Money, Income and Time: A Quantum-Theoretical Approach (Bloomsbury Academic Collections: Economics) 1472505840, 9781472505842

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MONEY, INCOME AND TIME

Bloomsbury Academic Collections: Economics This 26-volume Bloomsbury Academic Collection makes available to the 21st century scholar a range of classic titles on economics originally published in the 1980s. Embracing works on globalization, the effects of US international policy and the projected impact of fiscal harmonization in Europe, the collection also contains works on classical political economy and international development financing. The collection is available both in e-book and print versions. Other titles available include: American International Oil Policy: Causal Factors and Effect, Hans Jacob Bull-Berg Classical Political Economy: Primitive Accumulation and the Social Division of Labor, Michael Perelman Colonial Trade and International Exchange: The Transition from Autarky to International Trade, R. A. Johns Development Financing: A Framework for International Financial Co-operation, Edited by Salah Al-Shaikhly Economic and Social Development in Qatar, Zuhair Ahmed Nafi Economic Development in Africa: International Efforts, Issues and Prospects, Edited by Olusola Akinrinade and J. Kurt Barling Economics of Fisheries Development, Rowena M. Lawson Fiscal Harmonization in the European Communities: National Politics and International Cooperation, Donald J. Puchala Forming Economic Policy: The Case of Energy in Canada and Mexico, Fen Osler Hampson Globalization and Interdependence in the International Political Economy: Rhetoric and Reality, R. J. Barry Jones International Trade Theories and the Evolving International Economy, R. A. Johns Legal Aspects of the New International Economic Order, Edited by Kamal Hossain Long-run Economics: An Evolutionary Approach to Economic Growth, Norman Clark and Calestous Juma Perspectives on Political Economy: Alternatives to the Economics of Depression, Edited by R. J. Barry Jones Slow Growth and the Service Economy, Pascal Petit Tax Havens and Offshore Finance: A Study of Transnational Economic Development, R. A. Johns Testing Monetarism, Meghnad Desai The Developing Countries and the World Economic Order, Lars Anell and Birgitta Nygren The Financing of Foreign Direct Investment: A Study of the Determinants of Capital Flows in Multinational Enterprises, Martin G. Gilman The Political Economy of Development, Just Faaland and Jack R. Parkinson The Recalcitrant Rich: A Comparative Analysis of the Northern Responses to the Demands for a New International Economic Order, Edited by Helge Ole Bergesen, Hans-Henrik Holm and Robert D. McKinlay Time and the Macroeconomic Analysis of Income, Alvaro Cencini Urban Political Economy, Edited by Kenneth Newton U.S. Foreign Policy and the New International Economic Order: Negotiating Global Problems, 1974–1981, Robert K. Olson Wages in the Business Cycle: An Empirical and Methodological Analysis, Jonathan Michie

MONEY, INCOME AND TIME A Quantum-Theoretical Approach Alvaro Cencini

BLOOMSBURY ACADEMIC COLLECTIONS Economics

LON DON • N E W DE L H I • N E W YOR K • SY DN EY

Bloomsbury Academic An imprint of Bloomsbury Publishing Plc 50 Bedford Square London WC1B 3DP UK

1385 Broadway New York NY 10018 USA

www.bloomsbury.com Bloomsbury is a registered trade mark of Bloomsbury Publishing Plc First published in 1988 This edition published in 2013 by Bloomsbury Publishing plc © Alvaro Cencini, 2013 All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information storage or retrieval system, without prior permission in writing from the publishers. Alvaro Cencini has asserted his right under the Copyright, Designs and Patents Act, 1988, to be identified as Author of this work. No responsibility for loss caused to any individual or organization acting on or refraining from action as a result of the material in this publication can be accepted by Bloomsbury Academic or the author. Bloomsbury Academic Collections ISSN 2051-0012 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. ISBN: 9781472505842 (Hardback) ISBN: 9781472514356 (ePDF) ISBN: 9781472536112 (Bloomsbury Academic Collections: Economics) Library of Congress Cataloging-in-Publication Data A catalog record for this book is available from the Library of Congress

Money, Income and Time

To Ginevra

Money, Income and Time A Quantum-Theoretical Approach Alvaro Cencini

la

Pinter Publishers, London and New York

@ Alvano Cencini, 1988 First published in Great Britain in 1988 by Pinter Publishers Limited 25 Floral Street, London WC2E 9DS All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted by any other means without the prior written permission of the copyright holder. Please direct all enquiries to the publishers. British Library Cataloguing in Publication Data Cencini, Alvaro Money, income and time theoretical approach. 1. Money I. Title 332.4 ISBN 0-86187-943-0

:

a quantum-

HG22 1

Library of Congress Cataloging-in-PublicationData Cencini, Alvaro. Money, income, and time. Includes index. 1. Money. 2. Quantity theory of money. 4. Time and economic reactions. I. Title. HG221.C39 1988 332.4 87-7279 ISBN 0-86187-943-0

3. Income.

Photoset by Mayhew Typesetting, Bristol, England Printed by Biddles of Guildford Ltd.

Contents

Acknowledgements Foreword by Meghnad Desai Introduction

x xi 1

Part I: A New Approach to Monetary Analysis 1 The origins of an alternative definition of money 1. The exclusion of money from the commodity set 1.1. Money and output 1.2. Money and the value of money 2. Smith's great wheel of circulation 2.1. Money conceived as an empty vehicle 2.2. The circulation of money and the circulation of goods: their identity

9 9 9 10 10 10

3. Money as the form of value 3.1. Commodity-money and the form of value: their incompatibility 4. Walras' concept of numeraire 4.1. Money as a numerical standard of relative value 4.2. The numeraire and the function of money 2

3

13 15 16 19 19 20

Nominal money and real money 1. The classical distinction of Adam Smith and David Ricardo 1.1. Money and money's worth 1.2. Nominal money and real money 1.3. Money and the payment of labour 2. Marx's contribution to the classical distinction between nominal money and real money 2.1. The concept of money as the general equivalent 2.2. Real money and the payment of wages

23

28 28 29

3. Summing up

30

The Banking School and the Currency School

33

1. The Currency Principle 1.1. Convertibility and depreciation 1.2. Can real money be the cause of depreciation? 1.3. Depreciation as caused by the over-emission of nominal money

33 33 35

23 23 25 26

36

vi

Contents

2. The Banking Principle 2.1. The activity of banks and the increase in the circulation of money 2.2. Production and the depreciation of money 2.3. Depreciation and convertibility as viewed by the Banking School 4

5

6

Keynes's analysis of money 1. From commodity-money to bank money 1.1. Commodity-money, bank money and money proper 1.2. Bank money and the role of the state 2. The creation of money 2.1. Money as an 'asset-liability' 2.2. The example of overdrafts 3. The distinction between money and purchasing power 3.1. The definition of money's purchasing power 3.2. The origin of money's purchasing power 4. Money's value and production costs 4.1. Labour as the sole factor of production 4.2. Money, income and the payment of wages Money and time 1. The emission of money and the distinction between bank money and state money 1.1. The emission of outside money 1.2. The emission of inside money 1.3. The emission of book-entry money is not a source of income, either for the state or for the banks 2. The emission of money and time 2.1. Double accounting and credit 2.2. Credit and the emission of money 2.3. The emission of money, the creation of bank deposits and time 2.4. The creation of money and the demand for money to hold 2.5. Time and the circulation of money Income and time 1. The distinction between money as a means of payment and money as a medium of exchange

37 37 39 41 44 44 44 45 47 47 48 49 50 51 53 53 54 57 57 58 60 63 65 65 67 69 70 71 76 77

Contents vii

1.1. Money as a means of exchange 1.2. Money as a means of payment 2. TTbe creation of income 2.1. Income, purchasing power and prices 2.2. The creation of income, the first example of absolute exchange 2.3. The circuit of the creation of income 2.4. The creation of income and quantum time 2.5. Income, capital and time 3. The destruction of income 3.1. Income and consumption 3.2. The destruction of income as the second example of absolute exchange 3.3. The circuit of the destruction of income 3.4. The circuit of income as a whole 3.5. Income destruction and quantum time

77 79 81 81 82 85 87 88 89 89 90 91 93 95

Part II: A Critical Appraisal of Traditional Monetary Analysis 7 The concept of commodity-money 103 1. The concept of commodity-money within the classical theory of value 103 1.1. Money and the labour theory of value 103 1.2. Money as a dimensional standard of value 104 1.3. Gold as a general equivalent 106 1.4. The difficulties relating to the concept of commodity-money 107 Commodity-money and labour time 107 Ricardo's dilemma 108 2. The concept of commodity-money within the neoclassical theory of relative prices 110 2.1. From absolute value to relative prices 110 2.2. The numerical expression of commodity-money 111 2.3. The logical impossibility of transforming money into numbers within the neoclassical theory of relative prices 112 8

Two faulty concepts: money as a net asset and money as a veil 1. Money as a net asset 1.1. Money and relative exchange 1.2. Money's purchasing power 1.3. The social determination of money's purchasing power

114 114 114 116 117

viii

Contents

1.4. Purchasing power and the simultaneous solution oftheGES 2. Money as a veil 2.1. Purchasing power as a mirror image of relative exchange value 2.2. Can a veil circulate goods? 9

119 120 120 123

The neoclassical dichotomy 1. 'Legitimate' versus 'traditional' dichotomy 1.1. The rejection of the traditional dichotomy 1.2. The legitimate dichotomy 1.3. The logical inconsistency between Samuelson's legitimate dichotomy and Walras' law 2. The triumph of Walras' law 2.1. Walras' law and General Equilibrium Analysis 2.2. The logical impossibility of determining an excess demand within a GES 2.3. On the impossibility of determining an excess demand even within the boundaries of 'virtual' exchange 2.4. The necessary clearance of all markets

127 129 129 130

10 The quantity theory of money 1. From Adam Smith to Irving Fisher 1.1. The 'classical' origin of the equation of exchange 1.2. The tautological aspect of Fisher's equation 1.3. The attempt to transform Fisher's truism into a functional relationship 2. The monetarist restatement 2.1. From tautology to causal relationship 2.2. The quantity theory as a theory of the demand for money 2.3. The demand function for money and the demand function for income

141 141 141 142

11 The monetarists' attempt at generalization

154

1. The attempt to integrate Keynes's analysis 1.1. Friedman's theory of nominal income 1.2. Friedman's failure to determine monetary prices 2. Keynes's refusal of the quantity theory of money 2.1. Keynes's critical approach 2.2. On two possible interpretations of Keynes's critical approach to the quantity theory of money

132 133 133 135 136 139

144 146 146 148 150

154 154 156 159 159 160

Contents ix 12 The quantity theory of money and the neoclassical dichotomy 1. Nominal income, real income and the level of prices 1.1. The macroeconomic equivalence of nominal and real income 1.2. The neoclassical dichotomy and the net asset definition of money 2. The necessary equivalence of nominal and real income 2.1. The purchasing power of nominal income 2.2. The reciprocal definition of nominal income and real income 13 The neutrality of money 1. The neutrality of money and the neoclassical dichotomy 1.1. The homogeneity postulate within Walrasian and non-Walrasian models 1.2. Hahn's refusal of the neutrality of money 2. The concept of neutrality and the definition of money 2.1. Neutrality and the net asset definition of money 2.2. Towards a new definition of the neutrality of money

163 163 163 166 170 170 171 173 173 173 175 111 177 179

Epilogue

182

Bibliography

189

Index of names

196

Subject index

198

Acknowledgements

Based on the theory worked out by Bernard Schmitt, this book has greatly benefited from his critical support, and so it is no wonder that it is to my master and friend that I am particularly indebted. My thanks are also due to Meghnad Desai whose generous and competent encouragments are the mark of his open-minded attitude towards scientific research. Mauro Baranzini also encouraged my work and provided many useful suggestions. My thanks go to him as well as to Chrys Payjack and Adrian Pollock, whose work has been decisive in improving the style of the English manuscript. Finally, I am grateful to the Italian CNR (CTCNR 85. 01120. 10 and the triangular project Universities of Fribourg, Dijon and Cattolica, Milan) and to the Swiss FNRS for their financing of the research that led to the writing of this book.

Foreword

Alvaro Cencini's new book is as timely as it is disregarding of merely current fashions. The state of monetary theory no less than that of the real world monetary economy is in some disarray. Monetary theories of the neo-Keynesian-monetarist, as well as new classical varieties, have been much debated, each seeking to challenge the position of the other. But each in its own way has reached an impasse. Starting in the mid 1950s, when Milton Friedman tried to rehabilitate the Quantity Theory of Money, one strand concentrated on integrating monetarism and Keynesianism into a vulgar union built around the notion of a stable demand function for money. The latest news on that front is that the demand for money function is no longer stable 0udd and Scadding, 1982). The postulate of homogeneity (the classical dichotomy), frequently rejected in econometric studies of demand for commodities (Deaton and Muellbauer, 1980), is also now rejected for demand for money. Undaunted, economists are trying to rehabilitate this notion by exploring models of money as buffer stocks which will incorporate inertia in people's reaction to nominal shocks (Laidler, 1984). On the policy front, monetarism has been already abandoned by the Federal Reserve in 1983 and the UK government in 1985 (Desai, 1986). The collapse of stock market prices in October 1987 converted the central banks to a policy of cheap money as the only stopgap against a total panic. The programme to integrate money into a Walrasian General Equilibrium (GE) model has fared no better. Having dismantled Patinkin's attempt to put money in GE via the real balance effect, Frank Hahn went on to promise a new dawn in monetary theory by a rigorous development of a monetary Arrow-Debreu economy (Hahn, 1965, 1973). This programme yielded some interesting technical insights but the irreconcilability of money and the GE system remains despite valiant efforts by Jean Michel Grandmont and others of the French School (Grandmont, 1985). The new classical school has fared no better. The Lucas triumph in establishing a Rational Expectations/Natural Rate of Unemployment paradigm during the 1970s, has steadily run into the ground. The theory cannot generate endogenous business cycles, such as are observed in economic data, since its core hypothesis is that the past does not and cannot matter in a world of rational expectations and efficient markets. It is only by exploring 'cash-in-advance' constraints that money and time can be admitted any role in the newer version of the new classical theory. Once again only arbitrary constraints or inertia can give money

xii Foreword

a place in economic theory. (See, Desai, 1981, for a critique of new classical theories; and Lucas and Stokey, 1987, for recent developments.) In the meantime, the stock market crash has made the inadequacy of these various theories patent. Even Gary Becker, no enemy of the new classical economics, was driven to express scepticism about the Efficient Market Hypothesis in his column in Business Week following the Black Monday. How can one explain within a model of GE with Walras' Law, etc., that one trillion dollars were lost by some without anyone getting them? Bewildered people from stockmarket experts to policymakers wonder why they were never warned about this. Ex-post we can explain everything. Winston Churchill was never more correct than when he described the economist as the person who predicts what will happen and then explains why it was obvious that his prediction did not turn out to be true. All the conventional wisdom of the mainstream theories — the Modigliani-Miller Theorem, the Efficient Market Hypothesis, Rational Expectations, Superneutrality of Money — looks hollow in face of this sudden collapse. It is this background that should prepare the readers to look at Alvaro Cencini's book with sympathy. His work is part of the long research programme of Bernard Schmitt and the ecole de Dijon. There were days when mainstream economics was so confident that it could dismiss all unorthodox thought with contempt as ad hoc or unrigorous. But the ploys by which new thinking is denied entry into the economic mainstream are now running ragged. Cencini raises some very deep questions about the way we think about money. They are also simple questions and make one wonder why no-one has asked them before in such a challenging way. As I said once before, in my foreword to his earlier book (Desai, 1984), I do not yet wholly agree with him. But his message is more disturbing in 1987 than it was in 1984. Let me briefly summarise his main message and then sketch the differences I still have. The revolutionary message from the Schmitt-Cencini ecole de Dijon is that money and income are not two separate entities. Money is not a commodity and its value should not be related to its commodity-like properties. Money is just another way of expressing the economic (not the physical) nature of output. In exchanging money for output, one is exchanging two forms of an identical 'object'. Tautologies and identities impose a logic more ruthless than equations do, and the Schmitt-Cencini strategy is to adhere rigorously to the discipline of double entry book keeping. Thus the notion of banks creating money or of money circulating with a finite velocity are demolished carefully and thoroughly by Alvaro Cencini in this book. Money loaned by a bank is activated only when drawn upon by the borrower to pay someone but both before and after this instant of payment, banks' books balance. Each debt is matched by a credit, each liability by an equivalent asset.

Foreword xiii

A useful distinction is drawn between nominal and real money drawing on the classical writings of Adam Smith, David Ricardo and Karl Marx. Money acquires reality or purchasing power only by its ability to circulate real output. The key is the purchase of labour (power) by debt money. This debt money is fructified by the ability of labour to create output. Thus Keynes' insights into the labour power (earning) standard of money in The Treatise on Money and his use of the wage unit in the General Theory are integrated into a theory of money in a novel way in this book. This very quick sketch can hardly do justice to the argument in this book. You, the reader, will start reluctantly, unwilling to abandon firmly held beliefs. You will search for various ways of dismissing the argument or finding flaws with it. But if you persist you will find much that is refreshingly novel and thought-provoking. By hitching their heterodox economics to the modern quantum physics the Dijon School also overcome the legacy of the nineteenth century physics that bedevils much of modern Economics. By the time you have read the core of the arguments in Chapters Five and Six, you should be able to engage in a fruitful dialogue with the author of the book. It will involve parting with many of the old certainties, but they are being undermined by the 'real' world anyway. If I still remain sceptical, it is not because I have any attachment to the classical dichotomy. Indeed the removal of that albatross from the corpus of economic theory would be an immensely liberating act. My reservations have to do with the two aspects which again can be only briefly dealt with in this limited space. I am concerned that the Dijon School's theory is still an equilibrium one and leaves one very little room for disequilibrium dynamics. In my earlier foreword, I showed how I would reconcile a multiplier process with the equilibrium framework of Cencini's. I remain concerned that the very powerful real influence exerted by people's beliefs about money is another aspect neglected here. Money is accepted as a medium of exchange and a means of payment because of its public goods aspect. The analogy between money and language goes back to Turgot in the eighteenth century and has been revived as Cencini reminds us by Tobin in our own times (Turgot, 1765). But this acceptance of money as payment, or indeed even its use as a store of value, does not arise merely from the parallel presence of real output as the quantum theorists argue. Money is accepted on the belief that whoever offered it will make it good in the future. Money is to that extent partly a fiction, the stuff that dreams are made of. Normally institutional regulations, traditional habits of caution on the part of bankers and sheer luck, make the outcome not too different from the fiction; the money accepted yesterday can be 'cashed' in goods today. But a lot of it is fictitious. Indeed many of the trillions of dollars that were wiped out on 19 October, 1987 were

xiv

Foreword

fictitious capital to which nothing 'real' corresponded. It is this habit of money to be tolerably unreal in normal times, but wildly fictitious in times of speculation, that has yet to be accommodated into monetary theory. Marx was aware of this phenomenon as a perusal of Capital, Vol 3 will show. Keynes reminded us again of this in his eloquent chapter on long-term expectations. Minsky and Kindleberger tried in recent years to nudge our memories. Now it is too late for the real world, but for economic theorists the task has just begun. Alvaro Cencini's book is a contribution to that collective task we all have to accomplish. Bibliography Cencini, Alvaro (1984) Time and the Macroanalysis of Income, Frances Pinter: London. Deaton, A. and Muellbauer, J. (1980) Economics and Consumer Behaviour, Cambridge University Press: London. Desai, Meghnad (1981) Testing Monetarism, Frances Pinter: London. (1984) Forward to Cencini, op. cit. (1986) 'Is Monetarism Dead', De Roos Lecture delivered at the Free University of Amsterdam: NIBE, Amsterdam. Grandmont, Jean Michel (1986) Money and Value, Cambridge University Press: London. Hahn, Frank (1965) 'On Some Problems of Proving the Existence of Equilibrium in Monetary Economy' in F. Hahn and F.P.R. Brechling (eds), The Theory of Interest Rates, Macmillan: London. (1973) 'On the Foundations of Monetary Theory' in M. Parkin and A.R. Nobay (eds), Essays in Modern Economics, Longman: London. Judd, J. and Scadding, J. (1982) 'The Search for a Stable Money Demand Function', Journal of Economic Literature, 20(3): 993-1023. Laidler, David (1983) Conference Papers Supplement to the Economic Journal, 94: 17-34. (1984) 'The Buffer Stock Notion in Monetary Economies', AUTE. Lucas, R. and Stokey, N. (1987) 'Money and Interest in a Cash-in-Advance Economy', Econometrica, May, 491-514. Turgot, A.J.J. (1765) Valeur et Monnai.

Introduction

What is money? This simple question has been answered in many different ways. Generally speaking it is possible to distinguish between two different approaches: the empirical and the theoretical. Both have been followed since the early days of economics and are still alive in our times. The empirical approach is obviously the easiest one, being limited to the description of the various forms and functions historically attributed to money. Needless to say, this way of looking at money does not give us any insight into its true nature unless we consider its phenomenological status as the explicit manifestation of this nature. Unlike what happens in other sciences, however, in economics we cannot deduce the definition of a concept from the empirical observation of the phenomena accompanying its manifestation. On the contrary, some phenomenological characteristics can be attributed to a concept only on the basis of its previous definition. Even the simple enumeration of the forms of money or of its functions requires previous knowledge of the concept of money. True, this concept can only be very widely and approximately defined. But this does not undermine the fact that empirical observations are based on conceptual definitions. If money is not rigorously defined, then the description of its supposed manifestations will also not be rigorous, but if money is not defined at all, then it would be totally arbitrary to look for its phenomenology. We are thus driven to the theoretical appraisal of the concept of money, and to its analytical development. From a theoretical point of view, money has been analysed in two rather different ways. Broadly speaking, in fact, we can distinguish between what we call the traditional approach and the new approach to monetary analysis by considering the role played by the concept of commodity-money. According to traditional analysis, whether money is identified with gold, with a given amount of bank-notes or with a sum of net assets issued by the banking system, its value is determined independently of current output. In this sense, the theory is still closely linked to the idea that both money and its value can be reproduced ad infinitum (theoretically, at least, if not practically). Even banknotes or book-entry money, which have no direct intrinsic value (as opposed to gold or silver money), are in fact issued with a positive purchasing power which they derive from a previous real deposit. According to another approach, money has to be rigorously distinguished not only from its material support but also from every kind

2 Introduction

of deposit on which its emission supposedly depends. Money still derives its value from the commodity set, of course, but from the set of currently produced goods (and services) and not from the set1 of previously produced commodities. In the absence of any theoretical link with gold or with any other kind of deposit, money is freely issued by banks, and purchasing power is no longer explained by the relationship existing between money and a given commodity (or a given deposit) but by the integration of money and current output. The first part of this book is concerned with the analysis of a new approach, whose origins can be traced back to the works of Adam Smith. It was this great Scottish economist who provided the first arguments against the concept of commodity-money. And it was his definition of money as the 'great wheel of circulation' that introduced the idea of a totally dematerialized vehicle which identifies itself with its charge (current output). This idea was further developed by Smith when he distinguished between money (the great wheel) and money's worth (its charge), and was partially taken over by Ricardo and Marx (who analysed, respectively, the concepts of nominal and real money and the concept of money as the form of value) and by Walras (whose concept of numeraire stands for the complete a-dimensionality of money). Another decisive step towards the new quantum approach was made by Keynes. The monetary system had developed very fast since the period of classical economics and Keynes knew that banks alone cannot account for the purchasing power of money. This power must result from the association of money with current output, and Keynes was the first to explain how the neoclassical dichotomy could finally be dismissed. His famous identity between income creation and income expenditure is central here, and it is on this peculiar relationship that Bernard Schmitt's quantum theory rests. In the final stage of our investigation of the new approach we shall deal with the concepts of positive and negative 'emission' as well as with a novel definition of time. Freely issued by banks, money is used to circulate current output. This implies both an (instantaneous) emission of money and the simultaneous creation of a positive income. Thanks to the concept of emission, the classical distinction between nominal and real money finds its most rigorous assessment within quantum theory. Banks issue nominal money, and production creates real money in the same movement: the payment of wages. The analytical distinction of nominal and real money is therefore neither chronological nor causal. Money and income are so strongly interrelated that one can never exist without the other. The circulation of income necessarily entails the circulation of money, and vice versa. Keynes's identity between (income) creation and (income) destruction is then definitely corroborated as soon as the circuits defining these two events

Introduction 3

are defined with respect to time, their quantum simultaneity being perfectly consistent with the fact that they can take place at different instants of chronological time. In the second part of our work we shall try to prove that although the concept of money is the cornerstone of economic analysis, its definition has often been extremely vague if not altogether incorrect. Apart from the rare moments of 'high theory' when analysis was playing a leading role, economists have mostly tried to catch up with the practical historical development of money, constantly re-elaborating their theoretical apparatus in the relentless hope of better describing reality. Traditionally confined within the dichotomous description of economics, monetary analysis has too often failed in its noble task, and, as we shall argue repeatedly, the reason for this failure is to be found in the erroneous belief that money is a simple IOU possessing the intrinsic, and therefore unexplained, power of being an asset. As we all know, before acquiring its actual status as a pure spontaneous indebtment of the banking system, money has been identified for a long time with a particular element of the commodity set. The historical use of gold (or silver) as money has certainly been one of the major causes of confusion in monetary analysis, the same object having been considered simultaneously as a product and as the unit of account and payment of every product. Yet the dimensional aspect of money seems fundamentally preserved by the (aprioristic) net asset definition of money: gold can be replaced by paper and script without modifying the tenets of traditional analysis. The very function of means of payment is inconceivable without identifying money with an asset, and it would be at least extremely curious to pretend that pure nominal money could do the job as well. On the other hand, it is also obvious that money is no longer physical. Issued by the bank through an operation of spontaneous acknowledgement of debt, money is nowadays just a book-entry and it would be anachronistic (and logically wrong, as we shall see later on) to look for its material substratum. Thus the conclusion seems to be an unavoidable petitio principii: though freely issued by the bank as an IOU, money defines a positive purchasing power over the product since its very nature identifies it with an asset. How can banks create a sum of positive money by the simple stroke of a pen? The first idea is that banks issue money on the basis of a previous deposit. But, in this case, they do not really create money: the deposit is momentarily transformed into money, which acquires a positive value only reflectively. Money is thus conceived as a kind of veil, an intermediary which can split (relative) rekl exchanges into net sales and net purchases. Yet, this argument is not entirely satisfactory. If money is the form of a deposit, the exchange between a given commodity and money is still a relative exchange between two real terms: the ghost of barter reappears, and money remains unexplained.

4 Introduction

Hence the analysis seems incapable of avoiding Walras' law and, by the same token, getting rid of the traditional dichotomy between real and monetary variables. Another solution is then proposed by the quantity theory of money. According to this theory, money's purchasing power can be explained only by relating to prices. From Fisher's first version of the equation of exchanges to Friedman's restatement of the quantity theory, the level of prices has always been considered as the key variable for the determination of money's value. Thus, although the variation of prices is said to depend on the adjustment between the 'mass' of money and the 'mass' of output, money's purchasing power is defined relative to prices. In other words, real income is made equal to nominal income level of prices and the level of prices is derived from the relationship between nominal income and real income: nominal income real income The circularity entailed by the preceding argument is evident. The inconsistency could be dodged only if the initial level of prices (successively modified by the interaction of money and output) could be determined independently of the relationship between the quantity of money and the quantity of output, or if money's value was identified with current output. Now, in the second case, money and output could no longer be construed as two different 'masses', whereas in the first this theoretical construction would be preserved only by assuming the complete arbitrariness of prices. The failure of the quantity theory is further confirmed by the analysis of the monetarists' attempt to generalize their approach in order to include Keynes's theory within their monetary framework. In brief, even restated, the quantity theory does not provide an alternative to the neoclassical dichotomy. Considered as two autonomous entities, money and output are kept separate by a theory to which Keynes's identities remain totally alien. In this work we examine how money has been alternatively defined as a commodity and as the general equivalent of all commodities.to be, subsequently, identified with the concept of numeraire, and, finally, reduced to the actual notion of credit. To better clarify the terms of the problem, we analyse it through the main theories of money which have been developed since the works of the classical economists. Yet the

Introduction

5

exposition nowhere takes the form of a history of economic doctrines, its aim being at the same time less ambitious and more precise, that is defining the true nature of money through a critical and synthetical appraisal of its various analyses. Our reassessment of some of the monetary concepts developed by Smith, Ricardo, Marx, Walras and Keynes will probably surprise the reader. However, any new theoretical approach is bound to have surprising repercussions on the interpretation of preceding theories. In our case, the quantum analysis on which we found our approach necessarily affects our interpretation of the works of the 'founding fathers' of economics. This would also happen, of course, if we derived our analysis from any other theoretical framework or paradigm. What has to be questioned, therefore, is not whether our reading of the texts is faithful to the spirit of their writers,2 but whether it can take us further into the understanding of our subject-matter. The only necessary requirements to which every interpretation has to conform are logical consistency and empirical support, and it is against these two principles that what we have called 'the new quantum-theoretical approach to monetary analysis' has to be tested. Notes 1. Obviously, the set of commodities can also be made up of only one element, as in the case of money-gold. 2. Purely rhetorical if taken within the boundaries of textual exegesis, this question is obviously bound to remain unanswered and of very little scientific interest.

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Part I A New Approach to Monetary Analysis

The aim of this first part is to introduce the reader to the new quantum analysis of money and to its historical foundations. Although it is widely acknowledged that money is issued at a trifling cost by the banking system and that it no longer bears any special relationship with gold, it is still worth examining the logical reasons why money cannot be identified with any commodity whatsoever. In particular, it is certain that our understanding of the very concept of money can be widened by taking into account the arguments put forward by the classical economists (particularly by Adam Smith) against the concept of commodity-money. Likewise it is no less certain that the analysis of Marx's form of value and of Walras' numeraire is of fundamental importance in explaining the introduction into economics of a totally a-dimensional standard of value (see Ch. 1). Another argument which is also worth reconsidering is the classical distinction between nominal and real money, as well as the dispute to which this distinction gave rise (see Ch. 2). The analyses developed both by the Currency and the Banking Schools are in fact extremely topical and their approach is a useful introduction to the new quantum theory. Yet it is only with the works of Keynes that some of the essential features of this theory become evident (see Ch. 3). Keynes's monetary analysis is indeed the first to provide the elements for the definitive solution of the neoclassical dichotomy between real and monetary variables. And the integration between (a-dimensional) money and output is precisely the cornerstone of quantum theory. Since the emission of money pertains to the banking system, the association of money and output shall result from this emission. No wonder, therefore, that this operation is the first to be analysed by the new theory (see Ch. 4). Analogously, since money and income are strictly interrelated, the theory must also account for the relationship existing between income and output (see Ch. 5). Finally, the circuit of income has to be explained consistently with the chronological succession of time, and with the presence of distributional effects and of positive savings (see Ch. 6).

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Chapter One

The Origins of an Alternative Definition of Money

1. The exclusion of money from the commodity set 1.1. Money and output Analysing the problem of money in its relation to (national) output, Smith claims that it would be mistaken to add money to the value of goods and services. Whether we use gold or bank-notes, shells or credit cards, it is always true that money is not the complementary part of output in the measure of national income. Smith points this out clearly in The Wealth of Nations-. The great wheel of circulation is altogether different from the goods which are circulated by means of it. The revenue of the society consists altogether in those goods, and not in the wheel which circulates them. In computing either the gross or the net revenue of any society, we must always, from their whole annual circulation of money and goods, deduct the whole value of the money, of which not a single farthing can ever make any part of either. (Smith [1776] 1978: 385)

It is therefore obvious that the relationship between money and product is of a particular nature. If the value of money were itself part of national income, then we should have to infer that, fundamentally, no distinction can be drawn between output and money. Once this hypothesis has been discarded, however, it has to be admitted that: 1. Money is not a product. 2. Money is the social form of the whole output. This second attribute is a direct implication of the fact that income is essentially a monetary concept. The strict relationship that Smith establishes between income and output implies the presence of money but — and this is the fundamental novelty of his message — money is not seen as part of output nor is it included in the definition of national income. Hence it seems possible, following Smith's own analysis, to define money-income as the monetary expression of the product, and to keep the concept of money logically separate from that of a physical good endowed with a positive intrinsic value.

10 A New Approach to Monetary Analysis

1.2. Money and the value of money According to Smith the value of money has nothing to do with the intrinsic value of the material used as money: it is the whole output that, by defining the totality of income, defines what Smith calls the money's worth. When, by any particular sum of money, we mean not only to express the amount of the metal pieces of which it is composed, but to include in its signification some obscure reference to the goods which can be had in exchange for them, the wealth or revenue which it in this case denotes, is equal only to one of the two values which are thus intimated somewhat ambiguously by the same word, and to the latter more properly than to the former, to the money's worth more properly than to the money. (Smith 1978: 386)

Simplistically, the identification of money's worth with the value of the purchased goods and services could appear tautological. In reality, it is of the utmost significance to know that the purchasing power of money is exactly equal to the value of output independently of any intrinsic value of money itself. This not only tells us that purchasing power is linked in a very strict and particular way to the goods which it conveys to the final consumer, but that its origin cannot be found within the physical substratum of money. This conclusion is strongly supported by Smith's analysis, according to which the purchasing power of money identifies itself with the revenue perceived by the producers. But the power of purchasing, or the goods which can successively be bought with the whole of those money pensions as they are successively paid, must always be precisely of the same value with those pensions; as must likewise be the revenue of the different persons to whom they are paid. That revenue, therefore, cannot consist in those metal pieces, of which the amount is so much inferior to its value, but in the power of purchasing, in the goods which can successively be bought with them as they circulate from hand to hand. (Smith 1978: 387-8)

The reasoning is again extremely clear. The income earned 'consists' in the purchasing power which, in its turn, 'consists' in the product, thus corroborating Smith's initial claim that real output is the only income or revenue of society. Two points of Smith's analysis are particularly important to our argument. The first is the identity established by this author between (national) output and (national) income; the second is the exclusion of money from the measure of both these concepts. In identifying current output with current income it follows that money is not facing the set of produced goods (and services) as an autonomous entity of equivalent value. Thus output is defined by money-income since money is nothing

The Origins of an Alternative Definition

11

but the social expression of output. The non-additivity of money and output is then stressed by excluding the value of money from the value of the (national) product. This clearly means that money cannot be identified with any particular commodity whatsoever, or else its value would necessarily have to be added to the measure of production. Being logically necessary, the previous conclusion is valid in every possible case. In particular, it is verified even when a commodity is used as money. Let us suppose that it is gold that is used as money. According to Smith's argument it is then necessary to distinguish between commodity-gold and money-gold. As a commodity, gold is obviously a product of a given value. Commodity-gold is therefore part of the value of (national) output. However, when used as money, gold is not a product, and so does not pertain to the commodity set of which it expresses the value. Thus, whereas the value of commodity-gold is determined on the basis of its costs of production (in terms of labour), the value of money-gold is the total aggregate of the produced goods and services. The use of a particular commodity as money is always possible, of course, but this is not the point. The important argument is that money cannot be identified with the commodity to which it is linked, whether it be gold, paper or electrical impulses. 2.

Smith's great wheel of circulation

2.1. Money conceived as an empty vehicle Let us start immediately with the definition of money. In The Wealth of Nations Smith speaks of money as 'the great wheel of circulation' (1978:385). As we have already pointed out, Smith is definitively opposed to the addition of money and output: 'The revenue of the society consists altogether in those goods, and not in the wheel which circulates them' (p. 385). Clearly, this means that money is conceived as an empty vehicle whose value is determined by its load (current output) and not by its own physical characteristics. It is therefore obvious that the use of an expensive vehicle such as gold is a pure waste implying no real advantage whatsoever. 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. (p. 388)

The necessity of replacing gold with paper money is not very surprising. Everybody seems to agree that it is useless to go on using gold when a simple piece of paper could do the job as well. The only difficulty is

12 A New Approach to Monetary Analysis

in determining how paper money can be given the power of purchasing the product. The traditional and most rigid solution relied on the concept of convertibility. Theorists after Ricardo released some of the constraints of this first solution and gradually legal definition took the place of convertibility. Whether in its strongest or in its weakest version, this kind of solution is, however, inconsistent with Smith's original argument. Even if only legally linked to gold, money would still be a substance and its value would still be derived from it, thus contradicting the message implicit in Smith's tenet of non-addition. Surprising though it may initially appear, this principle requires money to be defined as an a-dimensional medium of circulation. The physical qualities of the material used as money are totally irrelevant precisely because money cannot be identified with its physical substratum. In itself, money has no value at all. If, nevertheless, it acquires a positive value, it is because it identifies itself with the product it carries: 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. (p. 392)

At this stage it should be sufficiently clear that Smith conceives money as a means of circulation with no intrinsic value. Now, money can play its role only if it defines a positive purchasing power. Thus, in the absence of any direct link between money and a particular commodity such as gold, this purchasing power can only be derived from the association of money with the goods which are carried by it. In other words, as soon as it carries real output, money is transformed into income (what Smith calls revenue), which is nothing but the economic definition of its 'load'. That money defines the whole set of produced goods (and services), without being identifiable with any particular element of this set, is confirmed by Smith's claim that the payment of wages does not double the revenue of society: In order to put industry into motion, three things are requisite; materials to work upon, tools to work with, and the wages or recompense for the sake of which the work is done. Money is neither a material to work upon, not 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. (p. 392)

The Origins of an Alternative Definition

13

Wages are paid in money and what workers get as their income is the product itself under its monetary form: money's worth. Smith's analysis reaches its deepest and most abstract level here. Unfortunately, the identification of money and output is not only a discovery of the greatest importance in economic analysis, but it is also one of the most difficult to master. The temptation to link money to some kind of concrete support has always been strong among the classical economists, and that explains why almost all of them have finally opted for a definition in which money is still considered a substance. The merit of Smith's analysis is that it clearly marks some of the risks implied in this dimensional approach to money. The double counting of national income is one of these risks, and the author of The Wealth of Nations was perfectly correct in pointing out that money and output should not be thought of as separate aspects of revenue. Now, another important message of Smith's investigation can be derived from his definition of money: the two-faced reality of circulation. 2.2.

The circulation of money and the circulation of goods: their identity

The concept of the 'great wheel of circulation' introduces the obvious idea that money allows for the circulation of goods among economic agents. What is less obvious, however, is how money fulfils this function. In particular, it has to be determined whether money itself circulates and, if it does, in which direction its revolution takes place. According to the dimensional conception of money, for instance, products and money do move in opposite directions, one being offered (received) as the counterpart of the other. Smith's analysis does not support this view. Money and output are not defined as two equivalent and opposed entities. Hence the circulation of money is immediately seen as the form under which output itself circulates. The two terms of the alternative are clear. Either we accept the traditional definition of money as a net asset and the existence of two separate circuits where money and products move in opposite directions, or we stick with Smith's conception of money as an empty vehicle and maintain that the circulation of products is defined by the circuit of money. Apparently, the first term is the most plausible. Let us think of the purchase of say commodity b by agent A. In this transaction, A gives a certain amount of (real) money and receives in exchange the physical product b. It seems legitimate to infer that money moves (from A to B, the seller of b) in the opposite direction of the product (which moves from B to A).

14 A New Approach to Monetary Analysis

commodity b

money Yet, according to Smith's inquiry, this conclusion is too hasty. Money and output are not two distinct and additive objects. Transaction (1) has therefore to be reinterpreted bearing in mind that the circulation of money (the vehicle) from A to B defines an equivalent circulation of the product (its load) from A to B. Thus, buying commodity b, A sends to B this same commodity under its monetary form. This means that (1) defines the exchange of b against itself: agent B receives, under the form of money, the same product which he is selling. Instead of having a traditional exchange between two distinct objects (as we should have if money were an independent item of net wealth), we are faced with a kind of metamorphosis where physical goods (and services) are changed into money and vice versa. The implications of Smith's monetary analysis are completely original, and complex, especially for those who have been brought up within the influence of traditional paradigms. The exchange between distinct objects seems to be a much easier concept to master than the exchange between a given object and itself. As strange as this result may appear initially, it cannot, however, be aprioristically dismissed, since it is the only logical possibility avoiding the risk of identifying money either with a particular commodity or with a net asset. A closer examination is needed. It is only after having taken into account Keynes's contribution that we shall be able to make up our mind about the validity of Smith's intuitions. For the time being, let us try to clarify some aspects of the new proposition. The unity of money and output has a very precise implication: the identification of (real) money with the product. When A spends a given sum of (real) money for the purchase of commodity b, he is effectively giving up part of his monetary income to change it into a physical object. Shall we conclude, then, that the purchase of A defines the exchange between two products, commodity b on one side and money (= product) on the other side? Certainly not, since the product defined by money is precisely the one which is purchased by A. The product is only one, that is the meaning of this apparent paradox, and the owner of its physical form is not B but A, since commodity b is the very object of ^4's monetary income (purchasing power). By spending his income, A gets hold of a physical object which he already owned under its monetary form. It is because physical object and money are joint aspects of the same reality that current output can exist either under one form or the other: The whole revenue of all of

The Origins of an Alternative Definition

15

them taken together is evidently not equal to both the money and the consumable goods, but only to one or other of those two values, and to the latter more properly than to the former' (Smith 1978: 387). The expression * great wheel of circulation' refers to the circulation of physical goods as it is defined by the circulation of money. In other words, with the analysis developed by Smith the circulation of goods is for the first time identified with the circulation of money. The dichotomous conception of the circuit characteristic of the Physiocrats' approach is replaced by a new theory founded on the identity of money and output. Money becomes a central feature of economic analysis in general, and of the analysis of the circuit in particular. Of course, the physical product remains central in Smith's work. Yet, considering money as the economic definition of current output (and not as its counterpart), he is implicitly shifting the focus from the physical circulation of goods to their monetary circulation. Moreover, using the metaphor of the wheel, Smith introduces the idea that money's displacement is necessarily circular.1 This idea is a further confirmation of the fact that money is deprived of any intrinsic value. If money were a commodity or a net asset, its movement would not necessarily be circular, since its own value would make it an object worth keeping out of circulation. But if money is a simple vehicle whose value is derived only from the product which it is carrying, then it is bound to exist only when playing its role of circulating medium. It is still true, of course, that income can be partially or even totally saved, yet this process does not have money as its object. What is saved is income (money's worth) and not money itself (Smith's great wheel). This clearly shows that the true object of saving is current output since output is precisely what defines money's worth. As is well known, Ricardo and Marx have partially taken over Smith's monetary analysis, trying to develop some of its apparently mysterious aspects. Ricardo's distinction between nominal money and real money, and Marx's concept of the form of value, imply, in fact, a definition of money totally different from the traditional one. Both authors look for the integration of money within the process of production. Money, the empty vehicle, is associated with current output because of this process, and this explains how nominal money can become real money (the loaded vehicle), and how physical goods can express their economic value in a form that allows for their transformation into commodities. Let us analyse first the Marxian concept of the form of value. 3.

Money as the form of value

In his monetary writings Marx claims that money is essentially the form by which absolute value is expressed. Confirming the insights of Smith

16 A New Approach to Monetary Analysis

and Ricardo, his analysis shows that money is simply the form without which the product's value could never be socially assessed. In the Grundisse Marx writes: The exchange value of a commodity, as a separate form of existence accompanying the commodity itself, is money-, the form in which all commodities equate, compare, measure themselves; into which all commodities dissolve themselves; that which dissolves itself into all commodities; the universal equivalent. (Marx 1973: 142)

According to Marx, the creation of (absolute) value can be ascribed to labour and to labour alone. In this respect Marx's theory simply takes up the thesis of Smith and Ricardo. Yet his analysis goes deeper into the nature of value and its link with labour. Value is no longer defined as a particular dimension or substance of the product, but as a pure relationship between labour and output. Now, once it has been established that value is a relationship and not a substance, and that money is the form of value, it becomes possible to define money independently of any reference to a particular physical product. As a pure form of value, money is simply the numerical expression of the relationship between labour and output: 'Labour on the basis of exchange values presupposes, precisely, that neither the labour of the individual nor his product are directly general; that the product attains this form only by passing through an objective mediation, by means of a form of money distinct from itself (Marx 1973: 172). 3.1 Commodity-money and the form of value: their incompatibility Referring to the concept of the form of value it is possible to provide more proof of the fact that money cannot be identified with an element of the commodity set. As indicated by the classical economists, money is, first of all, the standard of value. Without money it would be impossible to give value its social expression (the form of value). Let us start therefore from the simple consideration that, being the source of value, labour cannot have itself a value. Besides underlining the obvious fact that labour is not a commodity, this also shows that money cannot be the form of labour. If labour were an object, then money could be used to measure it. Being the source of every commodity, labour does not pertain to the category of products and therefore money cannot be its unit of measure. Yet, though money does not measure labour by measuring its product, it allows us to solve the problem of its heterogeneity. Physically defined, labour is heterogeneous; evaluated in terms of money it acquires the homogeneity of this standard. Obviously, if money were a commodity, the difficulty due to the physical heterogeneity

The Origins of an Alternative Definition

17

of labour could never be overcome. Fundamentally, to define money as a commodity is not different from defining it as labour-time since in both these conceptions money is identified with a dimension, and according to classical theory, even the value of commodity-money is determined in terms of labour. Then, how could it be possible to homogenize labour by referring to a standard that is itself evaluated in labour-units? If the standard of labour is itself heterogeneous, it is plain, a fortiori, that it cannot be used as a standard of value, and that is exactly what is implied in Marx's analysis of time-chits. Being not immediately homogeneous, labour cannot be used as a standard of value. This effectively means that, although it is the effect of labour, value cannot be identified with it: value is not the labourdimension of output. If value were dimensional, its measure would also be dimensional, and — as Ricardo did — we would have to look for an invariable standard amongst commodities. But if value is not a dimension, then its form also must be a-dimensional. And this is exactly what seems to be suggested by Marx when he claims that labour-time is not the form of value. From his rejection of Proudhon's plan to use timechits as money, we can thus infer that money can neither be identified with labour-time, nor with any particular commodity. Even commodity-money is not a commodity. The necessary rejection of the idea that money is a commodity is therefore not only founded in the fact that it is impossible to find an invariable standard of value (Ricardo's problem), but, more fundamentally still, on the impossibility of determining any physical standard whatsoever. In other words, the invariability is a problem that can be posed only by reference to a given standard. If this standard cannot be expressed, then obviously there is no point in investigating the problem of its constancy. A heterogeneous unit of measure is what Marx would have called a contradictio in adjecto. It follows that none of the physical qualities of products can be used as a standard of value. Also, dimensionally defined in time-units, labour cannot be the unit which we are looking for. Hence, as the form of value, money must never be confused either with labour or with any particular product, not even when a given commodity (such as gold) is used as money. As we have seen, it is money that allows for the social expression of output, since it is money that allows for the expression of its economic value. In its function of form or standard of value, money therefore plays a central role in the determination of the measure of goods, a role so central that, without it, it would be impossible to have any economic theory based on the classical conception of the product. In fact, a theory can exist only if the object of its investigation exists, and the object proper to classical economic theory is the product (the product as economic determination, of course, and not as a physical object). Now, the product can exist as the object of economic enquiry only if its value

18 A New Approach to Monetary Analysis

can be expressed through a homogeneous unit of measure. Using Marx's terminology, we would say that the object proper to economics is the commodity, and that a physical object is transformed into a commodity only when it is endowed with a positive economic value. Then, given that value itself has an effective existence only through its form, it follows that money is the concept around which the whole of economic theory has to be built. Marx is categorical in the Grundisse-. The process, then, is simply this: The product becomes a commodity, i.e. a mere moment of exchange. The commodity is transformed into exchange value. In order to equate it with itself as an exchange value, it is exchanged for a symbol which represents it as exchange value as such. . . . The definition of a product as exchange value thus necessarily implies that exchange value obtains a separate existence, in isolation from the product. . . . In the form of money, all properties of the commodity as exchange value appear as an object distinct from it, as a form of social existence separated from the natural existence of the commodity. (Marx 1973: 145)

As the form of value, money is essential, both for the expression of the product's exchange (absolute) value and for the transformation of physical objects into commodities. But, if money is the necessary condition for the existence of commodities, then money cannot itself be a commodity. How could the physical object gold be transformed into commodity-gold if this required the intervention of a money mistakenly identified with gold? For money to be a commodity it is necessary that the physical object used as money be endowed with a positive economic value. However, this can be achieved only if the economic value of the chosen object can find its social form: gold becomes commodity-gold as soon as its value is expressed in terms of money. Thus the very determination of money as a commodity is possible only through the mediation of money. Alternatively, if money were identified with a commodity, then money would simultaneously be the result of, and the condition for, the transformation of its physical substratum into a commodity. Finally, since commodities exist only if money is their form of value, it is logically impossible to identify money with any of them. The concept of commodity-money being inconsistent with the analysis of the form of value must be replaced by a new concept allowing money to be an invariable standard of value, and a perfect medium of circulation. On their way towards this end, the classical economists made a distinction between nominal and real money. Before dealing with these fundamental concepts, however, it is important to show that it was only with Walras that the idea of an absolute value was definitively abandoned in favour of a simple numerical relationship. It is in Walras' analysis that value becomes relative, and it is here that we find the clearest attempt to identify money with a pure set of numbers.

The Origins of an Alternative Definition 4.

19

Walras' concept of numeraire

The idea that money is essentially a unit of account and that, as such, its function is to provide the economy with a numerical expression of real output, is very old indeed. Keeping our analysis within the restricted boundaries of modern theory, we can claim, without reservations, that the classical economists were perfectly aware of this function and the part played by money independently of its contingent intrinsic value. As Marx put it so clearly, 'the commodity achieves a double existence, not only a natural but also a purely economic existence, in which latter it is a mere symbol, a cipher for a relation of production, a mere symbol for its own value' (1973: 141). In this function money is reduced to a pure number, and for this very reason the economic definition of the product is itself purely numerical. This is why money has been successfully separated from its material substratum, and is actually defined as a spontaneous indebtment of the banking system measured arithmetically. Though already present in the theories of the classical economists and of Marx, the numerical concept of money was difficult to understand, and was often swept aside in favour of a material concept of money, the only one effectively consistent with the definition of value as a 'substance'. 4.1 Money as a numerical standard of relative value Moving away from the idea of absolute value, Walras worked out a system in which transactions occur between commodities without their being previously socially defined. The important point in Walras' analysis is that money is not defined as a particular economic substance, but as a'mere number: a numeraire. The fact that a commodity is used to play the role of money should not side-track us. Whether or not we use a commodity, it is still true that money cannot be added to the commodity set. In Walras' theory we do not have output on one side and money on the other as two distinct masses of autonomous value. There are two main reasons for this. First, the general equilibrium model is an attempt to determine (relative) prices on the commodity market, independent of any preexistent value derived from the production process. Commodities are compared on purely subjective grounds and they only face each other, and not their 'materialized' value. Thus the only values determined by the system are expressed in terms of relative prices, and do not require the intervention of money as a substance not already included in the commodity set. Second, when a particular commodity is used as money this does not double its quantity. In other words, the number of possible relationships

20

A New Approach to Monetary Analysis

between commodities remains the same whether we choose one of them as numeraire or not. In the exchange between gold and all other commodities we express the relative price of each of them in terms of gold. Yet the number of prices determined by the equations of GES is not increased by the presence of money-gold. If we have n commodities (one of which is gold), we can, at most, determine n - 1 relative prices. From what we have just said, it should thus be clear that money in itself is not a commodity or a substance, even when it is a commodity that plays this role. Walras' numeraire is a pure number whose significance lies in its being used to express relative prices. In some respects our analysis does not corroborate Hahn's claim that money is totally superfluous in a general equilibrium framework. The most serious challenge that the existence of money poses to the theorist is this: the best developed model of the economy cannot find room for it. The best developed model is, of course, the Arrow-Debreu version of a Walrasian general equilibrium. A world in which all conceivable contingent future contracts are possible neither needs nor wants intrinsically worthless money. (Hahn 1982: 1)

Reading Walras' Elements d'economic politique we somehow get the opposite impression. The concept of numeraire is neither useless nor undesirable since it provides the only logical possibility of building an economic theory: the numerical expression of real output. To consider Walras' theoretical approach as a non-monetary one is thus partially incorrect. Of course, it is true that money is not really explained in its relationship with the product, and that, by applying Walras' own law, the monetary equation can always be put aside and the system reduced to a kind of generalized barter economy. However, this is only half the story. The concept of numeraire is much richer than it appears at first sight. To choose a commodity as a means of exchange is a practical device which has been introduced since ancient time; what is really new is the claim that, as with money, this means of exchange is essentially a number. The complete non-materiality of money is something which was only partially perceived by the classical economists. Walras' analysis is a step forward, a real improvement the consequence of which has not yet been fully understood. One of the reasons for this partial failure is that Walras himself did not succeed in explaining how the numeraire could be organically introduced into his system. 4.2. The numeraire and the functions of money One implication of the concept of numeraire is that money is not a commodity. The historical evolution of the monetary system has since confirmed this theoretical intuition: book-entry money is the form

The Origins of an Alternative Definition

21

which takes us closest to the meaning of the numeraire, and which proves * factually' and 'a posteriori' that money has been neither a commodity nor a substance. In one of its functions money is a unit of account. As such it does not need to have any proper value, the only logical requirement being to establish a relationship between numbers and output. The analytical difficulty which has to be solved is therefore perfectly defined: to be able to play its role, money has to be integrated into the real world of products. Although it is true that GEA does not provide an answer to this problem, it has the great merit of opening the way towards a new understanding of money. Let us say it again. Introducing the concept of numeraire, Walras was not merely concerned with the possibility of expressing numerically relative prices by arbitrarily putting the price of a commodity equal to one. This simple mathematical device cannot be confused with a concept that requires the clear distinction between money and goods. In fact, if the numeraire were the result of this artificial pricing of a commodity, it would be implicitly identified with the arbitrarily chosen commodity. And to define the numeraire as an element of the commodity set is to completely miss the originality of Walras' contribution to monetary theory. Moreover, we would again face the problems never solved by the classical economists and the undeniable fact that book-entry money is totally independent of any particular real good. It is thus clear that in order to avoid any misinterpretation it is essential to define money in a purely numerical way. But the role of money is not only that of being a unit of account. As everybody knows, money must also be a unit of payment, which means that the numeraire has to define a positive purchasing power over goods and services. Yet, as long as the value of goods is defined relative to the exchange of goods on the commodity market, money's purchasing power remains unexplained. Analysis proves in fact that it cannot result from exchange, and the concept of numeraire shows that it cannot be derived from any specific link with a particular commodity. Deprived of any intrinsic value, the numeraire can derive its value only from its association with the whole output. But how can that be done if the value of goods is merely relative? Having rightly rejected the classical assumption that money is (or is defined in terms of) a commodity, the followers of Walras have tried to relate the numeraire to real output through exchange (and, therefore, through the determination of relative prices). However, they have overlooked that, in order to function as a medium of exchange, money has to be endowed with a positive purchasing power before this power can be exerted on the market. Their explanation is therefore circular, and is no real answer to our previous question: how can the numeraire fulfil its functions and become a unit of account and of payment?

22 A New Approach to Monetary Analysis

Finally, although correctly introduced by Walras with his analysis of the numeraire, the problem of money and of its association with the real world has not been successfully dealt with by neoclassical theory. The numeraire remains an empty concept if it does not allow for the social expression of the output. It is correct to claim that money is no longer material, and that its logical substratum is nothing more than a simple set of numbers. Yet for the numbers to be transformed into money an operation is necessary to bring them into a close relationship with current output. In the absence of any such operation, money could not even exist. The fact that money does exist (which is intuitively shown by observation and theoretically established by modern analysis) tells us that this operation also exists, but it does not tell us what it is. Theory must provide us with an explanation. If it does not, it is bound to remain sterile, deprived of any explanatory power over reality. The attempt to work out an economic theory starting directly from the commodity market can only lead to a dichotomous appraisal of the world which is inconsistent both in logic and facts. As rigorous analysis shows, monetary and real sectors can be integrated only if (absolute) monetary prices can be determined by the system. Referring to the commodity market will not do, because exchange on this market either occurs on the basis of (monetary) prices already given or at most it can determine a relationship between real goods, but not between output and money. From this we can conclude that in order to solve the dichotomy problem we have to look for a process of exchange preceding the one taking place on the commodity market. If exchange takes place between goods already produced, it is too late to associate numeraire and output. This association must therefore result from the same operation which allows for the very appearance of the product. As the classical economists had so clearly perceived, production is the 'core' of the whole economic process. The solution we are seeking lies in the synthesis between this process and the fundamental results of Walras' analysis of the numeraire. Notes 1. If we were bold enough, we could also infer from Smith's metaphor that money's circular displacement is also necessarily instantaneous, since an unfinished wheel (of circulation) is in reality no wheel at all.

Chapter Two Nominal Money and Real Money

In economics, as in other sciences, some central discoveries appear, expost, as being almost self-evident. This is certainly true in the case of the classical distinction between nominal and real money. The claim that money is both a unit of account and a unit of payment would easily be accepted by everyone, and, by many, it would be considered as being a simple axiom. In fact, the classical distinction is very often accepted because it seems to follow directly from the functions that are usually attributed to money. Yet this procedure is obviously incomplete, since the mere description of the functions played by money cannot fully explain its nature. It is evident, of course, that money is a unit of payment since payments are made in money; but this observation does not tell us how it is that money can play this role. Fundamentally, it is a simple tautology: not increasing our knowledge, it can only be the starting point of analysis. Classical monetary theory has another approach. Nominal and real money are not conceived as qualitative attributes of money derived from two of its main functions, but as specific definitions which explain how money can effectively play these roles. In other words, definitions of nominal and real money are the result of a rigorous analysis going beyond the factual description of the ways money is used in practice. As we shall see in the next chapter, the importance of the classical distinction, and its theoretical and empirical implications, are stressed by the animated dispute, known as the Bullion Controversy, carried on between the members of two different schools of thought: the defenders of the Banking Principle and the paladins of the Currency Principle. The analysis of this long-lasting debate shows how fundamental the classical distinction is in understanding the approach to money developed by neoclassical economists, and particularly by monetarists. 1.

The classical distinction of Adam Smith and David Ricardo

1.1. Money and money's worth Let us start, once again, with the work of Smith. Written more than two centuries ago, his famous book is, in fact, still very stimulating and

24 A New Approach to Monetary Analysis

extremely topical. As we shall see, this is particularly true of his monetary analysis, since he is the first author to have clearly stated and clearly proved that money should not be confused either with an element of the commodity set, or with money's worth. One of the most important conclusions reached by Smith, in The Wealth of Nations, is that national revenue is equal to the totality of the output, and not to the sum of money and current output: 'The whole revenue of all of them taken together is evidently not equal to both the money and the consumable goods; but only to one or other of those two values, and to the latter more properly than to the former' (Smith 1978: 387). The non-additivity of money and current output is the proof that money cannot be identified with any particular commodity — we already know that — but does this imply that money is deprived of a proper value? If by the value of money we mean a kind of intrinsic value, the answer is certainly affirmative. Being logically opposed to the concept of commodity-money, Smith's analysis can only be consistent with a definition of money that does not ascribe to its object the value of the commodity which was historically chosen to play this role. On the contrary, if we refer to the purchasing power of money, it is equally certain that the answer to our question is negative. Money is undoubtedly endowed with a positive purchasing power over the produced goods and services, and it is this power that defines its value. Following Smith, therefore, we have already determined that: 1. money is not a commodity, 2. income is equal to current output, 3. the purchasing power of money is equivalent to current output, from which we can easily derive that 4. income is equal to the purchasing power of money, and that 5. income is money's worth. The legitimacy of the last two propositions is corroborated by Smith himself. In The Wealth of Nations he writes, in fact, that: Though we frequently, therefore, express a person's revenue by the metal pieces which are annually paid to him, it is because the amount of those pieces regulates the extent of his power of purchasing, or the value of the goods, which he can annually afford to consume. We still consider his revenue as consisting in this power of purchasing or consuming, and not in the pieces which convey it. (p. 387)

In addition to the obvious observation that money has a positive value only in so far as it carries a positive purchasing power, it is extremely important to note that Smith introduces a clear-cut distinction between money and money's worth: 'The wealth or revenue . . . is equal only to one of the two values which are thus intimated somewhat ambiguously

Nominal Money and Real Money

25

by the same word, to the money's worth more properly than to the money' (p. 386). If, as is claimed by Smith, revenue and output are equivalent and not additive, then money's worth and real output must also be two equivalent definitions of the same object. Perfectly consistent with the rejection of commodity-money, this conclusion leads us to another significant result of Smith's inquiry — the distinction between money and money's worth is fundamentally equivalent to the distinction between money and output: 'The great wheel of circulation is altogether different from the goods which are circulated by means of it' (p. 385). Thus nominal money is comparable to an empty vehicle whose function is to transport the product. Real output being precisely what defines the purchasing power of money (its worth), it follows that money is also the great wheel which circulates money's worth. Hence, in the same way as the load cannot be confused with the vehicle transporting it, money's worth cannot be confused with money. And since national revenue consists of the whole of produced goods (and services) 'and not in the wheel which circulates them' (p.385), the value of money is correctly identified with its load. As soon as money carries the product, it acquires a positive value defined precisely by what it is carrying. Then, although the vehicle and what it carries are two different objects, the vehicle's value is only equal to its load: money's worth is equal to current output, and not to the sum of output and money. 1.2. Nominal money and real money Smith's distinction between money and money's worth amounts to what is known as the distinction between nominal and real money. Thus, according to our metaphor, nominal money is the empty vehicle, the great wheel which circulates the output under its monetary form. Real money is what is circulated by nominal money. It is the purchasing power of money, its worth, and, as such, it is defined by the whole of produced goods (and services). The distinction between these two kinds of money is both conceptual and functional. Does this mean that nominal and real money are two distinct and autonomous objects? At this stage of the analysis we can only partially answer the question. In fact, whereas we should conclude that real money cannot exist independently of nominal money when it circulates, we cannot be certain whether it exists outside circulation. Moreover, the difficulty seems compounded by the observation that, at least at first sight, nominal money can be used separately from real money. When products are given a nominal price on the market, or when they are simply registered in the book-accounts of firms, it seems that no reference is needed to real money, whose presence is required only

26 A New Approach to Monetary Analysis

when products are effectively sold (bought). In reality, classical theory could never bear out this conclusion. Within that theoretical framework it is not allowed to look for the determination of prices independently of production. Thus prices are immediately real, and so is the money in whose terms they are expressed. It would therefore be wrong to define nominal money as a unit of account, and real money as a unit of payment. Though it is certainly true that payments require the intervention of real money, it is wrong to believe that commodities can be evaluated in terms of purely nominal money. Money's worth is nothing other than real output, which means that to count the product is to express the value of money. But the value of money is its purchasing power. Thus current output is evaluated in units of purchasing power, that is in units of real money. Though the product's value is not a substance, its numerical definition cannot be ascribed to nominal money alone since the product is precisely what is carried by nominal money. In other words, it is correct to say that nominal money can count the product because it carries it, but, carrying it, nominal money is real money so that, finally, it is the latter and not the former that plays the role of unit of account. 1.3. Money and the payment of labour That nominal and real money are immediately perceived as closely related concepts and objects is confirmed by the analysis of Ricardo. In his Notes on Bentham's 'Sur lesprix' Ricardo says literally that 'Labour is paid not by money but by money's worth' (Ricardo 1951-5, vol. Ill: 329). Two important ideas can be deduced from this quotation. First, it is obvious that Ricardo's distinction refers to money and to its purchasing power. Besides, it is also obvious that money and purchasing power are thought of as two distinct concepts defining either two different, though strictly related, objects or two different aspects of the same object. Second, we are told that what is given to workers is money's worth and not money alone. What does Ricardo mean by that? Certainly not that workers are paid in a medium materially different from money. What workers obtain is, of course, money. But money endowed with a positive purchasing power, and not a purely nominal unit of account. Thus, although the 'vehicle' is always the same money, it makes all the difference whether it is 'empty' or 'loaded'. Nominal money is what we have described as an empty vehicle, whereas real money is the vehicle with its charge. Wages are paid in real money so that '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' (Smith 1978: 392).

Nominal Money and Real Money

27

It is evident from this quotation that Ricardo's and Smith's analyses are mutally consistent and that both emphasize the distinction between money and its value referring to the same transaction, that is the payment of wages. This is certainly not fortuitous. On the contrary, it clearly shows that money's worth is closely related to production and not, as is so often claimed by neoclassical economists, to the general price level. Both Smith and Ricardo are perfectly aware that prices can only be explained once the value of money has been accounted for: nominal prices are meaningless if money is itself purely nominal. As soon as it has been understood that money's worth is the purchasing power of money, it becomes almost self-evident that the origin of real money must be found in the relation money holds with current output. But how do we have to define this relationship? Here again Smith's and Ricardo's analyses are extremely valuable. In fact, those authors do not have any doubt whatsoever about where to look for the process linking money to the product. It is not on the commodity market, where the purchasing power is exerted (but not formed) that they concentrate their attention. Avoiding the danger of reasoning in a vicious circle (trying to explain the formation of purchasing power through the expenditure of purchasing power), they relate money to output in the labour market. The formation of money's purchasing power is thus explained referring to work and to the payment of its corresponding wages. The secret of real money lies in the equivalence between income and purchasing power which is established by the payment of wages. As Smith says, workers' income 'consists not in the money, but in the money's worth' (p. 392). What remains to be explained, of course, is how nominal money can become real money; what is the exact nature of the relationship between money and real output defined by this process? Referring to production and to labour is certainly consistent with the classical theory of value; but the problems of Ricardo (the determination of an invariable standard of value1) and Marx (the monetary realisation of surplusvalue2) are a clear example of the difficulties that lie in the way of monetary investigations. Before proposing a solution, it is therefore wiser to clarify the terms of the question as much as possible. With this purpose in mind, let us briefly justify the distinction between nominal and real money applying to Marx's theoretical framework.

28 A New Approach to Monetary Analysis

2.

Marx's contribution to the classical distinction between nominal money and real money

2.1. The concept of money as the general equivalent The concept of the form of value is an essential theoretical step towards the understanding of money. A second theory is necessary for complete comprehension, namely the elaboration of a 'general equivalent'. Marx discusses this theory in his monetary analysis. According to him, as soon as money takes up the form of value, it becomes the exact equivalent of the product. This clearly means that defining (absolute) value money is not an empty form but, on the contrary, that it carries the output whose value it defines. Money, as the general equivalent, has the power of purchasing the product and therefore can be exchanged for it on the commodity market: 'Everyone knows, if nothing else, that commodities have a common value-form which contrasts in the most striking manner with the motley natural forms of their use-values. I refer to the moneyform' (Marx 1976, vol. I: 139). However, the purchasing power which instantaneously fills the form of value with the attribute of a general equivalent does not flow from the commodity market. In fact, the process which defines money as the form of value is exactly the same as that which defines money as the general equivalent. In other words, the determination of money as a unit of account follows necessarily from its determination as a unit of payment. As a form of value, money counts the product (in the exact sense that it expresses the economic value of output numerically) and is thus a unit of account. As a general equivalent, money allows for the final purchase of output and acts as a unit of payment. Now, as soon as the relation labour-product (value) is socially defined (i.e. as soon as money takes the form of value), output itself finds its social definition in money terms. By the same operation, money becomes the form of real output and the product is lodged in it. Thus money acquires a purchasing power over the product because money becomes the true economic definition of output. This conclusion could seem dubious to the faithful reader of Marx's works. However, even a close textual exegesis should be enough to drive away any doubt about Marx's own position on the matter. The earliest sections of Grundrisse's first book are concerned with the problem of money and so are several other writings amongst which The Analysis of the Form of Value is probably the most interesting. In these texts it is easy to find the elements of a more subtle and abstract analysis of money than that first developed by Smith and Ricardo, and subsequently taken over by Marx himself in the first book of Capital. In particular, money is no longer conceived of as a substance but as a form,

Nominal Money and Real Money

29

and, what is almost more important, not as a form of a substance but as a form of the mere relationship between labour and product: As a value, a commodity is an equivalent for all other commodities in a given relation. As a value, the commodity is an equivalent; as an equivalent, all its natural properties are extinguished; it no longer takes up a special, qualitative relationship towards the other commodities; but is rather the general measure as well as the general representative, the general medium of exchange of all other commodities. As value, it is money. (Marx 1973: 141)

The reasoning followed by Marx is extremely clear. Being the simple form of a social relationship, money has a function which lies in its capacity to express this relationship numerically. It is thus obvious that, as the form of value, money can be perfectly devoid of any intrinsic value. As a unit of account money is a mere collection of numbers, and not a commodity. We are thus back to Ricardo's definition of nominal money. Yet as soon as it is used to measure value (numerically and not dimensionally since value is no longer defined as a substance), money also acquires a positive purchasing power and becomes real money. The fact that money is simultaneously nominal and real should not be surprising, since it is a matter of evidence that what carries the purchasing power (real money) is nominal money. The focal point here is that it is the same purely numerical money that acquires the purchasing power over the product. This means that this power cannot be explained in terms of a hypothetical intrinsic value, since money lacks any such dimension. The origin of purchasing power must be found, therefore, in the same operation which allows for the numerical expression of value. 2.2. Real money and the payment of wages The great intuition of Smith is confirmed by Marx's analysis. The relationship between labour and output finds its monetary expression (its form) through the payment of wages, and this same operation defines the formation of a positive purchasing power in the hands of workers. In exactly the same way as Smith's worker is paid in money's worth and not simply in money, what is received by Marx's worker is real money; not an empty form, but a vehicle loaded with the product itself. Defining workers' income, wages — the monetary expression of the relationship between labour and product — are a positive purchasing power and are, therefore, the monetary definition of output. The dual nature of money, nominal and real, is very clearly pointed out by this analysis. Although the purely nominal and the purely material conceptions of money are rejected as insufficient, they are both integrated in a synthetical approach where money is defined as being

30 A New Approach to Monetary Analysis

simultaneously nominal (form) and real (content). Of course, real money is not material in the obvious sense of the term. The materiality of money is defined by the identity, established through the payment of wages, between money itself and current output, and not by its physical properties. Likewise, nominal money is not money with no real existence. This term is only meant to define the concept of the form of value and not the virtual or hypothetical existence of money. But — and this is a crucial proposition to which we shall come back again and again — it would also be wrong to believe that nominal money can exist autonomously from real money. Nominal money and real money are so tightly linked together that it is impossible to determine one of them without simultaneously determining the other. Yet the distinction of the two concepts is of the uppermost significance since it allows the classical economists to prove that, although it is not a commodity, money defines the whole of produced goods. 3.

Summing up

Far from being self-evident, the distinction between nominal and real money is the result of a thorough analysis of the logical relationship existing between money and output. Were money to be identifiable with some particular element of the commodity set, then the distinction would lose a great deal of its meaning, being reduced to the almost trivial observation that the presence of money is not always materially necessary. Thus, if nominal and real money were simply two different terms used to distinguish between unit of account and unit of payment, their introduction would not be of notable significance. No one doubts that, to numerically express goods and services, a mere abstract unit is sufficient, yet this does not tells us whether this unit refers to nominal or to real money. Unless we identify money with a given commodity, in which case nominal money can only define the abstract use of real money, this question cannot be answered on factual grounds. Empirical observation is totally insufficient here, since it is not true that the functions played by money determine its nature; on the contrary, the nature of money determines the functions it can play. Hence the answer must result from a theoretical investigation into the reasoning that pushed classical economists to distinguish between nominal and real money. It is Smith who states the clearest argument in favour of the classical distinction. His analysis shows, in fact, that money and money's worth are both conceptually and functionally distinct. One one hand we find money, which, being logically external to the commodity set, has no intrinsic value. It is simply a means by which goods are circulated, a medium or 'great wheel' that can be used without increasing the value of the (national) product. On the other hand, we have money's worth,

Nominal Money and Real Money

31

which Smith immediately identifies with national revenue, that is with national output, since 'the revenue of the society consists altogether in those goods' (Smith 1978: 385). It is clear, therefore, that, being equivalent to output, real money is the 'load' carried by nominal money, the 'empty vehicle'. What still has to be clarified is whether or not the conceptual distinction of nominal and real money corresponds to a distinction of objects. If the answer were negative, we would have to conclude that the same object can have a positive value or not, according to the aspect of this object one wants to investigate. Alternatively, if we answered in the affirmative, we would be forced to claim the co-existence of two distinct kinds of money, without being able to determine how it is possible to change from one to the other. Moreover, in both cases, we would have to explain how real money can effectively exist, either resorting to the transformation of nominal money, or to its autonomous creation. The problem, therefore, is how money can have a positive purchasing power over the produced output. Is it already issued with this power or not? In other terms, is real money the result of production or of the monetary emission? When Smith says that wages are paid in money's worth and not in money, is he claiming that the payment of wages requires the pre-existence of real money, or that real money is the result of this payment? In the final chapters of the first part of this work we shall see that money acquires its purchasing power at the very instant it is paid out to workers. What we want to stress here is that the classical distinction between nominal and real money is an important step towards this conclusion. In particular, we have shown that Smith, Ricardo and Marx were able to establish the fundamental difference between these two concepts which cannot be explained simply by evoking the functional use of money as a unit of account and as a unit of payment. As will be clearly shown from the following analysis of the Bullion Controversy, the distinction between money and money's worth is rich in theoretical as well as empirical consequences, the importance of which extends far beyond the limits of this historical debate. Notes 1.

The logical impossibility of determining an invariable standard of value is due to Ricardo's definition of value as a dimensional entity. As he clearly stated, 'The only qualities necessary to make a measure of value a perfect one are, that it should itself have value, and that that value should be itself invariable, in the same manner as in a perfect measure of length the measure should have length and that length should be neither liable to be increased or diminished; or in a measure of weight that it should have weight and that such weight should be constant' (Ricardo 1951-5, vol. IV: 361). Yet

32

A New Approach to Monetary Analysis

commodities are not of a constant dimensional value. Both labour and capital vary as production changes and that makes it impossible to find a satisfactory solution to Ricardo's problem. The neoclassical attempt to determine value directly within exchange is no more successful. As has been proven by Cencini and Schmitt (1976), exchange does not define a unique standard of measure so that the economic standards used to homogenize goods remain fundamentally as heterogeneous as the goods themselves. 2. See Cencini and Schmitt (1977).

Chapter Three The Banking School and the Currency School

Following the Bank Restriction Act of 1797 the price of gold increased repeatedly. Many economists considered this proof of direct causality existing between the two events. The sharp rise in the price of gold in 1808 marked the start of a new series of controversial writings on the subject. Ricardo's articles on the price of gold published in the Morning Chronicle gave rise to what is known as the Bullion Controversy, and to the appointment, by the House of Commons, of the Bullion Committee (1810), whose explicit task was to investigate whether or not the high price of gold was caused by an over-issue of bank-notes. Yet the dispute did not end with the publication of the Bullion Report. Economists went on defending either the Banking or the Currency Principle without being able to find a common solution to the problem of money and banking. This problem was officially re-examined in 1840 by the Committee of the House of Commons on Banks of Issue. Besides the conjunctural aspect of the controversy, its analysis is of particular significance since both the Banking and the Currency Schools rest on a specific distinction between nominal money and real money. 1.

The Currency Principle

1.1. Convertibility and depreciation According to the defenders of this principle, metallic money is the best kind of currency, since every sudden change in its value would necessarily be reabsorbed by foreign exchanges. As Ricardo tells us in his Principles of Political Economy and Taxation-. Gold and silver having been chosen for the general medium of circulation, they are, by the competition of commerce, distributed in such proportions amongst the different countries of the world, as to accommodate themselves to the natural traffic which would take place if no such metals existed, and the trade between countries were purely a trade of barter. (Ricardo 1817: 137)

Now, if a change took place in the value of gold, fhis would modify the general level of prices and cause a movement of gold that would restore prices to the level compatible with the initial distribution of wealth among nations. For example, if gold depreciated due to the discovery

34

A New Approach to Monetary Analysis

of a new mine, this would also depreciate the currency and increase the price of commodities; gold would consequently be exported for the purchase of foreign goods, and the reduction of the quantity of currency would decrease prices, thus allowing the system to recover its previous equilibrium. Founded on the assumption that prices are homogeneous on a world scale (since gold is the money supposedly used by every nation), this mechanism is considered as an ideal point of reference, to which every monetary system should try to conform. Thus it is claimed that the introduction of bank-notes is a source of monetary depreciation unless it rigorously respects the rules of metallic circulation. As Norman, one of the advocates of the Currency Principle, said: A metallic currency is the most perfect, and should be looked upon as the type of all other currencies; and as from their superior convenience and greater cheapness, bank notes are introduced to supply the place of a certain portion of metallic currency, I think that bank notes should be so managed, that they should possess all the other attributes of a metallic currency, and among those attributes, I conceive the most important to be that they should increase and decrease in the same way that a metallic currency would increase and decrease. (Norman 1840, Question No. 1749)

The members of the Currency School seem, therefore, to be the most faithful followers of Ricardo, who, in his pamphlet The High Price of Bullion published in 1809, already ascribed the cause of depreciation to an excess of currency, and claimed that 'this depreciation is counteracted by the exportation of the precious metals' (Ricardo 19515, vol. III. 63-4). Of course, this effect would take place only if the banking system worked under the rule of strict convertibility: 'If, whilst the Bank paid their notes on demand in specie, they were to increase their quantity, they would produce little permanent effect in the value of the currency, because nearly an equal quantity of the coin would be withdrawn from circulation and exported' (p. 90). On the contrary, if bank-notes were not convertible on demand, then the depreciation would not be counterbalanced by an exportation of metal and its effect on prices would be permanent. One's first impression on reading some of the monetary writings of Ricardo, is that this author accepts the hypothesis of prices varying according to the quantity of money. However, it is accepted that, according to the classical economists, prices are simply the monetary expression of value. Thus we are apparently bound to conclude that it is the quantity of money that depends on prices and not the opposite.1 Particularly stressed by Hume, Tooke and Marx,2 this law of exchange was certainly not alien to Ricardo. Indeed, in his Principles, he very clearly stated that it cannot be claimed (as James Mill did) that prices are determined by relating the quantity of goods to the quantity of money. Thus it appears necessary to conclude that Ricardo's theory of money

The Banking School and the Currency School 35

is inconsistent with his theory of value and prices. However, this conclusion could only result from a superficial analysis that did not take into account Ricardo's fundamental distinction between nominal and real money. 1.2. Can real money be the cause of depreciation? As we already know, Smith defined real money as money's worth and identified it with purchasing power. 'That revenue, therefore, cannot consist in those metal pieces, of which the amount is so much inferior to its value, but in the power of purchasing, in the goods which can successively be bought with them as they circulate from hand to hand' (Smith 1978: 387-8). This clearly means that real money defines the product and not its monetary counterpart. According to Smith, (real) money and output are not two different objects facing each other, but the two equivalent aspects of the same object. 'The whole revenue of all of them taken together is evidently not equal to both the money and the consumable goods; but only to one or other of those two values' (p. 387). The fact that money is not added to current output is proof that prices cannot be determined through the interaction of supply and demand, since the comparison between (real) money and output is reduced to the comparison between the output and itself. Once more, money and real output being one and the same thing — since (national) income consists in the produced goods and not in the sum of money and goods3 — the very concept of over-emission of real money is selfcontradictory. Real money is the result of production and cannot be directly issued by banks, whose task is to furnish what we have metaphorically called an empty vehicle. If real money is identified with 'nominal money associated with its charge', then there can never be an excess of real money. In fact, allowing for such an excess would be tantamount to defining an excess supply without it being possible to define any over-production. It is only by comparing what has been produced to the available purchasing power that one can ascertain whether there is a measure of over-production or not. Now, Smith undoubtedly identified output and purchasing power, thus establishing a perfect correspondence between real money (money's worth) and product. No over-production is conceivable in this context (which means that output is totally defined in terms of money — (national) product = (national) income — and not, of course, that firms can never have a deficit due to a scarcity of their sales). Every increase of (national) product is an increase of real money, and correspondingly, no increase of real money can t^ke place unless there is an equivalent increase of output. It remains true, however, that, although real money is indissolubly linked to production, its nominal form, being immaterial, is not the

36 A New Approach to Monetary Analysis

result of any production. It is the bank that, by issuing nominal money, emits the vehicle whose load is current output. Thus, if it is indisputable that without production the concept of money would be empty, it is no less certain that the product can be determined in monetary terms only in so far as it is carried by nominal money, and nominal money is not the result of production, but of a banking emission. Hence banks issue nominal money, and production immediately transforms it into real money by creating a relation of equivalence between money and current output. This is the main teaching that we can derive from Smith's monetary analysis. Does it necessarily follow that the activity of banks can never entail the depreciation of the currency? 1.3. Depreciation as caused by the over-emission of nominal money Well aware of the distinction between nominal and real money, Ricardo tried to prove that depreciation was the unavoidable result of a policy which allowed banks to issue nominal money without there being the certainty that it would be immediately transformed into real money, by identifying it with current output4 (by means of strict convertibility, according to Ricardo): The law which gave the Bank the power of refusing to pay their notes in specie, has entailed upon us the evil of a depreciation in our currency of nearly 20 per cent, and has rendered it extremely difficult to restore it to the true standard by which it should be regulated — the value of the gold which is actually contained in the coin for which it is a substitute. (Ricardo 1951-5, vol. III. p. 132)

The problem of over-emission relates to nominal money. If banks were able to add nominal money to the amount of existing money already associated with the corresponding output, the currency would inevitably depreciate since the same purchasing power would be carried by an increased quantity of monetary units. Metaphorically, more vehicles would carry the same given load. Having no intrinsic value,5 nominal money acquires a positive significance in relation to its charge. Hence, if a part of nominal money issued by banks were not transformed into real money by production, it could acquire a value only by decreasing the load' of the existing units of money. Transported by an increased number of nominal units, output would not change in value, but its monetary expression would necessarily be greater than previously. This increase in the monetary expression of current output corresponds to what Ricardo defines as an increase of prices due to a depreciation of money. Even so, variations in price are not the result of a comparison between the value of two distinct masses — money on one side and output on the other. They are in fact determined by the

The Banking School and the Currency School

37

distribution of a given value (whose magnitude depends on production, and not on the adjustment of supply and demand) over a quantity of nominal money pathologically increased. According to Ricardo and to the defenders of the Currency Principle, banks should be restricted in their emission of money, since it is due to their imprudent conduct that depreciation occurs. In a letter to C. Wood — quoted by Tooke (1959) — Norman warned against the temptation of banks to issue nominal money in order to cover transactions that should be financed by real money: In this country the banks of England and Ireland, joint stock and private banks, are not merely creators, but also bankers in the proper sense of the term, dealers in money, and in this capacity they are exposed to a strong temptation to avail themselves of their privilege as issuers in aid of the other branch of their business. (Norman, quoted in Tooke 1959: 90)

The conclusion reached by Ricardo is well known: bank money should be convertible on demand so that its value always corresponds to the value of the produced goods which it defines. The members of the Currency School went even further, claiming that the danger of depreciation could only be avoided by returning to a system based on metallic circulation. In order to avoid this theory and its inevitable results, an opposing school of thought arose, called the Banking School. Its main aim was to prove that money circulation could not be influenced by the activity of banks alone. 2.

The Banking Principle

2.1. The activity of banks and the increase in the circulation of money Developing the arguments exposed by Horner in his speech in the House of Commons (1810), several writers and bankers claimed that other factors besides the emission of paper money had contributed to the high price of gold, and to the subsequent depreciation of currency. One of the points insisted upon by the defenders of the Banking Principle was that bank-notes were only a minor part of the circulating medium, and that they could have been extensively replaced by bills of exchange, thus avoiding the danger of over-emission linked to the creation of bank-notes. Another point was the claim that it is beyond the faculty of banks to increase the amount of money in circulation: 'It is not in the power of Banks of Issue, including the Bank of England, to make any direct addition to the amount of notes circulating in their respective

38

A New Approach to Monetary Analysis

districts, however disposed they may be to do so' (Tooke 1959: 122). An important argument against the Currency Principle was advanced by Tooke. He stated that, by distinguishing between currency and capital, commercial banks do not adjust their circulation of money to foreign exchanges and are not able, therefore, to increase circulation in any inflationary way. For the sake of clarity, let us introduce separately the functions carried out by banks. Undoubtedly, one of these functions consists in lending to some clients part of the capital deposited by other clients. In this case the operation does not modify the amount of money and cannot be the cause of any inflationary disequilibrium. In its role of intermediary, the bank can only lend to the public its own deposits. Now, given that the public's deposits are necessarily made from (national) income,6 and that income defines the (national) product, it is immediately clear that this kind of loan refers to real money. Capital consists of real money, and if loans can only be made out of capital, they can be carried out as many times as economic agents require without affecting the amount of real money. By simply transferring real money one does not increase its amount, and, while it is true that the advances and loans made by banks are influenced by foreign exchange (as the defenders of the Banking Principle were ready to admit), it is not true that banks can modify the circulation by transferring income from lenders to borrowers. Yet banks carry out another function: they create money making advances. Even in this case, however, Tooke's conclusion remains unaltered: banks can never increase the circulation and cause depreciation. But the immediate purpose of my reference to the evidence of Mr Blair and other managers of the Scotch banks, is to show that they do not and cannot regulate their circulation by the foreign exchanges; and that, when they make advances, it is out of their capital or that of their depositors, without any direct influence on their circulation; that they attend to the conduct of the Bank of England in regulating their advances, which, however, have no immediate influence on their circulation. (Tooke 1959: 45)

When Tooke claims that banks' advances have no influence on circulation since they are made out of capital, he clearly implies that money is just another form of capital. In other words he considers bank money as being immediately real. Hence, as monetary form of capital, (real) money can be repeatedly transferred between economic agents without determining any increase in circulation. Considering what had already been discovered by Smith, Tooke correctly identifies the circulation with the monetary expression of the output to be circulated or, in other words, with the real money (or income) defining it:

The Banking School and the Currency School

39

It is the quantity of money, constituting the revenues of the different orders of the State, under the head of rents, profits, salaries, and wages, destined for current expenditure, that alone forms the limiting principle of the aggregate of money prices, the only prices that can properly come under the designation of general prices. (p. 123)

Tooke's argument clearly implies that income determines prices and prices determine the quantity of money. This statement is perfectly in keeping with the principles of classical theory, and also with the thought that banks are neutral in respect to currency variations, when they act as financial intermediaries, and when they make advances. Yet is it not true that they also have the power of issuing (nominal) money in order to circulate goods? And were the amount of money thus issued to be greater than the amount of real money (income), would that not cause a depreciation of the currency? 2.2.

Production and the depreciation of money

The problem which confronted Tooke was the same that had been tackled by Ricardo. Does the purchase of bullion and securities, as well as the discounting of bills and the making of advances by banks have an inflationary effect when they are financed through the issue of banknotes? Let us first recall that banks finance their transactions out of preexisting capital. Money issued remains unaltered irrespective of the technique they use, whether they make advances, discount bills or purchase securities and bullion. Therefore, what has to be investigated is whether the purchase of products (under the form of goods, services, securities or bills) can be made in nominal money or not, and whether or not banks can finance their advances out of nominal money. Tooke's answer to these two questions is negative. He reaffirmed several times that banks cannot increase the amount of capital money and went so far as claiming that not only country banks but also 'the Bank of England has not the power to add to the circulation' (p. 60). But if banks cannot increase the circulation, who can? Obviously, the answer depends on what is defined by the term of circulation. As we have already seen, classical economists assume an identity between value and prices, and determine their amount by referring to production. Hence circulation is linked to production in two respects: first, of course, because its object is the product, and second because its amount is equivalent to the product's value. The circulation of money is determined by the value of what is circulated, and the equality between value and prices is the best guarantee of the fact that there can be no difference between money and output. By defining commodities in terms of money — Marx's form of value

40

A New Approach to Monetary Analysis

— and by identifying (national) income and (national) product (Smith) classical economists establish a strict relationship between circulation and (real) money, putting the emphasis on the process which determines the monetary expression of the output's economic value. As they so clearly stated, it is through production that physical objects acquire their economic identity. Hence the amount of circulation is determined, as far as real money is concerned, by production, and not by the banks' emission of (nominal) money: the classical economists' traditional claim that 'the amount of circulating medium is the consequence of prices' (Tooke 1959: 123) is thus definitely confirmed. The answer to our previous question follows immediately: it is production alone that can (by defining every new commodity in terms of money) increase the circulation. To claim that the purchase of securities and bills is necessarily financed out of real money (income or capital) seems obvious, since securities and bills are not fundamentally different from the goods which they represent. 'The country bankers having no power to purchase stock, or exchequer bills, or bullion, with their notes, an increase of circulation by them is indicative of an increase of trade in their districts' (Gilbert, in Tooke 1959: 57). But what about the advances banks can make to firms to allow for the production of entirely new output? Since banks do not have the power of issuing real money, are we not bound to conclude that advances are made out of nominal money whose emission necessarily increases the amount of circulation? This question sets up a dilemma: only banks can issue money, and yet the amount of circulation is determined by production. Thus either banks add to circulation by issuing real money, or production increases circulation. Both terms of the alternative are unacceptable. Banks cannot issue real money, and circulation cannot be increased by the activity of the real sector alone. Is there a way out of this dilemma? Indeed, Tooke claims that the notes issued by the bank by entering 'into some spontaneous operation which should be of such a nature as to require notes to pass out of its hands' (p. 60) would 'inevitably return to the Bank as deposits' (p. 60). Thus issued as nominal money, banknotes are immediately deposited; and, given that deposits define capital, nominal money necessarily becomes real money. Consistent with the classical theory of value, it is through production that this conversion can take place, for it is only by loading the hitherto empty vehicle (money) that it is possible to define money's worth. Hence, while it is true that an increase of circulation is caused by an increase of production, it is also true that this requires the emission by banks of an equivalent amount of nominal money. In fact, we do not have two additive increases, of output and money, but a single increment defining simultaneously its real and monetary aspects, and implying the transformation of nominal money into real money.

The Banking School and the Currency School 41

If, as Tooke seems to suggest, banks always spend capital when buying goods (and services), and if the money they issue inevitably returns to them as deposit, then the amount in circulation can never be increased without a corresponding increase of production. The central point here is not how many times capital changes hands, but if the amount of capital has been increased or not by any new production. If the answer is yes, then we would have to conclude that circulation has also increased, otherwise, following Tooke's distinction between capital and currency, we should infer that it has not, since the movements of capital have no direct influence over the amount in circulation. 2.3. Depreciation and convertibility as viewed by the Banking School Finally, the members of the Banking School refuse both the diagnosis and the remedy for depreciation proposed by the defenders of the Currency Principle. Thus prices are related to production and not to the quantity of money, and the re-establishment of a metallic circulation is considered 'essentially incorrect and unsound' (Tooke 1959: 121). The judgement is severe: The same error, being no less than that of substituting cause for effect, is observable in a still greater degree (because more importance is attached to it) in the influence ascribed by the currency theory to the amount of circulation, that is, of bank notes, on prices. It is an error which perverts the reasoning, and distorts the view of facts, in every attempt to apply the theory of the currency principle to the actual course of commercial affairs. (p. 76)

Strictly relating to the principle of classical theory, this judgement respects the idea that prices are determined through production. In spite of the rigour and elegance of the argument, it still does not explain how money can depreciate in a world where the emission of nominal money can have no influence on prices, and where real money can never be in excess since it defines current output. Depreciation has been, and still is, one of the most annoying results of the workings of our economic system. How does the Banking School account for it? Apparently, the source of this disequilibrium is to be found in the fact that bank-notes are not convertible: 'The issuer of inconvertible paper has the power up to the limit of utter worthlessness; while there are, as has been incontrovertibly shewn, narrow and impassable limits, totally independent of the foreign exchanges, to the power of issue of a strictly convertible paper' (p. 92). Tooke's remedy for the problem (strict convertibility of bank-notes) is exactly the same as that put forward by Ricardo. Shall we conclude

42 A New Approach to Monetary Analysis

that, despite all his claims to the contrary, Tooke is implicitly assuming that the quantity of money could be increased to an extent that would necessarily cause its depreciation? Since it is perfectly free under a system based on strict convertibility, has the emission of money to be regulated in case of inconvertibility? Neither Tooke nor the other members of the Banking School give a satisfactory answer to these questions. Their analysis of money conforms to the main conclusions reached by Smith, that is, the distinction between nominal and real money as well as the non-additivity of money and output. These conclusions very clearly establish that banks cannot add to circulation for: 1. Nominal money is transformed into real money by production and returns to the issuing bank as a deposit, and 2. Real money defines what is circulated by nominal money (the product carried by the 'great wheel of circulation') and can, therefore, never be in excess, since it is the result of production and not of banking. Yet, in a framework where money and output are perfectly well integrated, there is no place for depreciation. And it is in order to explain this phenomenon that Ricardo speaks of over-emission, trying to conciliate the inflationary rise of prices with the classical law of exchange according to which prices are always equal to value. It seems, therefore, possible to claim that both the Currency and the Banking Schools face the problem of depreciation from the same point of view. But, where the Banking School sees the monetary system as essentially sound and coherent, the Currency School sees all the problems coming from the modern methods of banking. Both schools accept the distinction between nominal and real money, yet they disagree about the possible consequences of an emission of nominal money. According to the Banking School, such an emission can never depreciate the currency since nominal money is necessarily transformed into real money (it returns inevitably to the issuing bank as deposit). Money is then never issued to suit the interests of banks,7 but to circulate output under the form of revenue.8 On the contrary, according to the Currency School, nominal money can also circulate as an empty vehicle, thus increasing prices. The disagreement between the two schools was never really settled. Other schools took over their arguments and economists went on quarrelling about the role of the quantity of money and its influence over prices. A definitive answer to this problem can be given only after having rigorously established the true nature of money. As we shall see in the next chapter, a decisive step towards this end can be made by carefully re-analysing the concepts of money worked out by Keynes.

The Banking School and the Currency School

43

Notes 1. David Hume states, 'Indeed, I believe that great delusion exists in the country with regard to the effect on prices of the currency. My opinion is, that the quantity of money depends on the rise of prices; and that the rise of prices does not depend on the quantity of money' (Hume, in Tooke 1959: 67). 2. See Hume (note 1), Tooke (1959: 135) and Marx (1969). Writing about the theories on money, Marx is very critical of Ricardo, who he accuses of having erroneously attributed the determination of prices to the quantity of money. Though Marx's criticism is valid when relating to the 'healthy state' of the economy, Ricardo's claim proves extremely fruitful when we analyse its 'pathological state'. A first approach to this distinction is offered here by referring to the concepts of nominal and real money. A full explanation of the possible synthesis between Marx's and Ricardo's points of view requires, however, a deeper insight into the theory of inflation and into the nature of 'empty' and 'full' emissions (see Schmitt 1984). 3. See Smith (1978: 386-7). 4. Defined as its content, of course, and not as its counterpart. 5. This is also true when a particular commodity is used as money, since money (which, according to Smith, cannot be added to real output) will never be confused with the material object which is chosen to represent it. 6. The public cannot issue its own money but can only deposit part of its monetary earnings. 7. 'Neither the country banks nor the Bank of England have it in their power to make additional issues of their paper, that is, of their notes, come in aid of their banking resources' (Tooke 1959: 123). 8. See Tooke (1959: 123).

Chapter Four

Keynes's Analysis of Money

The aim of this chapter is to show how Keynes successfully tackled the neoclassical dichotomy by taking over Smith's and Ricardo's distinction between money and income (money's worth). In particular, we shall argue that the core of Keynes's revolution can be found in his claim that wages are the ultimate standard of value. The logical succession accounting for the final rejection of the neoclassical paradigm, therefore, goes from money to income through the payment of wages. Of course, it could easily be claimed that most of Keynes's work does not support our interpretation. Our purpose, however, is not to put forth yet another comprehensive exegesis of his theory. As we have previously done with Smith, Ricardo, Marx and Walras, we shall merely try to emphasize the aspects of Keynes's theory providing a new definition of money. It is obvious that the results of our analysis cannot be dismissed on purely exegetical grounds: the central point is not to establish whether or not Keynes has effectively had the intuitions we ascribe to him, but to verify if our interpretation takes us further in the understanding of our object of inquiry. 1.

From commodity-money to bank money

1.1. Commodity-money, bank money and money proper One of the main features of Keynes's analysis is that it is essentially worked out in monetary terms. Keynes's starting point was money, and it is through a rigorous investigation of this concept that he was able to free himself from the tenets of neoclassical economists. Let us refer to the first pages of the Treatise. The first analytical distinction introduced by Keynes is between money of account and money proper, 'delivery of which will discharge the contract or the debt' (Keynes 1930: 5). In its primitive form money proper identifies with commodity-money. It is through the delivery of a particular commodity that contracts or debts will be discharged in this case. Yet the use of commodity-money is just a step, and an insufficient one, towards the transformation of barter into a monetary economy. A decisive improvement is realized by 'the discovery that for many purposes the acknowledgements of debt are themselves a serviceable substitute for money proper in the settlement of transactions' (p. 5).

Keynes's Analysis of Money

45

This spontaneous acknowledgement of debt can be issued by any private bank and is called bank money. According to Keynes, bank money has not to be taken as money proper. When acknowledgements of debt are used in this way, we may call them bank money — not forgetting, however, that they are not money proper. Bank money is simply an acknowledgement of a private debt, expressed in the money of account, which is used by passing from one hand to another, alternatively with money proper, to settle a transaction. (P- 5)

It seems therefore to be possible to settle transactions in two different ways: by the delivery of an acknowledgement of debt (bank money) or by the delivery of a money capable of definitively discharging the debt (money proper). Were this distinction to be final, then we would have to infer that the use of bank money never allows for the true payment of monetary transactions. Only the payments made in money proper would be effective, for money proper alone discharges contracts or debts. Yet the introduction of bank money is a real step forward in monetary analysis only if it can have a positive repercussion on money proper. If not, commodity-money remains the only kind of money available to play this role, and the system does not essentially differ from barter. Keynes seems well aware of this problem. In fact, he claims that the faculty of becoming spontaneously indebted pertains also to the state, and defines representative money as the bank money which represents 'a debt owing by the State' (p. 5). Thus, besides the old-fashioned concept of commodity-money, we find a particular category of debt, issued by the state with the power of discharging debts. 1.2. Bank money and the role of the state Representative money, which can take the form of fiat money or of managed money, is a direct result of the issuing of bank money by the state. In Keynes's analysis the intervention of the state is therefore the key element to explain the inclusion of bank money into the category of money proper. But why does he have to introduce the state to justify this result? His argument seems to be the following. Private banks can issue their own money, but only the state can issue money proper since the state alone has the faculty of transforming a debt into a means of payment. If we consider the set of agents at work in a given economy, it is obvious that although each element has the freedom to issue its own acknowledgement of debt, money proper cannot be identified with any of them. On the contrary, as long as it is external to this set, the state

46

A New Approach to Monetary Analysis

can effectively issue money which, used by economic agents, does not define their own acknowledgement of debt and can therefore be accepted as a true means of payment. Paying their transactions with a debt issued by the state (which is not an element of their set), agents are effectively discharged of any obligation since the object of this particular debt is precisely what is defined by the state money itself. In this respect, Keynes's state money is a debt of superior order which, used within the boundaries of a national economy, can legitimately take over the role previously played by commodity-money, thus definitively transforming barter into a true monetary system. The part of Keynes's analysis on which we would like to focus here is a change-over from a material conception of money proper to the revolutionary idea that money can be defined as an acknowledgement of debt whose object is the debt itself. Now, it is certain that, by giving his creditor his own money, the debtor is not discharged of his contract. Issued by the debtor, the acknowledgement of debt is a mere promise to pay at term and not a true payment. Things change radically, however, as soon as we pass from a private acknowledgement of debt to the spontaneous indebtedness of the state. Giving his creditor bank money issued by the state, the debtor is effectively discharged of his debt, and his payment is definitive since state money has the same status as money proper. According to Keynes, what distinguishes private bank money from state bank money is the fact that the former defines a private debt whereas the latter does not. Thus the determining factor is not the private or public character of the institution which is getting spontaneously indebted, but the nature of its debt. And this is strictly dependent on whether or not the issuing authority is a purchaser. If it is, then its acknowledgement of debt is not money proper (and, in Keynes's words, it defines a private debt). Reciprocally, if the issuing bank is not a buyer, its money defines a particular kind of debt whose object is the debt itself (Keynes's state money): 'When, however, what was merely a debt has become money proper, it has changed its character and should no longer be reckoned as a debt, since it is of the essence of a debt to be enforceable in terms of something other than itself (p. 6). The preceding argument shows that the faculty which Keynes ascribes to the state can also be considered a characteristic of every private bank which is logically excluded from the set of purchasers.1 Of course, this exclusion is correct only when private banks act as money creators. On the contrary, if they act as buyers, private banks become an element of that set and cannot pay by issuing their own acknowledgement of debt. From now on we shall therefore analyse bank money without investigating whether it is due to the activity of the state or of private banks, bearing in mind that in both cases, in their function of money creators, state and private banks cannot be included in the purchasers'

Keynes's Analysis of Money

47

set (for, let us say it again, no one, not even the state, can pay by getting indebted). Since money is created by the bank becoming spontaneously indebted, the owner of bank money has a claim against the issuing authority. Were he to ask for the enforcement of his credit, he would only get an equivalent amount of money (two £5 notes in exchange for a £10 note, for example) and not some other monetary or real asset. But how can banks issue their money? How can they manage to issue a claim against themselves? 2.

The creation of money

2.1. Money as an 'asset-liability' Having established that commodity-money can be advantageously substituted by an acknowledgement of debt spontaneously issued by the state, Keynes analyses in detail the process by which bank money is created. In particular, he singles out two different ways of achieving the creation of money. Banks can issue a claim against themselves either in exchange for deposits (cash or cheques) or by granting loans whose counterpart is not a deposit but a promise to refund them at term: The bank may create a claim against itself in favour of a borrower, in return for his promise of subsequent reimbursement; i.e. it may make loans or advances' (Keynes 1930: 21). Leaving aside the example of banks exchanging their claims against cash, which requires the intervention of the state as producer of notes and coins, it is immediately clear that the creation of bank money is not founded on the previous existence of some other kind of money. Cheques themselves, in fact, are just a means by which a client of a given bank can draw on his credit line. It is thus enough to suppose that this credit line is not backed by any income deposit (which is obviously the case when the monetary system is first introduced) for us to include the case of cheques within the more general case of new money creation. Defining a positive increase in the spontaneous indebtedness of the banking system, the creation of money also increases the debt of the client who benefits from the loan. It is a necessary consequence of double accounting to find the claim created by the bank against itself on both sides of its book account. And it is perfectly logical to find the client simultaneously being a debtor and a creditor of the bank. As beneficiary of the loan he is obviously indebted towards the issuing bank which, in its turn, is indebted towards him since money precisely defines the bank acknowledgement of debt. This situation occurs without the intervention of any previous deposit, either monetary or real. Logically, the bank does not need the

48

A New Approach to Monetary Analysis

backing of any deposit to create a claim against itself, and even if some kind of security is required in practice, this evidently does not mean that these securities are either necessary or sufficient for the creation of money. In other words, money is created by banks as an a-dimensional unit: book-entry money is a purely numerical inscription of double accounting. Thus the great intuitions of the classical economists and of Walras find in Keynes a confirmation and a conceptual framework within which they can finally be realized. 2.2. The example of overdrafts Overdrafts are a good example of the way money can be spontaneously issued by banks. When a client draws money from a bank without decreasing his deposits, he is taking advantage of the overdraft facilities the bank is offering him. By doing so he increases his debit with the bank which, besides owning a credit, is also spontaneously indebted towards him (since money defines the bank's acknowledgement of debt): [Facilities are] provided, equally well, by the overdraft, i.e. by an arrangement with the bank that an account may be in debit at any time up to an amount not exceeding an agreed figure, interest being paid not on the agreed maximum debit, but on the actual average debit. A customer of a bank may draw a cheque against his deposit, thus diminishing his credit with the bank; but he may, equally well, draw a cheque against his overdraft, thus increasing his debit with the bank.

(p. 36)

Yet it could be argued that this technique does not necessarily define money creation. Indeed, if the overdrafts are based on bank facilities (savings deposits as well as the capital owned by the bank itself), the client who makes use of them is simply spending what has been previously saved by some other client. To define real creation of money, overdrafts must take place independently of any previous deposit. It is only in this case that creation is possible, the increase of the client's debt being matched by an equivalent increase of his credit. Surprising though it may be, this conclusion is the only one consistent with the concept of creation. Metaphysical considerations notwithstanding, it is in fact certain that creation can occur only if it simultaneously defines a positive and a negative result (matter and anti-matter if we are allowed an analogy with physics). Thus money creation gives rise to a debit and a credit, of equivalent amount and referred to the same client. Since the client's assets and liabilities are simultaneously increased by the same amount, the emission of money is obviously not the creation of a positive asset. What is positively issued by the bank (its acknowledgement of debt) is perfectly compensated by a corresponding negative

Keynes's Analysis of Money

49

emission (the client's indebtedness) so that, finally, no net position can result from the bank spontaneously issuing a claim against itself. This does not mean, of course, that the whole operation is meaningless. The client's drawing against his overdraft is not a self-defeating process, since the credit towards the bank is immediately used for the payment of a third agent, who becomes the final creditor of the bank. Now, to determine the identity of this third agent and the nature of this payment it is necessary to know what the relationship existing between (the newly issued) money and output is. In other words, we have to establish how money can acquire a positive purchasing power and how we determine its total amount. 3.

The distinction between money and purchasing power

From our previous argument it should be clear that banks alone cannot create money already endowed with a positive purchasing power. The bank spontaneously getting indebted does certainly not define the creation of income (which requires the intervention of production) nor does it imply the pre-existence of any given income or deposit. In these conditions it is impossible to explain money's purchasing power, a solution being available only if money is linked to output by a further operation substantially different from the bank's creation of a claim against itself. Keynes explicitly supports this argument when he claims that 'banks cannot, by themselves, create real purchasing power' (1973: 19). In the same draft of Chapter 1 of the Treatise, he notes that 'The amount of bank money, on the other hand, which the banks, taken as a whole, can lend, bears no direct relation to the amount of real purchasing power which their depositors are prepared to leave with them' (1930: 20). It is thus perfectly clear that Keynes neatly distinguishes between bank money and purchasing power. The latter is not created by banks, which can only receive it as a deposit, and has no direct relationship with the amount of money banks can create. Money creation does not depend on the amount of purchasing power available within the banking system. Keynes's distinction is therefore also a functional one: banks can act either as creators or as financial intermediaries. When they play the role of intermediaries, banks transfer purchasing power (deposits) from savers to borrowers, whereas as creators they lend a mere acknowledgement of debt. But why should agents ask for new money to be created if what they get has no purchasing power at all? Literally, this question should bring us to the conclusion that, contrary to Keynes's claim, banks can effectively create a positive purchasing power. Yet another possibility is open to us: the association of money and output through a 'process'

50 A New Approach to Monetary Analysis

which takes place simultaneously with the banks spontaneously incurring a debt but which does not originate from any banking activity. To better understand this proposition let us spend a little time on the definition of money's purchasing power and on Keynes's distinction between the purchasing power of money and the labour power of money. 3.1. The definition of money's purchasing power The purchasing power of money is generally defined as 'the power of money to buy the goods and services on the purchase of which for purposes of consumption a given community of individuals expend their money income' (Keynes 1930: 48). Clearly tautological, this definition simply tells us that money has a positive purchasing power only in so far as it has the power to purchase goods and services. However, terminological definitions being arbitrary, the tautology implied in the definition of purchasing power does not pose a serious threat. In fact, what really matters, even from a terminological point of view, seems to be the possibility of expressing the value of money in an economic unit. How do we measure the purchasing power of money? This is the first question usually asked by theorists. As Robertson rightly pointed out, this question cannot be answered so easily, since we do not possess a standard by which to express the purchasing power of money: 'But a difficulty arises from the fact that we are in the habit, for the sake of convenience, of expressing the value of bread or cloth in terms of money, whereas obviously we cannot express the value of money in terms of itself (1959: 14). The solution apparently requires purchasing power to be measured in terms of the quantity of goods and services that a unit of money will buy, in which case we would have to distinguish between different kinds of standard according to the particular set of individuals whose purchasing power we want to determine: When, therefore, we speak of the value of money, we must be clear whether we are thinking of its value in terms only of the goods and services which enter into ordinary consumption, or of its value in terms of all the newly created things which make up the country's real income or output, or of its value in terms of all the things of whatever kind which are exchanged with its aid. (Robertson 1959: 15)

Obviously, the quantity of output which can be bought by a given amount of money depends on the price of the composite commodity taken as a reference. Hence the value of money (its purchasing power) would be a direct consequence of the level of prices, and changes in this value would be represented by an appropriate series of index numbers: Thus the money of account is the term in which units of purchasing power are expressed. Money is the form in which units of purchasing power are held. The

Keynes's Analysis of Money

51

index number of the price of the composite commodity representative of consumption is the standard by which units of purchasing power are measured. (Keynes 1930: 49)

On closer inspection, however, this level-of-price definition of purchasing power is seen to beg the question, for it rests on the tacit assumption that prices can be determined independently of purchasing power (which would in a certain sense be derived from them). In fact, prices define the (monetary) value of output so that, in order to find the value of money we refer to a set of goods and services (whose value is itself expressed in terms of money) as if this value could be known somehow a priori. The knowledge of prices presupposes the determination of money's purchasing power in exactly the same way as the knowledge of purchasing power presupposes the determination of prices. In other words, if we claim that the value of goods is defined in terms of money, we also claim, tautologically, that the value of money is defined by these same goods. Finally, the purchasing power of money is quite naturally determined simultaneously with prices so that to define one of these two concepts is enough to define the other. What has to be determined, then, is how money can have positive purchasing power or, alternatively, how goods and services happen to be expressed by a given set of prices. Where does the purchasing power of money come from? A man does not hold money for its own sake, but for its purchasing power — that is to say, for what it will buy. Therefore his demand is not for units of money as such, but for units of purchasing power. Since, however, there is no means of holding general purchasing power except in the form of money, his demand for purchasing power translates itself into a demand for an 'equivalent' quantity of money. What is the measure of 'equivalence' between units of money and units of purchasing power? (Keynes 1930: 47)

3.2. The origin of money's purchasing power Related to the final expenditure of income, the concept of purchasing power is immediately associated with the formation of money's value. This tells us that the total purchasing power is equivalent to the monetary value of total output, but it does not tell us where this value comes from. Issued by banks, money is a simple acknowledgement of debt. The fact that it can be spent to buy goods and services obviously means that it somehow acquires a positive purchasing power. What we still have to determine is how this can happen — how bank money can define income. An interesting step towards the solution of this problem can be made by introducing Keynes's concept of the labour power of money. As the

52 A New Approach to Monetary Analysis

author of the Treatise tells us, the labour power of money (or earning standard) 'measures the power of money to command units of human effort' (p. 50). Thus, while purchasing power is related to the final purchase2 of goods and services, labour power is derived from a process which is logically prior to the sale of commodities. Purchasing power is exerted on the commodity market whereas labour power is exerted on the factors market. Needless to say, labour is not a commodity, and 'to command units of human effort' (p. 50) is not the same thing as buying goods. If it is obvious that in order to buy a commodity we have to spend a positive amount of purchasing power, it is not equally evident what kind of money we can use for the payment of wages. Labour is a factor of production. The payment of wages is therefore a transaction which logically precedes the purchase of goods and services. Thus our problem is whether or not the payment of a factor of production requires the pre-existence of money purchasing power. Though very simple when referred to land and capital, this problem is extremely difficult when related to labour. And one important aspect of Keynes's concept is precisely the fact that it does take into account labour alone. Being the origin of output, can labour be bought at all? Purchase is an economic activity implying the presence of both income and commodities and, since labour is not a commodity, it is impossible to see how it could be purchased and sold.3 But if labour is not sold, then the payment of wages does not require the expenditure of a positive purchasing power. Shall we therefore conclude that, besides the power of purchasing goods, money is also endowed with the particular power of commanding labour? What is unquestionable is that Keynes puts great emphasis on the distinction between purchasing power and labour power. These two characteristics of money are seen as fundamental to the understanding of the whole of monetary analysis. In the Treatise, he writes: For the labour power of money and the purchasing power of money are fundamental in a sense in which price levels based on other types of expenditure are not. Human effort and human consumption are the ultimate matters from which alone economic transactions are capable of deriving any significance; and all other forms of expenditure only acquire importance from their having some relationship, sooner or later, to the effort of producers or to the expenditure of consumers. (pp. 120-1)

The concepts of purchasing power and of labour power play two distinct though interrelated roles. Yet, while it is almost self-evident that the use of purchasing power implies the existence of a positive income, it is still a mystery as to how money can exert a positive power on labour. Issued by banks as a spontaneous acknowledgement of debt,

Keynes's Analysis of Money

53

money can define a positive income only if it is associated with current output. It is through this association that money acquires a value (money's worth) and it is only at this stage that its purchasing power can be exerted. Money's power to command labour can therefore not come from its purchasing power (since before production money cannot define any purchasing power). From where does it come then? To be able to answer this question let us go back to Keynes's analysis. 4.

Money's value and production costs

4.1. Labour as the sole factor of production I propose, therefore, to break away from the traditional method of setting out from the total quantity of money irrespective of the purposes on which it is employed, and to start instead — for reasons which will become clear as we proceed — with the flow of the community's earnings or money income and with its twofold division (1) into the parts which have been earned by the production of consumption goods and of investment goods respectively, and (2) into the parts which are expended on consumption goods and on savings respectively. (Keynes 1930: 121)

Keynes's twofold division of money income is essential to the understanding of our problem. Earning and spending are two faces of the same reality: money income is defined by their unity, which holds good whether the system is in equilibrium or not. Equilibrium can at most have an influence on future incomes,4 but it cannot modify the fact that, every income being necessarily identical to itself, final expenditures on consumption and investment goods are always equivalent to their total costs of production. As the reader can easily recall, in his Treatise on Money Keynes identifies income with the cost of production (p. 111). The community's earnings are thus defined by what has been paid to the factors of production or, alternatively, by what has been spent on the purchase of their product. What is still undetermined is the identity of these factors. Are they many or is it possible to reduce them to a unique element? Though often used by classical economists to prove their theory of absolute labour value, the reductionist argument is not entirely convincing. Yet the neoclassical introduction of capital and land as factors of production is even less satisfactory since logically it cannot explain how products (capital and land are nothing but products) can be the source of their own value.5 Once again it is Keynes that shows us the way out: I sympathise, therefore, with the pre-classical doctrine that everything is produced by labour, aided by what used to be called art and is now called

54 A New Approach to Monetary Analysis technique, by natural resources which are free or cost a rent according to their scarcity or abundance, and by the results of past labour, embodied in investments, which also command a price according to their scarcity or abundance. In so far as we can identify prime costs with labour costs, the modern doctrine according to which price tends to equal marginal prime cost is, in a sense, a return to the old conception of the wage unit as the ultimate standard of value. It is preferable to regard labour, including, of course, the personal services of the entrepreneur and his assistants, as the sole factor of production, operating in a given environment of technique, natural resources, capital equipment and effective demand. (Keynes 1973, Vol. XIII: 454)

Since labour is the sole factor of production, it is through the payment of its costs that income can be determined. Wages are the cost of labour. Income is thus defined by the total sum of wages paid for the production of consumption and investment goods: wage-units are effectively the ultimate standard of value. 4.2. Money, income and tbe payment of wages The payment of wages, on the one hand, and the final purchase of output, on the other, are two equivalent definitions of income which respectively refer to money labour power and to money purchasing power. Money's power to command labour is thus measured in wageunits. 'We shall call the unit in which the quantity of employment is measured the labour-unit; and the money-wage of a labour-unit we shall call the wage-unit' (Keynes 1936: 41). But is the wage-units definition of money labour power sufficient to explain its origins? Nobody will deny that we do command labour through the payment of wages. What still has to be settled, however, is what kind of power is defined by wages. In order to command labour, wages must be endowed with the specific power to do so. This seems almost tautological. On the other hand, it is also evident that this power can only come from production, even though it cannot be identified with a positive income since, being the source of every commodity, labour is not itself a commodity. One of Keynes's most important conclusions is that income is the result of production. The payment of wages therefore cannot define an expenditure of income.6 On the contrary, this same payment defines a creation of income since wages correspond to the cost of production. Once they have been paid out, wages define positive income, and this explains how money can acquire a definite purchasing power or, in other words, how the bank's acknowledgement of debt can become a net asset. But can this also explain why a simple claim issued by the bank against itself can exert a positive power on labour? Through the payment of wages, workers get an income which has not

Keynes's Analysis of Money

55

been lost by anybody and which defines the new output. Even though they are not spent as income, wages are bound to define positive income, and this is enough to explain the power of money to command labour. In short, wages can be paid in bank money because as the result of this transaction they will define new positive income. The power of commanding labour is therefore derived from the fact that, through the payment of wages, nominal money is necessarily changed into real money. In a way, it is the payment itself which teleologically explains money's power to command labour. Finally, the payment of labour cost is the necessary and sufficient condition both for the creation of income (and, therefore, of money purchasing power) and for the understanding of money labour power. Issued as a positive and negative entity, bank money is thus immediately changed into a net asset through the payment of labour. This means that money and labour are the key elements of Keynes's economic theory: 'It is my belief that much unnecessary perplexity can be avoided if we limit ourselves strictly to the two units, money and labour, when we are dealing with the behaviour of the economic system as a whole' (Keynes 1936: 43). As we shall show in the next chapters, the new (quantum) analysis of monetary economics rests precisely on these two concepts. The new approach has therefore its historical foundations in Keynes as well as in Smith, Ricardo, Marx and Walras, and represents the living vindication of the validity of their intuitions. Notes 1. Of course, this does not mean that private banks cannot act as buyers. If they do, however, it is not by contradicting their own nature, which is effectively twofold. As money creators, banks are excluded from the set of purchasers whereas as income holders they are an element of this set. Thus, as with every other economic agent, banks can buy only if they earn positive money and not simply by issuing their own acknowledgement of debt, this conclusion being valid for private banks as well as for the state. 2. By final purchase we mean that part of a transaction which does not allow for any income redistribution. For example, the purchase of a given quantity of commodity a is final only in so far as it covers the social costs of producing a. What is spent on top of this cost does not define final purchase but a transfer of income from the buyer to the seller. 3. The exclusion of labour from the commodity set is a necessity of logic, since it is impossible to conceive of labour being simultaneously a product and the cause of all products. 4. In reality it has been established (Schmitt 1971, 1972) that there is no functional link between successive incomes, and that the earning-throughspending theory of income is logically inconsistent with Keynes's fundamental identities. See also Cencini (1984). 5. For a further investigation of this logical impossibility, see Schmitt (1984). 6. An exception is represented by what Schmitt calls joint expenditures,

56 A New Approach to Monetary Analysis defining the expenditure of a profit for the payment of wages. However, this exception does not apply here. Being concerned with the problem of explaining the formation of income, we must not take into consideration any previous production.

Chapter Five

Money and Time

In this chapter we shall try to work out the concept of money ab initio. Let us start with an indisputable empirical fact? the existence of double accounting. As we shall argue, it is on the sole basis of this evidence that bank money has to be explained. Fundamentally, bank money is book-entry money. The relationship between banks' double accounting and money's emission is therefore the first argument which must be tackled. From its analysis, some important information concerning the time dimension of money and the logical possibility of holding money through time can be derived. The link between money and time is of a very particular nature, which depends strictly on the way money can be issued (by banks) and used by the economy. In a modern analysis of money it cannot be forgotten that book-entry money is issued as a spontaneous acknowledgement of debt. Yet the problem which remains to be settled is whether or not this spontaneous indebtedness can be freely incurred by banks. The answer to this question suggests a new interpretation of the concept of money neutrality and shows how money's existence is necessarily instantaneous. Bernard Schmitt's quantum approach is founded on the circuit of money and on its instantaneity. Money is * emitted' precisely because its circulation is not a function of time. But this has very striking consequences on the definition of money and on its Velocity of circulation', consequences which show very clearly how strongly the analysis of money is linked to that of income. 1.

The emission of money and the distinction between bank money and state money

As we have seen in the previous chapter, Keynes distinguished between state credit money and banks credit money. Resumed by Gurley and Shaw in I960,1 this distinction seems to be derived necessarily from the substantial difference existing between the way bank and state money are respectively issued. It is in order to verify (or to falsify) the validity of this postulate that we shall successively analyse the accounting operations by which money is said to be issued either as outside or as inside money.

58 A New Approach to Monetary Analysis

1.1. The emission of outside money According to Gurley and Shaw's definitions, outside money is a kind of money which comes from outside the private sector, as a commodity (gold) or as a paper currency printed by the government. The main property of outside money is said to be the fact that it 'is an asset for someone without being a debt for anyone else' (Johnson 1978: 84). And this seems indeed to corroborate Keynes's claim that only state money is money proper. One of the functions of the Central Bank is to provide the private banking system with the required amount of national bank-notes. Playing this particular role, the Central Bank is however not creating any new money. In fact, bank-notes are just a material representation of bank debts. The Central Bank can have them printed and can distribute them among private banks. Yet this operation is necessarily recorded in the banks' balance sheets, so that every bank-note corresponds to a book-entry of which it is the mere 'image'. Now, the Central Bank can also act as the state's bank, and as such it can issue money by spontaneously incurring a debt to the state. This emission of money does not require any previous deposit, so that the Central Bank's acknowledgement of debt seems effectively to determine a net increase of wealth: 'Outside money represents wealth to which there corresponds no debt' (Johnson 1978: 82). Yet this result is far from being self-evident. How can, in fact, the Central Bank get spontaneously indebted? What are the instruments at its disposal for the creation of outside money? As the words 'book-entry money' indicate, what is issued by the Central Bank exists in the form of an entry in its book-keeping. But if we examine the accounting relationships of modern book-keeping, we immediately note that for each record on the assets side there is a corresponding record on the liabilities side. The rules that the Central Bank has to comply with are in fact determined by the unique principle of double accounting according to which each asset of the Bank must be faced by an equivalent debt and vice versa. For example, if the Bank issues &x million in favour of the state, it enters the operation by writing £x million (state) on the left-hand side of its balance sheet (Table 5.1). Table 5.1 Central Bank Liabilities

State Six million

Assets

Money and Time

59

What is represented in Table 5.1, however, is only half of the entry defining the creation of &x million by the Bank. The operation must in fact be completed by another registration (Table 5.2). Table 5.2 Central Bank Liabilities

Assets

State &x million

Issued by the Bank in favour of the state, the £x million is simultaneously an asset (the state owes the Bank) and a liability (the Bank owes the state), and the whole operation of creation is represented in Table 5.3. Table 5.3 Central Bank Liabilities

State &x million

Assets

State &x million

The entire operation means that a sum of &x million is placed at the state's disposal in the books of the Bank. The state can draw money from its account at any moment, but the obligation to pay the Bank back at term remains. The focal point of our argument is that the Central Bank can only create money which is defined by the simultaneous recording of a debt and a credit. And this rule is far from being arbitrary; on the contrary it is derived from the impossibility of investing the Bank with the faculty of creating something positive out of nothing.2 Issued by the simple stroke of a pen (or by an electrical impulse), bank money must necessarily be positive and negative: a pure a-dimensional vehicle that the Bank offers to the economy. It is now clear that the Bank's creation has nominal money as its object. By spontaneously incurring a debt to the state, the Central Bank

60 A New Approach to Monetary Analysis

lends it a certain amount of empty vehicles of zero value. Recorded as an asset and a liability, book-entry money is neither positive nor negative; it would therefore be mistaken to claim that outside money can be issued as a net asset. Through the emission of outside money the Bank credits the state with a given amount and simultaneously enters an equivalent debt against it. Obviously, this double recording cancels out and the result of the whole entry is nil. What does it mean then? Nothing, of course, if the state does not take advantage of the line of credit opened for it by the Central Bank. In terms of our analogy, the empty vehicle is 'no-vehicle' at all if it is not used to circulate current output. The creation of outside money becomes positive only if it is used by the state. The state can spend its money either on purchasing private output or on financing the production of public goods and services. In both cases, the payment splits the balance sheet recording of the Bank into a net asset and a net liability of the kind shown in Table 5.4. Table 5.4 Central Bank Liabilities

Assets

B &x

State £ x

The state now owes the Bank which owes B. Debt and credit are no longer 'carried' by the same client and the emission of money is undoubtedly positive. It has still to be analysed, of course, how a simple acknowledgement of debt can become a unit of payment. Yet is should already be evident that the Central Bank alone cannot issue such a unit. It is only because it acts on behalf of the state that the Bank can create positive money. Hence, what we have to examine is whether things change at all when money is issued by the private banking system. 1.2. The emission of inside money Broadly defined, inside money is the money issued by the private banking sector. In order to understand the precise nature of this money it is therefore necessary to analyse the way private banks can increase the amount of currency. Let us recall Johnson's definition: 'Inside money is typified by bank deposits created by a private banking system, the

Money and Time

61

deposits on the one side of the balance sheet corresponding to loans to private individuals on the other side, so that for every dollar of assets there is a dollar of somebody's debt' (1978: 82). According to Johnson's approach, inside money is created by commercial banks against a debt. As he clearly states, 'Modern monetary systems do involve money that is backed by the debt of somebody or other: either it is created against private debt or it is created against government debt' (p. 85). Newly created deposits are thus strictly related to debts, but where do these debts come from? Before answering this question it is important to clarify its terms. In particular, it must be stressed that the emission of inside money cannot be considered as an exchange between real assets offered by the public and deposit claims issued by banks. If the creation of money were defined as an exchange of claims (the public offering an asset of some sort and banks a spontaneous debt), then bank deposits could only be seen as the monetary form of real deposits and it would become impossible to explain how banks can effectively create any new (net) deposit. As Patinkin points out, inside money 'represents that part of the money supply which is generated by a fractional reserve banking system in its normal process of creating deposits by credit expansion' (1972: 146). The creation of money through an expansion of credit is fundamentally different from an exchange of deposits for, in the first case the debt of the bank is balanced by a debt of the public originated by the emission of money itself, while in the second case the claim against the bank is backed by a claim owned by the bank that exists (as an asset) independently of the creation of money. The distinction between the emission of inside money and the exchange of deposits is not easy to understand. Johnson himself seems to mix-up the two concepts when he writes that inside money 'is always created against some other kind of debt' (1978: 84). In reality the debt offsetting the deposit created by the bank is not of 'some other kind'. If it were, the creation would be reduced to a transformation where 'the bank deposits — i.e. the debts of the bank to the public — are always covered by the assets people have offered to the bank in exchange for deposit claims against the bank' (Sayers 1958: 12). On the contrary, the emission of money is a true creation precisely because it is not based on any previous real deposit of the public. Both the debt entered against the public and the credit entered to the public result from the creation of money so that the deposit created by the bank is balanced by a debt of the same sort. Coming back to our initial question we can now answer that every deposit of inside money created by the private banking sector in favour of a given economic agent is balanced by an equivalent debt of the same agent. In fact, the creation of money through credit expansion is

62 A New Approach to Monetary Analysis nothing other than the creation of a bank deposit through the lending of the debt spontaneously incurred by banks. By stating that 'in the case of expansion of bank credit to the private sector, the offsetting debt is that of the borrower from the banking system' (Patinkin 1972: 146-7), Patinkin explicitly asserts that banks issue money by incurring a debt to the public (expansion of credit) and by immediately balancing it by a debt of the beneficiary of the credit (the borrower from the banking system). Consistent with the principle that 'loans make deposits', the creation of money is the result of a double entry by which the banks' acknowledgement of debt is lent to the public. Thus banks own a claim against the public perfectly equivalent to the claim owned by the public against the banks (Table 5.5). Table 5.5 Commercial Bank Liabilities Public &x million

Assets Public £>x million

The bank at once places the sum of the loan to the credit of the client: its debts are increased by that amount, and since its debts constitute money, the supply of money is increased by the same amount. At the same time, the assets of the bank have increased by the amount of the loans. Its liabilities and its assets have increased by equal amounts. (Sayers 1958: 14)

Sayers analytical description is crystal clear. Assets and liabilities of the bank are simultaneously increased by an equal amount, for the loan defines a deposit of the client (and, therefore, a debt of the bank) and a promise of the same client of paying it back (i.e. a credit of the bank). By entering a credit to and an equivalent debt against its client, the bank creates a given amount of (nominal) money. Yet what is created is at the same time positive and negative, and the bank's double recording immediately cancels out. As in the case of outside money, the creation of inside money becomes a positive operation only when the client of the bank draws money from his credit line in order to pay his correspondent. Then the bank will still own a claim against its client, yet the offsetting claim against the bank will no longer be owned by this same client but by another agent, whose credit is therefore net and defines a positive income: 'To every dollar of deposits thus created and held by

Money and Time

63

some individual in the economy, there corresponds an offsetting debt of some other individual' (Patinkin 1972: 146). A priori, it seems that the agent who borrows from the bank (let us call him A) can spend his deposit either on the purchase of already produced goods and services or on the financing of new production. In both cases what we have defined as an empty vehicle (nominal money) is loaded with real output, and the creation of money has a positive result: the recording by the bank of a net credit in favour of the payee. Does this mean that banks alone do not have the faculty to increase the net wealth of society? Although we already possess all the elements necessary to answer this question rigorously, it is worth spending some more time on it, in a further attempt to clarify as much as we can the peculiar nature of bank money. 1.2. The emission of book-entry money is not a source of income, either for the state or for the banks As Johnson pointed out, there is a case in which the creation of bank money seems to provide a source of wealth either for the state or for the banking system.3 It is when credit money replaces commoditymoney and the resource's previously embodied in the commoditymoney move into the production of new goods and services. This example, however, has the double disadvantage of misrepresenting the creation of both money and output. As far as money is concerned, in fact, we already know that its creation cannot be defined as an exchange of deposits. By issuing money, the banking system is not giving another form to some real assets. Bank deposits are not the monetary form of real deposits. Bank money has no necessary link whatsoever with gold or with any other real asset.4 Banks issue money simply by entering a given amount in their books so that money generated 'by a fractional reserve banking system in its normal process of creating deposits by credit expansion . . . does not represent a net asset of this sector' (Patinkin 1972: 146). For the bank the creation of money is not the creation of a net asset. Yet what is still more important is that book-entry money does not define a net asset for anybody, and it is for this profound reason that banks cannot increase net wealth by creating money. Let us analyse this last point once again, for its conclusion is in opposition to the results often supported by traditional analysis. If bank deposits were created in exchange for assets of some other kind, then, of course, the accounting relationships of the banks would balance. On the liabilities side, banks would have a debt to the public and on the assets side a real deposit. On closer analysis, however, it would appear that, for the public, money is a net asset. This means that banks could create money against real deposits only by giving their clients a monetary

64 A New Approach to Monetary Analysis

asset of equivalent value. In other words, banks would have the mysterious, magic faculty of increasing the net wealth of society simply by issuing a monetary duplicate of their real deposits. Whether we limit this supernatural power to the emission of demand deposits (as done by Pesek and Saving (1967)) or we extend it to time and saving deposits, the difficulty remains unaltered. The exchange of money and real assets is conceived as a transaction between positive assets, and if this exchange defines the creation of money, it has to be explained how banks can multiply net wealth by a simple entry in their books. To avoid any metaphysical definition of the banks' activity, we must therefore infer that the emission of book-entry money cannot generate any positive asset, either for the banks or for society as a whole. This logical requirement is fulfilled only when money is created as an asset and a liability of the same agent. By this double entry banks are simply providing an overdraft facility for their clients. Unused overdraft facilities are not money proper, of course, and they do not 'appear anywhere at all in a bank's statement of its assets and liabilities' (Keynes 1930: 37). Yet Keynes does not hesitate in claiming that 'there exists in unused overdraft facilities a form of bank money of growing importance' (p. 37). According to quantum analysis, this kind of money is also the only one which can be created ex-nihilo by the banking system. All the other forms are derived from this 'facility' and require the intervention of the real sector. For example, when the client (4) draws a cheque against his overdraft he increases his debt with the bank. Simultaneously, the liabilities of the bank are also increased since an equivalent sum is entered on the debit side of its account. The agent in favour of whom the cheque has been drawn (let us call him E) now owns a credit appearing on the liabilities side of the bank's balance sheet. The payment made by A is thus recorded by the bank as a credit to B and debt against A. It is therefore the use of overdraft facilities that give rise to a positive double entry in the books of the bank. Considered independently of the real sector, it is certain that the banking system can only create a numerical, value-less support like Keynes's overdraft facilities. The fact that unused overdrafts do not appear in the banks' accounts proves once more that the creation of bank money cannot be identified with a source of net wealth. It is when the client to whom the bank has offered a credit line (overdraft facilities) takes advantage of it (draws against his overdraft) that his economic correspondent, i.e. the person with whom he deals actually becomes a net creditor of the bank, and his net credit is precisely what defines a positive bank deposit. It is therefore only through the use of overdrafts that the principle according to which 'loans make deposits' is verified.

Money and Time 2.

65

The emission of money and time

2.1. Double accounting and credit As we have just seen, the creation of money requires the opening of credit by banks. Indeed, bank money is often called credit money, a denomination which clearly stresses the link between money's creation and banks' lending, and which is an undepleted source of misunderstandings in monetary theory. The concept of credit, in fact, is closely related to that of income, so that the creation of money is sometimes mixed-up with the lending of income. Yet, from an analytical point of view, these two operations are completely distinct: by creating money banks do not lend positive income to the public but a simple promise which becomes a net credit only when it is spent by its borrower. Since the argument is highly important and controversial, let us proceed step by step. First of all, it is worth recalling that banks play at least two distinct roles in the economy: by issuing money they act as money creators while by lending income they act as financial intermediaries. As far as this second activity is concerned it should be evident that the amount of income banks can lend can never be greater than the amount they receive as deposits (Fig. 5.1). Deposits of income Public

— &x

Loan +~ Public

Banks &y

Figure 5.1

In Figure 5.1 y is equal or smaller than x. By simply transferring income from some economic agents to others, banks can obviously not increase its amount. The sums that banks give to borrowers come from preexisting deposits so that after these transactions the whole system is neither richer nor poorer than before. The final result is not a change in the total amount of income recorded in the banks' balance sheet, but a change of the economic agents to whom the entries refer. For example, if the initial situation were that shown in Table 5.6 and if the deposit of B were to be entirely borrowed by C, the operation would end up with a simple switch (which would also be recorded in B's and C's accounts) between B and C (Table 5.7). In the example of a financial intermediation, wliat is lent by banks is income, and in this context it is certainly correct to speak of credit money. Yet it should always be kept in mind that the credit thus allowed

66

A New Approach to Monetary Analysis

Table 5.6 Bank Liabilities

Assets

B&IQ

A&IO

Table 5.7 Bank Liabilities

Assets

C&IO

A&W

by banks is necessarily founded on a pre-existing deposit. Hence financial intermediations are based on the principle that * deposits make loans', and not on the principle characterizing the creation of money and according to which 'loans make deposits'. The difference between transmission and creation is clear. If, besides transferring an already existing income, banks want to increase the amount of money they can only act at a nominal level. Banks cannot create a positive income, but they can provide the necessary (numerical) support for this creation. They do so by opening a line of credit, by offering overdraft facilities to their clients. These facilities, however, define a purely nominal money and cannot be considered as financial credit. As the banks' accounting relationships show, the client does not receive a positive income (real money), so that the opening of a credit line is insufficient for the creation of a positive bank deposit. Nominal money has to be effectively lent to the public (it has to be used by it) in order to create a deposit which is not immediately balanced by an offsetting debt of the same client who owns it. Yet, although it is permitted by the bank's spontaneously incurring a debt, the lending of (newly created) money is not a transaction pertaining to the bank alone. The use of overdraft facilities is determined by the whole economy and not by banks.5 Hence banks do not create a positive deposit either as financial intermediaries or as money creators. The conclusion is clear: banks never create a positive asset in favour

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of the public. They either transfer a pre-existing asset or create an asset which is immediately balanced by an equivalent liability of the same agent. In the first case the credit that banks allow some of their clients (borrowers) is perfectly equal to the credit that other clients (depositors) allow them. In the second case the credit is nil, for what is offered to the public is not positive income but a mere acknowledgement of debt. 2.2. Credit and the emission of money Let us consider once again the creation of money. As we have seen, this emission is positive only if the public takes advantage of the overdraft facilities offered to him by banks. By drawing on his overdraft, client A can pay his correspondent B, and it is this triangular relationship among the bank, A and B which defines the positive creation of money. Now, quantum analysis proves that this creation is not an operation of credit, for it does not define a positive loan of the bank. Unless it acts as a financial intermediary, a bank can allow a positive new credit to one of its clients only if it lends money to him without borrowing money from another client. The beneficiary of this operation (A) would therefore be a seller of a security and the bank would have a correspondent debt to him. Yet when the bank creates money by paying B on behalf of A it acts precisely as a simple intermediary. Its assets and its liabilities are increased by the same amount so that, by creating money, it creates no credit at all. If we imagine a triangle having the bank as its upper vertex, we can see that the creation could perhaps define a credit between the two vertices of the base; but, for the bank, the relationship between the upper vertex and the base — between bank and economy — neither defines a net credit nor a net debt. On the contrary, the upper vertex is a simple monetary intermediary for, in the same movement, the same amount is entered both on the credit and on the debit side of the bank's account. It would therefore be illogical to identify the creation of money with an operation of credit by the bank: when it creates, the bank does not lend anything. (Schmitt 1984: 41)

Let us now analyse the relationship between the two vertices of the base of Schmitt's triangle. Does the payment made by A define a credit for B? The answer depends on the nature of the goods and services bought by A. If A buys securities from B, then the transaction is effectively a transfer of income from A to B (a credit of A to B). On the contrary, when A buys real goods or services B is paid if the amount of money he gets is definitively spent by A and not if he has to give it back to A. Being paid is not a synonym for getting a Iqan, so that by paying B, A is obviously not allowing him a credit. Coming back to the purchase of securities we must note, however, that it is a transaction which implies the pre-existence of income. Thus the only case in which

68 A New Approach to Monetary Analysis

the creation of money defines a credit is when the creation is functional to a financial intermediation. In other words, the credit between A and B is not originated by money's creation, for money is a simple vehicle of a previously determined income. We are therefore brought to the conclusion that the creation of money as such can never define a positive credit, neither of the bank nor of the public. Yet the situation of A should be investigated some more. It is true, in fact, that he does not get any credit from the bank (whose assets and liabilities are perfectly balanced), and that he does not give any credit to B (who owes him nothing), but it is also true that, because of his purchase, A has a debt to the bank. Let us represent the accounting relationships of the bank as shown in Table 5.8. Table 5.8 Bank Liabilities

Assets

B &x

A &x

From Table 5.8 it clearly appears that the bank owns a claim against A which is balanced by an equivalent claim that B owns against the bank. The claim owned by B defines his credit, of course, but this obviously does not mean that B has received a credit, either from A or the bank. The offsetting entry of the bank is the debt of A. Thus the position of A is simply the reciprocal of J3's: 'analysis leads us to the conclusion that Paul (4)'s situation is symmetrical with respect to Pierre (#)'s; whereas Pierre (B) gets positive money, Paul (A) "acquires" equivalent negative money' (Schmitt 1984: 43). The question is whether the debt of A is the sign of a positive credit allowed to him by B or not. If by credit we mean the lending of a positive income in exchange for securities, then the answer is no. A buys from B, he does not sell anything to him. It is only if we extended the meaning of credit to include in it any kind of loans (the explicit, which takes place through the sale of securities, as well as the implicit, which results from the balancing of banks' entries) that the answer could be positive. This particular kind of credit (implicit loan by B to A) would, however, partially modify our general conclusion, which would only remain correct relative to banks and borrowers. It would still be true that by creating money banks do not allow a credit to the economy and that payers do not lend income to payees, yet it would also become

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evident that there is a sense in which the creation of money is at the same time a monetary and a financial intermediation. The comprehension of the financial aspect of money's creation requires, however, a previous understanding of the relationship existing between bank money and bank deposits; and this is the argument we are going to analyse in the next section. 2.3. The emission of money, the creation of bank deposits and time Bank money is thus a spontaneous acknowledgement of debt which banks offer to the economy 'either for value received or against promises' (Keynes 1930: 21). Now, 'in both cases the bank creates the deposit; for only the bank itself can authorise the creation of a deposit in its books entitling the customer to draw cash or to transfer his claim to the order of someone else' (p. 21). Let us refer back to the example shown in Table 5.8. Everything happens at the same instant. The bank issues a claim against itself which A uses to pay B and which B deposits into the bank. It is a peculiarity of book-entry money that it exists as an accounting relationship. And this explains why the money paid out by A to B is immediately deposited. The very entering of B on the bank's liabilities side defines his payment and the fact that his money exists precisely as a bank deposit. Schematically, the different operations are the following: 1. The bank offers overdraft facilities to its client A. Money is not yet created and bank deposits are only virtual. 2. A makes use of his facilities and asks the bank to credit his correspondent B with a given amount of money. 3. The bank pays B by crediting his account. At this precise moment money defines a positive deposit of B.

Strictly speaking, money never leaves the bank. The payment of B is made by the bank (on behalf of A) through a simple double entry, and its result is immediately formed as a deposit. Hence money is deposited as soon as it is created, which means that, as such, money exists only during the payment of B. Before this creation, money is only virtual, a possibility offered to A by the bank through the opening of a line of credit. After the payment (nominal) money disappears and leaves its place to a deposit defining the positive income earned by B. In terms of our previous metaphor this means that banks lend the economy an empty vehicle they take back as soon as it has been used to convey transactions. Thus the payment of 1? is made using a vehicle (nominal money) which disappears immediately after this transaction leaving its charge (income) as a deposit of B.

70 A New Approach to Monetary Analysis 2.4.

The creation of money and the demand for money to hold

Money as such (nominal money) ceases to exist after it has been used, so that the traditional concept of demand for money to hold has to be reinterpreted taking into account the particular nature of bank money. If we refer to money as the 'great wheel of circulation', then it is certain that money can only be demanded to circulate output (or income, which is the monetary form of output). As a 'vehicle', money exists only when it fulfils its function, when it circulates; and since it circulates only through banks' book-entries, it is obvious that (nominal) money can never be held by anyone. This corroborates 'the idea, so common in monetary literature, that money is useful, performs a function, or yields services only during the moment in which a transaction takes place. Thus there is no demand to hold money' (Perlman 1971: 152). Although money cannot be held as the great wheel of circulation, things change when we take into account the possibility of holding money as capital. No one doubts, of course, that income can be saved and held in the form of a bank deposit. The motives for the holding of capital money are many and so are the forms taken by the deposits (according, for example, to the interest they bear or to the degree of their liquidity). Yet whatever the reason that pushes income holders to save their money, it does not affect the nature of the deposits which are always made up of real money. Hence, what is saved is income and not (nominal) money, and what is held over time is not money but capital. Nominal money is created by banks to be used in economic transactions, and it is destroyed (by the same banks) as soon as it has been so used; income is defined by a positive net deposit (of B in our example) and can be conserved through time in the form of capital. Now, given the distinction between money and capital, what could be asked is whether transactions also require the holding of some kind of bank deposit. According to Perlman: The necessary condition for the existence of a demand for money, and therefore for a monetary theory (as opposed to a statement of technical constraints), is the existence of transactions costs — not only between money and assets but also between money and goods. Once these costs are taken into account, a monetary theory can be developed in which the holding of money is an economic decision rather than a technical necessity. (1971: 251)

The central point of Perlman's argument is that economic agents must face the existence of positive transaction costs. A certain number of bank deposits is therefore held in order to cover these costs and the demand for money to hold becomes 'a demand to hold money as an asset or a capital good, regardless of whether money is a store of value or a medium of exchange' (p. 252). Economic transactions take place in the form of monetary payments.

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These payments require the presence of (nominal) money as a pure vehicle whose existence is confined to the moment in which transactions take place. It would thus be mistaken to speak of a demand to hold nominal money. However, transactions entail also positive economic costs, and the covering of these costs requires the existence of positive bank deposits. Hence 'once we take account of transactions costs and extend the medium-of-exchange function of money to include that of reducing transactions costs (by the substitution of money inventories for goods inventories), we do arrive at a theory of a demand for money to hold' (p. 252). Thus the possibility of holding money depends on whether we refer to nominal money or to capital. As Perlman admits, when we take into account transaction costs, 'even as a medium of exchange, money becomes a "temporary abode of purchasing power"' (p. 252). Hence money is not held as a circulating medium,6 but as a temporary abode of purchasing power, that is as capital. The fact that (nominal) money cannot be held, for it only exists during transactions, seems to support the idea that money has an expectation of life which varies according to the interval of time required for the carrying out of transactions. Consistent with the technical impossibility of making instantaneous transactions, this idea recalls a concept of money strictly related to the traditional definition of expenditures as functions of time. But is it correct to speak of the flow of money, and if it is, what would be the velocity of circulation of money? 2.5. Time and the circulation of money Let us first note that the idea that money could be thought of as a flow is indeed very curious. The classical image of a flow is given by water. Both the total flow of water in a given period of time and the velocity of its stream are functions of time. Hence the greater the velocity, the lesser the stream required in order for the same quantity of water to flow per unit of time. In the case of money, this would imply that the amount required for a given transaction is proportional to the velocity of circulation of money. Thus the payment of £100 could be equally well carried out with £50 or with £10 according to the velocity of the stream of money. The nonsense of this proposition is evident. The measure of an economic transaction is determined by the amount of money spent once and for all, and not by the product of this amount and time. Neither money nor expenditures7 are flows in time. As Sayers puts it, 'No asset is in action as a medium of exchange except in the very moment of being transferred from one ownership to another, in settlement of some transaction' (I960: 712). The time required for the transfer of money from one account to another does not modify the amount transferred, and this is sufficient proof of the

72 A New Approach to Monetary Analysis

fact that money is not a function of time. Yet it could still be claimed that (nominal) money exists during the whole interval of time necessary for the transfer to take place. Is it not true that nominal money is a vehicle whose charge is current income? Thus, if the transfer of income requires time, nominal money has a positive existence in real time equal to this interval. Therefore the question we have now to deal with is the following: what is the period of time logically required to carry out a monetary transaction? Before being answered, this question has to be correctly understood. In fact, it could easily be thought that the period which has to be determined is of a variable length, for transfers occur more or less rapidly according to the technical means used by economic agents and banks. Yet this answer could be justified only if our question referred to the period of time physically required for the settlement of a transaction. The transfer of income from one account to another can be analysed as a physical operation, of course, and in this respect time is a variable strictly dependent on the chosen technique. On the contrary, from the point of view of economic analysis the time physically necessary for a monetary transaction to take place is totally irrelevant for the determination of the velocity of circulation of money. Whether the payment of B is made by a transfer recorded manually (handwriting) or electronically (computer) in the bank's balance sheet, it would be wrong to identify it with the physical act of writing or typing. Economically, the payment is effective only at the very moment B is credited. Before this instant the payment is merely announced; afterwards it belongs to the past. An economic agent, A can pay the person with whom he deals (his correspondent), B, only if he has a positive income, either of his own or which has been lent to him by another agent. Since income is necessarily construed as a bank deposit, the payment of B implies the transfer of A's deposit into ZTs account. Technically, this operation may require minutes or seconds (or even just a fraction of a second), but economically the payment is positive only when the transfer is completed and B owns the deposit previously owned by A. The problem pertains to logic and not to technology, and from a logical point of view expenditures are events which take place instantaneously. Nominal money, the vehicle required for the settlement of transactions, exists therefore no longer than an instant. As the great wheel of circulation, money plays its role at the very instant payments occur. It is only at this instant that money exists; immediately after having been used it disappears leaving unaltered the amount of income for the circulation of which it was created. Money is issued by banks as an asset and a liability, and as such it is offered to the economy as a means of circulation. The creation of this (empty) vehicle can therefore occur as many times as is required by the

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economy, since by creating money banks do not increase the amount of wealth at all (either in the form of capital or of income). This fact is thus confirmed here by the observation that not only is (nominal) money immediately destroyed after having been used (since the recordings of the banks' balance sheets define positive deposits of real money) but also that its life is purely instantaneous, for expenditures last no longer than an instant (i.e. a period of time of no duration). Fundamentally, money exists only because banks can get spontaneously indebted and can lend their acknowledgement of debt to the economy. Being used, nominal money is destroyed. On request, banks can issue money every time the economy needs it. In this case, money becomes a reality, but just for the time necessary for recording the payment: an instant. As soon as the recording has taken place money is back to its state of potentiality so clearly expressed by the term 'bookentry money'. The logical succession of events is the following: 1. Money is created by banks as a pure vehicle. 2. The vehicle is used by the economy to carry out monetary transactions. 3. Money is destroyed by the same banks by which it was created. Now, chronologically, these events are simultaneous: money is created, used and destroyed in the same instant. In fact, analysis proves that: 1. If it were not used as soon as it is created, money would not even exist (assets and liabilities would cancel each other out perfectly). 2. Payments are events taking place instantaneously so that money is also used instantaneously. 3. The result of monetary transactions is the transfer of bank deposits and not of nominal money which disappears immediately after the transfer has been carried out. When a bank opens a credit to one of its clients the operation is still virtual (it defines what is called a 'line of credit') and remains so until the client asks the bank to effectively pay his correspondent. Yet, at this moment credit money 'hits' the payee's patrimony in the same way as light hits the object it illuminates. Being immaterial, bank money is necessarily and without delay deposited in the bank which issued it. All money reaching its beneficiary is immediately and instantaneously sent back to the issuing authority, i.e. it is immediately destroyed. (Schmitt 1986b: 82)

But if money plays its role as a medium of circulation in an instant, and this is precisely what it does by transferring bank deposits, then its velocity must necessarily be infinite. Used as we are of thinking in terms of classical mechanics or, at most, in terms of relativity, we could be surprised to find velocities which are

74 A New Approach to Monetary Analysis

much greater than the speed of light. And our scepticism would be perfectly justified if this velocity were referred to as the physical displacement of an object called money. Even if money were merely identified by electrical impulses, it would be wrong to claim that it can move faster than light. However, this is not what the circulation of money is about. As the classical economists already knew, money must not be identified with its physical support. Likewise, monetary transactions should not be analysed in economics as they are in physics. In economics monetary transactions are nothing other than payments, and payments are not a function of time, they are instantaneous. Hence, since it is through payments that money circulates, the velocity of circulation of money is logically infinite: the displacement of bank deposits does not require an interval of time greater than zero, for it occurs at the very moment the account of the payee is credited by the amount transferred by the payer. It is impossible for the payment of B and A to take place before A has been debited and B credited. The simultaneity of these two distinct operations (aspects of the same transaction) is definitively opposed to the idea of the spatial displacement of money. If money reaches B at the very moment it leaves A the distance (A, B) does not define a space but a point. Reciprocally, if the two agents are not confused this means that money does not circulate between them otherwise it could not reach B at the instant it leaves A. (Schmitt 1984: 247)

The 'circulation' of money is an old-fashioned concept which recalls the idea of a physical displacement in space. In reality money does not circulate — except instantaneously — which means that what is called a circulation is effectively an emission. If money did not exist, B could not be paid. On the contrary, if B is paid (his account is credited), it is because the bank has created the 'vehicle' necessary for this transaction to take place. Yet the vehicle is immediately created as a credit of B and a debt of A. Thus money is instantaneously deposited and disappears as a vehicle leaving a book-entry record defining the simultaneous creation of B's deposit and the destruction of ^4's deposit. Given the peculiar characteristics of (nominal) money it could be asked why it is so important to analyse it. Why should we be bothered by money which is destroyed at the very instant it is created? As we shall see in the next chapter, the fact is that without nominal money the formation of bank deposits could not be explained at all. Thus nominal money not only circulates pre-existing income but it also allows new income to be created every time money is associated with a newly produced output.

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Notes 1. See Gurley and Shaw (I960). 2. Leaving aside considerations of metaphysical order, it is certain that the working of economics has to be consistent with Lavoisier's principle (nothing is created, nothing is destroyed), so that the emission of money can never be the creation of a net asset by the banking system. It is only through the association of money and output that the negative and the positive sides of money can be separated and that it becomes possible to speak of positive creation (of income). Even in this case, however, Lavoisier's principle is observed, since what is created by production is neither matter or energy, but a mere a-dimensional form. 3. 'The first way of replacing commodity-money by credit-money establishes a fiat money or "outside" money system, and adds to the wealth of the community the resources previously embodied in the commodity-money now replaced by credit-money, this wealth being owned by and contributing an income source to the state. The second way of replacing commodity-money by credit-money establishes a banking or 'inside' money system, and equally adds to the wealth of the community the resources previously embodied in the commodity-money now replaced by creditmoney, this wealth being owned by and contributing an income source to the banking enterprise, and consequently being reflected (through discounting of the income stream) in the capital value of that enterprise' (Johnson 1978: 246). 4. It is true that, like the Central Bank, private banks own important reserves of real assets such as gold, diamonds, works of art or euro-monies (which are also a kind of real asset since, within the actual international monetary system, national monies are bought and sold precisely as if they were commodities), yet these reserves are meaningful only in relation to the activity banks carry out as financial intermediaries and not as money's creators. 5. In our economies banks can partially influence the use of their overdrafts through the rate of interest, of course, but this is justified only by a still imperfect understanding of the creation of money, which is too often considered as if it were a particular case of financial credit. Actually, being almost costless to issue, bank money should be lent at a rate of interest nearly equal to zero. On the other hand positive interest should be charged and paid out relative to income deposits alone, and the financial department of banks kept separate from their issuing department. 6. The very idea that a circulating medium can be held is indeed linked to the material conception of money. As soon as it is understood that money is totally a-dimensional, it becomes evident that what can be held is not money (the empty vehicle) but its charge (output). 7. A critical analysis of the traditional conception of expenditures as functions of time can be found in Cencini (1984).

Chapter Six

Income and Time

In this chapter we shall analyse how money, freely issued as an asset and a liability by the banking system, can acquire a positive purchasing power over current output and how it can lose this power through its final expenditure. In other words, we shall investigate the emission of income as a dual-faced process taking place in quantum time. Income is in fact created through the association of money and output, and it is destroyed as soon as it is spent for the purchase of this very output. Both creation and destruction are (instantaneous) monetary events recorded in the banks' balance sheets. Yet the time dimension of these two events is nil only as far as chronological time is concerned. Being both related to the same production, they also define the same period of time (which corresponds to the period of production). Thus a positive interval of time is emitted every time an output is produced (income creation) or purchased (income destruction): economic transactions are instantaneous events which quantize time. As is well known by physicists, light has both a wave-like and a corpuscular nature. Surprising as it may appear, analysis shows that money also has a dual nature. Being issued by banks as a spontaneous acknowledgement of debt, money can never be 'paid out' without being immediately sent back to its starting point, in an instantaneous circular movement defining its wave-like characteristic. Now, in this infinitely rapid circular flow, money is associated with real output, and it is through this association that money acquires also a corpuscular identity. Income is the 'particle' aspect of money; income creation and income destruction are the two moments characterizing the emission of income, and quantum time is the indivisible period of time defined by these two instantaneous events. To introduce what has been called 'the macroeconomic quantum analysis of income' we shall first develop a few arguments about the traditional distinction between means of exchange and means of payment, trying to show that money can circulate output only if it also has the power to offset debts. Having established that bank money alone can play the double role of means of payment and means of exchange, we shall then argue that its power to settle transactions derives from its quantum identity with current output. It is through an absolute exchange that money is associated with the product, and it is this exchange which defines the creation of income. Analogously, it is through another absolute exchange of opposite sign that income is destroyed and that the circuit of income is definitively achieved.

Income and Time

1.

77

The distinction between money as a means of payment and money as a medium of exchange

If we consider the various functions that money can play, it is quite natural to distinguish between the means-of-payment role of money and its role as a medium of exchange. However, this distinction also seems to suggest that money can be a medium of exchange without simultaneously being a means of payment, that is without possessing positive purchasing power. One of the first questions relative to this distinction is, therefore, whether or not it is because it has the power to settle transactions that money can circulate goods and services among economic agents. In order to answer this question, let us analyse separately the two functions of money. 1.1. Money as a means of exchange In a famous handbook first published in 1922 Roberston wrote that 'It is not necessary that everything which is used as a medium of exchange should itself be also a standard of value, but only that it should be expressed in terms of something which is a standard of value' (Robertson 1959: 3). This quotation can obviously be used to corroborate the once widely accepted idea that a valuable money (such as gold or silver) can be advantageously substituted with paper money as long as the latter is expressed in terms of the former. Alternatively, Robertson's argument could also be interpreted as an attempt to establish that the value of money is somehow irrelevant to the circulation of goods. Let us analyse this last possibility. If we were able to show that the circulation of goods can take place independently of the value of what is used as a medium of exchange, then we would also be able to prove that the two functions of means of payment and medium of circulation can be played by two different kinds of money. Thus, as a means of payment, money would have to possess a value (purchasing power) allowing for the settlement of transactions, while as a medium of exchange, it would not, a simple promise being sufficient for the circulation of output. Let us suppose money is issued by a purchaser (B) as his spontaneous acknowledgement of debt. Obviously, the IOU issued by B defines a mere promise of payment, but it seems that the correspondent of B could well accept it in exchange for his goods if he were certain that every other economic agent would do the same. Thus B would buy from A giving him an acknowledgement of debt which A would give to C and C to D and so on, until the IOU was returned to B. Each one of these transactions would be a false payment, of course, since the simple promise to pay at term does not free anybody from his debt. Yet goods would be indirectly exchanged and, being recovered by B, the IOU would finally be destroyed.

78 A New Approach to Monetary Analysis

If the circulation of goods could effectively take place in this way, then bank money would not be the only possible medium of exchange. A simple extension of credit by firms or by any other economic agent would do equally well, and the term 'means of exchange' would apply to a rather large quantity of objects. When all the assets included in this class are reviewed in detail we find that they include not only the deposit liabilities of banks but also the readily callable liabilities of a large and widening range of other financial intermediaries. The ease with which these intermediaries enlarge their balance-sheet totals is as relevant to the monetary situation as is the behaviour of those financial intermediaries we call 'banks'. Nor should we limit the range to firms ordinarily regarded as financial intermediaries. Among firms whose main activity is manufacturing or trading, most do a great deal of lending and borrowing: they extend 'trade credit' to their customers, and they take 'trade credit' from their suppliers. (Sayers I960: 713)

As a matter of fact, the credit granted by firms to their clients is generally not accepted by other agents as a means of exchange. Furthermore, trade credit is tantamount to an incompleted transaction, whose payment is merely postponed but which is bound to take place sooner or later in money terms. Thus, in short, the extension of trade credit does not increase the means of exchange available in a given economic system, for financed through trade credit, sales and purchases are not exchanges at all. As is easily proven, in fact, credit transactions neither define relative nor absolute exchanges. A relative exchange presupposes the existence of at least two goods one of which is given for the other. When goods are 'sold' through trade credit, firms give them against a promise of payment and not against other goods. Therefore, goods on one side and an IOU on the other are not two equivalent assets and their exchange does not define a barter transaction (relative exchange). As far as absolute exchange is concerned, the conclusion is also negative since this kind of exchange is verified when a good is exchanged against itself, that is against a sum of money defining its numerical form, and it is obvious that the acknowledgement of debt which the client gives to the firm in the case of trade credit is not the monetary counterpart of the product he buys. If the IOU issued by a given debtor were to be accepted by every economic agent, it seems that the circulation of goods would take place in spite of the arguments we have just put forward. True, but what would be the consequences of the use of this pseudo-money in a chain of non-payments? The fact that every agent would be able to discharge himself from the false payment by passing it over to his correspondent does not transform the mere promise (IOU) into a true payment. Thus, although the circulation of goods is accelerated through the extension of trade credit, it is also certain that the use of the debtor's IOU as a

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79

means of exchange artificially increases the amount of money available for the purchase of current output. The pseudo-money represented by the debtor's acknowledgement of debt is added to the money distributed for the production of output and this has the negative effect of causing an inflationary increase of prices. Hence, even if it is practically possible to circulate goods by means of a debt, this circulation leads unavoidably to inflation which proves ad absurdum that a purchaser's acknowledgement of debt is not a means of exchange. In other words, analysis establishes that a true means of exchange also has to be a means of payment. It is only a medium which has the power to settle transactions that can circulate goods and services without causing any inflationary gap. 1.2. Money as a means of payment In the last paragraph we have just seen that the medium of exchange function of money has to be played by a unit which is also a true means of payment. In particular, we have argued against the extension of credit as a way of increasing the circulation of real output. Whether they are carried out by firms or by non-bank institutions, these financial transactions do not define a payment, so that it would be wrong to use trade credit as a generalized means of exchange. What opposes the use of trade credit as a unit of payment (and therefore also as a unit of exchange) is the simple fact that payments are effective only if they do not define the indebtedness of the purchaser. Hence, if what is used as a medium of exchange is an acknowledgement of debt, the IOU has to be issued by an element logically external to the set of purchasers. Let us consider bank money. As we know, banks issue money by getting spontaneously indebted and by simultaneously lending their debt to the economy. Book-entry money seems therefore to have the necessary qualifications to play the double role of a medium of exchange and a means of payment. The banks' indebtedness, in fact, does not define the debt of a purchaser. The appearance to the contrary could arise only because banks act also as purchasers and not only as money creators. Yet, as we shall soon see, this problem can easily be disposed of once it has been established that all commercial transactions have to be paid out of income. Banks create money and not income, and this is a necessary and sufficient condition for them to be excluded from the purchasers' set (as creators of money, of course): 'Bankers cannot create means of payment to finance their own purchases of goods and services' (Tobin 1963: 415). Being an IOU which is not issued by a purchaser, bank money can effectively be used to settle transactions. When A pays B by giving him a certain amount of bank money he does not get indebted, and this is precisely why the payment is effective. Tobin (1963) does not seem to

80 A New Approach to Monetary Analysis

share this point of view. According to him, the creation of bank money is not essentially different from the emission of a claim made by a financial intermediary (as a savings and loans association, for example). The creation of a means of exchange would not therefore require a clear-cut distinction between the institution issuing it and the set of purchasers; rather it would entail the search for the equivalence between loans and deposits: Whether or not (money) stays in the banking system as a whole is another question, about to be discussed. But the answer clearly does not depend on the way the loan was initially made. It depends on whether somewhere in the chain of transactions initiated by the borrower's outlays are found depositors who wish to hold new deposits equal in amount to the new loan. Similarly, the outcome for the savings and loan industry depends on whether in the chain of transactions initiated by the mortgage are found individuals who wish to acquire additional savings and loan shares. (Tobin 1963: 413)

Apart from the erroneous confusion between the two distinct functions played by banks (money creators and financial intermediaries), Tobin's statement is based on the interesting idea that money should be created only in so far as it is deposited. It is true that Tobin considers the equivalence of loans and deposits only as a conditional result and that he forgets that the purchase of savings and loans shares of a nonbank institution requires the pre-existence of bank money (so that it is obviously mistaken to identify the emission of money with the emission of a claim by a non-bank financial intermediary). Yet the necessary equivalence of loans and deposits is a law of double accounting from which the creation of money cannot escape. What Tobin does not seem to have perceived is that one of the peculiarities of book-entry money is that it is always deposited into the banking system from which it is issued. In fact, money is issued by a simple double entry which defines the deposit of the agent whose reference is to be found on the liabilities side of the bank's balance sheet. For example, if C is paid by A, Cs earnings are made up of a bank deposit which is formed at the very instant Cs account is credited by the bank on behalf of A. Hence, whereas Tobin's rule is submitted to the unpredictable behaviour of the public, the law of double accounting is verified in all circumstances and it is this law that safeguards the equivalence between loans and deposits. Bank money fulfils therefore both the requirement of being the acknowledgement of debt of a non-purchaser and of creating a deposit as soon as it is lent. Yet as we have so often noted, transactions can be definitively settled only if payments are made out of income. In other words, money can be a true means of payment only if it has a positive purchasing power over real output, and the existence of the banking

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system does not seem sufficient to explain this purchasing power. The creation of money has to end up with the creation of income in order for money to be entitled to play the roles of means of payment and medium of exchange, and this result can be reached only if money is associated with the real world of goods and services. 2.

The creation of income

2.1. Income, purchasing power and prices Let us start from the emission of money. Since money is issued as an asset and a liability, and not as a net asset, banks alone cannot create positive purchasing power. Yet it is certain that the emission of money is meaningful only if it ends up with a double entry whose parts do not cancel out. Table 6.1 Bank Liabilities

Assets

B &x

A &x

The entries of Table 6.1 show that, having been paid by the bank, B is a net creditor, while A is a net debtor since the bank has paid B on his behalf. Now, saying that B has a net monetary asset, we are also saying that he is the owner of a positive income. Hence the operation which allows for the crediting of B must also account for the association of money and output. What we have therefore to determine is the exact nature of the payment of B. Following from our previous analysis of prices and purchasing power, the payment of B cannot define the purchase of goods and services, for this purchase is possible only on the basis of a pre-existing income. Having to determine the purchasing power of money, it would be wrong to consider it as initially given. At the beginning of our theoretical experiment we do not possess any positive purchasing power, which is tantamount to saying that prices are still totally undetermined. But if A does not buy either goods or services from B, what does he pay him for?

82 A New Approach to Monetary Analysis

Known since the period of classical economics, the answer is simple: labour. In fact, labour is not a commodity but the source of every commodity. Hence the payment of labour does not require the expenditure of a positive income. If labour were a commodity, then of course it would have to be purchased through the expenditure of a net monetary asset. Yet, since goods and services are the result of labour, the payment of wages indeed defines a particular kind of transaction. Income (purchasing power) is determined simultaneously with prices. Before the payment of wages, prices are undetermined, and so is income: output exists only as a physical object and not yet as an economic entity. It is through the payment of wages that money is associated with the physical product and that output, by acquiring a price, becomes the economic object of income. When Keynes says, in his Treatise, that 'the flow of the community's earnings or money income' is defined by what has 'been earned by the production of consumption goods and of investment goods respectively' (p. 121), he is giving a precise heuristic status to the process of production and in particular to the payment of its costs. And since 'human effort and human consumption are the ultimate matters from which alone economic transactions are capable of deriving any significance' (p. 120), it is immediately evident that it is the payment of labour which plays the central role in the theory of income creation. 2.2. The creation of income, the first example of absolute exchange

The previous analysis has shown that although B is paid out of nominal money, his earnings define a positive asset. Thus, since the income earned by B has not been lost by anybody, the payment of wages defines a true creation of income. Labour being the source of commodities, it is not surprising to find that it is also the source of the purchasing power of money. But what is the relationship between these two objects of the creation of labour? Are they distinct, cumulative results or not? Let us reformulate the example given in Table 6.1. We now know that A is a firm and B its workers, and that the payment of B by the bank is the payment of wages made on behalf of the firm (Table 6.2). Table 6.2 Bank Liabilities

Workers &x

Assets

Firm &x

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Once again, what has to be clearly understood is that, through the payment of wages, workers (W) earn an income which is not lost by the firm (F). The way income can be first formed proves this, and the analysis of book-entry money confirms it. F has its wages paid by the bank, which creates the money necessary for this transaction simply by entering W on the liabilities side and F on the assets side of its balance sheet. This double entry defines a positive creation of money (the use by F of its overdraft facilities) but not an expenditure of income, which appears here for the first time and is entered as the net asset of W. If we consider the transaction between firm and workers we must therefore conclude that the payment of wages does not define the purchase by F of Ws output1 and that the exchange between firm and workers cannot be of a relative kind. In fact, a relative exchange (if any2) can only take place between two distinct objects. Although exchange makes these objects equivalent, they remain separate and circulate in the opposite directions (Fig. 6.1). a

B

A b

Figure 6.1

In Figure 6.1 commodity a is given in exchange for commodity b and in its circulation it goes from A to B (whereas b goes from B to ^4). This is not what happens when workers are paid by F. The positive income earned by W does not come from F, so that the output produced by W is not definitively given (sold) to F in exchange of wages. It is true, of course, that physical output can be found in F, but only as a deposit. Output is thus formed as the counterpart of wages only in so far as it becomes the very object of the income created by W. Through their labour, workers create a physical output which defines the content of their income. Money and output are therefore not exchanged as two autonomous entities. One being the object of the other, they form a logical identity, so that their exchange pertains to the category of absolute exchanges. An absolute exchange is in fact an exchange which takes place between a given object and itself, and money income is the economic definition of the output with which it is exchanged: The payment of wages is an emission; this means that workers receive their own output in money. This transaction does not merely define an equivalence but an identity: every worker gets a sum of money which, because of it being issued through the payment of wages, identifies itself with the real output of this same

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worker. Within the same transaction the firm gives and receives the same object, which proves that the exchange is indeed absolute. (Schmitt 1984: 347)

Through the payment of wages, money is thus associated with output in the most rigorous form: identity. Wages are not given to workers in exchange for output. On the contrary, workers receive their own output, though in the form of money. In other words, output is literally changed into money and as such it is totally owned by W. The identity of money and output confirms the fact that the physical product is only deposited in the firm; economically it belongs to W since workers are the first (though not necessarily the last3) owner of the purchasing power necessary for its acquisition. Let us present the argument by means of some graphical illustrations. The starting point is the creation of bank money. The opening of a line of credit gives rise to (nominal) money which can be represented as shown in Figure 6.2.

Figure 6.2

The positive and negative components of book-entry money are then separated as soon as the public draws on its credit line — or more precisely, as soon as firms take advantage of their overdraft facilities and ask the banks to pay the workers on their behalf.

Workers Figure 6.3

Firm

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As is shown in Figure 6.3, workers own positive money which is balanced by the negative money owned by F. The creation of income being linked to the payment of wages (and, thus, to labour) it is clear that output is formed as the content of (real) money. Wages (money income) take the place of output, which they define and which is momentarily stocked within the negative money of F

Figure 6.4

The positive money of Figure 6.4 is the newly created income, and output is its object, so that it would be wrong to consider the two spheres as autonomous entities. The creation of income is the creation of output which, through its association with money, becomes an economic object. Without this association, money would remain empty and output would only be a jumble of heterogeneous physical objects. Thus money gives its numerical homogeneity to physical output, and output becomes the content of money income. 2.3. The circuit of the creation of income In Chapter 4 we have seen that money is issued by banks in a circular movement which takes it back (instantaneously) to its starting point. Money circulates, therefore, at infinite speed between bank and public.

Figure 6.5

86 A New Approach to Monetary Analysis

The three operations represented in Figure 6.5, namely the payment of workers by the bank on behalf of F (arrows 1 and 2) and the deposit of Ws earnings in the bank (arrow 3) are simultaneous. As a result, money (the vehicle used for the payment of wages) is immediately recovered (and therefore destroyed) by the bank which issues it, and positive new income is created as a deposit owned by W. The instantaneous circulation of money leaves behind it a double entry defining the net credit of W and the net debt of F. Let us represent the creation of income by the circuit shown in Figure 6.6.

Figure 6.6

Since the payment of wages is a monetary transaction and since money exists only instantaneously, the income earned by W is necessarily formed as a bank deposit (arrow 1). Moreover, since the net asset owned by W is balanced by the debt of F it is immediately evident that the deposit of Wis in fact lent to the firm (arrow 2). We have now to explain the meaning of arrow 3. Literally, the firm gives its workers the very income which they lend to it. Hence workers pay themselves through the intermediary of F, which is just another way of saying that income is created by W and not by the firm or by the bank. Like the circuit of money, the circuit represented in Figure 6.6 is also instantaneous. Yet, unlike money, income is not definitively destroyed at the same chronological instant in which it is created. Earned at a given moment of continuous time, wages are only subsequently spent, and this is why the whole circuit of income has to be explained by referring to both events. In order to do so, the chronological difference between creation and destruction has to be bridged and, as we shall soon verify, it is through quantum time that this can be done.

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2.4. The creation of income and quantum time For many years economists have thought of income as being a (continuous or discontinuous) function of time. Indeed, if income were a kind of flow, it would have a certain intensity per unit of time, and its absolute magnitude would be the product of this intensity and time. As has been shown (Schmitt 1984; Cencini 1984), however, this assumption is inconsistent with the true nature of income, which cannot be construed like the concept of velocity of classical mechanics. Fundamentally, income is the result of a monetary transaction. This clearly means that income is instantaneously given as a whole: it is created as a sum of money. Money wages are the numerical definition of income. Yet income is not purely numerical. It also has a real content determined by the association of wages to output. Thus it is through money wages that physically heterogeneous goods and services become homogeneous elements of the same set. Production is precisely the operation by which physical output is changed into money and, hence, it is evident that production is an instantaneous event defined by the payment of wages. Now, since current output is the real content of wages, it is possible to see that output is (instantaneously) emitted as a whole, even though the process of physical transformation of input takes place in a finite period of time. Production has therefore the dual characteristic of being instantaneous and of defining a non-zero interval of time. The creation of income is tantamount to the production of output. Hence the creation of income defines the emission of an interval of time corresponding to the 'period of production' of physical output. Economically, production is an instantaneous event (defined by the payment of wages); physically, it is a process taking place in continuous time. Far from being contradictory, these two aspects of production are perfectly well compatible within the quantum theory of time. According to this theory, in fact, an instantaneous event such as production is an emission of time. Thus a finite and indivisible period of time is emitted as a quantum at the very moment wages are paid out. The idea of time being emitted as quanta is new in economics. Yet it should not astonish anybody in a period when physicists speak of antimatter, virtual particles, 'retroactive creation of reality' (Wheeler 1979), spontaneous creation and destruction of space and time, and so on. The concept of quantum time is certainly less mysterious than the idea of time being created by the big bang, and Einstein's theory of relativity, which proves the existence of a fourth dimension, presents much greater difficulty than the quantum theory of income. The payment of wages is a monetary transaction and, as such, it takes place instantaneously; the result is positive income defining current output. But, since income and output are one and the same thing, the

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creation of income is the emission of output, and therefore also of the period of time which is indissolubly related to it.4 In other words, current output has a time dimension equal to its 'period of production' taken as an indivisible whole (quantum). This has nothing to do, of course, with the classical definition of value as materialization of labourtime. Output is not evaluated in a dimensional standard whatsoever: money is a purely numerical unit and wages are paid out in money. Output itself being neither material nor a materialization of labour, its time dimension is therefore not a physical dimension. The quantum of time related to every product is defined numerically, in wage-units, which means that wages define the product and its quantum time dimension. Output is a quantum of time which is emitted through the payment of wages. Hence output is created as income at a given instant of time. What happens then, to this income between the instant in which it is created and the moment in which it is finally spent for the purchase of the produced goods and services? The circuit defined by the creation of income has to be immediately completed if it is to exist at all. What therefore are the consequences of this instantaneous circulation of income? The answer leads us to the concept of capital. 2.5. Income, capital and time Our previous analysis has shown that income is created by workers to be immediately deposited into the bank system. This deposit does not depend on the behaviour of W but is the necessary instantaneous result of the payment of wages which banks carry out on behalf of firms. It is in the nature of book-entry money to flow immediately back to the issuing bank, and it is in the nature of money income to be recorded as a deposit in the bank's balance sheet. The fact that workers own a deposit means that they have saved their income. And that this is so, is proven by the simultaneous lending of this income to F which is finally indebted to W through the bank system. In the bank's account of our example, the debt of F is indeed balanced by the credit of W, whose income is thus automatically lent to the firm. Created through the payment of wages, income is immediately saved by W to be only successively spent on the commodity market. During the whole period of time which elapses between these two events income exists as a bank deposit, as positive saving. But saving is the first form of capital. Thus income is transformed into capital at the very instant it is created, and it subsists as such until it recovers its original form for the purchase of output. Even though it is true that the creation of income is not an operation of credit, since income derives from the work of man and not from the activity of banks,

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incomes are ready to leave at the very instant they are formed. The creation of income is not a credit but the newly created income becomes immediately the object of a credit. As soon as incomes are formed they are therefore lent by their owners until the moment comes in which they will be definitively spent. This means that incomes are instantaneously transformed into savings or, identically, into capital. (Schmitt 1984: 158)

As we have previously seen, the creation of income can be represented by the simultaneous creation of negative money in F and positive money in W. The instantaneous transformation of income into capital implies the immediate lending to F of the positive money owned by W. As a result, the negative money of F is replaced by a debt, and the positive money of W by a security defining the claim of workers against the bank. Output, which was momentarily stocked in the negative money of F, is now indirectly owned by W (in the form of a security, since the firm owes it to the bank which owes it to W). Freed from their negative deposit, stocks are therefore the real aspect of capital, while the financial aspect is the credit of workers to their bank deposits. Finally the necessary, immediate, deposit of all newly created income transforms instantaneously this income into a security which has the stocked output as its object, that is into capital whose lifetime depends on the period of existence of the bank deposits originated through the payment of wages.5 As soon as workers (or some other agents to whom the deposited income is lent by the bank) spend their savings, capital is immediately retransformed into income and is definitively cancelled out. Let us now analyse in some detail what happens to income when it is spent on the final purchase of current output. 3.

The destruction of income

3.1. Income and consumption In Chapter 10 of his Treatise on Money Keynes writes that: Human effort and human consumption are the ultimate matters from which alone economic transactions are capable of deriving any significance; and all other forms of expenditure only acquire importance from their having some relationship, sooner or later, to the effort of producers or to the expenditure of consumers. (Keynes 1930: 120-1)

Keynes's argument is clear. The work of man is the necessary condition for the creation of income. It is because the payment of wages is the payment of labour that this transaction acquires a particular economic

90 A New Approach to Monetary Analysis

significance. On the other hand, income is bound to be spent on the purchase of output, so that income can be defined by this transaction as well as by the payment of wages. Consumption is therefore seen as the final expenditure of income and the payment of labour as its creation. By retaining only labour and consumption as key elements for the determination of the value of money, Keynes was implicitly suggesting that the totality of income is necessarily spent on the purchase of current output. This means that savings are merely a 'temporary abode of purchasing power' (in the form of capital) and that they will, sooner or later, be definitively spent in the commodity market. Income is thus bound to be entirely 'consumed' even though it can be partly spent on the purchase of investment goods. The division of output between consumption and investment goods does not modify the fact that their purchase implies the expenditure of income, and it is in this sense that the word 'consumption' has to be interpreted here. From Keynes's twofold division of income, '(1) into the parts which have been earned by the production of consumption goods and of investment goods respectively, and (2) into the parts which are expended on consumption goods and on savings respectively' (Keynes 1930: 121) we can derive another important piece of information, namely that the expenditure of income entails its destruction. The argument is the following. Suppose that income were reproduced through its consumption. In this case, it is evident that the same income could be spent several times without being socially 'consumed'. But, then, the measure of income resulting from its repeated expenditure would obviously not coincide with the measure given by the payment of wages. If income is to be defined by what has been 'earned by the production of consumption goods and of investment goods respectively' and, equivalently', by what has been "expended on consumption goods and on savings respectively', the expenditure of income must necessarily be unique. Hence, the pre-eminence of human effort and human consumption claimed by Keynes implies that what is created through production must be destroyed through consumption. 3.2. The destruction of income as the second example of absolute exchange Absolute exchange is a peculiar transaction in which a given object is exchanged against itself. The first example of such a transaction is the payment of wages, where current output is literally changed into money. Production is thus defined as the event by which money takes the place of output and physical output becomes the content of money. The second example of absolute exchange is the exact reverse of the first, money being changed into physical output as soon as it is spent.

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In fact, when income holders spend their assets they give up the monetary form of output in exchange for its physical form; they give the product (as money) and they receive that same product (as a physical object). The proof that the purchase of output is an absolute exchange is given by the fact that this transaction defines the destruction of income. If exchange between money and output were relative, then the displacement of these two objects would also be relative, money taking the place of output and vice versa. In reality the expenditure of income is not an exchange between two distinct objects. Income exists only in so far as money is associated to output and not as an autonomous entity whose value is given independently of this association. As is shown by a thorough analysis of book-entry money, banks can only issue money which is simultaneously negative and positive. The passage from this nominal money to income requires the intervention of production. Through the payment of wages, current output is momentarily lodged in negative money, and this gives the positive money earned by IF the status of income. By filling the negative deposit of F, output provokes the simultaneous creation of income. It is therefore perfectly clear that income exists only as long as the debt of F is balanced by current output.6 Now, when income is spent on the final purchase of output, the positive money of W rejoins the negative money of F and they neutralize each other. The positive asset previously owned by Wis now earned by F, and this entails its instantaneous destruction since F is also the owner of an equivalent liability. At the same time current output is definitively freed from its monetary wrapper and is appropriated by W as a mere physical object. Through the payment of wages, money and output are associated, through the final expenditure of income they are dissociated. The first transaction defines the creation of positive income, the second its destruction. Analysed from the point of view of output, this means that, through their association with money, goods and services acquire an economic status which they inevitably lose to recover their initial physical dimension when they are sold on the commodity market. The creation of income and its destruction are therefore two absolute exchanges of opposite sign. The first, which we could call positive absolute exchange, defines the transformation of current output into money income, whereas the second, negative absolute exchange, defines the transformation of income into physical output. 3.3. The circuit of the destruction of income Like any other monetary transaction, the expenditure of income is an instantaneous event defined by a book entry in the bank's balance sheet. By spending their income at tlt workers (or their substitutes) give up their bank deposits which are henceforth held by firms (Table 6.3).

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Table 6.3 Bank

Now, this transaction requires the emission, by the banking system, of Vehicular' money. We already know, in fact, that banks create money every time a transaction has to be carried out by the economy, and that they destroy it as soon as it has fulfilled its task. Hence the purchase of physical output implies a circulation of money which can be represented as in Figure 6.7.

Figure 6.7 Issued by banks, money flows instantaneously back to its starting point and, in its revolution, it circulates income from workers to firms. The reader will certainly remember that income is transformed into capital at the very moment it is created. The final purchase of output entails the reconversion of capital into income. Deposited in the bank at f 0 , income subsists as capital until it is definitively spent on the commodity market. Thus, between t0 and tl a positive purchasing power is saved and W holds capital in the form of a security (a claim against the bank whose object is the saved income). When income holders spend their monetary assets, they do so by decreasing their deposits. The circuit of income expenditure goes therefore from the bank (where savings are deposited) to workers and from them to firms. But this is only half of the circuit. From F income must flow back to

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the bank, otherwise its movement would not be circular. This last displacement of income takes place without delay, since it is in the nature of book-entry money to exist only as an accounting relationship.

Figure 6.8

In Figure 6.8, arrow 3 stands for the instantaneous deposit of the income spent by W and earned by F. Income, drawn by workers from their bank deposit (arrow 1) and used by them to purchase output from firms (arrow 2) is immediately deposited in the banking system. Both the circuit of money (Fig. 6.7) and the circuit of income (Fig. 6.8) are instantaneous. Once again this is due to the particular nature of monetary transactions which can only be instantaneous events. The immediate deposit of the income earned by firms is also due to the bookentry nature of money. Thus the circulation of income is characterized both by its instantaneity and by the fact that it occurs 'between deposits'. When workers spend their income, they increase the bank deposit of F and they do so by decreasing their own deposits held in the form of capital. This means that, as soon as it is spent, income is instantaneously transformed into an asset owned by firms as a bank deposit. Does this not imply that, by selling their output, firms become the owners of capital? Is it not true, in fact, that firms earn an income which, being immediately saved (since it is earned as a deposit), defines their monetary capital? In order to answer this question let us consider the whole circuit of income of which the payment of wages and the purchase of output are the two constituent parts. 3.4. The circuit of income as a whole As we have done in the previous section, let us suppose that workers spend their income at time tl. Thus at tl firms are credited with a positive deposit and workers with an equivalent negative deposit. Firms are entered on the liabilities side of the bank's balance sheet and workers on the assets side. Yet at tQ (payment of wages) workers and

94 A New Approach to Monetary Analysis firms had already been entered on the opposite sides, so that both the accounting positions of W and F are now definitively cleared (Table 6.4). Table 6.4

Output has been totally sold and what remains is a set of physical objects (goods and services) which can be 'consumed' as 'value in use'. Destroyed through its final expenditure, income cannot revive unless it is created anew, but this implies a new production and the beginning of an entirely new process. Income is created through the payment of wages and destroyed through its final expenditure; this is the main teaching of the analytical revolution started by Keynes. If we consider, in fact, that income is defined as 'the earnings of the factors of production' (Keynes 1930: 111) and that'income = value of output = consumption + investment' (Keynes 1936: 63), it is immediately clear that the expenditure on the final purchase of output (C + /) is necessarily equal to the sum spent to cover the cost of production. It is then enough to add that labour is the ultimate factor of production (1930: 120; 1936: 213-14) to reach the conclusion that C + I is logically equivalent to the payment of wages (C1 + /'). Once it is realized that money is issued as a spontaneous acknowledgement of debt of the banking system, the passage from Keynes's identity (C + / = C' + /') to the concepts of income creation and income destruction is an easy step. Let us repeat it again; money and credit are two different concepts whose theoretical confusion is the main reason for the gap existing nowadays between economics and the real world. When this distinction can be agreed upon it becomes apparent that income must first be created to become an object of credit. Once associated with real output, money becomes a net asset and it is as such that it is saved and transformed into capital. When capital is later retransformed into income and spent, the link between money and output is definitively broken. At this very instant income ceases to exist and the product gives place to a set of physical goods (and services).

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Since income is definitively destroyed through the purchase of output, how can firms own positive capital? Obviously, this requires firms to get hold of positive income; what about destruction then? The answer is simple. Firms can earn a positive profit only if workers transfer to them part of their own income. But this only means that firms can take the place of workers as income holders. Output will therefore be purchased partly by workers and partly by firms, but the final result will not be substantially modified: in every case the final purchase of output will induce a destruction of income corresponding to the output's cost of production. One last question remains to be settled. Does the creation and the destruction of income taking place at different instants in chronological time imply that the circuit of income has a time duration of a variable length? Part of the answer is given by the instantaneous deposit of income in the banking system. In fact, being earned as a bank deposit, income is immediately transformed into capital. Hence it is not income but capital which subsists in chronological time and provides the link between present and future. And since income does not survive either its expenditure or its deposit, we are led to think that the circuit of income is logically instantaneous. Yet t0 and tl are chronologically distinct points in time. How is it then possible to reconcile the instantaneity of the circuit of income with this chronological difference? As we have already seen, the contradiction is vanquished as soon as we introduce the idea of a displacement taking place in time at an infinite speed; that is, when we refer to quantum time. 3-5. Income destruction and quantum time Like the payment of wages, the final purchase of output is a monetary transaction which defines a given set of products (goods and services). Thus we are faced here with an instantaneous event defining a whole interval of time (corresponding to the output's period or production); which necessarily means that this interval is emitted as a quantum of time. The expenditure of income is an instantaneous event which quantizes time or, in other words, which defines an infinitely rapid displacement in time. This displacement is the wave-like aspect of the transaction while the quantum of time is its corpuscular aspect. Let us take the example of workers spending 100 units of their income on the purchase of goods. For the sake of clarity let us also suppose that profits are already included in this expenditure (and therefore that, as income holders, firms are part of the set of workers). In exchange for their 100 units of income, workers obtain a product whose cost of production is precisely equal to 100 and which is referred to a given period of production, say week 1. Since the final expenditure of income implies its destruction, in our example the purchase of goods is an

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instantaneous event defining week 1. The time dimension of the transaction is thus determined by the period of production of the purchased output. Hence week 1 is not only a quantum of time of a given length (a week) but also of a precise historical collocation (represented here by index 1). Every product defines a particular quantum of time, both at the very instant it is created (as income) and at the moment it is destroyed (again as income). Payment of wages and final purchase of output have therefore the same time dimension since they define the same quantum of time. But this means that, although they take place at different instants, these events are simultaneous in quantum time. The logical succession is the following: 1. Income is created through the payment of wages (instant tQ) and it is immediately transformed into capital. 2. Income is destroyed through its final expenditure on the commodity market (instant ^). 3. Defining the same time dimension as the payment of wages, transaction (2) coincides retroactively with (1). Even though the purchase of output follows the creation of income, it has a retroactive effect over this first transaction. Thus the payment of wages and their final expenditure are the positive and negative aspects of a unique operation. Their quantum unity defines the circuit of income and definitively establishes its instantaneity. The analysis can easily establish the nature of income, which effectively exists only instantaneously. The key to the solution lies in the fact that the expenditure of income has a retroactive effect: it goes back to the instant of the formation of income. The proof is quite simple. We know, in fact, that expenditures are instantaneous events which have a finite time dimension. This means that the expenditure of a given income quantizes a precise portion of continuous time. Now what is this portion? It is known very exactly: it is the same portion already quantized by the formation of income. Retroactivity is not only a good solution but it is also necessary since the 'expenditure-consumption' of income is identical (though of opposite sign) to the 'production-formation' of income: the time dimension of the two events is rigorously the same quantum of time. (Schmitt 1984: 463-4)

Finally, the existence of quantum time is derived from the double nature of monetary transactions which are instantaneous events of a finite time dimension. Transactions defining the same interval of time possess the same time dimension and are therefore simultaneous in quantum time. This is precisely the case of income creation and income destruction. Created through the association of money and output, income is destroyed through the purchase of this very output, and quantum time shows that both transactions are so strictly correlated that they coincide retroactively. Hence it would be meaningless to go on looking

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for a functional link between successive incomes. Every income defines an autonomous entity which production confers to money and whose inertia in time7 is strictly nil. The whole body of traditional theory is based on the supposed analogy existing between money and credit, an analogy which implies the inertia of income in time. The choice between traditional and quantum analysis is thus strictly dependent on whether or not income can be defined as a continuum. Let us then try to clarify this crucial point by developing a critical appraisal of traditional monetary analysis. Notes 1. Obviously, this does not mean that F can never be able to purchase part of the produced goods and services. On the contrary, our economic system is still very much characterized by the possibility for such a purchase to take place on the labour market. However, this can only be achieved when firms pay their wages out of their profits and this can clearly occur only if firms dispose of a positive income of their own (which is not permitted by our analysis, whose end is to explain the creation of income). 2. Schmitt has in fact established that every economic exchange pertains necessarily to the category of absolute exchange, even the exchange between two distinct commodities defining 'in reality the relationship between two absolute exchanges' (1984: 341). 3. As has been established by quantum analysis (Schmitt 1984), profits, dividends, interests and all sorts of indirect incomes (such as pensions, allowances, etc.) are derived from wages, so that there is no inconsistency in saying that wages define the whole output and that part of this output is finally bought by firms, shareholders and so on. 4. Here we find again the idea of infinite velocity which is linked to the concept of emission. Being emitted as a quantum, time (a finite period of time) is travelled at an infinite speed. The limit of speed established by Einstein with regard to spatial displacement does not apply here, where the process is a quantum displacement in time. If, for example, the payment of wages occurring at period pn is related to a 'period of production' of a month, p0 - pn, this month is emitted as an indivisible whole (quantum) at the very instant wages are paid. This means that the month is instantaneously travelled, both backwards (from pn to pQ) and forward (from p0 to pn), at an infinite speed. As Schmitt puts it, 'on our planet production and expenditure are no displacements in space, for the 'spaceproduct' and the "space-number" are created by these events. Production and expenditure are therefore only displacements in time: the time dimension of these events is precisely defined by a wave which quantizes an interval of continuous time by travelling it instantaneously backwards and forwards' (1984: 74). 5. The role of banks is determinant here, since by lending W's savings to other economic agents who spend them to purchase the stocked output, banks reduce the period during which income is held as^capital: 'By lending the income saved by income holders, banks accelerate the sale of stocks and in so doing they tend to reduce and even to cancel the capital-time of society' (Schmitt 1984: 162).

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A New Approach to Monetary Analysis

6. This is also true when current output is the real aspect of capital; that is, when it exists as a stock. In this case the debt of F no longer defines a negative money and the credit of W reveals the existence of a positive capital. Yet income is still somehow present, even though only in the form of savings (capital-time). 7. The concept of inertia in time is introduced by Schmitt to show that, contrary to the assumptions adopted by traditional analysis, income has only an instantaneous existence in time.

Part II

A Critical Appraisal of Traditional Monetary Analysis

We use the expression traditional monetary analysis' to label the theoretical investigations generated, either directly or indirectly, by the belief that money derives its value from the particular relationship it holds with a given commodity. It is when silver or gold were used as money that this relationship took its strongest form. Nowadays, commodity-money having been replaced by bank money, the link is less obvious, of course; but no less certain, at least according to traditional analysis. Apparently, in fact, bank money can be issued only on the basis of a real deposit so that its value is almost as 'intrinsic' as in the case of money-gold. Initially adopted by the classical economists, the concept of commodity-money was later taken over by neoclassical economists as well as by the monetarists. Yet the reasons that pushed these authors to define money in much the same way were completely different. Smith, Ricardo and Marx were looking for a unit of measure of absolute value, Walras for a standard of relative prices and Friedman for an asset whose supply could account for the variations of prices and output. The influence exerted by these authors and their school has been very uneven: the classical, 'material' definition of absolute value was rapidly laid aside, whereas Walras' relativistic approach became the leading paradigm of economic theory. Within this paradigm several monetary analyses were developed, among them the quantity theory of money occupies a pre-eminent position. Yet its acceptance is far from being unanimous even among neoclassical economists. Why is this so? Empirical considerations notwithstanding, are there analytical reasons to justify the sceptical attitude adopted by so many economists? We certainly do not lack answers to this question. In fact, so many scientific papers and books have been written on this matter that any new contribution is easily seen as redundant. Nevertheless, it could be worthwhile to show that the analyses which have so far opposed the quantity theory do not entirely reject its theoretical foundations. In particular, the definition of money implied in the monetarists' approach has tacitly been taken over by the great majority of its opposers, who do not seem to realize that this definition is central to what could be called the core of the neoclassical paradigm. Accepting the neoclassical definition of money, both opposers and defenders of the quantity theory find themselves trapped within the same analytical framework, thus corroborating Friedman's attempt to

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generalize the validity of his approach. To avoid this result, only one possibility is open to us: the critical appraisal of the neoclassical conception of money. It is well known that neoclassical economists tried to develop their analysis with direct reference to the exchange taking place on the commodity market. Their theory of relative prices is an attempt to define the product (the specific object of every economic investigation) without resorting to the classical axiom of absolute value. In this context, where prices are fundamentally determined in real terms, what is the role of money? Although many economists have claimed that in a neoclassical framework there is no place for money,1 it could be answered that even for neoclassical economists prices are expressed in monetary terms, which means that, even for them, money plays the essential roles of unit of account and unit of payment. The problem is therefore to determine how money can express prices, given that the value of modern book-entry money cannot be explained by the same factors that explain the (relative) value of commodities (supply and demand can perhaps modify a given value of money but they can never account for its origin). Obviously, the transformation of relative prices into money prices requires the integration between real and monetary sectors. To solve this problem — known as the neoclassical dichotomy — it is necessary to define money as rigorously as possible; in particular, it has to be determined how money can be endowed with a positive purchasing power, and whether or not it can be issued as a net asset. The concept of money as a net asset is not peculiar to neoclassical theory. Its almost general acceptance makes it a kind of axiom, with the consequence that its validity is taken for granted. Yet analysis shows that its scientific status is greatly usurped, since money acquires its value in relation to output. Another concept is then proposed by neoclassical economists: being a simple unit within real exchanges, money is like a veil with no intrinsic value. The relationship between money and output would therefore be ensured by exchange, and money would be an asset only by 'substitution'. Though this definition is more sophisticated than the ordinary conception of money, it does not avoid the criticisms addressed to its next of kin: the veil has its own positive dimension, and its emission poses the same problems as the emission of a net asset. The two definitions of money proposed by neoclassical economists are therefore unsatisfactory. This is not really surprising, since a thorough examination of the neoclassical dichotomy shows that the integration of money and output can never be overcome within the theory of relative exchanges. Analysed in Chapter 3, the problem posed by the dichotomous approach to economic reality is of great importance for the understanding of the neoclassical approach and represents a very

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useful introduction to the analysis of the quantity of money which is developed in the following chapters. The first two chapters deal with the concept of money which is at the origin of both the neoclassical dichotomy and the quantity theory. Chapter 1 provides a short account of the reasons why money was initially identified with a commodity, while in Chapter 2 it is shown that, even as a net asset or as a veil, money is still conceived of as a dimensional entity existing beside real output.

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Chapter Seven

The Concept of Commodity-Money

1.

The concept of commodity-money within the classical theory of value

1.1. Money and the labour theory of value Let us start with the traditional approach to money adopted by the classical economists at the first stage of their economic inquiry. As is well known, the whole of classical analysis is built around the concept of absolute value. Whether we use the terminology adopted by Smith, Ricardo or Marx, it is plain that their main concern was to provide a theory of labour-value. One of the problems which confronted them was how to express this value. It is here that the concept of money is introduced into the analysis. Originating from the labour of man, the value of output is expressed in terms of money since ' though labour be the real measure of the exchangeable value of all commodities, it is not that by which their value is commonly estimated' (Smith 1978: 134). Thus money was first perceived of as a standard of value. As such, it seemed obvious to define it as a dimensional unit endowed with positive value. In fact, if labour and labour alone is 'the ultimate and real standard by which the value of all commodities can at all times and places be estimated and compared' (Smith 1978: 136), then money can express this value only if it is also the product of labour. According to this approach, therefore, money was identified with a particular commodity. Although gold has been historically chosen to play the role of money, mostly for technical reasons, the principle has nothing to do with the physical characteristics of commodities. The important point is that money is itself the product of labour, and that, as a commodity, it has a positive absolute value. Thus, in the same way that commodities can be compared to one another on the basis of their labour-value, they can also be compared with money-gold on the same basis. Of course, labour could be used as the correct ultimate standard of value only if it were homogeneous. Yet the classical economists do not seem to have been seriously troubled by the difficulty posed by the physical heterogeneity of labour. Either by referring to the bargaining of the market (Smith) or to the social determination of abstract labour (Marx), they dismissed the problem as a kind of second-order obstacle easily removed by the real working of the economic system. Let us

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momentarily suppose that this procedure is logically acceptable. If so, the value of every commodity — money included — can be determined in terms of labour. The role of money in this model is therefore construed to represent, either directly or indirectly, a certain amount of labour-value. Once it is agreed that the monetary expression of every commodity is derived from the objective relationship (in terms of labour) that can be established between each of them and money, it is even possible to substitute gold with bank money. Given the convertibility of paper money into gold, or its legal definition in terms of the precious metal, it would in fact be useless and wasteful to go on using an expensive commodity instead of introducing a medium issued by the bank almost without cost. As Smith clearly points out: The judicious operations of banking, by providing, if I may be allowed so violent a metaphor, a sort of waggon-way through the air, enable the country to convert, as it were, a great part of its highways into good pastures and cornfields, and thereby to increase very considerably the annual produce of its land and labour. (Smith 1978: 420)

The concept of commodity-money initially adopted by classical economists has apparently the twofold advantage of being consistent with their theory of value, and of allowing for the immediate connection between real and monetary worlds. In truth, the problem caused by the dichotomous perception of reality — which gave so many problems to neoclassical economists — is not even considered within the theoretical framework of classical economics. As a commodity, money is immediately integrated with real output, and its value is determined by its direct relationship to labour. Thus the problem of purchasing power is also immediately solved: possessing a positive intrinsic value, money can be exchanged against any other commodity whose production requires the same quantity of homogeneous labour. Moreover, if the bank issues money by linking its promise to gold, the purchasing power of bank money is easily explained by the fact that this currency is endowed with the value of the real goods that it represents. Finally, the exchange between money and output defines the exchange between two products even when money is reduced to a simple stroke of a pen. 1.2. Money as a dimensional standard of value The reasoning behind the introduction of the classical concept of commodity-money is simple. Having defined the value of goods in terms of labour, it became apparent that this economic predicate of real output was somehow analogous to its physical attributes, necessitating

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a standard of value comparable to the standards used in physics. In other words, it was assumed that value is a kind of economic substance pertaining to the product. This concept of dimensional value — discussed as early as Smith (1978: 136) — is particularly evident in the works of Ricardo. In his search for a constant standard of value, the author of the Principles clearly defines the logical boundaries of the classical analysis of labourvalue. If output is economically defined through its value, and if this value can only be expressed in terms of labour, then it is necessary to look for an invariable measure of labour, that is for a commodity whose labour-value remains constant in time. In the same way that a standard measure of length is required to measure distance, Ricardo implies that in order to measure value we also have to find a standard possessing the dual quality of being first a value and second a value which remains constant under all circumstances. There can be no unerring measure either of length, of weight, of time or of value unless there be some object in nature to which the standard itself can be referred and by which we are enabled to ascertain whether it preserves its character of invariability, for it is evident on the slightest consideration that nothing can be a measure which is not itself invariable. (Ricardo 1951-5, Vol. IV: 401)

A necessary condition for the working of classical theory is the definition of money as an invariable standard of value. But, according to Ricardo, such a standard must be found within the commodity set: it has to be 'some object in nature' (p. 401). Thus the problem is how to find a commodity whose production always requires the same quantity of labour. Were it not possible to find such a commodity, the whole theoretical system would have to be re-elaborated. Smith was already well aware of the fact that 'a commodity which is itself continually varying in its own value, can never be an accurate measure of value of other commodities' (1978: 136). And in fact, if our standard is not invariable, it becomes impossible to use it to express the variations in the value of all other commodities.2 Now, though very clearly worked out, this problem has not been solved by classical economics. The attempt to determine a commodity-money of a constant value has never been successful. It becomes important, therefore, to establish whether this failure has been due to the incapacity of the classical economists to master the problem, or to the logical impossibility of including money in the commodity set. Finally, Ricardo's identification of value with a particular economic dimension of the produced goods is the logical consequence of the classical attempt to establish a strict relationship between value and labour. As long as labour is conceived of as a physical (and psychical) effort whose evaluation can only be dimensional, the conclusion

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remains the same: whether we use energy or time as a standard, economic value appears to be a substance attributed to output by the work of man. Since labour itself is dimensionally defined, money too is necessarily perceived as a dimensional entity. If absolute value is a substance, then money's value must also be a substance, since the two values are equivalent definitions of the product. Furthermore, if money is the unit of measure and if labour-value is dimensional, money must be evaluated in the same dimensional unit as labour: the standard of value is necessarily (defined in terms of) a commodity. 1.3- Gold as a general equivalent Let us first note that, even within the strictest version of labour theory, money has always been thought of as the only possible standard of value. This is a very important point, since it clearly implies that money cannot be immediately identified with labour. Claiming that value must be expressed in terms of money, classical economists were giving money a status of its own, considering it central to the theory of value. Particularly evident in Smith and in Marx, who uncompromisingly refused every attempt to substitute money with labour time-chits,3 the distinction between labour and money was never seriously challenged within the classical paradigm. Hence, although labour was considered to be the unique source of value, it was explicitly claimed that its social expression requires the intervention of money: 'The necessity of a money other than labour time arises precisely because the quantity of labour time must not be expressed in its immediate, particular product, but in a mediated, general product' (Marx 1973: 167). Labour-value and commodity-money seem therefore to be complementary concepts of a theory that regards the act of production as central, and that considers value as the specific economic attribute of output. In the first book of Capital we find a clear example of the way money was conceived of by classical economists. Starting from the exchange between two commodities, Marx shows in fact that each of them can be taken as a standard of value. Since commodities possess a given absolute value independently of their exchange, and since exchange occurs only between commodities of equivalent (absolute) value, the standard of value can be arbitrarily chosen among the elements of the commodity set. Physical properties are bound to influence the choice of commodity-money, of course, but this is irrelevant here. What matters is that a given commodity can be related to all the others on the basis of their labour-value. It is thus possible to establish a whole series of possible exchanges between, say, gold and every other commodity so that gold would become Marx's 'general equivalents'. The specific kind of commodity with whose natural form the equivalent form

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is socially interwoven now becomes the money commodity, or serves as money. It becomes its specific social function, and consequently its social monopoly, to play the part of universal equivalent within the world of commodities . . . Gold confronts to other commodities as money only because it previously confronted them as a commodity. Like all other commodities it also functioned as an equivalent, either as a single equivalent in isolated exchanges or as a particular equivalent alongside other commodity-equivalents. (Marx 1976, Vol. I: 162-3)

A further step can then be taken by replacing gold with paper money. If, for example, a £1 note is made equal to 0.1 gm of gold, the absolute value of every commodity can be expressed in purely monetary terms simply be converting their 'exchange values' from gold into pounds in the proportion of 0.1 gm of gold to £1. As the classical use of the term 'exchange value' shows, gold can be the standard of value not only because it has (or represents) a given absolute value but also because, being exchangeable on the commodity market, it acquires the form of general equivalent. For the classical economists, the exchange value of commodities is not a relative concept. Yet it is exchange that accounts for the existence of money. Produced by labour alone, commodities have a positive (absolute) value which would remain completely abstract if exchange did not support it by providing a real standard of value. Production and exchange are therefore very closely related: as the general equivalent, money is a commodity which is immediately exchangeable with any other. 1.4. The difficulties relating to the concept of commodity-money

Commodity-money and labour time. The first problem associated with the analytical concept of commodity-money is the physical heterogeneity of labour time. Despite the efforts of Smith and Marx to find a homogeneous standard of labour, this problem has never been satisfactorily solved. What is the common denominator among different kinds of labour? This question is obviously condemned to remain unanswered if we look for a physical quality capable of homogenizing labour. Besides, it would be useless to refer to the working of social forces, either on the labour or on the commodity markets. In fact, although these forces can count for the undifferentiated expression of labour, this evaluation is totally alien to the dimensional definition of labour characterizing the classical approach to the theory of value. For example, it is certainly possible to claim that one hour of labour a is equal to two hours of labour b if the wages corresponding to a are twice the wages paid for b. However, this comparison has nothing to do with the traditional version of classical theory. According to this theory, wages are determined on the basis of the labour value of what is given in exchange for them. But to determine this value it is

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necessary to express labour in terms of a homogeneous standard, and it would be inconsistent to sustain that this expression is both the necessary condition and the result of the payment of wages. In other terms, wages are determined before being paid, with reference to their labour value. Exchange between equivalents is a law whose validity requires that the values of the two terms of every exchange be perfectly equal. Thus wages must necessarily have the same value as the commodity sold by workers. If the value of this commodity (were it to be labour itself or what Marx calls the labour force) cannot be determined because of the heterogeneity problem, then neither can the value of wages. The recourse to wages is therefore of no use in overcoming our initial difficulty, which becomes even greater once we consider Ricardo's claim that, as soon as the analysis has to account for the existence of fixed capital, labour can no longer be the unique source of value. Ricardo's dilemma. This difference in the degree of durability of fixed capital, and this variety in the proportions in which the two sorts of capital may be combined, introduce another cause, besides the greater or less quantity of labour necessary to produce commodities, for the variations in their relative value. (Ricardo 1817: 30)

Confronted with the problem caused by what Marx was later to call 'the organic composition of capital', Ricardo was bound to give up the search for a dimensional standard of value, and to introduce factors other than labour as determinants of value. The careful reader of his works can easily verify how hard he tried to avoid this conclusion. Yet there seems to be no possible alternative. If we remember, in fact, that according to classical theory value and price are always equal,4 it is immediately evident that labour alone cannot explain variations in price due to the differences in the composition of capital or in the periods of time during which this capital has to be invested. Ricardo is well aware that a commodity whose production requires only capital has a positive price which cannot be explained if labour is considered to be the unique source of value. Since the exchange between equivalents does not allow for any difference between price and value, it is necessary to infer that capital is also a source of value. But, if this conclusion cannot be avoided, how is it still possible to determine absolute value at all? Since the writings of Smith, it has been claimed that value flows from the work of man. Fixed capital is a mere instrument, an instrument that can increase the physical production of goods, of course, but one that cannot modify their economic value. Smith's distinction between

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use-value and exchange-value clearly illustrates this result: capital can modify the commodities' use-values, but their exchange-values are determined by labour alone. If it were claimed that capital can also determine value, it would be necessary to explain how a product of labour can be endowed with such power given that, according to a simple rule of logic, the original source of value cannot itself be a value. As a product, fixed capital can, at most, transfer part of its own value, but it can never create value. Moreover, it can be shown5 that fixed capital transfers value only within the limit of its depreciation and, therefore, only if labour replaces what has been transferred by an equivalent new value. Finally, even in this case, value is determined by a unique factor: the work of man. Yet the problem remains: the price of goods must include a profit corresponding to the amount of fixed capital and to the period during which it is invested. And if price and value are equal, then profits must be part of value, not only of price. Ricardo struggled all his life to master this problem, and in the end, he was still caught between the two terms of the same dilemma. Has labour to be considered as the unique source of value, in which case it would be impossible to explain how prices are inclusive of profits on capital; or is it necessary to add fixed capital (and, eventually, land) to labour, thus giving up the possibility of explaining the very existence of value? Now, the reason for Ricardo's impasse is twofold. The exchange between equivalents and the dimensional conception of value forced him to introduce fixed capital as a source of value, and to look for a physical expression of its measure. Thus, already complicated by the heterogeneity of labour, the search for an invariable standard of value becomes totally hopeless when fixed capital is introduced into the picture. As Ricardo points out, 'In this then consists the difficulty of the subject that the circumstances of time for which advances are made are so various that it is impossible to find any one commodity which will be an unexceptionable measure' (Ricardo 1951-5, Vol. IV: 370). As far as the determination of money is concerned, the result of Ricardo's analysis is clear. Whether we consider labour alone, or in conjunction with fixed capital, money cannot be defined as a dimensional standard of value. The reason why theorists never succeeded in finding an invariable standard of value is that they construed value as a dimensional entity. The rejection of the concept of commodity-money follows immediately from the logical impossibility of identifying value with any of the dimensional properties of real output.

110 Appraisal of Traditional Monetary Analysis 2.

The concept of commodity-money within the neoclassical theory of relative prices

2.1. From absolute value to relative prices When defined as a materialization of labour time, value is conceived of as a dimensional property of commodities. Accordingly, the standard of value is thought of as a dimensional unit and both value and its standard are made dependent on production. In this classical framework, exchange plays an important role as well, for it is as exchangeable value that a given commodity is chosen as money. Yet the role of exchange is subordinated to the possibility of determining the value of every commodity, and therefore also of money, before it is exchanged on the commodities' market. Perfectly aware of the logical difficulties linked to this metaphysical conception of value,6 neoclassical economists abandoned the search for an absolute value and tried to develop a theory based on the concept of relative exchange. Even for classical economists exchange was relative, of course, for it defined a transaction between autonomous objects. But these objects (money included) were believed to have a given value independent of exchange. On the contrary, for neoclassical economists, value (price) is itself relative: it is determined by exchange and can be expressed only relatively to it. The relative price of two commodities, for example, is given by the proportion in which they are exchanged, proportion derived from the adjustment between supply and demand, and not from a mythical (dimensional) absolute value. If one unit of commodity a is exchanged against two units of commodity b, the relative price of a is 2b and, conversely, the relative price of b is \l2a-. Trices, or ratios of values in exchange, are equal to the inverse ratios of the quantities exchanged. The price of any one commodity in terms of another is the reciprocal of the price of the second commodity in terms of the first' (Walras 1954: 87). This relationship is not predetermined, so that the price of a in terms of b can vary according to the market forces. The equilibrium is reached every time an exchange takes place, but nobody is supposed to know whether it will be stable or not. When exchange occurs between more than two commodities the equilibrium becomes multiple, and its determination requires the use of mathematics. The system of equations by which Walras' general equilibrium model is represented is well known. Each equation relates supply to demand and the entire system (composed of a number of independent equations equal to the number of commodities minus one) is supposed to determine an equivalent number of relative prices. Now, although these prices are indirectly comparable to one another, since the simultaneous solution of GES makes them homogeneous, it is

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obvious that a decisive improvement can be obtained if they are all expressed by the same unit of account: money. 2.2. The numerical expression of commodity-money Relative prices are all initially expressed in terms of the exchanged commodities: a in terms of b, if a is exchanged against b\ c in terms of d, if c is exchanged against d, and so on. Some commodities are never exchanged with some others, but even so a complete set of possible interrelationships can be established by resorting to indirect exchange. The result is similar to the one reached by Marx: the (relative) value of every commodity can be expressed in terms of a particular product chosen as money. Hence it is enough to set the price of the arbitrarily chosen commodity equal to one to provide the system with a numerical standard of value. Essentially reduced to a mathematical device, the determination of money prices does not modify the foundations of GEA. Money, even bank money, remains fundamentally a commodity, a positive asset whose supply and demand are justified by its intrinsic qualities (namely, its immediate exchangeability with all other commodities). Agents are supposed to be endowed with a certain number of commodities, among which is money. In order to maximize their utility, they exchange these commodities, either directly (in the absence of money) or indirectly. Money becomes, therefore, an intermediary between the exchanged commodities, but an intermediary which is itself a real asset, so that every exchange between commodities and money is in reality no different from an exchange between commodities. The sale of commodity a against money is the purchase of money against a, both a and money being positive assets which are held for their own merits. As we have seen, the choice of a given commodity as money is arbitrary, and in this respect neoclassical and classical analyses are the same. Fundamentally, this means that according to both these theories money is commodity-money. Yet the value of this particular commodity is not defined in the same way. Within the classical paradigm, money has a value determined by labour-time, whereas for the neoclassical economists it is derived from exchange. While both put the price of commodity-money equal to one, they interpret it quite differently, for, in one case (classical theory) money's price is a measure of absolute value, whereas in the other (neoclassical theory) it is a pure number. Once again this difference is due to the acceptance (refusal) of the dimensional definition of value. By identifying value with labourtime, classical economists were ascribing a positive dimensional value to money independent of exchange, which meant that, even when its price was made equal to one, money could never be reduced to a pure number. On the other hand, the value of the commodity chosen by the

112 Appraisal of Traditional Monetary Analysis

neoclassical economists to play the role of money can be determined only within exchange, and this means that outside exchange the price of money has nothing to do with its value. If it is not exchanged, money has no value, but it can have a 'price': it is what Walras called a numeraire. The price of money is therefore purely numerical and, associated with the GE system, it seems to provide all the elements necessary for the determination of the whole set of economic variables. 2.3. The logical impossibility of transforming money into numbers within the neoclassical theory of relative prices The neoclassical rejection of the dimensional definition of value indisputably represents a positive step forward for modern economics. In particular, the introduction of Walras' concept of numeraire is extremely significant since it clearly suggests that, fundamentally, money is nothing other than a set of numbers. The passage from absolute to relative value is therefore proposed as the passage from metaphysics to reality, from the dimensional to the numerical definition of value and prices. Now, despite Walras' correct claim that there is no such thing as money — The word franc is the name of a thing which does not exist' (1954: 188) — neoclassical analysis does not provide a satisfactory explanation of the way numbers can be transformed into money. The mathematical device of taking a given commodity as standard by making it equal to number one is tantamount to being an illusory trick of arbitrarily associating real output and numbers. In reality this association cannot be arbitrarily determined: prices must result from a real process of integration between money (numbers) and output, and this operation can be neither arbitrary nor the consequence of exchange. It is true, of course, that through exchange, commodities are related to one another even when one of them is chosen as money. But this clearly means that the price of every commodity, money included, can only be determined relative to the price of another commodity. In other words, the price of (commodity) money can never be purely numerical: the concept of numeraire is logically inconsistent with the neoclassical determination of (relative) prices. Another argument against the definition of money introduced by neoclassical economists is that relative prices presuppose the existence of commodities and money as distinct and autonomous objects. If money is a simple numeraire, it becomes impossible to understand why it is demanded (supplied) and exchanged against real output. The fact that money is actually exchanged against commodities shows that it is not only a pure number, but a positive asset. Yet, since the (relative) value of money can only be determined through exchange, neoclassical economics must assume that money is a positive asset already before

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being exchanged on the commodity markets and on the factors markets, that is before being associated to real output. Since exchange is the only operation through which money is related to output, it is clear that, if money is purely numerical, it cannot be a 'desirable object' submitted to the forces which, according to neoclassical analysis, are bound to determine relative prices. Thus money has to be either a commodity or some other kind of net asset. In the first case, however, the whole system is not substantially different from barter, while in the second case — as we shall see in the next chapter — the explanation of money's worth becomes viciously circular. Notes 1. See, for example, Hahn (1982), Glower (1969) and Davidson (1978a). 2. As Ricardo puts it, 'When commodities varied in relative value, it would be desirable to have the means of ascertaining which of them fell and which rose in real value, and this could be effected only by comparing them one after another with some invariable standard measure of value, which should itself be subject to none of the fluctuations to which other commodities are exposed* (1817: 43). 3. First supported by two English political economists — Bray and Gray — the idea of expressing value in labour-money was later taken over by the Utopian socialists of the nineteenth century, and in particular by the French philosopher Proudhon. Marx criticizes this approach in Grundrisse (1973: 135-40, 153-60 and 172-3). 4. The necessary equality of prices and value is the direct consequence of the classical law of exchange and of the fact that prices are defined as the monetary expression of value. 5. See Cencini and Schmitt (1976). 6. If value is a dimension, then production must account for the creation of a positive dimensional entity out of nothing, a metaphysical problem par excellence.

Chapter Eight

Two Faulty Concepts: Money as a Net Asset and Money as a Veil

1.

Money as a net asset

1.1. Money and relative exchange In a series of lectures first privately printed in 1840 by Fellowes in London, Senior wrote: My principal object in this long discussion has been to show that the value of money, so far as it is decided by intrinsic causes, does not depend permanently on the quantity of it possessed by a given community, or on the rapidity of its circulation, or on the prevalence of exchanges, or on the use of barter or credit, or in short, on any cause whatever, excepting the cost of its production. (Senior, in Glower 1969: 78)

Senior's point of view was, however, not generally accepted in his time. Long before the emergence of neoclassical theory it was in fact already claimed that 'the value of money depends partly on its quantity, and partly on the rapidity of its circulations' (Senior, in Glower 1969: 67). As Senior tells us, this was 'the general' (p. 67) doctrine which shows that the majority of economists were clearly distinguishing between money and output. Their argument leads, indeed, to the unavoidable conclusion that, playing the role of money, gold cannot be considered on the same level as any other commodity, and that its value cannot be determined by the cost of its production alone. It appears, therefore, that the traditional concept of commodity-money has been questioned since the beginning by a more abstract and sophisticated concept based on the exchangeability of money — that is, on the specific role played by gold as a circulating medium irrespective of its material characteristics. As a commodity — so we are told — gold has a value determined by the cost of its production; as money it has a value determined by its quantity. A sudden change in the quantity of any commodity will not have any repercussion on other commodities (according to the classical doctrine that the value of output is defined by the labour cost of production), whereas a change in the quantity of money will necessarily have a consequence on the money price of every commodity. By making the value of money depend on factors other than the cost of production of its material support, the same concept of money is given an autonomous

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status, and since according to this new approach money is directly analysed in its exchange with real output, a way is cleared for the use of the neoclassical interpretation and of the traditional version of the quantity theory. But neoclassical economists do not only relate the value of money to its quantity, they also claim that the value of every commodity depends on its supply and demand. Determined by the commodity market, relative values are first expressed in real terms. The monetary expression of prices is therefore of secondary importance, and money seems to play only a subsidiary role. The first impression is, in fact, that any commodity could be used as money by arbitrarily fixing its price and relating it to (either directly or indirectly) all other commodities. Yet this result is not fully consistent with the neoclassical approach. Although the concept of commodity-money seems to explain the variations of price due to changes in the quantity of money, this is true only when money is strictly material. As soon as banks are taken into account, monetary changes can no longer be determined by referring to the supply of and demand for commodity-money. Having the faculty to issue money, banks can influence its value independently of the characteristic of its physical substratum. For example, even if bank money were defined in terms of gold, its value would not only depend on the quantity of gold supplied and demanded, but also on the policies followed by the issuing banks. This is particularly evident nowadays, when book-entry money is no longer defined relative to gold. Money prices can therefore not be determined by the traditional device of making the price of a given commodity equal to unity, since money is not identifiable with any commodity whatsoever. This seems to be also the opinion of Glower, who clearly states that 'what presently passes for a theory of a money economy is in truth descriptive of a barter economy' (1969: 205). As a matter of fact, his own definition of a money economy is based on the explicit assumption that money is a commodity with the specific characteristic of being directly tradable with all other commodities in the economy. Thus, according to Glower, 'a money economy is one in which not all commodities are money' (p. 207). In contrast with this monetary world, a barter economy is defined as a state in which any commodity can be offered directly in exchange for every commodity. In his own words, 'a barter economy is one in which all commodities are money commodities' (p. 206). The claim that 'the peculiar feature of a money economy is that some commodities (in the present context, all but one) are denied a role as potential or actual means of payment' (p. 207) does not seem to be sufficient to define a true money economy. In reality it could easily be argued that the two definitions proposed by Glower do not fundamentally differ.

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The fact that money is still considered as a commodity is significant, and underlines the essential similarity between barter and a money economy defined in Glower's terms. In both models prices are relative and the role of money is mainly subsidiary. If the task of money were only to facilitate exchanges, then, obviously, any commodity fulfilling certain particular physical requirements could be used as money, and this could happen independently of the existence of any monetary institution. As the reader can easily ascertain, this is the situation which prevails in most of the so-called primitive barter economies. Thus the use of a particular commodity to facilitate exchange is not a sufficient condition for the appearance of a money economy. Let us note also that the problem remains essentially unchanged when money is defined as a good having zero transaction costs (Niehans 1971) or as an extra commodity not subject to the 'double coincidence of wants' (Starr 1972). In both cases the attempt to 'explain how it is that the use of money enables an economy to attain equilibria that are not possible without money' (Barro and Fisher 1976: 52), is successful only in so far as it is intended to account for different kinds of barter. As in Glower's analysis, money is still a commodity and the assumption of zero transaction costs is not fundamentally different from the concept of 'direct exchangeability'. Glower's aphorism — 'Money buys goods and goods buy money; but goods do not buy goods' (pp. 207-8) — is too poor a definition to act as the basis for the theory of money. Therefore a new definition is required which can only result from a rigorous analysis based on the principle that money cannot be identified with any particular commodity whatsoever. Glower is not incorrect in saying that the role money, and only money, can perform is the buying of goods in a world where money alone buys goods. But, as Hahn points out, his requirement 'is simply a postulate, and one that makes sense only if money indeed has a positive exchange value' (Hahn 1982: 21). Denying that money is a commodity, however, does not necessarily imply that money has no value of its own. Issued by banks almost without cost, why ought money not be endowed with a positive value corresponding to its purchasing power? Then, the question to settle is whether or not the value of money can be explained independently of relative exchange: that is whether or not bank money is issued as a net asset whose price varies according to supply and demand. 1.2. Money's purchasing power The argument most frequently put forward is that money is itself a net asset. Even though economists often tend to define money in an inaccurate way, claiming that definitions are a matter of convention

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rather than something that can be settled on wholly a priori grounds, they seem to agree on this point. Whether they refer to fiat money or to fiduciary money, whether they include, or otherwise, time deposits in the definition of money, they always define money as a positive asset.1 Let us consider credit money alone. Issued by the banking system, it has a positive purchasing power over the produced output and can therefore be defined as a net asset since, according to the theory we are analysing, exchange occurs either between goods or between goods and a money with which they are compared according to their 'utility'. From the moment of its emission, it is assumed that money is endowed with a positive value whose utility has to be matched by the real goods offered in exchange. Any beneficiary of an emission of bank money is credited with a positive deposit defining a net asset. Of course, the client of the banking system can also be a debtor to the extent of the entire amount of money issued on his behalf. However, this does not imply that what he gets from the bank is worthless. On the contrary, the whole tradition of monetary theory tells us that the emission of money gives him a positive power over the goods and services produced. But how is it possible for a bank to issue a net asset given that the emission of credit money is no longer linked to any legal definition of money in terms of gold or of any other commodity? The answer seems to be that money is a positive asset because it is issued with a positive purchasing power, and this, of course, begs the question. The problem is not to prove that if money is endowed with positive purchasing power it is definable as a net asset, but to show how money can be emitted already endowed with such a power. Where does this power come from? Is it possible to claim that the banking system has the faculty to create a net asset by the simple stroke of a pen? Like any other type of credit money, book-entry money is construed as a positive asset. But that does not really answer our question, except if we are ready to believe that the banking system is an all powerful economic agent. If not, the problem remains and has to be tackled differently. 1.3- The social determination of money's purchasing power A solution has been put forward by Hahn, who claims that the value of money directly derives from its general acceptance as a means of payment. Tobin (1980) has spendidly remarked that money is like language. My speaking English is useful in so far as you do also: just so, money is acceptable to me provided it is acceptable to you. One can think of this argument as a Nash equilibrium. Once there is a rule that transactions should proceed via money,

118 Appraisal of Traditional Monetary Analysis it is not advantageous for an agent to attempt to deviate from this rule. Moreover, the rule ensures its own viability, in the sense that, if it is adhered to, money will have positive exchange value even when there are rival assets, provided we deal with infinitely long-lived economies or with a sensible interpretation of rational expectations equilibrium. (Hahn 1982: 21-2)

According to Hahn, therefore, the problem of money's worth can easily be solved by taking into account the general benefit of following the social rule that transactions should proceed via money. However, general acceptance of money as a means of exchange does not explain how monetary and real sectors are first integrated. And it should be immediately obvious that the value of money depends entirely on this integration. Let us consider book-entry money. Its emission by banks requires a simple double entry, and its intrinsic value is nearly equal to zero. Yet, as Hahn suggests, its extrinsic value can be very high indeed, since it is defined by the products that can be purchased with it. Thus the value of money is identified with its purchasing power. But how is the purchasing power itself defined? To avoid going around in a full circle, it seems to be necessary to postulate its existence, and to endow the bank with the faculty to issue it. Since people agree to accept it as a means of payment, , money would therefore be created with an immediate positive power over the produced goods and services, even though it is issued without cost by banks. Although this argument is extremely simple and apparently irreproachable, it must be noted that it is founded on the implicit assumption that prices can be determined independently of the emission of money. The very notion of purchasing power is meaningless unless it refers to the level of prices. If the value of a given sum of money is defined by its purchasing power, how could it be determined without the previous knowledge of prices? This almost trivial consideration leads us to the logical rejection of Hahn's suggestion. Prices, in fact, are nothing other than the monetary expression of output, and their determination requires, quite naturally, the intervention of money. Thus prices can only be known once money has already been integrated. Without this integration prices are still undetermined, and so is the purchasing power of money. In order to explain this last concept it is necessary to explain prices, and to determine prices it is necessary to establish a relationship between output and money. Hence, if the purchasing power derives from this relationship, it would be incorrect to claim that when money is issued it is already endowed with such a power. The central point made by Hahn and by many other economists is that money has a positive value because people accept it in exchange for their products (goods, services and financial assets). Yet it is exactly the

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opposite that is true: people accept money because it has a positive exchange value and not the other way around. As Marshall wrote in 1924, 'Money is not desired mainly for its own sake, but because its possession gives a ready command of general purchasing power, in a conventional form. . . . so currency is valued in accordance with the amount of ready purchasing power over which it gives command* (Marshall, in Glower 1969: 80). 1.4. Purchasing power and the simultaneous solution of the GES Why not refer to simultaneity, then? Subscribed and particularly cherished by neoclassical theorists, could this concept not be profitably introduced here to justify the claim that money is issued as a net asset? As soon as it is created by banks, money would be compared to real output, and the prices determined through this operation would immediately define its purchasing power. The simultaneous determination of prices and purchasing power cannot however be accepted within the neoclassical framework, since it has a corollary which is logically inconsistent with the traditional definition of money as a net asset, namely the necessary identity of prices and purchasing power. In fact, if these two variables are determined by the same operation, they necessarily relate to the same object. According to their simultaneous determination, prices and purchasing power have meaning only because they are associated to real output. They both define the available output and could not exist independently of it. But this clearly means that money cannot be considered as an autonomous entity endowed with intrinsic value and facing output as its possible counterpart. Money's positive value can be established only in relation to prices, and if prices define the product as well as the purchasing power (simultaneously determined), then money's value cannot be compared to output as if it were autonomously defined. Therefore, it would be mistaken to go on defining money as a net asset exchangeable against another net asset (output) while accepting the idea that prices and purchasing power are the simultaneous result of a unique operation.2 We now seem to be caught in a trap. If we claim that money can be issued already endowed with a positive purchasing power independently of the determination of prices, we are bound to argue that money's value can be determined without referring to prices which is obviously nonsense. On the other hand, if we claim that purchasing power and prices are simultaneously determined, we can no longer define money as the counterpart of output without contradicting ourselves. Both solutions are evidently unsatisfactory, and they both reach the same conclusion: money cannot be issued by banks as a net asset. Thus besides being based on the metaphysical assumption that

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banks can create a positive entity (net asset) out of nothing, the neoclassical definition of money also implies the impossibility of determining the value of what is supposedly created. Despite this negative conclusion, is it not still possible to retain Hahn's suggestion of defining money and its value by referring directly to its exchange on the commodity market? 2.

Money as a veil

It is generally thought that money is a means of payment for the reason that it is used as such. Accordingly, money would have no intrinsic value definable outside exchange. It would only be a veil, and its value would therefore be the mirror image of the purchasing power possessed by real goods. As a mere reflection of the real world the purchasing power of money would come from the goods which it only temporarily replaces. In GEA the value of goods is determined through their exchange. Relative prices are the result of this exchange and money is the medium in which prices can be numerically expressed. Walras' concept of numeraire is the corner-stone here. The numerical expression of relative value, in fact, does not require the use of any real standard since money neither modifies the value of exchanged goods not is it added to real goods. In this approach the real world is all that matters, since money is never demanded just for its own sake. The general acceptance of money as a medium of exchange is essential to explain its value, but this time it seems possible to claim that the explanation merely concerns the form of money's value and not its origin, which is to be found in the relation of exchange between real goods. Social acceptance would therefore sanction a value that is indirectly attributed to money. The fact that everybody agrees to use credit money as a unit of account and of payment is a necessary condition for the existence of a modern monetary economy; yet it is not sufficient. The definition of money as a veil seems to provide the missing element, no circularity being involved, since purchasing power is not derived from purchasing power. Goods are exchanged on the commodity market in transactions which define their (relative) value as well as the value of the medium through which the exchange takes place. 2.1. Purchasing power as a mirror image of relative exchange value The attempt to explain money's value by defining it as a mirror image of the real exchange power exerted by goods on the commodity market is an interesting alternative to traditional analysis which can perhaps

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explain the possible social acceptance of money. Simply interposed between the two real terms of exchange, money would derive its value from them, that is, it would merely be the temporary deposit storing the value of the commodity that is sold until exchange is completed. Money would therefore be constantly endowed and deprived of a purchasing power that transforms it, at least momentarily, into a unit of payment. The fact that money is only provisionally a unit of payment is perfectly consistent with the concept of veil introduced by neoclassical economists, and in a certain way also to the concept of the temporary abode of purchasing power adopted by Friedman. Used as a medium of exchange, money is invested with a positive purchasing power derived from the real world of goods, and it holds this power until it is definitively spent on the commodity market. Between the sale of a (transaction defining the exchange of a and money) and the purchase of b (which defines the expenditure of money) the medium of exchange is a 'temporary abode of purchasing power'. Acting as an intermediary between the real terms of exchange, money can be used to avoid the simultaneity of sales and purchases. From a chronological point of view this seems rather trivial. It is obvious that, as soon as money is introduced into the model, the sale of commodity a does not imply the simultaneous purchase of commodity b. Yet the important point is not chronological but logical. What we have to investigate is whether or not the use of money splits exchange into two separate operations: a net sale and a net purchase. Take two agents A and B exchanging their respective commodities a and b without the intervention of money. The transaction thus defined is simultaneously a sale and a purchase for both agents. In fact, A demands commodity b by supplying commodity a and J5's demand of a is simultaneously his supply of b. Supply and demand being expressed in real terms, it necessarily follows that when A buys b he sells a, and vice versa. The same transaction, the exchange of a and b, defines a pair of identities on A and B (Fig. 8.1).

Figure 8.1

Well known by every neoclassical economist, this implication of real exchange is the foundation of Walras' law according to which in a GES one of the equations is redundant, since it is necessarily implied in the others. Now, so we are told, the sale-purchase identity is split into two separate operations as soon as money is introduced into the system.

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Money being a perfect means of exchange, A sells his product without having to buy the product of B (in the same operation). Analogously, every agent can purchase the commodity he wants without selling simultaneously his own commodity. Money is thus an intermediary used in transactions which, logically and chronologically, are sales as distinct from their corresponding purchases (Fig. 8.2).

Figure 8.2

Referring to the direct exchange between commodities, it seems possible to determine their (relative) value. The introduction of money as a simple intermediary does not modify these (relative) prices. It follows, almost tautologically, that money is not a commodity, since, otherwise, its exchange against a or b would define a relative exchange between commodities instead of a net sale or a net purchase. Thus, can money be positive in these net transactions? Directly related to the exchange taking place on the commodity market, the value of goods cannot be explained before this exchange takes place. And if the value of a cannot be known before a is exchanged (against another commodity), it is impossible to maintain that money acquires the value of the commodity with which it is exchanged. How could money be endowed with the value of a if this value can only be determined once a is exchanged with ft? If an agent agrees to sell his commodity for one unit of money, it is because he knows that, using this same unit of money, he will later be able to buy another commodity. But how can he assess the precise amount of purchasing power of the received sum if its value depends on the terms with which his commodity is finally exchanged with the other? Money separates the sale of a from the purchase of b only if between these two transactions it can play the role of a temporary abode of purchasing power. 'Even as a medium of exchange, money becomes a temporary abode of purchasing power' (Perlman 1971: 252). Yet to play this role money has to derive its value from the goods with which it is exchanged. It is here that neoclassical theory fails to give an answer. The value of money remains unexplained because it is said to depend on a

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value that can only be determined once exchange has finally related real goods to one another. Being the product of real exchanges, relative value cannot be determined in advance, that is before transactions on the commodity market. Consequently, however, monetary transactions can no longer be accounted for, since money can only be introduced into the system once goods have already been exchanged. In other words, when the relative value of goods is known and can be temporarily passed over to money it is too late, the exchange between goods having taken place without the intervention of any medium of exchange. Thus, if money has to derive its value from the products, it is necessary to explain how this can be done before their exchange on the commodity market. As we have pointed out at the beginning of this section, the concept of money as a veil is strictly related to the idea that money's purchasing power derives its existence from social acceptance. Deprived of any intrinsic value, the veil would act as a means of payment only because people accept it as such. Thus money (veil) would allow for the circulation of goods since people agree to accept it as a general equivalent. But how could a simple veil circulate goods and services? 2.2. Can a veil circulate goods? No metaphysical assumption about the capacity of banks to create net assets is necessary here. Conceived as a veil, money would be a kind of social illusion whose general acceptance makes it a useful intermediary between exchanges. These exchanges remain fundamentally a kind of barter. Consistent with what we have already claimed about the possibility of attributing a positive value to money through relative exchange, we can now note that the use of a veil does not define any monetary transaction unless the veil is previously related to output. If agent A accepts payment in money because he knows that he can use this same money to pay B or any other agent C, D, . . . this does not mean that his payment is truly monetary. Given that money is conceived of as a simple veil, A does not get a positive value in exchange for his commodity, and the fact that everybody else agrees to sell his commodity against this veil does not transform it into a net asset. A chain of transactions where every agent accepts payment by means of a 'social illusion' does not transform this illusion into a real object. But why should this concern us? If a simple veil can allow for the circulation of goods, it is all for the better since in the end goods will have been exchanged against goods, and the veil will have fulfilled its role perfectly. There are two arguments against this conclusion. It is almost self-evident, in fact, that a system based on the concept of money as a veil is not a monetary system at all. Since money is essentially a social illusion, all the payments are real. But in this case, how can

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monetary prices be determined? And if (money) prices cannot be explained, how can we quantitatively determine the 'veil' necessary for the circulation of goods? Simply referring to relative prices will obviously not do, since the demand for and the supply of money — a non-commodity — depend on the level of (money) prices. The only alternative is to suppose that money can be associated with real output, for example via the payment of costs. This * integration', however, would transform our veil into real money, and would have to be explained before products can be exchanged on the commodity market. The traditional concept of money as a veil cannot be accepted for another reason, closely related to the neoclassical definition of money and output as two distinct interacting masses. If price variations are to be explained by variations in the quantity of money, then money has to be considered as an autonomous entity whose value can vary independently of real output. Thus, according to the law of supply and demand, if the mass of money is increased (decreased) relative to the mass of products, prices rise (fall). In order to compare money and output as two separate masses it is necessary, however, to give money the status of a net asset. Although money is perceived as a veil, it is not identified with an empty form. The veil has its own consistency, and this explains why it can effectively mask real transactions under its cover. If money were not to have this substantive character, it would also not be a veil, and monetary transactions would either be reduced to barter or be beyond the reach of neoclassical analysis. But if money must be an asset even though it is a veil, the problem of its value arises again with renewed insistence. In fact, money can play the role of the output's counterpart only if it is endowed with a positive value, and this condition has to be fulfilled before transactions occur on the commodity market. Exchanges officially validate prices once they are already determined through the mutual adjustment of the 'masses' of money and real output — adjustment that can only take place if the value of money has its own separate existence. Thus, to reconcile the concepts of money as a veil and of money as a net asset, two conditions must be fulfilled: it is necessary to explain how money can acquire a positive purchasing power (value) (1) independently of the transactions relating money to product on the commodity market, where this power is exerted and not created, and also (2) independently of the transactions relating product to product (since they require the intermediation of money as a veil). Let us consider once again the example of two commodities a and b. According to neoclassical economics, the real exchange between a and b is split into a net sale and a net purchase as soon as money is introduced as a means of circulation. The owner of commodity a sells it against money: this is, the first transaction taking place on the market and defining the net sale of a. Of course, this transaction requires

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money to be endowed with a positive purchasing power. Yet the criticism can be developed even if we accepted the idea that, being the mirror image of real goods, money is indirectly invested with such a power. In fact, when money is exchanged with a, we are told that a is given in exchange for an equivalent sum of money which defines its counterpart. The circulation of money is seen as a displacement taking place in the opposite direction as the corresponding displacement of goods. Commodity a passes from seller to buyer, whereas money circulates from the buyer to the seller of a. In such a transaction two different objects (assets) are exchanged one against the other so that, finally, the whole operation is reduced into the change of form of the assets owned respectively by the seller and the buyer. But if this is actually the case, how could we still be able to claim that money makes it possible to have a net sale or a net purchase? The sale of commodity a could be net only if it did not define the simultaneous purchase of money. Correspondingly, the purchase of a is a net purchase only if it does not imply the sale of an equivalent sum of money. If money were not to be an autonomous asset, then its exchange with output could possibly define a net transaction.3 Within the neoclassical framework, however, money is always considered an asset existing separately from the goods with which it is finally exchanged. It is then obvious that the purchase of a can only define the exchange between two distinct objects: every sale is a purchase of an equivalent amount and vice versa. The conclusion at which we arrive is that money — in its neoclassical definition — cannot determine any net sale (purchase). Fundamentally, this means that every exchange is a real transaction, even when one of its two terms is money. When two assets are exchanged the transaction occurs between real and distinct objects, whatever their physical form, be it goods, bonds or money. What, then, is the difference between barter and a monetary economy where money is immediately defined as a net asset? Apart from the physical differences existing between money and commodities, the two systems are essentially the same. As Clower so clearly states, 'A barter economy is one in which all commodities are money commodities' (1969: 206). If an exchange between money and commodities can define a barter economy, it is only because money is not fundamentally different from a commodity. Accordingly, it is obvious that, since the exchange between money and output is also defined as an exchange between net assets, the entire system is reduced to barter. Needless to say, this result disproves the neoclassical approach to monetary analysis, whose validity is even further challenged by the logical impossibility of solving the crucial problem of the dichotomy between real and monetary sectors.

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Notes 1.

2. 3.

For example, analysing the general equilibrium approach to monetary theory Barro and Fisher say that 'A key element in the approach is that money is viewed as just one among a spectrum of imperfectly substitutable assets, the demands for some of which can be determined on the riskaversion basis of the portfolio approach' (1976: 149-50). Or of a unique set of operations which, as far as our argument is concerned, is fundamentally the same. This is effectively what happens once money is no longer considered as the product's counterpart but as its own economic definition. Relative exchange is then substituted by absolute exchange and money becomes the central concept of economic theory (see Part I of this book).

Chapter Nine

The Neoclassical Dichotomy

Since the publication of Walras' general equilibrium system, neoclassical economists have always considered supply and demand to be the most important variables of the economy and the market as the central stage where these variables interact. Accordingly, the whole economic system has been analysed in terms of the general equilibrium of opposing forces. The important point here is that both supply and demand are defined in real terms. From the start the system was concerned with the direct exchange of goods (and services) and was worked out with the explicit purpose of determining relative prices. Thus the price of every commodity was defined relative to any other commodity with which it was exchanged. Formally, the system is represented by a series of equations relating supply to demand. But as Walras pointed out, in the case of n commodities the system can only account for n - 1 independent equations, since one of them necessarily follows from the others. The number of variables to be determined being itself equal to n - 1, the system is neither over- nor under-determined. What happens when we introduce money into this neoclassical framework? To reduce the argument to its fundamental aspect, let us suppose that money is completely abstracted from any material support. How is this dematerialized money integrated into the GES? The first possibility which comes to mind is to treat money as if it were an asset among others, and to apply to it the traditional categories of supply and demand. By simply transposing analysis from the market of real goods to the market of 'monied' commodities, this approach implies a definition of money which essentially identifies it with a security which can be sold and purchased in the same way as commodities are. As a consequence, money is included in the GES simply by adding an equation to it, an equation that, according to Walras' law, can be eliminated just like any other equation relating supply to demand: But it must be observed that the argument merely enables us to eliminate one out of the n + 1 equations; it does not matter in the least which equation we choose to eliminate. If we decide to eliminate the money equation, then we can think of prices and interest being determined on the markets for goods and services, and the market for loans; the money equation becomes completely otiose, having nothing to tell us. (Hicks 1946: 158)

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The very reason why the money equation can be eliminated from the system is that it is necessarily implicit in the other equations, and this can only be if the supply of and demand for money are simultaneously the demand for and the supply of some real commodity. This is obviously the case here, where money is a net asset and can therefore only be demanded by supplying a commodity. Essentially, this system does not differ from the traditional one defining the direct exchange of commodities. In such a system money remains completely alien to output and its value totally undetermined. 'The (relative) values of commodities and the value of money become entirely separate questions, even entirely separate subjects; they can be, and have been, handed over to separate specialists to study and even to teach' (Hicks 1978: 159). The preceding conclusion, however, has not discouraged neoclassical economists. The mere fact that any other equation could be eliminated instead of the money equation was sufficient reason to believe that money could, after all, be explained by GE models. Of course, as Hicks had pointed out, money's value has somehow to be explained exogeneously, but this seems to be an easily solved problem since it is generally agreed that money is a security ('money appears simply as the most perfect type of security' (Hicks 1978: 163)) and can therefore be immediately issued with a positive value. That the origin of this value remains mysterious did not trouble the neoclassical economists. Convertibility, legal definition or social agreement seemed to be devices equal to the task of dealing with this problem, and no one thought of reviving the classical distinction between nominal and real money. Yet a difficulty remains: how can money's value be integrated into the real world of products? Known as the neoclassical dichotomy, this problem is the unavoidable consequence of Walras' homogeneity postulate, and seems to imply that in GEA there is no place for money, either as a medium of exchange or as a store of value. Confronted by this extreme point of view, many economists have tried to overcome the traditional dichotomy with a kind of trade-off between real and monetary sectors, with the explicit intention of implementing an analysis of the effect of a rise in the money supply on output and prices. Now, the common characteristic of the various attempts which have been developed by neoclassical economists is that they do not reject the dichotomy at all. As we shall try to prove, in fact, Walras' law cannot be avoided so that even Samuelson's attempt to establish a 'legitimate' dichotomy is bound to remain vain.

The Neoclassical Dichotomy 1.

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'Legitimate7 versus 'traditional7 dichotomy

1.1. The rejection of the traditional dichotomy In his well-known * classic', Money, Interest and Prices (1956), Patinkin starts from the consideration that, in a GES, the commodity markets' equilibrium necessarily implies equilibrium on the money market, and claims that the logical inconsistency between the analysis of exchange (where demand and supply depend only on relative prices) and monetary analysis (where the absolute price level is determined by the quantity of money) can be solved by means of the concept of real cash balances. What has since come to be known as the real balance effect is the mechanism which — according to his 'conceiver' — should account for the integration of money and value theories through the behaviour of economic agents. Often referred to as the neoclassical solution to the dichotomous perception of economic reality,1 Patinkin's analysis has provoked different reactions among fellow economists. The publication of his book caused widespread debate, but we shall refer here to only two of the criticisms addressed to Patinkin's solution. The first was developed by Archibald and Lipsey in a paper published in October 1958 by the Review of Economic Studies. The two authors claimed that the real balance effect is relevant only to short-term disequilibrium situations, and that, in the long run, equilibrium can be determined in terms of relative prices alone. According to their analysis, therefore, real balances are a useless device since it can be shown that 'the disequilibrium level of real balances is uniquely determined by tastes and incomes, and invariant to the money stock' (p. 9). Fundamentally, they argue, Patinkin's charge of inconsistency addressed to traditional theory is wrong, since it is perfectly possible to integrate the homogeneity postulate (demand and supply functions homogeneous of degree zero) and the quantity equation in order to explain monetary and relative prices simultaneously. Against this attack, Patinkin found in Samuelson a generous and subtle defender. In fact, Samuelson not only refuted Archibald and Lipsey's thesis, defining it as 'uninteresting' and 'wrong', but he also claimed that Patinkin's criticism of the dichotomy was unquestionably justified if it was addressed to the 'conventional dichotomy'; that is, the system where a non-homogeneous equation of money (Br) completely decomposable from A' is added to a set of equations determining relative prices (A'). Samuelson's point is that besides this 'traditional' and wrong dichotomy there is a true 'legitimate' dichotomy 'between "real elements" and "monetary elements which determine only the absolute level of prices"' (Samuelson, in Glower 1969: 176). Thus there is a sense

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in which the analysis of Samuelson and that of Archibald and Lipsey are on the same level: they both presuppose the existence of a legitimate dichotomy in neoclassical monetary theory, and they both agree that Patinkin's own positive contribution must be assessed within this theoretical framework. Substantially, it appears that these authors have attempted to elaborate a monetary approach consistent with the analytical structure of neoclassical GES. The differences between their respective analyses do not lie in their definition of money but rather in the way they try to avoid the implications of Walras' law. 1.2. The legitimate dichotomy As Samuelson says, 'There is one, and only one, legitimate dichotomy in neo-classical monetary theory' (in Glower 1969: 178). Thus it would be wrong to believe that the dichotomy is an avoidable consequence of GEA; on the contrary, it is its essential theoretical 'core'. That is why neoclassical authors have tried so hard to prove its fundamental validity imputing the theoretical weaknesses of GEA to a mechanical compliance with Walras' law. Fundamentally, they all accept the definition of money as a 'veil', as the lubricant of industry and commerce (Stuart Mill) or the great wheel of circulation (Smith). Consequently, they also agree that monetary changes should not affect the real sector. We should be able to prove rigorously what is probably intuitively obvious — doubling all M will exactly double all long-run prices and values, and this change in the absolute price level will have absolutely no effect on real outputinputs, on price ratios or terms of trade, on interest rates and factor shares generally. (Samuelson, in Clower 1969: 176).

Yet the complete autonomy of the real from the monetary sector has the annoying consequence of reducing the whole system to a kind of barter economy. In order to avoid this, Patinkin, Samuelson and many others have tried to conciliate the fundamental neoclassical dichotomy with the rejection of Walras' law. Let us briefly analyse the logical assumptions on which Samuelson's solution is based, since they represent the implicit presuppositions of all other neoclassical elaborations. In his famous paper 'What Classical and Neo-classical Monetary Theory Really Was', first published in the Canadian Journal of Economics (1968) and successively reprinted in Monetary Theory? Samuelson sets up to prove that it is possible to base a monetary theory on the 'legitimate' neoclassical dichotomy. His model is essentially formed by a set of equations (A) determining prices relative to the stock of money, and by an equation (B) determining this same stock and,

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hence, the absolute level of all prices in proportion to an exogenous supply of money. The novelty of Samuelson's approach is that the quantity theory's equation of exchange is included in set A in a kind of organic way, and that all the equations in this set are homogeneous functions of degree zero in all prices and M (the supply of money). Now, despite its originality, this approach is not essentially different from the one followed by, say Patinkin or Archibald and Lipsey in that they all introduce monetary variables (though in different ways and clearly differentiating between prices and money stock) into the equations defining the various transactions occurring on the commodity market. Of course, this does not only seem perfectly justified but also highly necessary since it is precisely the aim of monetary analysis to explain and determine monetary variables such as prices and M. If a model is worked out in monetary terms, it is tautological to say that transactions are defined in terms of money. This is undoubtedly true. What is less certain, however, is whether this monetary aspect of transactions can be arrived at simply by introducing real and monetary variables side by side. To be logical, this operation must account for the existence and magnitude of monetary prices, since — as the following quotation from Samuelson's paper clearly shows — money acquires its significance only in relation to output: Set A consists of the Al equations relating to production and implied pricing relations, and of the Au equations relating to long-run equilibrium of zero saving and investment, where technological and subjective interest rates are equal and provide capitalized values for land and other assets. Finally, Am are the demand conditions for the consumer, but generalized beyond the barter world to include explicitly the qualitative convenience of money and to take into account the peculiar homogeneity properties of money resulting from the fact that its usefulness is in proportion to the scale of prices, (p. 182)

What is the problem then? It quite simply consists of the fact that Samuelson's model can be elaborated only if monetary prices are previously determined, which means that the whole analysis is useless since it cannot reach its end, namely the determination of prices. The model can be worked out in monetary terms only if it can account for the supply of and the demand for money. Being exogeneously determined, the supply of money does not create any difficulty. Yet the same cannot be said for the other monetary component of the system. In fact, the demand for money can only be defined on the basis of a given set of monetary prices. If these prices are not known, how is it possible to determine the amount of money demanded in exchange for commodities?

132 Appraisal of Traditional Monetary Analysis

1.3. The logical inconsistency between Samuelson's legitimate dichotomy and Walras' law The specific nature of money is opposed to a mechanical transposition of the traditional general equilibrium model from real to monetary transactions. In particular, it is not true that money prices can be determined by the intersection of demand and supply schedules, since the demand for money acquires a significant meaning only if M can be related to a set of commodities having an already established monetary price. Quite differently from what happens when only real goods are concerned, the demand for money cannot be determined before, or even simultaneously with, the determination of prices. Whereas for the analysis of relative prices it can be claimed that supply and demand are based on a 'principle of utility' which in itself is not dependent on relative prices, for monetary prices this does not apply any longer. Money being a means of exchange, its value or utility is a function of the commodities which can be purchased with it, and this clearly depends on M and on prices. Though money is simply 'like a catalyst in a chemical reaction, which makes the reaction go faster and better' (p. 172), it can play this role only if 'M enters quantitatively in Set A in certain specified homogeneous ways' (p. 173). Despite the efforts of Samuelson, this result cannot be obtained through a GE type of analysis.3 His 'certain specified homogeneous ways' can only be a true integration of money and output which is logically incompatible with a dichotomous view of the economic world. If integration is not achieved, money remains totally unexplained, and prices are necessarily undetermined since — let us say it once again — one of their determining factors (namely, the demand for money) is itself a function of prices as is the utility of money. Finally, money is fully dependent on monetary prices whose determination, therefore, cannot be explained in terms of the demand for money. According to GEA, money is a simple intermediary, a 'catalyst'. It then necessarily follows that 'its usefulness is in proportion to the scale of prices' (p. 182), and that a non-integrated money is a contradiction in terms. As Samuelson states, 'true money — unlike pearls, paintings, wine and coffee — is held only for the ultimate exchange work it can do, which depends upon the scale of all Ps in a special homogeneous way' (p. 172). Understanding this, it is obvious that money does not add to the output's value. And this is the essential meaning of the message brought forward by Walras' law. The fact that the money equation is formally implicit in all the others is an unmistakable sign that money and output are not two different objects facing each other. The entire system of GEA relies entirely on the

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real sector, the numeraire being simply the numerical expression of the product, and not its monetary counterpart. What remains unexplained, of course, is how numeraire and output are integrated. This missing information notwithstanding, it is certain that Walras' law, far from accounting for the general soundness of the neoclassical dichotomy, gives us a precise indication of the way this dichotomy can finally be dismissed. Before analysing this possibility, however, it is worth considering Glower's criticism of Patinkin's approach, since this will give us the opportunity of testing the validity of Walras' law. 2.

The triumph of Walras' law

2.1. Walras' law and General Equilibrium Analysis According to Glower (1969), Walras' law owes its validity to general premises which are taken as axioms by orthodox theorists. Thus the law holds good even when money is introduced in the GES, since money is simply conceived of as a 'mirror image' of the real sector. Even if money is demanded for purposes other than transactions, it is claimed that its equilibrium can always be determined by an equation relating its supply to its demand, both expressed in commodity terms. To demand money is to offer goods, and vice versa, so that Walras' law seems to apply equally well to 'barter' and to a monetary economy. Against this widely accepted approach, Glower claims that what is thought of as a general law is in reality a theorem that can well be proved false in some particular conditions: 'Walras' law is not, after all, an independent postulate of orthodox analysis; it is a theorem which is susceptible of direct proof on the basis of premises which are typically taken as given in contemporary as well as classical price theory' (Glower 1969: 278). Consistently with his interpretation of Keynes' analysis Glower distinguishes between a Walrasian general equilibrium approach where all markets are simultaneously cleared, and a non-Walrasian version of GEA where the excess-demand functions do not conform to Walras' law: 'This more general theory leads to market excess-demand functions which include quantities as well as prices as independent variables and, except in conditions of full employment, the excess-demand functions so defined do not satisfy Walras' law' (p. 279). Glower's argument is simple and clear. Orthodox GES is described by a set of equations where relative prices are the only independent variables; quantities are given and correspond to the amount of goods available, so that, when the system yields a solution, all markets are necessarily cleared. Equilibrium (relative) prices are precisely the prices which allow an exchange between all the goods available on the

134 Appraisal of Traditional Monetary Analysis markets. In a system like this, Walras' law always applies, but what happens if quantities as well as prices are taken as independent variables? It is claimed that the solution of such a system does not generally imply the clearing of all markets. Except when the system is at the fullemployment level, excess demands do not cancel out, so that it is usually inferred that Walras' law is logically inconsistent with this theoretical framework. According to Glower, this situation characterizes every state of involuntary unemployment and, in particular, Keynes's income analysis, since 'incomes are defined in terms of quantities as well as prices' (p. 280). Hence Walras' law ought to be replaced by the less rigorous condition that: the sum of all market excess demands, valued at prevailing market prices, is at most equal to zero. Indeed, since the equality sign applies with certainty only in the absence of factor excess supply, the dual-decision hypothesis effectively implies that Walras' law, although valid as usual with reference to notional market excess demands, is in general irrelevant to any but full employment situations. (p. 292) Glower's thesis, successively taken over by many 'Keynesians', is that Walras' law is valid only in the case of the simultaneous clearing of all markets. Outside these limits the law does not apply, and it would therefore be useless to look for a solution based on it, even if we adopted Patinkin's device of the real balance effect. Glower's analysis is an attempt to show that 'Keynesian economics is price theory without Walras' law, and price theory with Walras' law is just a special case of Keynesian economies' (p. 295). Is it successful? To answer this question it is first necessary to show beyond doubt that GEA requires all markets to be simultaneously cleared. This claim might seem absurd at first. Is it not self-evident, in fact, that in a situation of 'disequilibrium economies' — as Patinkin calls it — there are excess demands which cannot be satisfied or reabsorbed by a variation of (relative) prices? And is it not true that Walras' law implies that all excess demands be nil? If we analyse the traditional formulation of the GES, disequilibrium economics seems to be the exact antithesis of what is stated by Walras. Yet the question cannot be disposed of by a simple and dogmatic reference to orthodoxy. It is true, of course, that the perfect state of general equilibrium is one in which all markets are cleared, but is this a necessary condition for the working of Walras' law? We claim that it is not; that if a system of equations relating demand to supply can be worked out, its solution is perfectly compatible with Walras' law, even if it does not describe a full-employment situation. In other words, the clearance of all markets is not an essential feature of Walras' law, whose

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validity can never be refuted within a GE approach, whether Walrasian or non-Walrasian. The proof is extremely simple, and can be divided into three parts. The first shows that Walras' law holds good for every system of realized exchanges (whether they are said to clear the markets or otherwise), the second that excess demand cannot be determined even within the limits of virtual (or desired) exchanges, and the third that, either directly or indirectly, all markets are always necessarily cleared. 2.2. The logical impossibility of determining an excess demand within a GES

Let us take as an example the exchange of two commodities a and b. General equilibrium theory tells us that exchange will take place at a (relative) price for which demand for a = supply of a (and, correspondingly, demand for b = supply of b, demand for b being equivalent to supply of a, and supply of b to demand for a). Now, logically, this price is not necessarily the price which allows us to exchange all a against all b. In fact, it is perfectly conceivable that exchange takes place without directly clearing the market, in which case we could not say that demands and supplies were not equal, but merely that they equalized at a level different from the clearing one. Every time an exchange takes place it defines an equivalence between its two terms, which means, given the tautological identity of Da = Ob and Oa = Db, that supply and demand are equal for any level of realized exchange. Thus, as soon as exchange is formalized through a set of equations the solution of this system is a set of prices defining a number of identities between demand and supply equal to the number of commodities exchanged minus one. In the case of n commodities the system defines n - 1 relations of equivalence independently of whether they clear the markets or not. The important point here is that every exchange defines a set of realized prices for which demand equals supply, which means that every system defining a realized exchange is perfectly consistent with Walras' law. Each time relative prices are determined through a Walrasian system of equations, the equilibrium is 'general', even though it can be highly unstable. At equilibrium, supply and demand are necessarily equal, and this equality is precisely what is defined by Walras' equations. Glower's thesis is founded on the possibility of supply being different from demand and is, therefore, logically inconsistent with the fundamental axiom of GEA. Based on the indisputable observation that every exchange defines the equivalence of its two terms, this analysis cannot

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be refuted by introducing a gap between D and 5. In fact, only two possibilities are offered to us. Either we consider the GES as an attempt to formalize the relations of exchange as they occur on the market, or we suppose that the relations between commodities can be known before exchange really takes place. In the first case, supply and demand are equivalent whatever the level of relative prices defined by exchange; in the second they can diverge since exchange is only a possible future event. As Walras' law only applies when demands and supplies equal each other, the second alternative seems to justify Glower's argument. On closer examination, however, this proves to be wrong. In the absence of realized exchange, commodities are bound to remain heterogeneous, so that no relationship between them can ever be established. Being defined in terms of commodities, supplies and demands can only be known once exchange has effectively taken place, and it would be hopeless to look for their expression outside exchange: virtual or desired supplies and demands cannot logically be determined. What would be the virtual supply of, say commodity a, given that it has to be expressed in terms of commodity b and that the equivalence between these two commodities can only be determined by their real exchange? In his attempt to transpose (albeit mechanically) Keynes' analysis of effective demand from the domain of production to the sphere of exchange, Glower completely overlooks this difficulty, and that explains why he arrives at the incorrect conclusion that Walras' law could be dismissed within the logical framework of equilibrium analysis. In reality the introduction of desired variables is of no help here, since only real variables relating to realized exchange can enter GE equations. In a Walrasian system it is impossible to have an excess demand function which is not immediately matched by an equivalent excess supply function, given that supply and demand are only two aspects of the same reality: exchange. In other words, the .very concept of excess demand (or excess supply) is ill-founded; since for every realized exchange, supply and demand are equivalent, there is no way of determining any net supply (or demand). 2.3. On the impossibility of determining an excess demand even within the boundaries of 'virtual' exchanges By definition, an excess supply is a supply which is not matched by a correspondent demand. Since Aristotle, theorists agree in saying that exchange determines the equivalence of its two terms. Thus, given that no difference between supply and demand can be found in exchange, excess supply (demand) can only be related to virtual exchange. We are told that during the interval of time separating realized exchanges a set of virtual prices is proposed to the agents (for instance, by the famous

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auctioneer). On the basis of these virtual prices the agents express their willingness to exchange through a series of real demands (supplies). Finally, once these forces find their equilibrium, exchanges can take place, thus determining a set of realized prices. Apparently, this result allows us to claim both that (relative) prices are determined through the adjustment of supply and demand, and that supply and demand are determined relative to prices. In reality, however, these two propositions are mutually exclusive, unless they are related to actual exchange. When commodity a is exchanged against commodity b then it seems legitimate to express supply and demand by relating to the price thus defined. But if exchange is only a probable future event, how would it be possible to determine supply and demand since they both depend on a set of prices which can only be known when exchange effectively takes place? Let us refer to virtual prices as they are cried out by the auctioneer. If, for example, the auctioneer sets a price of \al2b it is perfectly possible that A and B decide not to exchange because they both consider this price unsatisfactory, or because one of them is not prepared to meet the supply (demand) of the other. If A offers ten units of a and B offers ten units of b, there is an excess demand for b which seems to explain perfectly well why the two agents do not exchange their commodities. However, this is only half the story. Before reaching any final conclusion we have, in fact, to establish whether or not by offering ten units of b agent B is effectively demanding five units of a (or, correspondingly, if by supplying ten units of a agent A is really demanding twenty units of b). The answer seems obvious, since the demand for a is tautologically the supply of b and vice versa. But are we really sure that this correspondence is always verified? Is it not true that to pass from the supply of a to the demand for b we have to know the relationship existing between these two commodities? And is it not also true that this relationship can only be determined through exchange? Given the supply of a we can know the demand for b only by deriving it from the relative price of a (b). Thus the tautology can effectively be verified on the basis of realized exchange alone, since it is precisely when exchange takes place that the relative price of a (b) is determined. Hypothetical (virtual) prices, such as those cried out by the auctioneer, define an exchange which is also hypothetical, and this is why they cannot be used to determine an excess demand (supply). Let us try to explain what we mean by this. Of course, we are not claiming that agents A and B do not really offer their respective commodities. It is clear, in fact, that even though the price is virtual, supplies are real. What we are concerned with is whether or not from these real supplies we can infer anything about demands. If, as in our example, A offers ten units of a and B offers ten units of b, can we determine the value of the demand for a and of the demand for b? The very existence of the

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concept of real excess demand obviously depends on the possibility of answering this question positively. Thus our problem is perfectly defined: we have to determine what is the amount of b (a) that A (B) is demanding by offering ten units of a (b). The relative price proposed on the market (\al2b) should provide an easy answer, namely that A is demanding twenty units of b, and B five units of a. Yet this result is correct only if the price on which it is based defines an objective relationship between a and b. To offer ten units of a is in fact equivalent to demanding twenty units of b if, and only if, la = 2b. Since this equivalence can result from exchange alone, it becomes impossible to find any positive excess demand, because exchange always defines the perfect equality between supply and demand. In other words, since virtual prices do not establish any equivalence between a and b (if they did, in fact, they would necessarily define a realized exchange, and would, therefore, no longer be virtual), they cannot explain the passage from supplies to demands which means that they cannot permit any comparison between the supply of and the demand for the same good: excess demand remains a totally virtual concept with no influence at all over the determination of relative prices. A last remark should convince the perplexed reader. When A and B meet on the market, they try to find a combination of price and quantity at which they both agree to enter exchange. They do so by proposing a series of prices derived from the utility they attach to both commodities, a and b. For example, A could agree to exchange ten units of a against ten units of b, while B could be interested in exchanging five units of his commodity against ten units of a. Now, these two virtual prices are not only different but also completely heterogeneous. Outside exchange no unique relation of equivalence can possibly be determined between a and b, so that it would be vain to look for a common evaluation of the prices proposed by A and by B. Is the price of lOa/lOb greater than the price of Wa/5b? It is impossible to answer this question because we only have two different relationships available between a and b giving two opposing results. But if virtual prices cannot be compared, how could they reciprocally adjust in order to determine the price of equilibrium? The heterogeneity of prices explains why supplies and demands cannot be compared outside exchange. By simply observing that by offering their commodity agents are demanding specific quantities of another commodity, we can immediately infer that each of them is proposing a given price to the other. The demand of A is determined by the price he would like to impose on the market, and so is the demand of B. Yet, without a common standard allowing for a unique relationship between a and b, these two prices cannot even be mutually compared. Consequently, it also becomes impossible to establish any comparison between

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supplies and demands, which means that the concept of excess demand is totally undefinable within the neoclassical paradigm. 2.4. The necessary clearance of all markets We now reach the second part of our demonstration. The logical impossibility of defining any excess supply (demand) implies the necessary clearance of all markets. Although this statement seems to be a paradox, it can easily be understood once we take into account not only the direct sale (purchase) of goods on the commodity market but also their indirect sale on the factors market. All the goods that are not directly sold are, in fact, necessarily purchased by firms through the payment of their cost of production. Thus, as soon as we add together direct and indirect purchases, we can immediately verify that the totality of goods has been sold. From the point of view of the whole system, the indirect or forced purchase is as real and effective as the direct purchase, and it would be mistaken to claim that, since products have been only partially sold to the consumers, some of the markets are not cleared. The main point of GEA is that goods are offered in exchange for goods. Supply and demand are therefore expressed in terms of goods, and their equilibrium defines a (relative) price which is also expressed in real terms. Thus, when a firm is offering a product that is not demanded by any consumer, this can only mean that the product is demanded by the firm itself. This is not only true as far as firms are concerned: all markets are necessarily cleared even if the system refers to consumers alone. Let us take again the example of a two-commodity world. It could be said that if the price determined by supply and demand fails to clear the market, one of the agents will have an excess supply not compensated by a net demand from his economic correspondent. This is true of course. But if A does not succeed in selling all his commodities to J5, this does not mean that he is a net supplier. Within neoclassical analysis it is impossible for the supply of one commodity not to define the demand for another commodity. Then, the positive supply of a has to be matched by an equivalent demand, which, at first sight, seems to be a demand for b. But, according to our hypothesis of an excess supply of a, B is not offering any commodity in exchange for a. The demand for b exerted by A can therefore not be satisfied. Deprived of its object, this force finds its raison d'etre only by referring to the same product from the supply of which it first originated: the demand corresponding to the supply of a is the demand for a. Hence the part of the produced goods that is not purchased by B is demanded by A, and the equality between supply and demand is verified both for A and for B, and for the whole amount of goods of which they dispose.

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Summing up, it should now have been established that supply and demand of a given commodity can be evaluated and compared only if the commodities entering these equations (of supply and demand) are made commensurable through the determination of their relative prices. The equivalence being the result of exchange, the only price accounting for the homogeneous evaluation of supply and demand is the price of equilibrium. But the price defining exchange also defines the equality of supply and demand. Within the theoretical framework of GE analysis it is therefore impossible to determine any excess demand since demand and supply can only be mutually compared within exchange transactions which logically entails their very identity. From the preceding argument it follows that Walras' law is verified whether or not the economy is in a situation of full-employment equilibrium. The failure to clear the markets cannot define an excess supply: supply and demand are always equal, since they are determined by exchange, and this process precisely defines their equivalence. Hicks, therefore, was right in claiming that an excess supply of labour on the labour market could not upset Walras' model,4 and he would also have been right if he had added that no excess supply of any sort could upset this model, since excess supplies are inconsistent and undefinable within GEA. Whether we refer to a situation of full employment (defined according to neoclassical analysis) or not, the conclusion is therefore the same: supply and demand are always equal, and their relationship is perfectly consistent with Walras' law. Finally Walras' law cannot be eliminated, either through real balance effects or through the assumption of hypothetical virtual variables determined ex-ante, outside exchange. As in physics the real progress came from the working out of Einstein's relativity theory, and not from the suppression of Maxwell's demon, in economics improvements must come from the elaboration of truly new elements, and not from the far-fetched dualdecision hypothesis, or from the simple suppression of Walras' auctioneer. Notes 1. H.P. Minsky notably says that The "real-balance" effect, identified with Patinkin, becomes the full content of contemporary neoclassical monetary theory' (1977: 299-300). 2. Edited by Glower (1969). 3. The introduction of a paper asset whose transactions are taken to be costless (Starret 1973) obviously does not modify this situation. In fact, it is not sufficient to claim that money is a particular asset allowing for the temporal sequence of exchanges to determine a true monetary economy (which has to be based on the integration of money and goods and not on the simple juxtaposition of a paper asset to the set of goods). 4. See Hicks (1980-1: 142).

Chapter Ten

The Quantity Theory of Money

1.

From Adam Smith to Irving Fisher

1.1. The 'classical' origin of the equation of exchange The attempt to establish a functional relationship between the quantity of money and prices can be traced back to the earliest stages of our science. However, in the beginning it was nbt believed that the quantity of money could determine the price level. On the contrary it was thought that the amount of money necessary for the circulation of goods and services could only be established on the basis of the previous determination of their prices.1 This was the thinking followed by Smith, who emphasized the role played by production and confined the quantity of money to a totally subordinate task, that is the circulation of commodities whose price is already fully determined. Thus, observing that the same piece of metal (or the same bank-note) can be used several times, he concluded that the amount of money used in a given country is much less than the value of circulating goods. But the amount of the metal pieces which circulate in a society can never be equal to the revenue of all its members. As the same guinea which pays the weekly pension of one man today, may pay that of another tomorrow, and that of a third the day thereafter, the amount of the metal pieces which annually circulate in any country must always be of much less value than the whole money pensions annually paid with them. (Smith 1978: 387)

This consideration is not as simple or as self-evident as it first appears. In fact, its implications had far-reaching consequences on the subsequent developments of monetary theory. In particular, according to Smith, the determination of the quantity of money seemed to imply a comparison between two autonomous objects of given value: money and output. The dichotomy between money and output was thus the first important step towards the quantity theory of money, and it clearly announced the neoclassical dichotomy. With the publications of Hume (1826), it became evident that the relationship between money and output could only be analysed in terms of adjustment of separate magnitudes. According to Hume, the ratio between the two magnitudes requires every increase of the amount of money to be matched by a proportional rise in the price of commodities and vice versa.

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It seems a maxim almost self-evident, that the prices of everything depend on the proportion between commodities and money, and that any considerable alteration on either has the same effect, either of heightening or lowering the price. Increase the commodities, they become cheaper; increase the money, they rise in their value. (Hume, in Rotwein 1955: 41)

As Desai (198 la) points out, the first clear formulation of what would nowadays be called the homogeneity postulate can be ascribed to Hume. This postulate is just another expression of the perfect mutual independence of two sectors, monetary and real. As a matter of fact, this clear-cut distinction between the two sectors is not fully perceived by Hume, who claims that an increase in output, effort and employment can be due to an increase in the money supply. Yet the outline of the neoclassical dichotomy can already be perceived. According to many authors, this is particularly clear in the works of Ricardo, who is said to have expressed the quantity theory 'in its most rigorous form to date' (Desai 198la: 17). Following a long-established tradition of reinterpreting classical theories in modern neoclassical terms, these authors classify Ricardo among the first quantity theorists, ascribing him with the paternity of neoclassical dichotomy: This long run output is determined by real factors — labour supply, capital stock and natural resources. Movements in the money stock, either autonomous or induced by government policy, can have no influence on the real output level. . . . Economic theory thus becomes a theory of the long run, and questions of nominal changes in the value of output become divorced from questions of real changes. The classical dichotomy between real and monetary aspects of the economy is achieved by Ricardo. Real factors determine real output and money becomes a veil. (Desai 1981a: 19)

Ricardo is thus seen as an economist for whom 'the eventual influence of money on prices is all that matters' (Desai 1981a: 20). Were this interpretation correct, then it would also be correct to consider Fisher's equation of exchange as a mere mathematical formulation of Ricardo's monetary theory. Let us briefly analyse this equation. 1.2. The tautological aspect of Fisher's equation Let us start with the traditional version of Fisher's equation. MV = PT

The symbols are so well known that there is hardly any need to define them. The meaning of this expression is perfectly clear. It is, in fact, widely agreed that the equation of exchange is a simple tautology with

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no explanatory power whatsoever. Transactions being made in money, the total amount of business transacted in a given period (PT) cannot be different from the total of monetary expenditures in this period (MV). The correspondence between the two terms of the equation is indeed so obvious that Marshall straightforwardly claims that the doctrine based on it 4s almost a truism' (p. 91). Fisher's equation simply shows that any change in M (given V), defines a corresponding change in P (given T). Such a proposition clearly does not need to be proven, since it is quite obvious that the stock of money is proportional to the price level given that PT is just the expression which determines MV. If we know one of the two terms of the relationship, we necessarily know the other: 'The equation of exchange must hold, of necessity, because Mv and/?T are two ways of measuring the same thing, the aggregate value of all transactions taking place over some given time period' (Jackman, Mulvey and Trevithick 1981: 10). Taking exception to this rather negative conclusion, Fisher claims that his equation can be given the far more prestigious status of a theory as soon as we separately consider the consequences produced by a change in M (the quantity of money) over V (velocity of circulation of M), (quantities) Qt (bank deposits) M' and their velocity V. While therefore, the equation of exchange, of itself, asserts no causal relation between the quantity of money and price level, any more than it asserts a causal relation between any other two factors, yet, when we take into account conditions known quite apart from the equation, viz. that a change in M produces a proportional change in M'', and no changes in V, V or the g's, there is no possible escape from the conclusion that a change in the quantity of money (M) must normally cause a proportional change in the price level (the Ps). (Fisher 1911: 156-7)

How can Fisher be so positive in affirming the heuristic status of his equation? Apparently his analysis reveals a simple consideration perfectly consistent with common sense. Is it not factually evident that both the volume of trade and the velocity of circulation are socially determined and that, at least in the short term, they can be considered as constant? And, if so, is it not equally obvious that increases in prices are necessarily equi-proportionate to increases in the quantity of money? Thus it would seem otiose to conclude with Fisher that the equation of exchange establishes a causal relationship between money and the price level: 'We may now restate then in what causal sense the quantity theory is true. It is true in the sense that one of the normal effects of an increase in the quantity of money is an exactly proportional increase in the general level of prices' (p. 157). Despite its attractive simplciity, however, Fisher's conclusion cannot be accepted, since it begs the question: to consider T and V as given

144 Appraisal of Traditional Monetary Analysis

constants cannot have the effect of transforming MV = PT into a causal relationship. The claim that M and P vary equi-proportionally is equivalent to the assertion that the quantity of money is tautologically defined by the price level, and vice versa. Both variables being simultaneously determined, it is not possible to establish an order of causality between them, that is, the question of whether M is to determine P or P M, does not permit an answer. When an exchange takes place it defines an expenditure which can equally well be determined by a given amount of money or by the price at which the transaction occurs. It is perfectly equivalent to claim that x units of money have been spent since the price was equal to x, or that the price was x since the transaction implied the expenditure of x units of money. As in Walras' theory, exchange between two commodities, a and b, defines a unique relative price (the price of a in terms of b or, equivalently, the price of b in terms of a), in Fisher's analysis the equation of exchange can only define one variable: M or, tautologically, P. Yet the analogy does not go very far. In fact, whereas GEA is a serious attempt to determine relative prices on the basis of the equivalence between supply and demand established by exchange, Fisher's equation simply determines itself. If exchange is defined by the equality of MV and PT, it is vain to look for any causal determination between these two terms. In the theory of relative prices, supply and demand can be considered as two somehow autonomous forces whose interactions cancel out only when exchanges take place. MV and PT, on the contrary, are not autonomously determined since, according to Fisher's equation, they define the two faces of the same reality and are jointly determined. 1.3. The attempt to transform Fisher's truism into a functional relationship The unavoidable redundancy of the two terms of the equation notwithstanding. Fisher's analysis has often been considered the first step towards a better understanding of monetary phenomena. In particular, it is still argued that MV = JPTcan give us a better insight into the relationship between monetary and real sectors. Of course, the equation does not integrate the two sectors and thus does not abolish the neoclassical dichotomy: real output determination remains strictly separate from any influence exerted by monetary factors. Yet, although the relationship between money and output cannot be direct, the equation of exchange seems able to account for it and, therefore, to allow for the bridging of the dichotomy. Defining money and prices in such a way that MV always equals PT, the variations of M are related to P on the basis of the quantity of real

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output. From a tautological definition of monetary transactions we pass to a relationship between two distinct masses: money and real output. Autonomously determined, by monetary factors and by production respectively, these two masses are nevertheless related through the equation of exchange. It therefore seems possible to determine prices through the interaction of real output and the quantity of money. The main logical argument against this attempt to analyse price variations in terms of these two masses is, quite obviously, that a tautology can never be transformed into a causal relationship. As we have already argued, in MV = PT there is no direction of causality, the equality of the two terms being a self-evident truth or, in Marshall's own words, a mere truism. The total value of a country's currency, multiplied into the average number of times of its changing hands for business purposes in a year, is of course equal to the total amount of business transacted in that country by direct payments of currency in that year. But this identical statement does not indicate the causes that govern the rapidity of circulation of currency: to discover them we must look to the amounts of purchasing power which people of that country elect to keep in the form of currency. (Marshall, in Glower 1969: 85)

Another objection to Fisher's theory is that it does not even bridge the dichotomy. Even if it were possible to claim that the price level is directly influenced by the quantity of money, it would in fact be useless to evoke this relationship to determine the initial money price of real output. The influence of the stock of money over prices can be exerted if these two terms are previously determined; if not it is completely meaningless to speak of price variations. And the equation of exchange does not explain how prices are determined. Smith relates money income to the quantity of goods that can be purchased with it: 'Their real riches, however, the real weekly or yearly revenue of all of them taken together, must always be great or small in proportion to the quantity of consumable goods which they can all of them purchase with this money' (Smith 1978: 387). Obviously, the quantity of purchasable goods depends on the price at which goods are sold. Here again we are faced with the problem of how to determine prices. The question, however, is not posed on the same previous terms. More precisely, what has to be determined is not the price independently of the stock of money. According to Smith, money is not given exogeneously but is immediately identified with the payment of the costs of production. Consequently, the price is also immediately determined, since it is necessarily equal to the amount spent for financing production: 'The whole price or exchangeable value of that annual produce must resolve itself into the same three parts, and be parcelled out among the different inhabitants of the country, either as the wages

146 Appraisal of Traditional Monetary Analysis of their labour, the profits of their stock, or the rent of their land' (pp. 381-2). Money income and prices are equal since they both define the costs of production. It follows that the quantity of goods that income can purchase is equivalent to the production which has given rise to this income. The determination of prices is the result of the integration between money and output. Since this association is also the result of the payment of costs, it is evident that the total price is necessarily equal to the amount of money income available for the final purchase of the produced goods. Even in Smith's theory, then, money and prices are equi-proportional, but this relation cannot be reduced either to a oneway causality or to a simple tautology. On the contrary, the analysis provides a coherent explanation of price formation, and establishes the identity between income and price which can only erroneously be taken for a petitio principii. Finally, Smith's theory has very little in common with Fisher's. In particular, their analysis of prices is completely different: determined by the process of production according to Smith, they are essentially undetermined in F'isher, who tries to find a solution directly on the commodity market. Resorting to the equation of exchange, however, is hopeless, since the quantity of money can, at most, influence an already determined set of prices. And this proves once more that Fisher's equation has, if any, very little heuristic value. Although it is incapable of determining prices, can this first version of the quantity theory lead to a scientific proposition about the working of a monetary economy? In other words, can the tautology be avoided by the monetarists' reformulation of the theory? 2.

The monetarist restatement

Restated with the explicit intention of integrating part of Keynes's monetary analysis into a neoclassical framework (and with the implicit one of offering a neoclassical alternative to Keynes's theory of the demand for money), the quantity theory has mainly been the result of the work of Friedman and of his school. In order to help the reader follow our critical appraisal of this restatement of Fisher's theory, we shall analyse some of its main features in successive points. 2.1. From tautology to causal relationship Expounded by Friedman in his Theoretical Framework for Monetary Analysis, the modern version of the quantity theory is the result of the conversion of the transaction equation developed by Fisher into the

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Cambridge cash-balances approach. The first step towards Marshall's formulation is represented by the income form of the quantity equation. From MV = PT

(1)

we pass to MV = Py = Y

(2)

where Y stands for nominal national income and y for national income in constant prices. The income form of the equation differs from its original version in that it relates to income transactions rather than gross transactions. Though expressed in terms of money income, equation (2) has, according to Friedman, the disadvantage that it 'completely neglects both the ratio of intermediate to final transactions and transactions in existing capital assets' (Friedman, in Gordon 1974: 7). That is one of the reasons why this equation is considered only as an intermediate step towards the Cambridge version:

M = kPy

(3)

where k is the ratio of money stock to income. The Cambridge equation can formally be made equivalent to the equation of exchange, since k is the reciprocal of V in (2), and since (2) is fundamentally equivalent to (1). Now, this formal equivalence is not fortuitous. As Friedman himself points out, equation (3) is simply a mathematical transformation of equation (2) which, in its turn, is directly derived from equation (1). Strictly related to each other, the three versions of the quantity equation have a major characteristic in common: they are all identities. 'Equations (1) and (2), like the other quantity equations I shall discuss, are intended to be identities' (in Gordon 1974: 6). But if all the three versions are identities, and if they can be obtained through a simple mathematical transformation, it seems obvious that even the more sophisticated version of the theory necessarily shares the same status as Fisher's original equation. This means that if the equation of exchange is a tautology, the Cambridge equation is also necessarily a tautology. Otherwise it should be proven that through a mere mathematical manipulation a truism can be made into a positive theory. It seems an unavoidable conclusion that the quantity theory must be rejected as an attempt to analyse monetary variables on the basis of quantitative considerations. However, the mainstream economists do not reach this conclusion. Referring to the traditional analysis of

148 Appraisal of Traditional Monetary Analysis

Keynes's income equations, they argue instead that quantity equations are just another example of how identities can be transformed into functional relationships: 'As with the national income identities with which we are all familiar, when the two sides, or the separate elements on the two sides, are estimated from independent sources of data, many differences between the two sides emerge' (Friedman, in Gordon 1974: 6). Yet it is a mystery how it could be possible to estimate the two terms of an identity independently of each other in such a way that there can be a difference between them. If A is identical to B each variation of either A or B simultaneously defines the equivalent variation of B or A. Algebraically, an identity is defined as the 'equality of two expressions for all values of the literal quantities, expression of this'. MV and PT (or, equivalently, M and Py) being two expressions of this kind, their values must be equal under all circumstances, which precludes any gap arising between them, even momentarily. Due to its devastating consequences, this conclusion can obviously not be accepted by monetarists, who claim that the unidirectional link between changes in the stock of money and changes in prices is the central feature of both the traditional and the restated quantity theory. Analogous to laws in physics, this relationship was and remains the core of the monetarist paradigm: There is perhaps no other empirical relation in economics that has been observed to recur so uniformly under so wide a variety of circumstances as the relations between substantial changes over short periods in the stock of money and in prices; the one is invariably linked with the other and is in the same direction; this uniformity is, I suspect, of the same order as many of the uniformities that form the basis of the physical sciences. (Friedman, in Gordon 1974: 111).

2.2. The quantity theory as a theory of the demand for money Taking the first exponents of the theory to task for having expressed this uniformity in unduly simple form, Friedman claims that the supposed constancy of the velocity of circulation can be replaced by the more sophisticated assumption of the stability of the demand function for money. The quantity theory is therefore essentially conceived of as 'a theory of the demand for money' (p. 95). From MV = PT to MV = Py, and from this to M = kPy the equation of exchange is thus progressively transformed into an equation where the demand for money is expressed as a function of P, y and k (where k is itself a function of other variables). This change of perspective can easily be explained in terms of the influence that the works of Keynes had on monetary analysis. Seriously challenged by the effective demand theory of income, neoclassical theorists had to work out an alternative analysis of output and

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employment, and they did so by trying to transform the equation of exchange into a functional relationship capable of determining income as well as the price level: 'Thus the 1956 version of the quantity theory combines the Marshallian version with the Walrasian classical dichotomy to provide an alternative to the Keynesian money demand function' (Desai 1981a: 61). In the same way as real variables are determined in a GES through the adjustment of supply and demand, monetary variables are said to result from the interaction of the demand for and the supply of money. The supply of money being exogeneously determined by the monetary system, the analysis is quite naturally built around the concept of the demand for money and its formalization in terms of the Cambridge cashbalances approach: 'The quantity theorist not only regards the demand function for money as stable; he also regards it as playing a vital role in determining variables that he regards as of great importance for the analysis of the economy as a whole, such as the level of money income or of prices' (p. 109). The question we are confronted with at this stage is whether or not the passage from Fisher's equation of exchange to Friedman's equation of the demand for money leads to a fundamental renewal of the quantity theory. In other words, we want to know whether the tautological equality of MVto PTcan indeed be transformed into a conditional relationship or not. One of the first things which has to be noted in relation to Friedman's restatement of the theory is that the original equation is practically split up into two distinct and autonomous parts. M - kPy defines only the demand for money and its value is supposed to be determined independently of the value of the supply, so that their relationship is far from being tautological and can be used to determine P or y. The claim is always the same — the existence of a causal link between the stock of money and prices — but this time the theory seems capable of supporting it. More precisely, Friedman speaks initially of a mutual interaction between money stock and prices 'with money rather clearly the senior partner in longer-run movements and in major cyclical movements, and more nearly an equal partner with money income and prices in shorter-run and milder movements' (in Gordon 1974: 321). Then, on the basis of further empirical observations, he openly suggests that 'the major direction of influence is from money to business' (p. 321). Thus, although Friedman claims that 'timing evidence is suggestive but by no means decisive' (p. 321), he does not reply convincingly to Tobin's attack, since all his empirical results can be taken as positive evidence as to the direction of influence only if timing evidence is itself considered as an 'empirical proof of propositions about causation' (Tobin, in Gordon 1974: 303). From the analysis proposed by Sims

150 Appraisal of Traditional Monetary Analysis

(1972), it clearly follows that the monetarists' claim that the causality runs from money to income and prices rests on the possibility of resorting to statistical evidence and time-series methodology. The post hoc ergo propter hoc principle is fundamental to this attempt to prove that variations on the side of money cause variation on the side of income and prices. Now, this principle is far from being widely accepted. On the contrary, it is well known that sequence and consequence are two different concepts which should never be confounded either in philosophy or in science. We must conclude therefore that Friedman's statement that 'money exerts an independent influence on income' (in Gordon 1974: 322) has the scientific status of an arbitrary assumption unless its validity can be proven logically without any doubtful reference to timing evidence. Apart from the arbitrariness of the direction of causality, the main problem remains that of establishing whether or not prices and income can be determined through the adjustment of the demand for and the supply of money. M = kPy defines the demand for money. The monetary system determines the nominal quantity of money available Ms. What we have to examine is the suggested autonomous determination of these two quantities, and the possible result of their mutual interplay. To do this we shall refer to the apparently straight analogy between monetarists' analysis of income and prices and Keynes's determination of (national) income. 2.3. The demand function for money and the demand function for income According to the traditional analysis of Keynes's theory, income is determined through the interaction of demand and supply. Hence, the supply side being influenced by technical and structural factors, the central role is played by demand, which is said to be a function of income and can be represented either by

For the sake of simplicity let us retain the first formulation. Accordingly, the demand function for income is reduced to the consumption function

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Given the values of the constant, a, and of the marginal propensity to consume, c, it is possible to determine the level of income for which Y = C = a + cY. By analogy, the level of prices and of nominal income is established through the adjustment of a supply of money institutionally and technically determined, and a demand for money which is a function of prices and nominal income &* = fP, y).

In both the Keynesian and monetarist models demand is a function of the variable which has to be determined by the whole system. Of course, this is not surprising since both models have been built following the method characterizing general equilibrium analysis. Thus, in the same way that relative prices are determined by the simultaneous solution of the GES, income results from the solution of an equation whose terms are strictly dependent on income itself. Now, applied to income analysis, this procedure leads to an annoying consequence: supply and demand can only be known at equilibrium and their reciprocal adjustment is therefore logically impossible. Let us explain this last statement. As should be obvious to everyone, the demand for income (DY = C) is real only when it can be related to an existing income. In fact, how could the demand for consumption goods (C) be exerted if income were only virtual? The necessary existence of income for DY to be positive is, however, incompatible with the degree of liberty required for demand to be logically independent of supply. If income has to be determined by the interplay of supply and demand, these two forces must be, at least partially, autonomous. Hence, if one of the two forces — demand — can only be effectively (as opposed to virtually) determined simultaneously with the other, it would be illusory to believe that income results from their adjustment. In reality, whatever the level of income created by production, demand must necessarily equal it, since, according to the theory, every realized income defines an identity between supply (Y) and demand (C). Thus the attempt to transform this identity into a functional relationship seems seriously flawed by the logical impossibility of determining demand independently of an already given income. What then happens to the quantity theory of money? Can the demand function for money be known independently of the equilibrium price level? Let us remind the reader that DM is a function of P and that P is supposed to result from the adjustment between D1* and 5^. But if the demand for money is a function of prices and if prices can only be determined by solving the equation D^ = 5^, how can DM be autonomously established? The demand for money must have its own autonomous existence if

152 Appraisal of Traditional Monetary Analysis it has to play a role in the determination of prices. Yet referring to virtual magnitudes will not do, since only real forces can effectively intervene in a process of adjustment. Likewise, the concept of a reciprocal and simultaneous determination must also be refuted, since if prices and demand for money can only be the twin results of a unique solution, then it would be logically impossible to establish any causal relationship between them. Now, though the theory is thus put in a very critical state it seems possible to find a way out as soon as we reason in terms of successive periods. Let us start at period p0 with a given amount of money MQ and a given level of prices P0. If in the following period, p0, the stock of money is arbitrarily increased by x the public will not be instantaneously aware of this change, so that the demand for money at p1 will still be determined on the basis of p0. The discrepancy between DM (= M0) and SM (= M0 + x) is evident and it seems perfectly licit to infer that their equivalence can only be re-established through an increase in the price level from PQ to Pl. Thus it seems also licit to conclude that the price increase has been caused by the increase in the supply of money relative to the demand for money. Well equipped, the theory should, therefore, be able to confront the difficulty due to the simultaneous determination of P and DM. Yet this is not so. Close examination reveals, in fact, that prices are totally unexplained by the quantity theory of money. Even if Pl could be derived from P0, nothing can actually be said about the determination of P0. To claim that the initial level of prices can be considered as given is no answer. A theory of price is a theory which has to explain how this initial price can be determined. Even the subsequent variation from P0 to Pl is meaningless if the theory cannot explain P0. And, indeed, it is certain that it cannot. The equation Lf* = SM, which should determine PQl can only be established if P0 is already known, and in this case it is too late to look for any adjustment between its two terms. Let us say it once again. If the level of prices, P0, is not known, the value of D^ remains totally undetermined, since it is itself a function of prices. Of course, if it were possible to determine prices, it would also be possible to simultaneously determine the demand for money: but the theory tells a completely different story. According to the quantity theory, prices result from the solution of D** = SM and not D*1 from SM and P. At most the determination of all these variables is simultaneous — a case of mutual interaction — but then it can no longer be claimed that prices are determined by the adjustment of SM and DM. At equilibrium these two forces are always equal, and if DM can only be known at equilibrium (since it depends on P which is known only then) it is clear that their interaction is only a figment of the imagination. Finally, since it is impossible to know the demand for money independently of the level of prices, the theory cannot explain the formation of prices, which, therefore, remain totally undetermined.

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Notes 1.

This path was followed by most of the classical economists, even though in different ways which gave rise to the famous controversy between the Banking School and the Currency School (see Ch. 3).

Chapter Eleven

The Monetarists' Attempt at Generalization

1.

The attempt to integrate Keynes's analysis

1.1. Friedman's theory of nominal income Following his belief that monetarist and neo-Keynesian theories mainly differ in their choice of which key factors determine short-run economic change, Friedman introduces his theory as an alternative way of solving a system of equations which is fundamentally the same for both monetarists and Keynesians: The six equations would be accepted alike by adherents of the quantity theory and of the income-expenditure theory. On this level of abstraction, there is no difference between them' (in Gordon 1974: 31). The six equations to which Friedman is referring are the following:

The first three equations describe the traditional neo-Keynesian model of income determination, whereas the other three define the monetarist approach to monetary analysis. By accepting these equations as his theoretical starting point, Friedman is clearly trying to incorporate Keynes's analysis into a broader framework capable of accounting

The Monetarists' Attempt at Generalization

1 55

both for Fisher's and Keynes's theories as particular cases. This becomes obvious as soon as Friedman introduces the alternative ways of providing the system with the 'missing equation' (p. 31). Of the three approaches it offers us, two define the traditional 'Fisherian' quantity theory and the Keynesian (or income-expenditure) theory respectively, and the last his own restated version of monetarism. By adding the equation

the classical quantity equation can easily be derived from equations (1) to (6) by a simple series of mathematical manipulations. Conversely, the Keynesian multiplier equation can be mathematically derived from the original set of relationships by adding to them the alternative equation

Hence it seems possible to infer that Fisher's theory rests on the assumption that real income is exogeneously determined, whereas Keynes's theory is based on the assumption that it is the price level which is determined outside the system. Friedman's own approach differs from these two in that it is an attempt to use the initial system to work out a theory of nominal income. 'A third form of the missing equation involves bypassing the breakdown of nominal income between real income and prices and using the quantity theory to derive a theory of nominal income rather than a theory of either prices or real income' (p. 34). According to Friedman, neither the traditional quantity theory nor the Keynesian approach are successful in explaining nominal income, their limited purpose being, respectively, that of determining prices and real income. Considering these two approaches as partially unsatisfactory and too extreme, he aims at a synthesis between Fisher's and Keynes's theories based on the assumption that the interest rate is determined by speculators and that the difference between 'the permanent real interest rate and the secular growth of output can be taken as a constant for short period fluctuations' (p. 45). In his own words: This simple model for analyzing short-term economic fluctuations seems to me more satisfactory than either the simple quantity theory which takes real output as determined outside the system and regards economic fluctuations as a mirror image of changes in the quantity of money or the simple Keynesian incomeexpenditure theory which takes prices as determined outside the system and regards economic fluctuations as a mirror image of changes in autonomous expenditures. (P-43)

156 Appraisal of Traditional Monetary Analysis

Despite the differences between the three approaches — which are clearly singled out by Friedman himself and by some of his critics1 — it is significant that they are based on the same theoretical structure which makes them essentially equivalent. By saying this we are obviously not trying to play down the relevance of the observations put forward by many authoritative opponents of Friedman's analysis. We are not claiming that, in the end, 'the basic differences among economists are empirical, not theoretical' (p. 61). What we would like to stress is that, notwithstanding all the theoretical and empirical differences between these analyses, Keynesianism and monetarism stem from the same basic assumption: that income can be determined as the result of an equilibrating process which can be represented by the IS-LM apparatus. This is what makes Friedman's attempt to include the Keynesian approach into his monetary framework possible, thus allowing Tobin to claim that the main issue of the monetarist-Keynesian controversy is 'the shape of the LM locus' (Tobin, in Gordon 1974: 77). 1.2. Friedman's failure to determine monetary prices Let us explain our point by resorting to Friedman's problem of how to divide a change in nominal income between output and prices. In order to solve this problem it is necessary to relate money to real income. According to Friedman, neither the solution proposed by the traditional quantity theory nor the solution offered by the Keynesians is satisfactory since they both rest on the arbitrary assumptions that the change in nominal income will be totally absorbed by a change taking place in only one or the other variable (either in prices or in output). Consistent with his analysis, he then proposes a revised version of the quantity theory and explains what he considers a synthetical approach between the Keynesians and the monetarists. Friedman's approach describes the attempt to mediate the integration of money and output through the intervention of the demand function for money and its adjustment to the supply function of money: The quantity theory is in the first instance a theory of the demand for money. It is not a theory of output, or of money income, or of the price level. Any statement about these variables requires combining the quantity theory with some specifications about the conditions of supply of money and perhaps about other variables as well. (Friedman 1956: 4)

The demand for money plays a central role in this context. In particular it seems possible to solve our initial problem by evoking Friedman's claim that 'as in all demand analyses resting on maximization of a utility function defined in terms of 'real' magnitudes, this demand equation must be considered independent in any essential way

The Monetarists' Attempt at Generalization 1 57

of the nominal units used to measure money variables' (p. 11). Yet this solution rests on the extremely doubtful assumption that it suffices to define real income as nominal income/prices in order to happily 'marry' real and monetary variables. Let us suppose that this definition of real income holds. Then the marriage is possible if we can determine the level of prices independently of the relationship between nominal and real incomes. The two expressions. real

norminal

and norminal

real

are obviously tautological. Hence, if (9) is to be meaningful, it is necessary that P be determined by the same process which accounts for the existence of nominal and real income. In other words, the theory has to provide an explanation of the way output and money are put into a relationship defining P. If it fails to meet this challenge, the theory has to be abandoned and the investigation must change direction. Irrespective of the validity of Friedman's own approach and of his critical survey of previous theories, it is possible to claim that none of the three analyses to which he pays particular attention provides a theoretical account of the way money and output can be integrated. As we have already pointed out, the neoclassical attempted explanation fails since the money equation is simply added to the series of equations defining relative prices. Even in its monetarist version, the neoclassical theory is in fact based on a strict distinction between real and monetary variables, and the system is not essentially different from barter: 'In the monetarist Walrasian economy differences in the money stock, if expected, can affect no real variable. The reason, as already noted, is the homogeneity postulate* (Hahn 1980: 10). Money and commodities remain totally independent in a theory whose main purpose is to explain prices in real terms. In fact, how could it be possible to determine income by introducing into a GES an equation which does not establish any link between money and output? The money equation only relates monetary variables to the measure of monetary variables (M to P), without explaining how they can be associated with commodities. Hence no bridge links the real and the monetary sector, and income remains completely unexplained. Of course, it could still be argued that the very existence of prices proves

1 58 Appraisal of Traditional Monetary Analysis

that, after all, money and output are actually associated. True to the facts, this observation cannot, however, be used to rescue GEA since the formation of money prices is undetermined and simply taken for granted. The following conclusion is therefore unavoidable: traditional neoclassical theory does not provide a consistent explanation of income formation, thus confirming Hahn's claim that 'The Walrasian economy that we have been considering, although one where the auctioneer regulates the terms at which goods shall exchange, is essentially one of barter' (Hahn 1970: 3). What about resorting to the neo-Keynesian framework formalized by Hicks in his IS-LM apparatus? Despite differences in the transmission mechanism, a case could be made for the fact that money and output are associated in the process accounting for the determination of income. However, if we expect to establish this link through the adjustment of 75 and LM, we are confronted with the crucial problem of explaining how the 75 curve can be drawn given that 7 and 5 depend on income and that income must result from the association of money and output, an association that can only be given by the interaction of 75 and LM. Reciprocally, we would have to explain how the LM curve comes into existence, since it also depends on income and, therefore, on the IS-LM equilibrium. Income could be said to be determined at the point where the IS and LM curves meet (Hicksian cross) only if IS and LM can be defined independently of income. This is not a simple problem of sequence which could be solved by the simultaneous solution of the equations of the system, but a much more fundamental question on which the validity of the neo-Keynesian theoretical framework depends. The possibility of reasoning in terms of IS-LM adjustment rests on the assumption that saving and investment can be known and equalized independently of the equalization of the supply and demand for money, and vice versa. Now, saving and investment are functions of r and F, so that both can be known only in terms of income. True, but what keeps us from imagining a series of possible incomes and determining the values of 7 and S corresponding to each value of virtual income? Having already developed a critique to this procedure in other contexts,2 we shall not come back to this. What we can now add is that, logically, the determination of income must be explained before we start considering the series of its possible values. If we cannot explain income, then we cannot explain saving and investment. Likewise, if a theory of income exists, then a definition of saving and investment will follow naturally and consistently from it. This means that the validity of the 75 curve is totally subordinated to the previous elaboration of a theory explaining the integration of money and output. Hence it is not permissible to derive this integration from the process of adjustment between 75 and LM.

The Monetarists' Attempt at Generalization

1 59

Not surprisingly, we once again come up against the same problem of establishing a causal relationship between mutually dependent variables.3 The difficulties are too well known for us to dwell upon them. It is enough to stress therefore that the IS-LM apparatus cannot be found in Keynes's own works, and to deplore the fact that, although overtly criticized by his own conceiver, it is still widely used to (mis)represent Keynes's analysis. Finally, we can conclude that the link between money and output is the first fundamental element in the building of a monetary theory. Without this, nothing can be said about the supposed influences of money supply, the 'adjustment mechanism' and the proportion in which an increase of nominal income affects output and prices respectively. 2.

Keynes's refusal of the quantity theory of money

2.1. Keynes 's critical approach In his Treatise on Money Keynes criticizes both versions (Cambridge and Fisher's) of the quantity theory of money. Against the latter, whose origins can be found in Newcomb's Principles of Political economy (1886), he argues that it is of no use in solving the central problems of every monetary economy 'for neither P2 nor T correspond to the quantities in which we are likely to be interested for their own sakes. P2 is not the purchasing power of money and T is not the volume of output' (Keynes 1930: 210). Were it even possible to determine P — so claims Keynes — this conclusion would not be substantially modified: 'the more accurately we calculate P2 the clearer does it become what a hotchpotch standard the cash transactions standard is and how unreliable as a guide to the purchasing power of money' (p. 211). It is clear therefore that Keynes does not identify the purchasing power of money with the price level of the articles traded (his cash transaction standard), and that he also does not consider the volume of trade (T) as a good approximation of the value of output. The Cambridge version, first proposed by Pigou in 1917, seems to please Keynes more. However, he rejects it too, mainly because it relates only to current income and because it 'entirely obscures disturbances — which in practice are one of the most important types of disturbances — arising out of a change in the proportions in which deposits are held for the different purposes distinguished above as savings, business and income' (p. 208). Having developed a quantity equation starting from Marshall's and Pigou's works on the Cambridge model, Keynes was well aware of the limits inherent in this approach. As he clearly admits, the real balances

160 Appraisal of Traditional Monetary Analysis

quantity equation which he used in his Tract on Monetary Reform (1923) does not determine money's purchasing power and must be replaced by a new set of equations taking into account saving, investment and the rate of interest as well as real and money balances: But it now seems to me that the merging together of all the different sorts of transactions — income, business and financial — which may be taking place only causes confusion, and that we cannot get any real insight into the pricemaking process without bringing in the rate of interest and the distinction between incomes and profits and between savings and investment/ (Keynes 1930: 205)

2.2. On two possible interpretations of Keynes's critical approach to the quantity theory of money What we would like to stress here is that Keynes's critical assessment of the quantity theory of money can be construed in two very different ways. According to the traditional interpretation of his followers, Keynes was fundamentally pointing out the weaknesses of the quantity theory approach, which, according to him, neither accounted for the causal determination of the price level nor for the dynamic transition from one level of prices to the other. The well-known fundamental cquationsof Chapter 10 of the Treatise are thus seen as alternatives to Fisher's and Pigou's equations. An alternative whose peculiarities are often emphasized and opposed to the modern version of the quantity theory. Yet Keynes himself was well aware of the fact that, thus interpreted, his fundamental equations were only a set of the tautologies already expounded by his predecessors. These conclusions are, of course, obvious and may serve to remind us that all these equations are purely formal; they are mere identities; truisms which tell us nothing in themselves. In this respect they resemble all other versions of the quantity theory of money. (p. 125)

If we stopped our analysis at this point we could claim that Pigou was correct in saying that Keynes's 'formula is a variant that forms a more convenient skeleton than the Cambridge equation on which to hang a connected account of the various real causes at work' (Pigou, in Keynes 1973, Vol. XIII: 217). Despite the important differences existing between the analyses of Fisher, Pigou and Keynes, it would therefore be possible to extend them by alternative approaches which could then easily be merged together within the same theoretical framework. Yet much as we would like to, this result cannot be avoided by emphasizing the role played by some variables such as the rate of interest since in the general framework proposed by Friedman the emphasis belongs to any element of the system.

The Monetarists' Attempt at Generalization 161

The solution rests on a fundamentally renewed analysis of Keynes's work. According to this second interpretation, Keynes's equations have to be explained in the light of a novel analysis of money and of a novel definition of its purchasing power. In the first two books of the Treatise we find the clues for the solution, as we have seen in the first part of our work. Here let us simply note that the originality of Keynes's contribution can best be highlighted by contrasting it to the quantity theory of money. As Hayek so clearly pointed out in his Prices and Production, the quantity theory is much more than a simple set of tautologies, it is a serious obstacle towards the progress of our understanding of monetary economics: 'What I complain of is not only that this theory in its various forms has unduly usurped the central place in monetary theory, but that the point of view from which it springs is a positive hindrance to further progress' (Hayek 1931: 3-4). To avoid this obstacle it is necessary to develop a theory whereby money and income are no longer mechanically related through the level of prices but are organically apprehended in their synthetic unity. It is along these lines that Keynes worked out his analysis of (national) income opening the way to a new interpretation of the functional relationship existing between money and output. The neo-Keynesian approach is sometimes very close to a solution based on this new relationship. When Tobin claims that * Keynes certainly included in his system a relationship between real output and the price level, derived from a theory of labour demand and supply' (Tobin, in Gordon 1974: 83) he is on the right track. Unfortunately, the theory of labour is still thought of in terms of the neoclassical adjustment between demand and supply. This is why Friedman can lightheartedly cast this theory aside saying that it "is correct about the price level in wage units; it is wrong about the price level in money units' (Friedman, in Gordon 1974: 143). The distinction between money units and wage units is based on a neoclassical interpretation of Keynes's theory, which does not account for the particular role played by wages in associating real output to money. In asserting that production was to be defined in wage units, Keynes was opening the way to a completely new analysis of income. Having failed to understand his message, his followers constantly hesitated between the intuition that income can be determined independently of the money supply and the logical impossibility of proving it.

162 Appraisal of Traditional Monetary Analysis Notes 1. See Gordon (1974). 2. See Cencini (1984). 3. On the existence of causal relations among dependent variables, see the excellent article by Hausman (1983).

Chapter Twelve The Quantity Theory of Money and the Neoclassical Dichotomy

The neoclassical dichotomy between money and output is not fundamentally refuted by the quantity theory. On the contrary, we shall argue that it is one of its central features, and that it is because of its acceptance that money is sometimes said to be neutral. In particular, we shall try to prove that, taking the form of the distinction between real and nominal income, the dichotomy cannot be disproved by having recourse to the concept of the price level. As a matter of fact, the very distinction between these two kinds of income is highly questionable. Necessarily associated to production, income can neither be purely nominal nor purely real. Yet Friedman founds his analysis on this distinction, and he essentially derives from it the effects of a variation in the supply of money. Identifying money with a net asset, he seems able to avoid the contradiction of mutually opposing two equivalent definitions of the same object (nominal and real income). However, his solution implies that money can no longer be related to output and that its purchasing power remains totally unexplained. Thus, after having criticized Friedman's distinction between real and nominal income and having shown on what restrictive assumptions it rests, we shall conclude that the monetarists' analysis is caught between two extremes: (1) accepting Friedman's distinction and the neoclassical dichotomy with all its negative implications, or (2) refuting the dichotomy giving up the possibility of distinguishing nominal income from real income. 1.

Nominal income, real income and the level of prices

1.1. The macroeconomic equivalence of nominal income and real income In a recent book, Hahn (1982) maintains that, within the quantitativist paradigm, money does not matter if monetary shocks are avoided. Thus the importance of money seems to be limited to^pathological states of disequilibrium caused by the erratic behaviour of monetary authorities. Undesirable changes in the money supply notwithstanding, all that matters is real variables. Money is supposed to adjust, or 'marry', its relative values. Essentially based on the neoclassical dichotomy,1 this

164 Appraisal of Traditional Monetary Analysis

analysis corroborates the claim that, in the absence of external shocks, the economy is perfectly expounded in real terms and through the concepts developed within Walras' GEA. As a mirror image of real transactions, money does not modify this ideal equilibrium. Hence the conclusion that, in a theory where real variables determine each other, money does not pertain to the internal logic of the system. The real working of the economic system is, however, dependent on the variations of the money supply. As claimed by Friedman, an unforeseen change in the money stock can have repercussions on prices and output, thus establishing a relationship between monetary and real changes. Hence the dichotomy seems to be partially brought up for discussion again. Carefully considering the problem, it appears that this impression is essentially founded on the erroneous belief that in order to relate monetary to real variables it is sufficient to observe that, empirically, a relationship of some kind must effectively exists between them. What has to be proven, however, is that the theory can account for this relationship. If it were possible to prove this, of course, it would then also be possible to establish how a change in the money supply can influence prices and (or) output. But, obviously, this result can only be derived from the previous integration of real and monetary sectors. It is only after having bridged the gap between these two sectors that we can solve Friedman's problem. Now, even in its new formulation, the quantity theory fails to explain how money and output can actually be integrated, as is confirmed by Friedman's claim that, in the long run, real income is determined only by real forces, and nominal income only by monetary forces: We have accepted the quantity-theory presumption, and have thought it supported by the evidence we examined, that changes in the quantity of money as such in the long run have a negligible effect on real income, so that nonmonetary forces are 'all that matter' for changes in real income over the decades and money 'does not matter'. On the other hand, we have regarded the quantity of money, plus the other variables (including real income itself) that affect k as essentially 'all that matter' for the long-run determination of nominal income. The price level is then a joint outcome of the monetary forces determining nominal income and the real forces determining real income. (Friedman, in Gordon 1974: 27).

Let us reiterate our argument. Starting from Friedman's quotation we can quite safely infer that nominal and real income are thought of as two distinct functions whose 'factors' are, apart from some negligible effects, mainly kept separate. Thus, as long as the investigation deals with the long run, monetary changes are said to have a repercussion on nominal income alone, the gap between nominal and real income being bridged by the price level. As we already know, however, to define real

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income by relating nominal income to the price level is a mere technical device that tells us nothing about the origin of income, prices and their relationship. Furthermore, the equation real income

nominal income price Level

is completely illogical when income defines the earnings of the society as a whole (national income). In fact, real income is only the definition of current output, whilst nominal income is its monetary expression. If equation (1) were true, then the monetary expression of output would be different from its (monetary) value, an obviously absurd proposition. If current output is monetarily measured by nominal income, and if real income defines current output, then it is hopeless to look for a difference between nominal and real income. This conclusion seems to go against empirical facts; yet it is indisputable that income is necessarily linked to output and vice versa. When we are concerned with national income, then, it is obvious that both nominal and real income define the same (national) product. In this context what can equation (1) mean? How could nominal income be greater than real income, and what would the difference between these two expressions mean? nominal income - real income = ? Of course, if we were concerned only with a particular category of income, then it would be possible to account for a difference, say between nominal and real wages (calling it profit). But at the national level no positive gap exists between nominal income and the sum of real incomes subsequently derived from it. Since the issue is important, let us tackle the problem from another point of view. If, for the production of a given period, 100 units of income are distributed among the different categories of economic agents, nominal income is equal to 100. The level of prices will most probably cause a redistribution of income, it is true, but, finally, the expenditure of these 100 units by the whole community will allow for the purchase of the entire output. Under these circumstances nominal and real (national) incomes are not substantially different. Yet it is argued that nominal income can be suddenly increased without a corresponding increase in production, thus causing a discrepancy between the two kinds of incomes. But how is it possible to increase nominal income without increasing real output? Certainly not by introducing the idea of an unforeseen shock in the money supply since it would be highly erroneous to identify nominal

166 Appraisal of Traditional Monetary Analysis

income with the supply of money. Income is neither a simple nominal concept nor a set of real goods. Using the term 'income' we necessarily refer to an entity which is both monetary and real. In other words, income is the monetary definition of production and, therefore, cannot be reduced to a simple amount of nominal money. Hence the increase in income is also an increase in production (of its economic definition, of course, and not of its physical constituents). Analogously, it is not possible to define a change in real income in terms of physical goods. This set becomes economically significant precisely because it is expressed in terms of money, so that every change in income defines a change in the economic expression of output and, therefore, a change in the output itself (from an economic as opposed to a physical point of view). 1.2. The neoclassical dichotomy and the net asset definition of money Having reached the conclusion that, at a national level, nominal and real incomes are equivalent definitions of the same object, we must now come back to our initial problem: the dichotomous perception of economic events attributed to the quantity theory of money. Is Friedman's claim that 'money is all that matters for changes in nominal income and for short-run changes in real income' (in Gordon 1974: 27) consistent with our conclusion? Obviously not, since changes in either nominal or real income define changes which take place simultaneously in both the real and the monetary sectors, and not only in one of them as the monetarists claim. Friedman's analysis does not attempt to disprove the neoclassical dichotomy. On the contrary it is founded on this principle and that explains why Friedman is not at all disturbed by the distinct role attributed to money in the determination of income. However, contrary to this assertion, it could be argued that it is precisely because money can influence one or the other kind of incomes that the dichotomy is effectively defeated and not corroborated by the quantity theorists. The channels through which money can act are thought of as being interdependent, and, thus, it always seems to be possible to pass from real variables to monetary variables and vice versa. Besides, even the fact that we can easily switch from nominal income to real income by referring to the price level seems to be further proof of this statement. But doubt remains. All these supposed relationships between real and monetary sectors must be explained, but what is the key concept on which the explanation rests? The correct answer is certainly income. Being the monetary definition of output, income is the 'living proof that the dichotomy is in reality an absurd result of a still inadequate

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monetary analysis. Can this conclusion effectively be derived from the monetarist analysis? Is Friedman's concept of income compatible with its twofold definition; that is, does it or does it not derive from the association of money and current output? Once again the answer is no. In fact, if income were seen by Friedman as being simultaneously monetary and real, then the distinction between real forces and monetary forces would appear contradictory to him. The very fact that this distinction is instead one of the central features of his analysis is a clear sign of his implicit acceptance of the neoclassical dichotomy. Hence, as a result of the following argument, even the adjustment process is an arbitrary, hypothetical construction which cannot account for a sudden variation in the stock of money. Let us start from Friedman's claim that a change in the money supply can have an effect on nominal or on real income according to the way other variables (in particular k) react to this change. His analysis is a clear attempt to prove that the distinction between nominal and real income is of paramount importance for economics. Refuting what he calls the implicit identification of nominal with real magnitudes accepted by many fellow economists, Friedman founds his argument mainly on two assumptions: (1) that prices should not be regarded as an institutional datum, and (2) that 'the effect on k is empirically not to absorb the change in M, as the Keynesian analysis implies, but often to reinforce it' (p. 27). Now, within this theoretical framework, the problem we would like to examine is whether or not the consequences of a change in the quantity of money can be determined at all, and if they differently affect nominal and real income. According to Laidler, changes in the money supply can affect the economy either by modifying the level of real wealth or by altering 'the rates of return at which existing stocks of assets will be held' (Laidler 1969a: 508). In both cases the final result on prices and employment is conveyed through a change in the level of aggregate demand and depends on a number of preconditions mainly dependent on the demand function for money.2 Leaving aside the long-lasting dispute between monetarists and Keynesians over the role played by the rate of interest, we can immediately note that the increase in the stock of money is traditionally seen by both schools as an increase in the quantity of purchasing power available on the market. In fact, they both define money as a net asset whose 'mass' is confronted by the 'mass' of physical goods. It is from this confrontation that variations in prices or output are said to be derived. And it is also because of this confrontation that it seems legitimate to oppose real income to nominal income. Issued by monetary authorities with a positive purchasing power, money can apparently be identified with a sum of nominal income. On the other hand, we have a set of physical products (goods and services) defining the object of the purchasing power of money. This set is

168 Appraisal of Traditional Monetary Analysis

precisely what is defined by real income. Hence the quantity of money (national income) is opposed to physical output (real income) and their adjustment is sought through a variation in the price level. The idea is simple. An increase in the supply of money increases nominal income, immediately and for the whole amount of the monetary change, since money is supposed to be issued as a net asset (and, therefore, to be identified at once with a sum of income). Then, according to 'anticipations about the behaviour of prices . . . and the current level of output or employment compared with the fullemployment (permanent) level of output or employment' (Friedman, in Gordon 1974: 49), nominal income can partially modify real income (output) and prices. Let us represent the two 'masses' of real and nominal income by two spheres of equivalent volume (Fig. 12.1).

Figure 12.1

A sudden, positive, change in the quantity of money increases the mass of nominal income leaving the mass of real income momentarily unchanged (Fig. 12.2).

Figure 12.2

The Quantity Theory and the Neoclassical Dichotomy

169

As a consequence of this initial change, real income can also be modified, and the final situation could, for example, be as shown in Figure 12.3Real income

Nominal income

Figure 12.3

In this case the initial situation of equivalence could be restored only through a change in prices, which would pass from a level of p0 to an increased level of pl. Thus, considering the effects of a variation in the money supply, we can easily verify that (always according to the restated version of the quantity theory) the change in real income is subsequent to the change in nominal income, and seems capable of reducing the initial change in the level of prices. From the situation shown in Figure 12.1 to the one shown in Figure 12.2, in fact, prices vary more than from Figures 12.1. to 12.3, where the gap between real and nominal income is partially filled by an increase in output. The central assumption on which the entire argument rests, is the identification of money with a net asset. Having already discussed the theoretical validity of this hypothesis (See Ch. 8), let us simply remind the reader that its acceptance also implies acceptance of the neoclassical dichotomy because money and products are confronted as two opposing assets, without being integrated in the same, homogeneous, * space'. But we could again ask, what about prices? Do they not establish a relationship between nominal and real income? We already know the answer. Prices cannot bridge the gap between money (issued as a net asset) and output since their own existence is possible only if this gap has already been bridged. Obviously, if prices result from the association of money and current output, they cannot simultaneously be considered the cause of this particular relationship. To explain prices we have to solve the dichotomy, and it would be illogical to claim that the dichotomy itself can be defeated by resorting to prices.

170 Appraisal of Traditional Monetary Analysis 2.

The necessary equivalence of nominal income and real income

2.1. The purchasing power of nominal income Another consideration concerning the net asset definition of money can be introduced here. Assuming that banks have the metaphysical faculty of issuing purchasing power ex-nihilo, is it possible to determine its magnitude simply by comparing the amount of nominal income with the amount of real income? Of course, the purchasing power of money is defined by the value of goods which can be bought with it. Thus the problem is to determine which part of current output can be bought by the newly issued money. Once again the answer requires previous knowledge of prices, and once again we cannot solve the problem unless we explain how money and output are related to one another without assuming the pre-existence of prices. Referring to the costs of production seems to be the quickest solution. But, within the neoclassical framework, the cost of production is itself determined by prices. The circularity is evident: prices are supposed to be explained by (the cost of production which is strictly dependent on) prices. And so the conclusion is definite. The purchasing power of money remains a mysterious concept as long as money and output are kept separate and the dichotomy triumphs. Finally, the distinction between nominal and real income rests on the possibility of opposing money (as a net asset) to output. But this opposition is the sign of a perfect dichotomy between real and monetary worlds which leaves prices totally unexplained. It then follows that both nominal income and real income are also unexplained by the theory, since, within the neoclassical paradigm, their relationship is essentially based on prices. Though annoying, this result is not really surprising. The attempt to associate current output (real income) with money is in fact rather curious when money is defined as an autonomous net asset issued by monetary authorities. What kind of relationship can be established between goods produced at a positive cost and monetary assets issued without cost? How can money be equivalent to (have the same independent value as) current output? An answer can be given only if money and output are integrated through the process of production, that is only if the product becomes the object defined by money. In other words, money can be a net asset only if it defines a real income. This means that money can never increase the amount of nominal income without simultaneously increasing the amount of real income.3

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2.2. The reciprocal definition of nominal and real income If money were issued as a net asset, then of course its emission would increase nominal income leaving the amount of real income unchanged (at least in a first stage). If, on the contrary, money cannot be issued as a net asset, the increase of nominal income caused by the activity of banks (monetary authorities) is necessarily nil. The subsequent transformation of money into a net asset which (being the result of production) increases real income,4 also increases nominal income (the amount of money paid out to the factors of production). Since nominal income is the monetary definition of real income and, reciprocally, current output is the real content of nominal income, these two categories of income never exist one independently of each other. The refusal of the neoclassical dichotomy requires therefore nominal income and real income to be two equivalent definitions of the same object. The result of the last paragraph has to be supported by positive analysis showing how money can effectively be associated with current output, which was the purpose of the first part of our work. In this critical assessment of traditional theory let us confine our study to a few remarks. As we have already repeatedly claimed it is possible to show that Friedman's attempt to distinguish between nominal and real income fails. Because of the net asset definition of money accepted by the monetarists, no relationship between output and money can ever be accounted for. Real output on one side and nominal income on the other are considered as two separate entities which have to be equilibrated through a variation in the level of prices. However, prices themselves are determined by relating money to product and, therefore, they cannot simultaneously be the necessary condition and the result of this relationship. Thus, unless the dichotomy is definitively removed, prices as well as nominal and real income are bound to remain logically undetermined. What is the main reason for this indeterminacy? Why does the dichotomy triumph over the monetarists' distinction between nominal income and real income? According to our analysis, this is essentially due to the attempt at establishing an external relationship between money and output. And this attempt is logically implied in the definition of money as a net asset, issued independently of current output and opposed to it as an autonomous positive entity. To defeat the neoclassical dichotomy the relationship between money and product has to be internalized, this process implying the refusal of the traditional definition of money in favour of a new definition founded on Smith's concept of 'great wheel of circulation' and Walras' concept of numeraire.

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Appraisal of Traditional Monetary Analysis

Notes 1.

It is perhaps useful to note that the dichotomy to which we are referring cannot be reduced to a mere methodological procedure of simplification introduced in order to allow for an easier analysis of reality. If Coddington's (1983) claim that dichotomies are simply analytical procedures were true, then we should not be at all worried about the problem posed by the gap existing between real and monetary variables. Resulting from a methodological choice, this gap could always be avoided by resorting to another kind of approach found within the same theoretical framework. In reality — as has been proven by the continuous effort to get rid of it — the dichotomy is not a matter of free choice but the unavoidable result of a whole theoretical paradigm. 2. This problem is rigorously investigated by many authors. See, for example, Friedman (1970a) and Laidler (1969). 3. In order to explain inflation we must therefore refer to Ricardo's distinction between nominal and real money and not to Samuelson's distinction between nominal and real income. See Schmitt (1984). 4. The order of succession is here logical and not chronological, the two operations being in fact simultaneous.

Chapter Thirteen

The Neutrality of Money

1.

The neutrality of money and the neoclassical dichotomy

1.1 The homogeneity postulate within Walrasian and non-Walrasian models In his presidential address to the American Economic Association (1968) Friedman clearly exposed the concept of money neutrality as a direct implication of the homogeneity postulate. In short, it was meant to show that a change in the quantity of money has no effect on output and velocity, both of which are essentially determined by real forces. Hence a change in M would lead to a proportionate change in the level of prices, thus corroborating the claim that economic systems are best investigated by neatly distinguishing between real and monetary sectors. According to the monetarists, however, the neutrality of money is only verified in the long-run, the short-term effect of a variation in M being characterized by a possible change both in the levels of prices and of output. In the words of Stein, we can say that the monetarists 'believe that there is a short-run trade off between the speed at which inflation is reduced and the temporary rise in the unemployment rate' (1981: 139). Pushing the dichotomy to its extreme consequences, the so-called new-classical economists1 take a more rigorous position, and claim, that, even in the short-run, anticipated monetary changes affect the price level without modifying either the level of output or velocity. The neutrality of money is therefore a central feature of New Classical Economics (NCE). As Tobin tells us, the NCE 'relies heavily on the neutrality of money, even on super-neutrality, and applies the 'classical dichotomy' to continuously moving equilibrium' (1981: 35). For the sake of precision it must, however, be stressed that this new school of thought does not discard the possibility of interferences between monetary and real changes. According to Lucas — unanimously considered to be the father of the rational-expectations school — monetary fluctuations 'lead to real output movements in the same direction' when 'the information conveyed to traders by market prices is inadequate to permit them to distinguish real from monetary disturbances' (1981: 84). His work is an attempt to reconcile the neutrality of money with the unpredictability of monetary changes by resorting to the rational-expectations hypothesis (i.e. to the assumption

174 Appraisal of Traditional Monetary Analysis

that the forecast error is a serially uncorrelated term with a zero expectation). Taking the limits posed by Lucas into consideration, it seems legitimate to claim that, within the rational-expectations approach, money neutrality is a result which holds good both in the short-run and the long-run. As is suggested by Hahn (1980), this conclusion rests on the assumption that rational-expectation equilibrium is unique. But in its turn this assumption presupposes that 'the equilibria of the economy are homogeneous of degree zero in money stock and in current expected prices' (p. 2). Thus, clearly unsatisfied with the analysis developed within the NEC paradigm, Hahn sets out to prove that the homogeneity postulate does not pertain only to the Walrasian model on which this analysis is based. Referring to Tobin and Buiter's (1976) investigations, Hahn claims that the existence of several possible equilibrium values of P and T (due to the fact that even in full rational-expectations Walrasian equilibrium 'the behaviour of the government sector has implications for equilibrium velocity and for equilibrium level of real output that is produced by a given labour force' (Hahn 1980: 9)) is perfectly consistent with the homogeneity postulate. From this first conclusion he infers that the homogeneity postulate is also valid within the non-Walrasian equilibrium approach. The difference between a Walrasian and a nonWalrasian economy is therefore a matter of intensity, the non-Walrasian model allowing for a broader conception of the homogeneity postulate which 'is now insufficient to rule out a dependence of natural value on the money stock' (p. 10). Hahn's argument is particularly interesting in many respects. His central point is that the NCE is founded on an assumption — derived from the Walrasian model — that is neither sensitive or correct. He claims, in fact, that the acceptance of a unique rational-expectation equilibrium requires us to abstract from very important phenomena such as the distributional effects. This seems to support the incorrect idea that the homogeneity postulate implies the perfect invariance of the natural values of real variables to the quantity of money. According to Hahn's analysis, however, this postulate can be true even in a nonWalrasian framework, that is in a setting allowing for real effects of monetary change. Hence the validity of the homogeneity postulate cannot be limited to the case of equi-proportionate changes in prices. Actually, once this conclusion has been understood it should become evident that it can also be applied to a Walrasian setting permitting more than one equilibrium. It follows that the homogeneity postulate can be true both within the Walrasian and the non-Walrasian models, the difference between these two models being reduced to the fact that only one of them (the non-Walrasian) accounts for different levels of involuntary unemployment:

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175

There is still a large gap between the homogeneity postulate and the proposition that the doubling of the money stock at each date and in each state will lead to a doubling of all prices in each state at each date. This gap I think is wider in non-Walrasian economies than it is in Walrasian ones. In the latter if there are many equilibria they none the less have it in common that there is no involuntary unemployment in any of them. In the non-Walrasian case one equilibrium may have less involuntary unemployment than another. In both cases however the stability question is quite unsettled. We do not even have many plausible adjustment mechanisms, and we have none that can be deduced from the first principles of rational actions. (Hahn 1980: 15)

1.2. Hahn's refusal of the neutrality of money Apart from the obvious interest which should be raised by Harm's claim about the lack of a rigorous dynamic analysis characterizing both Walrasian and non-Walrasian approaches, it could be worthwhile to investigate the way the concept of money neutrality is influenced and eventually modified by his definition of the homogeneity postulate. At the beginning of this chapter we stated that, according to the monetarists, money neutrality is a direct implication of the homogeneity postulate. Hahn refutes this result and claims that homogeneity does not necessarily imply neutrality. His analysis is a rigorous attempt to prove that money is not neutral, whether monetary changes are random or not. Monetarists as well as new-classical economists accept the possibility of monetary changes having real effects (in the short term) when shocks in the quantity of money are unforeseen. But they also maintain that fully anticipated monetary changes are perfectly consistent (in the longrun) with the concept of neutrality. According to Hahn, however, 'fluctuations in output and employment may occur even with a perfectly predictable monetary policy' (1982: 45). Real changes would therefore always be possible in a monetary economy, a conclusion which is substantiated by Tobin and Buiter's proof that variations in the quantity of money are not a necessary condition for changes in the level of prices2. Clearly opposed to the neutrality of money, this analysis does not, however, imply the rejection of the homogeneity postulate. From Hahn's point of view, homogeneity can in fact be verified for a whole series of non-Walrasian (or Walrasian) equilibria. And if the homogeneity postulate is verified within a non-Walrasian model, it does not 'rule out a dependence of natural values on the money stock. For one theory the agents may hold is this: if the money stock is higher, then demand for goods will be higher' (Hahn 1980: 10). From what has just been said it follows that the concept of money neutrality is seriously challenged by Hahn's investigation of what he

176 Appraisal of Traditional Monetary Analysis

calls 'rational conjecture-expectations equilibrium model' (p. 6). What we are particularly interested in, is whether or not the refusal of neutrality implies the long awaited defeat of the traditional dichotomy between real and monetary variables. To answer this question we have first to determine what kind of relationship (if any) exists between the concepts of neutrality and dichotomy. In fact, though they are sometimes used as if they were synonyms, these two concepts are as different, fundamentally, as prices and quantities are. Traditionally, the neutrality of money is identified with the independence of real variables from changes in the stock of money. By this it is meant that, at least in the long-run, changes in M lead to proportionate changes in the price level leaving unaltered the level of real output. The concept of dichotomy, on the other hand, defines the total absence of any relationship between real and monetary variables. In its purest form, then, the dichotomy is inconsistent with money neutrality since prices (on which this last concept heavily rests) are bound to remain undetermined in a world where no relationship can ever be established between money and output. Prices can be explained only if the dichotomy has been definitely removed. Thus the traditional concept of neutrality can only be introduced once money and output have been associated through the determination of prices. The whole discussion about the validity of that concept is founded on the possibility of this association. Hahn's argument obviously presupposes the existence of money prices as do the arguments put forth by monetarists and new-classical economists. The refusal or the acceptance of money neutrality is therefore of no consequence to the dichotomy, which is supposed to be successfully tackled from the start through the predetermination of prices. It may be worth reminding ourselves of the arbitrariness implied in this assumption. The fact that prices do effectively exist in our economies is certainly a good enough reason to try to explain them theoretically, but it would be erroneous to infer that, given their real existence, they can be defined as initially known variables. The fundamental problem is not whether (or not) these variables partially or totally absorb the effects of a change in the stock of money, but whether they can be assumed as initially given. If money and output are integrated in a homogeneous set of relationships, then prices can be explained, but if they are not (and this is the sense of the traditional dichotomy), it would be meaningless to look for the influence of monetary changes on prices which cannot even be determined. And this certainly is the case here. Neither the monetarists nor the Keynesians are successful in solving the problem posed by the dichotomous appraisal of reality. In both their theories monetary prices remain essentially unexplained because money is either defined as a commodity (in which case the system is equivalent to a barter economy) or as a net asset,

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whose value depends precisely on the set of prices which it should determine. As clearly appears, the definition of money is essential to the correct understanding of the dichotomy and of neutrality. Let us therefore go back for a short moment to the Hahn-Friedman (Lucas) controversy and re-examine it in the light of the net asset definition of money. 2.

The concept of neutrality and the definition of money

In the first part of this section we shall argue that to refuse the idea of money neutrality (as Hahn does) is a consistent implication of the net asset definition of money chosen by the monetarists as well as by the Keynesians, while in the second part we shall suggest a new conception of money neutrality compatible with a new definition of money. 2.1. Neutrality and the net asset definition of money Money is traditionally identified with a net asset issued by the banking system: 'an asset to its holders but a liability to no one'. The stock of money is therefore endowed with a positive value and can be compared to other stocks on this basis. Both Walrasian and non-Walrasian models are founded on this assumption, their disagreement being related to the number and role of assets other than money, and not to the nature of the money stock. Thus, according to Hahn, while the Keynesians take into consideration all kinds of stock, the monetarists confine their analysis to the stock of money. To a theorist, competitive excess demands depend not only on prices and the stock of money hut on stocks of endowments of all kinds. In describing the dynamic motions of the system one needs to have equations describing the movements of all the stocks. The Monetarists, by simply ignoring all stocks other than money, do not have such equations. They should not be surprised then if one does not share their unfounded confidence in the well mannered performance of the economy. (Hahn 1982: 61)

Whether we consider one model or the other, it is always true that money is supposed to be issued as a net asset and that its influence on prices and output is investigated starting from this assumption. What does it mean, then, to state that money is neutral? Can a thesis claiming that an increase in the quantity of money has no influence on real variables be consistent with this definition of money? As repeatedly stated by Friedman, a change in the stock of money is a change in nominal income. In the absence of error, the rationalexpectation hypothesis ensures that non-random monetary changes do

178 Appraisal of Traditional Monetary Analysis not affect the natural value of real variables so that the variation in nominal income does not modify the value of real income. Realized through a proportional change in the level of prices, this constancy of real output requires the uniqueness of rational-expectation equilibrium and can be criticized by resorting to Hahn's arguments (redistribution effects, cost of price adjustments, uncertainty, changes in the asset composition).3 The traditional neutrality postulate can also be challenged on more fundamental grounds. In fact, if monetary changes have a direct influence on nominal income, they can hardly be considered neutral since income is nothing other than the monetary expression of output. If, by issuing money, banks increase the amount of nominal income, they also increase the nominal value of current output, and this nominal change is far from being neutral. Why is it so? Real income is determined by production, and if the money stock is increased without modifying production, how could this change have any real effect? The answer is simple and is founded on the classical argument that commodities can be economically determined only in monetary terms. Being physically heterogeneous their aggregation is impossible unless they are related to the same common denominator: money. But this conclusion has as a necessary consequence the logical equivalence of nominal (national) income and real (national) income. Although we have already discussed this astonishing result, we do not expect the reader to be fully convinced of its ineluctability. The attempts to express output in purely real (physical) terms is as ancient as the origins of our science. Yet neither Ricardo nor Sraffa succeeded in determining an invariable standard of value. Moreover, it has recently been proven4 that this problem cannot be solved by resorting to exchange either. The conclusion is therefore unavoidable. The economic definition of produced goods and services requires the intervention of money so that real output can only be determined by money income since no distinction is possible at a national level between real and nominal income. Every increase of nominal income is therefore an increase in the economic expression of what are traditionally called real variables. Under these conditions, what could be the meaning of money neutrality? Real and monetary variables are so strictly interrelated that the concept of neutrality has no longer an heuristic value if it is used to describe the traditional neoclassical dichotomy. Indeed, it is obvious that the equivalence of real and nominal income is so strong that it is opposed to any kind of dichotomy between monetary and real variables. Hence, if we give neutrality the traditional meaning proposed by the monetarists, the two concepts of neutrality and dichotomy share the same destiny; the refusal of one of them necessarily implies the rejection of the other. Even though the homogeneity postulate is

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essentially different from the traditional dichotomy (for this postulate implies the existence of money prices which cannot be determined if the dichotomy is effectively verified), the integration of monetary and real sectors through the equivalence of nominal and real income does not in fact admit of a monetary change having no repercussions on real variables. Thus the perfect equivalence of monetary and real variables seems to entail the logical impossibility of establishing the neutrality of money. 2.2. Towards a new definition of the neutrality of money The conclusion we have reached in the last section has a very annoying consequence: when applied to the traditional monetary framework, the equivalence between real and monetary variables does not allow us to determine any kind of disequilibrium. Inflation and deflation are irremediably out of reach if the theory identifies money with income from the very moment of its emission. Within the net asset definition of money, the equivalence of nominal and real income leads to the erroneous confusion of two distinct operations: production on one side and money emission on the other side. Thus, being issued as a positive amount of nominal income, money increases the economic value of current output without it being possible to determine whether or not this increase is associated with real production. If, for example, the money issued by banks for a given period is equal to 100, the output of this same period is also equal to 100. If banks now increased their emission to 110, output would also increase by the same amount, but it would be impossible to know if the corresponding production is of 110 or of 100 — since, let us say it once again, money issued by banks is immediately identified with (nominal) income, and output (real income) can only be defined in terms of money. What,is at stake is not the equivalence of nominal and real income but its consistency with the net asset definition of money. The equivalence is the necessary result of the integration between the real sector and the monetary sector, and as such it cannot be dismissed unless we believe in the possibility of explaining economic phenomena through their dichotomous appraisal. The scientific necessity to investigate reality beyond its appearance is, however, clearly opposed to this alternative approach. The identification of money with nominal income, on the other hand, is a mere assumption whose justification relies on an extremely descriptive monetary analysis which does not succeed in catching the true nature of modern (bank) money. It is therefore quite natural to ask how money could be better defined and what would happen if a new definition were to be introduced in the theoretical body of economic analysis. As the reader can easily realize, the answer to these questions can only follow from a rigorous inquiry into the nature of money as well as income.

180 Appraisal of Traditional Monetary Analysis The independence of real changes from monetary changes is a condition which cannot be respected when money is defined as a net asset. But for what reason should we be bound to look for this independence? If the identification of real variables with monetary variables is the only possible solution to the dichotomy5 there is no point in trying to avoid it. And if this implies the refusal of the traditional concept of money neutrality, let us abandon it. From this conclusion we should, however, not infer that money can never be proven to be neutral. Let us suppose, for example, that money can be neatly distinguished from income and that banks have no possibility to create income. Then, as a pure number, deprived of any intrinsic value, money is effectively neutral. If, nevertheless, money defines current output, it is because it has been associated with it (through the process of production), and not because banks have the faculty of issuing a positive income. In our example, money results from the issuing activity of banks, income from production. Thus their identification is not given a priori as an implicit condition of the equivalence between real and nominal income. This equivalence does not result from the identity of money and income (as in the traditional theories) but, on the contrary, it is what explains how (valueless) money can be changed into income. In other words, with our example we are here suggesting that money is issued as a pure number whose economic significance is given by its association to current output. Money acquires, therefore, a positive existence only through this association since it is only through it that money defines the produced goods (and services) and is instantaneously transformed into income. Thus, since money as such has no positive value,6 it is obvious that it cannot have any influence on real output. It is production that gives a value to money and not the other way around. Hence, in our example, money is immediately construed as a neutral tool offered to the economic world in much the same sense as mathematics is offered to physics. In Part I of this book we expounded some of the principles on which this new approach to monetary analysis rests. We can therefore conclude our critical appraisal of traditional theory by reminding the reader that money is all that matters in a world where money is the only possible economic form of real output. 'Money then is not something trivial, which pure theory can afford to ignore. Without money, production would be instantaneous consumption and economics would have no object. Money is not matter, but the form which goods take in non-nil duration and is the only conceivable mode of existence for products in time' (Schmitt 1986: 126).

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Notes 1. Lucas, Sargent and Barro are some of the most distinguished members of this school. 2. See Tobin and Buiter (1976). 3. As a matter of fact, some of the arguments introduced by Hahn do not pertain to the problem of money neutrality. If we refer the expression 'public expenditure' to the financing of state production (any possible kind of public works), then it is immediately clear that this activity has both a monetary and a real aspect. The production of roads increases real output as well as the amount of available income. Thus the problem of money neutrality obviously cannot be related to this kind of public expenditure. It is only when the stock of money is increased without a simultaneous increase in production that Friedman's thesis becomes meaningful. The role of monetary authorities and particularly of banks (commercial banks as well as central banks) is of the uppermost importance here. By issuing money, banks can effectively increase Af, and only a rigorous analysis can tell us whether or not this operation affects the value of real output. 4. See Cencini and Schmitt (1976). 5. As should have been proven in the first part of this work, this is not a simple supposition but the unavoidable result of the integration between real and monetary variables. 6. Which means that money as such has also no positive existence since it is simultaneously recorded as an asset and a liability of the same agent. See Chapter 2.

Epilogue

Inflation, erratic fluctuations of exchange rates, capital flight and external debts are among the most well-known examples of the disequilibria characterizing the actual working of our monetary economies. The unprecedented importance of these pathological events shows both the centrality of the role played by money and the still unsatisfactory level of our understanding of its true nature. And this is certainly one of the reasons why economics is so often described as the Cinderella of sciences. Its heuristic value is far from being generally considered on the same level as its more praised step-sisters, and economists themselves seem reticent to claim an indisputable scientific status for it. The fact is that economists have not always been able to define the object of their science's inquiry clearly. In particular, they have traditionally hesitated between a physical and a monetary description of economic events. Throughout the short life of economics, these two different approaches have been intertwined and this is why money has for so long been identified with a particular commodity (traditionally silver or gold) or with a net asset. Yet it is also true that from a material conception of money the analysis soon passed to the more sophisticated concept of an a-dimensional standard of value. The origins of this approach can indeed be traced back to Smith's great wheel of circulation, to Marx's form of value and to Walras's numeraire. Both the classical economists and the founders of neoclassical economics were confronted with the difficulty of interpreting a system that was strongly based on the unanimously recognized power of gold. Nowadays this difficulty no longer exists. Book-entry money cannot be converted into gold and its direct link with the physical world is through the electrical impulse feeding the computer system of the issuing bank. Empirical observation corroberates the intuition of both the classical economists and of Walras and gives weight to the idea that money is nothing other than a numerical standard. The quantum-theoretical approach introduced in the first part of this book is essentially based on this idea. In contrast, the quantity theory, either in its original version or as it has been reformulated by the monetarists, remains anchored to the dimensional conception of money and this explains why it does not succeed in providing a satisfactory analysis of our monetary economies. Conceived of as a net asset, money is not essentially distinct from real output and it basically remains an element of the commodity set. But then how can we avoid the conclusion that the system described by the theory is not a monetary system

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at all? Moreover, if money were a net asset, how could it be created by banks? The shortcomings of the traditional approach to monetary analysis are evident. Yet it cannot be denied that this approach was mainly concerned with the determination of money's purchasing power and that every theory of money has to provide a consistent solution to this problem. As has been established by quantum analysis, money is a-dimensional: a purely numerical object created by banks through their spontaneously incurring a debt. But money defines also a positive purchasing power over the produced output. The problem is therefore to reconcile these two definitions without attributing any metaphysical power to banks and without adding the value of money to the value of output. The solution can be arrived at by starting from the analysis of value. Like money, value was first considered to be dimensional. The absolute value of output was then identified with labour-time and its standard with a unit possessing the same dimensional properties; that is, it was conceived of as being itself a product of social labour. The theory proves, however, that value is not a substance and, therefore, that its unit of measure can only be numerical. The set of integers is all we need to express the value of goods, provided we can find a way of associating output to some elements of this set. But this is precisely what is required in order to explain the passage from nominal to real money. Nominal money is just a set of numbers which shows that book-entry money is the a-dimensional standard of value the theory has so long been looking for. Real money, on the other hand, is much more than a set of numbers: it is the produced output itself. Through the association of (nominal) money and output, commodity values are given a numerical expression. This is how physically heterogeneous objects acquire the commensurability of numbers. And this also explains how it is that the value of money is not added to the value of output. In short, what the classical economists called 'money's worth' is current output. Reciprocally output is made identical to a sum of money so that the net wealth of society is given by the amount of money to which current output is associated. What we have tried to show in the first part of this book is the way quantum theory achieves this result. Issued by banks as an asset-liability, money is associated to output through the payment of wages. It is through this payment that income is created as the very definition of output. What had been so clearly intuited by Smith is therefore definitively established by the new theory: income and physical output are the two identical faces of the same object. The central concept of the quantum-theoretical approach is that of emission. Classical economists had already put forward the idea that to produce is to create but they were never able to substantiate their claim,

184 Epilogue which resembled a metaphysical assumption rather than an economic principle. The fact was that value was still thought of as a substance and that the creation of a substance is not within the capacity of human beings. With the development of the neoclassical approach a new concept of value was then worked out which seemed definitely to do away with the idea of creation. Yet relative value is an ill-founded concept if it is not based on the previous determination of absolute values. The value of commodity a can be expressed in terms of another commodity, b, only if a and b are known before their exchange. But the knowledge of a and b presupposes the existence of a standard by which each of them can be independently evaluated. And it is at this level that the argument of creative production can be reintroduced without invoking the intervention of any supernatural power. The evaluation of output, in fact, does not require any dimensional standard, since value is no longer conceived of as a substance. What is created by human labour is merely the social form of output and the expression of this form is purely numerical. The concept of production is linked to the concept of emission of money. It is money that plays the role of a dimensional standard of value and, therefore, it is in terms of money that production has to be defined. Being a numerical unit, money is created by means of a simple double entry. Yet this operation is necessarily associated with the payment of wages, since it is only by separating the liability from the asset side of money that we can account for the creation of income. Output is thus created as income and nominal money is the Vehicle' allowing for the instantaneous occurrence of this event. A very important point here is the instantaneity implied in the concept of creation. If to produce is to create then production must be an event taking place in a period of time of zero duration. And indeed this is the case since production is economically defined by a monetary expenditure: the payment of wages. If we leave out the physical aspects of this event (which could be analysed by physical sciences), it is certain that wages are paid at the precise instant workers are credited. At this very instant output is created as a sum of (money) income. But what about the physical component of production? Is it not true that to produce means also to transform and that the process of physical transformation takes place in time? As was already known by classical economists, commodities are physical objects whose social value is expressed in terms of money (the standard of value). Hence, if it is evident that without money output would remain a heap of heterogeneous physical objects, it is no less certain that without these Values in use' money would never define a positive entity. Income actually defines output because the two are being associated through the payment of labour. Thus, since labour spans over a finite period of time,

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production is an instantaneous event necessarily related to a positive interval of time. Analysing production by means of the quantum-theoretical approach, we thus arrive at the conclusion that the emission of output defines the emission of a finite and indivisible period of time: a quantum of time. In the history of philosophy and science time has always been an extremely difficult concept to handle. Is time to be considered as a subjective perception of changing phenomena or as an absolute dimension in which events take place? Is it theoretically reversible, as in classical mechanics, or irreversible, as in thermodynamics? To these open questions economists have never seemed able to offer any original contribution. On the contrary, the traditional analysis of production has been construed as an analogical copy of classical mechanics and the problem of time has mainly been identified with the temporal indexation of the variables of this system. Now the quantum-theoretical approach provides the analysis of time with the idea that time is emitted as a quantum. This emission implies the possibility of time being 'travelled' at an infinite speed and of chronologically distinct instants coinciding in quantum-time. The novelty of this new approach is evident and its implications have not yet been completely worked out. Let us just remind the reader of those we have been discussing in our work. Being emitted as an indivisible lump of time, quantum time is the corpuscular component of production, whereas the wave-like property of this particular emission is (nominal) money. Though the quantumtheoretical approach to economics has in no way been derived from physics, the similarity with the two-fold definition of light given by de Broglie is striking. Analogously to the emission of light, production is an event defining the (instantaneous) emission of a 'particle' and the (instantaneous) forward and backward movement of a 'wave'. But these two aspects of production are not 'physical'. The 'particle' is not made up of energy and the 'wave' cannot be traced out in space and time. Money circulates in a movement which is logically instantaneous and output is defined by pure numbers. Neither money nor income are 'material', the physical properties of output being logically outside the field of economic inquiry. Whatever the physical product of labour, its economic definition is numerical, and numbers are unanimously recognized as being a-dimensional entities. The association of numbers and output is the very definition of production, and this association can only take place through the circular emission of money. Why is this so? Why has money to flow back instantaneously to its starting point? There are at least two good reasons accounting for this result. First, it is certain that if no positive asset can be created ex nihilo this impossibility applies also to nominal money (the empty vehicle). Banks issue money by spontaneously incurring a

186

Epilogue

debt, which means that money is issued as an asset-liability, that is as a self-destroying object. To avoid the cancelling out of its asset and liability side, money has to be immediately used. But the use of money must also imply its destruction, otherwise banks (working here on behalf of the economy) would be endowed with the inexplicable power of creating something positive out of nothing. Besides, if the 'vehicle' issued by banks could have a positive existence in time, then we would have to add it to the amount of income created by the work of man, thus artificially inflating the measure of wealth. This is the second reason for the immediate destruction of money. To exist money has to be used but then, having been used, it is destroyed, and, since every monetary expenditure is an instantaneous event, money is created and destroyed at the same moment. This is only apparently surprising. In fact, issued by banks, money is nothing other that a book-entry and its expenditure can only define its immediate flow to and from the banking system (more precisely the theory proves that money flows back necessarily to the same bank which issued it). It is this instantaneous circular flow which stands for the wave-like aspect of the economic emission. The creation-destruction of (nominal) money is not a pure intellectual exercise with no empirical consequences. On the contrary, the payment of wages carried out by firms defines the emission of output as a sum of money entered by banks to the benefit of workers. Output is therefore the content of income, whose numerical expression is the social definition (valuation) of the quantum of time corresponding to the period of production. And it is precisely this quantum which defines the corpuscular component of production. The instantaneous circular flow of (nominal) money leaves behind it a positive income, a bookentry that gives its beneficiaries the ownership of the physical product defined by it. But even if nominal money cannot be created without being simultaneously destroyed, how can income survive its positive emission? The only logical answer is that it cannot. Hence, if income is immediately destroyed, what would be the reason for creating it? The answer to this last question is based on the concept of capital. The flow of time has in fact the consequence of transforming income into capital. This event is once more instantaneous and takes place automatically as soon as wages are paid out. Indeed income is necessarily deposited in the banking system, where it defines the credit of its owner. In other words, given the nature of book-entry money, income is saved at the very moment it is earned and is therefore instantaneously transformed into capital. It is only as capital that income can persist in continuous time until the moment at which it will definitively be destroyed through its final expenditure. Our initial difficulty has, however, not been entirely disposed of. From the metaphysical survival of income we have passed to that of

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capital but the problem remains essentially the same: every creation ex nihilo requires the immediate destruction of its object. Created at f0, income is destroyed at tv where tl follows t0 in continuous time. How is it possible then to make tQ and tl coincide in time without abolishing their chronological difference (which is obviously necessary if income and capital have to play their role in the economic system)? To tackle this problem it is necessary to refer to quantum time. In fact the creation of income is not the creation of a substance (whether it be matter or energy) but the association of numbers and output inscribes income (and capital) into a particular time dimension. The creation of income at tQ defines the emission of a quantum of time equavalent to the period of production of current output. The destruction of income at tl is determined by the final purchase of this output and defines, therefore, the same quantum of time. Thus, although tQ and t± are chronologically distinct, they define one and the same instant in quantum time. This quantum coincidence of t0 and ^ establishes the retroactive simultaneity of the two events (positive and negative emissions of income) and is the proof that the circulation of income is determined by the instantaneous equivalence of its creation and its destruction. Finally income is only the numerical (social) expression of physical output and its emission (simultaneously positive and negative) simply accounts for the circulation of the product leaving totally unaltered its material properties. Money is thus a pure, valueless intermediary by means of which output is distributed among the different economic agents. The quantum time simultaneity of the payment of wages and of the final purchase of output (positive and negative aspects of the emission of income respectively) is not in contradiction to the distinction of these two events in chronological time. During this positive interval of continuous time income is deposited into the banking system where it defines the monetary side of capital. Money, income and capital are thus different kinds of book-entries allowing respectively for the social expression of output, for its distribution and for its conservation as a stock. The nature of money has nothing miraculous in it. The principle of double accounting is all that is needed in order to create Smith's 'great wheel of circulation'. And it is through a correct Use of this principle that money can carry out its task without any negative side-effects. It is only through analysis that we can hope to arrive at the true understanding of what money really is. The observation of the working of our monetary systems can provide the elements for its analytical description but is in itself insufficient to reach this result. The listing of all the operations currently carried out by banks and by other financial operators can thus be more misleading than useful. It is because economists have often stopped their analysis at this stage that monetary

1S8

Epilogue

theory is still embedded in all sorts of false conceptions about money and the ways it can be issued and 'circulated'. The net asset definition of money is a direct consequence of this superficial approach. Unsurprisingly, the analyses derived from it fail to explain the monetary disequilibria characterizing our economies and do not provide any satisfactory solution to them. As we have tried to show, to attain a deeper insight into the laws ruling the economy it is necessary to develop a theory of money based on the tenets of double accounting and on the acknowledgement that money is an a-dimensional unit. Such a theory shows that income is created through a circular emission of money (and its association with output), it is conserved as capital (in continuous time) and it is finally destroyed through another circular emission of money. These three analytical phases describe the logical interconnections proper to every monetary system. Hence if the actual working of our system were consistent with the logical requirements implied by this analytical distinction no disequilibrium could ever occur. If this is not so it is because the practical rules followed by banks are not always capable of accounting for the logical relationship existing between money, income and capital. One of the main tasks of the quantum-theoretical approach is thus to put forth the consistent rules banks should follow in recording the operations they carry out on behalf of the economy. In order to fulfil this task the theory has first to explain how the different kinds of monetary variables present in our complex systems are determined. For example, it has to show how profits can be positive overall even though wages are the only income originally available and how other incomes (such as dividends, interest, allowances and so on) are derived from wages without even slightly modifying the measure of national wealth. It is only after having completed the positive analysis of the system that it becomes possible to investigate the nature of its pathological behaviour. In fact inflation and unemployment as well as international monetary disequilibria can be understood only if we have a theory defining the logical, healthy state of the economy. The elaboration of the quantum-theoretical approach has proved to be a fruitful step towards the building of such a theory. The discovery of concepts such as those of monetary emission and of quantum time opens the way to a new analysis of money whose implications seem to be as far reaching as they are unexpected. Let us then conclude our work with the hope that the novelty of the approach proposed here will stimulate the intellectual curiosity of the readers and encourage further developments of the quantum theory recently worked out by Bernard Schmitt.

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Index of names

Archibald, G.C. 129-31, 189 Aristotle, 136 Baranzini, M. x, 189, 190, 194 Barro, RJ. 116, 126, 181, 189 Bray, J.F. 113 Brechling, F. 190, 191 Brennan, G. 189 Brunner, K. 189 Buchanan, J. 189 Buiter, K. 194 Buiter, W. 174-5, 181, 189 Burstein, M.L. 189 Carson, D. 189, 194 Cencini, A. 32, 55, 75, 87, 113, 162, 181, 189 Coddington, A. 172, 189 Clayton, G. 189, 192, 194 Clower, R.W. 113-16, 119, 125, 129-30, 133-6, 140, 145, 189-90, 194

Crowley, K. 193 Davidson, P. 113, 190 Davies, P. 190 Desai, M. x, 142, 149, 190 Divisia, F. 190 Eichner, A.S. 190 Einstein, A. 140, 190 Ellis, H.S. 190 Fender, J. 190 Fisher, I. 4, 142-7, 149, 154-5, 160,

Gilbert, J.C. 189, 192, 194 Gnos, C. 191 Goodhart, C.A.E. 191 Gordon, RJ. 147-50, 154, 156, 161-2, 164, 166, 168, 191 Grandmont, J.M. 191 Graziani, A. 191 Gray,J. 113 Gurley, J. 57-8, 191, 192 Hahn, F. 20, 113, 116-18, 120, 137_8, 163, 174-8, 181, 190, 191 Hausman, D. 162, 191 Hayek, F.A. 161, 191 Hendry, D.F. 191 Hicks, J. 127-8, 140, 158, 191, 192, 194

Hines, A.G. 191 Hollander, J.H. 191 Horner, F. 37 Hume, D. 34, 43, 141-2, 191 Jackman, R. 143, 191 Jevons, W.S. 192 Johnson, H.G. 58-61, 192 Keynes, J.M. 2, 4, 5, 7, 14, 44-58, 64, 69, 82, 89-90, 94, 133-4, 146, 148, 150, 154-5, 159-61, 192

Klein, L.R. 192 Kregel, J.A. 192

Fisher, S. 116, 126, 189, 190 Friboulet, J-J. 190 Friedman, M. 4, 99, 121, 128, 146-50, 154-8, 160-1, 163-4, 166-8, 177, 181, 190-1

Laffer, A.B. 192 Laidler, D. 167, 172, 192 Lawson, R.W. 190 Leijonhufvud, A. 192 Leontief, W. 192 Lipsey, R.G. 129-31, 189 Lucas, R.E. 173-4, 177, 181, 192 Lutz, F.A. 190

Gale, D. 191 Gawland, D. 191

Marshall, A. 119, 143, 145, 147, 159, 192

190

Index of Names Marty, A.L. 192 Marx, K. 2, 5, 7, 15-19, 27-31, 34, 39, 43-4, 55, 99, 103, 106-8, 113, 182, 192 Maxwell, J.C. 140 Mayer, T. 192 Meltzer, A.H. 189 Merton, R.C. 193 Mill, J. 34 Mill, S. 130 Minsky, H. 140, 192 Mints, L.W. 190 Moggridge, D. 192 Moore, BJ. 192 Morgan, B. 192 Morishima, M. 193 Mulvey, C. 143, 191 Myrdal, G. 193 Nagatani, H. 193 Newcomb, S. 159, 193 Newlyn, W.T. 193 Newton-Smith, W.H. 193 Niehans, J. 116, 193 Nobay, A.R. 191 Norman, G.W. 37, 193 Omerod, P.A. 191 Parkin, M. 191, 193 Patinkin, D. 62-3, 129-31, 133-4, 140, 193 Perlman, M. 70-1, 122, 193 Pesek, B.P. 64, 193 Pigou, A.C. 159-60, 193 Powers, J. 193 Proudhon, P-J. 17, 113 Purvis, D.D. 193 Rasera, J-B. 191 Reder, M.W. 193 Ricardo, D. 2, 5, 12, 15-17, 23-9, 33-7, 39, 42-4, 55, 99, 103, 1059, 113, 172, 178, 193 Robertson, D.H. 50, 77, 193 Robinson, J. 193

197

Rotelli, C. 193 Rotwein, E. 142, 191, 193 Samuelson, P.A. 129-32, 193 Sargent, TJ. 181 Saving, T.R. 64, 193 Sayers, R.S. 61-2, 71, 78, 193 Scazzieri, R. 189, 194 Schwartz, A. 191 Schmitt, B. x, 2, 32, 43, 55, 67-8, 73-4, 84, 87, 89, 96-8, 113, 172, 180-1, 188-9, 193-4 Sedwick, R. 189, 192, 194 Senior, N.W. 114, 194 Shackle, G.L.S. 194 Shaw, E. 57-8, 191, 192 Sims, C.A. 149, 194 Smith, A. 2, 5, 7, 9-17, 23-8, 30-1, 35, 38, 40, 42, 44, 55, 99, 103-8, 141, 145-6, 171, 182, 187, 194 Solow, R.M. 194 Sraffa, P. 178, 193 Starr, R. 116, 194 Starret, D. 140, 194 Stein, J.L. 173, 194 Stiglitz, J.E. 193 Tang, A.M. 191 Tobin, J. 79-80, 117, 149, 156, 161, 173-5, 181, 190, 194 Tooke, T. 34, 37-43, 194 Trevithick, J. 143, 191

Trezza, B. 195

Walras, L. 2, 4, 5, 18-21, 44, 48, 55, 99, 110-12, 120-1, 127-8, 130, 132-6, 140, 144, 171, 182, 193

Weintraub, E.R. 195 Weintraub, S. 190, 195 Wheeler, J.A. 87, 195 Wicksell, K. 195 Williams, P. 191 Wood, C. 37 Younes, Y. 191

Subject index

absolute exchange see exchange absolute prices see prices assets and creation of money 58-65, 114-23 exchange of 60-3 auctioneer 137-8 bank money see money bank deposits and credit 48, 61-2, 65-9, 75, 94, 97, 114 and time 69-70, 87-9, 93 and the emission of money 2 , 3 , 58, 61-6, 69-74, 80-9, 99 Banking Principle 7, 23, 33, 37-43, 153

barter and money 20, 33, 44-6, 78, 114-16, 123, 125, 176 and neoclassical analysis 20, 114-16, 123, 130, 133, 157-8, 176

Glower's definition of 115-16, 125

Bullion controversy 31, 33, 153 Cambridge equation 147, 159-60 capital and bank deposits 88-9, 95 and income 70, 88-9, 92, 94-5, 97, 186-7 and money 70-1, 94, 186-7 and output 70, 89, 92-4, 98, 186 and time 88-9, 95 and savings 70, 88-9, 92-4, 186 fixed 108-9 causal relationships among dependent variables 159, 162

and identities 147-8, 151 and tautologies 145-8 and the quantity theory of money 143-5

and time series 149-50 circulation of goods 13-15, 122 of money 2, 13-15, 38-41, 71, 74, 92-3, 125, 187 of income 2, 7, 85, 93-6, 187-8 circuit of the creation of money 54-7, 71-6 of the destruction of money 71-6 classical economics and the theory of money 9-18, 23-32, 99, 103-9, 111 and the theory of value 16-18, 27, 40, 53, 88, 103-9, 111 commodities and money 9-11, 16-18, 24, 30, 125, 157 consumption and income 89-90 convertibility and depreciation 33-5, 41-2 costs and exchange see also transactions costs 140 and production 52, 54, 161, 170 credit and bank deposits 38, 47, 65 and double accounting 65-7 and money 67-9 and income 65-6, 88-9, 94 Currency Principle 7, 23, 33-7, 153 demand effective 136, 148 excess 133, 135-40, 177 for income 150-2 for money 128, 131-3, 148-52, 156, 158, 167 for money to hold 70-1 for goods 127-8, 136-7, 139 virtual 136 demand and supply in GEA 110, 127-40

Subject Index the logical identity of 138, 140, 151

depreciation and convertibility 33-5, 41-2 and nominal money 36-7 and production 39-41 and real money 35-6 and the emission of money 37-8, 42

dichotomy and neoclassical analysis 4, 22, 100, 127-40, 141-52, 163-72 and non-Walrasian models 173-80 and the level of prices 163-9 and the net asset definition of money 166-9 and the neutrality of money 163, 173-7 and the quantity theory of money 4, 141-5, 149, 163-72 and Walras' law 132-40, 173-5 legitimate versus traditional 129-31 emissions and creation 47, 54-7, 76, 81-8, 91, 94, 96, 187 and destruction 73-4, 76, 86, 89-102, 186-7 and expenditures 54-5, 82-8, 91, 93-4, 96-7, 183-4, 186 and money 2, 40, 47-9, 57-74, 80, 89, 117, 179, 183-4, 186, 188

and production 52, 54, 16 1 and wages 26-7, 29-31, 52, 54-7, 82-8, 91, 93-4, 96-7, 183-4, 186

equilibrium and exchange 110, 120, 135-40 and full employment 133-40 and the clearing of markets 139-40 and Walras' law 132-40 equivalence and exchange 42, 108-9, 135-6, 140

and nominal and real income 170-2 exchange absolute 14, 76, 78, 82-4, 90-1, 97, 126

199

and barter 123 and equilibrium 110, 120, 135-40 and equivalence 42, 108-9, 135-6, 140

and general equilibrium analysis 110, 120, 135-40 and money 13, 14, 21, 76, 78, 82-4, 90-1, 106-7, 110-16, 120-3, 126, 133-9, 141-73 and prices 19-21, 99-100, 110-13, 116, 120-40, 144, 151, 157

of assets 60-3 realized 135-8 relative 3, 14, 78, 83, 100, 110, 114-16, 122-3, 126 the equation of 141-4, 147-9 virtual 135, 136-9 expenditures and income 14, 51-2, 54-5, 89-91, 94-5, 186 and money 70-1, 121 and time 71-3, 87-8, 95-102 as emissions 54-5, 82-8, 91, 93-4, 96-7, 183-4, 186 factors of production in Keynes' theory 53-4 Fisher, I. equation of exchange 141-4, 147-9, 155 Friedman, M.

theory of nominal issue 154-6 restatement of the quantity theory of money 146-52, 155-9

general equilibrium analysis and barter 20, 114-16, 123, 130, 133, 157-8, 176 and excess demand 135-9 and exchange 110, 120, 135-40 and money 110-81 and the necessary clearance of all markets 134, 139-40 and the quantity theory of money 141-73 non-Walrasian 133-4 Walrasian 133-4 homogeneity postulate see dichotomy

200

Subject Index

income and capital 70, 88-9, 92, 94-5, 97, 186-7 and consumption 89-90 and credit 65-6, 88-9, 94 and expenditures 14, 51-2, 54-5, 89-91, 186 and money 2, 9, 12, 44, 53-5, 57, 63-4, 67-8, 72, 74, 87-9, 150, 180, 185 and output 7, 10, 14, 24, 35, 82-7, 156, 159, 165-6, 187 and prices 4, 27, 39, 81-2, 149,

155, 159, 161, 163-9

and savings 7, 15, 70, 88-90, 92-3, 186 and the costs of production 53, 170

and the payment of wages 29, 52, 54_ 5j 82-90, 183-4, 187 and time 76-98 equivalence of nominal and real 163-6, 170-1 nominal 4, 155-7, 159, 163-71, 177-80 real 4, 155-7, 163-71, 177-80 the circuit of 2, 7, 85, 93-6, 187 the creation of 76, 81-9, 91, 94, 96, 187 the destruction of 76, 86, 89-97, 186-7 the indeterminacy of 170-1 index of prices 50-1 inflation 33-5, 41-2, 79, 172 intrinsic value of money 1, 15, 29-30, 36, 99, 114, 119-20, 180 IS-LM and the quantity theory of money 157-9 Keynes, J.M. fundamental equations 160-1 refusal of the quantity theory of money 159-61 theory of money 44-56, 146, 159-62 labour and classical theory 15-18, 82, 103-9 and money 16, 51-5, 87, 90, 103-4, 106, 113, 183

and output 16, 25, 105 and time 17, 107-8, 183 and the theory of value 16-18, 103-6, 111, 113, 183 as the unique factor of production 53-4, 94, 106, 109 demand and supply of 16 1 materialization of 103-4 payment of 2, 12, 26-7, 29-31, 52-5, 82-8, 91-4, 96-7, 183-6 the heterogeneity of 16-17, 103, 107, 109 Marx, K. form of value 15-18 theory of money 15-18, 28-31 money and absolute exchange 76, 78, 82-4, 90-1 and barter 20, 33, 44-5, 78, 114-16, 123, 125, 176 and capital 70-1, 34, 186-7 and classical analysis 16-18, 23-32, 99, 103-9, 111 and commodities 9-11, 16-18, 24, 30, 125, 157 and credit 48, 61-2, 65-9, 75, 94, 97, 114 and deposits 2, 3, 58, 61-6, 69-74, 80-9, 99 and exchange 13, 14, 21, 76, 78, 82-4, 90-1, 106-7, 110-16, 120-3, 126, 132-9, 141-73 and expenditures 70-1, 121 and general equilibrium analysis 110-81 and income 2, 7, 9, 12, 53-5, 57, 63-4, 67-9, 72, 74, 87-9, 150, 180, 184 and labour 16, 51-5, 87, 90, 103-4, 106, 113, 183 and money proper 44-6 and money's worth 10, 12, 15, 23-7, 29-31, 35, 40, 183 and output 2, 4, 7, 9-15, 17, 19-22, 24-9, 31, 35-42, 49-53, 74, 81-98, 100, 104, 112-14, 118-19, 128, 131-2, 141, 144, 146, 156-9, 161, 163-4, 167, 169-71, 176, 180, 183-7 and prices 34, 40-1, 118-20, 124, 131-2, 141-52, 161

Subject Index and production 31, 53-5, 145, 179-80, 185 and profits 95 and purchasing power 2, 4, 10, 12, 14, 21, 24-9, 31, 35-6, 49-55, 77, 81, 100, 104, 116-23, 159-61, 170-1, 167, 183

and relative exchange 114-16 and the payment of wages 2, 12, 26-7, 29-31, 52, 54-5, 82-8, 91, 93-4, 96-7, 183-4, 186 and the quantity theory of 4, 141-52 and the quantum theory of 2, 40, 47-9, 57-76, 183-8 and time 57-75 and time-chits 17, 106 and transaction costs 70-1 and value 2, 4, 9-12, 50, 53, 77, 90, 103-6, 114-15, 118-25, 128, 132, 180, 185 as a dimensional standard of value 3, 103-6, 182-3 as a means of exchange 18, 72-3, 77-9, 118, 120-4, 128, 132 as a means of payment 21, 23, 26, 28-31, 46, 79-81, 118, 120-3 as a substance 20, 21, 28 as a temporary abode of purchasing power 71, 121-2 as a veil 3, 100, 120-5 as an asset 3, 13, 15, 55, 100, 114-20, 123, 125-6, 128, 163, 166-71, 176-9, 182, 188 as an asset-liability 47-9, 59-60, 62, 64, 72, 81, 183, 186 as capital 70-1, 88-9, 94, 186-7 as empty vehicle 11-13, 15, 25, 29, 31, 35, 40, 59-60, 63, 69-70, 72, 186 as form of value 2, 7, 15-18, 28-30, 182 as numeraire 2, 4, 7, 19-22, 182 as standard of value 18, 31, 77 as the general equivalent 4, 16, 28-9, 106-7 as the great wheel of circulation 2, 11-13, 15, 25, 30, 42, 70, 72, 171, 182, 187 as unit of account 21, 23, 26,

201

28-31, 44 bank 1, 40, 44-55, 57-75, 79-91, 99-100, 104, 115-79 book-entry 1, 3, 48, 57-75, 79-91, 100, 115, 117-18, 182-3, 186 commodity 3, 7, 15-18, 20, 24-5, 44_6, 75, 99, 103-12, 114-16 inside 60-3 Keynes's theory of 44-56 Marx's theory of 7, 15-18 nominal 2, 7, 15, 18, 23-32, 35-7, 39-40, 42, 55, 59, 63, 66, 69, 74, 84, 128, 183, 185 outside 58-60, 62-75 real 2, 7, 15, 18, 23-32, 35-40, 42, 55, 66, 73, 85, 128, 183 Ricardo's theory of 15, 33-7 Smith's theory of 9-18, 23-31 state 45-7, 57-60 the circulation of 2, 13-15, 38-41, 71, 74, 92-3, 125, 187 the circuit of 2, 13, 85-6 the creation of 40, 47-9, 57-74, 80, 89, 117, 179, 183-4, 186, 188

the definition of 115-17, 127, 171, 177-80 the demand for 128, 131-3, 148-52, 156, 158, 167 the destruction of 73-4, 76, 186 the functions of 3, 20-1, 23, 30 the integration of 21-2, 36, 76, 82, 94, 100, 112, 118, 132, 140, 156, 170, 180, 183 the intrinsic value of 1, 15, 29-30, 36, 99, 104, 119-20, 180 the labour power of 51-4 the neutrality of 57, 163, 173-81 the quantity of 41-3, 114-15, 124, 128-9, 141-52, 173, 175-8 the quantum approach to 57-102, 183-8 the traditional concept of 3, 13-15, 100, 114-28^163-71, 176-9, 182, 188 the velocity of circulation of 7 1 , 74, 114, 143-5, 148 Walras' theory of 19-22 monetarism and the definition of money 99

202

Subject Index

and the quantity theory of money 146-52, 154-61, 163-72 neoclassical economics and barter 20, 114-16, 123, 130, 133, 157-8, 176 and causality 143-9 and exchange 110-13, 120, 135-40, 144, 151, 157 and general equilibrium 127-40, 173-81 and money 4, 19-22, 100, 112-25, 127-40, 167-71, 176-9, 182, 188 and the dichotomy 4, 22, 127-40, 141-52, 163-72 and the quantity theory of money 99, 115, 141-52, 154-61, 163-72 neutrality of money and the definition of money 57, 163, 173-81 and the neoclassical dichotomy 163, 173-7 Hahn's refusal of 175-7 new-classical economics 173-8 non-Walrasian models 173-80 output and capital 70, 89, 92-4, 98, 186 and income 7, 10, 14, 24, 35, 82-7, 156, 159, 165-6, 187 and labour 16, 29, 105 and money 2, 4, 7, 9-15, 17, 19-22, 24-9, 31, 35-42, 49-53, 74, 81-98, 100, 104, 112-14, 118-19, 124, 128, 131-2, 141, 144, 146, 156-9, 161, 163-4, 167, 169-71, 176, 180, 183-7 and purchasing power 35, 159 and savings 15 and time 88 and wages 29, 39, 52, 54, 85-7, 161, 183, 187 the circulation of 13-15, 122 overdrafts and the creation of money 48-9 prices absolute 22, 110 and exchange 19-21, 99-100,

110-13, 116, 120-40, 144, 151, 157

and money 26, 34, 40-1, 118-20, 131-2, 146-52, 161 and production 26, 41, 146, 170 and the quantity of money 41-3, 115, 124, 128-9, 141-52, 173, 175-8 and value 34-5, 39, 42, 51, 108, 113

and wages 16 1 relative 19-21, 99-100, 110-13, 116, 120, 122, 124, 127, 129, 132-40, 144, 151, 157 the index of 50-1 the inflationary increase of 33-5, 41-2, 79, 172 the level of 33, 118, 129, 151, 155, 157, 160, 163-9, 176; and income 4, 27, 39, 149, 151, 161, 163-9 realized 137 virtual 136-7 production and income 10, 14, 24, 35, 82-7, 156, 159, 165-6, 187 and money 31, 53-5, 145, 179-80, 185 and prices 26, 41, 146, 170 and wages 29, 52, 54, 85-7, 161, 183, 187 as creation 87, 183 as transformation 184 the costs of 53, 170 the factors of 52-4 profits and money 95 and wages 97, 165, 188 purchasing power and money 2, 4, 10-14, 21-9, 31, 35-6, 49-55, 77, 81, 100, 104, 116-23, 159-61, 170-1, 167, 183

and output 35, 159 and the level of prices 26, 41, 46, 118-19, 159, 170 and the simultaneous solution of the GES 119-20 as a mirror image of relative exchange value 120-3 the social determination of 117-19

Subject Index quantity theory of money 99, 115, 141-52, 154-61, 163-72 and the IS-LM 157-9 and general equilibrium analysis 141-73 and the neoclassical dichotomy 128, 130, 141, 163-72 as a theory of the demand for money 148-50, 156 Keynes's refusal of 159-61 the Monetarists' restatement of 146-52, 155 quantum theory and emissions 47, 54-7, 73-4, 76, 81-8, 89-102, 183, 185-8 and income 76-102, 186-7 and money 2, 40, 47-9, 57-76, 183-8 and profits 97, 165, 188 and time 76, 87, 95-7, 185-8 rational expectations equilibrium 174-6, 178 hypothesis 173-4, 177-8 school 173 real balance effect 129, 140 relative exchange see exchange relative prices see prices Ricardo, D. the dilemma of 108-9 theory of money 23-8, 33-6, 108-9 Samuelson, P. A. legitimate dichotomy 129-31 savings and capital 70, 88-90, 92-4, 186

and income 7, 15, 70, 88-90, 92-3, 186 and output 15 and time 88-9, 95, 186 Schmitt, B. quantum approach 3, 57-102, 183-8 Smith, A. great wheel of circulation 2, 10-13, 25, 30, 42, 70, 72, 171, 182, 187 theory of money 10-13, 23-7

203

distinction between money and money's worth 23-7 supply excess 134, 140 of money 18, 131, 133, 142, 156, 158-9, 161, 163-7, 169, 173 real 127-8, 136-7, 139 virtual 136 theory classical 9-41, 103-9 Keynes's 44-56 neoclassical 110-81 quantity, of money 141-72 quantum 57-102 time and bank deposits 69-70, 87-9, 93 and capital 88-9, 95 and expenditures 71-3, 87-8, 95-102 and income 76-98 and money 57-75 and output 88 and labour 17, 107-8, 183 and savings 88-9, 95, 186 and the circulation of money 71-5, 93 and the emission of money 65-75, 184

as a quantum 76, 87, 95-7, 185-6 chronological 95 displacement in 95, 97, 185 inertia in 97-8 quantum 87, 95-8, 187-8 transactions instantaneous 71 and money 71, 73, 125, 131-2, 143

and time 72, 74, 76 transaction costs and exchange 140 and money 70-1, 116 value absolute 15, 16, 18-19, 28, 99-100, 103, 107-8, 110, 112, 183-4 and labour 16-17, 103-4, 106, 111, 113, 183 and money 2, 4, 9-12, 25, 28, 34, 50-1, 53, 103-9, 183-5

204

Subject Index

value (Cont.) and prices 34-5, 39, 42, 50, 108, 113

and the a-dimensional standard of 7, 29, 105 and wages 45, 107-8 as a substance 16, 19, 29, 106, 184 of output 24, 28, 35, 82-7, 156, 159, 165-7, 187 exchange 109-13, 115, 120, 122-3, 184 relative 18, 108, 110-13, 115, 120, 122-3, 184 the form of 2, 7, 15-18, 28-30, 182

the classical theory of 16-18, 27, 40, 53, 88, 103-9, 111 use 28, 94, 109, 184 wages and income 29, 52, 54-5, 82-90,

183-4, 187 and money 2, 12, 26-7, 29-31, 52, 54-5, 82-8, 91, 93-4, 96-7, 183-4, 186 and output 29, 52, 54, 85-7, 161, 183, 187 and profits 97, 165, 188 and value 45, 107-8 wage-units and quantum time 88 and the price level 16 1 as standard of value 54 Walras, L. law 4, 20, 121, 127-8, 130, 132-40 numeraire 2, 4, 7, 19-22, 112, 120, 133 Walrasian and the dichotomy 132-40, 173-80