The other day we
were deep in a discussion of bank reserves and the role of a reserve currency
when someone asked why this was relevant to anything. That was not in the sense of “Why are you
wasting my time with this garbage?” but a genuine question, i.e., “Why is this subject worth
discussing?”
That, in common
with virtually all honest questions, is a good point. It cannot, however, be answered very briefly,
as the concept of a “reserve currency” on which the idea of bank reserves is
based assumes a host of other
concepts that must be explained before we can understand what reserves are and
what they do.
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| Louis O. Kelso |
The first concept
we have to understand is money. This is
both much easier and much more difficult than many people believe. That is because the concept itself has become
so loaded down with cultural, religious, historical, and any other kind of
baggage you can think of that getting to the essence of money becomes a very
difficult task, indeed.
Nevertheless, we
are going to try. What is money? Money is anything that can be accepted in
settlement of a debt. As Black’s Law
Dictionary has it, money is “all things transferred in commerce.”
Knowing what
something is called, however, doesn’t tell us what it is or how it
functions. To do that we need to know a
little more.
A good place to
start is with the description Louis Kelso used; we say “description” because we
already defined money above. As Kelso
said,
Money is not a part of the visible sector of the economy;
people do not consume money. Money is not a physical factor of production, but
rather a yardstick for measuring economic input, economic outtake and the
relative values of the real goods and services of the economic world. Money
provides a method of measuring obligations, rights, powers and privileges. It
provides a means whereby certain individuals can accumulate claims against
others, or against the economy as a whole, or against many economies. It is a
system of symbols that many economists substitute for the visible sector and
its productive enterprises, goods and services, thereby losing sight of the
fact that a monetary system is a part only of the invisible sector of the
economy, and that its adequacy can only be measured by its effect upon the
visible sector. (Louis O. Kelso and Patricia Hetter, Two-Factor Theory: The
Economics of Reality. New York: Random House, 1967, 54.)
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| Adam Smith |
This covers (very
briefly) the definition of money, and what money does, but still leaves us
somewhat in the dark. At this point,
then, it will be useful to know how money is created, at least in its
essentials.
The idea of money
is rooted in Adam Smith’s first principle of economics. That does not mean, of course, that Adam
Smith invented money, or even that he was the first to articulate this
principle. Rather, Smith was the first
writer in the new science of political economy as far as we know to state as a
first principle what others simply took for granted.
And what is that
principle? “Consumption is the sole end
and purpose of all production” (Adam Smith, The
Wealth of Nations, IV.8.49.)
From this first
principle of economics, Jean-Baptiste Say derived “his” Law of Markets. Again, Say did not really develop the Law of
Markets. It is implicit in every
economic writer since Aristotle, and possibly earlier. And what is “Say’s Law”?
Most simply (and
misleadingly) put, Say’s Law is that production equals income, and therefore
supply (production) generates its own demand (income), and demand (income) its
own supply (production).
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| Jean-Baptiste Say |
Elaborating on
that, Absent theft, charity, or redistribution (or manna from heaven), there is
only one way to consume, then, and that is to produce. You must either produce everything that you
and your dependents consume yourself, or you must produce something that you
trade to another producer in exchange for what the other producer has
produced. Assuming that everyone who
consumes, produces, and that everyone who produces consumes, and that only what
is needed for consumption is produced, and all that is produced is consumed,
production will equal consumption.
Supply will generate its own demand, and demand will generate its own
supply — in aggregate.
Now, obviously
this ideal scenario does not exist anywhere.
Infants, the elderly, the disabled, the unemployed, and so on, are often
unable to produce anything because, unable to contribute to production through
their labor, they have nothing to exchange for what they want to consume. Say’s answer to that was to point out you
contribute to production with your labor and your capital (he also mentioned
land, which we include in capital as a non-human input to production).
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| Karl Marx |
What Say left out,
however, was how someone without capital who had only labor to sell is supposed
to purchase capital in order to be able to produce enough to be able to
consume. This allowed people like David
Ricardo, Thomas Malthus, Karl Marx, and John Maynard Keynes to reject Say’s Law
on the grounds that since not everyone owned capital, labor is the sole input
to production, and consumption and production are not in balance, Say’s Law
obviously does not work.
Of course, the
astute reader will immediately realize that Ricardo and company’s argument boils
down to claiming that because Say’s Law is not working, it therefore cannot
work . . . which is like saying that because your car cannot run without gas,
it cannot run. The response, of course,
is that if your car needs gas to run, or Say’s Law needs capital ownership to
work, then put some gas in the tank for the car to run or turn propertyless
people into capital owners for Say’s Law to work!
So how do you turn
propertyless people into capital owners?
That, while ultimately the most important economic issue, is not the one
we’re looking at today, although we will address it in the conclusion. What we are after in this discussion is a “pure
theory” of money to understand the thing itself, not the admittedly crucial
issue of how to get money to do its intended job.
So, taking into
account Say’s Law, we discover that “money” is the means or medium by which people exchange what
they produce; money is “the medium of exchange.” As Say explained in his discussion of this
subject with Malthus,
All those who, since Adam Smith, have turned their attention
to Political Economy, agree that in reality we do not buy articles of
consumption with money, the circulating medium with which we pay for them. We
must in the first instance have bought this money itself by the sale of our
produce.
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| Thomas Malthus |
To a proprietor of a mine, the silver money is a produce with
which he buys what he has occasion for. To all those through whose hands this
silver afterwards passes, it is only the price of the produce which they
themselves have raised by means of their property in land, their capitals, or
their industry. In selling them they in the first place exchange them for
money, and afterwards they exchange the money for articles of consumption. It
is therefore really and absolutely with their produce that they make their
purchases: therefore it is impossible for them to purchase any articles
whatever, to a greater amount than those they have produced, either by
themselves or through the means of their capital or their land.
From these premises I have drawn a conclusion which appears
to me evident, but the consequences of which appear to have alarmed you. I had
said — As no one can purchase the produce of another except with his own
produce, as the amount for which we can buy is equal to that which we can
produce, the more we can produce the more we can purchase. From whence proceeds
this other conclusion, which you refuse to admit — That if certain commodities
do not sell, it is because others are not produced, and that it is the raising
produce alone which opens a market for the sale of produce. (Jean-Baptiste Say,
“Letter 1,” Letters to Mr. Malthus, 1821.)
Although this is
one of the best explanations of Say’s Law of Markets from the hand of Say
himself, we immediately see a problem — aside from how propertyless people are
supposed to become capital owners, that is!
At the beginning of this posting we defined “money” as “all things
transferred in commerce.” Yet here it
sounds as though “money” is itself an article of commerce! How do we resolve that seeming contradiction?
That is what we
will address in the next posting in this series.
#30#