In the previous posting on this subject, we looked at the two main problems with Keynesian monetary theory. To summarize, these are, one, the amount of money (understood by Keynes as limited exclusively to government-created currency) in the economy is determined by political needs, not economic or financial. Two, all money should be backed by government debt instead of private sector hard assets.
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| Smith's law is common sense |
In other words (according to Keynes), government should absolutely control the economy to advance political needs, instead of people controlling their own lives by being productive and using money and credit to facilitate exchange. This actually overturns the whole nature and purpose of money.
This requires some explanation.
As we saw in our examination of Keynesian assumptions, Keynes defined savings — which are essential to finance new capital formation — as reductions in consumption to accumulate unconsumed production to finance production . . . which begs the question as to where the first production comes from!
To be blunt, Keynes ignored Adam Smith’s first principle of economics as stated in The Wealth of Nations: “Consumption is the sole end and purpose of all production.” As Jean-Baptiste Say realized, this necessarily implies that production must precede consumption, not (as Keynes would later assume) that consumption must precede production. It must, therefore, be possible to produce without first producing to be able to accumulate savings.
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| Say's Law is common sense |
As Say reasoned, there is only one way to be able to consume, and that is to have produced something first. Despite anything Keynes said later, production must precede consumption, not the other way around. Either you must produce directly for your own consumption, or you must produce something to trade to others for something they have produced that you want to consume.
Of course, you can always simply take what you want if you’re strong enough, or beg for it as charity, but that is not the way to encourage most people to be productive. As a general rule, if you want to consume, you must first produce . . . or give a good promise that you intend to produce and will give somebody a promise to give them something in the future if they give you something today. That is why “Say’s Law of Markets” can be summarized as “production equals income, therefore, supply generates its own demand, and demand its own supply.”
It works like this. In classic banking theory, “money” consists of a promise to deliver something of value on demand or at a specified time. The issuer of the “money” doesn’t have to have what he or she has promised at the time the “money” is issued, only when the “money” is presented for redemption. The issuer of the money — the maker of the promise — only has to have a reasonable and quantifiable assurance that he or she will be able to keep the promise at the agreed-upon time.
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| Keynes's law . . . meh. |
Thus, in the Spring the owner of an apple tree can tell a storekeeper, “I have an apple tree that each year typically produces twice as many apples in the Fall as I can use. I consulted an expert whom you know and whose word you trust that there is a 90% probability that the tree will do the same this year. The total value of the crop each year averages $2,000. If I promise to deliver half the crop to you in the Fall, an estimated value of $1,000, will you agree to provide me with goods from your store to the value of $900?”
Seeing a profit of $100 on the deal in addition to the usual retail markup on the goods, and knowing he can trust the tree owner, the merchant agrees and accepts the deal. In financial terminology, what has happened is the issuance and acceptance of a bill of exchange at a discount as a “merchants acceptance” that has been “discounted.” Between them, the tree owner and the merchant have created “money.”
Now, suppose the merchant knows he won’t need that many apples in the Fall, but he knows someone who does, i.e., the owner of a cider mill. Let us further suppose that the agreement between the tree owner and the merchant is in writing, and that it is “negotiable,” that is, the merchant can sell it to somebody else, a “holder in due course,” to whom the tree owner will deliver the apples in the Fall.
The merchant indorses the bill (for reasons we won’t go into, “indorse” is the correct spelling when it’s a financial instrument, although this is no longer strictly adhered to) and sells it to the cider mill operator for $950. The merchant has “redisdounted” the bill.
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| How do you like them apples? |
Obviously, this can continue with as many discounts as people want, with the rediscount price going up at each exchange the closer the time gets to when the bill can be redeemed for $1,000 worth of apples. On the day the bill is due, it is worth $1,000, and the owner of the tree must deliver $1,000 worth of apples to whoever is the holder in due course of the bill.
Those are the basic principles of commercial and central banking in a nutshell . . . or apple cart, if you prefer. The role of a bank in this process is to standardize the “money” issued by a single customer with all the other customers served by the bank. The role of a central bank is to standardize all the “money” issued by its member banks. This makes matters much easier in trade, for no one has to know the other party to a transaction as long as the “money” is good.
The bottom line here is that with a good money system, financing economic growth or any kind of production should never be a problem. Even meeting consumption needs should not be more than a short term difficulty. It is only necessary to figure out what someone needs, produce it, and exchange it for what the customer has produced or is reasonably expected to produce in the future.
And how do we make certain that people can be productive so that the system works? We will cover that in the next posting on this subject.
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