In yesterday's posting we looked at the fundamental assumption underpinning Keynesian economics: that it is impossible to finance new capital formation except by cutting consumption and accumulating cash. This assumption leads inevitably to the belief that, in order to be able to finance increasingly expensive capital as technology advances, ownership of that capital must be concentrated in a small elite. To ensure that people are taken care of, however, ownership and control must be separated, so that disposal of income (control) rests with the State, which redistributes enough wealth through taxation or inflation, at the same time ensuring that there is sufficient financial capital available to form new productive capital and create jobs.
On examination, however, we discovered that Keynes drew his conclusions based on what can only be described as a changed or "re-edited" definition of savings: the excess of income over the costs of consumption in the past. Keynes explicitly rejected the idea that savings could be anything else, e.g., the excess of income over the costs of production in the future. Keynes's restricted definition of savings implicitly limits the amount of financing for new capital to what has been withheld from consumption in the past — "past savings."
By including the excess of income over the costs of production in the definition of savings, however, any new capital that has the reasonable potential to pay for itself out of increases in future production can be financed without regard to prior reductions in consumption — "future savings." Reducing consumption in order to finance new capital is, in point of fact, harmful to the financial feasibility of the new capital. If people are saving, they aren't spending, and there's no demand for new products or greater quantities. This accounts for the slow rates of growth experienced before the reinvention of commercial banking and invention of central banking in the 17th century.
As Dr. Harold Moulton, president of the Brookings Institution from 1916 to 1952, demonstrated in The Formation of Capital (1935), however, in periods of rapid economic growth, financing for new capital formation does not come from previous reductions in consumption. Instead, through the proper functioning of the commercial and central banking systems, financing for new capital formation is obtained by creating negotiable instruments called "bills of exchange."
Bills of exchange are based on the creditworthiness of the issuer. They turn future increases in production, rather than past reductions in consumption, into money. The soundness of the money depends on the accuracy of the projections about future productions and sales, and the collateral that backs up the projections.
In contrast, Keynesian economics rejects private sector bills of exchange as money. Consistent with the principles of Georg Friedrich Knapp's "chartalism" (now called "Modern Monetary Theory"), only public sector bills of credit are money. Where private sector bills of exchange are backed directly by the present value of existing and future marketable goods and services in which the drawer of a bill has a private property stake, public sector bills of credit are backed by the present value of future tax collections which the taxpayer may or may not grant — or have to grant in the first place.
Why backing the money supply with government bills of credit instead of private sector bills of exchange is fundamentally unsound is the question we will address in the next posting in this series.
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