When high rates of inflation are anticipated, people wisely avoid holding paper money. As I said in my Ely lecture in 2004, “the demand for money today depends upon expectations of our collective decisions about the supply of money tomorrow.” In the twentieth century Germans saw their savings wiped out by hyperinflation. And as recently as 1990, Argentina experienced hyperinflation. I have been told that when people gave up using paper money in Argentina, they resorted to IOUs which were taken to the local Catholic priest for endorsement. Those IOUs were trusted because to renege on a promise endorsed by the priest would have very serious consequences, whether in this life or the next. It is sometimes tempting – as the examples of the Jacobins, Germany and Argentina show – for issuers of money to issue too much of it: cheap money and plenty of it, as the saying goes. 18 A public monopoly of paper money raises the question of how can we prevent the institution managing that money from abusing its issuing power. We cannot commit future generations – or even ourselves – to a particular policy. So how can we design an institution to create the reasonable expectation that money will retain its value? In 1997 a new institution – the Monetary Policy Committee of an independent Bank of England – was set up. And for the past decade inflation has been low and stable and economic growth more stable than at any time in living memory.
Coase understood the existence of firms to be a manifestation of how market based exchange between employers and employees was not efficient (see his 1991 Nobel lecture, for example). More recently, economists like Kiyotaki and Moore (an example is their 2002 paper) and many others have built models in which debt markets are incomplete because it is costly to enforce contracts, and which constrain the amount individuals can credibly borrow and pay back. These models can also be used to explain how money comes to exist, as I discuss below. Another body of work that seeks to study the institutions that underpin market exchange is the subject that has come to be known as 'law and economics'. Scholars in this field study the economic origins and consequences of the legal system. See, for example, many works by Gary Becker, Ronald Coase and Richard Posner. BIS Review 102/2006  3  laws, and to abolish the unhelpful ones. And it is that challenge of institutional design to which I now want to turn. As Governor of the Bank of England, you will not be surprised to learn that money is a social institution close to my heart. It is crucial in facilitating exchange and therefore, in allowing the division of labour.