Monday, January 28, 2008
A monetary history
The theology of monetary economics (from Critique of Central Banking 2002)
Inflation, the all-consuming target of central banking, is popularly thought of as too much money chasing too few goods, which economists refer to as the Quantity Theory of Money (QTM). QTM is one of the oldest surviving economic doctrines. Simply stated, it asserts that changes in the general level of commodity prices are determined primarily by changes in the quantity of money in circulation. But the theology of monetary economics has a long and complex history, an understanding of which is necessary for forming any informed opinion on the validity and purpose of central banking. Below is a brief summary of the stuff dinner conversation is made of among the gods of monetary theory. Jean Bodin (1530-96), a French social/political philosopher, attributed the price inflation then raging in Western Europe to the abundance of monetary metals imported from the newly opened gold and silver mines in the Spanish colonies in South America. Though he held many aspects of mercantilist views, Bodin asserted that the rise of prices was a function not merely of the debasement of the coinage, but also of the amount of currency in circulation. Bodin's religious tolerance in a period of fanatical religious wars drew upon him the accusation of being a "freethinker", a label as damaging as being called a communist sympathizer in the United States in modern times. In his Les Six Livrers de la republic (1576), Bodin replaced the concept of a past golden age with the concept of progress. He foreshadowed Thomas Hobbes (1588-1679: The Leviathan, 1651) by stating the political necessity of absolute sovereignty, subject only to the laws of God (morality) and nature (reality). Bodin also anticipated Baron Montesquieu (1689-1755: De l'esprit des lois, 1748) by highlighting environment as a determinant of laws, customs, beliefs and the interpretation of events, a view that influenced the US constitution, a view since rejected by current US moral imperialism. John Locke (1632-1704) and David Hume (1711-76) provided considerable refinement, elaboration and extension to the QTM, allowing it to be integrated into the mainstream of orthodox monetarist tradition. Locke developed the right of private property based on the labor theory of value and the mechanics of political checks and balances that were incorporated in the US constitution. Locke, in 1661, asserted the proportionality postulate: that a doubling of the quantity of money (M) will double the level of prices (P) and half the value of the monetary unit. Hume, in 1752, introduced the notion of causation by stating that variation in M (money quantity) will cause proportionate changes in P (price level). Concurrently with Irish banker Richard Cantillon (1680-1734), Hume applied to the QTM two crucial distinctions: 1) between static (long-run stationary equilibrium) and dynamic (short-run movement toward equilibrium); and 2) between the long-run neutrality and the short-run non-neutrality of money. Hume and Cantillon provided the first dynamic process analysis of how the impact of a monetary change spread from one sector of the economy to another, altering relative price and quantity in the process. They pointed out that most monetary injection would involve non-neutral distribution effects. New money would not be distributed among individuals in proportion to their pre-existing share of money holdings. Those who receive more will benefit at the expense of those receiving less than their proportionate share, and they will exert more influence in determining the composition of new output. Initial distribution effects temporarily alter the pattern of expenditure and thus the structure of production and the allocation of resources. Thus it is understandable that conservatives would be sympathetic to the QTM to maintain the wealth distribution status quo, or if the QTM is skirted, to ensure that the maldistribution tilts toward those who are more likely to engage in capital formation, namely the rich. Thus developing economies in need of capital formation would find logic in first enriching the financial elite while advanced economies with production overcapacity would need to increase aggregate demand by restricting income disparity. Hume describes how different degrees of money illusion among income recipients, coupled with time delays in the adjustment process, could cause costs to lag behind prices, thus creating abnormal profits and stimulating optimistic profit expectations that would spur business expansion and employment during the transition period. These non-neutral effects are not denied by the adherents of QTM, who nevertheless assert that they are bound to dissipate in the long run, often with great damage if the optimism was unjustified. The latest evidence of the non-neutral effects of money is observable in expansion of the so-called New Economy from easy money in the past decade and the recent collapse of its bubble. The QTM formed the central core of 19th-century classical monetary analysis, provided the dominant conceptual framework for interpreting contemporary financial events and formed the intellectual foundation of orthodox policy prescription designed to preserve the gold standard. The economic structure in 19th-century Europe led analysts to acknowledge additional non-neutral effects, such as the lag of money wages behind prices, which temporarily reduces real wages; the stimulus to output occasioned by inflation-induced reduction in real debt burdens, which shifts real income from unproductive creditor-rentiers to productive debtor-entrepreneurs; the so-called "forced saving" effect occasioned by price-induced redistribution of income among socio-economic classes having structurally different propensity to save and invest; and the stimulus to investment imparted by a temporary reduction in the rate of interest below the anticipated rate of return on new capital. Yet classical quantity theorists tended persistently to minimize the importance of non-neutral effects as merely transitional. Whereas Hume tended to stress lengthy dynamic disequilibrium periods in which money matters much, classical analysts focused on long-run equilibrium in which money is merely a veil. David Ricardo (1772-1823), the most influential of the classical economists, thought such disequilibrium effects ephemeral and unimportant in long-run equilibrium analysis. Gods, of course, enjoy longer perspectives than most mortals, as do the rich over the poor. As John Maynard Keynes famously said: "In the long run, we will all be dead." As leader of the Bullionists, Ricardo charged that inflation in Britain was solely the result of the Bank of England's irresponsible overissue of money, when in 1797, under the stress of the Napoleonic Wars, Britain left the gold standard for inconvertible paper. At that time, the Bank of England was still operating as a national bank, not a central bank in the modern sense of the term. In other words, it operated to improve the English economy rather than to strengthen the sanctity of international finance. Ricardo, by focusing on long term-equilibrium, discouraged discussions on the possible beneficial output and employment effects of monetary injection on the national level. Like modern-day monetarists, Bullionists laid the source of inflation, a decidedly evil force in international finance, squarely at the door of the national bank. As Milton Friedman declared some two centuries after Richardo: inflation is everywhere a monetary phenomenon. Friedman's concept of "money matters" is the diametrical opposite of Hume's. The historical evolution in 18th-century Europe from a predominantly full-metal money to a mixed metal-paper money forced advances in the understanding of the monetary transmission mechanism. After gold coins had given way to banknotes, Hume's direct mechanism of price adjustment was found lacking in explaining how banknotes are injected into the system. Henry Thornton (1760-1815), in his classic The Paper Credit of Great Britain (1802), provided the first description of the indirect mechanism by observing that new money created by banks enters the financial markets initially via an expansion of bank loans, through increasing the supply of lendable funds, temporarily reducing the loan rate of interest below the rate of return on new capital, thus stimulating additional investment and loan demand. This in turn pushes prices up, including capital good prices, drives up loan demands and eventually interest rates, bringing the system back into equilibrium indirectly. The central issue of the doctrines of the British classical school that dominated the first half of the 19th century was focused around the application of the QTM to government policy, which manifested itself in the maintenance of external equilibrium and the restoration and defense of the gold standard. Consequently, the QTM tended to be directed toward the analysis of international price levels, gold flow, exchange-rate fluctuations and trade deficits. It formed the foundation of mercantilism, which underpinned the economic structure of the British Empire via colonialism, which reached institutional maturity in the same period. Bullionists developed the idea that the stock of money, or its currency component, could be effectively regulated by controlling a narrowly defined monetary base, that the control of "high-power money" (bank reserves) in a fractional reserve banking regime implies virtual control of the money supply. High-power money is the totality of bank reserves that would be multiplied many times through the money-creation power of commercial bank lending, depending on the velocity of circulation. In the 1987 crash when the Dow Jones Industrial Average (DJIA) dropped 22.6 percent in one day (October 19) on volume of 608 million shares, six times the normal volume then (current normal daily volume is about 1.6 billion shares), the US Federal Reserve under its newly installed chairman, Alan Greenspan, created US$12 billion of new bank reserves by buying up government securities. The $12 billion injection of high-power money in one day caused the Fed Funds rate to fall by three-quarters of a point and halted the financial panic. If the government had been running a balanced budget and there were no government securities to be bought, the economy would have seized up. This shows that government deficits and debt are part and parcel of the modern financial architecture. In the three decades after Britain returned to the gold standard in 1821, the policy objective focused on the maintenance of fixed exchange rates and the automatic gold convertibility of the pound. But the Currency School (CS) versus Banking School (BS) controversy broke out over whether the "Currency Principle" of making existing mixed gold-paper currency expand and contract in direct proportion to gold reserves was sufficient to safeguard against note overissuance, or whether additional regulation was necessary. This controversy grew out of the expansion pressure put on the supply of pound sterling by the rapid expansion of the British empire. Members of the CS argued that even a fully, legally convertible currency could be issued in excess with undesirable consequences, such as rising domestic prices relative to foreign prices, balance-of-payment deficits, falling foreign-exchange rates, gold outflow resulting in depletion of gold reserves and ultimately forced suspension of convertibility. The rate of reserves drain often accelerated when the external gold drain coincided with internal domestic-panic conversion of paper into gold in fear of pending depreciation. Thus the CS promoted full convertibility plus strict regulation of the volume of banknotes to prevent the recurrence of gold drains, exchange depreciation and domestic liquidity crises. The apprehension of the CS was fully justified by past actions of the Bank of England, which had been perverse and destabilizing by international finance standards. The destabilizing argument stressed the time lag on the Bank's policy response to gold outflow and to exchange-rate movements. The inevitably too little, too late measures taken by the national bank, instead of protecting gold reserves, merely exacerbated financial panics and liquidity crises that inevitably followed periods of currency-credit excess. The famous Bank Charter Act of 1844, in modern parlance, imposed a 100 percent reserve requirement, with an unabashed bias toward wealth preservation over wealth creation. The CS also asserts that money substitutes cannot impair the effectiveness of monetary regulation. Thus if banknotes could be controlled, there would be no need to control deposits explicitly, on the ground that money substitutes have low velocity and are of declining substitutional value in times of crisis. Keynesians argue that the QTM is invalid because it assumes an automatic tendency to full employment. If resource under-ultilization and excess capacity exist, a monetary expansion may produce a rise in output rather than a rise in prices, as in the case of the 1930s Depression. Money is not a mere veil. Monetary changes may have a permanent effect on output, interest rates, and other real variables, contrary to the neutrality postulate of the QTM. Post-Keynesians also contend that the QTM erroneously assumes the stability of velocity and its counterpart, the demand for money. Velocity is a volatile, unpredictable variable (technically known as exogenous - due to external causes), influenced by meta-rationality and by changes in the volume of money substitutes, not to mention hedges in the form of derivatives. The erratic behavior of velocity makes it impossible to predict the effect of a given monetary change on prices. John Law (1671-1729), a contemporary of Bodin, elaborated in 1705 on the distinction drawn by Bernardo Davanzati (1529-1606) between "value in exchange" and "value in use", which led Law to introduce his famous "water-diamond" paradox: that water, which has great use-value, has no exchange-value, while diamonds, which have great exchange-value, have no use-value. Contrary to Adam Smith, who used the same example but explained it on the basis of water and diamonds having different labor costs of production, Law regarded the relative scarcity of goods in demand as the generator of exchange value. Davanzati showed how "barter is a necessary complement of division of labor amongst men and amongst nations"; and how there is easily a "want of coincidence in barter", which calls for a "medium of exchange"; and this medium must be capable of "subdivision" and be a "store of value". He remarked "that one single egg was more worth to Count Ugolino in his tower [prison] than all the gold of the world", but that on the other hand, "ten thousand grains of corn are only worth one of gold in the market", and that "water, however necessary for life, is worth nothing, because superabundant". That was of course before International Monetary Fund (IMF) conditionality requiring the poor in the indebted Third World to pay for water through privatization of basic utilities to service foreign debt. Davanzati observed that in the siege of Casilino, "a rat was sold for 200 florins, and the price could not be called exaggerated, because next day the man who sold it was starved and the man who bought it was still alive". Of course, modern economists would call that a market failure. Davanzati viewed all the money in a country as worth all the goods, because the one exchanges for the other and nobody wants money for its own sake. Davanzati did not know anything about the velocity of money, and only recognized that every country needs a different quantity of money, as different human frames need different quantities of blood. The mint ought to coin money gratuitously for everybody; and the fear that, if the coins are too good, they should be exported is simply illusory, because they must have been paid for by the exporter. Law's "Real Bills Doctrine" of money applied the "reflux principle" to the money supply. Money, Law argued, was credit and credit was determined by the "needs of trade". Consequently, the amount of money in existence is determined not by the imports of gold or trade balances (as the Mercantilists argued), but rather on the supply of credit in the economy. And money supply (in opposition to the Quantity Theory) is endogenous (growing from within), determined by the "needs of trade". Post-Keynesians have drawn on the Real Bills Doctrine, which asserts that the money supply is an endogenous variable that responds passively to shifts in the demand for it. Thus monetary changes cannot affect prices. Being demand-determined, the stock of money cannot exceed or fall short of the quantity of money demanded. In short, there is no transmission mechanism running from money to prices. Analysts should look instead for the source of economic dislocations in real rather than monetary causes. Inflation creates a corresponding increase in the money supply, not the other way around. Yet QTM theorists exposed the Achilles' heel of the Real Bills Doctrine by demonstrating that as long as the loan rate of interest is below the expected yield on new capital projects, the demand for loans will be insatiable. Thus the "real bills" criterion as an automatic regulator of the money supply is inoperative unless central banks intervene to raise interest rates in concert with expected return on capital.
Inflation, the all-consuming target of central banking, is popularly thought of as too much money chasing too few goods, which economists refer to as the Quantity Theory of Money (QTM). QTM is one of the oldest surviving economic doctrines. Simply stated, it asserts that changes in the general level of commodity prices are determined primarily by changes in the quantity of money in circulation. But the theology of monetary economics has a long and complex history, an understanding of which is necessary for forming any informed opinion on the validity and purpose of central banking. Below is a brief summary of the stuff dinner conversation is made of among the gods of monetary theory. Jean Bodin (1530-96), a French social/political philosopher, attributed the price inflation then raging in Western Europe to the abundance of monetary metals imported from the newly opened gold and silver mines in the Spanish colonies in South America. Though he held many aspects of mercantilist views, Bodin asserted that the rise of prices was a function not merely of the debasement of the coinage, but also of the amount of currency in circulation. Bodin's religious tolerance in a period of fanatical religious wars drew upon him the accusation of being a "freethinker", a label as damaging as being called a communist sympathizer in the United States in modern times. In his Les Six Livrers de la republic (1576), Bodin replaced the concept of a past golden age with the concept of progress. He foreshadowed Thomas Hobbes (1588-1679: The Leviathan, 1651) by stating the political necessity of absolute sovereignty, subject only to the laws of God (morality) and nature (reality). Bodin also anticipated Baron Montesquieu (1689-1755: De l'esprit des lois, 1748) by highlighting environment as a determinant of laws, customs, beliefs and the interpretation of events, a view that influenced the US constitution, a view since rejected by current US moral imperialism. John Locke (1632-1704) and David Hume (1711-76) provided considerable refinement, elaboration and extension to the QTM, allowing it to be integrated into the mainstream of orthodox monetarist tradition. Locke developed the right of private property based on the labor theory of value and the mechanics of political checks and balances that were incorporated in the US constitution. Locke, in 1661, asserted the proportionality postulate: that a doubling of the quantity of money (M) will double the level of prices (P) and half the value of the monetary unit. Hume, in 1752, introduced the notion of causation by stating that variation in M (money quantity) will cause proportionate changes in P (price level). Concurrently with Irish banker Richard Cantillon (1680-1734), Hume applied to the QTM two crucial distinctions: 1) between static (long-run stationary equilibrium) and dynamic (short-run movement toward equilibrium); and 2) between the long-run neutrality and the short-run non-neutrality of money. Hume and Cantillon provided the first dynamic process analysis of how the impact of a monetary change spread from one sector of the economy to another, altering relative price and quantity in the process. They pointed out that most monetary injection would involve non-neutral distribution effects. New money would not be distributed among individuals in proportion to their pre-existing share of money holdings. Those who receive more will benefit at the expense of those receiving less than their proportionate share, and they will exert more influence in determining the composition of new output. Initial distribution effects temporarily alter the pattern of expenditure and thus the structure of production and the allocation of resources. Thus it is understandable that conservatives would be sympathetic to the QTM to maintain the wealth distribution status quo, or if the QTM is skirted, to ensure that the maldistribution tilts toward those who are more likely to engage in capital formation, namely the rich. Thus developing economies in need of capital formation would find logic in first enriching the financial elite while advanced economies with production overcapacity would need to increase aggregate demand by restricting income disparity. Hume describes how different degrees of money illusion among income recipients, coupled with time delays in the adjustment process, could cause costs to lag behind prices, thus creating abnormal profits and stimulating optimistic profit expectations that would spur business expansion and employment during the transition period. These non-neutral effects are not denied by the adherents of QTM, who nevertheless assert that they are bound to dissipate in the long run, often with great damage if the optimism was unjustified. The latest evidence of the non-neutral effects of money is observable in expansion of the so-called New Economy from easy money in the past decade and the recent collapse of its bubble. The QTM formed the central core of 19th-century classical monetary analysis, provided the dominant conceptual framework for interpreting contemporary financial events and formed the intellectual foundation of orthodox policy prescription designed to preserve the gold standard. The economic structure in 19th-century Europe led analysts to acknowledge additional non-neutral effects, such as the lag of money wages behind prices, which temporarily reduces real wages; the stimulus to output occasioned by inflation-induced reduction in real debt burdens, which shifts real income from unproductive creditor-rentiers to productive debtor-entrepreneurs; the so-called "forced saving" effect occasioned by price-induced redistribution of income among socio-economic classes having structurally different propensity to save and invest; and the stimulus to investment imparted by a temporary reduction in the rate of interest below the anticipated rate of return on new capital. Yet classical quantity theorists tended persistently to minimize the importance of non-neutral effects as merely transitional. Whereas Hume tended to stress lengthy dynamic disequilibrium periods in which money matters much, classical analysts focused on long-run equilibrium in which money is merely a veil. David Ricardo (1772-1823), the most influential of the classical economists, thought such disequilibrium effects ephemeral and unimportant in long-run equilibrium analysis. Gods, of course, enjoy longer perspectives than most mortals, as do the rich over the poor. As John Maynard Keynes famously said: "In the long run, we will all be dead." As leader of the Bullionists, Ricardo charged that inflation in Britain was solely the result of the Bank of England's irresponsible overissue of money, when in 1797, under the stress of the Napoleonic Wars, Britain left the gold standard for inconvertible paper. At that time, the Bank of England was still operating as a national bank, not a central bank in the modern sense of the term. In other words, it operated to improve the English economy rather than to strengthen the sanctity of international finance. Ricardo, by focusing on long term-equilibrium, discouraged discussions on the possible beneficial output and employment effects of monetary injection on the national level. Like modern-day monetarists, Bullionists laid the source of inflation, a decidedly evil force in international finance, squarely at the door of the national bank. As Milton Friedman declared some two centuries after Richardo: inflation is everywhere a monetary phenomenon. Friedman's concept of "money matters" is the diametrical opposite of Hume's. The historical evolution in 18th-century Europe from a predominantly full-metal money to a mixed metal-paper money forced advances in the understanding of the monetary transmission mechanism. After gold coins had given way to banknotes, Hume's direct mechanism of price adjustment was found lacking in explaining how banknotes are injected into the system. Henry Thornton (1760-1815), in his classic The Paper Credit of Great Britain (1802), provided the first description of the indirect mechanism by observing that new money created by banks enters the financial markets initially via an expansion of bank loans, through increasing the supply of lendable funds, temporarily reducing the loan rate of interest below the rate of return on new capital, thus stimulating additional investment and loan demand. This in turn pushes prices up, including capital good prices, drives up loan demands and eventually interest rates, bringing the system back into equilibrium indirectly. The central issue of the doctrines of the British classical school that dominated the first half of the 19th century was focused around the application of the QTM to government policy, which manifested itself in the maintenance of external equilibrium and the restoration and defense of the gold standard. Consequently, the QTM tended to be directed toward the analysis of international price levels, gold flow, exchange-rate fluctuations and trade deficits. It formed the foundation of mercantilism, which underpinned the economic structure of the British Empire via colonialism, which reached institutional maturity in the same period. Bullionists developed the idea that the stock of money, or its currency component, could be effectively regulated by controlling a narrowly defined monetary base, that the control of "high-power money" (bank reserves) in a fractional reserve banking regime implies virtual control of the money supply. High-power money is the totality of bank reserves that would be multiplied many times through the money-creation power of commercial bank lending, depending on the velocity of circulation. In the 1987 crash when the Dow Jones Industrial Average (DJIA) dropped 22.6 percent in one day (October 19) on volume of 608 million shares, six times the normal volume then (current normal daily volume is about 1.6 billion shares), the US Federal Reserve under its newly installed chairman, Alan Greenspan, created US$12 billion of new bank reserves by buying up government securities. The $12 billion injection of high-power money in one day caused the Fed Funds rate to fall by three-quarters of a point and halted the financial panic. If the government had been running a balanced budget and there were no government securities to be bought, the economy would have seized up. This shows that government deficits and debt are part and parcel of the modern financial architecture. In the three decades after Britain returned to the gold standard in 1821, the policy objective focused on the maintenance of fixed exchange rates and the automatic gold convertibility of the pound. But the Currency School (CS) versus Banking School (BS) controversy broke out over whether the "Currency Principle" of making existing mixed gold-paper currency expand and contract in direct proportion to gold reserves was sufficient to safeguard against note overissuance, or whether additional regulation was necessary. This controversy grew out of the expansion pressure put on the supply of pound sterling by the rapid expansion of the British empire. Members of the CS argued that even a fully, legally convertible currency could be issued in excess with undesirable consequences, such as rising domestic prices relative to foreign prices, balance-of-payment deficits, falling foreign-exchange rates, gold outflow resulting in depletion of gold reserves and ultimately forced suspension of convertibility. The rate of reserves drain often accelerated when the external gold drain coincided with internal domestic-panic conversion of paper into gold in fear of pending depreciation. Thus the CS promoted full convertibility plus strict regulation of the volume of banknotes to prevent the recurrence of gold drains, exchange depreciation and domestic liquidity crises. The apprehension of the CS was fully justified by past actions of the Bank of England, which had been perverse and destabilizing by international finance standards. The destabilizing argument stressed the time lag on the Bank's policy response to gold outflow and to exchange-rate movements. The inevitably too little, too late measures taken by the national bank, instead of protecting gold reserves, merely exacerbated financial panics and liquidity crises that inevitably followed periods of currency-credit excess. The famous Bank Charter Act of 1844, in modern parlance, imposed a 100 percent reserve requirement, with an unabashed bias toward wealth preservation over wealth creation. The CS also asserts that money substitutes cannot impair the effectiveness of monetary regulation. Thus if banknotes could be controlled, there would be no need to control deposits explicitly, on the ground that money substitutes have low velocity and are of declining substitutional value in times of crisis. Keynesians argue that the QTM is invalid because it assumes an automatic tendency to full employment. If resource under-ultilization and excess capacity exist, a monetary expansion may produce a rise in output rather than a rise in prices, as in the case of the 1930s Depression. Money is not a mere veil. Monetary changes may have a permanent effect on output, interest rates, and other real variables, contrary to the neutrality postulate of the QTM. Post-Keynesians also contend that the QTM erroneously assumes the stability of velocity and its counterpart, the demand for money. Velocity is a volatile, unpredictable variable (technically known as exogenous - due to external causes), influenced by meta-rationality and by changes in the volume of money substitutes, not to mention hedges in the form of derivatives. The erratic behavior of velocity makes it impossible to predict the effect of a given monetary change on prices. John Law (1671-1729), a contemporary of Bodin, elaborated in 1705 on the distinction drawn by Bernardo Davanzati (1529-1606) between "value in exchange" and "value in use", which led Law to introduce his famous "water-diamond" paradox: that water, which has great use-value, has no exchange-value, while diamonds, which have great exchange-value, have no use-value. Contrary to Adam Smith, who used the same example but explained it on the basis of water and diamonds having different labor costs of production, Law regarded the relative scarcity of goods in demand as the generator of exchange value. Davanzati showed how "barter is a necessary complement of division of labor amongst men and amongst nations"; and how there is easily a "want of coincidence in barter", which calls for a "medium of exchange"; and this medium must be capable of "subdivision" and be a "store of value". He remarked "that one single egg was more worth to Count Ugolino in his tower [prison] than all the gold of the world", but that on the other hand, "ten thousand grains of corn are only worth one of gold in the market", and that "water, however necessary for life, is worth nothing, because superabundant". That was of course before International Monetary Fund (IMF) conditionality requiring the poor in the indebted Third World to pay for water through privatization of basic utilities to service foreign debt. Davanzati observed that in the siege of Casilino, "a rat was sold for 200 florins, and the price could not be called exaggerated, because next day the man who sold it was starved and the man who bought it was still alive". Of course, modern economists would call that a market failure. Davanzati viewed all the money in a country as worth all the goods, because the one exchanges for the other and nobody wants money for its own sake. Davanzati did not know anything about the velocity of money, and only recognized that every country needs a different quantity of money, as different human frames need different quantities of blood. The mint ought to coin money gratuitously for everybody; and the fear that, if the coins are too good, they should be exported is simply illusory, because they must have been paid for by the exporter. Law's "Real Bills Doctrine" of money applied the "reflux principle" to the money supply. Money, Law argued, was credit and credit was determined by the "needs of trade". Consequently, the amount of money in existence is determined not by the imports of gold or trade balances (as the Mercantilists argued), but rather on the supply of credit in the economy. And money supply (in opposition to the Quantity Theory) is endogenous (growing from within), determined by the "needs of trade". Post-Keynesians have drawn on the Real Bills Doctrine, which asserts that the money supply is an endogenous variable that responds passively to shifts in the demand for it. Thus monetary changes cannot affect prices. Being demand-determined, the stock of money cannot exceed or fall short of the quantity of money demanded. In short, there is no transmission mechanism running from money to prices. Analysts should look instead for the source of economic dislocations in real rather than monetary causes. Inflation creates a corresponding increase in the money supply, not the other way around. Yet QTM theorists exposed the Achilles' heel of the Real Bills Doctrine by demonstrating that as long as the loan rate of interest is below the expected yield on new capital projects, the demand for loans will be insatiable. Thus the "real bills" criterion as an automatic regulator of the money supply is inoperative unless central banks intervene to raise interest rates in concert with expected return on capital.
# posted by MobyGrape : 4:40 PM
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