Essays in the Fundamental Theory of Monetary Economics and Macroeconomics

John Smithin

• Publisher: WSPC
• Year: 2013
• ISBN:
  9789814525299
• Topic: Economics
• Subtopic: Economic History
• Index: Economics

This book provides a comprehensive overview, in the form of eight long essays, of the evolution of monetary theory over the three-quarters of century, from the time of Keynes to the present day. The essays are originally based on lecture notes from a graduate course on Advanced Monetary Economics offered at York University, Toronto, written in the style of academic papers. The essays are mathematical in method — but also take a historical perspective, tracing the evolution of monetary thought through the Keynesian model, the monetarist model, new classical model, etc, up to and including the neo-Wickesellian models of the early 21st century. The book will be an essential resource for both graduate and advanced undergraduate students in economics, as well as for individual researchers seeking basic information on the theoretical background of contemporary debates.

Contents:

• Money, Debt and Credit in the Enterprise Economy
• The Recurring Debates in Monetary Economics
• Variations on the Theme of the Quantity Theory of Money
• Wicksellian and Neo-Wicksellian Models of Monetary Economics
• Keynes, Samuelson, Hicks and the Fate of Keynesian Economics
• Long-Run Models of Monetary Growth, Forced Saving, Wealth, Time Preference, and the Neoclassical Theory of Capital
• An Alternative Monetary Model of Economic Growth, the Business Cycle, Inflation and Income Distribution
• Capitalism in One Country?: A Re-examination of Monetary Mercantilism from the Financial Perspective

Readership: Graduate and advanced undergraduate courses in monetary theory.

CHAPTER 1

MONEY, DEBT AND CREDIT IN THE ENTERPRISE ECONOMY

Introduction

This essay is the first in a collection with the overall title Essays in the Fundamental Theory of Monetary Economics and Macroeconomics, and the choice of words immediately raises the question of whether, or not, there is any essential difference between the two fields. In my opinion there really should not be any distinction, in spite of the numerous attempts that have been made (for at least two-and-a-half centuries since Adam Smith) to construct macroeconomic theories that ignore monetary and financial issues.

From a commonsense point of view, economy activity in a capitalist- type system is all about money (Smithin, 2000, p. 1). We continually speak and write about “making money”, “losing money”, “spending money”, “saving money”, and so forth. Yet, as I have remarked elsewhere (Smithin, 2010, p. 49), it is a curious fact that many of the social science and business disciplines studying economic activity, pay far less attention to this “most important institution in capitalist society” (Ingham, 2004, p. 195) than it seems to deserve. There are many existing theories about what money does, such as economic theories about money and inflation, political theories about money and power, sociological theories about money’s cultural sig- nificance, etc. What is missing, however, is any detailed discussion of what a philosopher would call the ontology of money (Searle, 2005, p. 1, 2010, p. 5; Mendoza España, 2012). This means thinking about what money actually is, how it comes into being, and what is its nature. In business disciplines like accounting and finance, for example, it is taken for granted that sums of money are the proper subject for discussion, without much further inquiry. In economics, one of the most influential approaches in today’s academic mainstream, that is the modern (now highly mathematical) version of the original “neoclassical” approach, has often taught that money itself is not fundamentally important, and that what is really going on when economic activity occurs is a barter exchange of goods and services.

The Idea that Money is “Just Another Commodity”

For many centuries, well into the modern era, the ruling idea was that the value of money derives from its own intrinsic worth as a commodity. Classic examples were the precious metals like gold and silver, either as coins or ingots. Such objects were believed to have become money because market forces had made one or other of them the most acceptable or “exchange- worthy” item in trade in a given society. This gave rise to the misleading concept of money as the medium of exchange, which still appears promi- nently in the textbooks to this day. It suggests that the role of money is merely to simplify, make easier, or “lubricate” as the common metaphor would have it, trades that would somehow be taking place anyway. The idea is misleading, because the very notion of an actual physical medium “changing hands” implies that the characteristic transaction is a simple “spot” exchange of one thing for another on the spur of the moment (Hicks, 1989, p. 41). This is not so in any real money-using economy. Particularly for the larger more important transactions it is usually required that some sort of agreement must be reached (some kind of formal or informal contract must be made) before trade takes place. Moreover, it is not possible to be dogmatic about the timing of payment. The contract or agreement always comes first. However, sometimes the buyer must pay “in advance” before delivery of the item, while at other times payment is made later “in arrears”. Spot payment is therefore only a special case of one of three possible types of contract (Hicks, 1989, p. 42). In all three cases, it is also implicit that money, the thing offered in payment (as opposed to mere exchange), is in a different category altogether from the particular good or service being sold. Money is something that, when tendered, definitively seals the bargain. Otherwise, when simply trading an apple for an orange, why not call either of them (or both) the medium of exchange?

It is a major weakness of traditional economic thinking that the only attempt made to understand the trading process beyond a simple act of barter was this assumption that market forces will “naturally select” one, or a limited number, of actual physical objects to serve as the money of exchange. Even during historical periods when money was obviously not a substantial physical object, for example, when it was a piece of paper or a book entry, it continued to be held that these representations were only symbolic of some more “intrinsically valuable” commodity underlying the whole transaction. However, the idea that the value of money could be guaranteed in this way, for example, by adherence to a commodity standard such as a gold standard or other metallic standard, was always extremely dubious (Innes, 2004/1913, p. 15). In today’s world when the physical form of money may be nothing more than electronic impulses in a computer network, the idea that money is intrinsically any specific commodity is impossible to sustain. The flickering numbers on the screen do not represent any specific good, they are only a generalized unspecific claim to a partial share of the total of goods and services, and the claim exists only because it is socially recognized as such. This part of the claim is what is usually called the “purchasing power” of some particular sum of money. Moreover, purchasing power itself, though it is something that all economic actors must possess to be able to participate in economic activity at all, is sub ject to continual fluctuation as money prices change.

On the other hand, even if it is true that modern money is (almost) entirely physically in substantial (the computer networks themselves do have to exist) it should equally well be noted that the advent of computers, the internet, and so forth, has not actually led to the disappearance of money. This is contrary to what was frequently claimed would be the “wave of the future” by pundits of the late 20th century (roughly when these sorts of purely technological innovations made their first appearance). Money, in fact, retains the same importance in social life that it has always had, and it is actually quite striking how the contemporary financial problems that have preoccupied the business press in recent years do continue to be discussed in very much the same sort of terms as they always would have been throughout the 20th, 19th and 18th centuries, and earlier, regardless of the state of the technology.

To use some terms from economic sociology, there are really two separate issues that need to be identified in determining the composition of the mysterious entity called money. The first is the question of its “formal validity”. What it is that makes money “money” in the sense of simply qualifying as 1 dollar, 20 dollars, or 100 dollars, and when tendered is “counted as” being able to settle debts in these amounts (and thereby complete contracts). The second is the “substantive validity” of money, which must mean something like the value of its purchasing power compared to the volume of goods and services available. Monetary theory eventually has to deal with both, but they are very frequently confused right from the start. This simple problem has been the source of much misapprehension and dispute on monetary matters over many centuries. In effect, the notion of intrinsically valuable money was supposed to solve both issues at once. However, the two are indeed separate and therefore the idea of commodity money has actually made very little contribution to understanding what money really is as a set of social relationships, and how the twin problems of the formal and substantive validity of money might be solved.

What is Money?

What, then, is money? The main alternative to a commodity theory of money is a “credit” or “claim” theory of money (Schumpeter, 1994/1954; Ingham, 2004, p. 6). Money is not thought of as (primarily) a physical object but as an entry in a ledger, a system of accounts, or a balance sheet. Debts are incurred and paid off by various balance sheet/accounting operations. As mentioned, it then becomes a key issue for the analyst to decide exactly what it is in any given system that “counts as” making payments or discharging debt in the circumstances.

The idea of credit money, or debt money, is sometimes expressed by statements to the effect “all money is credit” or “all money is debt”, and so forth. For example, the Nobel Prize winning economist, Sir John Hicks, wrote to me in 1988 (the year before his death) as follows ¹:

You are still at the stage I was at the time of my Critical Essays (2005/1967) making hard money and credit money as parallel alternatives. I now maintain that the evolution of money is better understood if one starts with credit ! (original emphasis)

Meanwhile, Geoffrey Ingham, in his influential book, the Nature of Money (2004, p. 198), explicitly states that “all money is debt ... ”, and at the same time refers throughout the work to the system of “capitalist credit money”.

These positions are obviously far more realistic, both in terms of the historical development of a distinctive system of capitalism, and in thinking about current affairs, than the idea that the origins of money lie merely in the offer of one or another physical item in exchange for some other physical thing. Adam Smith (1981/1776, p. 65) talked about “an early and rude state of society” in which he imagined this sort of thing taking place, but as Searle (2010, p. 62) has astutely remarked “there is no such thing as a state of nature ” (emphasis added) as far as human social institutions, including commerce, are concerned.

However, once we do start talking about social accounting and thereby use terms like “credit money” and “debt money”, there is one obvious pitfall that needs to be pointed out and dealt with straight-away. This is simply that in any banking or financial system, credit and debt are just the mirror images of each other. For every debt there is a credit and vice versa. If, for example, a commercial bank extends a loan to an individual or a firm, then that would correctly be described as the granting of credit, and the loan is an earning asset to the bank. On the other hand, if somebody makes a deposit in a bank then, from the bank’s point of view, that is a debt or liability. Confusion arises because, by definition, assets must be equal to liabilities in a balance sheet. Therefore, when a bank or similar financial institution does extends credit, its asset portfolio increases, but at the same time the liabilities side of the balance sheet must necessarily be rising also. In the simplest case, the person or firm receiving the loan just deposits the funds back with the same bank. Moreover, even if all of the funds are paid away to another financial institution the assets and liabilities of the system as a whole rise to exactly the same extent. So, there is always both credit creation and money creation at the same time. Conversely, when the loans are paid back this must amount to the “destruction” of money and credit. We need to be clear, therefore, in discussing these balance sheet operations, about which side of the balance sheet contains the entries we actually think of as money. The correct answer is that it is the funds (deposits) on the liabilities side of bank balance sheets that are the money, precisely to the extent that they can be transferred from one party to another, and therefore used to pay off other debts.

This corresponds to the definition of money given by Hicks in his last book, the posthumously published Market Theory of Money (Hicks, 1989, p. 42):

Money is paid for a discharge of debt when that debt has been expressed in terms of money.

Also relevant is the complete version of Ingham’s definition of the same phenomenon (already cited). The completed quotation from Ingham (2004, p. 198) is:

All money is debt in so far as issuers promise to accept their own money for any debt payment by any bearer of the money. (original emphasis)

I would say that taken together, these two definitions already cover the historical special case of precious metal coins (and for that matter token coins also) as well as debt money. To make the pieces of metal “money”, the issuer or guarantor of coins would always have agree to accept them back in payment of obligations to itself. It was this “acceptability” feature that was the key to the coins being money, not the physical properties of the bits of metal themselves (Ingham, 2004, p. 198). On this account it still needs to be explained why the issuers of money are in a position in which other actors have incurred binding obligations to them. If this can be done, then the formal validity of money is explained. Some of the answers that have been given to this question will be discussed in the section on “the hierarchy of money” below. The question of the substantive validity of money is still another matter.

Note that the statement that debts are “expressed in terms of money”, immediately introduces the notion of a “money of account”, which Keynes said was “the primary concept of a theory of money” (Keynes, 1971a/1930, p. 3). Modern textbooks similarly list one of the functions of money as providing the unit of account, meaning by this the abstract concept of a “dollar”, a “yen”, or a “peso”, and so on. This is the unit in which prices are expressed, accounts are recorded and profit is calculated. Unlike Keynes, however, the textbook writers apparently do not think that this function is all that important. This is a mistake, because if there were no such function, it would be impossible to conduct business on a rational basis, or to engage at all in such activities as quoting prices, keeping accounts, or obtaining finance.

It is true that the concept of a unit of account, by itself, is not enough to establish the existence of a “monetary economy”. There must also be a means of payment recognized as actually constituting the correct number of units of account when transferred. Keynes (1971a/1930, p. 3) explained that the money of account was the “description [of the thing]” and money itself was “the thing that answers to the description”. The description, for example, may be “a dollar” and the “thing” answering the description could be a coin, a note, or an entry in the accounts of a bank. It has already been sufficiently stressed that the means of payment need not be a substantial physical object, but can easily be a book entry or computer transfer, as seen every day. All that is necessary is that what is transferred counts as the required sum in the particular social context (the formal validity of money once again). There is, in fact, no real problem in understanding why such things as the liabilities of banks and other financial institutions can quite easily play this role.

It will have been noticed that a number of the standard textbook functions of money have already been mentioned in the discussion. Sometimes, the textbooks say that money is “a unit of account, a medium of exchange and a store of value”, whereas in other treatments, the functions are given as “a unit of account, a means of payment and store of value”. We have stressed that the idea of the unit of account is more important than is usually allowed for in textbooks. Also, that a medium of exchange and a means of payment are not the same thing, even though these terms are often used interchangeably, and that the idea of a means of payment is by far the more useful concept in an actual money-using capitalist economy.

What, though, of the third function of money, money as a store of value ? In academic theories of “portfolio choice” or the “demand for money”, this is usually treated as a ma jor issue, sometimes the major issue. Again, however, the emphasis seems all wrong. It is true that if money is to constitute “purchasing power” it must retain value, to at least to some extent, from one period to the next. Also someone, somewhere, must be willing to hold the money (that is, primarily, must b...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright
• Dedication
• Contents
• About The Author
• Introductory Remarks
• 1. Money, Debt and Credit in the Enterprise Economy
• 2. The Recurring Debates in Monetary Economics
• 3. Variations on the Theme of the Quantity Theory of Money
• 4. Wicksellian and Neo-Wicksellian Models of Monetary Economics
• 5. Keynes, Samuelson, Hicks and the Fate of Keynesian Economics
• 6. Long-Run Models of Monetary Growth, Forced Saving, Wealth, Time Preference, and the Neoclassical Theory of Capital
• 7. An Alternative Monetary Model of Economic Growth, the Business Cycle, Inflation and Income Distribution
• 8. Capitalism in One Country?: A Re-examination of Monetary Mercantilism from the Financial Perspective
• Bibliography
• Index