Money in Economic Theory

Hasse Ekstedt

• Publisher: Routledge
• Year: 2012
• ISBN:
  9781135126032
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The financial crash of 2008 showed the fragility of the financial system. A key question which surfaced in the aftermath of the global crisis was why economists were unable to predict this crash. This new volume argues that this failure can be attributed, at least in part, to the poor and inconsistent treatment of money and monetary matters in economic theory. The book takes this problem as its starting point, and from there aims to develop a more consistent treatment of the topic.

Here, Hasse Ekstedt affirms that the treatment of money in economic theory has been inconsistent and that the topic of money can in fact be seen as anomalous. He argues that this anomaly depends on deficiencies in the economic theory, which through an equilibrium approach mainly perceives money as an index of measurement.

In contrast, this volume puts forward the case for money as a non-equilibrium concept, and that the stability of money and financial markets are to be sought in social and institutional structures. In particular, the volume discusses the relationship between the market and public bodies, as well as addressing economic and financial stability in general and in relation to the globalized economy, particularly focussing on the problem of structural stability. In doing so, the book offers a new approach both to money and to its role in economic theory.

1	Introduction, scopes and methods

“Money makes the world go around” the Master of Ceremonies at Kit Kat Club sings in the musical Cabaret and it is probably right. In the Bible we read in Matthew 6:24 “No one can serve two masters, for either he will hate the one, and love the other, or he will be devoted to the one, and despise the other. You cannot serve God and money” (ESV Bible). Why does money make the world go around and what is meant by serving money: isn’t money a servant of ours? We quote St Thomas in Chapter 2 and he says that no object is evil in itself, but it is man himself who turns it into evil. But still – how can we become servants to money, it seems to be a kind of addiction?

Money is one of the most powerful concepts in human mind. Early in life we learn its power via weekly allowances, via aunts and uncles handing some coins to buy sweets; children learn quickly transforming different desires into relative prices.

In Wesley Mitchell’s paper, “The role of money in economic theory”, he ends his paper by saying:

The current tendency to make money “the centre around which economic science clusters,” then, is a tendency to be fostered. For that course promises (1) to clarify economic theory by giving it a better framework, (2) to render economic theory more useful by directing attention to those actual processes with which all serious proposals for governmental regulation and social reorganization must deal, (3) to make economics more realistic and therefore more interesting intellectually as well as practically, and, finally, to make economic theory more profound by orienting the economist for a fruitful study of his aspect of human behavior.

(Mitchell 1916: 161)

These words cut through the sophisticated neoclassical general equilibrium analysis as well as the huge Keynesian modelling as a knife in butter.

Money which has become a theoretical anomaly in main stream modelling is placed in the very centre of the analysis by Mitchell. The fundamental meaning of the economic analysis is the allocation of scarce real resources and the distribution among the agents of the production result, but, to analyse this, the understanding of the different roles of money is essential.

Economics is indeed a remarkable topic within social sciences, since there is a distinct moment of action combined both with a theoretical and a practical possibility of measurement, namely when the very exchange of money for commodities takes place. It is the more interesting since we know that the concept of money also represents the powerful concept of liquidity, normally in its highest form, and furthermore historical, current and future values are expressed in money whether it concerns accounting figures, contractual matters or future expectations. That means that we may actually observe the agents’ current choices and also, at least to some extent, the choice between actions now or at a later stage. From an empirical point of view that makes us to a certain degree observe inertia of different kind; we may also link actions to different, both microscopic and macroscopic, events. The interpretations of the very action and its purposes are difficult but at least we have an exact figure whatever it means.

Unfortunately economic theory, and this concerns both neoclassical and Keynesian theory, is often more occupied with a priori modelling of the nature of the agents and/or economic structures, which shuffles around real matters of commodities and production factors but leave the dreams, ethics, institutional matters and idiosyncracies, strange or not, outside the analysis and this is actually where money is of a prime interest. In creating a machine close to a perpetuum mobile more or less founded on the Aristotelian value of labour, the economic science has lost its contact with one of the most formidable powers in history, namely the human imagination and dream. From a scientific point of view the fundamental mistake is the confusion between science of studying objects and the science of studying subjects.¹

The essence of this difference is the very ability of the subjects to redefine values and wealth with respect to future actions. Thus the current accounting value of an asset is not The Value but an input in the subject’s contemplation of the future.

John Commons (1990 [1934]: pp. 413–14) in his discussion on MacLeod’s Economics for Beginners, touches the point with a needle;

Yet his negotiable debts are the modern meaning of capital. The economists, said MacLeod, “never made the slightest attempt to bring the subject of Credit and Banking into the general body of the science: in fact, they have given up the whole subject of Banking in hopeless despair.” MacLeod resolves this difficulty by shifting the physical things to the future and by substituting mental acts and operation of law which give rise to property rights. If property-rights are themselves credits, then banking is only a special case of the universal principle of buying and selling credits.
[…]

There was a double meaning, says MacLeod, in Adam Smith’s usage of the term Wealth. In the first half of his work wealth was defined as “the annual produce of land and labor”; in the second half it was anything exchangeable. Ricardo followed Smith but restricted his meaning to any product of labor designed to be sold…. Hence MacLeod followed what was included in all their meanings of wealth and made exchangeability the essence of wealth and value. This however, as we have said, confuses wealth and assets.

Furthermore Commons adds “according to MacLeod and the other physical economists who made exchangeability the sole subject-matter of economics, an exact science can be developed only when, like the physical sciences, it can be reduced to mathematical equations”. This doesn’t mean that we must interpret Commons as hostile to the use of mathematics in economics but what Commons puts his finger on is the absolute need of precise definitions of concepts and this is even more necessary when dealing with a science studying subjects.

The principles of empirical sciences are rather simple and straightforward. We observe somehow inert structures which we try to represent as neatly as possible in logical structures possible to analyse in deductive patterns. These deductive patterns will then in principle govern the mode of observations as well as the interpretation of further empirical observations. The representation however is always dependent on the questions we raise with respect to our observations. That of course means that our pre-understanding, prejudices and other idiosyncrasies play an important role already in the stage of observation; furthermore they play a crucial role in the forming of seemingly empirical structures which are the basis for deductive analysis. This is so in natural sciences, which are to be seen as sciences of objects and probably in a much larger degree in sciences of subjects.

When it comes to economics we additionally have to strive for universal modelling built on a priori axiomatic structures which not only restrict the structures of the deductive modelling but also restrict the empirical observation in the first case. This is indeed remarkable since even the natural sciences have left this stage of development of the scientific analysis.

It is refreshing to read the pious friars of Salamanca, from the sixteenth century, and their analysis of what was actually going on in the Spanish economy, in asking why the performance of the Spanish economy was so bad in spite of the huge inflow of gold to Spain. This gave rise to an intellectually satisfactory analysis of money which later was almost forgotten. Comparing the analysis of the pious Dominican friars of Salamanca with some of the economic analysis today one gets the impression that economic science has been degraded to a more or less religious faith.

Money is a concept easy to understand vis-à-vis relative prices and a budget restriction in a microeconomic setting; however when we introduce the concept of cash balance, we are already in trouble. Cash balances are difficult to handle in traditional optimization problems of the households given consistent preference structure. In a Walrasian setting money appears more or less as a residual. When we look at macroeconomic theory money plays a more prominent role. We discuss interest rates, liquidity preference, quantity of money and velocity of circulation. However when we try to close the theoretical gap between the microscopic and the macroscopic theory the two logical structures are seemingly ill-fit.

One route of thinking is to basically accept the microeconomic theory and its particular form of additive aggregation and add the quantity theory of money which deals explicitly with the quantity and circulation of money. In monetarist theory this has evolved into the interesting solution that as long as markets are free and works properly according to the neoclassical theory we can handle macroeconomic problems of inflation and unemployment solely through manipulating the quantity of money.

However many theoreticians get a gnawing unrest when looking at this reasoning and start to ask whether it is possible to add one theoretical approach to another where the theoretical concepts of the first don’t even exist. This has raised questions of whether we really have a consistent theory of money in economic theory.

An early proponent for these doubts is the Swedish economist Knut Wicksell who writes;

I already had my suspicions – which were strengthened by a more thorough study, particularly of the writings of Tooke and his followers – that, as an alternative to the Quantity Theory, there is no complete and coherent theory of money. If the Quantity Theory is false – or to the extent it is false – there is so far available only one false theory of money and no true theory.

(Wicksell 1936: xxiii)

Unfortunately Wicksell’s words are still relevant to a great extent. Thus the almost axiomatic inclusion of the quantity theory in the neoclassical building is a theoretical mystery and furthermore the adding of supposed Keynesian concepts of liquidity and even uncertainty is also mysterious from a logical point of view. Kenneth Arrow and Frank Hahn wrote in the concluding chapter with the title “The Keynesian Problem” of their fundamental study of economic theory in its neoclassical setting, General Competitive Analysis: “If a serious monetary theory comes to be written, the fact that contracts are made in money will be of a considerable importance” (Arrow and Hahn 1971: 356–7).

Our quotation from Wicksell expresses the same mood although it is written more than 70 years earlier. The modern portfolio analysis based on the theoretical achievements by Black, Scooles, Merton and Samuelson is indeed interesting but it is based on a completely different form of mathematical structure from the one in the neoclassical theory.

When entering an abstract analysis of the inconsistencies of money and money matters in economic theory our basic approach is that the inconsistencies do not depend on a lack of a theory of money but instead it is the fruit of more fundamental inconsistencies in economic theory.

Scopes of the book

This is not a book about the economic reality, although we often taken examples from and allude to rather common experiences. The author has reached an age where such studies are seen as a contradiction in terms of a comfortable life; furthermore experiences from the business world have effectively increased the state of confusion with respect to what reality, if it exists as a general concept, is.

The title Money in Economic Theory tells rather well the main scope. The basic question will be how money is treated in economic theory and this will give rise to methodological discussions on the relevance and implications. Naturally the first question will be “what do we define as economic theory?” followed by “what is money?” However since these two questions call for additional books to be written, the author has taken on a very simple attitude, namely to start the discussion with what we actually tell our first year students about what economics and money are.

The reader might not expect any breathtaking conclusions which lead to new universal theories but more a methodological inquiry of the theoretical treatment of money. Much of what can be said is to a certain extent well known except perhaps for some concepts brought from physics and mathematical logics, but these are just practical tools of analysis.

The conclusion is simple. Economics is not a machine and theoretical approaches striving to create such a machine are not penetrated with respect to the very essence of the concept of money. Thus the bad theoretical apprehension of money in economic theory does not mean that economists do not understand money and monetary matters in the empirical world but that the general economic theory does not allow for a relevant apprehension of money. Thus the so-called mainstream economic theory, which is a mishmash of neoclassical, Keynesian and monetarist thoughts, which by no means need to be wrong in principle, induces us sometimes to do exactly what Commons criticizes, namely mixing up concepts bringing contradictory elements into the same kind of theoretical representation.

That leads our interest from the question of what money really is towards what money is thought to be in conjunction with the rest of the theoretical considerations.

One could say that the expression of the Roman emperor Vespasian, pecunia non olet, is at the very centre of our analysis. Another expression which also will follow us is from Luigi Amoroso (1938: 6) “the dead city dominates through inertia the living city”.

Methodological matters

Our main scope is a methodological study of economic theory vis-à-vis money so the question of which kind of methodology we should use for this methodological purpose is indeed appropriate. We start from the fact that all empirical sciences have to penetrate possible inert structures both with respect to their fundamental dimensions and its dynamics, thus all inert structures have to be formulated in such a way that logical deductions are possible, not necessarily mathematical deductions but still meaningful with respect to causal consequences implied by their existence.

Thus with respect to such deductions we have to start from some form of assumptions which we hold at least temporally and locally for true. Then there appear two problems; the relevance of the assumptions and the consistency of the logical (causal) analysis. For the economic science this is of particular interest since the basic structure to which all other approaches have to relate is actually based on a precise set of a priori assumptions of the agents’ behaviour. As implicit in the quote from Commons above, the axiomatic structure focuses completely on the concept of market exchange of c...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• List of Figures
• List of Tables
• Preface
• Acknowledgements
• 1 Introduction, scopes and methods
• 2 The understanding of money: A retrospective glance
• 3 Money, value and prices in neoclassical economic theory
• 4 Money, value and prices in the Keynesian and monetarist theories
• 5 Concluding comments on the nature of money in economic theory
• 6 Uncertainty, money and liquidity
• 7 Inter-temporal valuation, expectations and stability
• 8 Money and stability
• Notes
• Bibliography
• Index