Thursday, July 23, 2015

Some (More) Thoughts on Money


We got some comments a week or so ago when we started the just-finished series on the Greek debt crisis.  While no doubt well-intentioned, however, the comments were based on misconceptions about money, credit, banking, and finance, as well as the facts of history, that made it impossible to respond.  Still, we tried.

Malthus: puzzled by Say's Law
While there were a great many problems with the specifics of the comments, the underlying problem was that the commentator didn’t realize that money is anything that can be used to settle a debt.  Money is thus a tool, as explained in Say's Law of Markets, especially in Say's first letter to Thomas Malthus.

The commentator seemed to think that the amount of money creates exchanges of goods and services, while in strict fact, it is exchanges that create money.  He also didn’t understand either what banks are (or the different types of banks) or the proper function of a central bank, failing to distinguish between banks of deposit, issue (circulation), and discount.

Just one example of his slightly distorted history, he claimed the Chinese were the first to use paper money.  Strictly speaking, and as far as we know, this is correct: the Chinese were the first to use paper in their creation of negotiable instruments.

Chinese paper money: not the first.
Prior to the Chinese, however, for thousands of years people used clay, wood, papyrus, parchment, leather (the Roman Senate financed part of the war effort during the Punic Wars using bills of credit written on leather), — anything on which a contract could be recorded.  The vast bulk of documents that survive from the ancient world are not literature, but “money” in the form of bills of exchange, letters of credit, promissory notes, bank drafts, and bills and notes of all kinds.  These forms of money preceded coined money — and the use of paper — by millennia.

Notes and bills, “document money,” are not a substitute for coin, rather, coin is a substitute for bills and notes, which themselves are substitutes for (symbols of) the “underlying,” that is, the present value of the marketable good or service conveyed in the contract as consideration.

Essentially, a mortgage or a bill of exchange is a symbol of the present value of an existing or future marketable good or service, respectively, while coins and banknotes are symbols of a mortgage or bill of exchange.  When government gets into the act and emits bills of credit, it uses its own liability and promise to collect taxes in the future instead of assets to back its liabilities.

Irving Fisher, developed MxV=PxQ
It was clearly evident that the commentator held to the currency principle.  In jargonese, that means that he believed that in the Quantity Theory of Money Equation, M x V = P x Q, where M is the quantity of money, V is the average number of times each unit of currency is spent in a period, P is the price level, and Q is the number of transactions, “M” is the “independent variable.”

That means that, in his view, the amount of money in the economy has a direct effect on P, Q, and V.  The problem is that, yes, M does have an effect on the other variables if you change M without changing anything else . . . but it’s an indirect effect, and you can’t predict what the effect is going to be with any certainty.

In the banking principle, M is the only dependent variable in the equation.  That means that the market or some other agency determines P, Q, and V, and the amount of money is determined by the needs of the economy directly by these variables.  Assuming that all money is created by issuing mortgages and bills of exchange, then changing P, Q, or V will automatically and directly result in a corresponding change in M.

We tried to explain this to the commentator so he would understand our response.  We explained the definitions we use and the meanings of the principles even before we attempted to respond.

The commentator came back and denied that he adhered to any principle at all, but especially did not go by the currency principle.  Since that was demonstrably false, we decided not to bother trying to respond.  If you reject our principles, you won’t understand what we say, and if you  reject your own principles, chances are you won’t understand what you’re saying, either.

#30#

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