Definition
Finance is the management of money through banking, asset management (investments), ministries of finance, central banks, and other financial instruments and institutions. Finance thus links people with a surplus of money with those who are in need of money on terms agreeable to both, like the interest paid on a loan or the share of the profit and loss for a more risky equity investment. Central and commercial banks have the ability to create money. Money is often defined by its three key functions: “Medium of Exchange”, “Unit of Account”, and “Store of Value” (see Money).
History
Throughout most of human history, people lived in groups of hunter-gatherers where each contributed according to ability and used according to need. It was only after humans settled that money came into use. The oldest known form of money can be found in clay tablets from Mesopotamia, dating back three thousand years, and used to record stored goods. Money is thus inextricably linked to the concept of debt. Owning money makes one a creditor, and hence someone else a debtor, who needs to do or give something to get even.
Since then, humanity has had an ambiguous relationship with money, debt, and the inequalities it gave rise to. Hence, for instance, the Jubilee Year developed as a periodic forgiveness in which all debts were forgiven. By the end of the second millennium BC, the Jubilee was scarcely practiced, hurting the general population and contributing to the “Bronze Age collapse”. This illustrates the great importance of society’s rules around money.
A Biblical prohibition of interest followed that lasted three thousand years. During the Enlightenment, the taboo on interest was lifted, giving way to the modern era of banking. For centuries, there have been various combinations of public and private money creation and rules for private money creation. Historically, from the 8th century BC when the first coinage was introduced, it was usually the sovereign who had the right to create this money. As coins were increasingly deposited at central and commercial banks, the paper proof of deposit also came into use as money. Because generally not all the coins were withdrawn at once, banks could issue more of this paper money. Thus banks also became money-creating institutions.
The current organization of the global banking sector arose after the financial crisis of 1929, in part caused by commercial banks creating too much money. The deep economic crisis that followed gave way to experiments and fundamental reform proposals (see Box 47.1). However, this was to no avail. Commercial banks even got an explicit guarantee from the state for their deposits, alongside an increase in regulation and supervision.
Box 47.1. The 1930s experiment and proposal that could have changed finance
In 1931, a historic monetary experiment took place in the Austrian village of Wörgl. Here, the municipal treasury was empty, as were the wallets of its inhabitants. The mayor initiated a system where the national currency, the Schilling, was exchanged for municipal vouchers with a negative interest rate of 1% per month. This stimulated the inhabitants to start spending their money, using the economic capacities of their neighbors who were lying idle. Suddenly there was plenty of economic activity again. And while unemployment continued to rise throughout Austria, it fell by 25% in Wörgl. The municipality was able to make additional expenditures: all houses were given a drinking water network connection, a new bridge was built, and even a ski jump. All this happened before the Austrian central bank ended the experiment (van Arkel, 2024).
On the other side of the Atlantic Ocean, in 1933, an equally bold plan was launched by some of the most prominent US economists of that time. The so-called Chicago Plan proposed to strip commercial banks of the possibility to create money through their lending. Such “full reserve” banks would essentially become asset managers that need to attract funds before they can be lent out again. Thus the public central bank would become the only money-creating institution, as it has been throughout a large part of history.
After the 2008 financial crisis, we witnessed a rerun of the discussion of the 1930s, with a similar outcome. Commercial banks are still the main money creators in the world economy (WRR, 2019). Next to banks, pension savings and growing inequality have led to a globally concentrated asset management industry that owns most companies. A handful of asset managers thus set the tone in the real economy, pushing relentlessly for the maximization of short-term profits.
Different Perspectives
Money and finance are relevant for sustainable consumption in two ways: first, as an enabler of the investments needed to make consumption sustainable, like in renewable energy capacity and the circular economy (see Energy Consumption Behavior, Energy Overshoot); and, secondly, finance can also play a less helpful role, providing a growth imperative, pressuring debtors to increase their income so they can pay the interest on their loans, or pressuring companies to increase their profits to satisfy their shareholders (see The Role of Business). This fuels the economic system to create new needs to be satisfied through economic growth.
Five thousand years of monetary history teaches us that finance can be organized in very different ways. The dominance of the current monetary and financial system by private financial institutions is historically an outlier. Whereas this system has been effective in growing financial capital (the value of the stock market is now a hundred times bigger than it was 50 years ago), this has come at too high a natural and social cost. It has become counterproductive, now that the economy needs to be brought within the planetary boundaries and work for all people (see Doughnut Economics, Fair Consumption Space). We seem stuck with a monetary system that is geared toward further growing financial capital, while the essential scarcities for human well-being are in natural and social capital (see Well-being Economy).
This is widely acknowledged. The main controversy seems to be whether reform of private finance will suffice, or whether public money creation is also needed.
Application
Sustainable consumption and lifestyles can be enabled through respective financing, for example, structural changes and complementary behavioral interventions. There is much that can be done along the lines of reform. Recent EU legislation on capital regulation (CRR/CRD), reporting (CSRD), and due diligence (CS3D) obliges banks to present transition plans that show how they will make their balance sheet aligned with the Paris Climate Accord. This way banks need to reduce their lending to harmful projects and increase their lending to households and companies for more sustainable consumption and production. Supervisors can also press asset owners, like pension funds and insurance companies, and their asset managers to draft transition plans (e.g., toward Socially Responsible Investing [SRI]). This will diminish the shareholder pressure for short-term profit at the expense of social and ecological values.
Sustainable finance, according to an EU definition, refers to the process of taking environmental, social, and governance (ESG) considerations into account for investment decisions so that these lead to more long-term investments in sustainable economic activities and projects. However, it is unlikely that this will be enough to bring the economy back within the planetary boundaries fast enough. For this, the unpriced externalities are too large and the wealth of a large part of the world is simply too small (see Climate Justice). Saving the world is simply not profitable.
This is where public finance needs to step in. All through history, central banks have created money if needed. Examples include the Bank of Venice being set up to finance the Crusade of Pope Urban the Second in 1157 and the Bank of England, founded in 1694 as a result of the deteriorating state of government coffers during the Nine Years War with France (1688–1697). In response to the Euro crisis, the ECB expanded its balance sheet, buying mostly government debt with no less than 6,000 billion newly created euros. Most recently, during the COVID crisis, the IMF created 650 billion US dollars worth of Special Drawing Rights (SDRs). New issuances of SDRs can pay for “nature and carbon coins” that also allow emerging economies to make the necessary investments (van Tilburg et al., 2023).
At the local level, local currencies can provide the means to start more sustainable local economies, with exchanges between neighbors and local small- and medium-sized enterprises. These can be designed not to push for ever more growth, for instance through negative interest rates (van Arkel, 2024).
Further Reading
Graeber, D. (2011). Debt: The first 5000 years. London: Melville House Publishing.
Schoenmaker, D., & Schramade, W. (2019). Principles of sustainable finance. Oxford: Oxford University Press.
van Arkel, H. (2024). Boosting your local economy by making money virtuous. Utrecht: Uitgeverij Jan van Arkel.
van Tilburg, R., Simić, A., & Murawski, S. (2023). The climate trillions we need; proposals for a new global financial architecture to end poverty and save the planet. Sustainable Finance Lab, November.
WRR. (2019). Money and debt. Den Haag: Netherlands Scientific Council for Government Policy.