Say's Law of Markets, Part VII: Banking School v. Currency School

The rise of the Nation-State, the Industrial Revolution, and a shift in the understanding of what it means to be human all combined to set the stage for the development of a financial and economic system that, to all intents and purposes, is contrary to what it means to be human. Consistent with humanity's political nature, society exists for one purpose only: to provide the environment within which the human person ordinarily acquires and develops virtue — pursues the good life — thereby fitting him- or herself for the end for which humanity was created.

The Rise of State Absolutism

Precipitated by the Currency Crisis of 1797, all this was changed. While it was vehemently denied at the time, the French Revolution profoundly affected the perception of the role of the State in England, which had been in the long, slow and often circuitous process of recovering from Tudor and Stuart absolutism. Where the more astute commentators, such as Edmund Burke, viewed the American Revolution as a restoration or partial realization of a traditional ideal of sovereignty of the human person under God, the French Revolution was widely recognized as substantially different from what had been the case in America.

The rhetoric and commentary, however, denied the reality of what was going on in England as well as in France: the shifting perception of the role of the State. Instead of residing in each human being as part of nature itself, rights such as life, liberty, property, and the pursuit of happiness were viewed as being a grant from an all-powerful State, revocable or re-definable at the will of the strongest — the rise of the absolutist, totalitarian State. The will, that is, the wants and needs of the all-powerful State, not the unchanging Nature of the Creator reflected in human nature, became the guiding principle of government.

Magna Charta was by this time an effective nullity, although its articles were not officially repealed until later. Official repeal began with the "Offenses Against the Person Act" in 1829 (9 Geo. 4, c. 31 s 1) and continued with widespread repeal in 1863 and 1872 as the idea of the all-powerful authoritarian Nation-State became the dominant model of government. After 1969, only Articles 1, 9, and 29 were still officially in force, although Article 1 has been effectively meaningless since the Act of Supremacy in 1534 (26 Hen. 8, c. 1) revoked the immunity of the Catholic Church, merged religious and civil society, and made the king the supreme head of both.

The Currency School

This new orientation was, naturally enough, reflected in the understanding of money and credit, and may even have been derived from it as widespread direct ownership of the means of production began to disappear from society. This was the orientation of the British Currency School of finance, that money and credit are both commodities, based exclusively on existing accumulations of wealth — "past savings." In this context, "money" becomes a claim on the present value of existing wealth. "Credit" becomes limited to a way of lending existing accumulations, or of creating more claims on existing wealth, thereby diminishing the value per unit of currency — inflation.

Further, the idea took hold that the amount of existing wealth is fixed in the short run — "in economic terms, everything is scarce." The money supply is thereby presumably restricted to representing whatever has been produced in the past but has not been consumed. Given this assumption, any increase or decrease in the amount of currency necessarily decreases or increases the value of each unit of currency, respectively. With the new concept of the absolutist Nation-State, only the State presumably has the power to create money, thereby taking over private property.

Given this understanding of money and credit, adherents of the Currency School necessarily reject Say's Law of Markets and the real bills doctrine. Under the Malthusian assumption that everything that exists is all that can exist (at least in the short run), and that credit must be based on existing accumulations, it becomes nonsensical to claim that money can be created through the expansion of bank credit to finance privately owned capital or by private persons drawing bills to match the present value of future production of marketable goods and services. "Value" is restricted to meaning the present value of existing marketable goods and services. The present value of future marketable goods and services does not fit within this paradigm.

The problem, of course, is that these assumptions do not hold true even in the extremely short run. Any time the owner of capital issues unsecured commercial paper — bills of exchange — he or she does not typically expect to redeem the paper out of existing inventories, but out of what will be produced in the future, even if "the future" is the same day the paper is issued. It otherwise makes no sense to issue unsecured commercial paper, for if the issuer had the existing inventories free and clear of all claims, he or she would simply sell the inventory in order to convert it to cash without the necessity of issuing a credit instrument, or issue a secured credit instrument.

Not surprisingly, the demonstrably false idea that production of marketable goods and services is fixed in the short run quickly evolved into the idea that "scarcity" is something from which the human race cannot escape. It is true that "in economic terms, everything is scarce," but "scarcity" in economic terms means something very specific: that at a single point in time, exactly so much of everything exists, no more, no less. This, of course, says nothing about how much of anything existed a microsecond prior to that point in time, or will exist one microsecond subsequent to that point in time. Properly understood, "economic scarcity" is an application of Aristotle's "law of contradiction," that nothing can both "be" and "not be" at the same time.

This precise understanding of "economic scarcity," however, when combined with the idea that all money and credit are necessarily tied irrevocably to existing accumulations of savings, was transformed into the idea that "scarcity" and "insufficiency" are 1) equivalent terms and 2) there can never be enough of anything to satisfy humanity's presumably unlimited wants.

It is no coincidence that the Reverend Thomas Malthus's 1798 Essay on Population took the economic and political world by storm at this time. Despite the fact that every premise in Malthus's Essay was disproved almost immediately upon publication (Joseph Schumpeter, History of Economic Analysis. New York: Oxford University Press, 1954, 578-583), the idea that humanity would soon breed itself into oblivion by creating hordes of insatiable consumers fit very neatly into the assumptions of the Currency School that it is impossible to finance new capital formation — and thus increase production of marketable goods and services — without first cutting consumption and saving before investing.

Say's Law (and, of course, the real bills doctrine as an application of Say's Law) that held that if some goods remained unsold it was because other goods were not produced, "and that it is production alone which opens markets to produce" (Say, Letters to Malthus, op. cit., 3) seemed to Currency School adherents to be the very height of insanity — as, in point of fact, Malthus himself complained to Say (Ibid.). "Interest" changes from a share of profits based on one's ownership contribution to production, to the rent of a commodity.

No Solid Front

Due to the fact that the tenets of the Currency School are not based on reality, however, cracks immediately appeared. All Currency School adherents, of course, agreed upon the basic assumptions: 1) Money and credit represent only the present value of existing marketable goods and services in the economy. 2) It is impossible to finance new capital formation unless money savings can be accumulated by cutting consumption of existing marketable goods and services. 3) Economic scarcity and material insufficiency are equivalent terms. 4) Humanity's wants can never be satisfied.

The Banking School responses to these assumptions are: 1) Money and credit represent the present value of both existing and future marketable goods and services. 2) New capital formation can be financed by drawing bills on the present value of both existing and future marketable goods and services. 3) Economic scarcity and material insufficiency are related, but not equivalent; while economic scarcity in its strict definition cannot be overcome, material insufficiency can be overcome through "ephemeralization," that is, doing more with less by using technological advances properly and ensuring widespread direct ownership of the means of production. 4) The theory of marginal utility is based on the observed fact that humanity can, in point of fact, satisfy not only its needs, but its wants as well. Both moral philosophy and empirical evidence demonstrate that neither wants nor needs are unlimited.

Nevertheless, the unending attempt to force observed reality to fit the assumptions of the Currency School resulted in the formation of three broad categories of Currency School adherents. These survive today in the three main "orthodox" schools of economics, 1) Keynesian, 2) Monetarist, and 3) Austrian. Viewing money and credit as a commodity and an effective limit on the rate at which new capital can be formed, and "interest" as the rent of money instead of a return on investment based on the pro rata share of an owner's contribution to production, all three of the mainstream schools of economics reject Say's Law of Markets, and, of course, the real bills doctrine. While agreeing on the basic assumptions, however, each school has its own approach to trying to fit reality into those assumptions, derived from the reaction of late 18th and early 19th century economists to the Currency Crisis of 1797.

Economists who fell into the first category believed that gold and silver are ultimately unnecessary, except, perhaps, to give the ignorant confidence in the currency. Since the government is the ultimate owner of everything, it is only necessary for the government, whether directly or through the central bank, to issue currency. The currency is backed not by the gold and silver in the coins or on deposit in the vaults of the State or the central bank, but by the government's power to tax, construed as an ultimate property right in the wealth of its own citizens. (Hobbes, Leviathan, II.29) If the economy needs more money, it is the State's obligation to create more claims on existing wealth by striking more coins or printing more money, and redistribute purchasing power through inflation. If there is too much money, the State taxes it away. The State also controls the rate of interest in order to encourage or discourage savings and thus investment. In its purest form, the monetary and fiscal policies that evolved out of this branch of the Currency School became "chartalism," (Vide Georg Friedrich Knapp, The State Theory of Money. London: Macmillan and Company, Ltd., 1924.) and is the most widespread theory of money and credit today through acceptance of Keynesian economics. (John Maynard Keynes, A Treatise on Money, Volume I: The Pure Theory of Money. New York: Harcourt, Brace and Company, 1930, 4.) As implemented, it is socialism in all but name.

Economists who fell into the second category believed that gold or some other commodity with a stable value is necessary as the basis of the money supply in order to ensure that the currency maintains its value. The amount of gold being relatively fixed, however, it is necessary in the long run to have some mechanism by means of which the money supply can be increased. If the supply of gold does not increase as fast as the amount of production being saved, i.e., production withheld from consumption to provide the savings considered essential to finance new capital formation, the government may create additional supplies of money to maintain the price level by issuing debt secured by future tax revenues, limited by the amount by which the unconsumed wealth in the economy — savings — increases. The interest rate should be set by the market, which will determine the rate of savings and investment without State interference. This was more or less the position of Irving Fisher and Milton Friedman, and provided the theoretical basis of Henry Simons's "Chicago Plan." (Infra.) As there is no defined direct private property stake in the new money created by issuing government debt, the effect is capitalism with a socialist overlay. The existing accumulations of money savings and capital assets are in private hands, but the bulk of the money supply — that part of it backed by government debt — is tied to the State's power to tax and relies on the stability of the government and the soundness of the economy to maintain its value.

Economists who fell into the third category believed that gold or some other commodity with a stable value is necessary as the basis of the money supply in order to ensure that the currency maintains its value and that private property rights are not eroded by State creation of money. Gold is ideal because it has historically maintained a stable value (not true, but that remains the belief of "third category economists"). An insufficient money supply is not a problem. If prices fall because of an insufficient supply of gold, the fact that the same amount of gold will buy more goods and services will draw additional gold into the economy until the price level rises once more to equilibrium. Similarly, if more gold is needed to finance new capital formation, the interest rate will rise and draw more gold into the economy until the interest rate is brought down to a level at which it is no longer profitable to import gold. If the interest rate falls, gold will flow out of the economy, seeking better returns elsewhere until the interest rate again rises to equilibrium. This was more or less the position of Ludwig von Mises and Friedrich von Hayek. As the money supply — gold — represents only savings in private hands and not government debt backed by future tax revenues, and there is, in general, no effective mechanism by means of which non-owners of capital can become owners of capital, this is pure capitalism.

The most obvious flaw in all three Currency School categories is the belief that money and credit can only represent the present value of existing marketable goods and services. From this assumption flow all the other errors of the Currency School. It also explains why, for all the sincerity and millennia of man-hours that have gone into trying to make an economy work in a manner consistent with this basic principle of the Currency School, there can never be any true reconciliation between the three categories, or any acceptance of Say's Law of Markets or the real bills doctrine. Being based on the wrong definition of money, much of what Currency School adherents of any category believe may be true, but it is not necessarily true as it must be when defining the application of principles by means of which a sound economy can function.

While there seem to be irreconcilable differences between the schools, these differences are based, in large measure, on different perceptions of the role of the State in the economy. All accept as a given the same definition of money, treating money and even bank credit as a commodity, and consequently maintain the belief that only existing accumulations of savings can be used to finance new capital formation. All three reject Say's Law of Markets and its practicable application in the real bills doctrine.

Truncating Say's Law

Nor does it make any real difference that two of the Currency School categories — those that developed into the Monetarist and Austrian schools — accept a reformulation of Say's Law of Markets that effectively abolishes Say's Law and promulgates something new under the same name. This redefinition posits an oversimplified understanding of the conclusion that production equals income and that, therefore, supply generates its own demand, and demand its own supply. In the modern, truncated version of Say's Law, "supply" is understood solely in terms of the present value of existing, not future marketable goods and services. Absent some form of redistribution by the State, this effectively limits ownership of the means of production exclusively to those who already own.

This redefinition of Say's Law is inevitable given the redefinition of money and credit. Under Say's Law — that is, Say's Law as understood within the framework in which money is a symbol for anything having a present value that can be used in settlement of a debt (a category including both existing and future marketable goods and services) — there is no reason why there should ever be any disconnect between the capacity to produce and the capacity to consume. Economic equilibrium should, absent disruptions of the economic system unrelated to the science of economics and finance, be the natural state of things, without any Keynesian "fine tuning," Monetarist compromise, or Austrian indifference.

Perhaps the most damaging aspect of the redefinition of Say's Law of Markets is the fact that it caused widespread misunderstanding of the application of the real bills doctrine. Even paying lip service to a truncated version of Say's Law did not prevent Currency School adherents of all categories from rejecting the real bills doctrine and thus a proper understanding of money, credit, banking, and finance. The effort to redefine Say's Law was so successful that few economists today can even define Say's Law accurately, as witness, for example, the entry in the "Wikipedia" as it stood in September of 2010, a confusing and misleading explanation that obscures more than it enlightens.

The Banking School

Part of the problem was that the opposition, what became the British Banking School of finance, did not present a unified front against the illogic of the Currency School. As noted, both the Currency School and the Banking School were split between those who held that gold was essential to the maintenance of a stable currency, and those who held the position that the selection of gold — or anything else — as the standard of value was simply a matter of convenience.

This allowed adherents of the Currency School position to divide the Banking School on the issue of gold. This changed the question from the essential nature of money and credit, to the importance of gold as the standard of value in the financial system. Once again, the effort was so successful that few economic historians today can state the issue with any degree of accuracy.

Although rejection of Say's Law and the real bills doctrine is the hallmark of the Currency School, diverting the question to gold meant that today's economists and historians classify support for gold as being the position of the Currency School (because gold and gold substitutes are considered the only legitimate currency), and the use of credit instruments as being the position of the Banking School — because, logically, only a bank can convert credit instruments into currency. The Banking School thereby lost recognition in the marketplace of ideas by having its basic precepts defined out of existence.

The departures from the actual position of the Banking School, of course, are obvious. Rejecting the real bills doctrine meant that the only credit instruments the Currency School recognized as convertible into currency were government securities, which presumably represent the State's property stake in future tax revenues: anticipation notes. Because the State does not have a property stake in future tax revenues (a grant from the people), these "anticipation notes" are necessarily classified as fictitious bills, not real bills. The outward forms of the real bills doctrine and Say's Law were maintained (thereby confusing the matter even further), but the substance — the present value of existing and future marketable goods and services in which the issuer of the bill has a private property stake — was completely missing.

Nevertheless, the principles of the Banking School were not abandoned all at once. Adherents of the Currency School held most of the political power, but the victory of the Currency School was not a walkover, nor were the principles ever actually implemented. As every auditor knows, there is the way a system is presumably designed to work, there is the way the people in charge think it works — and there is the way the system actually works.

Had the principles of the Currency actually been implemented, and had the system worked the way the powers-that-be thought it worked, the incredible economic growth experienced during the 19th century could never have taken place. There would either have been no economic growth, or what growth there was would have advanced at a glacial pace. However much those in power might delude themselves about the basis of reality and how society operates, until the State achieved primary control over the financial system through its mismanagement of the money supply, the economy could not be centrally planned, and growth could not be effectively controlled. As Mayer Anselm Rothschild is reputed to have said, "Give me control over the creation of money and credit, and I care not who makes the laws." The intellectual and political triumph of the Currency School, however, laid the foundation for the rise of totalitarian fascism in the 20th century, while the economic triumph of the Currency School led to monetary and fiscal policies that have ensured the very economic downturns and stagnation that those same policies are intended to prevent.

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