There is much more to Adam Smith (1723-1790), the purported high priest of laissez faire capitalism, than many today suppose. Part of this is because few people in positions of authority, whether Church, State, or Family, understand the underlying principles of his philosophy. Instead, they accept conventional wisdom based on the principles of a competing paradigm having little in common with Smith’s fundamental tenets.
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| Adam Smith |
Consequently, to get along in academia or politics these days one must say the accepted things about Smith. This demonstrates one has the correct attitude about capitalism and its purported high priest. Ironically, this is the case whether one is liberal or conservative, socialist or capitalist, or just about anything else.
Today’s economists and politicians of different parties and ideologies, although they often think themselves as utterly opposed to one another, share fundamental assumptions about money and finance. They can and do argue endlessly and — because they are operating from a flawed paradigm — fruitlessly about applying those assumptions. Nevertheless, they are in basic agreement on essentials when the day is done.
Smith baffles modern experts on two key points. One, money and credit and, two, the productiveness of labor. For the first, most simply put, with respect to money, today’s academics assume as a given money is a commodity the existence of which necessarily precedes its use. Because of this false assumption, they believe the quantity of pre-existing money in an economy determines the level of economic activity; production derives from money. As the aphorism goes, you need money to make money.
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| John Maynard Keynes |
This is called “the Currency Principle.” It is the basis for virtually the whole of economic and political thought and thus policy in the modern world. The three mainstream schools of economics, Keynesian, Monetarist/Chicago, and Austrian, take the Currency Principle as an absolute, unquestionable, irrefutable dogma. They are completely wrong.
This is easily demonstrated. According to Smith and the classical economists who followed his lead (known as the Smithian school of classical economics), production does not derive from money. Rather, money derives from production. Instead of the quantity of money determining the level of economic activity as the Currency Principle dictates, the level of economic activity determines the quantity of money.
This is called “the Banking Principle.” Classical banking theory, borne out by thousands of years of experience, is based on the demonstrable fact production can and often does precede the existence, even the thought of money.
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| Louis O. Kelso |
Money in this context — or any other — must be understood not as something valuable in and of itself. Instead, money is a complete abstraction, a creation of human minds, by means of which people measure value, primarily to facilitate economic exchange. Creating money in anticipation of carrying out economic exchanges is, in a sense, as ludicrous and wrong-headed as manufacturing inches or feet in anticipation of determining the length of something.
Money is not the thing or things exchanged, any more than a centimeter or meter is the thing measured. In both cases, money and meters, they are the mechanisms, the media by means of which a thing or things are exchanged or measured, respectively. Given this understanding, it is as nonsensical to speak of insufficient money to carry out transactions as it is to claim there are not enough miles to measure distance.
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| Irving Fisher |
Most simply put, money is how Person A measures value and exchanges what he produces for what Person B produces, and vice versa. As Louis Orth Kelso (1913-1991) explained, “Money is . . . 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.” (Louis O. Kelso and Patricia Hetter, Two-Factor Theory: The Economics of Reality. New York: Random House, 1967, 54.)
Mathematically, the functioning of money in an economy is expressed by the Quantity Theory of Money equation, M x V = P x Q. While this appears alarming to anyone who does not remember or never took algebra in school, it is really very simple. M is the quantity of money in the economy, V is the velocity of money (the average number of times a unit of currency is spent in a year), P is the price level, and Q (some economists use T instead of Q) is the number of economic transactions. Solving for M to get the amount of money in an economy results in M = (P x Q)/V.
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| Simon Newcomb |
Simon Newcomb (1835-1909), an astronomer, first stated the Quantity Theory of Money equation in mathematical form. Irving Fisher (1867-1947), a Currency Principle economist of the Monetarist/Chicago school of economics, further developed the theory. Despite the volumes written on the subject, however, there is only one thing the typical non-economist needs to know about the Quantity Theory of Money equation: it disproves — or at least does not prove — the Currency Principle! (Harold G. Moulton, Financial Organization and the Economic System. New York: McGraw-Hill Book Company, Inc., 1938, 496-501.)
This is easily explained. If Currency Principle economists are right, the quantity of money determines the level of economic activity, i.e., you need money to make money. If the Currency Principle is true, then correctly determining the amount of money to provide for the economy will result in the chosen price level, the desired number of economic transactions, and the required average number of times each unit of currency is spent in a year in an economy with full employment and no poverty.
Instead, what has happened is the current global debt crisis at both the individual and national level, massive government interference in economic and thus personal life, growing numbers in perpetual poverty, and economies staggering from catastrophe to disaster and back again as they await the inevitable crash. Even to the most economically illiterate, this suggests the experts have no better idea of how money functions than they do — perhaps not as good.
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