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Thursday, August 26, 2010

Say's Law of Markets, Part III: The Real Bills Doctrine

It's a popular truism that you need money to make money, or that banks will only loan money to the people who don't need it. Fortunately, these aphorisms are only true — and even then only in a limited sense — within a paradigm circumscribed by a limited understanding of money and credit. These limits are, one, that money is a State-authorized purchase order, backed by the general wealth of the economy on which the State can draw by taxation, and, two, that only existing accumulations of savings can be used to finance new capital formation.

Must Wealth Be Concentrated?

As we have seen, if existing accumulations of savings are the only source of financing for new capital formation, then, as Keynes observed, based on these erroneous assumptions, the demands of economic development require the elimination of small ownership from society. Only the rich — and the richer, the better — can afford to cut consumption and save in the presumably necessary amounts required to finance modern capital. As Keynes declared, "The immense accumulations of fixed capital which, to the great benefit of mankind, were built up during the half century before the war, could never have come about in a Society where wealth was divided equitably." (John Maynard Keynes, The Economic Consequences of the Peace, 2.III.)

Unfortunately, capital has become the predominant factor of production in the modern advanced economy. Human labor (considered solely as an input to production) has become relatively less important in the production process. The ability to gain sufficient income from labor alone, absent subsidies, union coercion, or redistribution by the State via direct taxation or manipulation of the currency has all but disappeared as a significant factor in the modern advanced economy.

The problem, of course, is that if the worker cannot produce by means of his or her labor, and if the State does not engage in some form of redistribution, the worker cannot consume. Even worse, if someone cannot turn his or her existing or future production of marketable goods and services into money by drawing a bill and discounting it, the market will be restricted to those who have either accumulated sufficient savings, have jobs that pay them out of existing savings, or those who receive tax monies from the State and so have effective demand.

According to Say's Law, if the economy is in a slump and goods and services remain unsold, it is because a significant number of people are not able to produce by means of their labor or capital, and thus do not have their own productions to exchange for the productions of others. Government redistribution, tax rebates, and inflation do not solve this problem. Instead, such measures make matters worse by maintaining, even increasing the "ownership gap." When the system relies on existing accumulations of savings to finance new capital formation, the non-owning worker is cut off from owning capital, the predominant means of production.

The problem is thus that, the way the system is currently structured, only those who already own capital have the capacity to finance (and thus own) virtually all new capital. At the same time, those who own little or no capital and therefore desperately need to become owners of income-generating assets to supplement or replace labor as the predominant factor of production, do not have access to the existing accumulations of savings that presumably provide the financing for all new capital formation. The reliance on existing accumulations of savings automatically means that Say's Law of Markets will not function, because most people cannot replace lost labor income with capital income.

A Better Understanding of Money

Once we understand that money is anything that can be used in settlement of a debt, however, Say's Law of Markets can function. Chiefly this is through the operation of the real bills doctrine. Simply put, the real bills doctrine — ridiculed and rejected on specious grounds by the three major modern schools of economics — is that money can be created or cancelled without inflation or deflation under certain conditions. These are 1) The amount of money created or cancelled must never exceed the increase or decrease in the present value of existing or future marketable goods and services in the economy. 2) The issuer of the money, whatever form it takes, must have a private property stake in the present value of the existing or future marketable goods and services — or the capital that will produce the marketable goods or services in the future — that stands behind the promise that the money conveys.

The problem with the current understanding of money — we can't call it "old," for it is newer than the understanding of money embodied in Say's Law — is that authorities who adhere to the belief that existing accumulations of savings are the sole source of financing for new capital tend to ignore the need to increase production when goods are not being consumed. Say's comments about the "vulgar prejudices" holding that consumption — effective demand — should be increased and production ignored, bring Keynesian monetary and fiscal policy forcibly to mind. Rather than concentrate on production and employment in productive activity to bring an economy out of recession, Keynesian policy — like that of Malthus — concentrates on dividing up existing wealth into smaller and smaller portions. Keynesian monetary and fiscal policies do this by manipulating the currency and inequitable tax burdens, policies that discourage small ownership and force as many people as possible into the wage system and the proletarian condition.

The main problem that so-called "orthodox" economists see with Say's Law of Markets, then, is the question of where to get the money with which to finance the acquisition of capital and land by people who cannot produce enough by means of labor alone to enable them to cut consumption and accumulate sufficient savings with which to purchase non-labor means of production. Adam Smith explained it in "Book II" of The Wealth of Nations.

After explaining that money evolved out of a need to trade one individual's production of goods and services for those of others in terms of a common unit of value (Ibid. "Introduction"), Smith reiterated the fact that production, not money, equals income. "Money" is not itself revenue, but a measure of revenue:
Money, therefore, the great wheel of circulation, the great instrument of commerce, like all other instruments of trade, though it makes a part, and a very valuable part, of the capital, makes no part of the revenue of the society to which it belongs; and though the metal pieces of which it is composed, in the course of their annual circulation, distribute to every man the revenue which properly belongs to him, they make themselves no part of that revenue. (Ibid., II.ii)
That is, money is not purchasing power — value — because money is not in and of itself valuable. Rather, money as a measure of revenue conveys the purchasing power — the value — inherent in the present value of the marketable goods and services that "money" represents, and on which the issuer of the money has a legal claim.

That being the case, are the extremely expensive gold and silver "game markers" that can be used to settle debts and convey and store value strictly speaking absolutely necessary? Smith claimed not. It is, in fact, much more rational and efficient to use inexpensive paper, not costly gold and silver, as the currency:
The substitution of paper in the room of gold and silver money, replaces a very expensive instrument of commerce with one much less costly, and sometimes equally convenient. Circulation comes to be carried on by a new wheel, which it costs less both to erect and to maintain than the old one. But in what manner this operation is performed, and in what manner it tends to increase either the gross or the neat revenue of the society, is not altogether so obvious, and may therefore require some further explication. (Ibid.)
Smith then proceeded to describe the functioning of a bank of issue, the process of discounting, and the operation of the banking system in Scotland, which most closely approximated a country in which paper credit had largely replaced gold and silver credit. Whether money is gold and silver, or paper, is — so far as the money supply itself is concerned — a matter of indifference, except, perhaps, for the cost involved in producing a metallic currency.

The real issue is in the purpose to which money is put. If money is created (whether by minting or printing) and used for consumption, it "is in every respect hurtful to the society." (Ibid.) If, however, money is created and put to work financing capital formation, "it promotes industry; and though it increases the consumption of the society, it provides a permanent fund for supporting that consumption, the people who consume re-producing, with a profit, the whole value of their annual consumption." (Ibid.) As Smith explained,
It is like a new fund, created for carrying on a new trade; domestic business being now transacted by paper, and the gold and silver being converted into a fund for this new trade.

If they employ it in purchasing foreign goods for home consumption, they may either, first, purchase such goods as are likely to be consumed by idle people, who produce nothing, such as foreign wines, foreign silks, etc.; or, secondly, they may purchase an additional stock of materials, tools, and provisions, in order to maintain and employ an additional number of industrious people, who reproduce, with a profit, the value of their annual consumption. (Ibid.)
What Smith set out is the basic rule for money creation, whether the monetary medium consists of precious metal, paper, electronic blips, or a handshake. If money is created to spend on consumption, that is, on financing the purchase of goods and services that do not generate their own repayment, it is not only foolish (Ibid.), but causes actual harm to society. (Ibid.). If, on the other hand, money is created and spent in ways that generate repayment of the money, the process represents a positive good to the society. (Ibid.) We must always take care, however, not to confuse money with purchasing power, that is, mistake the symbol of value for the actual value that stands behind the symbol. As Smith explained,
When we compute the quantity of industry which the circulating capital of any society can employ, we must always have regard to those parts of it only which consist in provisions, materials, and finished work; the other, which consists in money, and which serves only to circulate those three, must always be deducted. In order to put industry into motion, three things are requisite; materials to work upon, tools to work with, and the wages or recompence for the sake of which the work is done. Money is neither a material to work upon, nor a tool to work with; and though the wages of the workman are commonly paid to him in money, his real revenue, like that of all other men, consists, not in the money, but in the money's worth; not in the metal pieces, but in what can be got for them. (Ibid.)
Smith emphasized that it is not the amount of money created that is the important thing, nor even the material from which it is made, but the use to which it is put. It is the productive creation of money, not the mere fact of money creation that should govern how we view this extremely useful instrument. Again, if money is created to invest in productive projects and not for consumption, it is a great boon to society:
When paper is substituted in the room of gold and silver money, the quantity of the materials, tools, and maintenance, which the whole circulating capital can supply, may be increased by the whole value of gold and silver which used to be employed in purchasing them. The whole value of the great wheel of circulation and distribution is added to the goods which are circulated and distributed by means of it. . . . When, therefore, by the substitution of paper, the gold and silver necessary for circulation is reduced to, perhaps, a fifth part of the former quantity, if the value of only the greater part of the other four-fifths be added to the funds which are destined for the maintenance of industry, it must make a very considerable addition to the quantity of that industry, and, consequently, to the value of the annual produce of land and labour. (Ibid.)
Smith then made what at first glance appears to be a very puzzling statement, and one that seems to contradict what he had said up to this point in his argument. That is, "The whole paper money of every kind which can easily circulate in any country never can exceed the value of the gold and silver, of which it supplies the place, or which (the commerce being supposed the same) would circulate there, if there was no paper money." Ibid.)

That sounds as if Smith was saying that paper money can replace gold and silver, but it cannot supplement gold and silver, that is add to the money supply. A closer reading, however, reveals that is not, in fact, what Smith was saying, although monetary theorists over the centuries have believed that Smith was saying just that, most notably David Ricardo, (David Ricardo, Minor Papers on the Currency Question. Baltimore, Maryland: Johns Hopkins University Press, 1932, 15.) who made it an important criticism in his "corrections" of Smith's theories. (David Ricardo, The Principles of Political Economy and Taxation. London: J. M. Dent and Sons, Ltd., 1992, 239-241.)

Smith first stated that the amount of paper can never exceed the value of the gold and silver that it replaces. This statement, in and of itself, is false — as Smith himself explained later. It is very easy to "over issue" paper money; Smith complained that poorly run banks were doing it all the time:
Had every particular banking company always understood and attended to its own particular interest, the circulation never could have been overstocked with paper money. But every particular banking company has not always understood or attended to its own particular interest, and the circulation has frequently been overstocked with paper money. . . . The Scotch banks, in consequence of an excess of the same kind, were all obliged to employ constantly agents at London to collect money for them, at an expense which was seldom below one and a half or two per cent. . . . Even those Scotch banks which never distinguished themselves by their extreme imprudence, were sometimes obliged to employ this ruinous resource. (The Wealth of Nations, op. cit., II.ii)
No, Smith did not mean that it is impossible to issue more paper money than there is gold or silver in an economy. He meant that it is not safe to do so. Even that, however, is not the point he was making. The key to what Smith was talking about is in the second half of the sentence, that the amount of paper money cannot — to be safe — exceed the amount of gold and silver it replaces or (and this is the important point) would have been there, the commerce being supposed the same.

In other words, the "safe" amount of paper money is not dictated by the existing gold and silver, or even the gold and silver that used to be there but was melted, exported, or hoarded. On the contrary, the amount of paper money that an economy can safely absorb without harm is determined by the amount of gold and silver that would have been there to serve the same amount of commerce.

That is, ceteris paribus ("all things being equal"), the amount of currency of whatever material is determined by the demand for financially feasible capital in the economy (the needs of commerce), not the other way around. What Adam Smith was actually saying is that an economy need never have had any gold or silver at all, and can safely use paper or anything else, as long as the amount does not exceed the actual demand in the economy for money to finance capital formation. Richard Hildreth agreed (as have numberless subsequent authorities):
It is now well understood, that the currency of any country, whether it be coin or bank-notes, cannot be increased beyond the mercantile wants of that country, without producing a depreciation in the parts which compose the currency. The total value of the currency of a country, — business being supposed to remain the same — will always be a fixed and settled amount; and if the coins or notes which compose that currency be increased, and if there is no outlet by exportation, it follows, that the value of all the separate coins and notes composing that currency, will diminish in a just proportion, so that altogether they may make up exactly the same sum total as before. (Richard Hildreth, The History of Banks. Boston: Hilliard, Gray & Company, 1837, 17-18.)
What happens if the amount of paper money exceeds the demands of commerce? According to Smith, that is when gold and silver become necessary. If no excess paper is ever issued, of course, gold and silver (or the lack thereof) need ever become a matter for concern, as Smith demonstrated. If, however, excess paper money is issued, the paper currency will depreciate in terms of gold and silver. This will cause people to hurry to exchange their paper notes for gold and silver, reducing the excess paper and thereby reestablishing parity of paper with gold and silver. (The Wealth of Nations, op. cit., II.ii.)

Gold and silver are necessary to stabilize the parity of paper money. (Ibid.) This is because bankers cannot be trusted always to restrain themselves and limit the issue of paper money to the actual needs of the economy. (Ibid.) Were it not for that, the advantages of paper would far outweigh using gold and silver in an advanced economy with a sound banking system.

Many people are surprised to discover that Adam Smith was not advocating capitalism (he never even used the word, nor did he ever mention capitalists). Capitalism, a system where the ownership of productive assets (i.e., capital) is concentrated in a few hands, was actually an alien concept to Smith. He simply assumed that whoever wanted to acquire capital could use his labor to generate income, reduce his consumption, and finance the acquisition of capital out of past savings generated by labor. (Ibid.)

In Smith's analysis, the real bills doctrine was applied to monetizing the present value of existing inventories of marketable goods and services, not to the present value of future goods and services. In his assumption regarding the financing of capital, he was wrong — but it does not detract from the validity of his observations concerning the issue of paper money. To his analysis, we only have to add that in all cases there must be real value behind the money, whatever it is made of, and the amount of new money cannot exceed the present value of all existing or future marketable goods and services in the economy, or there will be a disaster.