Chapter 1
Money, production, and profit
Households, companies, and banks mainly interact the one with the others so as to pay out wages, to transfer monetary savings, as well as to allow for consumption. Wages and corporate gains are the motor driving individuals, companies, and banks to produce, distribute, and purchase the national product. In this context, money is a required component of any economic system. Yet, economists disagree with each other about the way in which economic players interact as well as about the nature of monetary and real incomes. Thus, this chapter shall propose a study of production, consumption, and banking, in hopes of a new consensus on the basic laws underlying economic phenomena. This chapter aims to prepare the ground for a study of corporate profits. In this light, the investigation shall seek to explain the relation between money and the real economy, focusing on productive activities, on consumption, and on the role of commercial banks as intermediaries between households and companies. An inquiry shall also be made about the historical and theoretical scope of central banks, with particular regard to the Bank of England and to the Federal Reserve System. What are the laws of production, consumption, and banking? What are the functions of commercial and central banks? What is the link between households, companies, and banks?
Bank money and the real economy
Production, consumption, and commercial banks
Traditionally, economists have thought of money as the currency in circulation; that is, banknotes and coins. It comes as no surprise, then, that most theories treat money as a physical object. Even at our times, whenever thinking of money, the one-dollar bill springs to mind. However, currency in circulation is just one side of the story. After all, todayâs massive use of electronic means of payment shows that scriptural money is by far larger in amount than banknotes and coins. One can even go further by asserting that some economies are transitioning very quickly toward a cashless future. On this regard, for instance, Sweden is in the lead. As argued by Wheatley (2017) in a study for the International Monetary Fund, banknotes and coins account for only 15% of payments in Sweden, a country where cash is used by less than half of commercial banks and has fallen âby nearly 15 percent between 2007 and 2015. Even homeless sellers of Stockholmâs street magazine accept mobile paymentsâ (Wheatley 2017: 32â3). What is money, then? What relation holds between money and output? What is the relation between money, production, and consumption?
History influenced the general opinion about money. As recalled by Smith in his Wealth of Nations (1776 [1981]: 41), the incomes of the Saxons, in ancient times, did not consist of money, but âin kind, that is, in victuals and provisions of all sortsâ; metal money was started being used only later on, under William the Conqueror. Iron was already used by the inhabitants of Sparta to facilitate the commerce of goods, and it was Servio Tullio who first coined money in Rome, using âa Roman pound of good copperâ (Smith 1776 [1981]: 42). Also, at the time of Alexander the First, the Scots already used âa pound of silver of the same weight and fineness with the English pound sterlingâ (Smith 1776 [1981]: 41). Over time, gold, silver, and paper money, for instance, have been used by the richest nations to facilitate production and trade.
Then, it is not surprising that money has usually been identified with a physical medium. Broadly speaking, economists (see, for instance, Phelps 1961; Friedman and Schwartz 1963; Brunner and Meltzer 1971; Phelps and Taylor 1977) usually refer to money as a stock whose quantity would determine the amount of money supply in circulation and under the form of demand deposits (for recent critiques of the quantitative theory of money and monetarism, see for instance Keynes 1936 [1964]; Desai 1981; Cencini 2005; Krugman 2016; Rochon and Rossi 2018; Rossiâs forthcoming a, forthcoming b analyses). The conception of money as a physical medium of exchange and means of payment is so widely diffused that its status is almost that of an axiom.
Interestingly, according to some authors, money is not of a physical nature, but scriptural; that is, a number in bank books without intrinsic value. On this regard, Bernard Schmitt (1960, 1975, 1984, 1986, 1996) was followed, among others, by Alain Parguez (1975, 1996, 2001), Alain BarrĂšre (1979, 1990a, 1990b), Alvaro Cencini (1984, 1988, 2001, 2005), and Augusto Graziani (1989, 2003). As Rossi (2007: 18) points out:
[m]oney does not need to be reified into a precious metal in order for it to be a means of payment: it would be enough [âŠ] a double-entry book by means of which [âŠ] economic transactions are recorded and settled with a mere book-entry device.
According to these authors, money is of a numerical nature, with no intrinsic value. Money is âa pure symbol, a stroke of the pen in the bankâs balance sheetâ (Realfonzo 1998: 43). It is on double-entry bookkeeping, which has existed since the 13th century, that this analysis of money is founded.
As odd or against the tide as it may appear, money is far from being the physical object described in most of the economic literature. Banking systems are based on scriptural money, which is issued by commercial banks, in the first stance, so as to allow for companies to pay out wages. The creation of money takes place alongside productive activities; better said, production is the raison dâĂȘtre of money creation. Hence, production and money creation must always be understood on logical grounds: without money, output would have no monetary value; without output, there would be no reason for money to be issued.
Think of a commercial bank and name it Nantucket Bank, after one of the oldest commercial banks in America. As any commercial bank, Nantucket Bank holds assets and liabilities corresponding to the credits and debits toward its clients. Assets include loans, securities, reserves with the central bank, cash, and other items. Liabilities include deposits, borrowings, and others. As the laws of double-entry bookkeeping require, the amount of assets and the amount of liabilities on any balance sheet must always match. This means that the value of assets is always equal to the value of liabilities.
Now, it is no mystery that loans are granted on the basis of the amount of deposits held by the bank on behalf of its clients, according to the saying âdeposits make loansâ. What is unknown to most people is the fact that a certain kind of loans gives rise to new deposits, according to the saying âloans make depositsâ. This kind of loan is made thanks to the activation of credit lines, or, in other words, when wages are paid. The payment of wages, in fact, does not rely on previously existing deposits. For the sake of clarity, an example may be of help.
Suppose a firm requests the bank to credit workersâ accounts with wages, relying on a credit line that the firm has previously obtained and backed by securities (on this topic, see for instance Rossi 2007: 25). Workers are credited with wages amounting to $100. The bank grants credit to the firm and simultaneously registers deposits of workers for the same amount. As soon as the payment of wages is made, the stylized balance sheet of Nantucket Bank will be affected as follows (Table 1.1).
Table 1.1 The stylized balance sheet of commercial banks Nantucket Bank (Massachusetts) |
Assets | Liabilities |
Loans | â$100 | Deposits | â$100 |
Securities | $⊠| Borrowings | $⊠|
Reserves with the central bank, cash, other assets | $⊠| Other liabilities | $⊠|
Source: authorâs elaboration from the Federal Reserve (2016a). â stands for âincreaseâ.
As soon as wages are paid to them, workers are credited with an amount of bank deposits that is matched by a net credit of the bank toward the company. This event triggers, so to speak, the creation of wage-income. Resulting from the activation of a credit line, the payment of wages gives rise to an increase in the overall level of the assets and of the liabilities on the books of Nantucket Bank. Wage-income has thus formed. Workers are credited, while the firm is debited. To the bank accounts of workers corresponds a security on the financial market, namely a certificate of deposit, whose real object is the output produced and warehoused within the company. Interestingly, the terms âoutputâ, âproductâ, and âgoodsâ also refer to services, for âgoods and services are both examples of economic goodsâ (Solow 2012: 271). The remuneration of workers coincides with the production costs incurred by the company, which are the objective, monetary value of real output. Identifying wages as the measure for output value is equal to defining a product-wages relation where money functions as a unit of account for wages â Keynes (1936 [1964]) used the expression âwage-unitâ to refer to the measure of output value. Keynesâs (1936 [1964]: 20) words can easily be borrowed here: âthe income derived in the aggregate by all the elements in the community in a productive activity necessarily has a value exactly equal to the value of the outputâ.
Now, the payment of wages always confers to wage-earners as a whole the right to purchase produced output. Whenever wage-earners use their credit cards, for instance, they spend their income to purchase a product or a service. Consumption allows companies to cover the production costs they have sustained on the labor market, also known as the market for productive services. Through consumption, goods and services leave the warehouses of companies and are allocated among their final users to satisfy their needs; the flow of money that is credited on corporate bank accounts allows for a reduction in the debts of companies toward the bank. Again, an example may be of help.
Think of a territory, which we call Nantucket. It well may be an island, an estate, or simply a university classroom. Suppose that Seafarer Co. is the sole company at Nantucket. Wage-earners at Seafarer Co. produce ten tons of seafood chowder. Hence, the output produced at Seafarer Co. is made of chowder. At the beginning of January, Seafarer Co. obtains the opening of a credit line by Nantucket Bank. At the end of the month, the credit line shall be activated and wages shall be paid. For the sake of simplicity, suppose all entries in Nantucket Bankâs balance sheet to be nil. Suppose also that only scriptural money is used; that is, neither coins nor banknotes exist (nonetheless, some comments on banknotes and coins shall be made further on). At Nantucket, wage-earners include all kinds of workers, without any social class distinction: for instance, workmen, employees, managers, consultants, and so on. In this sense, workers include entrepreneurs. The entrepreneur indeed should be regarded as a worker providing his services. âIt is preferable to regard labour, including, of course, the personal services of the entrepreneur and his assistants, as the sole factor of productionâ (Keynes 1936 [1964]: 213â14). It has to be noted that this is far from meaning that the company makes no profit. As argued later on, income is made not only of wages, but also of profit. In the real world indeed, as soon as output is sold, companies usually expect to make profits. Suppose also that, at Nantucket, for a number of reasons, some individuals do not work and receive a share of wages from wage-earners. For instance, some children receive tips by their parents to buy fresh chowder at the local market. Thus, it shall be assumed that bank deposits are constituted in favor not only of wage-earners, but of households broadly speaking.
Money is simultaneously a companyâs debt and a credit of workers considered as a whole, both toward the banking system (Schmitt 1966: 286â7). The remuneration of labor (nominal wages) constitutes the monetary form of global output, and, if companiesâ profit is zero, it confers to workers the right to purchase the whole of real product. An example may help clarifying this point. Suppose that households spend the totality of wages altogether to purchase seafood chowder. In this context, if the company does not seek to gain from the sale, the selling price of output shall be equal to production costs. Households shall purchase the totality of consumption-goods. The price of $100 being equal to production costs of $100, households dispose of the sufficient and necessary income to purchase ten tons of seafood chowder. Nothing remains unsold after the sale.
Accounting entries in Table 1.2 show this process. Entry 1 refers to the payment of wages. Seafarer Co. is debited, and households are credited by the bank. This is respectively shown in the assets and in the liabilities of the bankâs book. Entry 2 concerns income expenditure. When households spend their monetary income, Seafarer Co. covers its production costs and is able to pay back its debt to the bank. As soon as all the debit-credit relationships are extinguished, as shown in entry 3, monetary income is finally spent, and households benefit from using the goods they have purchased. The asset and the liabilities in the balance sheet of Nantucket Bank decrease accordingly.
Table 1.2 Wage payment and consumption Nantucket Bank (Massachusetts) |
Assets | Liabilities |
(1) Seafarer Co. | $100 | Households | $100 |
(2) Households | $100 | Seafarer Co. | $100 |
(3) | $0 | | $0 |
Source: authorâs elaboration from Cencini and Rossi (2015).
What is worth inferring with the help of double-entry bookkeeping is that the nature of money is twofold, for it is a numerical flow (money-as-a-flow or vehicular money) and a numerical stock (money-as-a-stock).
On the one hand, vehicular money is used as a means of payment in every single transaction. Money, as a vehicle, is instrumental to credit and to debit the accounts of income-earners. For instance, in the banking system a bookkeeping entry accounting f...