In the previous posting on this subject, we looked at the shaky moral foundation of Keynesian theory. This consists of Keynes’s own assertion that his system would only work if we lie to ourselves for at least a century. We also looked at the somewhat distorted and distorting concept of productivity as understood in economics and public policy. In contrast, we posed Louis Kelso’s concept of productiveness, the free market-determined value each factor contributes to the overall production process.
 |
| This is exactly . . . BACKWARDS |
Today we address a cornerstone of Keynesian economics: the Quantity Theory of Money. This is important, because there are two very serious problems with it as interpreted in Keynesian economics. One, there is a misunderstanding the Quantity Theory of Money equation which involves a fundamental mathematical error easily discerned by anyone who has taken high school algebra. Two, and related to this basic mathematical error, when used to justify monetary policy, is when an attempt is made to base real world decisions on the error, it results in a financial disaster of potentially epic proportions.
 |
| Irving Fisher |
To explain, the Quantity Theory of Money equation, developed in its final form by Irving Fisher (although Harold Moulton claimed Fisher didn’t understand his own equation!) expresses the relationship of the amount of money (M), the “velocity” of money (V, the average number of times each unit of money is spent), the price level (P), and the number of transactions (Q). As it is usually expressed,
M x V = P x Q
Right off the bat, however, problems of interpretation appear. To Louis Kelso (and Harold Moulton), “money” is anything that can be accepted in settlement of a debt; it consists of all things transferred in commerce. Money is therefore THE medium of exchange, solely and exclusively. As Kelso defined money,
 |
| Louis O. Kelso |
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.)
To the Keynesians, however, as well as the Monetarists, Austrians, and virtually all other schools of economics today, “money” consists exclusively of currency and currency substitutes; money is only one of many possible media of exchange. This, in and of itself, invalidates Keynes’s (and others’) use of the Quantity Theory of Money equation, for it mis-defines the very subject of the equation.
 |
| John Maynard Keynes |
How, after all, can you say anything about the quantity of something when you don’t know what that something is? By omitting from their definition of M all that is not currency or currency substitutes, the Keynesians and others fail to factor in the larger part of the money supply. This means their interpretation of the equation is not merely incomplete, it is incorrect from the word go.
There is, however, a bigger problem, and one that cannot be fixed by expanding the limited definition of money to include the broader Kelsonian (actually the original classical economic) concept. The bigger problem is how Keynesians and others interpret the equation itself. To Kelso and many of the classical economists, the level of economic activity determines the amount of money. It might not be the officially issued currency or a substitute thereof, and it might not even be measured in terms of the official currency, but economic activity creates money, however the parties to that activity value it or what form it takes.
To the Keynesians and others, however, the quantity of money determines the level of economic activity; money and credit are a commodity in limited supply. Consequently, all economic activity derives from money rather than (as with Kelso) all money derives from economic activity. The “game” then becomes not how to encourage and foster economic activity, but how to determine the right quantity of money to encourage and foster economic activity.
This sounds easy enough . . . until you try to do it. This is where basic algebra comes in, because the Quantity Theory of Money equation has four “variables.” That means the Keynesians and others are trying to find a single, unique solution to the equation to control or determine 1) the velocity of money, 2) the price level, and 3) the number of transactions . . . and it cannot be done. It is mathematically impossible.
 |
| With three variables, you need three equations |
You see, a single equation with four variables generally cannot be solved for a unique solution; it typically has an infinite number of solutions. While you cannot find specific values for each of the four variables, you can express three variables in terms of a fourth (independent) variable to define the “solution set.” And that means you can have as many solutions as there are possibilities, which is infinite.
In mathematical terms, without additional constraints (for example, restricting solutions to integers), for a single equation such as w + x + y + z = 10, w + x + y + z = 10 has infinitely many solutions. Thus, for M x V = P x Q, the politicians who want more money can simply say they want more M, and everything will work out the way they intend because they can fit anything into the equation and it is a solution . . . although so is virtually everything else!
Of course, if you want a unique, specific solution for four variables, you typically need a system of four independent equations. Once you have that, you can pick one variable and express it in terms of the others, such as w = 10 – x – y – z, and solve for one variable given specific values for the other three.
 |
| Norman G. Kurland |
This is, in fact, what Kelso advocated. As explained in “A New Look at Prices and Money” by Dr. Norman G. Kurland, M can be expressed as (P x Q)/V. Obviously, there is no way to determine P, Q and V by plugging in some value for M, but you can just as obviously know how much money there should be by plugging in P, Q and V! Thus, mathematically speaking, you cannot determine the level of economic activity by knowing M, but you CAN know M by knowing the level of economic activity!
Consequently, all the convoluted attempts to determine the right amount of money to create by Keynesians and others and pour into the economy are not merely mathematical nonsense, but a potential utter disaster. This is because whoever heard of a politician who would not want to print up as much money as he or she possibly could?
Perhaps that is why the Kelsonian solution is so unpopular. Not only would it take the money creation power away from the politicians, but it would also ensure money was created naturally, by people engaged in commerce, industry, and agriculture: you know, economic activity.
#30#
