acceptation' is to be understood only the acceptance at
State pay offices where the State is the recipient." (Knapp 1924:95)

Thus, it is the decision of the State to accept at State pay offices, and
not legal tender laws, that creates a chartal money.

According to Knapp, "centric" payments, or those involving the State, are
decisive; these take the form of either (1) "payments to the State as
receiver; these we call epicentric" or (2) "payments made by the State,
these we will call apocentric". (Knapp 1924:96-97) On the other hand
payments between private persons ("paracentric") "are not so important as
is generally supposed, for they mostly, so to speak, regulate themselves".
(Knapp 1924:96) Indeed, the actions of the state play a large role in
determining that which will serve as ("paracentric") means of payment in
private transactions.

"In the monetary system of a State there must be one kind of money which
is definitive, as opposed to provisional (convertible) money. ... Money is
definitive if, when payment is made in it, the business is completely
concluded...The payer is no longer under an obligation, the recipient has
no further rights either against the payer or against the State, if the
State has issued the money." (Knapp 1924:102)
"That kind of definitive money which is always kept ready and can be
insisted on for apocentric payments [payments made by the State] ... we
call valuta; all other kinds of money...we call accessory." (Knapp
1924:105)

The definitive, or valuta, money is that in which the State makes
payments, and that which the State insists it will accept at pay offices
and provide in payment.

"In Germany our gold pieces were valuta, not because they were made of
gold...but only because the State, when it made a payment, was ready in
the last resort to pay in gold pieces, and, if it found it at all
inconvenient, totally to refuse any other means of payment which the
recipient might happen to want." (Knapp 1924:107)

However, once the State has decided to accept one type of money as
"valuta", then that type will become the "decisive" money used in private
transactions.

"So, if from political necessity the State announces that henceforth it
will pay in State notes, as fountain of law it must equally allow the
State notes to suffice for other payments.... The consequence is, in a
legal dispute the means of payment which the creditor is compelled to
accept is always that which the State has put in the position of
valuta.... Apart from friendly agreement, all payments eventually have to
be made in valuta money." (Knapp 1924:110)

Thus, it is not simply a "legal tender" law that makes State notes
acceptable in private transactions, but it is the fact that the State
first decides what it will use or accept as money in its own transactions,
and the fact that this must then be acceptable as means of settlement of
private debts. "The laws do not decide what shall be valuta money, they
merely express a pious hope, for they are powerless against their creator,
the State; the State in its payments decides what is valuta money and the
Law Courts follow suit." (Knapp 1924:111)

As Knapp noted, State money need not be issued by the State, indeed, most
State money in the modern economy is issued by banks--originally bank
notes (but today, bank deposits)--as they "buy assets", or make loans.

"The bank makes notes and offers them in payment to its customers. Issuing
notes is not a special business...but a special way in which the bank
endeavours to make its payments.... It tries to pay in its own notes
instead of in money issued by the State, because then with a comparatively
small capital it can make greater profits than it otherwise could." (Knapp
1924:131) Acceptability of bank notes in private transactions is not (as
was commonly believed) due to the bank promise to convert these to specie.
In other words, bank money did not derive its value from the gold reserves
or specie coin, or even valuta money, into which it promised redemption.
"A bank-note is a chartal document, which specifies a sum of valuta money;
and the bank issuing it is pledged by law to accept it for a payment of
that amount." (Knapp 1924:134) Whether bank notes are convertible or
redeemable is irrelevant. "An inconvertible bank-note, then, is not a
nullity, but has this in common with the convertible bank-note, that it is
a till-warrant of the bank." (Knapp 1924:134) What is important is that
the note "is a private till-warrant available for payments to the
bank....but clearly the customers of the bank can use it for payments
between themselves, as they are sure it will be taken at the bank. These
customers and the bank form, so to speak, a private pay community; the
public pay community is the State." (Knapp 1924:134) Within the "private
pay community" (or "Giro"), bank money is the primary money used in
payments; however, payments in the "public pay community" require State
money--that which is accepted by the State. This can include bank money,
but note that generally delivery of bank money to the State is not "final"
because the State will present it to banks for "redemption". Bank money
when used in the public pay community is not "final, definitive, valuta"
money unless the State also uses it in its own purchases. Knapp goes
further than Smith in his recognition that banknotes do not derive their
value from the reserves (whether gold or government fiat money) held for
conversion, but rather from their use in the "private pay community" and
"public pay community"; this, in turn, is a function of "acceptation" at
the bank and public pay offices.

What makes bank notes State money? "Bank-notes are not automatically money
of the State, but they become so as soon as the State announces that it
will receive them in epicentric payments [payments to the State]." (Knapp
1924:135) If the State accepts notes in payment to the State, then the
bank notes become "accessory" and the business of the bank is enhanced
"for now everybody is glad to take its bank-notes since all inhabitants of
the State have occasion to make epicentric payments (e.g. for taxes)."
(Knapp 1924:137) The bank notes then become "valuta" money if the State
takes the next step and makes "apocentric payments [payments by the State]
in bank-notes". (Knapp 1924:138) However, States often required that banks
make their notes convertible to State-issued money "one of the measures by
means of which the State assures a superior position to the money which it
issues itself" (Knapp 1924:140), and thus maintained bank notes in the
role of accessory money (rather than allowing them to become valuta
money). If the State accepts bank notes in payment, but does not make
payments in these bank notes, then the notes will be redeemed at
banks--leading to a drain of "reserves" of valuta money (indeed,
governments and central banks used redemption or threat of redemption to
"discipline" banks).

In times of distress (frequently during wars that required finance
provided by banks), however, governments would pass laws ending
convertibility, announce that the State would henceforth make payments in
terms of the bank notes, and thereby declare that the bank notes were
valuta money. (Knapp 1924:143) Usually, this was for one bank only--the
bank which became the central bank. "The change from one kind of valuta
money to another can only come by the will of the State, valuta meaning
the kind of money with which the State makes its apocentric payments."
(Knapp 1924:194) Through action of the State, then, paper money can become
valuta money. "At first bank-notes and Treasury notes are employed only as
accessory money. ... The mournful hour arrives when the State has to
announce that it can no longer pay in the money that was till then valuta
[say, coined gold] and that those warrants themselves are now valuta."
(Knapp 1924:196) This often comes after the bank has purchased government
debt and issued notes that promised conversion; in times of war or other
distress, the government would "encourage" banks to issue far more notes
(to "finance" government spending) than they could conceivably convert.
Thus, suspension of convertibility served the interests of government as
well as the bank.

At this point we have a Chartalist, nonconvertible, paper money, as do all
modern developed countries. Of course, this extreme development came
nearly three-quarters of a century after Knapp's book was first published
(1905). However, he had recognized that the money of a State did not
derive its value from metal, and indeed, that no metal was needed
domestically. He did argue, on the other hand, that "To dispense with
specie money altogether would only be possible for very large federations
of States, [and, therefore, is] probably impracticable. On account of
foreign trade specie money is still necessary." (Knapp 1924:xv) Within a
State, however, specie is not necessary for "State money may be recognised
by the fact that it is accepted in payment by the State"; as Keynes said
(see below), the State not only enforces the dictionary (legal tender
laws) but writes it (decides what is to be accepted as money). Of course,
the type of monetary system envisioned by Knapp is similar to the one
adopted shortly thereafter by the US: a "gold standard" without domestic
convertibility, but with a specie reserve to satisfy international
purposes. Knapp did not foresee the time when metals could be dropped
altogether in favor of foreign currency reserves and flexible exchange
rates.

It can be seen that Knapp's analysis is consistent with Smith's. Most
paper money (today, mostly deposits) is privately issued and derives its
value not from a promise of redeemability but rather from State acceptance
at pay offices. Knapp goes further, for he argues the State eventually
realizes (usually during a crisis) that it can also make payments in that
which it promises to accept at pay offices. Once freed from domestic
convertibility on a metallic standard, the State's spending domestically
would not be constrained by the quantity of the metal available.
Abandonment of the metallic standard internationally would eliminate
metallic constraints on countries.