Money and Markets: A Doctrinal Approach (Routledge Studies in the History of Economics)

Money and Markets

In the development of the history of economic thought, contrasting views of money and markets have emerged. Whilst some economists have seen money as an instrument created by individuals in an attempt to overcome the difficulties of barter, others have seen it as something created before the market, maintained and promoted by the State. Similarly, whereas some economists have seen the market as a level playing field, others have seen it dominated by specific group interests. This book brings together 14 essays by leading authors in the field of economics to look at the relationship between money and markets thoughout economic theory and history, thus providing a key to understanding important issues in monetary theory and other important debates in contemporary economics. Taking a critical stance of much mainstream economics literature and offering alternative arguments, this title is essential reading for postdoctoral researchers in the field of both the history of economics and current economic theory. Alberto Giacomin is Associate Professor of History of Economic Thought at the University of Venice. Maria Cristina Marcuzzo is Professor of Economics at the University of Rome.

Routledge studies in the history of economics

1 Economics as Literature Willie Henderson 2 Socialism and Marginalism in Economics 1870–1930 Edited by Ian Steedman 3 Hayek’s Political Economy The socio-economics of order Steve Fleetwood 4 On the Origins of Classical Economics Distribution and value from William Petty to Adam Smith Tony Aspromourgos 5 The Economics of Joan Robinson Edited by Maria Cristina Marcuzzo, Luigi Pasinetti and Alesandro Roncaglia 6 The Evolutionist Economics of Léon Walras Albert Jolink 7 Keynes and the ‘Classics’ A study in language, epistemology and mistaken identities Michel Verdon

8

The History of Game Theory, Volume 1 From the beginnings to 1945 Robert W. Dimand and Mary Ann Dimand 9 The Economics of W. S. Jevons Sandra Peart

10 Gandhi’s Economic Thought Ajit K Dasgupta 11 Equilibrium and Economic Theory Edited by Giovanni Caravale 12 Austrian Economics in Debate Edited by Willem Keizer, Bert Tieben and Rudy van Zijp 13 Ancient Economic Thought Edited by B. B. Price 14 The Political Economy of Social Credit and Guild Socialism Frances Hutchinson and Brian Burkitt 15 Economic Careers Economics and economists in Britain 1930–1970 Keith Tribe

16 Understanding ‘Classical’ Economics Studies in the long-period theory Heinz Kurz and Neri Salvadori 17 History of Environmental Economic Thought E. Kula 18 Economic Thought in Communist and Post-Communist Europe Edited by Hans-Jürgen Wagener 19 Studies in the History of French Political Economy From Bodin to Walras Edited by Gilbert Faccarello 20 The Economics of John Rae Edited by O. F. Hamouda, C. Lee and D. Mair 21 Keynes and the Neoclassical Synthesis Einsteinian versus Newtonian macroeconomics Teodoro Dario Togati 22 Historical Perspectives on Macroeconomics Sixty years after the ‘General Theory’ Edited by Philippe Fontaine and Albert Jolink 23 The Founding of Institutional Economics The leisure class and sovereignty Edited by Warren J. Samuels 24 Evolution of Austrian Economics From Menger to Lachmann Sandye Gloria

25 Marx’s Concept of Money The God of commodities Anitra Nelson 26 The Economics of James Steuart Edited by Ramón Tortajada 27 The Development of Economics in Europe since 1945 Edited by A. W. Bob Coats 28 The Canon in the History of Economics Critical essays Edited by Michalis Psalidopoulos 29 Money and Growth Selected papers of Allyn Abbott Young Edited by Perry G. Mehrling and Roger J. Sandilands 30 The Social Economics of JeanBaptiste Say Markets and virtue Evelyn L. Forget 31 The Foundations of LaissezFaire The economics of Pierre de Boisguilbert Gilbert Faccarello 32 John Ruskin’s Political Economy Willie Henderson 33 Contributions to the History of Economic Thought Essays in honour of R. D. C. Black Edited by Antoin E. Murphy and Renee Prendergast

34 Towards an Unknown Marx A commentary on the manuscripts of 1861–63 Enrique Dussel 35 Economics and Interdisciplinary Exchange Edited by Guido Erreygers 36 Economics as the Art of Thought Essays in memory of G. L. S. Shackle Edited by Stephen F. Frowen and Peter Earl 37 The Decline of Ricardian Economics Politics and economics in post-Ricardian theory Susan Pashkoff

42 Piero Sraffa’s Political Economy A centenary estimate Edited by Terenzio Cozzi and Roberto Marchionatti 43 The Contribution of Joseph Schumpeter to Economics Economic development and institutional change Richard Arena and Cecile Dangel 44 On the Development of Long-run Neo-Classical Theory Tom Kompas 45 F.A. Hayek as a Political Economist Economic analysis and values Edited by Jack Birner, Pierre Garrouste and Thierry Aimar

38 Piero Sraffa His Life, thought and cultural heritage Alessandro Roncaglia

46 Pareto, Economics and Society The mechanical analogy Michael McLure

39 Equilibrium and Disequilibrium in Economic Theory The Marshall–Walras divide Michel de Vroey

47 The Cambridge Controversies in Capital Theory A study in the logic of theory development Jack Birner

40 The German Historical School The historical and ethical approach to economics Edited by Yuichi Shionoya

48 Economics Broadly Considered Essays in honor of Warren J. Samuels Edited by Steven G. Medema, Jeff Biddle and John B. Davis

41 Reflections on the Classical Canon in Economics Essays in honor of Samuel Hollander Edited by Sandra Peart and Evelyn Forget

49 Physicians and Political Economy Six studies of the work of doctor-economists Edited by Peter Groenewegen

50 The Spread of Political Economy and the Professionalisation of Economists Economic societies in Europe, America and Japan in the nineteenth century Massimo Augello and Marco Guidi 51 Historians of Economics & Economic Thought The construction of disciplinary memory Steven G. Medema and Warren J. Samuels 52 Competing Economic Theories Essays in memory of Giovanni Caravale Sergio Nisticò and Domenico Tosato 53 Economic Thought and Policy in Less Developed Europe The 19th century Edited by Michalis Psalidopoulos and Maria-Eugenia Almedia Mata 54 Family Fictions and Family Facts Harriet Martineau, Adolphe Quetelet and the population question in England 1798–1859 Brian Cooper 55 Eighteeth-Century Economics Peter Groenewegen 56 The Rise of Political Economy in the Scottish Enlightenment Edited by Tatsuya Sakamoto and Hideo Tanaka

57 Classics and Moderns in Economics, Volume I Essays on nineteenth and twentieth century economic thought Peter Groenewegen 58 Classics and Moderns in Economics, Volume II Essays on nineteenth and twentieth century economic thought Peter Groenewegen 59 Marshall’s Evolutionary Economics Tiziano Raffaelli 60 Money, Time and Rationality in Max Weber Austrian connections Stephen D. Parsons 61 Classical Macroeconomics Some modern variations and distortions James C. W. Ahiakpor 62 The Historical School of Economics in England and Japan Tamotsu Nishizawa 63 Classical Economics and Modern Theory Studies in long-period analysis Heinz D. Kurz and Neri Salvadori 64 A Bibliography of Female Economic Thought to 1940 Kirsten K. Madden, Janet A. Sietz and Michele Pujol

65 Economics, Economists and Expectations From microfoundations to macroeconomics Warren Young, Robert Leeson and William Darity Jnr 66 The Political Economy of Public Finance in Britain, 1767–1873 Takuo Dome 67 Essays in the History of Economics Warren J. Samuels, Willie Henderson, Kirk D. Johnson and Marianne Johnson 68 History and Political Economy Essays in honour of P. D. Groenewegen Edited by Tony Aspromourgos and John Lodewijks 69 The Tradition of Free Trade Lars Magnusson 70 Evolution of the Market Process Austrian and Swedish economics Edited by Michel Bellet, Sandye Gloria-Palermo and Abdallah Zouache 71 Consumption as an Investment The fear of goods from Hesiod to Adam Smith Cosimo Perrotta 72 Jean-Baptiste Say and the Classical Canon in Economics The British connection in French classicism Samuel Hollander

73 Knut Wicksell on Poverty No place is too exalted Knut Wicksell 74 Economists in Cambridge A study through their correspondence 1907–1946 Edited by M. C. Marcuzzo and A. Rosselli 75 The Experiment in the History of Economics Edited by Philippe Fontaine and Robert Leonard 76 At the Origins of Mathematical Economics The economics of A. N. Isnard (1748–1803) Richard van den Berg 77 Money and Exchange Folktales and reality Sasan Fayazmanesh 78 Economic Development and Social Change Historical roots and modern perspectives George Stathakis and Gianni Vaggi 79 Ethical Codes and Income Distribution A study of John Bates Clark and Thorstein Veblen Guglielmo Forges Davanzati 80 Evaluating Adam Smith Creating the Wealth of Nations Willie Henderson

81 Civil Happiness Economics and human flourishing in historical perspective Luigino Bruni 82 New Voices on Adam Smith Edited by Leonidas Montes and Eric Schliesser 83 Making Chicago Price Theory Milton Friedman–George Stigler correspondence, 1945–1957 Edited by J. Daniel Hammond and Claire H. Hammond

84 William Stanley Jevons and the Cutting Edge of Economics Bert Mosselmans 85 A History of Econometrics in France From nature to models Philippe Le Gall 86 Money and Markets A doctrinal approach Edited by Alberto Giacomin and Maria Cristina Marcuzzo

Money and Markets A doctrinal approach

Edited by Alberto Giacomin and Maria Cristina Marcuzzo

First published 2007 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN Simultaneously published in the USA and Canada by Routledge 270 Madison Ave, New York, NY 10016 Routledge is an imprint of the Taylor & Francis Group, an informa business This edition published in the Taylor & Francis e-Library, 2007. “To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.”

© 2007 Selection and editorial matter, Alberto Giacomin and Maria Cristina Marcuzzo; individual chapters, the contributors All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data Money and markets : a doctrinal approach / edited by Alberto Giacomin and Maria Cristina Marcuzzo. – 1st ed. p. cm. – (Routledge studies in the history of economics ; 86) Includes bibliographical references and index. 1. Money. 2. Finance. I. Giacomin, Alberto. II. Marcuzzo, Maria Cristina, 1948– HG221.M81415 2007 332.4–dc22 2006029606 ISBN 0-203-09996-6 Master e-book ISBN

ISBN10: 0-415-38403-6 (hbk) ISBN10: 0-203-09996-6 (ebk) ISBN13: 978-0-415-38403-2 (hbk) ISBN13: 978-0-203-09996-4 (ebk)

Contents

List of illustrations Notes on contributors Acknowledgements

1

Money and markets: introduction

xiii xiv xvi

1

ALBERTO GIACOMIN AND MARIA CRISTINA MARCUZZO

PART I

Alternative representations of market and monetary relationships

13

2

15

Monetary and social relationships CHARLES A. E. GOODHART

3

Complexity theory’s network conception of the individual

30

JOHN B. DAVIS

4

Does game theory offer ‘new’ mathematical images of economic reality?

48

GIORGIO ISRAEL

PART II

History of monetary ideas in the light of modern theory

57

5

59

Money, markets and property GUNNAR HEINSOHN AND OTTO STEIGER

6

Money and markets as twin concepts? Some lessons from the recent history of market theory JEAN CARTELIER

79

xii

Contents

7

The monetary-policy relevance of an international settlement institution: the Keynes plan 60 years later

96

SERGIO ROSSI

8

Price and prejudice: the statics and dynamics of money-wage flexibility

115

ANNAMARIA SIMONAZZI AND FERNANDO VIANELLO

PART III

At the origin of monetary ideas 9

Beyond the quantity theory: a reappraisal of Jean Bodin’s monetary ideas

133

135

JÉRÔME BLANC

10 Money as a social bookkeeping device: from mercantilism to General Equilibrium theory

150

HEINZ-PETER SPAHN

11 Death in Venice – John Law: art collector, monetary theorist and corporate financier

166

ANTOIN E. MURPHY

12 Paper money: a reassessment of Adam Smith’s views

181

ALBERTO GIACOMIN

PART IV

Neglected contributions to monetary theory and policy

201

13 ‘Incalculability’ and the heterogeneity of agents in Frederick Lavington’s monetary theory of markets

203

CÉCILE DANGEL-HAGNAUER AND ALAIN RAYBAUT

14 Profit rate, money and economic dynamics in Fanno’s thought

222

CRISTINA NARDI SPILLER AND MARIO POMINI

15 Money and usury in the economics of Ezra Pound

238

MEGHNAD DESAI

Index

247

Illustrations

Figures 7.1 11.1 13.1

The two circuits of international money Law’s Financial System The prospective net returns of a safe and a risky security

108 176 207

Tables 7.1 7.2 7.3

The result of an international payment in bancor in Keynes’s plan The result of an international payment in bancor: step I The result of an international payment in bancor: step II

100 105 107

Contributors

Jérôme Blanc is Associate Professor of Economics at the University of Lyon 2 ‘Lumière’, France. Jean Cartelier is Professor of Economics at the University of Paris X-Nanterre, France. Cécile Dangel-Hagnauer is Associate Professor at the University of NiceSophia Antipolis, France. John B. Davis is Professor of History and Philosophy of Economics at the University of Amsterdam, the Netherlands and Professor of Economics at Marquette University, USA. Meghnad Desai is Emeritus Professor of Economics at the London School of Economics, United Kingdom. Alberto Giacomin is Associate Professor of History of Economic Thought at the University of Venice ‘Cà Foscari’, Italy. Charles A. E. Goodhart is Emeritus Professor of Banking and Finance, Financial Market Group, at the London School of Economics, United Kingdom. Gunnar Heinsohn is Professor of Social Sciences at the University of Bremen, Germany. Giorgio Israel is Professor of History of Mathematics at the University of Rome ‘La Sapienza’, Italy. Maria Cristina Marcuzzo is Professor of Economics at the University of Rome ‘La Sapienza’, Italy. Antoin E. Murphy is Professor of Economics at Trinity College Dublin, Ireland. Cristina Nardi Spiller is Professor of Macroeconomics and Economics of art at the University of Verona, Italy. Mario Pomini is Professor of Economics at the University of Padua, Italy.

Contributors xv Alain Raybaut is Research Fellow at the University of Nice-Sophia Antipolis, France. Sergio Rossi is Professor of Economics at the University of Fribourg, Switzerland. Annamaria Simonazzi is Professor of Political Economy at the University of Rome ‘La Sapienza’, Italy. Heinz-Peter Spahn is Professor of Economics at the University of Hohenheim, Germany. Otto Steiger is Emeritus Professor of Economics at the University of Bremen, Germany. Fernando Vianello is Professor of Macroeconomics and History of Economic Analysis at the University of Rome ‘La Sapienza’, Italy.

Acknowledgements

Brought together in this volume is a selection from the papers presented at the 8th European Society for the History of Economic Thought Conference held in Treviso and Venice on 26–29 February 2004. Without implicating them in any way, we wish to express our thanks to Tony Aspromourgos, Alberto Baccini, Tony Brewer, Pascal Bridel, Victoria Chick, Ghislain Deleplace, Michel De Vroey, Bruna Ingrao, David Laidler, Arrigo Opocher, Ugo Pagano, Alessandro Roncaglia, Annalisa Rosselli, Bertram Schefold and Roy Weintraub, whose comments and criticisms have been of great help to us in preparing the volume. In our Introduction we address those issues to which, in our view and in our understanding of the topic, these papers provide a contribution. However, they can and, we hope, will be read following other threads. We have, therefore, chosen not to take them in the same order of presentation as in the table of contents, to stress that our Introduction reflects what we have been stimulated to ponder and learned by reading and editing this book.

1

Money and markets Introduction Alberto Giacomin and Maria Cristina Marcuzzo

Two alternative conceptions of money In the history of economic thought the relationship between money and market has been interpreted from two contrasting points of view. On the one hand, money is seen as an instrument created by individuals to overcome the difficulties involved in barter, its basic function being as a medium of exchange, while the other view has it that money developed before the market and that its principal function is that of a standard of value. Evidently, therefore, in the former case the unit of account function is seen to have emerged from a practice (exchange of goods and services) based on the advantages to be had for individuals seeking to maximize their utility, while in the latter case money emerges as a rule adopted by members of the community (the political authorities promoting it and ensuring it be respected) which pre-dates the market. These contrasting views date back as early as the times of Aristotle, who defined money, alternatively, as a commodity selected by agents to serve as a medium of exchange, and as a simple token created by the political authorities to be used as a means of payment. In his Politics (I, 1257a) he argues that money is the means created by agents for convenience in exchanges, and that the State intervenes only subsequently to facilitate measurement of the weight and assessment of the quality of the chosen commodity (Aristotle 1977: 38–42). In the Nicomachean Ethics (V, 5, 1133b), on the other hand, money is seen as a legal convention – a measure of value that enables the exchange of goods and thus collaboration between members of the polis. Money is a social convention, and performs its function by dint of a decision made by the political authorities (Aristotle 1982: 284–8). Aristotle’s two theories represent a heritage that has been drawn upon throughout the history of pre-modern economic thought, and it was not until the eighteenth century that a significant change came about. It was then, with the dawn of political economy, that its theoreticians (Hume, Quesnay, Smith) levelled their critical fire at mercantilism as a convenient target to match themselves against. The thesis to be confuted was that true wealth lay in gold and silver: for the sake of the country’s prosperity, therefore, it was necessary to accumulate the precious metals. Actually, this was not the mercantilist idea; rather, it

2

A. Giacomin and M. C. Marcuzzo

held that the accumulation of the precious metals by virtue of a positive balance of trade was but a consequence of the economic system’s capacity to produce wealth and generate employment. This idea was to be rediscovered and subjected to searching analysis by Keynes after a lapse of 150 years, as we shall see later on. The idea that it was money that represented true wealth was not hard to confute. For the classical economists it sufficed to observe that wealth was a composite set of useful things, while money was but a means to facilitate exchange. What counted was not the wealth and power of the State but the wellbeing of the individual members of the community. The criticism advanced by the classical economists had great success, in the space of 50 years sweeping away the mercantilist doctrine, which remained confined to government practices ignored by the new theory. So classical political economy described in real terms the functioning of the market economies, drastically downsizing the role and importance of money. One possible reason for this outcome is that money, like the State or income distribution, represented a formidable stumbling block for an economic science to be constructed on the model of Newtonian physics, eliciting those natural laws that govern the economic world. If only it were demonstrated that economic activity was subject to natural laws – not human, that is, and so immutable – all that governments could do would be to respect them and seek to remove the obstacles compromising their efficacy. This interpretation of the economic world offered support to the social groups emerging in the society of the ancien régime: entrepreneurs, bankers, ship-owners, insurers, property-owners and capitalists and, in general, all who looked to the development of production and trade to promote and consolidate their own positions in society. Asserting the existence of natural laws to which the production (and distribution) of wealth was subject meant denying the legitimacy of interventionist government policies, while at the same time calling for extension of the autonomy and freedom of initiative of the private agents operating in the economic field. It also required that the tools employed by the political authorities to regulate the market economy and keep it under control, such as taxes, income distribution and money, be blunted and relegated to a marginal role. And the classical economists accordingly concentrated their attention on the private sector, confining within narrow limits the scope for action by the State, limited to providing the essential services for the functioning of the economic system, or, in short, defending property. Money was to be seen as a mere medium of exchange: a ‘neutral’ means that was not to interfere in the determination of prices but simply to ensure transparency for the ‘signals’ they transmit to the production and consumption decision-makers. Like the wheel or the steam engine, money was but a technical means to reduce production costs: in the specific case, to guarantee that productive specialization and the market prove advantageous. There is no need to invoke the social aspect of economic activity to account for its existence: it is enough to consider the exchange of goods and services between individuals pursuing self-interest, society being simply the sum of individuals collaborating among themselves through exchange.

Introduction 3 In their contribution, Gunnar Heinsohn and Otto Steiger (Chapter 5) argue that only in a society that recognizes private property is there any point in the existence of money, created through the granting of credit whereby the debtor offers his property to guarantee repayment of the capital and payment of interest. This represents a ‘property premium’ due to the creditor for having accepted the constraint on his right to dispose of his property until the credit granted is repaid. There could be no propertied class if its members lacked the ability to win the consensus of the community or the means to assert their right to property with the use of force. Money assumes the form of a means designed by private citizens to obviate the temporary difficulties they may come up against in a society where the collective guarantees prove wanting and each individual has to cope with the necessities of life on his own strength. On the basis of this interpretation the market emerges as a consequence of money. It is precisely that ‘place’ where debtors sell their products to acquire the means to pay off the debts they have taken on with the due interest. Heinz-Peter Spahn, on the other hand, interprets money in Chapter 10 as a means for social accounting – a substitute for the creditor’s trust in the debtor. This account opens the way to the interpretation of money as a certificate of debt by a third party who enjoys the confidence of the creditor: here the stress is placed not on the cost borne by the producers, but on the level of interest rate that is to be paid by the holder of money and that measures scarcity in relation to commodities. Charles Goodhart (Chapter 2) also contests the idea that money came about to obviate the difficulties of barter, holding that it was introduced to ‘settle fundamental social relations’, such as a dowry, the bride-price, compensation for damage or assault, or taxes, as well, of course, as market relations in general. Money is a social institution that precedes the market, which could not function if there were not an authority providing law and order and ensuring the implementation of contracts. Jérôme Blanc (Chapter 9) decries this idea in the thought of Jean Bodin, who considers money within the context of the question of sovereignty. For Bodin money is a phenomenon that transcends the private sphere and represents a constituent element of social organization. Thus full control over the issue and circulation of money is a matter for the ‘Prince’. Even he, however, finds his powers restricted by certain limitations, such as the prohibition to counterfeit or debase money. While attributing the ‘Prince’ with absolute sovereignty, Bodin holds that in money matters he is bound to his subjects in a pact requiring him to respect the fundamental characteristics of money. In his contribution Jean Cartelier (Chapter 6) demonstrates that all attempts to advance a globally stable explanation of market equilibrium without starting from the assumption of the existence of money or introducing money into the utility function are doomed to failure. On the other hand, in the classical approach à la Cantillon the inclusion of money serves the purpose in that in essence prices represent the ratios between the value of money (held by the agents in advance) and excess supply of commodities. The difference consists in

4

A. Giacomin and M. C. Marcuzzo

introducing money into the system from the very outset, or in other words recognizing that the system is able to determine the value of commodities inasmuch as the agents are in possession of money, that is a socially recognized means to acquire them from the producers.

Money in history Historical evidence in support of the idea that money existed before the market is offered by the wergeld and the tally, two institutions that have come under the lens of anthropologists and historians of economics and law. ‘Wergeld’ is a term from old German referring to compensation for the murder of a member of the community or some offence against his person, family or patrimony. It is a practice we find documented in pre-classical Greece, and among the Celtic, Germanic, Scandinavian and Slav populations of the Dark Ages. Apparently the aim was to assuage the wrath of the injured party or his family and prevent the outbreak of feuds, seen as threatening the solidity of social structures. Both the offences and compensations were assessed through common practice, which ensured the force of a binding principle. It has been observed that the English verb ‘to pay’(from the French payer), referring to settlement of a debt, derives from the Latin pacare, which means ‘to pacify’ and refers to the process of seeking an agreement with the injured party to prevent his revenge. According to Grierson (1977: 22), geld (a term cognate with the Old English gild, geld) indicates a unilateral payment (a fine, a tax, compensation or a feudal due), while werd recalls the English ‘worth’, from the root word wair (‘man’), like the Latin vir. Weorp or wairp are Old English terms indicating ‘price’, although, Grierson suggests (ibid.), the second of the two terms ‘may have included a more sinister element’, in that it referred specifically to the price of a slave. Thus the connection with the evaluation of goods, at first sight totally lacking, could be detected in the institution of slavery, much like that of the bride’s wealth. Both are attested with certainty in ancient Greece, as indeed in the barbarian societies of western Europe, and may have represented the medium by means of which the assessment of offences could be extended from person to patrimony, and thus to all goods of economic value. Grierson (ibid.) goes on to point out that in Greek poléin (‘to sell’) originally referred to the sale of a person as slave, while the term timé (‘price’) included in its connotation the sense of ‘compensation’, ‘satisfaction’ and derived from the same root as timoréin (‘to have revenge’). A further point made in this respect (Wray 1998: 49) is that, supposing that it was in fact wergeld that lay behind the notion of debt and the search for a measure of value, the decisive factor determining its introduction was probably the need to establish the amount of levies. It is surely significant that in Mesopotamia, where the State first entered the scene, the standard of value was based on the unit of weight of the most common cereals, wheat and barley. This standard of value, or unit of account, is money in its primitive state, compatible, and – as the historical documentation shows, actually associated – with a wide

Introduction 5 range of objects serving as means of payment. A significant example is offered by the tally. According to certain scholars (Innes 1913: 394 and 396; Davies 1994: 147–52), for many centuries the major means of payment in Europe was the tally, a stick of squared hazel-wood with notches cut into it to indicate how much the debt came to. The name of the debtor and date of the contract were written on either side of the stick, which was then cut in two lengthwise, thus splitting the notches into two parts, each with the name of the debtor and date of the contract. The cut in the stick stopped about an inch short of the end; the longer part, called the stock, was held by the creditor, while the shorter, called the stub, was left to the debtor. On payment the two parts of the stick were brought back together to verify the effective sum of the debt. In England the tally became increasingly important from the twelfth century, to peak in the period preceding the foundation of the Bank of England. This momentous event did not put an end to use of the tally, which continued for over a century up to its termination in 1834. The factors behind the spread of the tally were the ban on usury and the scarcity of currency. In the course of time the tally became a wooden bill by means of which it was possible not only to obtain credit harmless of the penalties laid down by the law, but also to settle any debts and acquire commodities of all sorts (Innes 1913: 396). It was rapidly adopted by the Treasury. The first step consisted in the assignment with which the Exchequer transferred the taxpayers’ debt to the sovereign’s creditors, handing over the stock. Next came the tallia dividenda, which were consigned to the court suppliers, and refunded on expiration by the Exchequer like modern-day state bonds. Finally, at a later stage, the tallies were issued in great quantities by the Treasury as advances on fiscal revenue, and holders could trade them for money on the market. Thus, as Davies points out (1994: 150), ‘a system of discounting tallies arose especially in London, operated in a number of recorded instances by officials working in the Exchequer’. A function much like that of the tally was, according to Innes (1913: 395–6), served in Babylonia by clay tablets called shubati (‘receipt’) on which were recorded the quantity of goods sold – wheat, for example – the name of the issuer and that of the recipient, together with his seal and the name shubati. There were two ways to prevent counterfeiting: either the tablets could be deposited in a temple, or they could be sealed in a closed container that had to be broken like a money box to get at the tablets. In the latter case all the details recorded on the tablets were copied onto the container, except for the recipient’s name and seal. The container was broken only when payment was carried out, and the inscriptions could thus be compared. Unlike the tablets deposited in the temples, those sealed in containers could circulate like the tallies. What the tallies and shubati tablets have in common is that they both certificated debts and served as means of payment, disappearing from circulation once the credit was offset by a debt of the same amount, as was the practice with letters of exchange in the medieval fairs. Some scholars argue that these records could not be considered money since the settlement of any remaining debt was,

6

A. Giacomin and M. C. Marcuzzo

once compensation had been performed, probably concluded with money proper, or in other words minted gold and silver. Others point out that the shubati tablets were documented in Babylonia at least 2,500 years before the kings of Lydia minted the first metal coins around the second half of the seventh century BC. On the other hand, the metal currency that we are accustomed to consider real money seems to have come into existence as certification of the sovereign’s debt to the subjects whose goods and services he acquired – mercenary soldiers, for example, or suppliers liable to pay taxes (Grierson 1977: 10). It was no great problem for the political authorities to have their promises of payment accepted in exchange for goods and services since they were able to levy taxes and stated their readiness to accept their own promissory notes in payment. The use of costly supports such as gold and silver, which were rare metals and, in the absence of mines, usually came with war booties, is generally explained as a way of avoiding forgeries. Supposing that the function of a means of payment was served from the very outset not by a commodity but by a certificate of debt issued by an agent enjoying the confidence of the public, then the introduction of money seems obviously not due so much to the agents’ intention to reduce the costs of exchanges as to the fact that the issuer claims credit of the community and so is able to levy taxes. Thus money takes the form of an institution transcending the purely economic sphere in that it guarantees the exchange of goods and services between governors and governed, and with it the very foundations of social order. Like every other institution, this, too, owes its existence to the decision of the groups holding power to establish it, and the ability of those representing these groups to exact the respect of the entire community. Meghnad Desai (Chapter 15) associates a great twentieth-century poet’s diatribes against usury with a time-honoured tradition whose origins lie deep in Greek and Hebrew culture. Ezra Pound ascribed the unemployment of the 1930s to the scarcity of money for which the monopoly of the private banks was responsible. This, Pound held, was to be transferred to the State, which had the duty to make money available to all at zero interest rate. This highly censorious attitude to interest is also to be found in Aristotle and the Bible: not being a living organism, money cannot regenerate and bear interest; it is not a natural phenomenon but man-made, and so interest amounts to misappropriation of the wealth others have produced. According to Desai the prohibition of usury in the monotheistic religions may possibly be accounted for with the lack of surplus typical of societies settled in arid regions, like those where these religions were born. Antoin Murphy (Chapter 11) traces the idea that money is essentially a means to settle debts to John Law, one of the first economists to have realized that money did not derive from exchange but preceded it. Moreover, in a market system money precedes production and conditions its levels. Hence Law’s extraordinary insight into the vast possibilities of economic development offered by the bank. Its capacity to create generally accepted means of payment places it at the very heart of the market system. It is in fact by granting credit that the bank

Introduction 7 is able to provide firms with the wherewithal to invest and boost the growth of the economic system. However, it is to Adam Smith, as Alberto Giacomin (Chapter 12) argues, that we owe our appreciation of the importance of paper currency where he shows that, like any other capital good, money is subject to a ceaseless process of innovation seeking to reduce the costs involved in its use, and that gold and silver can be conveniently replaced with a token devoid of any intrinsic value. In his analysis of the inconvertible paper money system of the American colonies, Smith develops a sophisticated account of the determinants of its value which has recently been revived in the attempt to save the quantity theory of money from the counterexamples offered by monetary history. Sergio Rossi (Chapter 7) analyses the plan for reform of the international monetary system drawn up by Keynes at the end of the Second World War to show that the international currency serves to regulate exchanges between the different countries; thus its role differs from that of the national currencies, which serve not only for exchange but are also required to finance production economies.

Two alternative views of market As in the case of money, also for the market two approaches have come into confrontation in the course of the history of economic thought. With the first the market is seen as a column bearing the economies characterized by private property and freedom of enterprise. It represents the means by which members of society democratically come to decisions about the use of resources and distribution of income. Thanks to the market, in fact, all individuals, whatever their role, wealth or education, engage in the decision-making process on an equal footing with all the others. In the second approach, on the other hand, the market is seen as the means by which decisions on the use of resources and distribution of income, once taken by the groups enjoying economic command, are passed on to the other members of society to be implemented. In the first case the market lies at the heart of the system and serves to prevent the enjoyment of privileges and position rents by some members of society excluding others, while in the second it merely plays a supporting role for the existing patterns of power. What does, however, distinguish a market economy? In centrally managed economic systems like the ‘hydraulic’ economies of Mesopotamia and ancient Egypt (Wittfogel 1959), the European feudal system or the planned economy of the former Soviet Union, those in charge of the economy exercise their decisionmaking powers regarding the channelling of resources and distribution of income giving direct orders to those working under them. In the market economy, by contrast, in order to exercise their power the figures in charge of the economy make use of indirect orders, which take the form of contracts: thus it is not immediately evident that real orders are being given. While we cannot but recognize the fact that any exchange presupposes the existence of needs that

8

A. Giacomin and M. C. Marcuzzo

cannot be satisfied autonomously by those involved, we must also bear in mind that not all parties share the same degree of urgency; thus dependence on the counterparty is greater for some than for others. The most significant exchanges that take place in a market economy, like the buying and selling of work services, consumption goods or securities, are characterized by a distinct difference in the power of the two parties. Here the term ‘power’ is understood as a relationship between two social agents when there is conflict in their aims or values, or on the line to follow to achieve them. One of the two agents accedes to the other’s demands for fear that he may deprive him of one or more values which he holds dearer than those he is to sacrifice. In other words, power always goes hand in hand with a sanction, and involves a degree of rationality since the agent exercising it looks to the counterparty’s capacity to weigh up his own advantage. It is in the exercise of power that we find the key to the functioning of market economies. As we are reminded by Marglin (1974: 51–3), at the time of the industrial revolution entrepreneurs were able to get the workers into their factories only by facing them with the choice of working or starving. Discharged soldiers, peasants driven from their villages with the enclosure of common land, orphaned minors hired from the parishes for periods of ten or even more years, wives and children of home-based workers sent to the factories by their respective husbands and fathers to eke out the family income, and ‘the scum of every class and of every occupation’ (Mantoux 1961: 375) – such was the human material that composed the first generation of factory workers. The process was repeated in the course of capitalistic development, to the point that wage labour became a ‘natural’ fact that had no need of explanation. What we witness here is the quest for positions of power by economic agents on the strength of which they can bend the behaviour of other agents to their purposes. If we see it in these terms, we can appreciate the concern of the early critics of the market, who contested the vaunted capacity of the system to guarantee equality for the members of society, keeping the privileges and inequalities that had characterized the society of the ancien régime from setting in once again. The exponents of political economy answered back with the metaphor of the ‘invisible hand’, an ideal mechanism situated outside time that was entrusted with the task of guaranteeing freedom of access to economic activity in all its forms, together with efficiency in the use of resources and fairness in the distribution of income. The mechanism was to be descried in the market price system and the free play of forces in competition; acceptance of this interpretative scheme has long been – and indeed remains – a dominant feature of economic reasoning. According to John Davis (Chapter 3), individuals cannot be considered independent agents but are to be seen as components of groups, and it is these alone that are the real economic actors. Individuals are entrenched in their social contexts, having strong links with the group they belong to and weak links with the members of other groups. It is precisely on these weak links, Davis argues, that their autonomy rests. The individuals shift from one group to another according to the advantages to be expected with the move, and it is this that

Introduction 9 accounts for the dynamics of social groups characterizing modern industrial societies. Giorgio Israel (Chapter 4) points out how the game theory of von Neumann and Morgenstern offers an alternative approach to Walras’, with its emphasis on the centrality of the strategic interaction between economic agents. What von Neumann set out to accomplish was to free economic theory from its subjection to the Walrasian scheme, which he saw as an unhappy attempt to apply classical mechanics and its formal apparatus of mathematical analysis to economics. Giving up the search for equilibrium situations, von Neumann held, cleared the way for recognition of the fact that the real economic world is more often than not characterized by the presence of a few agents whose decisions are based on careful consideration of the opponents’ strategies. It opened the way to adoption of an approach that took the economic system as one whole, consisting of an ever changing network of strategic relations between agents. The stabilizing function of the price system comes in for criticism in two chapters analysing business cycle theory in authors who may, perhaps, not have received all the attention due to them in the history of economic thought, namely Frank Lavington and Marco Fanno. As Cécile Dangel-Hagnauer and Alain Raybaut (Chapter 13) point out, Lavington stresses the unpredictability of the results of economic initiatives, leading to losses in wellbeing for the community at large. The role of the entrepreneurs is to reduce these losses to the minimum. A constant preoccupation for entrepreneurs is to predict the trend in prices, both of input and of output. It is the errors in forecasting that set the cycle moving. When confidence is high, prices rise, and when it wanes prices fall, thus confirming agents’ expectations and further amplifying the see-saw trend of the economy. Cristina Nardi-Spiller and Mario Pomini (Chapter 14) stress the importance that expectations had for Fanno, too, in this case with regard to the rate of future profit. In the upward phase prices rise and generate profit. This phase comes up against two hurdles, one real – consisting of full employment – the other monetary, represented by the availability of credit. The downward phase of the cycle begins when the discount rate becomes equal to or above the rate of profit. Again, the overall result is cyclic instability, and not equilibrium. Annamaria Simonazzi and Fernando Vianello (Chapter 8) point out the destabilizing nature of deflation, both for the disastrous effects it has on the financial equilibrium of firms, compelled to sell off their assets below cost in the effort to pay back debts run up with the banks, and for the expectations generated of further falls in prices, sending profits and aggregate demand plunging down. The neoclassical economists conjure up visions of the positive effects of a fall in wages and prices on the consumption of holders of liquid assets, able to counterbalance both the liquidity preference and the insensitivity of investments to the interest rate, but it is the stickiness of prices more than their flexibility – as Keynes teaches us – that performs a positive, stabilizing role.

10

A. Giacomin and M. C. Marcuzzo

The power structure of the economy The alternative conception that sees in the market a social institution historically determined, like money, property or the State, derives from the idea that every economic system rests on a clearly defined power structure that assigns to certain individuals the authority to decide on the use of resources and the allocation of the final product. With its assumed price equilibrating mechanism, the market loses its central position to take on a more modest role as technical means to facilitate the exercise of power by those in control of the economy. Productive efficiency and distributive equity prove illusory, and with them evaporates the theoretical importance attached to the quest for positions of equilibrium. It is in fact the theory of effective demand formulated by Keynes (and Kalecki) that offers this alternative. The demand for goods and services expressed by the community contains active and passive components, or in other words some elements (active) that determine others (passive), but are not in turn determined by them: in the industrial economies the investments made by firms are the active component of global demand, while family consumption constitutes the passive part. In this new scheme the market is merely the means employed by firms (or the social groups that have some interest or other in their success) to achieve the end of unlimited accumulation of wealth. In a capitalistic system firms advance the liquid assets obtained from the banks, hire the workers, use their services to produce goods, and subsequently sell their consumption goods and stock in order to regain possession of the money they advanced, keeping for themselves part of the capital goods after paying the banks their interest. As had already been pointed out by Marx, in a system of this type the economic process can be summed up with the sequence: D – M – D', where M, which stands for the goods, and thus for the market, performs an instrumental role with respect to D, money, which constitutes the condition and objective of the entire process. Keynes takes explicit reference from this scheme when he introduces the distinction between ‘cooperative economy’ and ‘entrepreneur economy’ (1979: 81). The former is purely conjectural and constitutes the object of study in traditional theory, while the latter, which actually exists, is to be examined with a new approach which he terms ‘monetary theory of production’ (1979: 49–50). This is the picture of the market that emerged in sharp definition subsequent to contributions by Keynes, Kalecki and economists following in their wake, but its origins are quite remote, going back at least to Cantillon, who described the pre-industrial economy of the ancien régime as consisting of two classes: the landowners (the independent class) on one side, and the entrepreneurs and wage workers (the dependent class), on the other. The property owners’ spending on luxury goods constitutes the active component of the global demand, upon which depends the necessary consumption of the dependent class. Since the entrepreneurs produce only what they believe they can sell at a remunerative

Introduction 11 price, the market assumes the form of a means used by the property owners to transmit to the producers the decisions to be taken on the utilization of resources. Distribution of the final product between rents and wages is also decided by the market on the basis of the power relations between property owners and the dependent class. Obviously, this is a sui generis market picture in which the property owners’ wishes are law, since – as he points out – if they ‘close their Estates and will not suffer them to be cultivated, it is clear that there would be neither Food nor Rayment for any of the Inhabitants’ (Cantillon 1964: 43; see also Giacomin 1994). Thus Cantillon, like Keynes and Kalecki, held that the position of a social group in command over others rests on the possibility it has to abstain from spending its income for a period of time long enough to condition the existence of the others. However, we must also bear in mind that a significant change occurred in transition from pre-industrial to advanced industrial economy. The land owners departed from the scene, and the banks set up in their place. It is the banks that control access to resources for the producers. The rents taken by the landowners of the ancien régime are now represented by the interest obtained by the banks on the financing of firms. The task has passed to them to determine with their investments the directions resources are to take and the intensity of their use. The amount of the investments determines the demand for labour and, subsequently, the supply of goods and services. All that remains for the workers to do is to adjust their spending on consumption goods and securities to the income available in observance of their budget constraint. The granting of credit, the hiring of manpower, the sale of investment and consumption goods and securities show a non-competitive structure ranging from oligopoly to monopoly throught more or less disguised forms of collusion. According to the metaphor of the invisible hand attributed to Adam Smith1 and embraced in the scheme of general economic equilibrium, through the market individuals guided purely by self-interest are driven unwittingly and willy-nilly to achieve ends of general interest such as equal access to roles, efficient use of resources and fair distribution of product. According to the alternative view, on the other hand, the market is a social institution that reflects the particular needs of each system and is to be understood in the light of a pattern of power that assigns economic dominance to one or more groups of agents with the exclusion of others. The pattern emerges transparently from the hierarchy formed among the components of global demand. The fact that the investments play an active role in a capitalistic system while consumption is left with a passive role is neither a matter of chance nor arbitrary. Rather, it is the natural consequence on the economic plane of a supremacy sanctioned at the institutional level through the right to property, freedom of economic enterprise and the state’s abstention from direct management of productive activities. With the support of the banks, it is the firms that control access to resources, including labour, since there is a vast supply of people compelled to sell their personal services to earn a living, and compelled to accept the conditions laid down by the firms with regard to income

12

A. Giacomin and M. C. Marcuzzo

distribution. In other words, wages have to be set at a level that leaves room for the firms to make profits, whatever the workers’ needs may be. On the other hand, the conception of the market as a mechanism bending the action of individuals to the pursuit of aims of general interest leaves economic facts devoid of explanatory power, renders superfluous the analysis of effective demand as an element linking institutions and productive machinery, and relegates money to a subordinate, inessential role.

Note 1 The attribution of this theory to Smith has been hotly contested by authoritative scholars (cf., e.g. Rothschild 1994 and Roncaglia 2005), who see in it an attempt lacking any textual support to enlist the father of economic science among the upholders of a view that emerged only subsequently, in the sphere of marginalist thought.

References Aristotle (1977) Politics, Cambridge, MA: Harvard University Press (Loeb Classical Library). —— (1982) Nicomachean Ethics, Cambridge, MA: Harvard University Press (Loeb Classical Library). Cantillon, R. (1964) Essay on the Nature of Trade in General, ed. by H. Higgs, New York: Augustus M. Kelley. Davies, G. (1994) A History of Money: From Ancient Times to the Present Day, Cardiff: University of Wales Press. Giacomin, A. (1994) ‘Richard Cantillon: Potere, Domanda Effettiva e Popolazione in una Economia Pre-industriale’, Studi Economici, 52: 5–41. Grierson, P. (1977) The Origins of Money, London: The Athlone Press. Innes, A. M. (1913) ‘What is Money’, Banking Law Journal, 25: 377–408. Keynes, J. M. (1979) The Collected Writings of John Maynard Keynes, vol. XXIX: The General Theory and After. A Supplement, ed. by D. E. Moggridge, London: Macmillan and Cambridge University Press for the Royal Economic Society. Mantoux, P. (1961) The Industrial Revolution in the Eighteenth Century, London: J. Cape. Marglin, S. (1974) ‘What Do Bosses Do? The Origins and Functions of Hierarchy in Capitalist Production’, The Review of Radical Political Economy, 6: 33–60. Roncaglia, A. (2005) Il Mito della Mano Invisibile, Roma: Laterza. Rothschild, E. (1994) ‘Adam Smith and the Invisible Hand’, American Economic Review, Papers and Proceedings, 84: 319–22. Wittfogel, K. A. (1959) Oriental Despotism. A Comparative Study of Total Power, New Haven: Yale University Press. Wray, L. R. (1998) Understanding Modern Money. The Key to Full Employment and Price Stability, Cheltenham, UK: Edward Elgar.

Part I

Alternative representations of market and monetary relationships

2

Monetary and social relationships Charles A. E. Goodhart

Introduction The social sciences are much more complex than the physical sciences. Not only are experiments generally easier to undertake in the physical sciences, but also the subject matter of any such studies in the social sciences, we individuals, respond and change our own behaviour in the light of those same economic experiments. Moreover, human behaviour is both variable and reactive, especially in response to major regime changes. So, any attempt to depict the economic macro-system has to involve models which are gross simplifications of underlying reality. How best then to simplify our macro-models? It is such macro-models which will be the main subject of my discussion. When we macro-economists started building quantitative models at the outset of the computer age, some 40, or so, years ago, we generally aimed at getting a detailed and comprehensive structure of the economy, on a sector-by-sector, equation-by-equation basis, using national income statistical categories, and this led to large computable macromodels, often with 50, or more, equations. Amongst the resulting problems, however, were that the optimizing, so called micro-foundations were weak, if not non-existent. Expectations, when considered at all, were often inconsistent with the model’s own workings; and some of the implications of such large models were difficult to discern, and when worked out often totally implausible. All this led to the Lucasian revolution, whereby macro-models had to have ‘rigorous’, optimizing, micro-foundations, often based on so-called rational expectations. This, in turn, led to a degree of mathematical and analytical complexity. In order to continue with these more complex models, the effective solution was to simplify the initial structure of the model, for example by abstracting from aggregation issues via the use of ‘representative agents’, to allow it to support the heavier analytical superstructure. Thus, a surprisingly large proportion of the models currently used for policy analysis (though not, thanks be, for forecasting) in the macro-monetary field have been thinned down to three equations, an IS curve, an AS (Phillips) curve, and a Taylor reaction function; two players, central bank and private sector; and two assets, money and short-dated riskless debt.

16

C. A. E. Goodhart

I shall spend much of the first half of this chapter arguing that in many respects the Lucasian revolution has transferred the focus of implausibility, often downright nonsense, from the implications of the solutions of the models to their initial structural assumptions. And one of the key deficiencies of such macro-models, including those used for analysis of longer-term developments, such as growth or optimal currency areas, is that all the action takes place in the private sector, so that the key role of government is frequently unrecognized. This will be the main topic of the second half of my chapter.

The structural basis of macro-models Let me, however, start with an important sub-field where the analysis has, instead, improved. When I started doing economics some 45 years ago now, one of the key building blocks of macro-economics was the LM curve. The assumed process was that the Central Bank would inject high-powered base money into the system; this would then be translated into growth in the monetary aggregate(s) via a variety of money multipliers, and finally market interest rates would be determined through the equilibration of the demand and supply of money. Of course, simple observation of the way that central banks and money markets actually behaved would reveal that this was the exact reversal of the truth. The process started with the Central Bank determining its official shortterm interest rate, in pursuit of its current policy objectives. Then the demand for bank borrowing, at the chosen policy rate, was the main determinant of the growth of the monetary aggregates. Given M, the money multiplier worked effectively in reverse, to determine the amount of base money that the authorities had to make available to the banking system to sustain their initially chosen interest rate. Faced with this divergence between reality and economic theorizing, the response of the profession was to ignore reality for pedagogic purposes; see any macro-economics or ‘money and banking’ textbook until a few years ago. On the normative front, another reaction was to argue that Central Bank behaviour, in setting interest rates, was a sub-optimal policy, and that the Central Bank should adopt a policy of choosing, announcing and sticking to a policy of monetary targetry. Indeed it was argued, notably in the influential Sargent and Wallace 1975 article, that the Central Bank policy of setting interest rates was bound to lead to Wicksellian instability. That argument was correct on its own terms, but that assumed that the Central Bank would set its policy variable (either M or interest rates) exogenously, that is without adjusting that variable endogenously in response to concurrent economic developments. That assumption was unrealistic, indeed somewhat silly. Central Banks invariably set interest rates endogenously in response to perceived economic developments. At times they may have done so in a bad, or destabilizing, fashion because of political constraints, inappropriate objectives, misperceptions of reality or various human frailties. That said, the idea that Central Banks might try to ‘fool’ the public into working harder by cre-

Monetary and social relationships 17 ating ‘surprise’ inflation was never a realistic description of their activities. The papers by Kydland and Prescott (1977) and Barro and Gordon (1983a and b) on this issue were academically extremely influential, and indeed contributed to the former author’s Nobel Prize in 2004, but were only tenuously related to the main causes of the inflation of the 1970s. But the modus operandi of how Central Banks can, and now generally do, set interest rates so as to achieve price stability, and as a necessary adjunct of that economic stability, has been worked out in practice through the adoption of inflation targetry, initiated in New Zealand and Canada in the late 1980s and early 1990s. Thereafter Mervyn King has played a major role in developing the approach to include, for example, Inflation Reports and fan charts, and the subsequent work of academics such as Bernanke, McCallum, Svensson, John Taylor, Walsh and Woodford has brought theory into line with best practice. The prior divorce between theory and practice has gone. This is a considerable and valuable step forward for the profession from its former state. This reconciliation of theory and practice was marked for me by the publication of Michael Woodford’s magisterial book on Interest and Prices (2003). But that is about as far as I go in applause for recent developments in macroeconomics. Let me now take aim at some of the other structural assumptions of modern macro-economics, which mostly are evident in that same book. First, we believe, at least in a rather general sense, that if all prices and wages were infinitely flexible, the real economy would remain in equilibrium at all times, and money would be continuously neutral. Consequently an understanding of the rationale and workings of wage and price stickiness would, one might have thought, be central to modern macroeconomies. Indeed there was an upsurge of interest in this topic, stimulated first by Clower in the 1960s, for example 1965, and then by the work of Akerlof and Yellen in the mid-1980s, for example (1985a and b), but I confess to seeing little real progress on this front since then, either in theory or, perhaps, more important in generally accepted empirical findings. Instead, what one sees much more often is that macro-models are based on Calvo pricing mechanisms, whereby a particular (and constant) percentage of firms is allowed in each period to change prices, and the remaining firms are prevented from doing so – though why is never explained. Nobody believes this to be literally true; it is a mathematically convenient fiction; but it forms the pricing basis for much current macro-work. I might add, parenthetically, that quadratic utility functions are just such another convenient mathematical fiction. The likelihood that going from an inflation rate of say 100 per cent to one of 103 per cent per annum, is likely to reduce utility by vastly more than going from 4 to 5 per cent inflation is obvious nonsense, as Margaret Bray and I have recently argued (2002). Be that as it may, much of the structural foundations, relating to price/wage stickiness in modern macro-economics, rest on a convenient fiction, which has only a distant relationship with reality. Why such procedures are somehow regarded as professionally acceptable, whereas the assumption of adaptive expectations was not (especially when empirical studies generally show that

18

C. A. E. Goodhart

purely backwards-looking expectations have a better forecasting record than purely forwards-looking ones) is beyond me. Perhaps the greatest remaining gap between the work of academic money macro-economists and policy-makers in Central Banks and Ministries of Finance relates to lags, specifically the lag before policy measures affect economic outcomes. In most of the formal models the policy change immediately affects current output, because not all prices and wages are allowed, by a deus ex machina, to adjust, and also affects current and expected future inflation, and usually, depending on the model, future output. Although the lag structure, engendered by price stickiness, can have a long tail, the usual implications are that the largest effects on both output and inflation are immediate. This is not what policy-makers observe from the data. The standard databased rules of thumb are that, unless there is an immediate sharp shock to exchange rates, there is a short lag before output reacts at all, and then there is a hump-shaped response, and an even longer lag before inflation responds. This latter delay of the inflation response behind the output response is especially problematical for the theoreticians. It can hardly be doubted that monetary policy initiatives, in the sense of interest rate changes, are front-page news, as indeed are continuous ‘expert’ commentaries on the likely future paths of both nominal interest rates and of inflation. So any suggestion that those making the individual price/wage decisions are slow in learning about changes in current and future patterns of real interest rates is surely far-fetched; there are few islands where media reports of Alan Greenspan’s latest words are not instantly relayed.1 Yet if there is an observed change to the predicted future time path of real interest rates, then in theory those allowed to change prices/wages should now do so immediately. It was, perhaps, this timing problem that led those who were determined to maintain rigorous micro-foundations to turn away from monetary explanations of the cycle to real business cycle theories, which have, of course, their own serious shortcomings.2 To summarize, current macromodels find it extraordinarily hard to replicate the lag structure which is a key feature of the conjuncture for policy-makers, and for their own forecasters/economists, especially the quite lengthy delay before inflation responds perceptibly to observed changes in monetary conditions. Is it unfair to claim that the reaction of most theoretical model builders is to ignore this discrepancy, and to continue with constructs where both the rationale for, and time profile of, the lag structures has little relationship with reality? To be blunt, I cannot quite see how theoreticians can square the apparent actual lag profiles with the present dominant paradigms about price-setting mechanisms, without substantial modification of their present theories. The purest theoreticians of the Lucasian age get around the problem of modelling wage/price stickiness and lag profiles for the effects of monetary policy by assuming them away. In such real business cycle models money is neutral, prices are fully flexible and fluctuations come from real productivity shocks. Here we usually have representative agents, a representative consumer and firm, optimizing its utility over an indefinite time span and, normally, in a system of

Monetary and social relationships 19 complete financial markets. Such an assumption of complete financial markets is, for example, a key element in Woodford’s recent book which I have already mentioned. Why is this assumption central? It means that all eventualities can be foreseen and appropriately hedged at the correct insurance/option price. If all eventualities can be appropriately foreseen, hedged and priced, then there are a number of consequentials. All information problems are effectively solved; rational expectations is a logical implication; there is no residual, unhedgeable risk, financial or otherwise; all agents can borrow/lend at the riskless rate (plus, in a world of heterogeneous agents, an actuarially correct risk premium for the known risk of the agent defaulting, decamping or otherwise failing to meet the transversality condition – (that is that all debts are paid in full at the horizon). There could, moreover, never be any financial innovations since all the necessary instruments for transferring wealth among future states of nature would already exist. This assumption, of complete financial markets, lends itself admirably to the construction of soluble models with ‘rigorous’ micro-foundations of optimization within a general equilibrium system. The problem, of course, is that the assumption has no connection with the real world. Indeed, the favourite asset of such models, Arrow securities, (which pay out one in the event of some given event and zero otherwise), only occur rarely (for example some insurance products, credit default swaps, and so on). In particular, the complete financial markets assumption effectively means that all information problems relating to granting credit, expectation of repayment, and so on, have already been resolved. In such a system it is not clear why either money, or banks or other financial intermediaries should exist. I have never been able to understand how the necessary information is collected and distributed to all participants in such a system in the first place. An assumption of a system of complete financial markets, in effect, assumes away all Coaseian transactions costs, either because some Divine Auctioneer provides all the necessary information or because there is no time constraint, so we can all spend an infinite amount of time collecting information and establishing and pricing appropriate hedges. Unfortunately for us there is no Divine Auctioneer, and the time constraint always binds. Besides the fact that this implies incomplete financial contracts, indeed incomplete contracts more generally, it also implies that I can use my scarce time to work, play, sleep, shop or to gain information and educate myself. Improving my knowledge of the world, and making my expectations more accurate, requires use of my scarce time. It is not rational for agents to have expectations that are consistent with the outcomes of the best (or even the currently used) model; let alone to have the best possible expectations. What is rational is to use up scarce time until the expected marginal addition to utility from spending more time in learning about aspects of the world equals the marginal opportunity cost in foregone use of time in other pursuits, as Stigler (1987) has argued. Applications to business schools rise during periods of downturn and lay-offs in financial markets.

20

C. A. E. Goodhart

On this basis there is nothing inherently irrational about backwards-looking adaptive expectations, or on relying on the views and forecasts of others (as a part-time sheep-farmer I am a proponent of rational herding). Yet the Lucas critique, of course, still holds. Faced with a shock, a regime change, one will have to reallocate one’s scarce time, and that may well, indeed should, include a decision whether to allocate more time to learning about the new world. In calm conditions simple rules of thumb economize on scarce time; in disturbed conditions it pays to spend more time learning how best to navigate. What this implies is that the expectations’ generating process will itself be time-variant and endogenous, and not constant, as most models assume. That said, there is a heavy initial cost to learning about complex issues, which can be recalled through memory at virtually zero cost, at least until Alzheimer’s strikes. So expectation formation processes are likely to be subject to inertia, hysteresis and initial conditions. To summarize again, the way in which the rational expectations assumption is normally deployed assumes away Coaseian transactions costs, and would itself be irrational in the real world of binding time constraints. Once we dispense with complete financial markets, default (the failure of transversality conditions to hold) becomes a greater problem because it may, indeed usually is, impossible to hedge, or at least to do so completely, against it. That causes problems for representative agent models. Either the whole system collapses, or no agent does. If the solution chosen is to rule out all possibilities of default, then that is, I believe, equivalent to reverting to an implicit adoption of complete financial markets. In any case the assumption that everyone, all consumers, all firms, is identical is again a convenient fiction, and, for sure, far further from reality than adaptive expectations or the various other shortcomings in internal logical consistency of the earlier large forecasting macro-models. It matters for several reasons. If your model contains a single representative consumer, you more or less have to assume that that consumer meets the transversality condition (that is that in all conditions the consumer chooses a course of action so that her debts are ultimately repaid). That means that it is always perfectly safe to lend to the representative consumer, so that she can borrow or lend at the riskless rate. Consequently the representative consumer is never financially constrained, and can always make a forwardslooking optimizing plan, subject to the transversality constraint. But many of us (perhaps most of us, possibly all of us) choose courses of action which under some circumstances mean that we cannot, and do not expect to be able to, pay all our debts. Some of us, amongst them the criminal fraternity, only expect to pay our debts under unlikely circumstances; fraud is hardly unknown or uncommon. As Martin Shubik has argued (1973), default is a common chosen facet of optimizing behaviour.3 If we now assume the existence of incomplete financial markets and heterogeneous agents, then we start getting back into the real world of financial intermediaries, whose raison d’être is largely risk assessment, of risk premia, of financial constraints on behaviour, (because of Stiglitz–Weiss type problems), and so on. In this world money, credit-worthiness, confidence and collateral all

Monetary and social relationships 21 play a major role. Some agents find that their optimizing plans are constrained, not by some ultimate transversality clause, but by immediate credit constraints; thus the young cannot anticipate future higher incomes to smooth their consumption over time; small firms cannot borrow enough from banks to finance all their perceived investment opportunities, and so on. This is a much messier, but far more realistic, world than that represented by most macro-models. The challenge is to meld, and to combine, theory and empirical realism. The Lucasian critique of the early large forecasting models was that they were developed by building up individual equations on an empirical, ad hoc, pragmatic basis; and that the resulting construction had little theoretical basis, and often had internal logical inconsistencies. My own riposte is that the resulting family of macro-models, based on so-called ‘rigorous’ micro-foundations, are in turn empirically absurd, with complete financial markets, no (credit) risk, no default, transversality conditions always met, representative agents, no necessity for financial intermediaries, hardly any of the attributes of the real world that fill the life and concerns of, for example, a Central Bank official. Can theory and practice, in the money/macro-economics field, be reconciled? My own view is that the best attempts to do so, and to give an explicit role for default, credit risk and money, are to be found in the work of Martin Shubik and his followers, amongst them Geanakoplos, Dubey and Polemarchakis. A basic problem is that models which embrace incomplete financial markets, default and heterogeneity are inherently complex and extremely hard to present lucidly and simply. Thus, these real-life features, for example heterogeneity, money, default and incomplete markets, make necessary the modelling of default laws, formal treatment of liquidity, regulatory policy, banks, and so on. Moreover, the importance of incomplete markets and heterogeneity (as well as institutions) is underlined by the fact that equilibria are constrained inefficient (Geanakoplos and Polemarchakis, 1986) (that is not achieving the second best). So, government, Central Bank and regulatory intervention can lead to efficiency gains. Partly in consequence of the inherent complexity of such models they have not made the impact, at least not yet, that I believe that they should. One field where it is patently impossible to use the complete financial market, no default, representative agent type of model is in studying financial risk and contagion, which is one of the areas in which I have worked as a part-time consultant at the Bank of England. Instead one needs a model in which incomplete financial markets, default and heterogeneous agents, especially banks, are central to the process. In this respect I have been fortunate to find Dimitrios Tsomocos at the Bank. Fortunate for two reasons; first, my own mathematical, model building skills are deficient; second, Dimitri is one of the best students and exponents of the Shubik school. Anyhow, using some of my suggestions about modelling heterogeneous banks and incomplete financial markets, he has developed a model for studying systemic financial stability issues. With the aid of Ton Sunirand, we have demonstrated that simplified versions can be numerically simulated; and our present, continuing exercise is to calibrate it against the data, see Goodhart et al. (2004a, 2004b, 2006).

22

C. A. E. Goodhart

One problematical deficiency in this field of trying to model and assess financial stability is that virtually all methods of monitoring such financial stability relate to individual banks, and other financial intermediaries, for example VARs, stress tests, solvency and capital requirements, liquidity ratios, and so on. What matters, from society’s view-point, is systemic, not individual, stability. The two are obviously related; for example a system where most of the component members are weak is not likely to be systemically strong. Nevertheless it does not take much ingenuity to construct examples where each individual bank appears to be initially strong, but the overall system is nevertheless fragile, for example because of various interconnections; or indeed vice versa, where the individual participants seem weak, but the overall system is well protected. This has been done ever since Henry Thornton (1802), if not before. The Holy Grail in this field, which many of us are pursuing, is to be able to complement the known procedures for monitoring individual banks with new methods for assessing systemic strength. We are, I believe, moving forwards, but there is a long way to go.

The role of government Let me turn, however, from modelling to another area where I believe that theory has become divorced from reality. One of the main subjects of topical interest over the last two decades has been the formation of the euro-system. The main academic tool for assessing whether it was appropriate for countries to share a common currency has been optimal currency area theory, or OCA. This theory described several factors that would make a common currency appropriate, for example openness, wage/price flexibility, trading patterns, size; but it gave very little role to the interaction of government, and especially of governments’ fiscal policies, with the domain of monetary policy. Yet, as Michael Mussa noted, the greatest economic regularity in this field, prior to the eurosystem, had been the association between country and currency; whereas the predictive power of OCA theory was almost nil (apart from correctly predicting that micro-states, such as the Vatican, Andorra, Lichtenstein, would share the currency of their larger neighbours). Now one might try to dismiss the currency/country link as an inessential symbol of sovereignty, like flags, or national anthems, or made in France labels of origin; but in my view such dismissal would be wrong (also, see Issing 1996). It is, perhaps, easiest to appreciate the necessity of some link between governments and their fiscal policies on the one hand and money on the other in the case of a fiat money system. Why do people accept such unbacked pieces of paper? The answer, of course, is because of the power of the government, and in particular of its power to tax, and to specify what paper currencies it will accept in payment. Of course, such sovereignty can be shared, and the acceptability of the euro is completely assured by the agreement of all member states in the euro-system to do so. But there are additional key links between fiscal and monetary policies.

Monetary and social relationships 23 Within a given monetary domain, one cannot use monetary policy to iron out asymmetric regional imbalances and shocks, but, when the monetary and fiscal domains overlap, one can use fiscal policy to stabilize and to redistribute, as far as political consent allows. Within the euro-system the monetary system is federal; the main fiscal competences are national. Earlier in the 1990s I worked on a specialist group commissioned by the European Commission to try to bridge that gap. Our Report (‘Stable money – Sound finances’ (1993), also see ‘The Economics of Community Public Finance, Reports and Studies’(1993)) then was pigeon-holed, dismissed by representatives of most member states, and largely ignored. Ever since, I have felt that the failure to deal with that separation of the domains of monetary and fiscal policies was a potential flaw in, the soft-under-belly of, the euro-system. The travails of the Stability and Growth pact underline both the difficulties and complexity of trying to run a system that divorces the locations of fiscal and monetary competencies. It is not just in macro-policy, stabilization issues that this separation matters. In the field of financial stability, financial crises often require resolution through the use of tax-payers’ moneys, frequently a lot of money, as multiple examples around the world attest. There are insufficient funds in the ECB for such a purpose, and none effectively available for such uses from the federal budget in Brussels. If a bail-out in a crisis is undertaken, it will have to come from national budgets and tax-payers in each separate nation-state. He who pays the piper calls the tune. One can talk as long as one likes about the tidiness and efficiency of combining the monetary domain with the regulatory domain at the federal level, and of likely overspills between nations in any financial crisis. So long as the actual fiscal payments to resolve a crisis come out of national Treasuries, not from the federal budget, the corollary will be that regulatory and supervisory issues will be decided in conclaves in which national Treasuries take the lead, and the federal institutions become sidelined as observers. The relationship and, in particular, the separation between a federal monetary system and national fiscal competence, to my mind, was the main problem facing the euro-system. Yet it did not get, and still hardly receives, sufficient attention. It received no mention in the latest discussion on the European Constitution, perhaps because it was perceived as ‘too difficult’ to resolve. This failure to tackle what is the crucial issue, in my view, arose largely because economic theorists have consistently tended to ignore, or to underestimate, the essential links between government, fiscal policies and money. This goes right back to the theories of the evolution of money itself. Moreover, there remains the questions of political accountability. Since the 1920s at least, the view that monetary policy can be used for stabilization purposes (later simply controlling inflation) gives it a political significance in its own right that leads (or ought to lead) to questions of how to make monetary policy makers accountable to the electorate, which exercises its authority primarily at the national level. In the meantime the ECB has been given such absolute independence, in

24

C. A. E. Goodhart

excessive deference to the Kydland and Prescott (1977) model, that the various channels of accountability, such as the President’s appearance before the European Parliament, have a somewhat anaemic quality.4 The dominant mainstream theory of the evolution of money is that this developed from indirect barter in a private sector trial-and-error process with the aim of reducing transactions costs in (market) exchange. It is often emphasized that, whereas governments may have played some subsidiary role in extending and enhancing monetary functions, for example in establishing mints for coinage, they were strictly inessential in its initial evolution. This was one of the key messages of Carl Menger’s seminal work in this field at the end of the nineteenth century, work that our President this year Erich Streissler (2002) has recently commented upon. It remains the dominant paradigm today, involving technically fancier papers, such as Kiyotaki and Wright, for example (1989, 1991 and 1992), but they maintain the same basic intuition. Although most economists share this same view, about the evolution of money, most other social scientists working in this field, amongst them numismatists, archaeologists, anthropologists, and so on, and a minority of economists do not. This latter group, of which I am a member, find the origins of money in the need to resolve social interrelationships, for example the bride-price, restitution of personal injuries, settling feuds, and so on, rather than, or certainly as well as, market relationships. I have written several papers on this theme recently (2003 and 2004), and I do not want to go over the ground again at any length. Let me, however, give a brief quote: [The standard mainstream, Mengerian] M-form theory finds it difficult to account for the role, or existence, of money within a general equilibrium model. Money in the utility function, or cash-in-advance models, are proposed, without much conviction. This difficulty is not surprising given that such models also abstract from the existence and role of government. While it is, of course, the relationship between taxation and the demand for money that the [Cartalist, Keynesian] C-form theory emphasizes, it should also be remembered that it is the maintenance of law and order, the form and enforcement of contracts, and the whole infrastructure of regulation within society, that allows the epiphenomena of (organized) (private sector) markets to occur at all. A disclaimer may, however, also be needed. The purpose of this [passage] was to argue, first, that money frequently played an initial meansof-payment role in inter-personal social and governmental roles before it played a major role as a medium-of-exchange in market transactions, and second that the relationship of the State, the governing body, to currency in all its roles has almost always been close and direct. But I do not claim that the private sector cannot, and has not, ever been able to develop monetary systems without the involvement of state authorities. (Goodhart 2003: 9)

Monetary and social relationships 25 Let me just give you one more telling example. A common word for a monetary recompense is that it is pecuniary. The word pecuniary derives from the Latin word pecus which means cow, or cattle. Cattle were commonly used in large deals in early Roman history before the introduction of coinage, see Burns (1927), and are commonly used in societies studied by anthropologists for such socially related exchanges. But does a cow satisfy the standard characteristics required for market exchange? Is a cow standardized, durable, divisible? Could you go out shopping with a couple of cows in your purse? On all this, also consult the excellent paper by Hudson (2004). Economics is a relatively new social science. Recently both the London School of Economics and the Faculty at Cambridge University celebrated their centenaries. Few statistical series go back before about 1870. Perhaps in consequence, economists focus mostly on current and near-future prospective events. For such purposes the underlying institutional framework of law and governance tends to be taken largely for granted, as a given. Yet the successful functioning of markets depends on that same legal and governance structure. In the field in which I have been working recently, concerned with the prevention of financial crises, linkages between the infrastructure of markets and the maintenance of financial stability are clear and important. The development of globally accepted accounting standards, the use of standardized legal pro forma for financial contracts, netting arrangements, the role of centralized counter-parties, clearing and settlement systems, to name but a few examples are crucial to the health and continuing development of financial markets and the financial system. It is not possible to build a superstructure of (financial) markets, or of theories relating to the workings of such markets, unless the underlying infrastructural plumbing is sound. That plumbing, which relates to the organization, administration and resolution of disputes within such markets, is a social construct and relies on law and governance. It may often be boringly detailed, but it is essential. Our monetary and financial systems will not work without it. Normally this governance infrastructure, of which I suggest that the institution of money is itself a part, is taken largely for granted, as a constant in the background. Recently, however, there have been shocks that have underlined its importance. Foremost amongst these has been the collapse of communism. Trying to shift from a directly controlled command system to a market economy has been made much more difficult by the need to build-up a governance system that extended beyond the passage of laws onto the record book also to a general understanding and acceptance of the underlying governance principles by the wider population. It is particularly hard to do so in countries with no prior history of the rule of law, outside the State’s will. Not that such principles are always followed in our own economies, as various scandals at home and abroad have testified. In a series of justly celebrated papers (amongst them La Porta et al. 1997 and 1998), Shleifer and various colleagues have attributed the relative economic success of countries to their adoption of differing legal systems. I wonder

26

C. A. E. Goodhart

whether their focus was perhaps too narrow, so that possibly the successful working of a particular legal system reflected a more broadly well-functioning governance system. When I consider cross-country and regional differences in income and wealth, my own view is that governance is hugely important. If you could offer a benighted country, say in Africa or the Middle East, extra resources, for example access to oil, or extra capital, or extra foreign aid, or better governance, which would you think most important? Yet, with the exception of (applied, empirical) studies, such as those by Barro (1991) and Barro and Sala-i-Martin 1995, most of the formal models of growth omit any role for government and associated legal and governance structures. Indeed almost all the studies examining the influence of government and governance on growth have been empirically based. Once again, the simplifications which macro-theory have employed seem to me to have excluded many of the key features of the real economy. But how could one best incorporate governance issues within a long-run growth model? Alas, an answer to that question is well beyond my own abilities or competence.

Conclusion You all know that joke about the parade of armed forces in Moscow where the procession of weapons of increasing destruction, tanks, planes, rockets, was concluded with a truck carrying a few grey-suited men. But ‘Who are these?’ asked an onlooker. ‘Economic theorists’, was the reply – ‘But why?’ ‘You should see the devastation that they can achieve’. As an epitaph for the economic desolation caused by command and control centralized systems, it is perhaps reasonable to allocate a great deal of blame to bad theory, as Keynes emphasized more widely. Moreover, I have recently been doing a review of Allan Meltzer’s first volume, monumental History of the Fed, in which, of course, the Great Depression of the 1930s takes central place. In this sad story, it seemed to me that reliance on prior theories, particularly on the Classical Dichotomy, whereby price/wage flexibility will soon allow the real economy to be equilibrated by real determinants, but also on the Real Bills Theory, in the face of overwhelming evidence to the contrary, played a major role in encouraging the Fed to remain passive. Fortunately no disasters on that scale are currently affecting the developed world, though conditions in parts of Africa seem still terrible enough. Even so, the divorce between much of modern macro-theorizing and what I take to be empirical reality strikes me as being greater today than in earlier decades. Back in the 1960s we tried to build up our models, equation-by-equation, on a largely pragmatic basis, to fit the empirical facts as we perceived them. The criticisms of this earlier approach, its lack of theoretical microfoundations, its internal inconsistencies, its ill-considered treatment of expectations, were all fully justified. But has the Lucasian counter-revolution tossed out plausible empirical foundations, thrown out the baby along with the bath-water?

Monetary and social relationships 27 When I try to read much of modern macro-economics, I generally find that the initial structural assumptions are chosen largely to facilitate the subsequent technical/mathematical analysis; the fact that their relationship with reality might be tenuous, or even non-existent, seems to be of little, or no, concern. I have tried to give examples along the way, amongst them Calvo pricing, complete financial markets, no default, representative agents, rational expectations (as usually defined), and so on. This covers so much of the guts of modern macro-economics that you may think that I am simply against all macro-theory. Not so. There are a few theorists, notably Martin Shubik and his followers, who have tried to build up theory on the basis of real world conditions, such as incomplete financial markets, default, credit and confidence, rather than try to cram down an overly simplified, but internally rigorous, theoretical system upon reluctant economic data. Perhaps the greatest such gap in money/macro-economics, between theory and reality, has been the general exclusion of the role of government, especially in setting the underlying infrastructure of governance and law, from our analysis. Again I have tried to give examples, relating to the evolution of money itself, to the centrality of the links between fiscal and monetary policies, including effects on the structure of financial regulation and its importance for the working of the euro-system, and, indeed, to economic growth and welfare more widely. The 1960s were a great decade of hope for macro-economists that we could steer the economy in a successful way. Those hopes were punctured by the bad decade of the 1970s, and the theoretical explanations of the inherent failings of the 1960-type macro-models. In the last decade, or so, that hope about steering the economy, through the monetary policies of independent Central Banks, seems to me to have been seeping back, but, in my view, as much despite, rather than because of, mainstream macro-theorizing.

Notes 1 Information was more slowly diffused in the nineteenth century, yet most studies find prices/wages were more flexible then than in the twentieth century. 2 I am indebted to an anonymous referee for this thought. 3 Also see Shubik and Wilson (1977) and Dubey et al. (2000). 4 Again I am indebted to an anonymous reviewer for reminding me of this consideration.

References Akerlof, G. A. and Yellen, J. (1985a) ‘Can small deviations from rationality make significant differences to economic equilibria? ’, American Economic Review, 75(4): 708–20. —— (1985b) ‘A near rational model of the business cycle with wage and price inertia’, Quarterly Journal of Economics, 100 (Supplement): 823–38. Barro, R. (1991) ‘Economic growth in a cross section of countries’, Quarterly Journal of Economics, 106(2): 407–43.

28

C. A. E. Goodhart

Barro, R. and Gordon, D. B. (1983a) ‘Rules, discretion and reputation in a model of monetary policy’, Journal of Monetary Economics, 12: 101–21. —— (1983b) ‘A positive theory of monetary policy in a natural rate model’, Journal of Political Economy, 91: 589–610. Barro, R. and Sala-i-Martin, X. (1995) Economic Growth, New York: McGraw-Hill. Bray, M. and Goodhart, C. A. E. (2002) ‘You might as well be hung for a sheep as a lamb: The loss function of an agent’, Financial Markets Group Paper no. 418. Burns, A.R. (1927) Money and Monetary Policy in Early Times, New York: Alfred Knopf. Clower, R. (1965) ‘The Keynesian counterrevolution: A theoretical appraisal’, in F. H. Hahn and F. P. R. Brechling (eds) The Theory of Interest Rates, London: Macmillan. Commission of the Economic Communities: Report of an Independent Group of Economists (1993) ‘Stable money – Sound finances’, European Economy, 53. Dubey, P., Geanakoplos, J. and Shubik, M. (2000) ‘Default in a general equilibrium model with incomplete markets’, Cowles Foundation Discussion Paper no. 1247, Yale University. European Commission Directorate-General for Economic and Financial Affairs (1993) ‘Reports and studies on the economics of community public finance’, European Economy, 5. Geanakoplos, J. D. and Polemarchakis, H. M. (1986) ‘Existence, regularity and constrained suboptimality of competitive allocations when the asset market is incomplete’, in W. Heller and D. Starret (eds) Essays in Honour of K. Arrow, vol. III, Cambridge: Cambridge University Press. Goodhart, C. A. E. (2003) ‘The two concepts of money: Implications for the analysis of optimal currency areas’, in S. A. Bell and E. J. Nell (eds) The State, the Market and the Euro, Cheltenham, UK: Edward Elgar. —— (2004) ‘Money, stability and growth’, in Financial Development and Economic Growth: Explaining the links, London: Palgrave Macmillan. Goodhart, C. A. E., Sunirand, P. and Tsomocos, D. P. (2004a) ‘A model to analyse financial fragility: Applications’, Journal of Financial Stability, 1: 1–30. —— (2004b) ‘A risk assessment model for banks’, Annals of France, 1: 197–224. —— (2006) ‘A model to analyse financial fragility’, paper in preparation presented at the 2nd Oxford Finance Summer Symposium, Bank of England. Hudson, M. (2004) ‘The archaeology of money: Debt versus barter theories’, in L. R. Wray (ed.) Credit and State Theories of Money: The Contributions of A. Mitchell Innes, Cheltenham, UK: Edward Elgar. Issing, O. (1996) ‘Europe: Political union through common money’, Institute of Economic Affairs Occasional Paper, no. 98. Kiyotaki, N. and Wright, R. (1989) ‘On money as a medium of exchange’, Journal of Political Economy, 97: 927–54. —— (1991) ‘A contribution to the pure theory of money’, Journal of Economic Theory, 53: 215–35. —— (1992) ‘Acceptability, means of payment, and media of exchange’, Federal Reserve Bank of Minneapolis Quarterly Review, 16: 2–10. Kydland, F. E. and Prescott, E. C. (1977) ‘Rules rather than discretion: The inconsistency of optimal plans’, Journal of Political Economy, 85(3): 473–92. La Porta, R., López-de-Silanes, F., Shleifer, A. and Vishny, R. W. (1997) ‘Legal determinants of external finance’, Journal of Finance, 52: 1131–50. —— (1998) ‘Law and finance’, Journal of Political Economy, 106: 1113–55.

Monetary and social relationships 29 Latzer, M. and Schmitz, S. W. (2002) Carl Menger and the Evolution of Payments Systems, Cheltenham, UK: Edward Elgar. Meltzer, A. (2003) A History of the Federal Reserve, Volume 1: 1913–1951, Chicago: University of Chicago Press. Sargent, T. and Wallace, N. (1975) ‘“Rational” expectations, the optimal monetary instrument, and the optimal money supply rule’, Journal of Political Economy, 83(2): 241–54. Shubik, M. (1973) ‘Commodity money, oligopoly, credit and bankruptcy in a general equilibrium model’, Western Economic Journal, 11: 24–38. Shubik, M. and Wilson, C. (1977) ‘The optimal bankruptcy rule in a trading economy using fiat money’, Journal of Economics, 37: 337–54. Stigler, G. J. (1987) The Theory of Price, 4th edn, London: Collier Macmillan. Streissler, E. (2002) ‘Carl Menger’s article “Money” in the history of economic thought’, in M. Latzer and S. W. Schmitz (eds), Carl Menger and the Evolution of Payments Systems, Cheltenham, UK: Edward Elgar. Thornton, H. (1962) An inquiry into the nature and effects of the paper credit of Great Britain, New York: Augustus M. Kelley. Woodford, M. (2003) Interest and Prices, Princeton, NJ: Princeton University Press.

3

Complexity theory’s network conception of the individual John B. Davis

One important source of recent agent-based modeling and complexity theory network approaches in economics lies in the critique of general equilibrium theory stimulated by Sonnenschein–Mantel–Debreu theory and doubts about the concept of the Walrasian auctioneer. An important target of this critique is the neoclassical atomistic individual conception, and the idea that all individual economic agents are isolated from one another, and can only interact indirectly through the price system. Proponents of the agent-based modeling and complexity network approaches argue that the way forward for economics is to focus on individual interaction in neighborhoods or local networks which have limited connections to larger global economies. Agent-based or network models are complex in that: (1) individual economic agents interact directly with some individuals and indirectly with others implying individual behavior is complex in possessing different motivational bases for different types of interaction; (2) when formulated dynamically, the basis on which both strong and weak ties operate may change and evolve reflecting learning and adjustment processes influenced by feedback effects; and (3) aggregate or macroeconomic behavior in economic systems is the product of cross-cutting relations between different levels of a system which are hierarchically structured. This chapter examines the agent-based modeling or complexity theory network conception of the individual in terms of the strong and weak ties distinction, as this distinction was developed in economic sociology in the 1970s, uses this distinction to interpret the agent-based modeling, network conception of the individual, and then argues that the network conception treats individuals as socially embedded rather than atomistically isolated. The first section begins by reviewing the origins of complexity theory network approaches in critiques of general equilibrium theory associated with Sonnenschein–Mantel–Debreu (SMD) theory, as interpreted by Kirman (1997), and associated with rejection of the concept of the Walrasian auctioneer, as interpreted by Tesfatsion (2005). Kirman and Tesfatsion are emphasized because they specifically link the problems of general equilibrium theory to the atomistic individual conception, and because they advance network models that employ alternative conceptions of individuals seen to be directly interacting with one another. The second section reviews models that Kirman and Tesfatsion develop to show how they make use

Complexity theory’s network conception 31 of direct interaction in terms of ties between individuals, first in connection with the analysis of buyer–seller loyalty relationships in the Marseille Fish market as developed by Kirman and his colleagues, and the second in connection with Tesfatsion’s labor market analysis of how workers and employers repeatedly seek preferred worksite partners. The third section then discusses the role of the strong and weak ties distinction in the analysis of social networks in terms of Granovetter’s ‘strength of weak ties’ (SWT) hypothesis (Granovetter 1973 and 1983), and then uses the SWT hypothesis to expand and reinforce the complexity dimensions of the Kirman and Tesfatsion models. The fourth section then draws on this enlarged framework to interpret the agent-based modeling, the network complexity conception of the individual economic agent as one approach to understanding individuals as socially embedded individuals, as this is understood in Davis (2003). The chapter concludes by briefly comparing the network complexity conception of the individual as socially embedded to two other embedded individual conceptions with different behavioral foundations.

General equilibrium theory to complexity models Though complexity has many interpretations and applications across the sciences, and though it has multiple interpretations and applications in economics,1 one important source of thinking about complexity in economics as it has been developed in connection with the analysis of networks lies in the critique of general equilibrium theory stimulated by Sonnenschein–Mantel–Debreu (SMD) impossibility theory and by reflection on the notion of the Walrasian auctioneer. Since both perspectives on this critique examined here trace the problems with general equilibrium theory back to the neoclassical atomistic individual conception, both raise the issue of how individuals should be reconceptualized in agentbased network models. Kirman does this by emphasizing agents’ capacity to adjust their behaviors in dynamic, complex structures of interaction; Tesfatsion does it by seeing agents as having a special kind of autonomy associated with their involvement in different sorts of ‘procurement processes’. SMD theory and complexity theory SMD theory was the result of a series of papers by leading general equilibrium theorists in the 1970s which demonstrated that when individual behavior is assumed to be well-behaved in terms of the standard axiomatic assumptions about preferences, aggregate excess demand functions in general equilibrium models turn out to be arbitrary (Kirman 2007; Rizvi 1994b, 1997 and 2007; Shafer and Sonnenschein 1982). That aggregate excess demand functions need not be downward-sloping means that, other than the existence of equilibrium and the properties it requires (continuity, homogeneity of degree zero, and Walras’ Law), no general results regarding the uniqueness and stability of equilibrium are possible, so that not only is comparative static analysis without solid theoretical foundation, but the postwar neoclassical project of explaining

32

J. B. Davis

aggregate phenomena strictly in terms of individualist microfoundations breaks down as well. Or, as Arrow had earlier put it, there is a limit to ‘the tendency implicit in price theory, particularly in its mathematical version, to deduce all properties of aggregate behaviour from assumptions about individual economic agents’ (Arrow 1968: 382). One attempt to get around this limit bears special comment for what it suggests about complexity theory strategies regarding the representation of individuals in models. SMD theory has been argued (Rizvi 2003) to be another instance of impossibility results associated with neoclassical theory, the most notable of which is Arrow’s famous impossibility theorem (Arrow 1963 [1951]). Arrow’s analysis offers one simple escape from the impossibility theorem, namely, dictatorship or when one individual’s preference ranking dominates the social ranking. Essentially, dictatorship ‘solves’ the impossibility problem by replacing many individuals with one, and thus is trivial as a solution since social choice essentially concerns the problem of how to combine the preferences of many individuals. From this perspective, it is interesting that a leading attempt to get around the limits of SMD impossibility theory to preserve general equilibrium theory involves modeling the aggregate behavior of consumers as though it were the behavior of one ‘representative individual’. The ‘representative individual’ strategy, that is, is the same type of ‘solution’ as dictatorship is for Arrow, and consequently is no less trivial as a response to SMD theory in that it also abandons the multi-individual framework of general equilibrium conception in all but name. There are also significant logical and technical problems with the representative individual conception (Summers 1991; Kirman 1992; Stoker 1993), but the importance of the ‘representative individual’ strategy for complexity thinking rather lies in what it eliminates. Thus, when one assumes that differences between individuals are sufficiently unimportant that the idea of an average individual might fully represent diversity in individuals, one also assumes that interaction between individuals can be explained in essentially one single way, or that modeling individuals in an economy does not involve multiple forms of interaction. Interestingly, Kirman points out that the assumption that individuals interact in only one way is made in both competitive general equilibrium theory and game theory – which arose in part as a response to the SMD theory (cf. Sonnenschein 1985: 176) – though their respective views of interaction are precisely the opposite of one another (Kirman, 1997). Competitive general equilibrium theory assumes that atomistic individuals only interact indirectly with one another through market signals. In contrast, game theory assumes that strategic individuals only interact directly with one another when they take into account other individuals’ strategies, including the knowledge that others do so as well, the knowledge that others also know this about all others, and so on. But, Kirman argues, if interaction can be either indirect or direct, then it is reasonable to suppose that there are a range of intermediate modes of interaction that involve individuals simultaneously interacting directly with some individuals and indirectly with others. Moreover, it seems it would be quite worth-

Complexity theory’s network conception 33 while to investigate this possibility, since in making their respective extreme assumptions about individual interaction both general equilibrium theory and game theory are unable to advance much beyond showing that equilibria exist. That is, just as general equilibrium theory has run aground on SMD theory, and can say little about the uniqueness and stability of equilibrium, so classical game theory, though it also possesses a well-defined equilibrium concept in the form of Nash equilibrium, has been largely unsuccessful in its so-called ‘refinement project’ in explaining when Nash equilibria are unique (Rizvi 1994a). Indeed in games of repeated play the ‘folk’ theorem tells us that virtually any sort of outcome is possible. Kirman accordingly recommends an intermediate modeling strategy regarding individual interaction ‘which lies between the two extremes’, including both indirect and direct interaction such that ‘agents communicate with some, but not necessarily all, other agents’ (Kirman 1997: 493). In this framework, there is a range of different ways of looking at the subject. At one end of the spectrum are ‘global interaction’ models in which individual agents may be capable of communicating with all other agents, but only communicate with some of them. At the other extreme are ‘local interaction’ models in which individual agents can only interact with those in an immediate neighborhood, though with repeated interaction there can be a diffusion of the consequences of this local interaction globally, such that changes at the local level can then have consequences for global interaction. In general, Kirman sees the investigation of different forms of local and global interaction as central to understanding the economy as a complex adaptive system. Particularly important is the emphasis this places on understanding individual behavior in terms of learning and adjustment to change. Note, then, that in standard general equilibrium dynamic models that emphasize convergence to equilibrium, individuals are assumed to learn relatively rapidly what optimal behavior requires, while at the same time the economic environment is assumed to change sufficiently slowly as to make further learning unnecessary. As Lucas sees it, for example, economics studies ‘decision rules that are steady states of some adaptive process, decision rules that are found to work over a range of situations and hence are no longer revised appreciably as more experience accumulates’ (quoted in Kirman 1997: 496; see also Lucas 1988). But, Kirman argues, if it is rather the case that learning and adjustment are slow relative to more rapid change in the economic environment, and if individuals are also thought to interact with limited numbers of other individuals in particular neighborhoods or social networks, an economic system can generate complicated system dynamics in which convergence to any standard conception of equilibrium might not occur. Changing our assumptions about the nature of interaction between individuals, then, opens up our theorizing about economic systems in two linked ways. Just as individuals may continually learn and adjust rather than endlessly reapply the same decision rules, so economic systems may continually evolve rather than settle into any particular equilibrium configurations.

34

J. B. Davis

The Walrasian auctioneer and complexity theory The idea of competitive Walrasian equilibrium rests crucially on the role of the Walrasian auctioneer.2 Individual economic agents interact through price signals, and are unable to influence either one another or prices; equilibrium is nonetheless possible because a mythical Walrasian auctioneer determines the prices at which trades occur. On one level, then, the auctioneer is simply an equilibrium clearinghouse device that ensures market-clearing prices. On a second level, however, the auctioneer is the precise means by which individuals are restricted to an indirect interaction with one another as isolated atomistic individuals. That is, that marketclearing through equilibrium price vectors is possible makes it unnecessary that individuals engage in any sort of direct contact strategic bargaining, and allows them to be limited to a passive, price-taking optimization behavior in their restricted capacity as atomistic individual economic agents. Thus, the lack of realism the mythical auctioneer involves implies a commensurate lack of realism in the idea that individuals are atomistic and only interact indirectly. This implies that once we begin to ask how market exchanges are really coordinated, we need to also ask how individuals need to be reconceptualized as interactive economic agents. Tesfatsion consequently begins by focusing on real-world interaction between individuals, and argues that once the assumption that individuals simply optimize is abandoned, production, pricing and trade need to be seen as resulting from ‘procurement processes’ in which individuals decide what goods and services they wish to buy and sell, in what volumes they will do this, at what prices and to what individuals. In contrast to a world in which the modeler only represents individuals as price-takers, in a world of direct bargaining the modeler must now come to grips with challenging issues such as asymmetric information, strategic interaction, expectation formation on the basis of limited information, mutual learning, social norms, transaction costs, externalities, market power, predation, collusion, and the possibility of coordination failure. (Tesfatsion 2005: 6) This added complexity implies that new computational tools are needed to model economic systems. It also implies that we ought to think of economic agents as having a much wider range of capacities, from human individuals ‘as active data-gathering decision-makers with sophisticated learning capabilities to passive world features with no cognitive functioning’ (2005: 6). This combination of new computational methods for modeling complex economic systems and a broadened conception of the economic agent underlies the definition of the complexity approach as agent-based computational economics (ACE). The term ‘agent’ itself refers broadly to bundled data and behavioral methods representing an entity constituting part of a computationally constructed world. Examples of

Complexity theory’s network conception 35 possible agents include individuals (e.g., consumers, workers), social groupings (e.g., families, firms, government agencies), institutions (e.g., markets, regulatory systems), biological entities (e.g., crops livestock, forests), and physical entities (e.g., infrastructure, weather, and geographical regions). (Tesfatsion 2005: 6) Further, the term ‘agent’ is preferred to the term ‘object’ (an alternative computational entity used in object-oriented programming), because the term ‘agent’ captures ACE’s ‘intended application to problem domains that include entities capable of varying degrees of self-governance and self-directed social interactions’ (2005: 6, fn. 6). That is, for economic systems with complex features, such as described in the paragraph above, agents need to be conceived as being flexible in adapting the ways in which they interact to one another, where this involves a conception of autonomy different in nature from what is usually associated with the standard atomistic isolation idea. For humans in particular, this autonomy means ‘a capacity for self-governance’ (2005: 10). Yet non-human agents can also be said to exhibit a kind of autonomy or capacity for selfdirection in being able to respond to their environment in pursuit of an agenda in such a way as to affect their future responses to their environment (2005: 11). ACE models, then, employ a conception of agent autonomy substantially greater than attributed to homo oeconomicus to match the more complex environment produced by substituting realistic procurement processes for the Walrasian auctioneer. Among the capabilities that Tesfatsion believes this may include are: social communication skills; the ability to learn about one’s environment from various sources, such as gathered information, past experiences, social mimicry, and deliberate experimentation with new ideas; the ability to form and maintain social interaction patterns (e.g., trade networks); the ability to develop shared perceptions (e.g., commonly accepted market protocols); the ability to alter beliefs and preferences as an outcome of learning; and the ability to exert at least some local control over the timing and type of actions taken within the world in an attempt to satisfy built in (or evolved) needs, drives, and goals. (Tesfatsion 2005: 11) These capabilities, however, are differentially exercised according to the different ways in which individuals interact with one another. Indeed, to the extent that individuals learn from their different interactions, they learn to ‘socially construct distinct persistent personalities’ (2005: 12) for themselves appropriate to different types of interactions they are likely to have with others. As with Kirman, then, seeing economic systems as complex is closely connected to seeing economic agents as complex. The following section introduces two examples of network models that reflect this complexity at the level of the system and at the level of the agent.

36

J. B. Davis

Two network models Both the Marseille fish market analysis of Kirman and his colleagues and Tesfatsion’s analysis of work supplier–employer worksite partners are network models that show how behavior evolves across a series of interactions between individuals. Both show how repeated interaction between different kinds of individuals produces particular aggregate outcomes in markets. The Kirman analysis shows how loyalty trading relationships develop between buyers and sellers in the Marseille wholesale fish market, and the Tesfatsion model shows how different market power opportunities are generated across different worksites distinguished according to their forms of interaction. The Marseille fish market Kirman (1997) distinguishes two broad strategies regarding how connections between individuals develop, and how these connections are in turn related to market structure. First, one can imagine a physical or spatial lattice-type structure in which locations in that structure constitute nodes that are occupied by individual agents who then interact according to the nature of that pre-given structure. In this conception, ‘nearness’ can be defined such that each agent is influenced by only those agents who are ‘near’ in a given ‘influence structure’. A neighborhood for a given individual is then defined in terms of those other agents to whom the individual is ‘near’ in this influence structure, such that individuals’ probabilities of being in certain states are conditioned on the states of their neighbors. The question that then arises is: what explains the influence structure of a neighborhood, or what types of communication relationships underlie the influence links between individuals? Candidates include geographical proximity, various kinds of characteristics individuals share, or potential gains from bilateral trade with neighbors. But such models, while interesting in eliciting the idea of a neighborhood structure, naturally invite us to go on to consider how neighborhood structure itself might be endogenized to agent communication and interaction. Second, then, one can endogenize this idea of a given structure of interaction to imagine individual agents interacting with one another in such a manner as to create and reinforce particular links, so that there exist feedback loops between past and current behavior that cause both the structure of interaction and behavior to evolve. Together with a number of colleagues, Kirman has sought to exhibit this latter strategy in an analysis of a relatively simple and well-contained case, namely, the Marseille wholesale fish market with bilateral relationships between buyers and sellers of a perishable product in which there are no inventory carryovers (see Kirman and Vignes 1991; Kirman and Vriend 2000 and Kirman 2001). What was empirically observed in the pattern of trading relationships in the Marseille market was that ‘there are buyers who regularly buy from the same seller and are extremely loyal, and . . . there are people who shift between sellers all the time’ (Kirman 2001: 177). This situation was then

Complexity theory’s network conception 37 modeled to simulate buyers developing relationships with sellers on the basis of past experience in such a way that buyers’ probability of re-visiting particular sellers depends on profit remembered to have been received from past visits. The model employed a simple learning adjustment process known as reinforcement learning widely used by psychologists and evolutionary and experimental economists. Basically what the modeling shows is that the stronger the reinforcement mechanism or parameter, all other things equal, the more likely it is that buyer–seller loyalty relationships will emerge for a high proportion of total agents. The modeling strategy thus provides an account of one type of complex adaptive system in which a simple reinforcement learning principle endogenously generates a particular market structure with loyalty behavior between individuals. Worker–employer preferred worksite partners Tesfatsion (2001) is interested in market power in labor markets in which small numbers of work suppliers and small numbers of employers engage in repeated strategic interactions. If multiple equilibria with significantly different characteristics are allowed, the question is: how do agents with incomplete information and limited computational capabilities learn to coordinate on one equilibrium or another? Departing from the standard supply-and-demand, equilibrium-based labor market framework, Tesfatsion simulates a dynamic process of agent-initiated interactions in which work suppliers and employers are characterized in terms of internal states and behavioral rules, form expected utility assessments of their interactions with other agents, and seek to learn about each other’s behavioral rules, though these behavioral rules are coevolving. Activities in the labor market are then modeled as occurring across a sequence of generations during which both types of agents apply a behavioral rule governing worksite interactions understood in prisoner’s dilemma terms. Across a sequence of generations work suppliers and employers repeatedly choose and refuse worksite partners, each keeping ‘separate track of his interaction with each potential worksite partner’ (Tesfatsion 2001: 9), in order to continually update behavioral rules for different worksites based on what is remembered about past payoffs in past interactions. The idea of a network is then understood in terms of which individuals work with one another and with what regularity, and networks are classified in terms of the degree they depart (or their ‘distance’) from standard competitive outcomes. In the final generation of the economy, nonpersistent relationships are eliminated, and the pattern of relationships between the work suppliers and employers that emerges is characterized as a persistent network. Work suppliers and employers are inactive, repeat defectors, or persistently cooperative. Experimental results for 20 sample economies fall into three different (distance) clusters of networks. Closest to the competitive case worksite behaviors are persistently cooperative. Next distant from the competitive case, employers are repeat defectors, while in the final case employers’ repeated defection generates

38

J. B. Davis

defection behavior on the part of work suppliers as well. Tesfatsion’s aim is to understand the conditions under which market power is exercised in labor markets, where market power involves the ability of sellers or buyers to exert control over market outcomes for welfare levels better than in competitive conditions. Her hypotheses are that market power depends upon job capacity (the ratio of potential job offers to potential job openings) and job concentration (the ratio of work suppliers to employers). In her simulation, these are varied from high to low, and the main finding is that job capacity is dominant in determining the ability of work suppliers and employers to exercise market power; conversely, job concentration has little effect on ability to exercise market power from either side of the market.

Granovetter’s social ties analysis and complexity models Here I discuss Granovetter’s distinction between strong and weak ties and emphasis on social groups, describe its common ground with complexity theory network models, and then use it to interpret Kirman’s Marseille fish market analysis and Tesfatsion’s worker–employer worksite pairing model. While they focus on how feedback links in a structure of interaction cause particular behavioral rules and patterns of interaction to emerge dynamically, what Granovetter’s analysis offers is an account of how individuals make use of different types of social ties. Granovetter’s analysis Granovetter’s ‘strength of weak ties’ (SWT) hypothesis offers a particular view of the different roles strong and weak ties play in social structure. The distinction itself is both one of degree and kind. In regard to degree, strong ties are those that individuals have to others to whom they are ‘close’, where closeness may be measured, and ‘the strength of a tie is a (probably linear) combination of the amount of time, the emotional intensity, the intimacy (mutual confiding), and the reciprocal services which characterize the tie’ (Granovetter 1973: 1361). Social ties, then, can be arranged along a spectrum from strongest to weakest. But social ties also differ in kind, because they can be qualitatively distinguished in regard to the different ways in which they involve social groups. Strong ties hold between individuals who have some regular, recurring involvement with one another, such as family members, close friends and business partners, and accordingly strong ties effectively identify the social groups of which these individuals are members. Alternatively, weak ties hold between individuals who have some form of acquaintance and more intermittent contact with one another, and specifically not as members of the same social groups. That is, strong ties are within-group ties and weak ties are across-group ties.3 The SWT hypothesis is that, contrary to what one might expect in terms of the connotations ‘strong’ and ‘weak’, weak ties play an especially important role in regard to the coherence and the evolution of social systems – thus the ‘strength of weak ties’ hypothesis. Indeed, Granovetter advanced the SWT

Complexity theory’s network conception 39 hypothesis in part (see 1983: 203) with the intention of contesting a view associated with the Chicago school of urban sociology and especially the work of Wirth (e.g. 1938) that the increasing prevalence of weak ties in twentiethcentury industrial society created social alienation. To the contrary, Granovetter argued, weak ties are key to the diffusion and flow of novel information between social groups and across networks made up of many relatively independent social groups, and consequently play a special role both in how they link unlike individuals to one another, and also in how they prevent social isolation and fragmentation associated with individuals’ reliance on strong ties in noncommunicating social groups. The mechanism by which this occurs lies in how individuals’ weak ties with one another across groups can create bridges between these groups. Groups are defined in terms of strong ties, but they are bridged by individuals in terms of their weak ties to one another. Social systems, then, were populated not only by groups, but importantly by individuals as well. Granovetter was also motivated to address a ‘fundamental weakness’ in sociological theory as he found it at the time in that it did ‘not relate micro-level interactions to macro-level patterns in any convincing way’ (Granovetter 1973: 1360). The SWT hypothesis, he believed, offered a way of remedying this deficiency by providing an account of social structure in terms of social groups and their connections via individuals. It thereby went beyond an approach to social systems that more or less simply inventoried their contents by tallying up different kinds of social groups without either theorizing how they might be connected or how individuals were related to them. Indeed, the distinction between strong and weak simultaneously offered an account of groups and the links between them and also an account of relationships between groups and individuals. Groups as micro-entities were understood in a macro-social systems framework based on the role that individuals played in creating micro–micro bridges between groups. At the same time, ‘macro-level patterns’ were seen to be the product of ‘micro-level interactions’. Moreover, the basis for the SWT hypothesis regarding novel information flows struck Granovetter as straightforward and intuitive. First, there was ‘empirical evidence that the stronger the tie connecting two individuals, the more similar they are’ (Granovetter 1973: 1362). Second, it seemed reasonable to suppose that information flows within social groups based on strong ties between individuals who are similar in nature were more likely to exhibit redundancy than information flows across social groups between individuals who are dissimilar in nature. The SWT hypothesis, it turned out, was persuasive to others as well, as reflected in the large number of applications that subsequently followed. One influential application has been to information flows across different sciences, where the existence of weak ties leads to a division of labor not possible in the absence of their connecting links. For example, one might see scientific fields as having a center and periphery, where the latter, defined in terms of individuals’ weak ties with the center and also other scientific fields, is a likely source of high-risk innovation that when successful may be adopted by both the center and other sciences (see Chubin 1976 and also Collins 1974). Another

40

J. B. Davis

application is to socioeconomic status and how information flows are conducive to labor market mobility and access to social services. When individuals rely more on strong ties and make less use of weak ties, there exists a tendency for the social groups of which they are members to become isolated making those groups and individuals more vulnerable and impoverished. Thus: ‘heavy concentration of social energy in strong ties has the impact of fragmenting communities of the poor into encapsulated neighborhoods with poor connections between these units’ with the possible effect that ‘poverty is self-perpetuating’ (Granovetter 1983: 213). The SWT view and the Kirman and Tesfatsion network models How, then, is Granovetter’s social ties analysis relevant to complexity theory network models? First consider Granovetter’s basic distinction between strong and weak ties. The distinction is one between ties which individuals have to others in groups of which they are members and ties which individuals have to others in groups of which they are not members. Though groups and networks differ in important respects, nonetheless complexity theory network models use a similar but slightly different distinction cast in explicitly dynamic rather than static terms. Thus, while at any one time most individuals interact directly with other individuals in particular networks, over time they move across networks in the process giving up what effectively constitute one set of direct ties for other sets of direct ties. Former direct ties, however, still remain ties, that is, they are indirect ties, both because individuals remember them, and because they may choose to restore them as direct ties in the future. Thus individuals always maintain, at least potentially, an indirect interaction with individuals in other networks along with their direct interaction with individuals in the networks in which they are immediately involved. Suppose, then, that we take social groups and networks to be similar at least with respect to the strong ties–weak ties distinction. In this case, Kirman and Tesfatsion’s two models can be seen as limiting cases of Granovetter’s analysis in terms of groups by saying that their focus is on groups of the smallest possible size in the form of two-person direct interactions. In Kirman’s fish market analysis, there are both buyer–seller loyalty relationships and buyers who move continually between sellers. While these strong tie buyer–seller relationships are stable, individual buyers move back and forth between shopping and loyalty to sellers (not necessarily the same ones), thus exhibiting both strong and weak ties, even while preferring strong tie loyalty relationships most of the time. For Tesfatsion, there are three kinds of work supplier–employer worksite networks reflecting strong ties, and that individuals continually move across these different networks shows the importance of weak ties. Indeed, because each individual ‘keeps separate track of his interaction with each potential worksite partner’ (Tesfatsion 2001: 9), though at any one time most individuals directly interact with other individuals in one type of worksite or another, indirect ties and direct ties may always be interchanged as individuals change worksite networks.

Complexity theory’s network conception 41 Second, consider Granovetter’s SWT hypothesis itself. The main idea is that social structure depends on the bridging role that individuals’ weak ties play in knitting together different social groups. In the dynamic frameworks that Kirman and Tesfatsion develop, this knitting-together function operates through individuals’ circulation across networks or groups. The social structure that emerges – loyalty relationships between buyers and sellers for Kirman and the three kinds of worksite networks for Tesfatsion – is a product of individuals’ movement between groups that enables them to revisit and accept or reject pairings with different individuals. Thus, aggregate relationships in economic systems, or ‘macro-level patterns’ in Granovetter’s language, are generated by and explained in terms of how interaction between individuals takes place. Recall, then, the failure of general equilibrium theory satisfactorily to explain aggregate phenomena. What Kirman and Tesfatsion argue in this regard is that in its exclusive attention to indirect interaction between individuals general equilibrium theory has insufficient micro-level structure to explain aggregate phenomena. That structure, however, can be developed if one adopts a complexity view of interaction. Indeed, when one proceeds in this way, a wealth of insights emerges in regard to the many ways in which aggregate phenomena can be understood. Third, we saw that Granovetter’s explanation of social structure in terms of the between-group bridging function that individuals’ weak ties possess presupposes that the world is populated by two types of entities, social groups and individuals, and that neither is reducible to the other. Similarly, complexity network theory assumes that collections of individuals in networks, neighborhoods or groups are irreducible to the individuals that make them up, and that the world is populated by many kinds of agents rather than just individuals. Kirman tells us that a network complexity approach needs to ‘theorize in terms of groups who have collectively coherent behavior’ (Kirman 2004: 138). Tesfatsion goes on to characterize kinds of agents across an entire spectrum of types of entities from human individuals ‘as active data-gathering decisionmakers with sophisticated learning capabilities to passive world features with no cognitive functioning’ (Tesfatsion 2005: 6). This complexity theory enlargement of what we find in the world constitutes a significant departure from the general equilibrium theory view that allows for but one very simple type of agent – the atomistic individual – and that further assumes all supra-individual entities can be fully explained in terms of the behavior of individuals. What are the outlines, then, of this new view of individuals and agents? Granovetter followed his SWT arguments with the assertion that individuals need to be understood as having a ‘social embeddedness’ where this meant that they were neither to be seen as ‘undersocialized’ as in the model of the neoclassical individual nor ‘oversocialized’ (Granovetter 1985: 2005) in the sense of completely explainable in terms of social structures. The next section consequently examines how the complexity network conception of the individual might be understood in terms of the socially embedded individual conception as developed in Davis (2003).

42

J. B. Davis

The network conception of the individual as socially embedded Though the atomistic individual conception is problematic in a number of respects, it nonetheless represents individuals as independent and autonomous. Accordingly, if this conception of individuals is given up, what basis remains for supposing that individuals are still somehow independent and autonomous? Alternatively, if individuals are regularly in direct interaction with one another in social groups, neighborhoods and networks, what grounds are there for supposing that they retain any status as independent agents? Might we not rather suppose that economies function exclusively in terms of collections of individuals and individuals are not agents at all? Are individuals in this new framework again essentially passive in nature, if not relative to prices, now relative to the groups of which they are members? Clearly Kirman and Tesfatsion – and indeed Granovetter as well – still make individuals central to their explanations of aggregate economic and social behavior. I argue here that they do so on the basis of an understanding of individuals’ independence and autonomy that is different in important respects from what is involved in the standard atomistic conception of the individual. First, in the complexity network conception (and also essentially in the case of the SWT hypothesis) individuals are not exclusively associated with any one group or neighborhood, but move continually across groups or neighborhoods. Consequently they must have some status as agents over and above whatever identification they have within any groups or neighborhoods they may frequent. Tesfatsion expresses this in terms of the idea that individuals construct different personalities in their different interactions with others. Individuals are both independent, autonomous agents in their capacity to construct personalities and also as the single bearers of the different personalities they construct. Kirman’s analysis represents individuals as continually learning and adjusting. Individuals possess capacities that enable them to determine both how and when they will interact with others, and how they will alter how and when they interact with others. Thus, both the characteristics which individuals have that make them independent and autonomous agents are rooted in a view of their interaction with others as dynamic and evolving. Essentially, because how individual economic agents may act is not predetermined in a changing world, they need to be understood in terms of a set of open-ended capacities or capabilities which can be exercised in circumstances that cannot be anticipated. In simple terms, individuals’ autonomy in this capability sense is a kind of agent freedom. Second, the way in which individuals reflexively exercise their capacities to interact with different individuals in different groups or neighborhoods deserves particular attention. Tesfatsion is most explicit in this regard, but the point implicitly also applies to Kirman’s analysis. Thus she argues that individuals’ autonomy is associated with ‘a capacity for self-governance’ (Tesfatsion 2005: 10), and that while economic agents, human and otherwise, exhibit ‘varying degrees of self-governance and self-directed social interactions’ (2005: 6, fn. 6),

Complexity theory’s network conception 43 human individuals are said to demonstrate this capacity across an especially wide range of forms of self-direction. Self-direction, it should be emphasized, involves more than simply being the source of one’s own action. It also involves a capacity to appraise reflexively one’s own action as one’s own, and then revise future courses of action as a result of this appraisal. Reflexivity may be defined as being able to take oneself as an object, just as one takes objects separate from oneself as objects of perception, thought, action, etc. In terms of complexity thinking, when agents have such a capacity, their behavior exhibits feedback principles, whereby they learn and adjust by appraising and evaluating past actions seen as their own prior to further action. Supposing individuals have this capacity further invests them with autonomy as independent agents, because a source of action can then be said to derive from them rather than influences upon them. In effect, individuals are able to separate themselves from others when taking themselves as objects, and thereby exercise freedom seen as self-control. In two respects, then, the conception of individuals in the complexity network approach as seen here treats individuals as independent and autonomous. How, then, is this view an instance of the socially embedded individual conception? In Davis (2003), that conception is explained as treating individuals as separate and independent from one another precisely by virtue of their relations to one another, where in contrast the atomistic conception of the individual treats individuals as separate and independent from one another by virtue of their isolation from one another. The former notion, particularly in light of the latter, is counterintuitive, and indeed in the long history of heterodox economics where it is most often found there is arguably ambivalence about whether individuals can be seen to be separate and independent and at the same time still social in character. The argument in Davis (2003), however, is that individuals’ relation to others is a necessary condition of their autonomy. Does that argument, then, apply to the complexity network view of the individual? As the two points above regarding individual autonomy show, individuals are separate and independent agents not through lack of interaction with others, as is the case in general equilibrium models, but because of their contact or direct interaction with one another. While of course it is not always the same individuals with whom individuals interact, since interaction is explained dynamically, nonetheless individuals’ behavior in regard to how they move across groups or networks is always explained by contact with others. Further, because most individuals in Kirman and Tesfatsion’s models engage in persistent interaction with particular sets of individuals, the social character of individual action is always manifest. Thus, the independence and autonomy of individuals arises directly out of social interaction rather than in a disengagement premised on the idea of a mythical Walrasian auctioneer. This all may be put in terms of Granovetter’s understanding of social embeddedness. Individuals are neither ‘undersocialized’ in the sense of being understood entirely in terms of autonomy and independence, nor ‘oversocialized’ in the sense of being understood entirely in terms of their social or group associations. Rather, both dimensions are part of one single conception of the individual economic agent as socially embedded.

44

J. B. Davis

Differences from the other embedded individual conceptions The network conception emphasizes individual mobility in the circulation of individuals across groups and neighborhoods, and uses this to represent individuals’ autonomy and social embeddedness. In terms of decision behavior, individuals in many network models begin with a simple choice rule, and then revise it following their interactions with others. We might consequently say that their behavior is instrumentally rational, if not in the usual optimizing sense of standard theory, nonetheless in the sense that individuals revise their behavior based on some idea of a payoff received from past behavior so that action is always a means to an objective. In contrast, Sen’s conception of the individual makes use of an understanding of social embeddedness that employs quite different assumptions about individual behavior. Individuals make commitments to others when they identify themselves as members of social groups, and in this respect can be seen to be socially embedded, but commitment behavior is explicitly differentiated from instrumentally rational economic behavior as generally understood in standard maximizing models (see Sen 1977 and 1985 and Davis 2007). That is, commitments are not instrumentally rational, but constitute principles which individuals regard as intrinsically reasonable, and which are associated with an aspect of the self that Sen understands in terms of individuals’ capacity to engage in rational self-scrutiny. Sen also attributes independence and autonomy to individuals understood in this way, so his view shares with the network conception the idea that autonomy and social embeddedness combine with one another. His view of individuals’ attachment to social groups, however, differs from most complexity models which represent agents as circulating through different group interactions. Indeed, there is a fair amount of inertia in social identity for Sen, reflecting his different view of behavior in this regard. While individuals in network models examine the effects of their interactions with others with an eye to payoffs, individuals in Sen’s case examine their commitments according to whether they find them rational, so that those found rational are consequently likely to be maintained. A further treatment of social embeddedness derives from collective intentionality theory. Collective intentionality theory concerns individuals’ shared weintentions, and provides a basis for explaining how individuals behave autonomously when they freely obligate themselves to shared action in wespeech occasions in groups (see Tuomela 1995). In this emphasis on obligation, individuals also depart from instrumentally rational behavior, since they bind themselves to shared action not in order to achieve their individual goals but according to the logic of collective action in social groups. In contrast to Sen’s view, the focus is less on social identities that may be shared across many people, but is rather on activity in smaller groups in which shared action is fairly well-defined. Thus, as in Sen’s view, there is also no clear principle of how individuals move across social groups, as in the network models. However, it can be argued that when individuals settle into certain relationships with other indi-

Complexity theory’s network conception 45 viduals, then collective intentions might operate. In Davis (2004) I apply this view to Kirman’s Marseille fish market model using a two-person collective intentionality analysis as developed by Gilbert (1989) to represent persistent loyalty relationships between buyers and sellers. The implication of this application is that behavior is complex in being instrumentally rational in some circumstances and principles-based in others. That is, individuals may employ a certain payoff decision rule as they circulate across different interactions with other individuals, but then change their form of rationality when they interact with those individuals they prefer to shop with. Here I put aside further comparisons of these different approaches to treating individuals as socially embedded. In the spirit of the agent-based modeling and network complexity critique of general equilibrium theory, however, it seems that the general goal should be to expand the menu of conceptions of individual agents rather than to narrow them as that theory does. Thus, the best strategy seems to be to multiply and also where feasible combine different conceptions of agents. I simply close by noting one apparent implication of this broad strategy. Since enlarging our conception of the individual from what is available to us in the homo oeconomicus conception means introducing interaction between individuals into consideration, this enlarged view of individual economic agents must be one of individuals who are socially embedded. This, it seems, cannot but be an advance on past thinking in that the idea that individuals are separate and independent is retained but with the addition of a serious dose of realism on the score of their interaction with others.

Acknowledgments The author is grateful to Abu Rizvi, Leigh Tesfatsion, Jack Vromen, the editors and a reviewer of the volume for comments on an earlier version of the chapter. Any errors are the author’s alone.

Notes 1 See Arthur et al. (1997) and Rosser (2004) for a more general characterization of complexity in economics. 2 The expression apparently originated with Leijonhufvud (1967). 3 As a prior framework, Granovetter credits the models and experiments of Rapoport and Horvath (1961) on the overlap of acquaintance circles as an important stimulus to his thinking.

References Arthur, W. A., Durlauf, S. and Lane, D. (1997) ‘Introduction’, in W. A. Arthur, S. Durlauf and D. Lane (eds) The Economy as an Evolving Complex System II: 1–14, Reading, MA: Addison-Wesley. Arrow, K. ( 1951; 2nd edn 1963) Social Choice and Individual Values, New Haven: Yale University Press.

46

J. B. Davis

—— (1968) ‘Economic Equilibrium’, in International Encyclopedia of the Social Sciences, vol. IV: 376–89, London: Macmillan. Chubin, D. (1976) ‘The Conceptualization of Scientific Specialties’, Sociological Quarterly, 17: 448–76. Collins, H. (1974) ‘The TEA Set: Tacit Knowledge and Scientific Networks’, Science Studies, 4: 165–86. Davis, J. (2003) The Theory of the Individual in Economics, London: Routledge. —— (2004) ‘Complex Adaptive Systems: Individual Identity in Networks’, Revue de Philosophie Economique, 9: 115–34. —— (2007) ‘Identity and Commitment: Sen’s Conception of the Individual’, in B. Schmid and F. Peters (eds) Rationality and Commitment, Oxford: Oxford University Press. Gilbert, M. (1989) On Social Facts, London: Routledge. Granovetter, M. (1973) ‘The Strength of Weak Ties’, American Journal of Sociology, 78: 1360–80. —— (1983) ‘The Strength of Weak Ties: A Network Theory Revisited’, Sociological Theory, 1: 201–33. —— (1985) ‘Economic Action and Social Structure: The Problem of Embeddedness’, American Journal of Sociology, 91: 481–510. Kirman, A. (1992) ‘Whom or What Does the Representative Individual Represent?’, Journal of Economic Perspectives, 6: 117–36. —— (1997) ‘The Economy as an Interactive System’, in W. B. Arthur, S. Durlauf and D. Lane (eds) The Economy as an Evolving Complex System II, Reading, MA: AddisonWesley. —— (2001) ‘Market Organization and Individual Behavior: Evidence from Fish Markets’, in J. Rauch and A. Casella (eds) Networks and Markets: 155–95, New York: Russell Sage. —— (2004) ‘Economics and Complexity’, Advances in Complex Systems, 7: 139–55. —— (2007) ‘Demand Theory and General Equilibrium. From Observation to Introspection: A Journey Down the Wrong Road’, in D. W. Hands and P. Mirowski (eds) Agreement on Demand, Durham: Duke University Press. Kirman, A. and Vignes, P. (1991) ‘Price Dispersion: Theoretical Considerations and Empirical Evidence from the Marseille Fish Market’, in K. Arrow (ed.) Issues in Contemporary Economics: 459–502, London: Macmillan. Kirman, A. and Vriend, N. (2000) ‘Evolving Market Structure: An ACE Model of Price Dispersion and Loyalty’, Journal of Economic Dynamics and Control, 25: 459–502. Leijonhufvud, L. (1967) ‘Keynes and the Keynesians: A Suggested Interpretation’, American Economic Review, 57: 401–10. Lucas, R. (1988) ‘Adaptive Behavior and Economic Theory’, Journal of Business, 59: 5401–26. Rapoport, A. and Horvath, W. (1961) ‘A Study of a Large Sociogram’, Behavioral Science, 6: 279–91. Rizvi, S. A. (1994a) ‘Game Theory to the Rescue?’, Contributions to Political Economy, 13: 1–28. —— (1994b) ‘The Microfoundations Project in General Equilibrium Theory’, Cambridge Journal of Economics, 18: 357–77. —— (1997) ‘Responses to Arbitrariness in Contemporary Microeconomics’, History of Political Economy, 29: 273–88. —— (2003) ‘Postwar Neoclassical Microeconomics’, in W. Samuels, J. Biddle, and J.

Complexity theory’s network conception 47 Davis (eds) A Companion to the History of Economic Thought: 377–94, Oxford: Basil Blackwell. —— (2007) ‘The Sonnenschein–Mantel–Debreu Results after 30 Years’, in D. W. Hands and P. Mirowski (eds) Agreement on Demand, Durham: Duke University Press. Rosser, B. (2004) ‘Complexity in Economics’, in B. Rosser (ed.) Complexity in Economics (3 vols), Cheltenham: Edward Elgar. Sen, A. (1977) ‘Rational Fools: A Critique of the Behavioral Foundations of Economic Theory’, Philosophy and Public Affairs, 6: 317–44. —— (1985) ‘Goals, Commitment, and Identity’, Journal of Law, Economics and Organization, 1: 206–24. Shafer, W. and Sonnenschein, H. (1982) ‘Market Demand and Excess Demand Functions’, in K. Arrow and M. Intriligator (eds) Handbook of Mathematical Economics, vol. II, Amsterdam: North Holland. Sonnenschein, H. (1985) ‘Comment on Hart, O.D., Imperfect Competition in General Equilibrium: An Overview of Recent Work’, in K. Arrow and S. Honkapohja (eds) Frontiers of Economics, Oxford: Basil Blackwell. Stoker, T. (1993) ‘Empirical Approaches to the Problem of Aggregation over Individuals’, Journal of Economic Literature, 31: 1827–74. Summers, L. (1991) ‘The Scientific Illusion in Empirical Macroeconomics’, Scandinavian Journal of Economics, 93: 129–48. Tesfatsion, L. (2001) ‘Structure, Behavior, and Market Power in an Evolutionary Labor Market with Adaptive Search’, Journal of Economic Dynamics and Control, 25: 419–57. —— (2005) ‘Agent-Based Computational Economics: A Constructive Approach to Economic Theory’, Iowa State University working paper, 31 March, in K. Judd and L. Tesfatsion (eds) Handbook of Computational Economics, vol. 2: Agent-Based Computational Economics, Amsterdam: North Holland. Tuomela, R. (1995) The Importance of Us: A Philosophical Study of Basic Social Notions, Stanford: Stanford University Press. Wirth, L. (1938) ‘Urbanism as a Way of Life’, American Journal of Sociology, 44: 1–24.

4

Does game theory offer ‘new’ mathematical images of economic reality? Giorgio Israel

Modern developments in game theory, in the early twentieth century, have no special links with economic theory. The contributions by Ernst Zermelo and Emile Borel, for instance, were related above all to traditional parlour games. It is to John von Neumann that we owe the axiomatic foundation of the theory and its close linkage with economics. Indeed, the mention made in von Neumann’s first paper providing proof of the fundamental minimax theorem refers directly to the general economic equilibrium theory: any event – given the external conditions and the participants in the situation (provided that the latter are acting on their own free will) – may be regarded as a game of strategy if one looks at the effects it has on the participants . . . this is the principal problem of classical economics: how is the absolute selfish homo œconomicus going to act under given external circumstances. (von Neumann 1928: 1) Nevertheless this is the only reference by von Neumann to Walras’ theory that is not openly critical. As early as 1928 and subsequently, on numerous other occasions, he displayed a polemical attitude to general economic equilibrium theory.1 Morgenstern further emphasized this point of view, going as far, in the ‘seventies, as to speak of the advisability of actually dispensing with the term “equilibrium” ’ (Morgenstern 1973: 270).2 Von Neumann’s and Morgenstern’s critique of the neoclassical theory of equilibrium may be summed up as follows. (1) This theory is based on a form of mechanistic reductionism while, in order to be original and effective, any formalized (i.e. mathematized) economic theory must be based on an autonomous conceptualization and not simply imported from mechanics or physics. (2) One manifestation of this dreary reductionism is the adoption of the concept of equilibrium, the approach in terms of equations and the use of the methods of classical maximization: these must be replaced by the concepts of fixed point, minimax, inequalities, and an ‘interactive’ form of optimization, as it were.

Game theory and economic reality 49 (3) Game theory may represent the conceptual core of a new and original form of the mathematization of social and economic processes. However, to cut all remaining ties with the theory of equilibrium, it is necessary to consider as central the cooperative point of view since, according to von Neumann, it makes ‘more social sense’ (Shubik 1992: 155), rather than the non-cooperative one which is closer to the microeconomic approach. This statement was made by von Neumann to Shubik, as reported by the latter, precisely in a controversial reference to Nash’s approach in which priority is given to the non-cooperative approach. Furthermore, the approach of Theory of Games and Economic Behaviour 3 overshadows the concepts of minimax with respect to the centrality of the concepts of imputation and stable set. As Morgenstern observed later, the notion of stability that emerges in connection with imputations and stable sets ‘has nothing to do with the usual equilibria of physics . . . indeed the present notion differs so profoundly with the usual ideas of stability and equilibrium that one would prefer to avoid even the use of the words. But no better ones have yet been found’ (Morgenstern 1973: 270). (4) It is unwise to nourish too many illusions concerning the possibility of making a satisfactory descriptive analysis of a social and economic system because of the extreme complexity of the factors involved. On this point von Neumann goes as far as to adopt an almost holistic attitude when he asserts, in a letter to Harold Kuhn written on 14 April 1953, that ‘I think that nothing smaller than a complete social system will give a reasonable “empirical” picture’ (Morgenstern 1973: 270). This view entails a preference for the normative approach, which is particularly apparent in the interpretation given by von Neumann and Morgenstern to the concept of ‘mixed strategy’.4 Indeed they rarely appeal to the frequentist approach according to which the mixed strategy represents an average behaviour with respect to a large number of games and the randomized choice corresponds to the distribution of the frequencies of the individual strategies that are available to each player. They never utilize the psychologistic approach, which was preferred by Borel, in which the mixed strategy represents the description of the internal process leading a player to his final choice and in which the assignment of a probability to a strategy is a symbolic representation of the psychological mechanism involved in the final choice. They rather prefer the rationalist approach in which, if a player plays regularly, the opponent can guess his intentions, so that the choice of a mixed strategy corresponds to an attempt to protect oneself by probabilizing one’s behaviour and thus the choice of a set of probabilities is a ‘rational’ choice: it constituted a definite disadvantage for each player to have his intentions found out by his opponent. Thus one important consideration for a player in such a game is to protect himself against having his intentions found out by his opponent. Playing several different strategies at random, so that only their probabilities are determined, is a very effective way to achieve a degree of such protection. By this device the opponent cannot possibly find out what the player’s strategy is going to be, since the player does not know

50

G. Israel it himself. Ignorance is obviously a very good safeguard against disclosing information directly or indirectly. (von Neumann and Morgenstern 1944: 145–6)

In other words, von Neumann is not attempting to describe human psychology. He is pursuing the more limited and specific aim of axiomatizing as many of its aspects as possible, as this is the only available scientific method for objectivizing them: ‘There are of course many – and most important – aspects of psychology which we have never touched upon, but the fact remains that a primarily psychological group of phenomena has been axiomatized’ (von Neumann and Morgenstern 1944: 77). The gap between this approach and that of social atomism is quite evident. von Neumann and Morgenstern have sharply deviated from any attempt to construct a theory of individual rationality, aiming rather, as Robert Leonard pointed out,5 at the construction of a mathematics of society intended as a whole. In order to explain this diffidence towards what is now called methodological individualism it is necessary to consider the roots of von Neumann’s social conceptions which, probably under the influence of the political events in which he was involved, were increasingly influenced by a fundamental distrust of the individual’s rational behaviour. Unlike the theory of general economic equilibrium, which is based on a definition of the agent’s rational behaviour, he aimed rather at the determination of ‘wise’ and ‘reasonable’ conditions capable of establishing a comparatively rational social order. Among the various points mentioned above, (2) is the central one. In fact the appraisal of the different maximization approaches has represented a source of disagreement between mathematicians and economists concerning the actual import of the game theoretic approach. The difference of opinion between von Neumann and Samuelson is significant in this regard. The former, in a letter dated 8 October 1947 to Morgenstern, accused Samuelson of using primitive mathematics, at most acceptable at the time of Newton, and of having ‘murky ideas about stability’, adding that ‘even in 30 years he won’t absorb game theory’.6 On the other side, the latter, quite recently,7 accused von Neumann of having attempted a bluff with his theory about a new mathematics for economics allegedly based on game theory, and claimed that economics had never had any need for optimization processes other than those of Newton, nor would it ever. From a general standpoint, Samuelson was wrong and his attitude only confirmed von Neumann’s opinion that he would understand nothing about game theory even after 30 years. The difference between the competitive approach and the game theoretic approach is encapsulated in Osborne and Rubinstein’s effective statement: To clarify the nature of game theory, we contrast it with the theory of competitive equilibrium that is used in economics. Game theoretic reasoning takes into account the attempts by each decision-maker to obtain, prior

Game theory and economic reality 51 to making his decision, information about the other players’ behavior, while competitive reasoning assumes that each agent is interested only in some environmental parameters (such as prices), even though these parameters are determined by the actions of all agents. To illustrate the difference between the theories, consider an environment in which the level of some activity (like fishing) of each agent depends on the level of pollution, which in turn depends on the levels of the agents’ activities. In a competitive analysis of this situation we look for a level of pollution consistent with the actions that the agents take when each of them regards this level as given. By contrast, in a game theoretic analysis of the situation we require that each agent’s action be optimal given the agent’s expectation of the pollution created by the combination of his action and all the other agents’ actions. (Osborne and Rubinstein 1994: 3) Also in the modern version of game theory based on Nash’s concept of equilibrium, this difference remains. The question is a complex one, because the player’s behaviour in Nash’s equilibrium and Walras’ agent are similar, as both are parametric behaviours.8 However in Nash’s game theory the parameters are not prices but the others’ strategies, which makes a radical difference, precisely in the sense illustrated by Osborne and Rubinstein’s above remark. However, even though Samuelson was wrong from the mathematical viewpoint and did not understand the true nature of the problem, from the perspective of subsequent historical developments things by no means went in the direction predicted and hoped for by von Neumann and Morgenstern. It cannot be denied however that, even if classical maximization differs in any case from that of game theory, Nash’s point of view nevertheless is closer to the approach of general economic equilibrium theory. This is the result above all of the emphasis laid on the non-cooperative approach. Nash’s approach reduces the players to subjects that calculate their optimal strategies in complete isolation and without any actual interaction.9 Von Neumann and Morgenstern’s programme, with the emphasis it places on the cooperative approach, thus represents a radical alternative to Nash’s. In this connection a delicate question of interpretation is raised, which we shall now examine in a brief digression. There is no doubt that both von Neumann and Morgenstern progressively changed their attitude to the evaluation of methodological individualism. This is quite apparent in von Neumann, when the distance between his 1928 work and Theory of Games and Economic Behaviour is taken into consideration. No particular interpretative problems are raised in view of the weak link between von Neumann thinking and the various economic theory traditions. In the case of Morgenstern the question is more delicate as he came from the Austrian tradition at the centre of which lay the stance of methodological individualism. However, his writings, starting from the book with von Neumann and up to the general presentation of game theory in 1973 (Morgenstern 1973), reveal an increasingly marked change of approach and a distancing from methodological individualism. This development could be

52

G. Israel

explained also in terms of the influence, which was known to be very strong, that von Neumann had on Morgenstern. Coming back now to our main topic we observe that the first reversal came about as a result of Gerard Debreu’s work. Even though he acknowledged von Neumann and Morgenstern’s ‘outstanding influence which freed mathematical economics from the traditions of differential calculus and compromises with logic’(Debreu 1959: X) his Theory of Value represents a skilful reconversion of results obtained in the field of game theory for the purpose of making a reappraisal in axiomatic terms of Walras’ theory and of providing proof of one of its central results – the equilibrium existence theorem. This reconversion was achieved by ‘pruning’ all the results utilizable for this purpose of all references to game theory. It is no coincidence that the results obtained by von Neumann in different contexts become utilizable thanks to Nash’s theorem. As Defalvard pointed out ‘the existence of Nash’s equilibrium refers to the same conditions of Walrasian equilibrium as the Arrow–Debreu model, as those given by Brouwer’s fixed point theorem and as Kakutani for his extensions to correspondences’ (Defalvard: 2001: 45). Consequently, an analysis more strongly focused on Nash’s equilibria overshadows the dynamic aspects in favour of the fixed points of this dynamics. There is no doubt that von Neumann (more than Morgenstern) was relatively uninterested in the dynamic aspects, not because he considered them insignificant, but because he considered it preferable to put off considering them to a later stage. In his opinion, the mathematization of a complex subject such as economics would require much time and patience and to tackle the dynamic problem too precipitously would not lead to any worthwhile results. However, as far as the concept of equilibrium was concerned, von Neumann could not fail to realize that an approach à la Nash ultimately enhanced the centrality of Walras’ theory. It was again Defalvard who correctly pointed out that ‘while the formal kinship between the two concepts of equilibrium [of Nash and Arrow–Debreu] had already been noted en passant, it had never been subjected to any in-depth scrutiny’ (Defalvard 2001: 45). Any such scrutiny would probably reveal how Debreu’s use of the results of game theory, and in particular Nash’s, was instrumental in reproposing a classical microeconomic interpretation and of sterilizing or at least of marginalizing the role of game theory in the formalization of economics which should instead be considered central in the view of von Neumann and Morgenstern. Attention should be focused on the fact that the operation performed through Debreu’s Theory of Value (even more than through Arrow and Debreu’s model) corresponds to a programme designed to reinstate the centrality of methodological individualism, that is, precisely the point of view that von Neumann and Morgenstern’s mature research programme tended radically to challenge. The main aspect of this programmatic clash is the emphasis laid by von Neumann and Morgenstern on the primacy of the cooperative approach. In their view, the possibility of cooperation arises as soon as the number of players exceeds two and so the players form coalitions:

Game theory and economic reality 53 Interdependence has, of course, been recognized, but even where neoclassical economics of the Walras–Pareto type tried to describe this interdependence, the attempt failed because there was no rigorous method to account for interaction which is evident especially when the number of agents is small, as in oligopoly (few sellers). Instead large numbers of participants were introduced (under the misnomer of ‘free competition’) such that asymptotically none had any perceptible influence on any other participant and consequently not on the outcome, each merely facing fixed conditions. Thus the individual’s alleged task was only to maximize his profit or utility rather than to account for the activities of the ‘others’. Instead of solving the empirically given economic problem, it was disputed away; but reality does not disappear. In international politics there are clearly never more than a few states, in parliaments a few parties, in military operations a few armies, divisions, ships, etc. So effective decision units tend to remain small. The interaction of decisions remains more obvious and a rigorous theory is wanting. (Morgenstern 1973: 266) Research took a quite different path from that predicted by von Neumann and Morgenstern and, also as a result of the decline of the cooperative approach, gave a fresh lease of life to methodological individualism. That research went in this direction was explicitly acknowledged by Nash. In an interview given to Robert Leonard he declared he had followed a different ‘individualistic’ approach from that of von Neumann, who, in his view, had a more ‘European’ outlook. Therefore, Nash had correctly identified a divergence in the research programmes and not only a branching off of different formal approaches, as many tend to think today, reducing the question to a mere fact of modelling or mathematical convenience.10 The mathematical aspect no doubt plays an important role but only to the extent to which it is possible to provide a conclusive and fully general proof that every model expressed in cooperative terms may be related back to an equivalent model expressed in non-cooperative terms. If such a result were to be proved true – we repeat, in a fully general way and not only for specific cases, as is still the case today – von Neumann and Morgenstern’s programme could be considered to have failed, at least as far as the claim to the primacy of the cooperative approach is concerned. The utility of game theory in economics would therefore be limited to proposing an optimization approach different from that of Walras’ theory. Nevertheless, it would not be correct to present von Neumann and Morgenstern’s approach as being dictated by a series of prejudices. This is what Ken Binmore does when he accuses von Neumann and Morgenstern of having themselves placed obstacles in the path of their research.11 By so doing, Binmore apparently fails to realize that a research programme represents precisely a series of objectives, the deliberate choosing of which limits the direction of movement. For Binmore, who sees nothing wrong with adopting the methodological individualism approach, a programme like von Neumann and Morgenstern’s is legitimately unacceptable. However, this

54

G. Israel

does not mean that the programme itself is absurd. von Neumann and Morgenstern could likewise have considered the programme deemed feasible by Binmore as an ad hoc and meaningless way of proceeding. On the contrary, it is quite evident that Nash’s program represents a new ‘marriage’ between game theory and competitive economic equilibrium theory, as, in fact, the conditions of the existence of Nash equilibrium are the same of Arrow–Debreu equilibrium. In this way, game theory is essentially reduced to a question of fixed points theorems, and this was precisely the core of von Neumann’s criticism of Nash’s approach. In von Neumann and Morgenstern’s intentions, game theory had the role of providing new and more plausible images of economic reality. In their view, this role could be allowed to emerge only by demolishing the central role of the microeconomic methodological individualism approach. As it turns out, their research programme has been surreptitiously set aside rather than confuted. What is unsatisfactory about the way this happened is the vague boundary that separates issues of formal effectiveness from those related to the research programme: although no one can deny the effectiveness of Nash’s approach, it is completely unsatisfactory that a positive assessment can be influenced by an inextinguishable a priori attachment to the mythology of Walrasian equilibrium. Even if it were indeed true that game theory offers no substantial advantage to economic analysis, it would be necessary to arrive at a conclusion of this kind without being influenced by Walrasian equilibrium mythology. This becomes all the more necessary when the mediocrity of the results obtained in the framework of the general equilibrium model is taken into account.12 It has indeed been conclusively demonstrated that it is impossible to make any significant progress in the direction of dynamic analysis. It has been pointed out that many have fallen and continue to fall ‘into the equilibrium trap, which consists in believing that it contains the process, while it actually leads to its being discarded’ (Defalvard 2001: 45). However, it may be wondered under what conditions game theory can make a valid contribution to the development of economic analysis. In my view, it is not sufficient to enable use to be made of optimization processes that are conceptually richer than the classical ones. Game theory must also free us from the concept of equilibrium and of the entire mechanistic apparatus imported from mathematical physics. In other words, game theory should contribute to the introduction of a holistic approach and the abandoning of the customary inadequate reductionist schematas. In concluding this short note, I should like to mention that, in this climate in which so many hasty and superficial formalizations, each of which claims to say the final word, are being pursued, the most valid teaching we can draw from von Neumann and Morgenstern is expressed in the warning that the decisive break which came in physics in the seventeenth century . . . was backed by several millennia of systematic, scientific, astronomical observation, culminating in an observer of unparalleled caliber, Tycho de Brahe. Nothing of this sort has occurred in economic science. It would be absurd in

Game theory and economic reality 55 physics to expect Kepler and Newton without Tycho, – and there is no reason to hope for an easier development in economics. (von Neumann and Morgenstern 1944: 4)

Notes 1 2 3 4 5 6 7 8 9 10 11 12

See on this topic Leonard 1992 and 1995, and Israel and Millán Gasca (forthcoming). See also Israel forthcoming. von Neumann and Morgenstern 1944. See the analysis of the different approaches to the concept of mixed strategy developed in Dell’Aglio 1995. See Leonard 1992 and 1995. See Morgenstern 1976: 810. See Samuelson 1989. See Moulin 1981. On this question we agree with the analysis developed in Mirowski 2002. See, for instance, Giraud 2000. Binmore 1992. See Ingrao and Israel 1987.

Bibliography Binmore, K. (1992) Fun and Games: A Text on Game Theory, Lexington, MA: D. C. Heath. Debreu, G. (1959) Theory of Value. An Axiomatic Analysis of Economic Equilibrium, New Haven: Yale University Press. Defalvard, H. (2001) ‘Le hors d’équilibre dans la théorie des jeux: une affaire de croyances’, in J. Cartelier and R. Frydman (eds) L’économie hors de l’équilibre, Paris: Economica. Dell’Aglio, L. (1995) ‘Divergences in the History of Mathematics: Borel, von Neumann and the Genesis of Game Theory’, Rivista di Storia della Scienza (series II), 3: 1–46. Giraud, G. (2000) La théorie des jeux, Paris: Flammarion. Ingrao, B. and Israel, G. (1985) ‘General Economic Equilibrium Theory. A History of Ineffectual Paradigmatic Shifts, I-II’, Fundamenta Scientiae, 6: 1–45 and 89–125. —— (1987; 2nd edn 1996; 3rd edn 1999; 4th edn 2006) La mano invisibile. L’equilibrio economico nella storia della scienza, Roma: Laterza; English trans. (1990; 2nd edn 2000) The Invisible Hand. Economic Equilibrium in the History Of Science, Cambridge, MA: The MIT Press. Israel, G. (1993) ‘The Two Paths of the Mathematization of the Social and Economic Sciences. The Decline of the “Mathématique Sociale” and the Beginnings of Mathematical Economics at the Turn of the Eighteenth Century’, Physis, 30: 27–78. —— (1996; 2nd edn 1997; 3rd edn 2003) La mathématisation du réel. Essai sur la modélisation mathématique, Paris: Editions du Seuil; Italian trans. (1996) La visione matematica della realtà, Introduzione ai temi e alla storia della modellistica matematica, Roma and Bari: Laterza —— (2001) ‘La matematizzazione dell’economia: aspetti storici ed epistemologici’, in M. Emmer (ed.) Matematica e cultura 2001, Milano: Springer Verlag Italia: 67–80. —— (2002) ‘The Two faces of Mathematical Modelling: Objectivism vs. Subjectivism, Simplicity vs. Complexity’, in P. Cerrai, P. Freguglia and C. Pellegrini (eds) The

56

G. Israel

Application of Mathematics to the Sciences of Nature. Critical Moments and Aspects, New York: Kluwer Academic and Plenum Publishers. —— (2004) ‘Al di là del mondo inanimato: la storia travagliata della matematizzazione dei fenomeni economici e sociali’, Bollettino dell’Unione Matematica Italiana (series 8), 7-B: 275–304; reprinted in Atti del XVII Congresso dell’Unione Matematica Italiana, Milano, 8–13 settembre 2003 (2004), Bologna: UMI: 129–58. —— (2005) ‘The Science of Complexity: Epistemological Problems and Perspectives?’ Science in Context. 18: 1–31. —— (forthcoming) ‘Teoria dei giochi ed economia matematica secondo von Neumann e Morgenstern’, Bollettino dell’Unione Matematica Italiana, Sez. A. Israel, G. and Millán Gasca, A. (1995) Il mondo come gioco matematico. John von Neumann, scienziato del Novecento, Roma: La Nuova Italia Scientifica; Spanish trans. (2001) El mundo come un juego matemático. John von Neumann, un científico del siglo XX, Madrid: Nivola; American edn (forthcoming 2007), Durham and London: Duke University Press. Leonard, R. J. (1992) ‘Creating a Context for Game Theory’, in E. R. Weintraub (ed.), Toward a History of Game Theory, Durham and London: Duke University Press. —— (1995) ‘From Parlor Games to Social Science: Von Neumann, Morgenstern, and the Creation of Game Theory, 1928–1944’, Journal of Economic Literature, 33: 730–61. Mirowski, P. (1992) ‘What Were von Neumann and Morgenstern Trying to Accomplish’, in E. R. Weintraub (ed.) Toward a History of Game Theory, Durham: Duke University Press. —— (2002) Machine Dreams. Economics Becomes a Cyborg Science, Cambridge: Cambridge University Press. Morgenstern, O. (1973) ‘Game Theory’, in Dictionary of the History of Ideas vol. II, New York: Ch. Scribner’s & Sons. —— (1976) ‘The Collaboration of O. Morgenstern and J. von Neumann on the Theory of Games’, Journal of Economic Literature 14: 805–16. Moulin, H. (1981) Théorie des jeux pour l’économie et la politique, Paris: Hermann. Neumann, J. von (1928) ‘Zur Theorie der Gesellschaftsspiele’, Mathematische Annalen, 100: 295–320. Neumann, J. von and Morgenstern, O. (1944; 2nd edn 1947) Theory of Games and Economic Behaviour, Princeton: Princeton University Press. Osborne, M. J. and Rubinstein, A. (1994) A Course in Game Theory, Cambridge, MA: The MIT Press. Samuelson, P. A. (1989) ‘Revisionist View of von Neumann’s Growth Model’, in M. Dore, S. Chakravarty and R. Goodwin (eds) John von Neumann and Modern Economics, Oxford: Clarendon Press. Shubik, M. (1992) ‘Game Theory at Princeton: 1949–1955’, in E. R. Weintraub (ed.) Toward a History of Game Theory, Durham: Duke University Press.

Part II

History of monetary ideas in the light of modern theory

5

Money, markets and property Gunnar Heinsohn and Otto Steiger

Although our theoretical ideas about capitalism have been improved as mainstream economics developed, they have never matured into a theory of capitalism . . . / [because] the property rights system . . . is only implicitly involved in the theory that emerged. This theory takes the property rights foundation of capitalism for granted. (Demsetz 1998:144 and 146)

The challenge to markets and money as natural givens by an institution that is created by man: property In the history of economic thought, from the time of Aristotle to our days, the relation between money and markets has always been analysed in the same fashion. Apart from the world of Robinson Crusoe, as soon as two individuals meet they make barter exchanges, thereby creating the market. When the number of individuals increases, the problems of the double coincidence of wants and, therefore, of transaction costs arise. To facilitate barter and to reduce transaction costs, a special standard good emerges to be selected as numéraire – money, which allows the expression of the barter-exchange relations numerically. This hypothesis about the rise of money and markets was, however, never based on serious anthropological and economic-historical studies. ‘In much of economics, markets appear as a natural given; if there is a good, then there is a market’ (Loasby 2000: 299). And, one could continue, if there are more than two persons who want to exchange their goods on the market, then there is money. In this contribution, the assumption of a natural given market from which money likewise naturally is derived will be profoundly challenged. We will take into account the findings of economic historians and, especially, economic anthropologists, who were unable to identify either markets or money in tribal and feudal systems preceding the modern system of ‘capitalism’ (Demsetz 1998, as quoted in the epigraph above). However, there are shortcomings in their research1 that have induced us to develop the new approach of property economics. Unlike classical and neoclassical economics, this approach abandons a fit-all theory of material reproduction, distinguishing instead between three systems of

60

G. Heinsohn and O. Steiger

which only one, the property-based society, brings about money and markets because property is not a natural given but created by man. This will be demonstrated in the second section. Money and markets are institutions, which spring from the institution of property – an institution that in the history of economic thought, with the notable exception of a neglected mercantilist author, was never properly identified. Though the term ‘private property’ was, and still is, applied throughout the seminal works of both classical and neoclassical economists, it is always confused with the institution of private possession. This will be discussed in the third section. The surprising result that even the theory of property rights or new institutional economics is hampered by the inability to distinguish between possession and property will be demonstrated in the concluding section. In that section the renewed interest – by New Keynesians – in the property title called collateral is also discussed.

Where does money and the market come from? The controversy in economic anthropology and its solution by property economics Classical and neoclassical economics, we argue, have failed to derive money and the market from property because both schools did not base their assumptions on serious anthropological and economic-historical studies, which could have shown them that only possession, and not property as they assume (see the following two sections), is a universal phenomenon of all systems of material reproduction. When it comes to money, classical and neoclassical economists at least try – albeit in vain – to derive it from something social, that means, from barter exchange. This mutually advantageous operation they see anchored in human biology. The view has received its most popular expression by Adam Smith (1723–1790) with his assumption of ‘a certain propensity in human nature . . . to truck, barter and exchange one thing for another’ (Smith 1937 [1776]: 13). It is through his inborn drive – Smith and his successors are convinced – that man has moved ahead of the animal kingdom and turned himself into homo oeconomicus from the very beginning. ‘Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog. Nobody ever saw one animal by its gestures and natural cries signify to another, this is mine, that yours: I am willing to give this for that’ (Smith 1937 [1776]: 13). Though this biological view of the market has ruled economics ever since, it is not unchallenged. Economic anthropologists, who are eager to confirm a natural market with their own research, are surprised not to find the propensity to barter in primitive systems of material reproduction (see in detail Heinsohn 1984 [1982] and 2007). After having scrutinised a massive body of evidence on tribal systems, Karl Polanyi (1886–1964) summarises, in 1944, his failure to find the market. ‘In such a community . . ., the supposed propensity to barter, truck, and exchange does not appear. The economic system is, in effect, a mere function of social organization’ (Polanyi 1957a [1944]: 49).

Money, markets and property 61 As early as 1922, Bronislaw Malinowski (1884–1942), trained at the London School of Economics and founder of the field of social or economic anthropology,2 refutes neoclassical economists’ ideas of a universal market. Indeed, the Kula [a long distance ring of loyalty and gift exchange] shows us that the whole conception of primitive value; the very incorrect habit of calling all objects of value ‘money’ or ‘currency’; the current ideas of primitive trade and primitive ownership – all these have to be revised in the light of our institution. / It is especially a great error to use the word ownership with the very definite connotation given to it in our own society. (Malinowski 1961 [1922]: 516 / 116–17) Malinowski’s research is fiercely opposed by one of his disciples, David M. Goodfellow (1904–1985), who is determined not to move away from neoclassical dogma. It has long been recognised that the formulations of economic theory have in them a certain universality. . . . The aim . . . is to show that the concepts of economic theory must be taken as having universal validity, and that, were this not so, the result would be not only scientific confusion but practical chaos. (Goodfellow 1939: 3–4, emphasis added; see similarly Herskovitz 1940) It is Polanyi’s achievement to stop running away from such ‘chaos’. Simply by demonstrating that there are no market operations visible in either tribal or feudal systems, he forces upon the anthropological community a debate devoted to ‘the formal and substantive meanings of “economic”’ (Polanyi 1957b: 243, emphases added). Yet, the controversy has never been solved. Only in field research, Polanyi’s ‘substantivist’ disciples have won the day by abandoning the barter paradigm, as formulated by George Dalton (1926–1991). ‘Moneyless market exchange was not an evolutionary stage . . . preceding the arrival of monetary means of market exchange’ (Dalton 1982: 188). Yet, they are easily pushed aside, although they are capable of proving the biological theory of the market, as exhibited by the ‘formalist’ Goodfellow, wrong, because they are unable to replace it with a convincing one. Because the substantivist-formalist exchanges remained inconclusive, the controversy has been back in full swing since the 1990s when major summaries of the debate, which re-emerged in the 1960s and 1970s, were published (see, for example, Davis 1992 and Granovetter 1992). However, the last decade merely has seen a repetition of the earlier controversy, albeit with much less slandering. Could it be that substantivists and formalists have something in common which hinders both sides in advancing to a satisfactory explanation of the emergence of money and markets? Though Polanyi recognises that the ‘principle of [calculative] behavior’ of homo oeconomicus requires an ‘institutional structure . . . to become effective’ (1977: 42) in the market, he cannot identify this peculiar structure. Why?

62

G. Heinsohn and O. Steiger

Polanyi shares not only the formalist neoclassical view of markets as moneyemploying locations for exchanges of goods but also subscribes to the definition of money supposedly employed in barter exchanges. ‘Quantifiable objects’ or ‘physical units’ through which ‘barter is facilitated’ (Polanyi 1977: 102–3) are nothing but the idea of the classical and neoclassical standard good. The only difference to the formalist school lies in Polanyi’s correct insistence that no such money can be found in tribal and feudal systems. Like neoclassical theory, Polanyi is unaware of the role of the property title collateral in the creation of money. In his historical studies of ancient societies, he occasionally comes across collateral and property, as, for example, when a Greek named Pasion ‘had lent 50 talents on the security of real property’ (Polanyi 1977: 265). Yet, no analytical conclusion whatsoever is drawn regarding the property basis of the talent currency. The numéraire idea of money blinds the substantivists no less than the formalists. In contrast to Polanyi, ancient Greek and Roman historians had been aware of the emergence of money out of property on which they saw polis and civitas based. Lucretius (99–55 BC) is very clear in this respect. ‘Later, [after the rule of the castles], came private property with the gold [coined money] under which even the strong and the beautiful were quickly deprived of their former honours’ (De rerum natura, V: 1113–14).3 Drawing on ancient scholars as well as modern excavations, the substantivist anthropologist Sally Humphreys (*1936) strongly senses that the change from Greek Mycenaean feudalism to the polis results in a new institutional structure which triggers ‘sale, loan and credit’ (1978: 73). However, like Polanyi himself, she fails to identify the institution of property as the substance of the new structure. That is why another famous Polanyist and economic historian of Ancient Greece, Chester G. Starr (1915–1999), has to concede that the ‘manner in which loans became so mighty a machine is mysterious’ (1977: 183). The mystery can, however, be solved when the barter paradigm is replaced by the property paradigm. The producers of commodities are not part of some eternal and universal manufacturing of goods for barter. To meet their debt contracts, that means, to suck in money through sales, it is they who first constitute the market that has nothing to do with a barter location. It is not a generally assumed exchange-market, which turns their agents into private proprietors. On the contrary, it is the private proprietors only who have no choice but to constitute a market to turn their commodities into the means in which their debts are contracted. (Heinsohn 1984 [1982]: 129) By taking a closer look at property as different from possession, this ‘private property’ paradigm has been further developed by the school of property economics (see Heinsohn and Steiger 2006 [1996], and also 2003 [2000], 2006 and 2007b).4 The school starts from Polanyi’s seminal insight that, in history, mater-

Money, markets and property 63 ial reproduction is determined by different institutional structures: (i) the structure of reciprocity in tribal community; (ii) the structure of compulsory contributions in feudal seigniory; and (iii) a peculiar, however unspecified, structure bringing about the market society.5 By emphasising the different character of goods and resources in the three systems of material reproduction, property economics tries to expose the structure Polanyi and the substantivists could not reveal. Tribal and feudal systems know only of possessory rules to the physical use of goods and resources, not of property rights. A possessory rule in these systems is defined as the individual (not private) and common de facto rule, determined more or less arbitrarily by the power relations prevailing in tribal communities and feudal seigniories, that means, it cannot be enforced by independent courts of law. The rule determines who may use which good or resource in what manner, at what time and place, to what extent and by exclusion of whom. We will see that new institutional economics mislabels this possessory rule (together with the right of alienation) as the fundamental property right. However, only in the market society, which property economics labels property society, property rights exist, in addition to possessory rules that are now transformed into possessory rights. Property rights are de iure claims which entitle their holders to the intangible (non-physical) capacities: (i) to back and, thereby, burden in issuing money against interest; (ii) to encumber as collateral for obtaining money; (iii) to alienate, especially by sale and lease; and (iv) to enforce. Property rights exist as common and private rights and are regulated by independent law. Their holders take possessory rules de facto into their service, thereby making them de iure possessory rights. Therefore, individual rights to possession in the propertybased society are always private rights. Property rights transform goods and resources into saleable commodities and saleable as well as rentable assets. The possession-based systems of tribal communities and feudal seigniories are determined by power relations between non-free persons, while in the propertybased society independent courts of law overrule such relations. In the latter system, the law supervises credit, sales, lease and employment contracts between free private individuals6 as a legally formalised network on markets, the property net. Such contracts, independent law and markets are absent in the possessionbased systems. They can only organise material reproduction – production, distribution and consumption of goods – by mere control of resources, which is not an economic organisation. Occasionally, they achieve also accumulation of goods – only, however, by a reduction of consumption, that means, savings. The tribal and feudal systems know only one type of return, the material yield of the physical use of goods and resources. The property system, however, knows also of an immaterial yield. This yield is the starting point for understanding an economic system which property economics labels the property premium. A title to property never comes naturally. It can only be brought about by a legal act, not by ‘a certain tendency in human nature’ (Smith) – an act, which by

64

G. Heinsohn and O. Steiger

definition is intangible and initially does not alter the possession state of resources that now become assets. By whatever means property is created, revolutions from below or reforms from above, it carries the unearned property premium. What is the meaning of property premium? It is a non-physical yield of security inherent in assets. It allows proprietors of the assets to enter into credit contracts, and it is a measure of the potential of private individuals to become creditors or debtors. While only unburdened property is a free asset, burdening turns the asset into a ‘liability’ that, however, is not necessarily encumbered. An unburdened asset entails the capacity of a creditor to issue notified titles to his property, his equity or ‘own capital’,7 that means, to act like a credit bank of issue creating money notes. An unencumbered asset entails the capacity of a debtor to borrow the money notes by pledging titles to his property as collateral, thereby not only burdening but also encumbering it. It goes without saying that during the period of the loan, lender and borrower continue the physical use of the possessory side of their burdened asset. In principle, every proprietor can issue anonymised claims against his property which take the form of transferable documents or notes redeemable in the issuer’s property, because otherwise they would not be accepted or circulate. However, in the evolution of money, both in antiquity and early modern times, only those creditors survived as issuers of money notes who, as solvent proprietors with a high ratio of capital, established strong credit banks (for detailed economic-historical studies see Heinsohn and Steiger 2006 [1996]: 264–76, 2003 [2000]: 504, 2006: 118–19, and also 2007b). By burdening and, therefore, blocking its capital in the money-issuing contract, the credit bank gives up immaterial property premium in exchange for a specified amount of money promised by its debtor: the rate of interest. In other words, interest is explained as the compensation for the bank of issue’s loss of property premium. To secure the refunding of the loan, the borrower has to offer collateral. Thereby, his loss of property premium is turned into liquidity premium attached to the money notes he receives. As long as the debtor fulfils his obligations, the bank is not allowed to touch the collateral, for example by using it for redemption of its notes. This has to be done by the bank’s capital. It goes without saying that Keynes’s liquidity premium or monetary theory of the rate of interest overlooks the rate of interest charged by the bank of issue. The latter exists before liquidity premium can be transformed into interest charged by the borrowing bank in a loan to a non-bank. In the money-creating contract, creditor and debtor retain their material possessions, whose immaterial property titles are charged to guarantee the circulation of money (by the lender) and to encumber the contract (by the borrower). Both continue with their possessions’ capacity to earn a material yield, which exists beyond their property side, that means, beyond the immaterial yield of property premium. Therefore, goods are never transferred in a loan contract as the neoclassical theory of the rate of interest suggests (see, for more detail, Heinsohn and Steiger 2005: 75–8). The creation of money cannot be separated from the process of loaning it to a

Money, markets and property 65 proprietor-debtor. Thus, both the issuing of money notes and the establishment of a loan contract occur uno actu. Money is created in a credit contract but is not itself a credit.8 The bank of issue cannot help but establish its own standard, the money of account,9 in the very moment it issues notes or money proper. This standard must reckon the issued notes in terms of an abstract unit necessary for denominating their amount in the debt contract in which they are created. It must not be confused with a standard of measurement, which is derived from a standard physical good as unit of account or numéraire as in neoclassical theory. In the neoclassical model of a barter economy, the commodity chosen as unit of account is assigned the price 1 (one) and serves, thereby, as the nominal anchor for the prices of all other goods. However, this anchor can only help to express their exchange ratios or relative prices. In the truly monetary economy based on property, the bank of issue does not need such a commodity. Instead it issues – denominated in its money of account – money notes as anonymised claims to its assets as property, but never to the assets as possession. Uno actu with the credit bank’s setting a money of account by granting a loan, all property titles receive prices in this standard and are, thereby, nominal or money prices. To refund the money loan, the borrower has to start a production priced in these money prices, a monetary production to be sold as commodities against money proper at a location, the market. Thus, the market is not a place where goods are exchanged with the help of a standard good to the mutual benefit of their possessors, as neoclassical economics suggests, but an institution constituted by indebted producers to earn sales contracts for money. To pay interest on the loan, the debtor must be able to generate a value surplus in his monetary production, the rate of profit, to be realised by the sales contracts, too. Thus, interest-generated profit brings about the accumulation so characteristic of a property-based economy. Unlike in mere possession-based systems, this mechanism does not depend on a previous accumulation of saved consumption goods. By demonstrating the importance of property for all forms of economic activity, property economics offers an alternative explanation of the relationship between money and the markets, thereby turning on its head the traditional derivation of money out of naturally given markets. The neglect or misunderstanding of the institution of property, for nearly a quarter of a millennium since the end of mercantilism, has decisively hampered the development of economic thought, as will be shown in the following section.

Property in the history of economic thought: from James Steuart to Alfred Marshall In classical and neoclassical economics money is explained out of the necessity to reduce transaction costs of market exchange of goods. Both schools incessantly employ the term property, but, owing to their identifying it with the right to the physical use of goods – actually a right of possession – neither ever comprehends property’s formative role for money and markets.

66

G. Heinsohn and O. Steiger

From Adam Smith (see, for example, Smith 1937 [1776]: 48–9 and 365–7) to Karl Marx (1818–1883) (see, for example, Marx 1946 [1867]: 740–7 and 787) classical economists frequently speak of common property in place since the beginning of mankind. What they see as private property is supposedly derived from its common variant by ‘previous accumulation’ (Smith), respectively ‘expropriation’ (Marx), supposedly excluding entire classes from property. However, they never come to terms with the essentials of property, especially, to serve as collateral and capital and, hence, the foundations of money. What the classical school discusses as common and private property is nothing but common and individual possession of goods and resources, that means, whether the State or private persons are entitled to their physical use. Likewise, neoclassical economists of past and present, for example Irving Fisher (1867–1947) and Gérald Debreu (*1921), define property rights as mere possession rights, without using the term ‘possession’, which they do not know. ‘What is meant by owning wealth? We answer: to have the right to use it. To have a right is called property or, more explicitly, a property right’ (Fisher 1906:18, emphases added). Modern general equilibrium theory does not differ much from this view (see Debreu 1959: 78). However, in pre-classical economic theory, an eminent mercantilist, James Steuart (1712–1780), has something peculiar to say (see for more detail Stadermann and Steiger (2001: 21–86 and also 2007). He starts, like all other economists, with the barter paradigm. The most simple of all trade, is that which is carried on by bartering the necessary articles of subsistence. If we suppose the earth free to the first possessor this person who cultivates it will first draw from it his food, and the surplus will be the object of barter: he will give this in exchange who will supply his other wants. (Steuart 1767, I: 175) Yet, his medium of facilitating barter is not a good but a commodity beyond material use. ‘By MONEY, I understand any commodity, which purely in itself is of no material use to man’ (1767, I: 32). The employment of the term commodity as something without material use shows a lack of clarity. Yet, in later passages Steuart distances himself of money as a standard good and defines it as ‘a money of account’ to which the notes of a bank of issue correspond as money proper. ‘Money which I call of account, is no more than any arbitrary scale of equal parts invented for measuring the respective value of things vendible’ (1767, I: 526). He limits commodity money to State precious-metal coins that, unlike banknotes, do not enter circulation through credit operations. A bank note is an obligation. When I pay with a bank note I do no more than substitute the credit of the Bank in the place of my own, in favour of the man to whom I give it. (Steuart 1805 [1772]: 7)

Money, markets and property 67 The bank of issue is a credit bank whose notes are without ‘material use’ because they receive their value from property, not from bullion. Thus, it is not a bank of deposit whose notes supposedly originate from the receipts written by goldsmiths for gold valuables deposited with them, as is maintained even in most recent textbooks. A number of men of property join together in a contract of banking. . . . For this purpose, they form a stock which may consist indifferently of any species of property. . . . When paper is issued for no value received, the security of such paper stands alone upon the original capital of the bank, whereas when it is issued for value received, that value is the security on which it immediately stands, and the bank’s stock is properly speaking, only subsidiary. (Steuart 1767, II: 150–1, emphasis added) As will be shown immediately, ‘only subsidiary’ must not be read as secondary or less important. The issue of banknotes means a credit relation in which both bank and borrower must be proprietors. Then, ‘value received’ is the borrower’s collateral, a title to his property, and the ‘original capital’ is the creditor’s property. The banknotes forwarded to the borrower against collateral carry no interest but can only be borrowed against interest. With this observation, Steuart evades the confusion of money with credit, as we witness it in so many treatises in monetary economics. When a proprietor of lands gives his bond to a bank, it should be understood, that as long as he regularly pays the interest of the money borrowed, the bank is not to demand the capital. For this bond they give notes, which are considered as ready money, and therefore carry no interest. So the profit of the bank is to receive interest for what they lend, and to pay none for what they owe. What they owe is the paper they issue . . .; and the security which the public has, is the security which the bank received from the person who borrowed from them. . . . Their notes become money, and the whole property engaged to them. (Steuart 1767, II: 603, emphases added) Why is it so important that only the ‘whole’ property makes the notes ready money? The borrower has to offer property to the bank of issue so that the latter can secure the circulation of its notes, that means, to guarantee their holders, the non-bank public, their acceptability. However, when a borrower defaults, the notes he has received from the bank must be withdrawn from circulation by the bank’s capital, thereby protecting the acceptability of notes issued to sound debtors. Steuart is also already aware that the business of creating money is a risky one. Unlike not so few modern theorists of central banking (see Steiger 2006b:

68

G. Heinsohn and O. Steiger

151–8), he does not share the fallacy that intrinsically worthless paper money is created out of nothing by an institution that cannot go bankrupt. A bank, which issues notes without demanding the best of securities, endangers its capital and risks to run into bankruptcy. Many, who are unacquainted with the nature of banks [of issue], have a difficulty to comprehend how they should ever be at a loss for money, as they have a mint of their own, which requires nothing but paper and ink to create millions. But if they consider the principles of banking, they will find that every note issued for value consumed in place of value received and preserved, is neither more nor less, than a partial spending either of their capital, or profits on the bank. (Steuart 1767, II: 151–2, emphases added) Though Steuart does not advance to a satisfactory theory of interest, he clearly explains why people are ready to pay interest. Why does one proprietor become a creditor, who issues money to gain interest, while another proprietor encumbers property and pays interest? Would it not be smarter for the potential borrower to issue money against his property, thereby obtaining notes without paying interest? However, as long as a debtor obtains money through a loan from someone else, he is free from the obligation to redeem the notes with his property, whereby he would also forgo his possession. A debtor pays interest because only a credit bank of issue guaranteeing the circulation of its notes is able (i) to let the former keep the possession side of his collateral and, simultaneously, (ii) does not take away its property side but only enforces its temporary encumbrance. Although Steuart does not formulate these conclusions as clearly as stated in the section above, his phrase of the ‘advantage of circulation’ at least implicitly captures the difference between property and possession. For what does he [the borrower] pay that interest? Not that he has gratuitously received any value from the bank; because in his obligation he has given a full equivalent for the notes, but the obligation carries interest and the notes carry none. Why? Because the one circulates like money the other does not. For this advantage, therefore, of circulation, not for any additional value, does the landed man pay interest. (Steuart 1767, II: 131–2; emphases added) After Steuart, only a few economists follow his seminal insights into the relationship between property, employed as collateral and capital, to banknotes (see more detailed Stadermann and Steiger 2001: 89–281). To the best of our knowledge, it is first of all the founders of the theory of the lender of last resort responsibility of the central bank, Henry Thornton (1760–1815), Walter Bagehot (1826–1877) and Ralph Hawtrey (1879–1975), who emphasise, time and again, the necessity for the bank of issue to secure its credit contracts by collateral and capital. Also JeanBaptiste Say (1767–1832) and David Ricardo (1772–1823) in classical, and Knut

Money, markets and property 69 Wicksell (1851–1926), Joseph Schumpeter (1883–1950) and Alfred Marshall (1842–1924) in neoclassical economics at least discuss collateral – Say also capital – in their theories of money. None of these eight authors, however, come close to Steuart’s monetary theory, nor do they ever ponder the connection between the employment of collateral and the ensuing loss to be covered by interest. Of the theorists of central banking, Thornton is still aware of Steuart’s work and emphasises the necessity of collateral for the issuing of banknotes, because otherwise the bank of issue would risk incurring a loss (1939 [1802]: 244). Bagehot (1999 [1873]: 187–8) establishes two rules a bank of issue must obey: to loan (i) at the market rate of interest, and (ii) only against good banking securities, which he clearly recognises as property titles.10 If the bank would not follow the second rule by accepting bad securities, it would endanger its ‘reserves’. To Hawtrey (1970 [1932]: 126), too, refinancing at the central bank cannot mean that it should lend regardless of the borrowing bank’s circumstances, because this would imply ‘risks to its own capital’. Of the classical school, it is Ricardo who, like Thornton, is still aware of Steuart and knows that not only interest but also good securities must be offered to obtain notes in a loan from a bank of issue. However, he does not follow Steuart’s insight that ‘a well regulated paper money’ should be created against good securities because, according to his view that money is neutral, ‘the quantity of capital [goods] . . . can neither be increased or diminished by the operations of banking” (Ricardo 1951 [1817]: 365). Instead, to ‘ascertain the uniformity of the value of money’, paper money issued should be regulated according to the value of the metal, for example gold or silver, which is declared to be the standard good. Steuart’s idea of a money without any relation to such a commodity is rejected because, unlike good securities, bullion is not subject to variations in its value (1951 [1817]: 59 and 62). Although sharing Adam Smith’s view of money as a commodity, Say (1803, II: 31) observes that notes issued by a credit bank, unlike mere ‘paper money’ issued by the State, are not created out of nothing. Therefore, he requires that such a bank is endowed with capital in highly liquid form to keep its notes in circulation (1841: 306). By, however, identifying this ‘liquid form’ with coined bullion he cannot proceed to a view of gold as just one variety of property. In neoclassical economics, Steuart’s seminal insights are completely forgotten. Wicksell (1935 [1906]: 88–90) relegates collateral to ‘the questions of banking technique’. His analysis is hampered by the conviction that only bullion coins are money. Banknotes are wrongly defined as being ‘in essence the same’ as ‘cheques, since in both cases the bank is responsible for payment or redemption of the note’. Marshall (1923: 301) clearly recognises that banknotes are money, and not a substitute like a cheque. However, his bank of issue is not Steuart’s credit bank which creates notes against collateral, but the bank of deposit which creates notes against bullion coins deposited by the non-bank public: with its deposits, the public lends the bank ‘the power to issue notes’ (1923: 72). Collateral is of interest to Marshall only insofar as it protects the deposits of the public.

70

G. Heinsohn and O. Steiger

In his theory of money, Schumpeter (1934 [1911]: 102 and 112) first of all wants to disconnect money from goods by emphasising that the former always precedes the latter. Therefore, he postulates that money means ‘the creation of new purchasing power created out of nothing’ (1934 [1911]: 73, emphasis added). He does not deny the existence of collateral but regards it as not essential in the money-creating process. ‘Some kind of security . . . makes it much easier for him [the entrepreneur] in practice to obtain credit. But it does not belong to the nature of the thing in its purest form’ (1934 [1911]: 100–1).

The insufficient treatment of property titles in new institutional economics and in New Keynesianism In the mid-1960s, a new school emerges in neoclassical economics, the theory of property rights or new institutional economics founded by Harold Demsetz (*1930) (see Demsetz 1967) and Armen A. Alchian (*1912) (see Alchian 1977 [1965]) with traces in the writings of Nobel laureate (1991) Ronald H. Coase (*1910) (see Coase 1937 and 1960). It has been further developed by Nobel laureate (1993) Douglass C. North (*1920) (see North 1973 [with Robert P. Thomas]), 1981 and 1990). The new approach attempts to enhance the classical and neoclassical barter paradigm with ‘a more analytical view toward property rights’ (Demsetz 1998: 144), that is, with a ‘property rights paradigm’ (Alchian and Demsetz 1973: 16). However, new institutional economists do not bother to tell us how property rights are discussed in the classical and neoclassical schools. They merely complain that property has not been made an analytical foundation of their theory of the market economy: mainstream economics ‘does not investigate the role of property right arrangements’ (Demsetz 1998: 144). Though this is correct, the critics’ own endeavours are hardly different from their predecessors’ discussion of property (see the section above). By neglecting all their flaws, new institutional economists can muster the courage to repeat them as new and, of course, true. They start their analysis by regarding property rights as an eternal and universal instrument. ‘This implies that it is impossible not to have a property rights system’ (Demsetz 1998: 145, emphasis added). Of course, the fresh approach, too, confuses property with possession. ‘A property right to a good is a right to select among its, and only its, feasible physical uses or conditions, . . . [it is] wealth assigned to a specified person, who can alienate the right to others in exchange for at least similar rights to other goods’ (Alchian 1992: 223, emphases added; similarly Alchian and Demsetz 1973: 17; Demsetz 1998: 154; North and Thomas 1973: 12 and 19). However, unlike the neoclassical model, new institutional economics analyses how property rights are allocated and enforced as determined by transaction costs. There are inherent difficulties, frictions in economic exchanges and, therefore, substantial costs in any attempt to allocate property rights. In the absence of appropriate rights specification, external effects result, which have to be internalised by incentives. To economise transaction costs, wealth-maximising indi-

Money, markets and property 71 viduals substitute, therefore, common property rights for private property rights as soon as they recognise that the private rights leave room for unexploited gains of exchanges or benefits, which means that the rights are not used efficiently because individuals cannot be excluded from an inefficient use. While Alchian and Demsetz consider this change in property arrangements as triggered by selfinterest in the form of spontaneous order, North emphasises that they are imposed on society by civil authority, the State, in the interest of individuals.11 New institutional economics regards the right to appropriation of the returns of goods and resources, and the right to alienation of goods and resources, as the fundamental property rights. However, the school does not see that, as shown in the second section above, the right to appropriation is a possession right, not a property right. Furthermore, blinded by their universal approach to property, new institutionalists miss that the right to alienation becomes a property right only in the property-based society where it, unlike in tribal and feudal systems, refers not only to gifts, assignments and inheritance but also to sale and lease. However, sale and lease are absent in these systems because they only know of possessory rules, not of property rights. Demsetz eventually senses that the new approach does not lead very far. Pressed on what one can do with property rights economically, he becomes distinctively vague. ‘They designate the owner as that person or group, as compared to others, that exercises the most important subset of exclusive, alienable, and presumptive rights. There is no easy way to generalize “important subset” ’ (1998: 146, emphasis added). However, confusion of discussion can be avoided, Demsetz hopes, ‘if there is some understanding of “ownership” ’, for example, by looking at assets in the form of land. To have property rights in the land is not necessarily the equivalent of having the land. This is because many rights are normally associated with any given asset, and subsets of these rights can be possessed by different persons. When control of rights is separated in this fashion, it is not clear who, if anyone, controls the asset itself. To have the right to till a parcel of land is not equivalent to having all rights in the land. (Demsetz 1998: 145, emphasis added) Demsetz never tells who the ‘different persons’ are and what distinguishes their rights to the land. Therefore, instead of enhancing clarity of discussion, he enhances confusion of the subject by desperately looking for ‘subsets of these rights’ (see above). There exists, however, no common set of property rights to the land that can be divided into subsets, only a common set of possession rights. Each and every asset has the common characteristic only of being ‘owned’ by a proprietor and a possessor. And it is their rights that are different, not necessarily the persons to whom the rights are assigned. In the case of land, the right of property – the right to its encumbrance and sale – and the right of possession – the right to till, to use the land – can be assigned to one and the same person. But both rights can also be assigned to different persons, for

72

G. Heinsohn and O. Steiger

example, when the proprietor of the land rents it to a tenant. Then, the latter is the possessor of the land while the former remains its proprietor. What Demsetz fails to look for is what was already missed by classical and neoclassical economics: the right of the proprietor to burden and encumber property. In the most elaborate contract theory of new institutional economics, developed by Oliver E. Williamson (1985: especially 15–84), collateral is not mentioned either.12 In the most comprehensive assessment of the contributions of the school by Erik G. Furubotn and Rudolf Richter, collateral is never made a central topic of discussion. It is merely seen as one of several ‘extralegal safeguarding instruments’ (1997: 19) or ‘safeguarding techniques’(1997: 425). In the only comprehensive treatise of new institutional economics on money (Richter 1989), neither collateral nor capital is mentioned, and money, once again, is explained as a standard good to reduce transaction costs. By imprisoning possession in the term property and leaving property entirely unattended, new institutional economics, eventually, had to give way to Nobel laureate (2001) Joseph Stiglitz, for collateral to make a comeback. Stiglitz (1981 [with Andrew Weiss])13 is the founder of the New Keynesian school of credit rationing, which explains equilibrium on the credit market, for the first time since Steuart, by taking care of interest and collateral. As late as 1987, the authoritative encyclopaedia of economics, The New Palgrave: A Dictionary of Economics, does not carry an entry on ‘collateral’. Only in 1992 The New Palgrave Dictionary on Money and Finance eventually tries to fill this void (Kanatas 1992: 381–3). Following Stiglitz’s lead, it is recognised that neoclassical assumptions about market exchange are in obvious contradiction to phenomena in the credit market. For nearly two centuries the credit market had been analysed like a market for commodities. What was seen as the credit market’s price, the rate of interest, was to be determined solely by the demand and supply of credit, in the same manner as in the commodity market, where an excess demand is met in the short run by an increase of commodity prices and in the long run by a rise in supply, induced by the short-run rise in these prices, leading to their reduction. The price settled upon in a sales contract is sufficient to equilibrate supply and demand because both partners share symmetric information. In the credit contract, however, there exists a principal–agent problem, with the information between lender and borrower being asymmetric.14 Supposedly this asymmetry is circumvented by a rationing of credit, which requires a ranking of debtors according to their creditworthiness (Stiglitz and Weiss 1981: 393–4 and 408–9). The criterion for this worthiness is provided by information on the assets a potential borrower can offer as collateral to his lender, with the collateral serving ‘as a screening device’ (1981: 404). However, this offer cannot fully compensate for the information asymmetry because the requirement for collateral has not only a beneficial incentive effect, allocating the loan to safe borrowers, but also an adverse selection effect, allocating it to riskier borrowers – borrowers the lender cannot monitor. Therefore, equilibrium in the credit market is not seen as determined by the rate of interest and collateral alone but, in addition, by credit rationing.

Money, markets and property 73 The procedures required for credit rationing leave New Keynesians uneasy. After all, there is no systematic place for rationing in a theory of free market exchange. Collateral, to begin with, is not exchanged; it only secures the loan, like the underlying asset in a repurchase agreement.15 Collateral can be exchanged only when the borrower does not fulfil his obligations, that means, in the wake of foreclosure. Because of this embarrassing non-exchange, the creditrationing school has to concede that there is ‘little definitive evidence on the relative economic importance of the . . . explanations regarding collateral’ (Kanatas 1992: 382). What New Keynesians do not understand is that the difference between determining equilibrium in sales and credit markets is not due to information being imperfect in the latter market and perfect in the former. Imperfect information may also exist in the sales market, for example, when uncertainty about the buyers’ ability to pay is met by the seller’s claim of payment in advance, without, however, challenging the determination of market equilibrium by the commodity price. What distinguishes the credit market from the sales market is rather that in the latter, unlike in the former, an asymmetric distribution of risk between the contract partners exists. The credit risk is always with the lender and cannot be eliminated by symmetric information. Even with perfect information about the borrower, the lender can never do without the debtor’s property title, collateral. Unaware of collateral as a property title, Stiglitz does not see that the borrower has to compensate, with this title, the risk of the lender to lose his property title, his capital. Therefore, in spite of its renewed interest in collateral, New Keynesianism is not able to understand the necessary property foundations of the economy that Demsetz (1998, see epigraph at beginning) has been so eager to look for. Whether property economics has solved this problem, especially with respect to the explanation of money and markets, the authors of this approach have to leave to others to decide in – hopefully – further discussions.

Acknowledgements The contribution draws, in part, on Heinsohn 2007, Heinsohn and Steiger 2007a and Steiger 2006a. Valuable comments by the editors and an anonymous referee are acknowledged. We also thank Ernst Thomas, Bremen, for a careful reading of the text.

Notes 1 As will be shown in the next section, the shortcomings may explain why economic anthropology never accomplished its intended revolution of how to tackle the nature of economic life. Still worse, they may have contributed to the fact that its findings have never been taken seriously by mainstream economics. Rather, as complained by one of the leading scholars of the school, Marshal Sahlins (*1930), the development, in recent decades, of economic anthropology as an academic discipline has ‘seemingly been negative, if not fatal, as witness the fact that general university courses in

74

2

3

4

5

6

7

8

9

G. Heinsohn and O. Steiger “Economic Anthropology” are becoming increasingly quaint and correspondingly rare’ (Sahlins 2004: IX). Though educated as a neoclassical economist, Malinowski has got his inspiration, not from his teachers, but from a historian, Sir James George Frazer (1854–1941), who, in 1890, published The Golden Bough (Frazer 1994 [1890]). This study of ancient cults, rites and myths conveyed to Malinowski that social-institutional structures, utterly different from Western society, had dominated man through most of history. For the palace system of Mycenaean feudalism, which preceded the first propertybased systems in ancient society, Anthony Andrewes (1912–1990), the foremost British authority on the economic history of antiquity (Andrewes 1971: 29), has found nothing that could be called money. Likewise, Marc Bloch (1866–1944), the founder of the French ‘Annales’ school of economic history (Bloch 1961 [1939]: 168) has observed the absence of markets and money in European feudalism. Meanwhile, three authors have approached a view similar to our theory: (i) Tom Bethell (1998), (ii) Richard Pipes (1999) and (iii) Hernando de Soto (2000). De Soto (2000: 56 and 218) has recognised the striking similarity between his approach and ours; for a detailed discussion of the similarities, and differences in emphasis, of the different approaches see Steiger (2006a: 190–1). While Polanyi characterises all systems as ‘society’, property economics reserves the term to the market system, emphasising that only this system is constituted by contracts between free, private individuals. Therefore, the two former systems are characterised instead as ‘community’ and ‘seigniority’ respectively. In history, property-based societies knew also of non-free persons, the slaves. These unfortunate individuals, however, could only be bought and sold as long as free proprietors constituted slave markets. It is one of the merits of the property system of modern times to have abolished slavery – last, but not least, by establishing the free wage labourer. The term is borrowed from Ralph Hawtrey’s analysis of the balance sheet of a central bank (1970 [1932]: 146), indicating that a bank of issue, too, needs a surplus of assets over liabilities, that means, a ‘net worth’ as a buffer for bad loans. Hawtrey probably used the term ‘own capital’ not only for distinguishing it from ‘borrowed capital’ but also from the more usual term ‘capital’ in the economics of his time for ‘capital goods’. Nowadays, however, in the analysis of balance sheets of both banks and nonbanks, the term ‘capital’ clearly stands for ‘net worth’, and we will follow this practice. Money, of course, can also be created by buying property titles outright on the open market. But in such a case, the problem arises that, in order to control the circulation of money, titles regularly have to be sold outright too. However, this is nothing but a poor imitation of the credit issue of money which automatically guarantees the reflux of money as, for example, in the form of bills of exchange, the preferred methods of central banks in former times. The credit issue of money, especially as nowadays in the form of repurchase agreements, also has the advantage for the issuing bank that the risk of the titles depreciating is with its counterparty, the debtor commercial bank receiving the notes, while in outright transactions it stays with the bank as the creditor of the loan. The interesting question – where does the idea of a money of account come from? – has been answered by John Maynard Keynes in A Treatise on Money (1971 [1930]: 4 and 10–12) with the help of his State theory of money: in order to raise taxes, already the tribal community and the feudal state needed a standard of measurement, the money of account. However, as shown by Heinsohn and Steiger (2003 [2000]: 486), in such systems, preceding the property-based society, there existed no money standard by which values could be compared: items were just being counted, weighed or measured as they stood. In contrast, in the property-based societies of antiquity and modern times, it was private proprietors who, by forming credit banks, first issued

Money, markets and property 75

10 11

12 13

14

15

money as coins (antiquity) and coins and banknotes (modern times). And in this process of issuing money, they used the already existing standards of measurement – especially weights – of the preceding feudal systems as the name for their money of account: for example, the pound in early modern times. In his discussion of the public’s demand for liquidity, Bagehot states that when people offer good securities to obtain a loan from the bank of issue, they ‘wish to pledge [offer as collateral] . . . the value of any property”’(1999 [1873]: 89, emphasis added). Because Alchian and Demsetz neglect the role of governmental institutions for the emergence of private property rights, their approach is characterized as a ‘naïve’ theory. What they rely on are popular stories, like Garret Hardin’s famous one on ‘The Tragedy of the Commons’ (1968), which aims to show the overexploitation of resources under a regime of common property rights. However, Alchian and Demsetz do not know that Hardin’s story is not about the rules of a property-based system but analyses what may happen in a feudal command system, which is about common possession rules, not rights, vis-à-vis extra-‘legal’ individual possession rules. This verdict also holds for the contract theory of Oliver Hart (1986, with Sandra Grossman, and 1999, with John Moore). In the same year, Nobel laureate (1971) John Hicks (1904–1989), in a critical summing up of his IS-LM explanation of Keynes’s General Theory, feels a troubling and alarming sense that something very essential in monetary theory always has eluded both Keynes’s and his own focus. ‘We now know that it is not enough to think of the rate of interest as a single link between the financial and industrial sectors of the economy; for that really implies that a borrower can borrow as much as he likes at the rate of interest charged, no attention being paid to the security offered’ (1980–1981: 153, emphasis added). However, Hicks has not developed his late idea into anything substantial. A better explanation of the difference between the price on the commodity market and that on the credit market would be that interest is only a promised price. An excess demand in the credit market, therefore, can only be met by a higher promised price. Unlike the seller of goods, the lender has to take into account that the ability of the borrower to meet this higher promise is directly correlated to a higher risk to fulfil his obligation to redeem. In the worst case, the high level of interest settled upon may push the borrower into bankruptcy and pull the lender with him. It goes without saying that the credit-rationing school, too, never hints at the idea of capital as a buffer for the lender when, in the case of a bad loan, collateral depreciates in value.

References Alchian, A. A. (1977 [1965]) ‘Some Economics of Property Rights’, in A. A. Alchian Economic Forces at Work: 127–49, Indianapolis: Liberty Press. —— (1992) ‘Property Rights’, in The New Palgrave Dictionary of Money and Finance, 3: 223–6, London: Macmillan, 4 vols. Alchian, A. A. and Demsetz, H. (1973) ‘The Property Rights Paradigm’, Journal of Economic History, 33: 16–27. Andrewes, A. (1971) Greek Society, Harmondsworth: Penguin Books. Bagehot, W. (1999 [1873]) Lombard Street: A Description of the Money Market, New York: Scribner & Armstrong; reprint, New York: John Wiley & Sons. Bethell, T. (1998) The Noblest Triumph: Property and Prosperity Through the Ages, New York: St. Martin’s Press. Bloch, M. (1961 [1939]), Feudal Society. Volume 1: The Growth of Ties of Dependence, Chicago: University of Chicago Press.

76

G. Heinsohn and O. Steiger

Coase, R. H. (1937) ‘The Nature of the Firm’, Economica, N. S., 4: 386–405. —— (1960) ‘The Problem of Social Cost’, Journal of Law & Economics, 3: 1–44. Dalton, G. (1982) ‘Barter’, Journal of Economic Issues, 16: 181–90. Davis, J. (1992) Exchange, Minneapolis: University of Minnesota Press. Debreu, G. (1959) Theory of Value: An Axiomatic Analysis of Economic Equilibrium, New Haven: Yale University Press. Demsetz, H. (1967) ‘Toward a Theory of Property Rights’, American Economic Review, Papers and Proceedings, 57: 347–59. —— (1998), ‘Property Rights’, in The New Palgrave Dictionary of Economics and the Law, 3: 144–55, London: Macmillan, 3 vols. Fisher, I. (1906) The Nature of Capital and Income, New York: Macmillan. Frazer, J. G. (1994 [1890]) The Golden Bough: A Study in Magic and Religion (3rd edn 1906–1915), Oxford: Oxford University Press. Furubotn, E. G. and Richter, R. (1997) Institutions and Economic Theory: The Contribution of the New Institutional Economics, Ann Arbor: University of Michigan Press. Goodfellow, D. M. (1939) Principles of Economic Sociology, London: Routledge & Kegan Paul. Granovetter, M. (1992) ‘The Nature of Economic Relations’, in S. Ortiz and S. Lees (eds) Understanding Economic Process: 21–37, Lanham: University Press of America (for the Society for Economic Anthropology). Grossman, S. and Hart, O. (1986) ‘The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration’, Journal of Political Economy, 94: 691–719. Hardin, G. (1968) ‘The Tragedy of the Commons’, in G. Hardin and J. Baden (eds) Managing the Commons: 16–30, San Francisco: W. H. Freeman. Hart, O. and Moore, J. (1999) ‘Foundations of Incomplete Contracts’, Review of Economic Studies, 66: 115–38. Hawtrey, R. G. (1970 [1932]) The Art of Central Banking, London: Frank Cass & Co. Heinsohn, G. (1984 [1982]) Privateigentum, Patriarchat, Geldwirtschaft: Eine sozialtheoretische Rekonstruktion zur Antike, Frankfurt am Main: Suhrkamp. —— (2007) ‘Where Does the Market Come From? Why the Controversy Between the “Substantivist” Polanyi School and the “Formalist” Neoclassical Protagonists of an Eternal and Universal Market Was Never Solved’, in O. Steiger (ed.) Property Economics: Property Rights, Creditor’s Money, and the Foundations of the Economy, Marburg: Metropolis. Heinsohn, G. and Steiger, O. (2006 [1996]) Eigentum, Zins und Geld: Ungelöste Rätsel der Wirtschaftswissenschaft (4th edn), Marburg: Metropolis. —— (2003 [2000]) ‘The Property Theory of Interest and Money’, in G. M. Hodgson (ed.) Recent Developments in Institutional Economics: 484–517, Cheltenham, UK: Edward Elgar. —— (2005) ‘Alternative Theories of the Rate of Interest: A Reconsideration’, in G. Fontana and R. Realfonzo (eds) The Monetary Theory of Production: Tradition and New Perspectives (Essays Dedicated to and in Honour of Augusto Graziani): 67–81, London: Palgrave Macmillan. —— (2006) Eigentumsökonomik, Marburg: Metropolis. —— (2007a) ‘Collateral and Own Capital: The Missing Links in the Theory of the Rate of Interest and Money’, in O. Steiger (ed.) Property Economics: Property Rights, Creditor’s Money, and the Foundations of the Economy, Marburg: Metropolis. —— (2007b) Property, Interest and Money: Foundations of Economic Theory, London: Routledge.

Money, markets and property 77 Herskovitz, M. J. (1940) The Economic Life of Primitive Peoples, New York: Alfred Knopf. Hicks, J. R. (1980–1981) ‘IS-LM: An Explanation’, Journal of Post Keynesian Economics, 3: 139–54. Humphreys, S. C. (1978) Anthropology and the Greeks, London: Routledge & Kegan Paul. Kanatas, G. (1992) ‘Collateral’, in The New Palgrave Dictionary of Money and Finance, 1: 381–2, London: Macmillan, 3 vols. Keynes, J. M. (1971 [1930]) A Treatise on Money. Volume I: The Pure Theory of Money, in The Collected Writings of John Maynard Keynes, vol. V, London: Macmillan. Loasby, B. J. (2000), ‘Market Institutions and Economic Evolution’, Journal of Evolutionary Economics, 10: 297–309. Malinowski, B. (1961 [1922]) Argonauts of the Western Pacific: An Account of Native Enterprise and Adventure in the Archipelagos of Melanesian New Guinea, New York: E. P. Dutton. Marshall, A. (1923) Money, Credit and Commerce, London: Macmillan. Marx, K. (1946 [1867]) Capital: A Critical Analysis of Capitalist Production (3rd edn 1883), ed. by D. Torr, London: Allen & Unwin. North, D. C. (1981) Structure and Change in Economic History, New York: W. W. Norton. —— (1990) Institutions, Institutional Change, and Economic Performance, Cambridge: Cambridge University Press. North, D. C. and Thomas, R. P. (1973) The Rise of the Western World: A New Economic History, Cambridge: Cambridge University Press. Pipes, R. (1999) Property and Freedom, New York: Alfred Knopf and London: The Harvill Press. Polanyi, K. (1957a [1944]) The Great Transformation: The Political and Economic Origins of Our Time, Boston: Beacon Press. —— (1957b) ‘The Economy as Instituted Process’, in K. Polanyi, C. Arensberg and H. Pearson (eds) Trade and Markets in the Early Empires: Economies in History and Theory: 243–69, Glencoe, IL.: Free Press. —— (1977) The Livelihood of Man, New York: Academic Press. Ricardo, D. (1951 [1817]) On the Principles of Political Economy and Taxation (3rd edn. 1823), in The Works and Correspondence of David Ricardo, vol. I, Cambridge: Cambridge University Press. Richter, R. (1989) Money: Lectures on the Basis of General Equilibrium and the Economics of Institutions, Berlin: Springer. Sahlins, M. (2004) ‘Preface to New Edition’, in M. Sahlins, Stone Age Economics: New Edition: ix-xiii (1st edn 1972), London: Routledge. Say, J.-B. (1803) Traité d’économie politique, vol. II, Paris: Deterville. —— (1841), Traité d’économie politique, 6th edn by H. Say, Paris: Guillaumin. Schumpeter, J. A. (1934 [1911]) The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle (2nd edn 1926), Cambridge, MA: Harvard University Press. Smith, A. (1937 [1776]) An Inquiry into the Nature and Causes of the Wealth of Nations (4th edn 1790), ed. by E. Cannan (1904), New York: Modern Library. Soto, H. de (2000) The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else, London: Bantam Press. Stadermann, H.-J. and Steiger, O. (2001) Allgemeine Theorie der Wirtschaft – Erster Band: Schulökonomik (2nd ed 2006), Tübingen: Mohr Siebeck

78

G. Heinsohn and O. Steiger

—— (2007) ‘James Steuart and the Theory of the Monetary Economy’, in J. Backhaus (ed.) The Founders of Modern Economics: The Maastricht Lectures in Political Economy, Cheltenham, UK: Edward Elgar. Starr, C. G. (1977) The Economic and Social Growth of Early Greece: 800–500 B. C., New York: Oxford University Press. Steiger, O. (2006a) ‘Property Economics versus New Institutional Economics: Alternative Foundation of How to Trigger Economic Development’, Journal of Economic Issues, 40: 183–208. —— (2006b) ‘The Endogeneity of Money and the Eurosystem: A Contribution to the Theory of Central Banking’, in M. Setterfield (ed.) Complexity, Endogenous Money and Macroeconomic Theory: Essays in Honor of Basil Moore: 150–69, Cheltenham, UK: Edward Elgar. Steuart, J. (1767) An Inquiry into the Principles of Political Oeconomy: Being an Essay on the Science of Domestic Policy in Free Nations, vols I and II, London: A. Millar & T. Cadell. —— (1805 [1772]) The Principles of Money Applied to the Present State of the Coin of Bengal, in The Works, Political, Metaphysical, and Chronological, of the Late Sir James Steuart, vol. V, London: D. T. Cadell & W. Davies. Stiglitz, J. and Weiss, A. (1981) ‘Credit Rationing in Markets with Imperfect Information’, American Economic Review, 71: 393–410. Thornton, H. (1939 [1802]) An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, ed. by F. A. Hayek, London: Allen & Unwin. Wicksell, K. (1935 [1906]) Lectures in Political Economy. Volume 2: Money (3rd edn 1928), ed. by L. Robbins, London: Routledge & Kegan Paul. Williamson, O. E. (1985) The Economic Institutions of Capitalism: Firms, Markets, Relational Contracting, New York: The Free Press.

6

Money and markets as twin concepts? Some lessons from the recent history of market theory Jean Cartelier

Introduction In the canonical writings on value, price and market theory explicit links between money and market are not frequent. Since the mid-eighteenth century, emphasis has been laid rather on real wealth as opposed to monetary wealth. The so-called mercantilist view has been progressively rejected, which made money, viewed as an emanation of the Prince, the origin and end of trade and industry. One is tempted to go as far as sustaining that the emergence of value theory was responsible for severing any relation between money and market. However, a more careful reading of past economists shows that if money is no longer considered as wealth, it is sometimes considered as an important link between value, price and market. In fact, it is possible to distinguish two strands of thought according to the role money is supposed to play (or not to play) in the determination of values and prices. These two opposed ‘visions’, to borrow Schumpeter’s word, are present during the different periods of the history of price theory, even if their relative importance has greatly varied over time. Modern advances in money and market theory make it possible to reappraise this old question and to reinterpret the recent history of market process theory (namely tâtonnement and nontâtonnement models in the 1960s and 1970s). The main conclusion is that money and market are in fact two alternative but equivalent ways of giving an account of prices (or values) and individual wealth determination. That money and market are two faces of the same coin is not easily recognised even by the authors who have paved the way leading to that conclusion. They have nevertheless convincingly shown that a theory of market without money is an illusion, because effective transactions could not be explained without money. As such, money should be at the starting point of price theory along with preferences and endowments. The purpose of this chapter is to make this idea more explicit. Value theory supplies a general principle supposed to give a determinate signification to exchange ratios. But, whatever this principle may be – whether net value distribution according to the quantity of labour spent as in labour value theory or the marginal rate of substitution as in neoclassical theory – it is always

80

J. Cartelier

in the market that prices are observable. Smith, Marx and Walras all agree on this point.1 As a consequence, an explicit analysis of the working of the market is a necessary component of any sensible price theory. Deprived of such mechanism value theory would be empty and irrelevant (how might centralised and decentralised economies be distinguished?). Concerning the links between value theory and market analysis, it seems useful to compare, even to oppose, two traditions in price theory. The first introduces, besides so-called natural prices, market prices. Such prices are more or less contingent. For Petty, Cantillon or Steuart no clear principle could account for them except that of gravitation around natural prices. Natural prices, being determined by production and reproduction objective conditions, are the only possible object of science. Smith shared this view but tried to fill the gap between natural and market prices and supplied a mechanism of market price determination (in fact borrowed from Cantillon) linking the two types of prices. The Cantillon–Smith market price theory seems promising for modern theoreticians in search of a theory of a market economy. The second tradition ignores natural prices and considers as market prices only those prices that are given by a condition of simultaneous equilibrium in all markets. Such prices only are the ‘true prices’. Other prices may however exist, but they are given by disequilibrium processes (tâtonnement, non-tâtonnement, etc.) about which nothing is very well known (at least before the Second World War). That tradition is that of competitive general equilibrium theory, which has dominated – and still dominates – modern theory. A comparative study of these two conceptions about the relations between value and market, centred on the 1960s and 1970s, leads to the following counter-intuitive conclusion: it is less by their positions about value properly speaking that the two traditions may be contrasted than by the relation they suppose to exist between money and market. This does not mean that specific value theories do not correspond to determinate money theories, but rather that value does not play a prominent role in modern market process theories, either classical or neoclassical. Indeed, the views about the market differ not according to the different value principles, but according to the role money is admitted to play in the market process. In other words, money matters more than value for understanding the opposition between the two main paradigms of market price theory. That money theory could be the proper place to confront classical and neoclassical price theory sounds paradoxical since money neutrality is advocated by both theories. But a comparison between natural prices and competitive general equilibrium is less interesting than an investigation into the reasons why price theory in both cases fails to determine disequilibrium prices (i.e. market prices in the classical tradition and out-of-equilibrium prices in the neoclassical one). However classical economists seem less off the mark than modern theoreticians. For the latter arbitrary parametric prices2 are supposed to be those at which disequilibrium transactions are realised in non-tâtonnement models, which amounts to the renouncement of the assessment of the effect of disequilibrium on market prices. By contrast, market prices are determined in the classical tradition by a very clear and simple rule, the Cantillon–Smith

Money and markets as twin concepts? 81 mechanism, which links them to the importance of disequilibrium. But this mechanism makes sense only with money playing an active role in the realisation of transactions, be they in or out of equilibrium. Due to its role as an intermediary of exchange, money becomes an important element in the theory of the market. For classical tradition gravitation was the key problem to be dealt with by market theory, whereas investigations into the working of a market economy were prompted by the question of global stability of general equilibrium. Modern gravitation models tend to be formally similar to those used by general equilibrium theoreticians and face the same problem: does a competitive market economy tend over time towards a general equilibrium? In order to deal with this issue theoreticians have built dynamic models intended to make explicit the law of supply and demand. An interesting question, evoked by Walras himself, was whether transactions are effective during the process or are realised only when equilibrium is (hopefully) reached. Gravitation and non-tâtonnement models favour the former, tâtonnement models the latter. The advances in economic analysis during the 1970s have answered the question. Walrasian tâtonnement, allowing transactions realisation only in equilibrium, appears to be the metaphor of a negotiation process controlled by an auctioneer rather than a representation of a decentralised market. A market deprived of effective transactions ceases to be a market. Moreover, stability properties of the tâtonnement are very poor, as we have known since 1972. The so-called ‘law of supply and demand’, which consists of changing parametric prices according to the sign of the aggregate excess demand, proves to be a nonefficient algorithm for solving general equilibrium equations. Saari and Simon (1978) have shown that any efficient algorithm must take into consideration simultaneously the excess demands in all markets, which is equivalent to centralized regulation and thus is not compatible with the idea everyone has about a market economy. Before these results had been known some theoreticians had already elaborated dynamic models in which transactions take place at any time. Studying equilibrium stability naturally leads to dealing with transactions taking place out of equilibrium. An immediate consequence is that individual endowments change over time, the trajectory of the economy is path-dependent and the model far more complex than that of tâtonnement. But the most difficult point is not technical but conceptual. Making explicit the rules according to which transactions are effective proves to be problematic. The solutions adopted were to assume that the process of transactions satisfies some fundamental properties sufficient to get global stability and likely to hold in a market economy. Two have appeared so evident (but not innocuous) that they are retained by almost all models:3 total quantities of commodities are not affected by exchanges and exchanges are subject to equivalence. These models did supply important results, namely the global stability of market processes, which was their main purpose. But the price paid for this achievement soon appears to be prohibitive. As we shall remind the reader, global stability had been obtained at the cost of

82

J. Cartelier

inconsistency. More precisely, all the models of market processes of this period have shaky microfoundations, the fundamental properties of transactions process being hardly compatible with individual rationality or with information decentralisation. Most problems encountered in these models concern the microeconomic justification of transactions behaviour. The Arrow–Debreu model of competitive general equilibrium does not allow money to play any role. But this model does not allow transactions to take place in a decentralised way either. Both remarks are closely related. Without money (or without a generally accepted means of payment) it is difficult, indeed almost impossible, to deal with transactions realisation. As early as 1965, F. Hahn had made it clear that some formidable obstacles must be overcome in order to prove the existence of a monetary equilibrium. It turns out that the shortcomings of the theory of money were the stumbling-block to the development of the theory of market processes during the 1960s and 1970s. The well-acknowledged failure of modern price theory, which is unable to account for price formation, is negative proof of the crucial link between money and market. Unable to integrate money and price theory, mainstream theory leaves unexplained the monetary aspect of market relations and hence the market appears as an empty box. By symmetry, it would have been nice to find in the (alternative) monetary tradition recalled above some positive proof of the link between money and market. This is only partially the case. To my knowledge, there are no wellfounded dynamic monetary models exhibiting properties of global stability. However, it is possible to show that a key element of the monetary tradition, namely a market mechanism intrinsically related to money, is responsible for some fundamental and promising results. This market mechanism, an algorithm giving market prices and allocations starting from individual actions only, is to be found in many old texts of Cantillon, Smith and even Keynes (in the Treatise on Money)4 but also in modern theory. It is the centrepiece of some strategic market games (Shapley and Shubik) and at the origin of a major result: when the conditions of effectiveness of transactions are specified, it appears that the basic properties of the Walrasian competitive general equilibrium may cease to be true. The quantity and the distribution of money, which play no role in the Arrow–Debreu model, greatly matter. The chapter is organised as follows. The second section is devoted to the neoWalrasian tradition and the respective shortcomings of the two main families of market process models, with emphasis laid on the consequence of non-appropriate treatment of money. The third section briefly reminds the reader of Hahn’s attempt to remedy these failures and the reasons why this path could not be followed. The final section presents a market mechanism common to Cantillon and Smith on the one hand and to modern strategic market games on the other. It is shown that along this line of reasoning market and money are two sides of the same thing, that is a way of implementing a decentralised co-ordination among autonomous individuals.

Money and markets as twin concepts? 83

The failure of the neo-Walrasian theory of market: the unbearable dichotomy between price determination and transactions realization Though impressive and remarkable, competitive general equilibrium theory has its Achilles’ heel. It does not deal with the way desired transactions take place, even in equilibrium. More precisely, Debreu dismisses this question by allowing a centralised clearing or accounting bureau to check that agents comply with the principle of equivalence. Yet in a world where autonomous individuals freely decide their desired transactions, taking into account only parametric prices and budgetary constraints, it makes little sense to assume a centralised mode of realisation of transactions. In a market economy transactions must also take place in a decentralised way. But, the study of possible decentralised procedures of transactions brings very negative results, even if the problem is limited to equilibrium situations. In this respect, at the beginning of the 1970s Ostroy and Starr achieved results that merit special attention. Ostroy and Starr’s main results seem to have general validity. This is why they will be taken hereafter as a benchmark in the discussion of neo-Walrasian models of market processes. They consider an economy in equilibrium where the only problem to solve is the transition from initial endowments to equilibrium allocations. They show that there always exists a centralised procedure ensuring that transition in one round, a round being a succession of bilateral meetings such that any agent has met all other agents once. It is always possible to decompose the matrix of excess demand into a sum of submatrices, each forming a chain linking agents along which transactions are easily realised. Any pair of agents generally belongs to several chains. The key point is information. A centralised realisation of transactions is always possible since all agents are supposed to know exactly which chains they belong to. This is not the case in a decentralised world. Two agents meeting at random do not know the exact transactions they have to perform in order to make possible the realisation of all the desired transactions in the economy. Just by following a decentralised rule of exchange they may prevent other agents from obtaining their equilibrium allocation. Indeed, Ostroy and Starr demonstrate the fundamental result that there does not generally exist a decentralised procedure ensuring the realisation of all desired transactions in equilibrium. Therefore competitive general equilibrium theory appears dramatically incomplete. Existence and welfare theorems become irrelevant since agents in a (decentralised) market economy will not generally get their equilibrium allocations unless some additional assumptions are made. Ostroy and Starr suggest two alternative remedies. One is to assume that there exists a special agent whose endowment is such that for any commodity it is greater than the sum of all positive excess demands (such an agent ‘acts as a clearing house. He is the hub of commodity exchange’; (Starr 1989: 164). The other is to assume that there exists a special commodity whose value is such that the value of endowments of any agent in this commodity is greater than the value of his positive

84

J. Cartelier

excess demands. Such an assumption ensures that any agent is able to settle the balance occurring in a bilateral meeting at random. Of course both assumptions are purely ad hoc. All the research made in this field, that of Ostroy and Starr being the most well known,5 confirms that the question of the microfoundations for the transition from initial endowments to equilibrium allocations, has been unduly neglected. It still remains unsettled in a neo-Walrasian framework. Such a situation emphasises the fragility of the main models of non-tâtonnement built during the 1960s and 1970s. It seems useful to distinguish two classes of these models according to a technical criterion, namely the type of Lyapunov function associated with the model, which corresponds in fact to a very fundamental opposition. In one class, the demonstration of global stability rests on the evolution over time of a weighted average of individual actual utilities whereas, in the other, it is a weighted sum of individual target utilities. In the first case, the market is conceived of as an engine improving social welfare (a co-operative vision). In the second, the market appears as a device constraining people to limit their pretensions to what is socially acceptable (a non-cooperative vision). But, in both cases, the absence of a generally accepted means of payment prevents these models from accounting satisfactorily for the working of a market economy. In the Edgeworth–Uzawa process, transactions take place at parametric prices only if they increase (or non-decrease) individual utilities. Besides, prices evolve according to the standard law of supply and demand, i.e. according to the sign of aggregate excess demand. The difference with the tâtonnement process lies in the fact that transactions are allowed even if the economy is not in equilibrium. Formally, the tâtonnement is given by: p⬘(t) = G[Z(p(t), X] where p(t) is the price vector at time (t), p⬘(t) the time derivative of p, dp/dt, X is the matrix of initial endowments, Z[p(t), X] the (matrix) function of excess demands, and G[.] a continuous function preserving sign. The Edgeworth–Uzawa process combines the law of supply and demand and a change in the endowments due to a partial realisation of desired transactions: p⬘(t) = G[Z(p(t), X(t))]] X⬘(t) = E[p(t), X(t)]

(1)

where X⬘(t)=dX/dt and E[.] satisfies the specific property that transactions are Pareto-improving, besides that of conservation of quantities and of equivalence in exchange. This specific property matters for the demonstration of global stability. It ensures that while the mutually advantageous transactions are not yet realised a weighted sum of individual utility increases over time and is constant when all the mutually advantageous transactions have taken place. The opposite of such a sum is a Lyapunov function. Is the process modelled by X⬘(t) = E[p(t), X(t)] to be interpreted as describing a market economy? The answer must be negative. Pareto-improving transactions

Money and markets as twin concepts? 85 are a necessary condition for effective transactions in an economy subject to voluntary exchange. But the inverse is not true. From the mere fact that mutually advantageous transactions exist it does not follow that they actually take place. These opportunities have to be discovered by agents in a decentralised way. Remembering the Ostroy and Starr models, it is easy to understand that exploiting exchange opportunities may require a huge amount of information and sometimes to have perfect knowledge of the whole economy. This would apply if a systematic lack of double coincidence of wants occurred which would require a unique multilateral exchange. It should be clear from the example above that we must have mutual compatibility between the properties attributed to the exchange process (which ensures global stability) and the rules of behaviour of individual agents (microfoundations), the latter depending on the organisation of the market. How can/should agents meet one another? What information is available to them? In the Edgeworth–Uzawa process it is not clear how Pareto-improving transactions may take place. Equivalence in exchange and voluntary exchange are a priori sound principles but they do not shed any light on the way transactions are organised. The internal logic of the Edgeworth–Uzawa process is more reminiscent of the core than of the market. It implies that a possibly great number of agents are able to co-ordinate themselves. Following Fisher it is possible that there is no mutually advantageous bilateral or trilateral or multilateral trade and that the only mutually advantageous trade involves a very complicated swapping of commodities among millions of people. To require, as the Edgeworth Process does, that such a trade must take place is to put very heavy requirements on the dissemination of information and to assume away the costs of coalition formation. (1983: 29–30) The Edgeworth–Uzawa process does not suit an economy where individuals meet at random with no other information than the prices and the excess demands of the two would-be traders. Charging the (mythical) auctioneer to organise the exchange process, besides his/her role of posting prices, would definitely stray too far from a market economy. A market with bilateral meetings does not solve the problem and meetings in n(n⫺1)/2 trading posts are not a solution either, due to the ever-possible absence of double coincidence of wants. Despite such adverse circumstances, a solution has been proposed by Madden thanks to a special assumption about endowments. If each agent holds at any time a positive quantity of each commodity, bilateral meetings are sufficient to exhaust all mutually advantageous transactions. Such an assumption is an ad hoc remedy to the lack of a generally accepted means of exchange. It ensures that in any mutually advantageous trade multilateral transactions may be decomposed in bilateral ones since a commodity at least will serve as a means of payment (generally different for each pair). But Madden’s assumption, besides its arbitrariness, leads us to a dead-end. It

86

J. Cartelier

cannot be interpreted as an embryo of a theory of exchange intermediation. By its very definition, an object serving as an intermediary of exchange is void of any intrinsic utility. It is demanded only to be immediately supplied. Money in competitive general equilibrium must be assumed without any role in production or in consumption, as modern theoreticians are well aware. Hence, introducing money in the Edgeworth–Uzawa process does not help. By virtue of the principle of voluntary exchange nobody would accept money in exchange against a commodity since this would amount to agreeing to a decrease in utility (no speculation is allowed in competitive market processes). The reasons for rejecting Edgeworth–Uzawa process as a good theory of the market are not marginal ones. Its logic is contrary to that of a decentralised economy and money cannot prevent that failure since it is excluded by the very principle on which the model is grounded, namely voluntary exchange (or Pareto-improving transactions). A co-operative conception of the market does not offer suitable foundations for market theory. Are the prospects better along a non-cooperative one? Examination of the Negishi process will clarify why the answer is negative. The Negishi process may be formally summed up as follows. For a price vector taken at random individual excess demands are not mutually compatible; nevertheless some transactions will take place that cannot exhaust all the desired transactions. Effective transactions are determined according to the hypothesis of well-ordered markets. This means that, at the end of the market, there exist no rationed agents on either side of the market. Frustrated individuals are either those with a net excess supply (if the market is in excess supply) or with an excess demand (if the market is in excess demand) but not both simultaneously. Like the Edgeworth–Uzawa process, the Negishi process combines the standard law of supply and demand with a special process of evolution of endowments over time: p⬘(t) = G[Z(p(t), X(t))] X⬘(t) = F[p(t), X(t)]

(2)

The exchange process F[.], besides the usual properties of conservation and equivalence, has a specific property, that of well-ordered markets, which implies: zhi(t).Zi(t) ⱖ 0 ᭙h,i,t

(3)

where zhi is individual h excess demand in the market for commodity i and Zi is aggregate excess demand. Thanks to assumption (3), it is possible to show that individual target utility decreases over time in disequilibrium and is constant in equilibrium (a detailed demonstration is given by F. Fisher). The intuition is the following: as a consequence of zhi(t).Zi(t) ⱖ 0, an agent rationed in his various excess demands necessarily faces an increase in the price of commodities he demands and a

Money and markets as twin concepts? 87 decrease in the price of commodities he supplies. As a consequence, his budgetary constraint evolves unfavourably and he can no longer pretend to achieve the target utility he was pretending in the preceding market. Target utilities decrease over time for all agents in disequilibrium. A weighted sum of target utilities is a good candidate for being a Lyapunov function. In fact, the Negishi process is globally stable. The anonymous forces of the market act as an objective limit to individual pretensions. They constrain each individual to adjust his desires progressively to what the market allows him, which depends on global desires. It is however impossible to accept Negishi’s views on the market uncritically. The property of well-ordered markets is entirely arbitrary. It does not rely on any microfoundations. There is absolutely no reason why such a property could be spontaneously met in the absence of a generally accepted means of payment. The absence of a double coincidence of wants – that case haunts all investigations in the realisation of transactions – directly contradicts that assumption of well-ordered markets since no transactions can take place even at equilibrium. A total or a partial absence of double coincidence of wants prevents the function F[.] from being a possible description of the transactions process over time. In the two approaches reviewed above, co-operative or non-cooperative, the market process theory appears to lack firm microfoundations. This lack not only impairs non-tâtonnement models but reveals that market prices determination in disequilibrium is out of reach for standard theory. Indeed, this insufficiency could seem very specific since the remedy is to be found in a theory of money as a generally accepted means of exchange. But the introduction of money in the neo-Walrasian theory of market processes proves almost impossible. It is essential to understand why.

Money and market: the neo-Walrasian dead-end Let us examine briefly an attempt by F. Hahn to relieve the Negishi process of its main drawback through the introduction of money. Assume then a special commodity serving as an exclusive intermediary of exchange, but entering nevertheless in utility functions. The transactions that we have to consider are no longer the Walrasian positive excess demands but only those positive excess demands backed by money. Two consequences of money introduction are worth noticing. On the one hand, budgetary constraints must encompass the additional commodity and, more fundamentally, the quantity of money held constrains the value of the positive excess demands (cash-in-advance constraint). Hahn’s version of the Negishi process is now: p⬘(t) = G[A(p(t), X(t))]] X⬘(t) = F[p(t), X(t)]

(4)

88

J. Cartelier

where A(p(t), X(t)) denotes the active excess demands, i.e. those respecting the cash-in-advance constraint. Active excess demands are derived from Walrasian ones through a multiplicative factor according to: ahi(t) = bzhi(t)

mh (t) with b = min[1, ᎏ+ᎏ] ∑ z hi(t)

(5)

Thanks to money and cash-in-advance constraints it makes sense to assume that active excess demands satisfy the well-ordered markets hypothesis: ahi(t).Ai(t) ≥ 0. Now, the fact that active and Walrasian excess demands have the same sign ensures that Negishi’s demonstration also holds for Hahn’s version. The Hahn–Negishi market process is therefore globally stable. Are we out of the woods? Unfortunately not. It is not necessary to contemplate this model at length to understand it is not acceptable. Hahn himself thinks that it was a piece of ‘bad monetary theory’ (Hahn’s own terms) since money was supposed to be an argument of the utility function contrary to the tradition of competitive general equilibrium. But there is also a problem with the maximisation programme used to determine active excess demands. With a cash-in-advance constraint ∑pix+hi ≤ mh it is not sure (for n > 2) that excess demands and Walrasian excess demands have the same sign. It is to avoid this unfavourable conclusion that Hahn resorts to the assumption ahi(t) = bzhi(t), which is absolutely necessary in order to have the global stability property. But this amounts to abandoning a true maximisation of utility without any clear reason except an ad hoc one. The acknowledged failure to integrate monetary and value theory bears inescapable consequences; namely that of leaving exchange processes microeconomically unfounded. Is it possible to overcome this crucial difficulty by introducing alternative rules of exchange avoiding the use of money? The answer is doubtful. The rule proposed by Ostroy and Starr, although perfectly reasonable in a non-monetary economy, does not do the job. This rule reads as follows: in a bilateral meeting agents will accept to exchange only when excess demands have the opposite sign; the quantity effectively traded will be the minimum in absolute value of the two excess demands; to respect the quid pro quo the balance between the two agents is settled with commodities for which the paying agent has a negative excess demand. Note that such a trading rule respects quantity conservation and value equivalence in exchange but not the weak principle of voluntary exchange.6 Moreover it does not ensure that all desired transactions will be realised in a round, as we have seen above, even in equilibrium.

Money and market: market mechanism as a synthesis The models of market processes mentioned above do not fail for a technical but for a very fundamental reason, the dichotomy between price determination and transactions realisation. That prices could be determined without any reference

Money and markets as twin concepts? 89 to transaction process is not consonant with any sensible idea of a market economy. Two symptoms of that failure are the following. First, the Arrow–Debreu framework for individual utility maximisation is inaccurate since it does not take into consideration the way individual allocations are to be obtained. Imposing the usual budgetary constraint only on agents means not only that strategic behaviour does not exist but also that agents do not care about the way in which they can buy or sell the commodities for which they have excess demands. Such a view was challenged in Walras’s time. Implicitly by Walras himself in the 29th and 30th lessons of the Eléments d’économie politique pure when he deduces the level of the encaisse désirée from the way transactions are carried out. Explicitly by Menger who was strongly against that dichotomy: ‘it is an error in economics, as prevalent as it is patent, that all commodities, at a definite point of time and in a given market, may be assumed to stand to each other in a definite relation of exchange, in other words, may be mutually exchanged in definite quantities at will’ (1892: 71).7 The Arrow–Debreu model has been adopted instead of that of Walras as the reference of general equilibrium theory. The preference of modern economists for a moneyless framework is partly responsible for the pitfalls of neoclassical theory of the market. Second, the macroeconomic result of the combination of individual actions generally remains unspecified. Following uncritically the usual law of supply and demand, non-tâtonnement theoreticians fail to determine disequilibrium prices (and fail to make explicit the evolution of endowments over time). According to the above law, market disequilibrium produces a virtual qualitative evolution of prices, but not a quantitatively determined level of prices. Put in plain terms this means that market prices are left undetermined. Adopting the law of supply and demand as the auctioneer’s algorithm definitely prevents economists from investigating what happens in disequilibrium because all the weight of adjustment is left to an arbitrary institution not microfounded. In order to overcome that obstacle it is necessary to replace the mythical auctioneer by a mechanism in which individual agents only matter. In what we have called the monetary approach such defects are not to be found. First, the framework in which individuals are defined is now accurate. A monetary economy is assumed at the very outset. The modern illusion that money existence could (and should) be deduced from commodity exchange was not common when value theory was not well developed, say until the 1750s. Money holding was considered as a normal requisite for participating in the market. The modern cash-in-advance constraint, advocated by Clower, may be interpreted in a sense a resurgence of an ancient tradition. The organisation of transactions faced by individuals when they maximise utility is now clear: ‘money buys goods and goods buy money; but goods do not buy goods’ (1984: 86). Agents are still price-takers and perfect competition still holds but dichotomy between price determination and transactions realisation no longer holds.

90

J. Cartelier

Second, the law of supply and demand now receives a sensible interpretation. Instead of being a mere hypothesis about qualitative price evolution (with the doubt raised by Arrow 1959: who does post prices?) it is a result derived from a market mechanism, that is an algorithm giving market prices and allocations starting from individual actions alone. Moreover market prices and allocations are nothing but the effect of transactions realisation. That market mechanism was precisely defined by Cantillon in the Essai sur la nature du commerce en général and taken up by Smith in Book I, Chapter 7 of Wealth of nations: the market price is the ratio of the quantity of means of payment spent in the market to the quantity of commodity bought in order to be sold. In modern terms, with monetary parametric prices, the rule says: the market price is the ratio of the money value of positive excess demands (amount of orders to buy) to aggregate negative excess demands. Modern strategic market games use Cantillon’s rule in that way so that it can be called Shapley–Shubik’s rule as well. Market prices are now completely determined in equilibrium and out of equilibrium as well. Taking for granted the monetary organisation of the economy and its associated market mechanism implies a new definition of economic agents and, at the same time, a specific view about the reciprocal relations between money and market, quite contrary to that defended by standard theory. Economic agents are now dependent on their position in the monetary system: are they in a position to raise money from a banking system? Are they able to issue private money? Do they have enough money for what they intend to do? Are they prevented from getting money other than by selling their services? In the same way as, according to Wittgenstein, ‘what the pawn is is determined by the rules of chess’ an individual in a monetary economy is defined by the rules of the game. An economic agent does not exist unless he complies with principles that are logically in front of him. He cannot order, for example, a given quantity of commodities if he does not hold a sufficient amount of an accepted means of payment. Moreover he cannot consider that what he has bought belongs to him unless he satisfies a quid pro quo condition: he must not spend more than he has received during a given period. In this sense, a market economy is an empty notion without money. The Cantillon–Smith mechanism is taken again in the recent story of market theory, namely in the strategic market games models of Shapley and Shubik and other theoreticians. These models belong to an ancient tradition, even if their authors do not seem very conscious of this filiation. That they are very sophisticated pieces of modern analysis must not make us forget that they systematise a very old view. Though it lies beyond the scope of this chapter to give a detailed account of this literature (see survey in the Handbook of Monetary Theory – Friedman and Kahn 1990), it is possible, first, to emphasise briefly one specific feature and, second, to report a major result. First, the game mechanism is logically anterior to the assumptions about individual behaviour. An agent is not defined independently of an institutional context. His behaviour although based on a utility maximisation hypothesis makes sense only in a specific framework defined by specific rules. The market

Money and markets as twin concepts? 91 mechanism is made of two fundamental elements: (i) how transactions are processed; there exist n markets (one for each commodity) in which agents participate by putting determinate quantities of a predetermined means of payment, i.e. money (if they want to buy) or determinate quantities of a commodity (if they want to sell); and (ii) how individual actions combine to give a macroeconomic outcome; in each market the price is given by the ratio of the total quantity of money put in the market to the total quantity of a commodity brought there; individual market allocations are determined as a consequence: the change in agent h endowment in commodity i is given by the sum of two terms, the ratio of the quantity of money he has put in the market to the market price minus the quantity of a commodity he has brought to the market; the change in agent holding of money results from the difference between the total quantity of money he has put across all markets and the total quantity of money he has obtained by selling his commodities. Second, adopting the standard maximisation of utility (except for the cash-inadvance constraint) as a behavioural assumption, it is possible to define equilibrium solutions (according to the Nash criterion) and to compare them with the Walrasian equilibria derived from preferences and initial endowments only. A comparative study of the results obtained for these two institutional frameworks, which essentially differ in the organisation of transactions, shows that equivalence between the two sets of equilibria does not generally hold (even with a continuum of agents). Such an equivalence is subject to conditions on the quantity of money and on its distribution among agents (conditions which clearly do not make sense in Walrasian competitive general equilibrium). Taking into account simultaneously solvency (the Walrasian budgetary constraint) and liquidity (cash-in-advance) strategic market games models supply a particularly well-adapted framework for studying a market economy. In a market economy price determination and transactions realisation are one and the same thing. Money and market cannot be distinguished in their modus operandi. They are two alternative names for a single mechanism, which delivers market prices and allocations in equilibrium as out of equilibrium. By contrast, standard theory, which deals with solvency only, as exemplified by Walras’s theorem of equivalent distributions, leaves money and transactions out of its field. As a consequence it fails to give an account of the working of the market. Let us come now to the difficult problem of dynamics and complexity. It is not sufficient to determine market prices out of equilibrium. Even if that task is beyond the capabilities of standard theory, non-standard economists cannot content themselves with their superiority on this point. There is a need to know whether the market is self-regulating or if a market economy cannot be possible without stabilising interventions of a political authority correcting its spontaneous trajectory. Let us briefly sketch the sort of model to which a monetary approach may lead. A comparison with standard model’s properties will make it clear why the former is really promising. The story told by a monetary approach based on the Cantillon–Smith

92

J. Cartelier

mechanism is the following. Considering some expected prices, individual agents calculate their excess demands by maximising their utility under a budgetary and a cash-in-advance constraint. Transactions are carried out on decentralised markets (one commodity one market). Agents give their orders (sales are constrained by the amount of commodities and purchases by the amount of cash available to the agent) in each market. Each market is independent from others (decentralisation) but each market performs some partial centralisation of transactions. The market price emerges as the result of Cantillon-Smith’s rule:

冱h mhi pi(t) 冱h z+hi πi(t) = ᎏ = ᎏᎏ – z 冱 zhi– 冱 hi h

(6)

h

where πi(t) and pi(t) are respectively the market and the parametric price of commodity i; mhi, the amount of money spent by agent h in the market for commodity i; ∑ zhi+ and ∑ zhi– respectively the aggregate demand and supply of h h commodity i. A special case is that of equilibrium in which parametric and market price are equal as a consequence of equality between aggregate demand and supply. The general case is however that of disequilibrium. But, in both cases, the market price is perfectly determined. It depends only on the individual actions and not on an arbitrary behaviour of a no less arbitrary auctioneer. What is even more interesting are the comparative properties of disequilibrium positions. In standard theory agents are always in equilibrium (they believe that their planned actions will be realised) but the markets do not clear (only the auctioneer can be aware of disequilibrium and can react to it ). Here it is exactly the opposite: nobody cares about the market but individual agents care about their own situation and they are conscious of the disequilibrium since market price differs from their own expected price. As a normal consequence they individually react to the disequilibrium by changing their expectations: pi(t + 1) = ⌽(πi(t),π–i(t))

(2)

where ⌽(•) is a continuous function and π–i(t) the market prices of the other commodities. It is certain that this change in expectations may be very different from one agent to another and from time to time. This introduces some inescapable arbitrariness into the dynamics but in every case expectations reflect individual behaviour about which economic theory is relevant and not some arbitrary action of an auctioneer left unexplained. Moreover disequilibrium now has two aspects, a real one due to the fact that the buyers do not get the quantities and the sellers do not get the amount of money they expected. Changes in expected prices will make real disequilibrium evolve over time whereas changes in monetary policy (at large) will be

Money and markets as twin concepts? 93 prompted by monetary authorities in order to get rid of the monetary aspect of disequilibrium. Combining (6) and (7) and recalling that excess-demand functions depend on quantities of money available to agents, we get the following dynamic model: πi(t) = F(πi(t – 1),π–i(t – 1),m(t))

i = 1,2, . . . ,n

(3)

where m(t) is the vector of monetary endowments at period (t, F(•) is a combination of expectations and excess-demand functions and n the number of commodities. Nothing guarantees that (8) is globally stable. However there is a crucial difference with standard theory. Here it is plainly recognised that the institutional setting of a market economy includes a central bank or a monetary authority deliberately able to change money availability over time. It is thus possible to introduce in (8) some policy action which would not make sense in the standard framework (and by the way find a Lyapunov function ensuring global stability). Note that this is not a question of level of abstraction. Monetary approach is as abstract as the standard one, but what is claimed by monetary approach is that at the highest level of abstraction a monetary authority is necessary. The recent history of market theories briefly sketched above clearly shows how money theory was led into a dead end in the 1960s. Accepting the Arrow–Debreu institutional setting (no transactions out of equilibrium, no bilateral and decentralised meetings of agents, etc.) theoreticians could not satisfactorily settle the question of monetary equilibrium existence. At the same time (or a bit later) theoreticians dealing with market processes were constrained by the shortcomings of money theory. They could not propose schemes of transactions realisation relying on firm microfoundations. On the whole, market theory faced a twofold obstacle which could not be overcome unless one breaks with the usual vision of price and money theory and follows again a long neglected tradition: that of a monetary approach to the market. At the end of the 1970s, strategic market games theory paved the way for a revival of that tradition. But despite some recent, tentative attempts there is still much effort needed in order to obtain a true dynamic theory of a market economy.

Acknowledgements Many thanks are due to Cristina Marcuzzo for her meaningful comments on a preliminary version of this chapter. I am also grateful to an anonymous referee for his/her excellent advice.

Notes 1 Smith, writing about labour value determination, concludes: ‘It is adjusted, however, not by any accurate measure, but by the higgling and bargaining of the market’ (1976: 49). Marx, in the first chapter of Capital, affirms: ‘Let us remember that commodities possess an objective character as values only in so far as they are all expressions of an identical substance, human labour, that their objective character as values is therefore

94

2 3 4 5 6

7

J. Cartelier

purely social. From this it follows self-evidently that it can only appear in the social relation between commodity and commodity’ (1976: 138–9). Walras is very clear: ‘On voit clairement à présent ce qu’est le mécanisme de la concurrence sur le marché; c’est la solution pratique, et par hausse et baisse des prix, du problème de l’échange dont nous avons fourni la solution théorique et mathématique. On doit comprendre d’ailleurs que notre intention n’est aucunement de substituer une solution à l’autre. La solution pratique est d’une rapidité et d’une sûreté qui ne laissent rien à désirer’ (1988: 93). Parametric prices are posted by the auctioneer. They are taken as a basis by agents for their calculation of excess demands. See however Fisher (1983). Marx and Keynes (General Theory) are not mentioned here despite their insistence on the role of money because they do not resort explicitly to a monetary market mechanism. See also Veendorp (1970). The weak principle of voluntary exchange implies that nobody can receive a greater quantity of commodity than that which he has demanded. The strong voluntary exchange means that transactions do not take place unless they are Pareto-improving. The latter precludes money circulation, not the former. It is interesting to note that Negishi, in an attempt at rationalising Menger’s view, resorts to perceived demand curves and not to the question of transactions realisation, as search theoreticians will later do. Yet again the question of transactions realisation was neglected.

Bibliography Arrow, K. (1959) ‘Toward a Theory of Price Adjusment’, in M. Abramovitz et al. (eds), The Allocation of Economic Resources: Essays in Honor of B. F. Haley, Stanford: Stanford University Press. Arrow, K. and Hahn, F. (1971) General Competitive Analysis, San Francisco: HoldenDay. Benetti C. (2002) ‘Le problème de la variation des prix: les limites de la théorie walrassienne’, Revue économique, 53: 917–31. Benetti, C. and Cartelier, J. (2001) ‘Money and Price Theory, International Journal of Applied Economics and Econometrics, 9: 203–23. Cantillon, R. (1952) Essai sur la nature du commerce en général, Paris: INED. Cartelier, J. (1991) ‘Monnaie et système de paiement: le problème de la formation de l’équilibre’, Revue française d’économie, 6: 3–37. Clower, R. (1984) ‘A Reconsideration of the Microfoundations of Monetary Theory’, in D. Walker (ed.) Money and Market: Essays by Robert W. Clower, Cambridge: Cambridge University Press. Feldman, A. M. (1973) ‘Bilateral Trading Processes, Pairwise Optimality, and Pareto Optimality’, The Review of Economic Studies, 40: 463–73. Fisher, F. (1983) Disequilibrium Foundations of Equilibrium Economics, Cambridge: Cambridge University Press. Friedman, B. M. and Hahn, F. K. (1990) Handbook of Monetary Theory, Amsterdam: North Holland. Gobillard, B. (2003) ‘De l’équilibre général aux jeux stratégiques de marché: Monnaie et déséquilibre dans une économie d’échange de marché’, mimeo. Keynes, J. M. (1971) ‘A Treatise on Money’, in The Collected Writings of John Maynard Keynes, vol. V, ed. by D. E. Moggridge, London: Macmillan and St. Martin Press.

Money and markets as twin concepts? 95 Madden, P. (1978) ‘Why the Edgeworth Process Assumption Isn’t That Bad’, Review of Economic Studies, 45: 279–83 Marx, Karl, (1976), Capital: A Critique of Political Economy, vol. I, Harmondsworth: Penguin Books. Menger, C. (1892) ‘On the Origin of Money’, Economic Journal, 2: 23955, reprinted in R. M. Starr (ed.) (1989) Negishi, T. (1961) “On the Formation of Prices”, International Economic Review, 2: 122–6. Negishi, T. (1985) Economic Theories in a non-Walrasian Tradition, Cambridge: Cambridge University Press. Ostroy, J. M. and Starr, R. M. (1974) ‘Money and the Decentralization of Exchange’, Econometrica, 42: 1093–113, reprinted in R. M. Starr (ed.) (1989). Petty, W. (1899) The Economic Writings of Sir William Petty. Together with the Observations upon the Bills of Mortality, more probably by Captain John Graunt, ed. by C. Hull, 2 vols, Cambridge: Cambridge University Press. Saari, D. and Simon, C. (1978) ‘Effective Price Mechanisms’, Econometrica, 53: 1117–31. Shapley, L. and Shubik, M. (1977) ‘Trade Using One Commodity as a Means of Payment’, Journal of Political Economy, 85: 937–68. Shubik, Martin (1990) ‘A Game-Theoretic Approach to the Theory of Money and Financial Institutions’, in B. Friedman and F. K. Hahn (eds) Handbook of Monetary Economics, vol. I, Amsterdam: North-Holland. Smith, A. (1976) An Inquiry into the Nature and Causes of the Wealth of Nations (2 vols), Glasgow: Clarendon Press. Starr, R. M. (ed.) (1989) General Equilibrium Models of Monetary Economies: Studies in the Static Foundations of Monetary Economies, Boston: Academic Press. Steuart, J. (1805) ‘An Inquiry into the Principles of Political Economy’, in The Works Political, Metaphisical & Chronological of Sir James Steuart (6 vols), Boston: Academic Press; London: Cadell & Davis. Uzawa, H. (1962) ‘On the Stability of Edgeworth’s Barter Process’, International Economic Review, 3: 218–32. Veendorp, E. C. H. (1970) ‘General Equilibrium Theory for a Barter Economy’, Western Economic Journal, 8: 1–23. Walras, L. (1988) ‘Eléments d’économie politique pure: ou théorie de la richesse sociale’, in A. Walras and L. Walras, Œuvres économiques complètes, vol. VIII, Paris: Economica.

7

The monetary-policy relevance of an international settlement institution The Keynes plan 60 years later Sergio Rossi

Introduction The constitution of a new international monetary and financial architecture has been debated for at least 60 years now, since the 1944 conference at Bretton Woods set up the ‘twin institutions’, that is, the International Monetary Fund and the International Bank for Reconstruction and Development. A number of important questions that were at stake at the Bretton Woods conference have not been answered yet. To cite only a few of them: can a national currency play the role of international money essentially? What are the basics for the creation of a truly international money? Which institution should issue it? What are the links between money and credit at the international level? This chapter focuses on the need of a structural monetary reform of the international payment system in the spirit of Keynes. It analyses international money and credit from an endogenous-money perspective, showing that these issues need to be addressed, and solved, together to set up an institutional system that can avoid world monetary disorder as well as financial turmoil. The chapter also shows that the so-called incompatible triad of fully liberalized finance, monetary policy autonomy, and stable (though not fixed) exchange rates can be disposed of, if Keynes’s message for a world monetary reform is elaborated today considering the financial issues pari passu with the monetary ones. The approach we take is based on the idea, first advocated by Rueff (1979), that a key-currency country subjects its money to a process of duplication when it pays in national money for its net commercial imports. Duplication of the bank deposits owned by the rest of the world, then, creates an international, speculative capital that is crucial for explaining the observed, yet unpredictable, volatility on foreign exchange markets. The argument runs as follows. Suppose that a key-currency country, A, has to pay for its net commercial imports a given amount of money A to the rest of the world, R. In today’s regime, country A transfers to R a financial claim on A’s deposits in its banking system. The deposits themselves are recorded in A’s banking system, in which they had been formed as a result of the working of the local monetary economy of production. These same bank deposits, however, are recorded – as a duplicate – also in the banking system of the rest of the world, which is a net commercial exporter in

The Keynes plan 60 years later 97 this stylized example and, as such, is paid with an amount of money A that it enters – as foreign exchange reserves – on the assets side of its banking system’s balance sheet. Now, these claims (a financial capital) circulate erratically, subjecting foreign exchange markets to erratic fluctuations that hamper the development of our capitalist economies, be they advanced, emerging, developing or in transition. In short, the present regime of international payments – which lacks an international standard proprio sensu – transforms national currencies from means of payment into objects of trade: their exchange rates vary thus according to their sales and purchases, and in this market speculation arises with a view to making capital gains from these variations. Indeed, this kind of speculation becomes the main cause of exchange rate fluctuations, which, in turn, become the main incentive to speculate on foreign exchange transactions. The structure of this chapter is as follows. The next section recalls the backbone of the proposal for an International Clearing Union (ICU) that Keynes developed in the early 1940s and then submitted to the Bretton Woods conference. The third section focuses on a point that, to the best of our knowledge, has been neglected, or even ignored, in the endogenous-money literature so far, namely, the distinction between money and credit at the international level, where the International Clearing Bank (that is, the settlement institution for national central banks) would operate for the settlement of international transactions. The fourth section develops Keynes’s proposal on modern grounds, and puts forward some structural changes to reform the current international monetary system along post-Keynesian lines. The fifth section concludes, illustrating some main benefits that result from the implementation of an international settlement institution and raising questions for further thought.

Keynes’s proposal: an overview During the Second World War, Keynes was concerned with the negative effects that the war was likely to bring about in the United Kingdom, whose current account balance was in deficit as a result of the need for this country to import many commodities from the United States without being able to pay for them by an equivalent flow of commercial exports. In particular, the United Kingdom feared beggar-thy-neighbour policies from the United States. As a matter of fact, the US economy was in a very strong position in the early 1940s: its production system was not affected by the war, and its current account recorded huge surpluses as a result of the needs to reconstruct those European economies devastated by the war. Further, the United States had an enormous stock of gold in their reserves, and could thus guarantee convertibility of their currency into precious metal. As a result, the US dollar was in a strong position with respect to any other currency. Keynes was persuaded that the United Kingdom had to put forward a plan in order to limit the US domination – especially with respect to his own country. On 8 September 1941, he thus published two memoranda in which he called for a new international monetary order, and from which he started to develop his view about the new monetary architecture to be set up internationally.

98 S. Rossi He namely put to the fore the idea to create a world central bank – for the creation of a truly international money – that in his own words ‘might become the pivot of the future economic government in the world’ (Keynes 1980: 189). Keynes was indeed one of the first proponents of an international payment system in which a non-national book-entry money, instead of a commodity like precious metals, is used by participating countries to settle their trade imbalances – hence an international netting (or clearing) system, where settlements are made in real (barter) terms as long as foreign trade is balanced and all trade deficits are settled using an international bank money (instead of gold).1 It remains true, however, that Keynes linked the international bank money, which he dubbed bancor, to gold, because in his plan the bancor ‘would be defined in terms of a weight of gold’ (ibid.: 85). Most importantly, in Keynes’s plan gold has still some bearing on international settlements, since member countries are entitled to obtain a credit in terms of bancor by paying in gold to the Clearing Union for the credit of their clearing account (ibid.: 175). According to Keynes, this would turn a stone (gold) into bread (ibid.: 177), in order for it to nourish economic growth (ibid.: 176). In fact, the starting point of Keynes’s analysis relies on the merits of the (ideal) gold standard for the orderly working of the international settlement system that existed before the First World War. ‘Years ago, money was an international thing: if you had the money of one country you could change it into the money of another at a fixed rate, and you never had to think which currency you held’ (ibid.: 3). As a matter of fact, under the gold standard system there was an international standard, to wit, gold, which rendered the various national currencies homogeneous owing to the convertibility principle. Hence, Keynes’s proposal is to revert to the structure of the international gold standard system, which is ‘a means for trading goods against goods’ (ibid.: 12). To be sure, Keynes insisted on the importance of money as a means of payment at both the national and international levels. His argument, however, is that ‘[any] trading transaction must necessarily find its counterpart in another trading transaction sooner or later’ (ibid.: 18). Let us recall Keynes’s line of reasoning. First of all, Keynes clearly distinguishes those transactions that only concern a country’s residents from those transactions that also concern countries themselves. The distinction between a country and its residents follows from the fact that any national currency loses its purchasing power when it trespasses the country’s borders, namely, the national payment system issuing it (see Guttmann 1988: 255–6). In fact, no national currency can be a means of final payment in the international economy, hence play the role of international money, for in this environment it represents a debt of one of the trading partners (that is, a nation), and everybody knows that no one can finally pay by surrendering a debt. As Keynes pointed out with respect to the essence of international money: We need an instrument of international currency having general acceptability between nations . . . that is to say, an instrument of currency used by

The Keynes plan 60 years later 99 each nation in its transactions with other nations, operating through whatever national organ, such as a Treasury or a central bank, is most appropriate, private individuals, businesses and banks other than central banks, each continuing to use their own national currency as heretofore. (Keynes 1980: 168, emphasis added) Indeed, Keynes’s goal was not the replacement of national currencies with a world currency: every local currency is a valid means of payment within the currency area where it is issued. Keynes’s aim was to give to international transactions a means of final payment that was, and still is, lacking in foreign trade.2 In this respect, Keynes (1980: 33) suggested that ‘[w]ithin any member-country or currency unit the provision of foreign exchange [has] to be concentrated in the hands of its central bank which would deal with the public through the usual banks’. This means that to obtain foreign exchange, non-bank agents have to turn to banks, which in turn ask the central bank for it. Moreover, ‘[i]nternationally all transactions [have] to be cleared between central banks, operating on their accounts with an International Clearing Bank’ (ibid.: 34). Two characteristics of the international monetary order that Keynes proposes are thus plain: the bank to set up must act as a settlement institution, that is to say, it must imitate national central banks in their capacity of finally settling interbank debts (see Rossi 2005); and it must be an international bank, that is, the central bank of national central banks.3 In Keynes’s own words: the Clearing Union is set up, not for the transaction of daily business between individual traders or banks, but for the clearing and settlement of the ultimate outstanding balances between central banks (and certain other super-national institutions), such as would have been settled under the old gold standard by the shipment or earmarking of gold, and should not trespass unnecessarily beyond this field. (Keynes 1980: 125) As Keynes explains, the goal of his plan is ‘to set off transactions against one another so far as you can clear and then to deal with the resulting credit and debit balances as still off-setting one another in the same way they do in internal banking’ (ibid.: 210). Keynes’s plan is clear. It aims to reproduce at the international level the monetary order that exists in any country, owing to the working of domestic settlement systems headed by a central bank. One cannot be clearer than Keynes himself: The idea underlying my proposal for a Currency Union is simple, namely to generalise the essential principle of banking, as it is exhibited within any closed system, through the establishment of an International Clearing Bank. This principle is the necessary equality of credits and debits, of assets and liabilities. (Keynes 1980: 44)

100 S. Rossi To reproduce at the international level the fundamental principles governing national payment systems, Keynes went as far as to claim that the proposed International Clearing Bank creates its own payment unit, the bancor, for any transaction it settles. If no credits can be removed outside the banking system but only transferred within it, the Bank itself can never be in difficulties. It can with safety make what advances it wishes to any of its customers with the assurance that the proceeds can only be transferred to the bank account of another customer. (Keynes 1980: 44) We recognize here the loans-make-deposits causality on which the endogenousmoney paradigm is based (see Gnos 1998). Yet, how does it actually work in Keynes’s plan? Let us illustrate it with a stylized example. Consider a trade imbalance between two countries, A and B, which participate in the ICU system as proposed by Keynes. The central banks of all member states (and also of non-members) would keep accounts with the International Clearing Union through which they would be entitled to settle their exchange balances with one another at their par value as defined in terms of bancor. (Keynes 1980: 171) Suppose that country A has a trade deficit worth z bancor, which must be settled via the International Clearing Bank (ICB) to the benefit of country B. When this occurs, the former country obtains a credit of z bancor from the ICB, which owes an identical amount to the latter country (Table 7.1).4 Owing to the banking principle that loans create deposits, the ICB accepts the granting of a credit to country A – for the payment of the trade imbalance – because the amount of bancor so created is mechanically deposited by country B and, as a result of the very mechanism of double-entry bookkeeping, no single bancor can leave the system. It is at this juncture that money and credit come to light in Keynes’s plan.

Money and credit in Keynes’s plan The Keynes plan for world monetary reform does not distinguish explicitly between money and credit in so far as the working of the ICB is concerned. In Table 7.1 The result of an international payment in bancor in Keynes’s plan International Clearing Bank Assets Country A

Liabilities +z bancor

Country B

+z bancor

The Keynes plan 60 years later 101 fact, were the plan implemented as Keynes suggested, it would solve the international monetary problem but would leave the credit problem unsolved. Consider the example stylized in Table 7.1, which epitomizes any international payment in bancor according to the Keynes plan. As a result of the payment carried out in the ICB ledger, country B is entitled to a deposit in bancor for the amount of country A’s trade deficit. Hence, as Lutz noted: If this world bank grants a credit to country A by creating a bancor deposit in its favor, and country A then turns this deposit over, in payment for its deficit, to country B, which then keeps the deposit, it is of course country B which is really giving the credit to country A. (Lutz 1963: 241) It is precisely at this stage that Keynes’s plan blends money and credit, allowing deficit countries to live beyond their income – up to some predetermined quota (see Keynes 1980: 173–6). In fact, Keynes’s analogy between domestic and international banking does not fully apply to his own plan. As argued by Schumacher: The analogy with a national banking system, greatly emphasized in the Memorandum [Keynes’s plan], is justified only as far as the creation of bancor quotas is concerned. They indeed, like bank credit, are created out of nothing. But once bancor quotas have been allotted and fixed, the analogy becomes confusing. (Schumacher 1943b: 15) In domestic banking and payment systems, as a matter of fact, money is issued by banks as a means of final payment between non-bank agents. It does not constitute an asset on its own for any agent, who must earn an income to have a purchasing power over produced output. By contrast, Keynes’s bancor would be issued (in exchange for gold) as a reserve asset for the ICU participating countries,5 which may use it in final settlement of international transactions and acquire thereby real goods and services. In other words, the bancor created by the ICB would be a liquid asset (a financial capital) for the country that would dispose of it in order to pay for its net commercial imports. Indeed, as Keynes (1980: 176) explains, his plan is to allow each country ‘a certain margin of resources and a certain interval of time within which to effect a balance in its economic relations with the rest of the world’. This margin, according to Keynes, is to be provided by the ICB itself, and is intended as an ‘initial reserve’ (ibid.: 272). In his own words, ‘[t]he margin of resources provided by the Clearing Union must be substantial. . . . This margin, though substantial, must be regarded solely as a reserve with which to meet temporary emergencies and to allow a breathing space’ (ibid.: 272). In sum, Keynes’s bancor would be created with a purchasing power of its own, and would serve only for the payment of trade imbalances – as in a netting

102 S. Rossi system – and not for the payment of each single international transaction – as in gross settlement systems. Any country would be entitled to pay for its net imports of real goods and services by merely a stroke of the ICB pen, provided that its deficit does not exceed its predetermined quota (see Keynes 1980: 173). Under such a scheme, Keynes is therefore obliged to provide a series of measures, namely, a system of fines, to prevent the piling up of credit and debit balances without limit in the accounts that countries hold at the ICB (ibid.: 173–5). These measures are of an institutional order and depend on the good will of participating countries, whose behaviour may or may not abide by the system of regulations devised by Keynes. It is thus legitimate to ask whether these fines, and the other conditions stipulated by Keynes, are enough to exert pressure towards equilibrium in foreign trade. According to Schumacher: the fines which under the [Keynes] Plan are to be imposed upon surplus countries must be viewed with a certain amount of doubt. They may help to achieve equilibrium, but will they exert an expansionist pressure? Not if the surplus countries react to them by cutting their exports, for then the result will be restriction and a contraction of world trade. (Schumacher 1943b: 14) Further, ‘[i]f it appears doubtful whether the treatment proposed for excessive surpluses will, in fact, lead to an expansion of world trade, it is almost certain that the treatment proposed for excessive debits will be a restrictive force’ (ibid.: 15). At another level, Schumacher argues that it would not ‘be wise to place much reliance upon the efficacy of persuasive efforts emanating from an international authority’ (ibid.: 14). The regulations proposed in Keynes’s plan are thus problematic on two counts, granted: (1) that the suggested pressure by means mainly of fines and persuasion is quantitatively and qualitatively too weak to exert any measurable influence; and (2) that the expansionist effect which a penalization of surpluses might have (on special assumptions) may easily be neutralized, if not overcompensated, by the restrictive effect of the regulations applying to deficit countries. (Schumacher 1943b: 15) Yet, even on the assumption that countries are ‘well behaved’ and that the designed institutional measures of Keynes’s plan function well, the implementation of this plan without any further elaboration might give rise to some inflationary pressures at the international level on the markets for produced goods, because it does not distinguish money from credit explicitly. In fact, to revert to the example stylized in Table 7.1, country A would be allowed to pay for its net commercial imports by becoming indebted to the ICB, that is, without disposing of an equivalent amount of financial claims. In other words, total demand for world output (that for expositional ease we limit to the output of countries A and

The Keynes plan 60 years later 103 B) would be greater than total supply, owing to the purchasing power that Keynes’s plan attributes to the bancor deposits in the accounts at the ICB and that adds to the purchasing power that exists in the form of bank deposits in national currencies (money A and money B in our example). In other words, owing to the fact that there is no production outside the countries, to wit, at the international level, the creation of bancor generates a stock of money with no corresponding output, so that a country is not finally (that is, really) paid until it spends its bancor deposit and obtains real goods and services in exchange for it. As noted by Schumacher (1943b: 17), ‘[t]he creation of bancor quotas, unlike the creation of gold, costs nothing; consequently, it produces no new incomes and no new spending’. So, if we were to stop here, the Keynes plan would not solve the problem of how countries are to finance their trade deficit eventually. To be sure, each country must provide the real or financial backing of its net commercial imports for equity reasons. ‘In simple terms, this means that a country must finance its net commercial imports by an equivalent amount of exports of goods, services or securities’ (Cencini 2001: 13). To put it differently, if the bancor is not used for the payment of each international transaction, but only for the settlement of foreign trade imbalances, as in Keynes’s netting scheme, then it remains a unit of account. No trade deficit, however, can be financed with a unit of account: a means of final payment is needed for that purpose (Schmitt 1985: 204–6). The problem with Keynes’s plan is that it applies the overdraft principle, which indeed functions very well in domestic banking systems, to the international economy.6 As a matter of fact, as Guttmann (1988: 273–4) notes, there exists an essential difference between national economies and the international economy: whereas the former are monetary economies of production, the latter involves exchange transactions only. The international monetary unit (Keynes’s bancor), therefore, cannot be associated with an international output, because no international production exists in order to give to this money a purchasing power of its own, which in point of fact can only be derived from national currencies, and production. Overdrafts in the international economy have thus to be grounded on financial assets – to wit, claims on present or future production – that countries may exchange between them through the intermediation of the ICB.

Keynes’s proposal refined: the ICB as money purveyor and credit purveyor In his speech before the House of Lords on 18 May 1943, Keynes (1980: 270) pointed out that the principal object of his plan is ‘to provide that money earned by selling goods to one country can be spent on purchasing the products of any other country. In jargon, a system of multilateral clearing.’ Now, settlement of international transactions on real goods and services in such a system means that: The importer in country A pays for the goods he buys from country B by handing over to the Clearing Authority in his own country a sum of

104 S. Rossi A-money which is deemed to discharge his debt. The exporter in country B receives from the Clearing Authority in his country an equivalent sum of Bmoney which is deemed to satisfy his claim. (Schumacher 1943a: 150) In other words, multilateral clearing implies that every single international transaction has to be finally settled, in local currency within the countries concerned as well as in an international monetary unit, say bancor, between them.7 In this framework, ‘[b]eing linked to equivalent payments by and to individuals in their respective currencies, [any international settlement in bancor] only transfers existing purchasing power from one country to another’ (Guttmann 1994: 433). Let us elaborate on the example stylized in Table 7.1. Suppose that countries A and B participate in the ICU as suggested by Keynes, and that we aim to modernize and forge ahead in this section. Suppose also that country A has a trade deficit worth x units of money A (MA) or, equivalently, z bancor. For expositional ease, assume that country A’s deficit is country B’s surplus, as if the ICU were composed of two countries only. To refine Keynes’s plan and make sure that the money-purveying and credit-purveying functions of the ICB are clearly separated, let us introduce a two-department bookkeeping in each national central bank involved (see Schmitt 1973 for an analogous proposal at the international level). In other words, let a country’s central bank record any international transaction in two separate monies: its Domestic Department enters the payment in local currency, while its External Department enters it in international money, namely, in bancor. The result of the payment of the trade imbalance between countries A and B is shown in Table 7.2. So far, the only difference with Keynes’s (and Davidson’s) proposals is the explicit departmentalization of monetary flows. In fact, the double entry in the ICB ledger is the same in Tables 7.1 and 7.2. So, as we noticed, if the settlement of the international transaction were stopped here, country A would be allowed finally to pay for its net commercial imports from country B without relinquishing an equivalent amount of securities (see the Domestic Department account of country A’s central bank in Table 7.2). Country A would thus live beyond its income, because it could pay for its net commercial imports without exporting goods, services or securities for an equivalent amount. If the ICB intervention were to stop at this stage, in fact, a deposit of z bancor would coexist alongside of a sum of bank deposits in money B (MB) worth the same amount (see Table 7.2). In other words, the number of money units existing as a result of a single payment would be twice (2x) the value of the exchanged items (x MA) – recall that in our example x MA = z bancor = y MB. To make sure that the total sum of bank deposits corresponds to the value of the underlying transaction, the international payment system has to ensure that either one of the two sums of money worth y MB each – the deposit in the Domestic Department of country B’s central bank and the deposit at the ICB –

The Keynes plan 60 years later 105 Table 7.2 The result of an international payment in bancor: step I Central bank of country A Domestic department

External department ■

Assets

Liabilities

Assets

Liabilities

Bank B1 (importer) +x MA

External department +x MA

Domestic department +z bancor

International Clearing Bank +z bancor

International Clearing Bank Assets

Liabilities

Central bank of country A (External department) +z bancor

Central bank of country B (External department) +z bancor Central bank of country B

Domestic department

External department ■

Assets

Liabilities

Assets

Liabilities

External department +y MB

Bank B2 (exporter) +y MB

International Clearing Bank +z bancor

Domestic department +z bancor

Note x MA = z bancor = y MB.

disappears as soon as it is formed. Only in this case will the ICB intervention, which is needed to finalize international payments, leave the money–output relationship unaltered worldwide. At this stage, the recent advances made by domestic banking systems in the management of settlement risks can provide the missing element to forge ahead Keynes’s plan. In short, it is possible to link together funds transfers and securities transfers at the international level to make sure that delivery of a financial asset occurs if, and only if, the corresponding final payment occurs, too (this is the delivery-versus-payment mechanism by means of which both actions take place at the same time; see Committee on Payment and Settlement Systems 2003: 492). Let us illustrate this mechanism by referring to our stylized example. When the central bank of country B is informed that it is entitled to a deposit in international money at the ICB, it should decide whether to lend this amount directly to a deficit country (like A) or to spend it for buying securities in the

106

S. Rossi

international financial market (see below). If country B lends its bancor deposit to country A voluntarily, this means that country A sells an equivalent amount of financial assets to country B. If so, then the book-entry situation after this financial transaction has taken place, and has been finally settled in bancor, is depicted in Table 7.3 (previous entries are shown in bold). Table 7.3 shows that as a result of the international payment in bancor through the ICB no country has a monetary deficit, because all trade imbalances are finally settled by a transfer of eligible assets in a multilateral framework. In this setting, national as well as international monies are used in a purely circular way, that is, as a means – and not as an object – of payment. To be sure, country A ends up with a net financial outflow, since it sells an amount of securities to finance its final payment to country B (through the ICB). Needless to say, these securities, while they provide the means to finance the country’s net commercial imports, are in no way the ultimate export of a deficit country: any trade deficit can only finally be paid by a net export of goods or services, thereby compensating over time a country’s trade deficit with the same country’s trade surplus. The sale of financial assets, nevertheless, provides a bridge between the present and the future, that is, between a trade deficit and a trade surplus recorded by the country considered (country A). In other words, if country B spends the bancor deposit it received as a result of its trade surplus (worth z bancor) for purchasing the securities sold by country A, this allows the latter country to find in the international financial market the funds it needs to pay for its trade deficit and reimburse the overdraft obtained at the ICB. In the end, international money disappears as the reflux principle indicates (see the ICB balance sheet in Table 7.3), and hence no inflationary pressure can arise in the market for produced goods: a bank deposit of y MB exists (in country B) as a result of the international settlement of A’s trade deficit (B’s trade surplus). This bank deposit is backed by financial assets – as a collateral – which are transferred from country A to country B with the monetary intermediation of the ICB. Now, although the most needed purpose of the ICB is that of providing participating countries with a means of final payment for the orderly working of the international monetary system, it would be wise to let the ICB act also as a financial intermediary, lending on a long-term basis the amounts saved by surplus countries. The ICB could, notably, lend to deficit countries the whole amount of bancor deposited by those surplus countries that spend it neither on the product nor on the financial markets around the world. Consider in this respect the ICB balance sheet in Table 7.3. From a circular-flow perspective, the two double-entries in the ICB ledger are the result of two distinct circuits of international money that occur in one and the same point of time. The first circuit concerns the payment in bancor of the trade imbalance between country A and country B. The second circuit concerns, by contrast, the payment in international money of a transaction on the financial market that has been induced by the former circuit (see above). The second circuit being induced by the first, we may analyse them together (Figure 7.1).

The Keynes plan 60 years later 107 Table 7.3 The result of an international payment in bancor: step II Central bank of country A Domestic department

External department ■

Assets

Liabilities

Assets

Liabilities

Bank B1 (importer) +x MA External department +x MA Financial assets (sold to country B) –x MA

External department +x MA

Domestic department +z bancor International Clearing Bank +z bancor

International Clearing Bank +z bancor Domestic department +z bancor

Bank B1 (importer) +x MA Financial assets (sold to country B) –x MA International Clearing Bank Assets

Liabilities

Central bank of country A (External department) +z bancor Central bank of country B (External department) +z bancor

Central bank of country B (External department) +z bancor Central bank of country A (External department) +z bancor Central bank of country B

Domestic department Assets

Liabilities

External department +y MB Financial assets (bought from country A) +y MB

Bank B2 (exporter) +y MB External department +y MB

Financial assets (bought from country A) +y MB

Bank B2 (exporter) +y MB

Note x MA = z bancor = y MB.

External department ■ Assets International Clearing Bank +z bancor Domestic department +z bancor

Liabilities Domestic department +z bancor International Clearing Bank +z bancor

108

S. Rossi ICB (settlement institution) z bancor

z bancor

z bancor

z bancor

z bancor Country A

Country B z bancor

Figure 7.1 The two circuits of international money.

The goods-market circuit of international money, represented anticlockwise in Figure 7.1, is elicited by the money-purveying role of the ICB as regards international trade. Countries need to ask the ICB in order for their commercial transactions to be settled. By contrast, the financial-market circuit of international money, represented clockwise in Figure 7.1, is elicited by the fact that the first (anticlockwise) circuit alone would not be enough for the surplus country (B) to be finally paid: the monetary intervention of the ICB, in fact, would give rise to a mere promise to pay if it were not complemented by a reverse operation whereby the newly created international money is destroyed. This reverse operation amounts to a purchase of securities by country B, which in so doing spends the bancor deposit it is entitled to at the ICB as a result of the goods-market circuit of international money. On the whole, if country B is led to spend on the international financial market the amount of bancor it obtains from foreign trade, it contributes to ensure the orderly working of the international payment system, namely, the bancor standard system. What happens, however, if country B does not spend its bancor deposit at the ICB to buy those securities sold by country A, which seeks to finance its trade imbalance? It is at this juncture that the credit-purveying function of the ICB acquires its full sense. As a matter of fact, instead of selling its securities to country B, country A may sell them to the ICB, which, in so doing, advances a payment that country A will benefit from when exporting real goods or services. If so, there may be two kinds of financial assets behind the entries in Table 7.3: country A’s securities sold to the ICB, and the ICB’s securities sold to country B. These securities may be denominated in either local currencies (MA, MB, or any third-country’s currency) or bancor, the important point being that the final settlement of these financial transactions between countries occurs using international money as a vehicle, that is, a means of payment, whose load is the amount of securities transferred from the seller to the buyer. By selling its own securities (or certificates) on the international financial market, the ICB would collect private as well as public capital and invest it in those countries most in need of a recovery and in which capital would otherwise not flow (see Kalecki and Schumacher 1943: 30–3 and Arestis and Sawyer 1997: 362–3). As Stamp (1963: 81) noted, ‘[t]he certificates would end up with the countries which are in over-all surplus – which, therefore, would have auto-

The Keynes plan 60 years later 109 matically lent . . . that surplus to the rest of the world’. Needless to say, the ICB open-market and lending operations would have to be supervised and respect the principles of sound banking as well as international best practices. The ICB lending facilities are not to be granted ad libitum, but some limit must be provided, and an interest rate must be paid by those countries obtaining the ICB (unconditional) financial assistance. The interest rates paid by deficit countries on their borrowings, from either surplus countries or the ICB, would depend on the extent of their trade deficit, stock of foreign debt and capital account balance. A country recording a financial deficit, especially one elicited by capital outflows, is hardly in a position to issue new debt instruments at favourable terms. It must accept either the onus of paying higher rates of interest on new debt, or that of slowing down the national economy by a hike in domestic interest rates in the hope of attracting foreign capital (both short and long term). Alternatively, or additionally, the country might devaluate, hoping thereby to boost exports and improve its trade balance in a not too distant future.8 In fact, the main objection against our plan is that it might invite abuse, and that the quality of the securities sold by deficit countries to the ICB (in its acting as long-term purveyor of funds) might not match the quality of the ICB’s securities sold to surplus countries, so that the quality of the latter financial assets is likely to deteriorate over time too. In this respect, the ICB statutes need to provide some limit, say in terms of a percentage of either total foreign trade or GDP (for instance, calculated on a ten-year moving average), beyond which no country is allowed to finance its current account deficit by selling financial assets – namely, when the country’s risk and stock of debt are already too high for this country to provide sound collateral – and it must thus cut back on its commercial imports and/or increase its exports of real goods and services (not least to pay for debt service, that is, interest on securities sold either to surplus countries or to the ICB to finance the country’s trade deficit). To be sure, no creditor country would suffer from any credit risks under the proposed international settlement system: bancor balances would always be fully, and immediately, convertible into real goods and services sold by any member of the system, or into securities sold either by any (deficit) country or by the ICB acting as a financial intermediary between member countries.

Conclusion The creation of an International Clearing Bank as proposed by Keynes would not be enough to address the problem of funding the economic transactions between trading countries. This chapter shows that a structural monetary reform is needed to provide for final finance in the settlement of current account deficits. In fact, analysing international money and credit with the endogenousmoney paradigm leads to the conclusion that these issues need to be addressed together, to set up an institutional system that can avoid world monetary disorder and financial turmoil.

110

S. Rossi

The delivery-versus-payment protocol that we propose for the international settlement machinery guarantees that each monetary transaction between any two countries gives rise to both a transfer of funds via the ICB ledger and a transfer of securities between the countries involved by the final payment in bancor (or whatever the name of the international money will be). The first merit of our system would indeed consist in introducing a mechanism by means of which any surplus country spends its bancor balances as soon as it earns them, so that at the end of each settlement day no credit balances at the ICB would be held idle.9 If the latter balances were not spent by surplus countries buying the securities sold by deficit countries, a protocol would make sure that end-of-day bancor balances are automatically spent by the same surplus countries for the purchase of ICB’s securities. If international settlements are carried out through the monetary and financial intermediation of the ICB, then each local currency will be instantaneously exchanged against itself through international money. In the example we analysed in the previous section, for instance, x units of MA are supplied (against z bancor) in the payment of country A’s trade deficit, at the same time as x units of MA are demanded (against z bancor) in payment of the securities sold by country A. Similarly, y units of MB are demanded (against z bancor) in the payment of country B’s trade surplus, at the same time as y units of MB are supplied (against z bancor) in payment of the securities bought by country B. Each currency being simultaneously supplied and demanded against an identical amount of bancor, its exchange rate can never be affected by international transactions – be they on product or financial markets. Hence, speculation cannot alter exchange rates in such a system. To be sure, even though there may still exist a ‘cash’ market for foreign exchange on which local currencies can be traded according to individual supply and demand conditions, arbitrage between this market and the structurally reformed international payment system makes sure that the former market prices will rapidly converge to official exchange rates: either one of the trading parties, in fact, will take advantage of the official exchange rate to carry out its foreign exchange transactions, so as to bring the ‘cash’ exchange rate in line with the official rate necessarily and before long. This international payment machinery is particularly needed in today’s world of free international capital flows and multi-currency international banking. To be sure, these are essential characteristics of modern open economies, be they advanced, emerging or in transition, and their importance has been growing in line with the emergence of globalized financial markets. In spite of highly integrated financial markets, however, the international infrastructure for the settlement of cross-border transactions is still fragmented, and one may even say cacophonic. This represents a major limitation of cross-border transactions, because they lack a sound monetary–institutional framework within which international payments can occur without generating destabilizing effects on exchange rates, current and capital accounts, interest rates, and thus affect economic performance negatively. As a matter of fact, the Continuous Linked Settlement (CLS) system operated by the New York based CLS Bank as from 9

The Keynes plan 60 years later 111 September 2002 represents the private sector answer to globalized financial markets and the changed structure of the balance of payments, in which capital flows are now prominent. This system allows the settlement of foreign-exchange transactions in some major national currencies. In this system, various central banks provide accounts and some also offer settlement services for CLS participating banks. What is still lacking, however, is a settlement institution for central banks themselves, which would notably homogenize their national currencies by the emission of an international central bank money that would guarantee exchange rate stability – though not fixity. Indeed, in the system we propose, any participating currency would have an exchange rate that is stable (although not fixed) in terms of bancor, hence also in terms of any other participating currency, in a framework of free capital movements,10 without this being incompatible with a high degree of flexibility in policy making. In fact, our plan grants another major benefit to participating countries, because it increases their room for manoeuvre when gearing their economic policies (particularly an autonomous and independent monetary policy) to the needs of their domestic economies. The age-long conflict between domestic and external goals of a country’s monetary policy would therefore be solved definitively, to the benefit of growth, employment and effective demand. A number of questions, however, remain to be addressed and should be on the agenda of an international conference aiming to reform the international payment system in the spirit of Keynes. In the system we propose in this chapter, indeed, and up to some limit (see above): no individual member State would be prevented from determining for itself to what extent it wished to allow its Current Account to be unbalanced. . . . Such a country might aim, for instance, at a drastic over-valuation of its own currency, thus being able to pay highly attractive prices for its imports and making its (potential) exports inordinately dear to the foreigner. (Kalecki and Schumacher 1943: 30) If so, then on what grounds should a country’s policy makers determine the exchange rate of the local currency against the bancor, within the limits outlined in the previous section? The answer depends on the country’s policy targets. A country might decide to have a current account surplus, to secure employment and have a positive amount of net investment abroad, or it might decide to have a current account deficit, to develop itself through foreign capital inflows.11 In either case, the exchange rate (between the local currency and the bancor) has to be set at a level that allows the country to hit its external target. Further, a country may have an output/employment target that it may want to hit using (also) the exchange rate instrument. If so, then the exchange rate between its currency and the bancor should be set at a level compatible with this goal. Any other policy variable may be considered, of course, the important point being that the country concerned will be able to set, and modify (if necessary),12 the exchange rate of its currency against the bancor, which would become the

112 S. Rossi standard of the structurally-reformed international monetary system. In such a system, monetary and exchange-rate policy decisions could be taken according to the real needs of increasingly-open market-economies – be they advanced, emerging, developing, or in transition.

Acknowledgements Earlier versions of this chapter were presented at the History of Economic Thought conference held at the University of Leeds, UK, on 3–5 September 2003, and at the European Society for the History of Economic Thought conference held at the University of Treviso, Italy, on 26–29 February 2004. The author would like to thank conference participants and an anonymous referee for their very helpful comments. Research and bibliographic assistance by Nunzio Canova and Dante Caprara is also gratefully acknowledged. The usual disclaimer applies.

Notes 1 See also Schumacher (1943a and 1943b), Kalecki and Schumacher (1943) and Schumacher and Balogh (1944). 2 As recent central-bank literature indicates, a final payment is ‘the discharge of an obligation by a transfer of funds and a transfer of securities that have become irrevocable and unconditional’ (Committee on Payment and Settlement Systems 2003: 496). The fourth section elaborates on this point. 3 ‘Keynes observed that the logic of bank money implied the hierarchical structure of banking systems. Within countries inter-bank settlements are daily proceeded in central bank money after multilateral clearing of net bank exposure. Keynes thought that the same logic could be forwarded to international settlements, if a third stage was built in linking national banking systems together’ (Aglietta 2004: 52). 4 Davidson (2002: 232) calls for an analogous system, substituting the bancor with what he labels the International Money Clearing Unit (IMCU). 5 ‘The liability of this institution [Keynes’s ICB] would be the exclusive international reserve asset for national central banks’ (Aglietta 2004: 52). Davidson (2002: 232) argues in the same vein, considering the IMCU as ‘the unit of account and ultimate reserve asset for international liquidity’. 6 According to Schumacher (1943b: 16), ‘[t]he great merit of the [Keynes] Plan is that, by a mutual exchange of overdraft facilities, it restores the international liquidity of countries. It should not claim more than this. It should not claim (par. 12) that it amounts to “the substitution of a credit mechanism in place of hoarding.” It does not abolish international hoarding. On the contrary, it creates a new object for hoarding, bancor balances’. 7 This contrasts with netting systems, in which only the net position of each participant is settled with a money transfer on the accounts held at the settlement institution, ‘such as would have been settled under the old gold standard by the shipment or earmarking of gold’ (Keynes 1980: 125). 8 The bancor standard is not a system of irrevocably fixed exchange rates. Generally speaking, ‘[c]hanges in parities can take place when money wages and profit margins relative to productivity are permanently out of line, or when countries experience chronic difficulties in their balance of payments for other reasons’ (Arestis and Sawyer 1997: 363).

The Keynes plan 60 years later 113 9 International hoarding would thus be mechanically impossible. By way of contrast, see note 6. 10 Two-way convertibility between any participating currency and the bancor through the proposed two-department bookkeeping system in the national central banks (see Table 7.3) amounts to free capital flows across national borders. This contrasts with the one-way convertibility mechanism called for in the Davidson proposal (2002: 232), which permits each nation to control and regulate international capital movements, but which seems unrealistic in the current framework of full financial liberalization. 11 As argued by Kalecki and Schumacher (1943: 29), ‘[t]here is no merit in a general policy aiming at Current Account equilibrium for all countries, because different countries are at different stages of economic development, and a regular flow of investment from the more highly developed to the more backward regions of the world may redound to the benefit of all’. 12 The possibility of modifying the exchange rate is necessary to correct it in case of non-attainment of the relevant target (defined with respect to foreign trade, real growth, inflation or any other policy variable). In addition, the ICB may also be given the statutory power to require exchange rate changes if current account surpluses threaten economic growth in deficit countries, or if overvaluation of a currency’s exchange rate threatens financial stability.

References Aglietta, M. (2004) ‘The International Monetary Fund: past and future’, in M. Desai and Y. Said (eds) Global Governance and Financial Crises, London: Routledge. Arestis, P. and Sawyer, M. (1997) ‘Unemployment and the independent European System of Central Banks: prospects and some alternative arrangements’, American Journal of Economics and Sociology, 56: 353–67. Cencini, A. (2001) ‘What future for the international and the European monetary systems?’, Research Laboratory of Monetary Economics Working Papers, no. 4. Committee on Payment and Settlement Systems (2003) Payment and Settlement Systems in Selected Countries, Basle: Bank for International Settlements. Davidson, P. (2002) Financial Markets, Money and the Real World, Cheltenham: Edward Elgar. Gnos, C. (1998) ‘La théorie monétaire de Keynes: les enseignements du plan d’une Union de Compensation’, Économie Appliquée, 51: 79–94. Guttmann, R. (1988) ‘Crisis and reform of the international monetary system’, in P. Arestis (ed.) Post-Keynesian Monetary Economics: new approaches to financial modelling, Aldershot: Edward Elgar. —— (1994) How Credit-Money Shapes the Economy: the United States in a global system, New York: M. E. Sharpe. Kalecki, M. and Schumacher, E. F. (1943) ‘International clearing and long-term lending’, Bulletin of the Oxford University Institute of Statistics, 5 (Supplement): 29–33. Keynes, J. M. (1980) The Collected Writings of John Maynard Keynes, vol. XXV, Activities 1940–1944. Shaping the Post-War World: the Clearing Union, ed. by D. E. Moggridge, London: Macmillan and Cambridge University Press. Lutz, F. A. (1963) ‘The problem of international liquidity and the multiple-currency standard’, in H. G. Grubel (ed.) World Monetary Reform: plans and issues, Stanford: Stanford University Press and Oxford University Press. Rossi, S. (2005) ‘Central banking in a monetary theory of production: the economics of

114 S. Rossi payment finality from a circular-flow perspective’, in G. Fontana and R. Realfonzo (eds) The Monetary Theory of Production: tradition and perspectives, Basingstoke: Palgrave Macmillan. Rueff, J. (1979) Oeuvres complètes, Paris: Plon. Schmitt, B. (1973) New Proposals for World Monetary Reform, Albeuve: Castella. —— (1985) ‘Un nouvel ordre monétaire international: le plan Keynes’, in F. Poulon (ed.) Les écrits de Keynes, Paris: Dunod. Schumacher, E. F. (1943a) ‘Multilateral clearing’, Economica, 10: 150–65. —— (1943b) ‘The new currency plans’, Bulletin of the Oxford University Institute of Statistics, 5 (Supplement): 8–28. Schumacher, E. F. and Balogh, T. (1944) ‘An International Monetary Fund’, Bulletin of the Oxford University Institute of Statistics, 6: 81–93. Stamp, M. (1963) ‘The Stamp plan – 1962 version’, in H. G. Grubel (ed.) World Monetary Reform: plans and issues, Stanford: Stanford University Press and Oxford University Press.

8

Price and prejudice The statics and dynamics of money-wage flexibility Annamaria Simonazzi and Fernando Vianello

Introduction In the last decade of the twentieth century concern over the havoc wrought by deflation in Japan and the threat of contagion of ‘nipponitis’ to other developed economies aroused new interest in deflation as a theoretical subject, but does not appear to have undermined the reassuring belief (‘prejudice’) that, as a rule, money-wage flexibility (‘price’) can be counted on to make the economic system self-adjusting.1 To tell the story of how the above belief, peculiar to ‘classical’ economics, survived Keynes’s critique is among the aims of the present chapter. The idea put forward by Keynes in Chapter 19 of the General Theory – partly relying on his own and Irving Fisher’s previous analyses of deflation – is that under money-wage flexibility any departure from full employment would trigger a cumulative fall in prices and aggregate demand. What makes the real-world economy stable is indeed, in his opinion, the circumstance that money wages do not fall without limit as long as labour supply exceeds labour demand. Some aspects of Keynes’s (1923) and Fisher’s (1932 and 1933) analyses of deflation will be examined in the first section as a preliminary to the reconstruction – offered in the second section – of Keynes’s (1936) treatment of moneywage flexibility. Fisher’s and Keynes’s approaches, it will be pointed out in the above sections, are dynamic in nature, in the sense that both authors are concerned with the fall in (money wages and) prices as a process. In the third section we shall illustrate a scarcely noticed aspect of Keynes’s position, namely, its open-endedness as far as the final outcome of the deflationary process is concerned. A critical appraisal of the subsequent rehabilitation of the static analysis of money-wage flexibility – with its accompanying ‘closure’ of the Keynesian system, and vindication of the economy’s capacity for selfadjustment – will be provided in the fourth section. Not even in static analysis, it will be contended in the following two sections, can money-wage flexibility be reckoned to bring about a rise in aggregate demand and employment. As is well-known, the logical basis of the decreasing relationship between the demand for capital (as a stock and as a flow) and the rate of interest has been shown to be flawed. From this it follows that what has

116

A. Simonazzi and F. Vianello

become known as the ‘Keynes effect’2 falls to the ground (see Garegnani 1978–1979) and the deflation-induced redistribution of real wealth from debtors to creditors results in a completely (rather than partially, as in Tobin 1978) upward-sloping AD curve. As against the claim that the ‘Pigou’, or ‘real balance’ effect (as called in Patinkin 1948 and 1956, respectively) will eventually get the upper hand over the above redistribution (or ‘reverse Pigou’) effect, we shall maintain in the final section that whenever the task of causing aggregate demand to rise is assigned to a mechanism which takes a considerable time to produce its effects, a further difficulty arises. For long-lasting excess capacity will cause the productive capacity installed (which Keynes was taking as given) to shrink. Moreover, persistent unemployment will probably result in ‘discouraged’ workers leaving the labour market. Unemployment may thus disappear through an entirely different road than that envisaged by believers in the self-adjusting properties of the economic system.

Fisher and Keynes on deflation In Keynes’s Tract on Monetary Reform, published in the aftermath of the severe post-World War I deflation, a fall in prices is said to effect a redistribution of real wealth from those ‘who make the decisions which set production in motion’ to those ‘who are inactive once they have lent their money’ (Keynes 1923: 30). In Chapter 4, Section 1 of the Tract a debt is acknowledged, in this connection, to Irving Fisher’s article ‘Devaluation versus Deflation’, published in one of the ‘Reconstruction in Europe’ supplements to The Manchester Guardian Commercial, of which Keynes was the editor (11th Supplement, 7 December 1922). The title of the section is the same as that of Fisher’s article. Some ten years later observation of the disaster caused by falling prices in the Great Depression led Fisher to elaborate his celebrated Debt-Deflation Theory of the Great Depressions (Fisher 1933; see also 1932). According to this theory, overindebtedness, which (together with the over-investment and over-speculation it makes possible) characterizes the later stages of a boom, ‘will tend to lead to liquidation, through the alarm either of debtors or creditors or both’ (Fisher 1933: 341–2), thus triggering a chain of repercussions including ‘distress selling’; ‘contraction in deposit currency, as bank loans are paid off’; ‘a slowing down of velocity of circulation’; ‘a fall in the level of prices’; ‘a still greater fall in the net worth of business, precipitating bankruptcies’; ‘a like fall in profits’, which causes ‘a reduction in output, in trade and in employment of labour’. Falling profits, bankruptcies and unemployment give rise to ‘pessimism and loss of confidence’ (ibid.: 342).3 The fall in prices, Fisher contends, will cause not only ‘a rise in the real, or commodity, rates’ (in spite of the accompanying ‘fall in the nominal, or money, rates’) (ibid.: 342), but also a rise in the real debt to be paid off. Thus, deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debt cannot keep up with the

Dynamics of money-wage flexibility 117 fall of prices which it causes. In that case, liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed . . . The more the debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing. (ibid.: 1933: 344) Although no reference to the above analysis can be found in Keynes’s General Theory, the rise in the real burden of debt plays a key role in his account of the consequences of deflation. ‘Indeed if the fall of . . . prices goes far’, he observes, ‘the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency’ (Keynes 1936: 264). The consequent inability to carry out investment and production plans4 will adversely affect aggregate demand and the expectation of future yield from capital assets, thus causing the willingness to invest, too, to fade away. In the Tract Keynes draws attention not only to the consequences of an actual fall in prices, but also to those of an expected fall. ‘During the lengthy process of production’, he observes, the business world is incurring outgoings in terms of money – paying out in money for wages and other expenses of production – in the expectation of recouping this outlay by disposing of the product for money at a later date . . . Now, it follows from this that if prices are expected to fall . . . entrepreneurs will be reluctant to embark on lengthy productive processes involving a money outlay long in advance of money recoupment – hence unemployment. (Keynes 1923: 33–4) The same ‘monetary’ approach to the problem5 is to be found in the General Theory, where the marginal efficiency of a capital asset is said to result from the sum of money to be spent on its purchase and the money yield expected from its employment in production. Given the schedule of the marginal efficiency of capital, investment will be pushed to the point where the marginal efficiency of capital equals the (long-term) nominal rate of interest. An implication of this is that the expectation of a fall in the value of money stimulates investment, and hence employment, because it raises the schedule of the marginal efficiency of capital, i.e. the investment demand schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital. (ibid.: 141–2) This, Keynes asserts, is ‘the truth behind Professor Irving Fisher’s . . . distinction between the money rate of interest and the real rate of interest’ (ibid.: 142). Fisher is, however, wrong ‘in supposing that it is the rate of interest on which

118

A. Simonazzi and F. Vianello

prospective changes in the value of money will directly react, instead of the marginal efficiency of a given stock of capital’ (ibid.: 142). Widely shared as it is, this reading of Fisher’s position should be qualified to the effect that in his view the adjustment of the money rate of interest takes a considerable time, during which inflation lowers the real rate and deflation raises it (see Tobin 1985: 36 and 1987: 375) – this being in fact an important aspect of his theory of business cycles, as expounded in Fisher (1923) and (1925), as also of his account of the dynamics of the Great Depression (Fisher 1932 and 1933).6 Needless to say, the above qualification makes Fisher’s view of the impact of (expected) deflation on investment less far from Keynes’s than the latter was prepared to concede.

Keynes’s case against money-wage flexibility In the General Theory the arguments reviewed above come into consideration as part of a more general argument, aimed at showing that the fall in money wages cannot be relied upon as a means to reach full employment. The latter argument is conducted in two stages. It is first contended (in Chapter 2) that, if aggregate demand remains unchanged, employment and the real wage (equal to the marginal productivity of labour) remain unchanged, too; this amounts to saying that a fall in money wages has no other effect than to cause money prices to fall in the same proportion. Subsequently (in Chapter 19) it is contended that the fall in money wages and prices is ineffective in causing aggregate demand to rise – and is, indeed, a source of instability. (In Chapters 3 to 18 money wages are assumed to remain constant. ‘But this simplification’, Keynes warns his readers, ‘is introduced solely to facilitate the exposition. The essential character of the argument is precisely the same whether or not money wages . . . are liable to change’; Keynes 1936: 27). The only way in which a fall in money wages and prices can affect aggregate demand, Keynes submits in Chapter 19, is through its effects on the three ‘independent variables’ (ibid.: 245) of his system – the marginal propensity to consume, the schedule of the marginal efficiency of capital and the rate of interest (see ibid.: 260). Now, as far as the marginal propensity to consume is concerned, the influence of the redistribution of real income (mainly from entrepreneurs to rentiers) operated by a fall in money wages and prices ‘is more likely to be adverse than favourable’ (ibid.: 262). A further transmission mechanism explored by Keynes goes from a fall in money wages and prices to a fall in the demand for money and in the rate of interest, and from the latter to a rise in investment. To rely on this mechanism (the ‘Keynes effect’) would, however, be wrong, in Keynes’s opinion, for two independent reasons. The first reason is that the longterm rate of interest may prove poorly sensitive to increases in the quantity of money in terms of the wage-unit. The second is that falling money wages and prices adversely affect the marginal efficiency of capital. As far as the rate of interest is concerned, Keynes makes the point that Just as a moderate increase in the quantity of money may exert an inadequate influence over the long-term rate of interest, whilst an immoderate

Dynamics of money-wage flexibility 119 increase may offset its other advantages by its disturbing effects on confidence; so a moderate reduction in money-wages may prove inadequate, whilst an immoderate reduction might shatter confidence even if it were practicable. (ibid.: 266–7) We are thus referred back to Chapters 13 and 15 of the book, where the efficacy of an increase in the quantity of money in forcing down the rate of interest is discussed. In Chapter 13 Keynes submits that a large increase in the quantity of money may cause so much uncertainty about the future that liquidity-preferences due to the precautionary motive may be strengthened; whilst opinion about the future of the rate of interest may be so unanimous that a small change in present rates may cause a mass movement into cash. (ibid.: 172) Near-unanimity of opinion is treated as the normal case in Chapter 15, where the rate of interest is described as a ‘highly conventional’ phenomenon, and its actual value is said to be ‘largely governed by the prevailing view as to what its value is expected to be’ (ibid.: 203). While ‘The short-term rate of interest is easily controlled by the monetary authorities’, Keynes contends, ‘the long-term rate may prove more recalcitrant’ (ibid.: 203) – and may even ‘fluctuate for decades about a level which is chronically too high for full employment’ (ibid.: 204). A few lines below we read: The difficulty in the way of maintaining effective demand at a level high enough to provide full employment, which ensues from the association of a conventional and fairly stable long-term rate of interest with a fickle and highly unstable marginal efficiency of capital, should be, by now, obvious to the reader. (ibid.: 204) Needless to say, the above difficulty is bound to become much greater if the task of forcing down the rate of interest is to be assigned to the fall in money wages and prices, rather than to the ‘persistence and consistency of purpose of the monetary authority’ (ibid.: 204). Let us now turn to the second of the two reasons, referred to above, why Keynes holds that the ‘Keynes effect’ does not work. His position, as reconstructed in the section above, is that while the actual fall in prices causes the real burden of debt to increase, thus bringing about financial distress and bankruptcies, their expected fall undermines the profitability of investment.7 To this it must now be added that in Keynes’s opinion the actual fall in prices will normally generate the expectation of a further fall (see ibid.: 263 and 265; see also below). It follows that, even in the event that a fall in (money wages and) prices

120

A. Simonazzi and F. Vianello

is capable of forcing down the rate of interest, any favourable effect this may be expected to have on investment is likely to be outweighed by ‘the schedule of the marginal efficiency of capital . . . falling more rapidly than the rate of interest’ (ibid.: 173). Joint consideration of the above two reasons leads Keynes to conclude that if labour were to respond to conditions of gradually diminishing employment by offering its services at a gradually diminishing monetary wage, this would not, as a rule, have the effect of reducing real wages and might even have the effect of increasing them, through its adverse influence on the volume of output. (ibid.: 269) This being so, it is obvious that in the real-world economy the stickiness of money wages (to be distinguished from their assumed constancy) plays the allimportant role of preventing unemployment from setting in motion a disruptive deflationary process.

Alternative resting places Suppose, however, that money wages were flexible. What would the final outcome of the deflationary process be like? The problem is touched upon incidentally in a handful of passages, scattered in different chapters of the General Theory. Workers, we find it stated in Chapter 18, will not seek a much greater money-wage when employment improves or allow a very great reduction rather than suffer any unemployment at all . . . whether or not this conclusion is plausible a priori, experience shows that some such psychological law must actually hold. For if competition between unemployed workers always led to a very great reduction of the money-wage, there would be a violent instability in the price-level. Moreover, there might be no position of stable equilibrium except in conditions consistent with full employment; since the wage-unit might have to fall without limit until it reached a point where the effect of the abundance of money in terms of the wage-unit was sufficient to restore full employment. At no other point could there be a resting place. (ibid.: 253) The foregoing passage appears to suggest that the continuous growth in the quantity of money available for satisfying the speculative and precautionary motives may eventually sweep away all the obstacles lying in the way of full employment. A passage in the Appendix to Chapter 14 qualifies the above reasoning to the effect that liquidity preference may ‘become absolute’, thus preventing the rate of interest from falling further, before full employment is reached:

Dynamics of money-wage flexibility 121 in the extreme case where money-wages are assumed to fall without limit in face of involuntary unemployment through a futile competition for employment between the unemployed labourers, there will . . . be only two possible long-period positions – full employment and the level of employment corresponding to the rate of interest at which liquidity preference becomes absolute. (ibid.: 191) Reference to liquidity preference becoming absolute is, indeed, ambiguous, since such a thing may occur at any level of the rate of interest, provided expectations as to the future rate are unanimous (see ibid.: 172; see also above). What Keynes appears to have in mind here is, however, a threshold below which the rate of interest cannot possibly fall. Such a ‘lower limit’, we read in a passage from Chapter 16, ‘in present circumstances may perhaps be as high as 2 or 2
 per cent, on long term’ (ibid.: 219; see also 309, fn. 1). The ‘possibility . . . that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute’ is also referred to in a passage from Chapter 15. Of this ‘limiting case’, Keynes observes, ‘I know of no example . . . hitherto’, although it ‘might become of practical importance in the future’ (ibid.: 207). Observe that only the first of the two above-described ‘long period positions’, namely full employment, is described as ‘a stable equilibrium’. In the second – a situation in which the rate of interest has reached its lower limit – money wages will continue to fall until (we may imagine) they become zero.8 Alternatively, money wages may be thought to become zero before the rate of interest has reached its lower limit. Such a possibility is contemplated in a passage from Chapter 21, where the fall in money prices is said to lead to one of three possible ‘resting places’: full employment, a situation in which the rate of interest has reached its lower limit and one in which money wages are zero: If . . . money-wages were to fall without limit whenever there was a tendency for less than full employment . . . there would be no resting place below full employment until either the rate of interest was incapable of falling further or wages were zero. (ibid.: 304) Keynes’s analysis of the deflationary process is, thus, open-end in character. Whether wages become zero before or after the rate of interest has reached its lower limit – or whether they stop falling before having become zero because full employment is somehow established – will depend on exactly how liquidity preference and the inducement to invest (and to consume) are affected by deflation. And this, in Keynes’s opinion, is a matter on which no general rules can be laid down.

122

A. Simonazzi and F. Vianello

‘A world of difference’ In order to turn the lower limit to the rate of interest – the ‘liquidity trap’, as it is so often called9 – into the only obstacle capable of preventing money-wage flexibility from securing full employment, two steps are required. The first step consists in removing all the obstacles other than the above limit that may prevent a rise in the quantity of money from forcing down the rate of interest. This is done by assuming away the disturbing effects of unanimity of expectations (for all rates of interest higher than the minimum one) and making liquidity preference independent of any change that may occur in the quantity of money. The nature and purport of this step will be easily grasped by comparing the difficulties Keynes envisages the monetary authorities encountering in their attempt to force down the rate of interest, described above, with the fairly automatic consequences of a rise in the quantity of money made possible by the perfectly stable, mainly risk-based liquidity-preference function contemplated in Hicks (1937) or Modigliani (1944). The second step consists in treating a fall in money wages and prices as perfectly equivalent to a rise in the quantity of money. According to Modigliani’s well-known formulation, unemployment results from a basic maladjustment between the quantity of money and the wage rate. It is the fact that money wages are too high relative to the quantity of money that explains why it is unprofitable to expand employment to the ‘full employment’ level. (Modigliani 1944: 77) The view that money wages are sticky is, according to Modigliani, the central aspect of Keynes’s position, and the ultimate reason why his conclusions differ from those of ‘classical’ economics. If, however, wages were flexible, this would correct the ‘basic maladjustment’ no less effectively than an increase in the quantity of money. The only case in which neither remedy is effective – the case of ‘liquidity trap’ – is dubbed by Modigliani ‘the Keynesian case’ (ibid.: 74). The resulting ‘closure’ of the Keynesian system can be described as near perfect, since the ‘Keynesian case’ is, in Modigliani’s words, ‘the exception and not the rule’ (ibid.: 76). As against the equivalence between a fall in money wages and a rise in the quantity of money, Keynes had pointed out beforehand that while a flexible wage policy and a flexible money policy come, analytically, to the same thing inasmuch as they are alternative means of changing the quantity of money in terms of wage-units, in other respects there is, of course, a world of difference between them. (Keynes 1936: 267) In Modigliani’s article one part of this ‘world of difference’ – the effects of deflation on the financial situation of entrepreneurs – is ignored outright.

Dynamics of money-wage flexibility 123 Another part is, instead, explicitly assumed away. ‘In order to simplify our task’, Modigliani writes, our analysis proceeds in general, under ‘static’ assumptions; this does not mean that we neglect time, but that we assume the Hicksian (total) ‘elasticity of expectation’ to be always unity . . . Since all the theories we examine or formulate in this paper are concerned with the determinants of equilibrium and not with the explanation of business cycles, this simplification, although it is serious in some respects, does not seem unwarranted. (Modigliani 1944: 45–6) In Hicks’s own words a unity ‘elasticity of expectation’ implies that a change in current prices will change expected prices in the same direction and in the same proportion; if prices were previously expected to be constant at the old level, they are now expected to be constant at the new level; changes in prices are expected to be permanent. (Hicks 1939: 205) What the above assumption rules out is both the ‘favourable’ contingency in which ‘money wages are believed to have touched the bottom, so that further changes are expected to be in the upward direction’ (Keynes 1936: 265), and the ‘unfavourable’ contingency in which ‘the reduction [in money wages] leads to the expectation . . . of a further wage-reduction in prospect’ (ibid.: 263). It is, however, the latter contingency that Keynes regards as normal ‘under a system of free wage bargaining’, while the former would require the wage reduction to ‘be accomplished by administrative decree’, as may perhaps happen ‘in Italy, Germany or Russia, but not in France, the United States or Great Britain’ (ibid.: 269).10

Money-wage flexibility and the investment function In the above discussion it has been taken for granted that investment is a decreasing function of the rate of interest. However, in the aftermath of the Second World War this appears to have been far from undisputed. For the experience of the 1930s had caused considerable distrust in the efficacy of cheap-money policy in fostering investment; and the relevance of rate-of-interest considerations for investment decisions had been cast doubt on by the surveys conducted before the war by the Harvard Business School (see Ebersole 1938) and the Oxford Economists’ Research Group (see Wilson and Andrews 1951; see also Shackle 1946). As a result, it was not uncommon to find Keynesian authors holding that ‘producer expenditures for capital equipment are insensitive to changes in the rate of interest’ (Klein 1947: 64) and even criticizing Keynes for having made use of ‘the marginal efficiency of investment (itself a first cousin of the old

124

A. Simonazzi and F. Vianello

productivity concept)’ and the implied notion of a rate of interest which ‘would call forth a full employment rate of investment’ (Musgrave 1948: 79).11 In the same vein, Tobin made the point that Modigliani’s ‘Keynesian case’ was by no means the only exception to the ‘wage-rigidity explanation of unemployment’; for a zero interest-elasticity of the demand for investment ‘would constitute another and very important exception’ – this consideration being ‘supported by the evidence that interest calculations play an insignificant part in business investment decisions’ (Tobin 1947: 576 and 576, fn. 1). In the 1950s the findings of the empirical studies carried out in the 1930s began, however, to come in for critical reappraisal and to be regarded as reflecting the special conditions of the Great Depression (see Schlesinger 1960: 602–3). It was increasingly argued that although investment may be less responsive to changes in the rate of interest than is assumed by the ‘classical’ theory, it is more so than some Keynesians previously held (see White 1956: 113). In the end, recognition of a considerable interest-elasticity of investment became the cornerstone of the new consensus view among American economists – aptly described in the fifth edition of Paul Samuelson’s textbook as ‘a grand neoclassical synthesis’ (Samuelson 1961: 403). According to neoclassical theory – accepted by the ‘Classics’, Keynes and the neoclassical synthesis alike – the interest-elasticity of the demand for investment, or for capital as a flow, reflects the interest-elasticity of the demand for capital as a stock, investment being the means by which the gap between the desired and the existing ‘quantity of capital’ is bridged. In the long run the relentless action of the systematic forces tending to cause the demand for capital to rise as the rate of interest falls – the substitutability in production between capital and labour and the substitutability in consumption between goods produced with different proportions of capital to labour – will easily outweigh, it is maintained, the capricious and ephemeral influences which make the marginal efficiency of capital ‘fickle and unstable’ (Keynes 1936: 204; quoted more fully above). However, it has been shown by Sraffa (1960) that the substitutability between capital and labour – and, by implication, the substitutability between consumer goods produced with different proportions of capital to labour – cannot be reckoned to work systematically in the direction assumed by the neoclassical theory. Once this is recognized, the familiar decreasing relationship between the demand for capital and the rate of interest turns out to be devoid of any theoretical ground (see Garegnani 1966 and 1970 and Samuelson 1966). And the same is true, as pointed out by Garegnani (1978–1979), of the relationship between the demand for investment and the rate of interest.12 (Nor can believers in the existence of such a relationship take much comfort from post-Second World War empirical studies on the subject.)13 The thesis that money-wage flexibility is unable to secure full employment through its effects on the rate of interest – argued by Keynes on dynamic grounds – is thus reasserted on static grounds, and placed on a more comprehensive theoretical basis than the one which Keynes himself was able to provide.

Dynamics of money-wage flexibility 125

The ‘Pigou effect’ and the ‘reverse Pigou effect’ Since Patinkin (1948), and its (1951) revised version, the ‘classical’ position was, however, increasingly defended on a new static ground: the ‘Pigou effect’, the canonical references for which are Haberler (1937)14 and Pigou (1943). The transmission mechanism implied – the discouragement of saving consequent upon the increase in the real value of the net wealth of the private sector denominated in money15 – was such as to ensure that under money-wage flexibility a full employment equilibrium existed also in the cases of an infinite interest-elasticity of the demand for money and of a zero interest-elasticity of the demand for investment. In a passage inserted in the 1951 version of Patinkin’s paper it is incidentally observed that the ‘Pigou effect’ may be jeopardized by debtors being ‘discouraged by a price decline much more than creditors are encouraged’, and that ‘a persistent price decline will cause a wave of bankruptcies’, in most of which ‘creditors also lose’ – the author’s conclusion being that only ‘further investigation’ will tell us whether a price decline does indeed have a positive net effect on total expenditure (see Patinkin 1951: 263). Similar considerations stand at the basis of Tobin’s ‘reverse Pigou effect’ (Tobin 1978: 15). As against the fashionable assumption that ‘agents are all alike’ (ibid.: x), Tobin observes that ‘Debtors are debtors because they have high propensities to spend’ (Tobin 1975: 197), be it for consumption or investment purposes. It follows, he contends, that the redistribution of real wealth operated by deflation causes the propensity to spend of the community to fall.16 The consequences of money-wage flexibility are analysed by Tobin by combining the ‘reverse Pigou effect’ with the ‘Keynes effect’. While the ‘Keynes effect’ works in the conventional direction, shifting the LM curve to the right, the ‘reverse Pigou effect’ shifts the IS curve to the left. Whether aggregate demand and production rise or fall will depend on the relative strength of the two effects – the traditional curvature of the LM ensuring, however, that the ‘Keynes effect’ becomes weaker and weaker as the price level and the rate of interest fall, to vanish altogether as soon as the ‘liquidity trap’ prevails. The resulting AD curve, as drawn by Tobin (see ibid.: 17), is upward-sloping at price levels corresponding to low interest rates, though at higher price levels and interest rates it assumes its traditional downward-sloping shape. If, however, as held long ago by Tobin himself (and many others) on empirical grounds and later argued by Garegnani on theoretical grounds, no decreasing relationship can be established between investment and the rate of interest (see above), then the ‘reverse Pigou effect’ has no need to outweigh the ‘Keynes effect’ in order to cause aggregate demand to fall, this implying that the AD curve is upwardsloping at all price levels. According to Tobin (1978: 11–12), the ‘reverse Pigou effect’ operates under the ‘short run’ assumption that debts contracted when money wages and prices were higher are still in existence. If, instead, the ‘long run’ assumption is made that no existing debt was contracted when prices were higher, then the ‘Pigou

126

A. Simonazzi and F. Vianello

effect’ will reign undisturbed, ensuring that (the net wealth of the private sector denominated in money being taken as given) employment is the higher, the lower money wages and prices.

Static analysis and the real-world economy A dynamic theory is, in Haberler’s words, ‘a theory that explains how a situation grows out of the foregoing’ (Haberler 1958: 250).17 As far as the problem of money-wage flexibility is concerned, a more specific reference is Tobin’s distinction between the (static) ‘price level effect’ and the (dynamic) ‘price change effect’ (Tobin 1975: 197). What Keynes claims is, in Tobin’s words, that ‘declining money wage rates are unfavourable to aggregate demand’ (ibid.: 195). What Modigliani (1944)18 and Patinkin (1948) claim (and Tobin concedes, if only as far as the ‘long run’ is concerned) is, instead, that lower money wages entail a higher aggregate demand. As we have seen above, Modigliani endeavours to shorten the distance between static and dynamic analysis by assuming the ‘elasticity of expectation’ to be always unity. Patinkin’s position is different. He acknowledges that ‘The end result of letting the Pigou effect work itself out may be a disastrous deflationary spiral, continuing for several years without ever reaching any equilibrium position’ (Patinkin 1948: 558). While, however, making this point consistently and as forcefully as possible (see Patinkin 1974, 1976 and 1987), he describes it as relevant to economic policy rather than to economic theory. Thus, the first part of his 1948 paper (Sections 1 to 9) is devoted to illustrating the ‘Pigou effect’ and to stressing its importance in static analysis; in the second part of the paper (Sections 10 to 12) it is, instead, contended that ‘dynamic considerations invalidate’ the use of price decline ‘as an immediate policy, regardless of its merits in static analysis’ (Patinkin 1948: 557).19 We are thus faced with an analysis which admittedly provides no key to current economic affairs and the policy measures to be adopted. If such an analysis is to be given any meaning at all, we submit, it must be believed to capture certain underlying tendencies of the real-world economy which, although temporarily outweighed by factors working in the opposite direction, are bound to assert themselves over a sufficiently long span of time – say, long enough for repayment and bankruptcies to have cleared the ground from debts contracted when prices were higher (as in Tobin’s ‘long run’), and expectations of further deflation to have been superseded by more encouraging ones. No solid ground for the above belief can, however, be found. What Patinkin says of ‘a successful anti-depression policy’ – namely, that ‘it should be able to achieve its objective rapidly’ (Patinkin 1951: 272) – is, indeed, true also of the theoretical mechanism to which one assigns the task of securing full employment. For persistent excess capacity will lead to dismantlement or lack of replacement of existing equipment. If in the initial situation the productive capacity installed was sufficient to employ the whole labour force of the country (as assumed by Keynes), this will no more be so (see Garegnani

Dynamics of money-wage flexibility 127 1978–1979, Part I: 337). The fall in actual and potential employment, it may be added, is liable to have negative effects on the rate of participation, and thus on the amount of the labour force. And the economy will presumably change also in other, less predictable ways. Somehow or another, the deflationary process will eventually come to an end, just as (if we are allowed to transplant into the present context a celebrated metaphor from the Tract) ‘when the storm is long past the ocean is flat again’ (Keynes 1923: 65).20 But where the boat will have been carried by the wind cannot be known in advance. (If, as Fisher imagines, it has capsized, it will require some effort to refloat it and make it capable of sailing again.)

Acknowledgements We are deeply indebted to Giovanni Bonifati, Antonietta Campus, Andrea Ginzburg, Cristina Marcuzzo, Antonella Palumbo, Paolo Trabucchi and an anonymous referee for helpful criticism and advice – though, of course, they bear no responsibility for the remaining mistakes and shortcomings of the text. Financial support from the Italian Ministry for the Universities and Scientific Research (MIUR) is gratefully acknowledged.

Notes 1 Since Krugman (1998), responsibility for the disruptive consequences of the Japanese deflation has frequently been blamed upon the operation of the ‘liquidity trap’ (rescuing this concept from the oblivion to which it had been condemned since the inflationary 1970s), rather than upon deflation as such. Thus a special section on deflation-induced stagnation in Japan has been inserted in latest-vintage textbooks (see, e.g., Blanchard 2003), while retaining the idea that under normal conditions falling money wages and prices, far from being harmful to the economy, cause it to move down along a well-behaved AD function. 2 ‘By the Keynes-effect I mean the hypothesis, granted by Keynes, that an increase in the supply of money, measured in stable purchasing power and caused by falling prices, reduces the rate of interest and thereby favourably influences the volume of investment’ (Haberler 1958: 491, fn. 3). 3 It may be observed, en passant, that – although Fisher’s analysis is conducted on the basis of the quantity theory of money – the fall in prices can be conceived of as the consequence of nothing but the ‘distress selling’ of products aimed at raising the money required to pay off debt, thus making reference to the quantity theory of money unnecessary. 4 As pointed out in Keynes (1931), the fall in the price of assets, which takes place as a part of the general process of deflation, is also liable to cause serious embarrassment of the banks, with negative repercussions on their lending policy. 5 In the preparatory notes for The Monetary Theory of Production – this being the original title of what was to become The General Theory of Employment, Interest and Money – Keynes makes the point that Marx was right in pointing out that ‘the nature of production in the actual world is not, as economists seem often to suppose, a case of C-M-C', i.e. of exchanging commodity (or effort) for money in order to obtain another commodity (or effort). That may be the standpoint of the private consumer. But this is not the attitude of business, which is a case of M-C-M', i.e. of parting with money for commodity (or effort) in order to obtain more money’ (Keynes 1932: 81).

128 A. Simonazzi and F. Vianello 6 As will be recalled, reference to falling prices causing ‘a rise in the real, or commodity, rates’ is made in a passage from Fisher (1933) quoted earlier in this section. 7 A further consequence of the expectation of a fall in prices is ‘the postponement of both investment and consumption’ (ibid.: 263). 8 For a critique of the idea that Keynes proved the possibility of an unemployment equilibrium with flexible money wages, see Patinkin (1948: 562). ‘What Keynesian economics claims’, he observes, ‘is that the economic system may be in a position of underemployment disequilibrium (in the sense that wages, prices and the amount of employment are continuously changing over time) for long, even indefinite, periods of time’ (ibid.: 563; see also Patinkin 1974: 3 and Lejionhufvud 1968: 161). 9 As for this expression, it may be observed that its inventor, Dennis Robertson, used it in a sense that has hardly anything to do with the lower limit to the rate of interest: see Robertson (1940: 19 and 34–6 and also 1936: 190). Elsewhere in the latter paper Robertson does refer to the lower limit to the rate of interest limit, but only to state that it does not stand at the basis of Keynes’s view of the rate of interest as a purely monetary phenomenon (Robertson 1936: 183). 10 According to Oskar Lange (1944: 83), the ‘very special conditions’ (including favourable ‘elasticities of price expectations’) under which ‘price flexibility result[s] in the automatic maintenance or restoration of equilibrium of demand and supply of factors of production’ may have been ‘approximately realized in the long run during a period which extended from the 1840s until 1914. During this period, price flexibility was a workable norm of long-run economic policy. The feeling of stability and security of the economic order which permeated this period (with possible exception during the years 1873–1896), created a strong belief in a “normal” level of certain economic quantities, including prices. Long-range effective price expectations were, therefore, prevailingly inelastic’. Reference to ‘people’s sense of normal prices’ is also made by Hicks (1939: 298) as setting ‘a limit to the fall in wages’ and encouraging entrepreneurs to think that prices have reached the bottom. As far as the latter point (price expectations) is concerned, he observes that ‘when prices have fallen to a certain extent, there will be some entrepreneurs . . . who will begin to think that the prices which have now been reached are abnormally low, and will therefore begin to develop production plans on the basis of a probability of rising prices in the future’. It is worth emphasizing that what Lange describes as a ‘very special’ state of affairs, prevailing under well defined institutional and historical conditions, is treated by Hicks as a normal occurrence. 11 See Keynes (1936: 223), where reference is made to a rate of interest ‘which is consistent with full employment’. 12 For the derivation of the investment function from the demand function for capital as a stock, see Garegnani (1978–1979, Part I: Section 5). The ‘popular derivation’ of the investment schedule based on an array of alternative investment opportunities, and ‘making no explicit reference to capital intensity’, is discussed by Ackley (1961: 472–3, fn. 6). The author shows that the schedule obtained by arraying the investment opportunities from the highest return to the lowest for any given rate of interest ‘cannot serve as the basis for any theory of investment’, namely, for an explanation of what happens if the rate of interest changes. The point is further elaborated in Bonifati and Vianello (1998: 115–17). See also Garegnani (1978–1979, Part II: 78, fn.). 13 Surveys of such studies, made at different points in time, suggest that ‘demand factors as represented by the accelerator are more important than relative prices in determining investment’ (Junankar 1972: 69), or that ‘on balance, the response of investment to price variables tends to be small and unimportant relative to quantity variables’ (Chirinko 1993: 1906). According to Hasset and Hubbard (1996: 32), empirical work trying to relate investment to the cost of capital has been generally disappointing, in spite of the considerable ingenuity devoted to the task of making empirical results conform with the ‘theoretical high ground’; recent studies, using micro-data and

Dynamics of money-wage flexibility 129

14 15

16

17

18

19

20

addressing problems of measurement errors and misspecification of adjustment costs, appear to ‘have reached more promising results’, though ‘one should be cautious . . . in moving from the microeconomic evidence to aggregate predictions’. Patinkin’s reference is to the third (1941) edition of Prosperity and Depressions. However, as has been pointed out by Laidler (1999: 288, fn. 10), the relevant passage can also be found in the first (1937) edition. Kalecki (1944: 132) appears to have been the first to notice that to the extent that money ‘is “backed” by credits to persons and firms . . . to the gain of money holders there corresponds an equal loss of the bank debtors’. We leave aside the question, raised by Barro (1974), of whether government bonds should be reckoned as a part of the net wealth of the private sector. The financial difficulties of both debtors and creditors, too, are referred to by Tobin as a channel through which deflation exerts a negative influence on aggregate demand (see Tobin 1978: 10–11). This aspect is further elaborated in Caskey and Fazzari (1987). Frequent reference to expectations made by Keynes, Haberler observes, ‘has given the impression to many readers that the General Theory of Employment is a dynamic theory’ (Haberler 1958: 252). What makes a theory truly dynamic is not, however, that ‘it runs in terms of expectations’ (ibid.: 252), but that it endeavours to account for ‘the formation of expectations’ (ibid.: 253). Although ‘Mr. Keynes has, of course, much to say’ on this subject, Haberler submits, ‘the dynamic aspects do not penetrate the heart of his theory’ (ibid.: 253). Whatever one may think of this reading of the matter as far as ‘the skeleton of Mr. Keynes’s theory’ (ibid.: 251) is concerned, it surely does not apply to Keynes’s treatment of money-wage flexibility. Though Modigliani (1944) sails most of the time in the wake of Hicks (1937), the latter does not pay attention to the fall in money wages as a way of increasing aggregate demand. This is why we took Modigliani, rather than Hicks, as our main reference. According to Kalecki, the smallness of the wealth capable of serving as a basis for the ‘Pigou effect’ implies that the required fall in money wages and prices ‘would catastrophically increase the real value of debts, and would consequently lead to wholesale bankruptcy and a “confidence crisis”. The “adjustment” would probably never be carried to an end: if the workers persisted in their game of unrestricted competition, the Government would introduce a wage stop under the pressure of employers’ (Kalecki 1944: 132). In static analysis, however, the size of the relevant wealth can in no case prove insufficient to generate full employment. This remains true, Patinkin contends, even if the fall in money wages and prices is accompanied by a larger fall in the money value of such assets as houses and shares. For (as privately pointed out to him by Milton Friedman) no matter how low the value of houses and shares is taken to be, ‘the real value of the fixed stock of money’, and thus of the overall wealth of the private sector, can be made as large as desired by reducing the price level sufficiently’ (Patinkin 1948: 550; see also Friedman 1948: 259, fn. 17). As pointed out by Ginzburg (1986: 70–1, fn. 9), here Keynes is echoing a metaphor employed by J. S. Mill in his Principles of Political Economy.

References Ackley, G. (1961) Macroeconomics Theory, New York: The Macmillan Company. Barro, R. (1974) ‘Are Government Bonds Net Wealth?’, Journal of Political Economy, 82: 1095–2017. Blanchard, O. (2003) Macroeconomics, 3rd edn, Upper Saddle River: Prentice-Hall. Bonifati, G. and Vianello, F. (1998) ‘Il saggio dell’interesse come fenomeno monetario e il saggio di rendimento del capitale impiegato nella produzione’, in N. De Vecchi and

130 A. Simonazzi and F. Vianello M. C. Marcuzzo (eds) A cinquant’anni da Keynes: Teorie dell’occupazione, interesse e crescita: 93–118, Milano: Unicopli. Caskey, J. and Fazzari, S. (1987) ‘Aggregate Demand Contractions with Nominal Debt Commitments: Is Wage Flexibility Stabilizing?’, Economic Inquiry, 25: 583–97. Chirinko, R. S. (1993) ‘Business Fixed Investment Spending: Modeling Strategies, Empirical Results, and Policy Implications’, Journal of Economic Literature, 31: 1875–911. Ebersole, J. F. (1938) ‘The Influence of Interest Rates upon Entrepreneurial Decisions in Business – A Case Study’, Harvard Business Review, 17: 35–9. Fisher, I. (1923) ‘The Business Cycle Largely a “Dance of the Dollar” ’, Journal of the American Statistical Association, 18: 1024–8. —— (1925) ‘Our Unstable Dollar and the So-Called Business Cycle’, Journal of the American Statistical Association, 20: 179–202. —— (1932) Booms and Depressions, New York: Adelphi. —— (1933) ‘The Debt-Deflation Theory of Great Depressions’, Econometrica, 1: 337–57. Friedman, M. (1948) ‘A Monetary and Fiscal Framework for Economic Stability’, The American Economic Review, 38: 245–64. Garegnani, P. (1966) ‘Switching of the Techniques’, The Quarterly Journal of Economics, 80: 554–67. —— (1970) ‘Heterougenous Capital, the Production Function and the Theory of Distribution’, The Review of Economic Studies, 37: 407–36. —— (1978–1979) ‘Notes on Consumption, Investment and Effective Demand’, Cambridge Journal of Economics, 2: 335–53 (Part I) and 3: 63–82 (Part II). Ginzburg, A. (1986) ‘Sraffa e Keynes su inflazione e deflazione’, in R. Bellofiore (ed.) Tra teoria economica e grande cultura europea: Piero Sraffa, Milano: Franco Angeli. Haberler, G. von (1937) Prosperity and Depression. A Theoretical Analysis of Cyclical Movements, Geneva: League of Nations. —— (1958) Prosperity and Depression. A Theoretical Analysis of Cyclical Movements, new revised and enlarged edn, Cambridge, MA: Harvard University Press. Hassett, K. A. and Hubbard, R. G. (1996) ‘Tax Policy and Investment’, NBER Working Paper no. 5683 (July). Hicks, J. R. (1937) ‘Mr. Keynes and the “Classics”: a Suggested Interpretation’, Econometrica, 5: 147–59. —— (1939) Value and Capital. An Inquiry into Some Fundamental Principles of Economic Theory, Oxford: Clarendon Press. Junankar, P. N. (1972) Investment: Theories and Evidence, London: Macmillan. Kalecki, M. (1944) ‘Professor Pigou on the “Classical Stationary State”. A Comment’, The Economic Journal, 54: 131–2. Keynes, J. M. (1923) ‘A Tract on Monetary Reform’, in The Collected Writings of John Maynard Keynes, vol. IV, ed. by D. E. Moggridge, London: Macmillan —— (1931) ‘The Consequences to the Banks of the Collapse of Monetary Values’, in The Collected Writings of John Maynard Keynes, vol. IX: 150–63, ed. by D. E. Moggridge, London: Macmillan. —— (1932) ‘The Distinction between a Co-operative Economy and an Entrepreneur Economy’, in The Collected Writings of John Maynard Keynes, vol. XXIX: 76–87, ed. by D. E. Moggridge, London: Macmillan —— (1936) ‘The General Theory of Employment, Interest and Money’, in The Collected Writings of John Maynard Keynes, vol. VII, ed. by D. E. Moggridge, London: Macmillan.

Dynamics of money-wage flexibility 131 Klein, L. R. (1947) The Keynesian Revolution, London: Macmillan. Krugman, P. R. (1998) ‘It’s Baaack!: Japan’s Slump and the Return of the Liquidity Trap’, Brookings Papers on Economic Activity, no. 2. Laidler, D. (1999) Fabricating the Keynesian Revolution. Studies in the Inter-War Literature on Money, the Cycle and Unemployment, Cambridge: Cambridge University Press. Lange, O. (1944) Price Flexibility and Employment, Bloomington, IN: The Principia Press Leijonhufvud, A. (1968) On Keynesian Economics and the Economics of Keynes, New York: Oxford University Press. Modigliani, F. (1944) ‘Liquidity Preference and the Theory of Interest and Money’, Econometrica, 12: 45–88. Musgrave, R. A. (1948) ‘Credit Controls, Interest Rates and Management of Public Debt’, in L. A. Meltzer et al. (eds) Income, Employment and Public Policy. Essays in Honor of Alvin H. Hansen: 221–54, New York: Norton & Co. Patinkin, D. (1948) ‘Price Flexibility and Full Employment’, The American Economic Review, 38: 543–64. —— (1951) ‘Price Flexibility and Full Employment’, revised edn, in American Economic Association, Readings in Monetary Theory: 252–83, London: Allen and Unwin. —— (1965 [1956]) Money, Interest and Prices. An Integration of Monetary and Value Theory, 2nd edn, New York: Harper and Row. —— (1974) ‘The Role of the “Liquidity Trap” in Keynesian Economics’, Banca Nazionale del Lavoro Quarterly Review, no.108: 3–11. —— (1976) ‘Keynes’s Monetary Thought: A Study in its Development’, History of Political Economy, 8: 1–150. —— (1987) ‘Real Balances’, in J. Eatwell, M. Milgate and P. Newman (eds), The New Palgrave: A Dictionary of Economics, vol. IV: 98–101, London: Macmillan. Pigou, A. C. (1943) ‘The Classical Stationary State’, The Economic Journal, 53: 343–51. Robertson, D. H. (1936) ‘Some Notes on Mr. Keynes’ General Theory of Employment’, The Quarterly Journal of Economics, 51: 168–91. —— (1940) ‘Mr. Keynes and the rate of interest’, in D. H. Robertson, Essays in Monetary Theory, London: P. S. King Samuelson, P. A. (1961) Economics. An Introductory Analysis, 5th edn, New York: McGraw-Hill —— (1966) ‘A Summing Up’, The Quarterly Journal of Economics, 80: 568–83. Shackle, G. L. S. (1946) ‘Interest Rates and the Pace of Investment’, The Economic Journal, 56: 1–17. Schlesinger, J. R. (1960) ‘Monetary Policy and Its Critics’, Journal of Political Economy, 58: 601–16. Sraffa, P. (1960) Production of Commodities by Means of Commodities. Prelude to a Critique of Economic Theory, Cambridge: Cambridge University Press. Tobin, J. (1960 [1947]) ‘Money Wage Rates and Unemployment’, in Harris, S. E. (ed.) The New Economics. Keynes’ Influence on Theory and Public Policy, 4th impression: 572–87, London: Dennis Dobson Ltd. —— (1975) ‘Keynesian Models of Recession and Depression’, The American Economic Review, 65: 195–202. —— (1980 [1978]) ‘Real Balance Effects Reconsidered’, in J. Tobin, Asset Accumulation and Economic Activity, Oxford: Basil Blackwell. —— (1985) ‘Neoclassical Theory in America’, American Economic Review, 75: 28–38.

132 A. Simonazzi and F. Vianello —— (1987) ‘Fisher, Irving’, in J. Eatwell, M. Milgate and P. Newman (eds) The New Palgrave: A Dictionary of Economics, vol. II: 369–76, London: Macmillan. White, W. H. (1956) ‘Interest Inelasticity of Investment Demand – The Case from Business Attitude Surveys’, The American Economic Review, 46: 565–87. Wilson, T. and Andrews, P. W. S. (eds) (1951) Oxford Studies in the Price Mechanism, Oxford: Oxford University Press.

Part III

At the origin of monetary ideas

9

Beyond the quantity theory A reappraisal of Jean Bodin’s monetary ideas Jérôme Blanc

Introduction The publication in 1997 of an English edition of the Bodin–Malestroit controversy about the causes of price increases in France during the 1560s renewed the economist’s interest in the debates of that period. The book includes a translation of the first part of the controversy – that is, Malestroit’s Paradoxes of 1566, and an edition of the two texts Bodin published in the context of the controversy, the first in 1568 (Response . . .) and the second in 1578 (Discours . . .). Nearly two and a half centuries later, the Bodin–Malestroit controversy gave way to another controversy among economists trying to identify pioneers in the quantity theory of money. The modern controversy did not come to an end with the English edition of the first one, judging especially by the papers of O’Brien (2000) and Arestis and Howells (2002). The present chapter states that things would change if the texts read in order to comment on the controversy and Bodin’s monetary ideas were not limited to Bodin’s Response of 1568 and Discours of 1578. The key seems to be the absence, in the economist’s bibliographies, of the seminal book Bodin wrote: Les six livres de la République, first published in 1576. It includes the argument of Response, amended and completed (in the sixth Book, Chapter three, quoted VI/3 below), but overall it contains the central theory of Bodin’s works: a theory of sovereignty. Put simply, his theory of sovereign power is deepened and changed from his earlier book dealing with this subject, Methodus (Bodin 1566), and reoriented towards an absolutist view. Franklin (1963) explains the difference by the context of the French religious wars, while Engster completes this argument with Bodin’s will ‘to preserve a minimal point of universal and immutable order for politics in a social world that he perceived as highly disorderly, corrupt and changing’ (1996: 471). Bodin’s theory is frequently received as an attempt (and, according to Franklin, the first one) to legitimize an absolutist power, like the one that took shape in France some decades later. Nevertheless, a careful analysis of the text allows one to avoid the risk of its caricature, identifying the ways by which Bodin tries to limit the exercise of the sovereign power, given that its principle is absolute (Goyard-Fabre 1989). The purpose of the present chapter is then to reassess the monetary thought of

136 J. Blanc the French thinker Jean Bodin (1529–1596), given the context, both historical and theoretical, in which his monetary writings took place. This reappraisal leads to reduce the importance of Bodin as a pioneer of a quantity theory of money, and to stress his ideas on the construction of monetary sovereignty. The chapter starts with the account of the controversy between Bodin and Malestroit. It then examines Bodin’s supposed formulation of the quantity theory showing that it appears to be secondary in Bodin’s theoretical construction. In fact, the central issue Bodin emphasizes is far less the abundance of gold and silver than what we call here ‘false money’. False money was commonly rejected at Bodin’s time. Lacking definition, it concealed monetary manipulations by the Prince behind the rejection of counterfeit coins and coins of bad quality. Clarifying this ‘false money’ accusation allows one to understand the very core of Bodin’s monetary thought: he aimed at building a sound and stable monetary system, that is, a system excluding all sorts of false money. The theoretical construction of this system leads Bodin to put constraints on the exercise of monetary sovereignty, although the principle of sovereignty appears to be absolute in Bodin’s writings. The Prince not only has to respect his promises, so that a sound currency is preserved, but he also has to cope with international pressures enforcing his monetary virtue. In some concluding remarks, Bodin’s influence is briefly summarized.

Bodin in the controversy with Malestroit In 1563, Jehan Cherruyt de Malestroit, officer of the Chambre des comptes, was commissioned on behalf of King Charles IX in order to study various monetary issues in the context of a growing general dissatisfaction with the rise in prices. Three years later, he published his arguments, entitled Paradoxes. It is commonly said that the refutation of these paradoxes in 1568 by Jean Bodin, a jurist and lawyer of relatively low status, was a pioneering moment in the quantity theory of money. Malestroit’s arguments combined two paradoxes. According to the first paradox, ‘one complains wrongly in France about the rise in price of all things, considering that nothing rose in price for three hundred years’ (Malestroit 1566: 57). Things would be more expensive only if it were necessary to give a larger quantity of gold or silver in order to purchase them. According to Malestroit, this was not the case. Indeed, the same coins with the same metallic content were worth more in terms of unit of account (for example, one écu rose from 20 to 50 deniers tournois, the king’s decrees raising successively their value),1 but prices rose as did the coin’s value in terms of unit of account. The rise in prices was thus no more than an ‘image of account’, or a sort of monetary illusion (ibid.: 60). The analysis is clearly a metallist one. According to the second paradox (ibid.: 57), a rise in the price of the coin impoverishes people whose incomes are fixed (the officer receiving a wage, the gentleman receiving a rent . . .). Indeed, they receive the same amount in unit of account, but with less coins (because of the cry-up) and finally with a lower metallic content. Inflation hits incomes that are stable in terms of unit of account.

Jean Bodin’s monetary ideas 137 In 1568, Jean Bodin publishes a Response to Malestroit’s Paradoxes. The argument is expanded in the first edition of Les six livres de la République in 1576, which constitutes his major work, and in which he constructs a theory of law and sovereignty. Bodin places the argument in a chapter that aims at defining solutions in order to avoid the falsification of money. In 1578, Bodin publishes once again his argument in Discours, which contains the Paradoxes of Malestroit and his amended and completed response. Bodin states that he refutes the arguments of Malestroit. Actually, he discusses only the first paradox. According to Bodin, prices really rose since at that time the prices of goods were higher than before, not only in terms of unit of account but also in terms of weight in gold. He criticizes the fallacious method of Malestroit, who based his argument on the trend of the price of velvet. Bodin asserts that it is not only a bad example (velvet was rare and expensive three hundred years ago contrary to its current abundance), but that this method does not allow a conclusion about the change in all prices, and especially in the price of current goods. Bodin’s reasoning is based on the prices of products such as corn and land and concludes that they rose. Bodin next discusses the causes of this rise. In 1568, he announces three causes but develops four of them; in 1578, he announces ‘four or five’ causes (1578: 421) and develops five of them. Among them, three are non-monetary reasons: (1) brotherhood between merchants, craftsmen and others; (2) shortages caused by the export of basic goods and their waste; and (3) the pleasures of kings and lords which raise the price of the goods they crave due to subsequent fashion effects. There are two monetary reasons: (1) the abundance of gold and silver, and (2) the price of the coin. Although Bodin had already dedicated many pages to this last reason in 1568 (see 1568: 94–107), he announces it as one of the causes of the rise in prices in the edition of 1578 only. This is the argument developed by Malestroit himself: cry-ups, that is, rises in the price of the coin. However, Bodin expounds that the main cause, almost the only one, which remained to be understood, was the abundance of gold and silver. Both were scarcer four hundred years ago. Bodin identifies several origins to this abundance: a flow of metal coming from Peru through Spain; a positive commercial balance especially with the British, the Nordic and the Baltic countries; a dynamic activity after the wars; and metal flowing into the kingdom during the fairs of Lyon.2 Moreover, according to Bodin, Spain and Italy, where gold and silver were more abundant than in France, were experiencing higher prices. This leads to a conclusion: ‘it is therefore the abundance of silver and gold which causes partly the expensiveness of things’ (Bodin 1568: 94).3 After Bodin’s Response, the idea gradually spread that, first, gold and silver were abundant as never before in the French kingdom and, second, this abundance would be the source of the rise in prices. Later, the publication of Bodin’s book Les six livres de la République in 1576, his role during the Estates-General gathered during the winter of 1576–1577 and the publication in 1578 of the refined Response under the title of Discours, contributed to making him a prominent thinker of the time.

138 J. Blanc

The abundance of precious metals as an incomplete and secondary argument According to O’Brien (2000: 268), ‘Bodin does indeed have a strong claim to be regarded as the pioneer formulator of that theory [the quantity theory]’. However, he also shows that there is no consensus on this matter. The later paper of Arestis and Howells (2002) confirms that lack of consensus. It is not the place here to discuss the historical construction of the quantity theory or to discuss the validity of a history of economic thought aiming at identifying pioneers with regard to what happened later. The purpose of the paper is to show how an exclusive attention to the supposed formulation of the quantity theory by Bodin leads to a misunderstanding of his monetary writings. In order to achieve this purpose, we will first stress how unlikely Bodin’s formulation of the quantity theory is and, second, how the issue of the abundance of precious metals is a secondary one in Bodin’s view. One should be conscious of how important the choice of the main features of the quantity theory is when these are used in order to reassess the contribution of former thinkers. O’Brien (2000) sets out a demanding set of requirements, including the conceptualization of a demand for money, a supply of money and the idea of a money market that clears. Nevertheless, he distinguishes, as nonnecessarily related, the quantity theory and the idea of an exogenous money supply – that is, one of the criteria that lead Arestis and Howells (2002) to criticize those of the historians of economic thought who consider Bodin as a founder of the quantity theory. A reading of Bodin’s own arguments leads to four observations. 1

2

3

4

Bodin clearly identifies a causal relationship between the quantity of gold and silver in the kingdom and the rise in prices. However, he never specifies if by ‘gold and silver’ he means the global quantity of precious metals or the minted ones only. This lack of precision undermines the quality of Bodin’s intuition of any quantity theory. Bodin never specifies if the causal relationship is a proportional one, and nothing in his analysis allows one to affirm that he thinks in terms of such a proportional relationship. As we have seen, Bodin states that ‘it is therefore the abundance of silver and gold which causes partly the expensiveness of things’. Thus, high prices do not exclusively come from the abundance of gold and silver, since Bodin identifies other causes of the rise in prices than the mere quantity of gold and silver. Finally, Bodin refers neither to any ‘market’ for money (neither to gold and silver as money nor as metals for industry or luxury), nor to any clearing constraint of such a market.

It is noticeable that O’Brien tends to weaken the nature of the quantity theory. Indeed, after having set out five propositions in order to define it, he finally

Jean Bodin’s monetary ideas 139 specifies that he is only looking for ‘the recognition that an increase in the money supply, whatever its source, is likely to raise the price level’ (2000: 269). In this quite weakened sense, it is clear that Bodin contributed to the idea. Nevertheless, Bodin’s arguments allow one to consider him more certainly as an ‘uncompromising metallist’ than a quantity theorist or a founder of the quantity theory. What Schumpeter (1954: 312) calls an ‘uncompromising metallism’ is an analysis in which all forms of precious metals are under consideration. This is very different from the ‘quantity theorem’ (ibid: 312–13). Intransigent metallism concludes that the value of gold or silver in relation to goods decreases with the increase in the metal’s production. Applied to Bodin’s time, such reasoning would lead to a conclusion that the rise in prices comes from the abundance of the metals even if they are not minted. The metallic currency at that time was part of the stock of gold and silver, which included plates, jewellery, unminted bullion and other gold and silver of ‘industrial’ use. The ‘quantity theorem’, as defined by Schumpeter, is more restrictive: it clearly distinguishes monetary or minted gold (or silver) from that which is non-monetary, and considers as significant only monetary gold or silver. Therefore, the decrease in the value of gold (or silver) comes from the increase in the quantity of minted gold (or silver) exclusively. The difference is important, and it is difficult to consider Bodin as a quantity theorist in such a presentation. That is why Schumpeter (1954: 311–17) considers that Bodin did not so much invent the quantity theory but rather first clearly expressed the causes of the high inflation of the sixteenth century – actually, a highly controversial interpretation of the high inflation (see, for example, Morineau 1977). Moreover, some argue, with serious reasons, that Malestroit should be seen as a more likely pioneer of the quantity theory than Bodin, for the argumentation of the former seems to better support the conditions of such a theory (Tortajada 1987). Finally, the absence of a serious quantity theory in Bodin’s arguments is as astonishing as the recurrent controversy on his supposed adherence to the principles of the quantity theory. Nevertheless, stating that Bodin was not a quantity theorist or a pioneer of the quantity theory does not mean that Malestroit won the controversy. Bodin clearly won because he explained the rise in prices by extended arguments, which included those of Malestroit (the cry-ups) and went further. The common account of this controversy concealed the other debates and monetary opinions of the time. Debasements were actually the central issue that appeared in most of the writings, and especially in Bodin’s writings. Indeed, Bodin does not provide any solution to the problem of the abundance of gold and silver, although this was considered as the main cause of high prices. A sentence is enough to get rid of the issue (Bodin 1568: 117). There is a historical reason for this: the scarcity of money was a much more harmful issue than its abundance, and inflation could be seen as the price to pay to avoid this scarcity.4 But there is also a biographical reason: it seems that if Malestroit had not published his Paradoxes, Bodin would have written on money anyway (Le Branchu 1934: XLIV), for instance in order to integrate money in his theory of

140 J. Blanc the sovereign power. In this theory, the central monetary issue is far from being the abundance of money: it is false money. During the 1560s, the debate on the causes of high prices grew in France. However, this debate was generally secondary in comparison with debates on debasement, either as the lowering of the quality of the coins, or as the rise in their legal tender. The recurrent issue was rather the second one (this was what Malestroit dealt with), related to the irrepressible rise in the voluntary prices of the coins. This issue of debasements led to debates on their origins, their consequences and the solutions to avoid them. This issue was at the very core of the monetary organization; that is why most of the monetary writers of the period discussed it. Many questions arose from this topic: concerning the necessity to accept the right of the Prince to act as a sovereign and to lower the metallic content of the coins or to raise their value; concerning the economic consequences of these debasements; concerning the key features of the monetary system which allowed such debasements to be perpetrated; concerning the capacity of the Prince’s decrees to change the trends in the rising voluntary prices of several coins and then to restore the order in the currency; finally, concerning the reorganization of the monetary system. These issues were developed in many texts and were debated around the Estates-General (1576–1577 and 1614) and during the preparation of (and sometimes after) important edicts (1577, 1602, 1609, 1614).5 Like many thinkers of the period, Bodin’s monetary thought is embedded in these debates. However, there are two main differences between Bodin and the others: first, he started writing on money as an answer to Malestroit’s opinion; second, he related his monetary ideas to a much wider analysis centred on sovereignty. Thus, Bodin conferred greater importance to the issue of false money than to the abundance of gold and silver.

From the common rejection of debased currency to Bodin’s proposals Bodin considers that coins are both inconvenient and unsuitable for storing wealth because of the manoeuvres of two groups of people: 1

2

those who intervene in the circulation of coins: treasurers, officers of the Mint, usurers, changers, refiners, goldsmiths and merchants, and those who interfere with exclusively fraudulent purposes like forgers, clippers and ‘billonneurs’ (Bodin 1568: 141);6 the Princes themselves, influenced by courtiers pushing them to raise or lower the fineness of coins (ibid.: 30 and after).

In these actions, several manipulations lead to false money, as commonly challenged at that time, generally without defining it. Identifying the forms taken by false money allows one to understand these accusations. A coin consists of three components: a piece of metal, the mark of the sovereign and the legal

Jean Bodin’s monetary ideas 141 tender. Manipulations can occur in relation to the metal, to the mark or to the legal tender. Hence, false money finds expression in three ways: debasements, degradations and counterfeiting. 1

2

3

Debasements induce higher legal tenders than the value of the coin’s metallic content. The gap is greater than the brassage (a fee charged by the mint operator to cover production costs, excluding the price of metal): it depends mainly on the seigniorage decided with the coinage, and rises along with the increases in the legal tender.7 Hence, the Prince is able to order two sorts of debasements: either a manipulation of the metallic content of new coins, in lowering their weight or raising the part of copper in the alloy,8 or a manipulation of the legal tender of coins already circulating (that is, an enhancement or a cry-up).9 Debased currencies are then opposed to an ideal currency whose legal tender depends only on the metallic content, whatever its quality. Degradations induce a difference between the actual metallic content of the coins and the legal one, as ordered by the royal edicts, whatever the official quality of the coins. The gap arises because of several causes: the diversion or the bad application of the edicts by the officers of the Mint; the clipping of individuals;10 or the natural wear of the coin. Counterfeit coins are forged by individuals not authorized by the Prince, whatever the quality of these coins (Bodin 1986 [1593], vol. I: 332–3 deals with local princes minting good coins but being considered as forgers by the king). However, the main case is that of individuals usurping the right of the sovereign in order to gain a profit and, consequently, issuing coins of low metallic content.

In those three cases, money appears to be false. It is worth noting that Malestroit’s concerns are about cry-ups, or rises in the legal tender, while Bodin’s concerns include both cry-ups and the lowering of the metallic content and go even further, including degradations and counterfeiting. Foreign coins can be easily integrated into this formal presentation of false money. First, the quality of foreign coins is often bad; second, the use of foreign coins in the kingdom competes with that of the coins bearing the mark of the sovereign, endangering his sovereignty; third, this circulation is one important cause of the rise in the legal tender of domestic coins. It is noticeable that Bodin worries about the circulation of foreign coins only when their metallic content is of a lower fineness than that of the domestic coins. In other words, those bad coins could flow in to be converted into good French ones, which would be melted and exported. Despite his theory of sovereignty, Bodin is more troubled by this risk than by the symbolic contradiction brought by foreign currencies to the royal mark. Other French writers after him will be more worried by this symbolic issue – for example Montchrétien (1889 [1615]). Finally, Bodin, like other contemporary monetary writers, with the exception of Turquam (1573), does not analyse the effect of the high prices of foreign coins on the price of the domestic coin.

142 J. Blanc Thus are related, in Bodin’s thought as in the thought of most of the writers of the time, debasements from the Prince, degradations from officers of the Mint, counterfeiting and clipping from individuals and foreign species of bad quality. The suspicion towards coins is entertained by the lean border between, on one hand, true and counterfeit coins and, on the other hand, good and degraded or debased coins. This leads to proposals of reform regarding the minting of coins, so that counterfeiting, degradations and debasements become more difficult, or even impossible. It is particularly the final purpose of Jean Bodin, but other writers or officers of the Mint were also looking for such results (for example, Nicolas Briot, during the first two decades of the seventeenth century). Clarifying the common view on false money by showing its underlying logic allows one to better understand the debates of the time. For example, it allows one to understand that the controversial debate on the royal ability to debase the currency can be hidden by a general and unanimous denunciation of bad coins applied to the special cases of counterfeiting and bad foreign coins, thus formally lessening the sovereign’s responsibility.11 Moreover, some stress the necessity of battling against counterfeiting, arguing that it is an impediment to the supremacy of the royal minting. These general debates found expression in proposals. In most cases, however, they were related to the false money issue only partially, proposing a combination of some of the following: severe sanctions against forgers; a change in the minting techniques making counterfeiting more difficult; a change in the definition of the metallic content of the coins; or a strict prohibition of the use of foreign coins. The issue of the royal ability to debase remained a very difficult one and Jean Bodin tried to resolve it. His proposals were intended to avoid definitively all forms of false money. We suggest that here lies the real place of Bodin in the history of monetary ideas. The originality of Bodin’s monetary analysis lies in its relationship with the core concept of his works, sovereignty. Given Bodin’s interest in the construction of this concept, counterfeiting from individuals should be a much more serious issue than debasements from the Prince, since counterfeiting usurps the mark of the sovereign and constitutes what Bodin calls a crime of lese-majesty. Arguably, a bad currency makes it difficult to achieve stable references in prices, which harms commercial activity. Nevertheless, it is by no means in contradiction with sovereignty, since sovereignty implies a right to debase. The hierarchy is reversed when Bodin deals with the priorities in the fight against false money. Bodin focuses his attention on the quality of metal, not on the mark of the sovereign. Indeed, the very existence of both counterfeit coins and debased coins proceeds from the same logic: profit, coming from the difference between the legal value of the coins and the minting costs. Forgers certainly divert the mark of the sovereign, but their only purpose is to make a profit by falsifying the metallic content of the coins they mint. Fighting against the falsification of the sovereign’s mark (on the counterfeit coins) is thus subordinated to the fight against the falsification of metal (on debased and degraded coins).

Jean Bodin’s monetary ideas 143 The core issue is then, according to Bodin, the design of a sound and stable system that definitively prevents debasements by the Prince. Suppressing the features of the official monetary system which makes the use of metal of low fineness possible should be the ground on which it would be possible to overcome completely the crime of lese-majesty stemming from counterfeiting, as well as debasements by the Prince and all forms of degradations.

Designing a sound and stable system Bodin’s proposals led to a monetary system made up only of good coins, whatever their origin. For Bodin (1568: 134 and 137–8), the circulation of foreign coins is not a problem as long as they are of good quality. That is why he proposes to demonetize foreign coins of lower quality and to prohibit the export of good coins. Here lies one more time a paradox between Bodin’s interest in the construction of sovereignty and the acceptance of something apparently going against monetary sovereignty. A distinction between the minting phase and the circulation phase clarifies this point. From the minting point of view, the authenticity of the mark is a peremptory necessity, the quality of the metal being a secondary issue. From the circulation point of view, Bodin reverses this order: the mark is nothing more than secondary, and the metal becomes the central point, the conditions in which economic activity is carried out being related to it. Consequently, it appears that the false money issue leads to a particular combination between, first, the three components of coins (metal, mark and legal tender) and, second, the two phases of coins (minting and circulation). A strict sovereignty point of view would lead to bringing up the issue of the mint and the mark, whereas an economic point of view would lead to bringing up the issue of the metal, the legal tender and the circulation. It is noticeable that Bodin constructs a theory of sovereignty with a monetary dimension but, in order to resolve the false money issue, deeply related to sovereignty, he takes up the economic point of view and then stresses the circulation, legal tender and metal issues. Bodin’s ideal system is devised to be convenient, coherent and stable. And, most importantly, it is meant to be falsification-proof. The transition to such a system should be progressive, so that all are able to get rid of their bad coins without losses (Bodin 1986 [1593], vol. VI: 144). According to its final version,12 the system consists of six technical proposals: 1

2 3

Coins should be minted in gold or in silver only. Alloys of silver and copper (billon) should disappear. Bodin is hesitant concerning small coins: he first hesitates between copper and silver, and finally prefers silver, given that copper coins would have a much too variable value. Copper coins should then disappear. The metallic content of coins should have an immutable fineness of 958 per thousand.13 The coins should have an immutable legal tender, which should be equal to

144 J. Blanc

4

5 6

their intrinsic value. This implies that no seigniorage and no brassage are charged on coins.14 The price ratio between gold and silver should be fixed definitively at 1 to 12, that is, according to Bodin, an average observed during several decades, around which the current ratio varies slowly.15 Minting should be concentrated in a single Mint, located in a single city of the kingdom. The Mint should abandon the hammer; Bodin (1568) proposes first to employ the German technique of the screw press but, in his further writings, he proposes the ancient technique of moulding.

Proposal (1) is a central one, for, according to Bodin, the root of the abuses resides in the combination of gold, silver and copper (1986 [1593], vol. VI: 135). Simplifying the set of metals used for coins should help to avoid many of the issues of false money. Proposals (1), (2), and (6) aim at making each coin immediately identifiable as a good or a bad one, with the simple techniques in use at that time by most of people. Counterfeiting should then be much more difficult. Proposals (2) and (3) aim at enforcing the legal tender as the only rate at which one can use the currency. With an immutable and pure metallic content, with a legal tender fixed at the mere metallic value of the coin without any seigniorage and brassage, a voluntary rate distinct from the legal tender should not appear and speculation, endangering the monetary sovereignty, should not occur. Proposal (5) aims at cutting off any temptation of officers of the Mint to degrade the quality of the coins they mint or control. Proposal (4) aims at supplying a stable and more relevant ratio considering the ones observed in the neighbouring kingdoms. This proposal is the weakest point of Bodin’s system, as noted by O’Brien (2000): it is enough to destroy all the system. Indeed, changes in the current ratio due, for instance, to the inflow of more silver than gold as it appeared before and after Bodin’s writings, leading to a change in the ratio in favour of gold, would induce flows of coins consistent with Gresham’s law. Be that as it may, no proposal among the six above, and no combination of them, can enforce the Princes not to debase the coin; this limit to his technical construction leads Bodin to draw up moral limits to the exercise of sovereign power.

Preventing the debasement by the Prince The suppression of counterfeit coins being subordinated to the suppression of bad coinage, Bodin concludes that there is a need to work out a debasementproof monetary system, as shown previously. Achieving this purpose implies a limitation of the exercise of sovereignty. It is quite interesting to understand how Bodin, frequently considered as the theoretician of the principle of absolute sovereignty, formally builds such a limitation. Bodin begins by recognizing that coinage arises from the law. By law, the Prince has the power to impose his mark, to determine the metal qualities and to

Jean Bodin’s monetary ideas 145 fix the legal tender of the coins thus marked. Law being a mark of sovereignty, which, in its principle, is absolute, Bodin can place a constraint on the actions of the Prince only by non-legal means.16 Bodin binds the Prince to the subjects by contract, or convention, concerning the metal characteristics and the legal tender of the coin. Law obliges all the subjects without obliging the Prince, while the contract obliges both. It obliges both parties reciprocally, bringing the Prince to the level of the subjects (Bodin 1986 [1593], vol. I: 195). It is by virtue (i.e. the desire to do justice) that the sovereign is led to respect his contracts (ibid.: 218). Such respect secures public faith. Concerning coinage, a breach of contract by the Prince would be the worst scenario because the coin would be debased, the Prince would break his own promise (whereas even God is bound to his promise), and this would endanger public faith, which is one of the foundations of the republic (ibid., vol. V: 62). In such a case, the Prince would become a counterfeiter (ibid., vol. VI: 118). The immutability of the coin’s fineness and legal tender, as featured in Bodin’s ideal system, should break the spiral of debasements and reinforce public faith. However, the achievement of this purpose implies that the Prince definitively banishes all temptation to debase currency. Bodin clearly knows that history is full of Princes succumbing to the debasement temptation, since he takes many examples of such cases. That is why he proposes to enforce the Prince’s virtue by an internationalization of the responsibility and the consequences of false money. This new kind of constraint is not developed in the first edition of Bodin’s Response to Malestroit (1568), but appears first in République in 1576, and then in Discours (1578) and afterwards. If the implementation of Bodin’s ideal system were extended to the neighbouring kingdoms (Bodin seems to be thinking about the whole of Christendom), each Prince would feel related to the others. That would produce at least two interesting effects. First, a kingdom would no longer fear the intrusion of bad currencies from its neighbours. Indeed, all the currencies would be identical, except for the mark of sovereignty. Second, a Prince could not afford to break the virtuous circle of good currency, fearing the consequences of debasements, both internal (social disturbances, riots, ‘jacqueries’ . . . ) and external. Bodin states that, in the past, false money, and sometimes bad currency from a neighbouring or vassal kingdom, was used as a pretext for an invasion. Here takes shape the effect of monetary falsification operated by a Prince isolated from the virtuous ones: war. This is a quite interesting contribution from the point of view of political and monetary thought. The sovereign being prevented from falsifying money, individuals would have no more possibility of counterfeiting coins. False money, in the broad sense we used here following the common view at Bodin’s time, should definitely disappear, leading to the disappearance of individuals living on falsification as forgers, clippers but also those courtiers that he so criticized. Bodin’s solution to the need for reorganizing the monetary system is a metallist one. This metallism settles in a realistic analysis of the roots and misconstructions of the monetary system. The resort to precious metals as the

146

J. Blanc

basis of the monetary system is viewed as the only way to rebuild a viable system secured against temptation – whoever it comes from, Princes, officers or individuals.

Concluding remarks In this chapter, we have argued that Bodin’s monetary thought is actually part of his theoretical construction of sovereign power, although in a paradoxical way. This is why he confers greater importance to the issue of false money (under the form of counterfeit coins or clipping by individuals, of degraded coins by individuals and the officers of the Mint, and of debased currency by the Prince) than to the abundance of gold and silver. Concerning the latter topic, it is quite clear that Bodin cannot be considered as a founder of the quantity theory of money. We suggest that it is in the construction of an ideal system excluding all forms of falsification that lies the genuine originality of Jean Bodin. In the context of a rising monetary and financial crisis, the debate amplified in 1576–1577, led to a central monetary reform in September 1577. An edict prohibited the use of money of account distinct from the means of payment. In order to achieve this purpose, it removed the livre tournois and organized the subsequent system of account around coins: the golden écu (60 sous), the silver franc (20 sous) and little copper coins. The écu was designed to be both the unit of account and the main and basic coin of the system. Another edict prohibited the use of most foreign coins, demonetizing nearly 180 sorts of coins and leaving only some Spanish coins whose fineness and value were well known. The reform, intended to stabilize money and to build a sound monetary system, achieved these goals for several years. Nevertheless, a rising difference between the voluntary price of the golden écu and its legal tender led Henri IV to put an end to the prohibition of foreign coins, to restore the livre tournois and to raise the price of the écu in 1602. Bodin tried to influence the debates of 1576–1577. King Henri III paid attention to him sometimes, but his political activism against the radical opposition between Catholics and Huguenots and his opposition to the king’s preferred solution to raise funds during the Estates-General (in order to finance the war) alienated the king and his council from him. Moreover, his institutional position was never central enough to influence royal decisions, especially the monetary ones. He was never admitted into the limited circle of those who decided on money matters, and who never considered him as a serious analyst of monetary topics: the Cour des monnaies, and, particularly, the general officers of money François Garrault and Thomas Turquam.17 Therefore, Bodin’s proposals were not put into practice. In fact, despite his involvement in two major monetary debates of his time (the controversy with Malestroit over the causes of the rise in prices and the debates on the reforms to implement in order to stop the monetary crisis of the 1570s), his purpose seems to be more a theoretical one or, at least, a long-run one, than an immediate response to the contemporary monetary crises. Many of the subsequent French monetary writers directly quoted Bodin or,

Jean Bodin’s monetary ideas 147 more often, were inspired by his writings. Montchrétien (1889 [1615]), for example, includes long paragraphs of Bodin’s writings in his own book, without quoting him. It is noticeable that some of these authors did not refer to him because of his controversy with Malestroit but also, or mainly, as Montchrétien, in relation to his reflections on an ideal system. A long time after, when modern economists tried to find pioneers of the quantity theory, they remembered Bodin, but his theoretical construction of money as an ambiguous part of sovereignty did not reappear.

Notes 1 A rise in the price of a coin in terms of unit of account is called ‘cry-up’ by Sargent and Velde (2003). 2 Arestis and Howells (2002) see in Bodin’s writings the development of an endogenous money conception, the abundance of gold and silver being explained by these elements rather than being the result of central decisions. 3 In the original text, one finds: La principale et presque seule (que personne jusques icy n’a touchée) est l’abondance d’or et d’argent’. Or: ‘La principale cause qui encherist toutes choses en quelque lieu que ce soit, est l’abondance de ce qui donne estimation et pris aux choses’; ‘c’est donc l’abondance qui cause le mespris’. Quoting Plutarch and Pliny: ‘c’estoit l’abondance d’or et d’argent qui cause le mespris d’iceluy, et la charté des choses prisées’. Finally: ‘l’abondance d’or et d’argent, qui est la richesse d’un pays, doibt en partie excuser la charté: car s’il y en avoit telle disette que le temps passé, il est bien certain que toutes choses seroyent d’autant moins prisées et acheptées que l’or et l’argent seroit plus estimé. Bodin (1934 [1568]: 83–94) 4 The last quotation in the previous note validates this interpretation. 5 For example, see the well documented texts of Parsons (2003) on the years 1576–1577 and Barbiche (1963) on the matter of the edict of 1609. 6 See also, for example, Bodin (1986 [1593], vol. VI: 121 and 134–6). 7 The legal tender can be seen as the sum of the intrinsic value of the coin, the brassage and the seigniorage. 8 The official minting of coins of low quality is then often described as a ‘forgery’. The French king Philippe le Bel, quoted by Bodin as well as many writers of that period, is an outstanding example of this kind. 9 Though it is of old use, Sargent and Velde (2003) define these manipulations as cry-ups in order to distinguish them from debasements strictly speaking, which are defined as a ‘lowering of the intrinsic value of a coin or currency’ (ibid.: 375). We choose in this text a broader, and more current, definition of debasements that includes both cry-ups and the lowering of the intrinsic value of coins. One can note that the definition is far from being neutral, for French terms referring to cry-ups are frequently translated in English as debasements broadly speaking, thus inducing misunderstandings. 10 Clipping, as well as counterfeiting and other fraudulent behaviours, may come from officers too, but in this text we simplify and separate the officers of the Mint, whose functions are central in respect to coinage, and other individuals, whatever their status. 11 See for example Bouterouë (1666: 7–9). He defines forgers as those who clip, wash and use other inventions in order to debase coins; but the main causes of debasement that he identifies later all proceed from the king’s practices. 12 The system he draws up in the first Response (1568) is reshaped and refined in République (1576) and in Discours (1578). 13 That is a fineness of 23 carats for gold and 11 deniers 12 grains for silver.

148 J. Blanc 14 Bodin recommends the institution of a tax to cover the cost of the brassage. 15 Actually, other explanations are possible. The ratio 1:12 has a meaning in everyday life. The base 12 is a simple and divisible base by two and three; it is commonly used because the monetary system is partly organized with this base (1 sou is worth 12 deniers). It also has an alchemistic connotation; for example, this ratio is also supposed to concern the sun and the moon, gold and silver being frequently compared to the sun and the moon. 16 See Blanc (2006) for a more thorough presentation of this point. 17 See especially Parsons (2003). Far older, less accurate and sometimes erroneous, see Gonnard (1935), Le Branchu (1934), Hauser (1932) and Harsin (1928).

References Arestis, P. and Howells, P. (2002) ‘The 1520–1640 “Great Inflation”: an Early Case of Controversy on the Nature of Money’, Journal of Post-Keynesian Economics, 24: 181–203. Barbiche, B. (1963) ‘Une tentative de réforme monétaire à la fin du règne d’Henri IV: l’édit d’août 1609’, XVIIe Siècle, 61: 3–17. Blanc, J. (2006) ‘Les monnaies de la République. Un retour sur les idées monétaires de Jean Bodin’, Cahiers d’économie politique, 50. Bodin, J. (1568) ‘La response de Maistre Jean Bodin advocat en la Cour au Paradoxe de Monsieur de Malestroit, touchant l’encherissement de toutes choses, et les moyens d’y remedier’, reedited in J.-Y. Le Branchu (1934, vol. I). —— (1578) ‘Discours de Jean Bodin, sur le rehaussement et diminution tant d’or que d’argent, et le moyen d’y remédier, aux paradoxes du Sieur de Malestroit’, reedited in J. Bodin (1986 [1593]). —— (1986 [1593]) Les six livres de La République (6 vols), Paris: Fayard. —— (1993) Les six livres de La République, abridged edn, Paris: Le Livre de Poche. —— (1614) Relation journalière de tout ce qui s’est négocié en l’assemblée Generalle des Estats, assignez par le Roy en la ville de Bloys, en l’an mil cinq cents soixante et seize, Paris: Martin Gobert. —— (1997) Response to the Paradoxes of Malestroit, Bristol: Thoemmes. Bouterouë, C. (1666) Recherches curieuses des monoyes de France depuis le commencement de la monarchie, Paris: Sebastien Cramoizy and Sebastien Mabre-Cramoisy. Budruss, E. (1987) ‘Erudition classique et théorie quantitative de la monnaie dans la “Réponse à Malestroit” de Jean Bodin’, Journal des savants: 89–125. Engster, D. (1996) ‘Jean Bodin, scepticism and absolute sovereignty’, History of Political Thought, 17: 469–99. Franklin, J. H. (1963) Jean Bodin and the Sixteenth Century Revolution in the Methodology of Law and History, New York: Columbia University Press. Gonnard, R. (1935) Histoire des doctrines monétaires dans ses rapports avec l’histoire des monnaies, vol. I: De l’antiquité au XVIIe siècle, Paris: Sirey. Goyard-Fabre, S. (1989) Jean Bodin et le droit de la république, Paris: Presses Universitaires de France. Harsin, P. (1928) Les doctrines monétaires et financières en France du XVIe au XVIIIe siècle, Paris: Félix Alcan. Hauser, H. (1932), La vie chère au XVIe siècle. La Response de Jean Bodin à M. de Malestroit, Paris: Armand Colin. Le Branchu, J.-Y. (ed.) (1934) Ecrits notables sur la monnaie (XVIe siècle). De Copernic a Davanzati (2 vols), Paris: Félix Alcan.

Jean Bodin’s monetary ideas 149 Malestroit, J. Ch. de (1566) ‘Les paradoxes du seigneur de Malestroict, Conseiller du Roi et maistre ordinaire de ses comptes, sur le faict des monnoyes présentez a sa majesté, au mois de mars, MDLXVI’, reedited in J.-Y. Le Branchu (1934, vol. I). Montchrétien, A. de. (1889 [1615]) L’économie politique patronale. Traicté de l’oeconomie politique dédié en 1615 au Roy et à la Reyne mère du Roy, Paris: Plon. Morineau, M. (1977) ‘La conjoncture ou les cernes de la croissance’, in E. Labrousse and F. Braudel (eds) Histoire économique et sociale de la France, vol. I: 1450–1660, Paris: Presses Universitaires de France. O’Brien, D. P. (2000) ‘Bodin’s Analysis of Inflation’, History of Political Economy, 32: 267–92. Parsons, J. (2003) ‘Governing Sixteenth-Century France: The Monetary Reforms of 1577’, French Historical Studies, 26: 1–30. Sargent, T. J. and Velde, F. R. (2003) The Big Problem of Small Change, Princeton: Princeton University Press. Schumpeter, J. A. (1954) History of Economic Analysis, London: Allen and Unwin. Tortajada, R. (1987) ‘M. de Malestroit et la théorie quantitative de la monnaie’, Revue économique, 38: 853–76. Turquam, T. (1573) Remonstrances faites au parlement de Dijon le X. jour de septembre 1573, par M. Thomas Turquam, . . . commissaire député par sa Majesté pour l’exécution du descry des espèces de billon estrangères qui s’exposent au duché de Bourgongne, Paris: J. Dallier.

10 Money as a social bookkeeping device From mercantilism to General Equilibrium theory Heinz-Peter Spahn Money is memory. Narayana R. Kocherlakota (1998) Evil is the root of all money. Nobuhiro Kiyotaki and John Moore (2002)

Introduction Money is what money does. This is a well-known phrase in the theory of money. Unfortunately however, economists do not seem to agree on what money does, i.e. on the true meaning of the functions of money. The trinity of a medium of account, a means of exchange and a store of value is mentioned in every textbook, but there is no agreement on the question of which of these functions is the basic one and on the relations to other concepts as, for example, the function of a means of payment. Presumably this vagueness mirrors the still unsettled controversy on the actual role of money in a market economy, i.e. whether money belongs to the ‘core’ of a capitalistic system or whether it merely smooths economic transactions in the process of allocation of resources, which essentially remains a regime of barter. In this chapter a further feature of money is presented, which can be found – possibly among others – in the writings of Galiani, Marx, Bendixen, Schumpeter and Luhmann, but also in the modern variant of neoclassical General Equilibrium theory. The common denominator in all these studies is that money performs a kind of a bookkeeping role: it records the value of market agents’ contributions to the national product and, at the same time, documents the ‘justification’ of its bearer to demand goods and services. The bookkeeping idea points to the principle of efficiently guided incentives in a society built on the division of labour and the necessity of monetary contracting instead of direct barter in large, anonymous societies. Money functions as a kind of memory of its bearers’ economic activities, signals that they keep to their budget constraint, and serves as a substitute of trust. The following two sections present the stages of the bookkeeping approach in

Money as a social bookkeeping device 151 the history of economic thought, before finally some critical conclusions are drawn with respect to the validity of the bookkeeping concept. It might appear as a convincing idea at first glance, conveys important insights into the working of a monetary economy, but nevertheless suffers from severe analytical flaws. In this context the pivotal role of the rate of interest for the stability of a monetary economy will have to be reassured.

Monetary contracts in mercantilist thought Whereas one track of mercantilist monetary theory deals with money as finance, i.e. an ‘input’ factor for production perceived to be in short supply, another begins with the more institutional question about the type of asset or medium that performs as money. The determination and the value of money according to Locke rest on a ‘consent of men’ (1956 [1690]: 26). At first glance, Locke seems to be a metallist, because in the long run the value of money is assumed to equal its cost of production. But it is an open issue which of the precious metals is chosen to perform as money. Even gold drew its high market valuation not from the mere value of being a precious metal, but rather from the (sometimes only implicit) agreement to use it as money. The acceptance of any currency does not depend on physical properties of that medium but from a social convention, derived from the collective expectation that it will perform its function as a means of payment in the future. This highlights the potential allocative inefficiency and global instability of such an expectation (‘sunspot’) equilibrium. The analysis of money as a precarious conventional equilibrium hardly made any analytical progress during the first half of the eighteenth century. But is seems to be rewarding to have a closer look at Galiani’s Della Moneta (1751), a book which has much in common with the work of Davanzati. Like the latter, Galiani is seen as a metallist in monetary matters, and he is praised for his presentation of the paradox of value (Schumpeter 1954: Ch. 6). However, Galiani’s much more important contribution to the history of economic thought, which more or less seemed to have been ignored, consists of his considerations on the institutional aspects of money. In an illuminating passage Galiani addresses the question of how a society should be organized obeying the principles of efficiency and fairness: I believe that large societies too . . . can live as happy communities. But I considered also that this depends on a particularly chosen and hard-working population. It is necessary that all people reliably deliver their products to public warehouses, from which they draw all necessities supplied by other fellow citizens. However, in this system the lazybones who withholds his products from the community is a parasite that lives off the others. There would be neither a reward for diligence through an increase of welfare nor a punishment of the idle who suffer from increased poverty. . . . In such a society all individuals aim for a ‘good life’ and little work; this system could not be maintained.

152

H.-P. Spahn As an improvement I worked out the following idea: we could keep account of each man’s work, and everyone would participate in the yield of other men’s work, proportionately to his own input. Everyone who delivers his products in a store should receive a certificate, which reads: ‘The owner of this paper has supplied the public warehouses with a quantified amount of a particular commodity. Hence, he has become a creditor of the community to the extent of the value of his contribution.’ Under no circumstances commodities should be distributed without collecting certificates of an appropriate value. After cashing in the paper ought to be destroyed. . . . But then I suddenly realized that I unintentionally had sketched an image of the actual world. . . . The certificates, i.e. the money, represent the credit, which everyone receives in exchange for his individual work. . . . Spending money means to give up shares of the yield of one’s own work. The difficulty in the first-mentioned system that could not have been solved by resorting to the command of virtue is perfectly resolved by bringing selfinterest into play. . . . My readers will have extended my considerations and recognized our existing order of society which rests on contracts and money. (Galiani 1999 [1751]: 157–61, emphases added)

First, Galiani shows a clear understanding of the basic problem of misguided incentives in any unified community or socialist economy. Second, like Smith who followed him, he hit upon the approach that made use of, rather than tried to restrain, private interests. But unlike Smith, he did not simply rely on the forces of competition, which are supposed to ‘channel’ selfish behaviour for the benefit of social welfare in classical economics. Rather, money is presented as a medium, which brings about an efficient allocation of resources and a fair distribution of real income. Galiani also intimates that the pattern of market interaction is structured by contracts, which is a modern view of the working of a private-property market system, maintained by institutional and post-Keynesian branches of economic theory. However, Galiani treads a rather short path from bureaucratic receipts to money, i.e. from a central-clearing-house way of allocating resources to decentralized market contracts. This will turn out to be a crucial distinction when assessing the bookkeeping idea. The notion of ‘social bookkeeping’ appears to differ from two of the more traditional money functions: 1

2

A money of account is any medium, which simply is able to express various valuations in a common standard. But in Galiani money is not some neutral yardstick, which itself has no necessary bearing on the society’s process of production; rather, it is supposed to carry the information on each market agent’s productive contribution to national welfare, and it documents that its bearer is entitled to demand resources from the common pool of the social product. A medium of exchange on the other hand is used to enhance the facility of

Money as a social bookkeeping device 153 bilateral exchange by solving the problem of a lacking double coincidence of wants. Galiani however does not address the problem of matching in isolated barter; the focus is not on the efficiency of decentralized exchange transactions, but rather on the fairness of income distribution at large, i.e. the stipulated equivalence of an agent’s product and his or her income or consumption. The social system that is under scrutiny is not a barter economy, but an accounting economy, in which, using the words of a modern General Equilibrium theorist, ‘each agent could be trusted to take out of the economy, in value terms, exactly what he put in’ (Gale 1982: 186).

Traces of Galiani’s idea in the history of economic thought The followers of Galiani did not make much of the above sketched-out part of his work. But Marx did: when he elaborated on the labour theory of value he picked up the thread of Galiani (though without explicit reference) and the concept of a labour-certificating currency, which in the meanwhile had been propagated by the socialist writer Owen. Marx (1975 [1857–8]: 53–8 and 85) hit upon serious shortcomings of the bookkeeping idea, i.e. the concept of issuing specific certificates (‘Stundenzettel’) documenting how much labour had been put into the production of some commodity by a particular worker; he recognizes that it would be impossible to honour simply each hour spent as an economic input; for value is only created by efficient work. Moreover, the ‘necessary amount’ (and quality) of labour, which determines each commodity’s relative price, is found ex post by forces of competition. Obviously, Marx conceived of a market process of allocation whereas Galiani (1999 [1751]: 159) in his benevolent-clearing-house approach recommended that the political sovereign ought to decree the value of each commodity and thus, indirectly, the value of each unit of labour used in their production. Marx (1975 [1857–8]: 46–7, 60 and 82) confirmed the bookkeeping approach with regard to money when he argued that the ‘socially necessary quantity of labour’, which serves as the standard of value, must exist in a physically observable form in the market because each commodity draws its effective value, not from a notional measurement, but from an actual exchange with money. He was puzzled by the seemingly strange trait of a capitalist market society that the – so to speak – collective average of all members’ labour input, i.e. money, is opposed to the market supply of each single member and thus executes a rating of his work: a social order of production embodied in an isolated object! Money does not certificate a market agent’s individual and labour input, but his contribution to the social product as assessed by the demand of other agents. The product of ‘private labour’ does not count as ‘socially necessary labour’ before it is successfully sold on the market. The interpretation of money as an embodiment of ‘socially necessary labour’ led Marx to believe that the money medium itself must be a produced commodity. Hence, he is to a greater extent a metallist than Galiani who recommended the use of precious metals only because of a

154

H.-P. Spahn

lower risk of being forged, but in his above vision stipulated that the sovereign controlled the quantity and authenticity of the labour certificates by his personal signature. The bookkeeping aspect in Marx’ monetary theory makes clear that the above-mentioned principle of fairness in the market distribution of real income in no way must be confused with the aim of equality of income distribution. The former requires that impersonal laws of competition govern market prices, whereas the latter might involve a far-reaching control or abolishment of the markets’ law of motion. For Marx, the exploitation of the labour force is no violation but the equilibrium outcome of a regime of a labour theory of value. The extraction of a surplus income from the labour class is efficiently accomplished by the interplay of money wages and prices, and overcoming the inequality of income would necessitate a changeover to another type of economic system. Shortly after Marx, the approach of understanding money as a bookkeeping device was overturned by a competing idea, which had a detrimental effect on the theory of money: Walras, who – like Marx – looked for a society where the market power of agents was less unevenly distributed than in the actual system of early industrialized capitalism, hit upon the idea of an auction where the economic inputs of all individuals should be converted into commodities that made up each agent’s personal income. The auction – a procedure to measure each person’s contribution to overall welfare – took the place of money, which in Marx accomplished the same task in a decentralized way. It can be questioned whether Walras really modelled a market society, as there are actually no markets in his theory (De Vroey 1999). The institutional set-up is basically different from a capitalist system; it is simply another type of economic order.1 Interestingly enough, Walras’ neoclassical companion Marshall also was motivated by visiting a bourse, but obviously it was the London stock exchange where transactions were carried through by means of a continuous trading, not the one-time spot trading organization, which was used in Paris (Kregel 1995). Therefore, differences between market and equilibrium prices, lack of information and false trading were among the issues in those theories, which had their source in Marshall. An aggregation of Marshall’s partial markets would not constitute Walras’ general equilibrium approach (De Vroey 1999). Money itself was not a key topic in Marshall. His most important descendant, Keynes, emphasized that contracting in terms of money is the essential characteristic of a market economy (1930: 3), but he was more concerned with the macroeconomic consequences of the use of money. The bookkeeping idea can be rediscovered in the sphere of the debate between metallist and nominalist theories of money. The less known German economist Bendixen (1922 [1920]) partly defended Knapp (1909) against his critics and confirmed the principle that the transfer of a money medium did not involve a transfer of a ‘real’ value given by that medium itself, but insisted that the buyer of goods makes over quantified symbols of some abstract value. He departs from Knapp though in the belief that these are not just nominal signs; the ‘essence’ of money, moreover, is an entitlement earned by each buyer’s work to

Money as a social bookkeeping device 155 acquire goods in the market.2 A concise summing up of his book Das Wesen des Geldes (1908) is given by his following statement: The modern style of economic activity does not consist in holding and exchanging goods between individual agents, but in the work of all and for the benefit of all people in the regime of an economic union, in producing for the community and in the consumption of the community. Therefore money, which has given the name to this economic order, is neither a tool for the execution of barter nor a medium of exchange, but rather a symbol indicating a service provided for the community, and the justification for receiving a return for one’s own input. (Bendixen 1922: V) This clearly is a resumption of Galiani’s vision, now embedded in the Historical School’s holistic view of the inseparability of the economic and the social system. Like Marx, money is seen to be the common denominator of all single, valued commodities. The rejection of the notion of money being a medium that facilitates barter paves the way for the conception of a means of payment. ‘Payment means the transfer of units of general value: economic entitlements to market commodities, given in a numerical, quantitatively specified amount’ (Bendixen 1922:19). The notion of a means of payment suggests itself if one – following Marx – conceives of money as a symbol representing abstract and highly liquid value, distinguishable only by its quantity; then a buyer hands over some parts of nominal wealth if he or she acquires a commodity. The notion of a medium of exchange, on the other hand, appears to be more reasonable if money only facilitates the technical exchange of goods, but is not being held as an asset by market agents, which also plays an important role in the savings and investment behaviour. Neoclassicals who see the essence of a market economy in a system of sophisticated barter tend to stick to the medium-of-exchange view. Thus Menger (1909: 579) explicitly denied any justification of treating money as a means of payment, in contrast to Keynes (1933a and 1979 [1933b]: 82) who headed for a ‘monetary theory of production’ that could be characterized by Marx’ famous formula M-C-M', i.e. the principle that investing and refunding sums of abstract wealth form the capitalist law of motion. Finally, also Schumpeter implicitly followed Galiani’s approach when he in one of his early writings defined money as ‘a certificate and valuation of productive services’ (1917: 634–6). In his subsequent book on monetary theory (which he hesitated to publish until his death) Schumpeter continued to speak of money as a claim to goods, which has its foundation in the money-using agents’ preceding work, when he elaborated on accounting problems in socialism and capitalism. In the first case, notes confirming a specified labour input might be issued by a central planning agency and later be withdrawn when spent for consumption goods. In the latter, the banking system is said to record the financial counterparts of all transactions and thus collects – although unintentionally – an

156

H.-P. Spahn

image of the society’s economic life. Each person’s account is credited with the value of his individual services, and debited with the value of his withdrawals of goods from the national product. Schumpeter envisaged an accounting economy, which serves as a ‘scaffold’ for each type of economic system. A main accounting agency actually takes over the job of Walras’ auctioneer. As a medium of account and a tool to distribute income he considered money, preferably in the form of bookkeeping entries, to be indispensable in all these economic orders. ‘The idea that everyone’s economic transactions will be recorded on an actual or imaginary account is extremely informative for the understanding of social interrelations and processes; it is thus a basic concept of monetary theory’ (Schumpeter 1970 [1930]: 127, emphasis added; see also Chs IV, VI and IX). As Galiani before him, Schumpeter does not draw a clear-cut distinction between the clearinghouse approach with its factual bookkeeping and a decentralized system where money can be interpreted to carry the information on its bearer’s productive services.

Accounting and payment in low-trust societies The great auction that was used by Walras to describe the working of a market system obviously excluded the problems of time and imperfect information. All contracting takes place once for all at the same time (whereas delivery of goods occurs at stipulated dates), and there are contracts for all future possible needs of market agents (Hahn 1980). There is no dispute on the realism of the Walras–Arrow–Debreu model. It is unable to grasp the evolutionary aspect of the economic process. The critical assumption with regard to the analytical content of the model, however, is that agents are believed to trust each other. ‘The Arrow–Debreu model concerns itself with trading at the first date only, because it implicitly assumes that a promise to deliver a commodity is as good as the thing itself’ (Gale 1982: 235). The auction where relative prices for future deliveries are determined thus has to be supplemented by another government agency, which guards the fulfilment of all contracts. This would amount to a tricky and costly task, as these contracts in general could be made contingent on various events or states of the world, which may not be observable with certainty. The follow-up model of sequential trading surely made a big step towards realism. Here agents equipped with some physical endowments move through historical time and randomly meet other agents who offer useful goods and services. It seems reasonable to assume that the potential buyer has nothing suitable to trade in return, particularly if the special case of a long-term relationship between the trading partners is ignored. The buyer’s only opportunity is to write a promissory note indicating that he or she is willing to deliver some amount of specified commodities at a future date. Each buyer thus becomes a debtor. As a consequence the markets would be flooded with millions of heterogeneous promissory notes of dubious solidity; the deplorable creditors would be busy

Money as a social bookkeeping device 157 hunting up their debtors and getting them to deliver the stipulated quantity of goods. Thus it becomes apparent why such a barter economy never existed at all. No seller would be ready to agree to these types of trading contracts altogether. The basic problem is, on the part of potential sellers of goods, a lack of information about the ‘character’ of market participants; and the difficulty of signalling their credibility, on the part of potential debtors. Therefore ‘limited commitment . . . rather than physical trading frictions’ call for a money medium (Kiyotaki and Moore 2002: 62). It is neither an essential feature of money that it reduces transaction costs, nor that it enhances the efficiency of barter; rather its existence is a precondition that enables the opening of economic transactions in a society based on the division of labour. A monetary economy thus is an alternative economic order vis-à-vis a Walrasian system (Laidler 1988). The following parable shows again that money can be used as a bookkeeping device: Two elderly, largely self-sufficient gentlemen live on an island. . . . Their sale contact is the irregular exchange of dinners. Since both agree that meal preparation is onerous, they take turns. However, because dinners are exchanged so infrequently and because their memories are not what they used to be, these Robinson Crusoes cannot always agree on who gave the last dinner. . . . These disagreements have produced so much tension and illwill that dinners are now exchanged even less frequently. To attenuate this problem, the one who is coming to dinner next picks up a stone and paints it an artificially colored green to distinguish it from other stones and brings it to his host. At the next planning session for a dinner, the most recent host will be reminded by the presence of the green stone that it is his turn to be invited, and he will be expected to bring the stone with him when he arrives. Indeed, without receiving the stone the host may feel justified in turning away his guest as not having the required evidence of an invitation. This quite rudimentary story reveals an essential feature of monetary exchange. Money is a commonly acknowledged record-keeping device. Here the only information about the past which has to be recorded is who gave the last dinner. Each gentleman ‘pays’ for his dinner by transferring the record of this fact to the other. (Ostroy and Starr 1990: 8–9, emphasis added) This story elucidates that money is needed even in the extremely simple case of a two-person barter society where only two goods of equal quantity and – let us assume – quality are regularly exchanged. Thus the Adam Smith problem, the missing double coincidence of wants, does not exist, and yet without money trade would not occur because of incomplete information or low trust. The parable even in a literal way gives the understanding that money serves as a kind of memory (Kocherlakota 1998). The touch of distrust noticeable between the two Robinsons also hints to the fact that market agents rightly act on the

158

H.-P. Spahn

assumption that their trading partners will behave selfishly, and might not even shrink back from fraud and deception if this appears to be advantageous after considering all sorts of costs. Because of their sheer size and complexity, market economies are low-trust societies, where people’s daily routine depends on the proper working of basic institutions; here, trust means to ignore the risk of that assumption. Moreover, individuals do not know whether their potential trading partners are able or willing to deliver a quid pro quo if they demand goods and services in the first place. The use of money is an attempt to ‘depersonalize’ this interaction problem. Two-party contracts, the realization of which is at risk due to information problems, are substituted by a three-party arrangement.3 The third party, i.e. money, acts as a kind of trustee, it contributes its own reputation to the otherwise instable bilateral business relations, and it relieves both participants of proving their solidity to each other before any contract can be signed. The buyer of any commodity thus does not write out an own promissory note, which requires him to deliver goods or services later, but hands over a token or medium that serves as a means of payment. Thus, distrust or evil is the root of money or, to put it inversely: ‘The institution of money can act as a substitute for trust’ (Gale 1982: 23).4 Historically, the promissory note issued by a veritable third party was used, who became known as a banker. This note was generally accepted as a means of payment, which resolves all kinds of debt, because of the high reputation of the issuing agent or institution. The history of banking teaches that in order to earn reputation the issue of bank notes often was restricted by various regulations. The above parable shows, however, that mere symbols can fulfil the money role if the persons involved agree on this convention and if the token chosen as the money medium exhibits the basic requirements of low verification and high counterfeiting costs. The general acceptance of a promissory note circulating as money reveals that a claim against a particular debtor has been substituted by a claim against the market society as a whole – as each of its members is willing to deliver goods in return for a money payment. From a sociological point of view, Simmel (1982 [1907]: 177–8) held it to be ‘the core of truth in the theory that money is only a claim upon society. Money appears . . . as a bill of exchange from which the name of the drawee is lacking; . . . the liquidation of every private obligation by money means that the community now assumes this obligation towards the creditor’. The notion of ‘payment’ involves a convention: one type of asset, the debt paper of the buyer, is merely replaced by another asset, money, which represents a social liability vis-à-vis its bearer. But the first type of asset is a ‘named commodity’ and exhibits a risk of default whereas the latter is defined to be without risk in this respect; this enthrones money as the asset, which measures the liquidity of all other assets. The seller of any commodity, if being paid in units of money, is no longer interested in the reputation of the buyer. ‘Because money is a claim on the economy as a whole rather than on a single individual, there is no need to acquire information about the individual who offers it in exchange’

Money as a social bookkeeping device 159 (Gale 1982: 187; see also Kiyotaki and Moore 2002: 186). The flipside of this argument is that money not only economizes on trust and information, but also enables anonymous trade on the part of buyers (Hahn 2002). The use of money establishes a payment society where debts resulting from acts of purchase are immediately discharged, as an alternative to the fragile structure of creditor–debtor relations, which is implied by a barter economy. Hence, in a way, money helps to relieve the economy from the complications related to the aspect of time, as spot payments replace intertemporal commodity loans (Spahn 2001: Ch. 2). Therefore, Keynes’s famous dictum that ‘the importance of money essentially flows from its being a link between the present and the future’ (1973 [1936]: 293) might appear to turn the essence of a monetary economy upside down. But on a second look an obvious justification for that assertion can be found if the question of budget constraints is raised: whereas in a one-time Walrasian auction a person trades his whole lifetime income against the flow of his lifetime consumption, sequential trading also implies that agents should be forced to obey to a sequence of monetary budget constraints so that moral hazard can be precluded. All members of a market society then can be sure that none of their fellow citizens is able to consume goods of a greater value today compared with his individual contribution to the national product yesterday. Budgets have to be balanced in money terms in each period, including intertemporal transactions, i.e. savings and loans. People also hold money in order to make provision for their solvency in a regime of stochastic trades (Laidler 1988 and Hellwig 1993). Needless to say that the possibility of receiving a general claim on all goods and services instead of a definite quantity of a specified commodity increases any seller’s utility, because this monetary payment opens up the option of reallocating the demanded bundle of consumption goods (or assets held) at some later date. This view leads to the interpretation of the market rate of interest as an option price (see Kregel 1998: 123 and Hahn and Solow 1995: 144). The procedure of allocating resources should preserve a ‘neutral’ status; its mechanisms and rules should not be opaque and suspected to involve acts of arbitrariness or bribery. People observing the consumption of others then are induced to keep quiet, because they know that in order to acquire resources they will not have to resort to physical violence, they also will be able to buy later by means of payment, which therefore becomes the ‘unit act’ of a market economy. Money not only serves as a common language in economic communications and transactions, but also brings about a definite transfer of property rights. ‘The problem of scarcity of resources is transformed into the shape of scarcity of money. The problem of scarcity arises if somebody excludes others from the access to resources for the sake of his own future welfare. The question is: on what condition and how is he allowed to do so? The answer given by the communicative medium money is: if he pays’ (Luhmann 1996 [1988]: 252; see also ibid.: 46–7, 52, 69, 246–7, 253 and Ostroy and Starr 1990).

160

H.-P. Spahn

The meaning and limitations of the monetary bookkeeping approach The use of some currency for writing monetary contracts, which in turn makes that currency the definite medium to settle these contracts, can be understood as the result of an implicit agreement of the members of a market society. Of course, government agencies may shorten the evolutionary process of search for a suitable money medium by suggesting and establishing a national currency – this is the element of truth in the view of Knapp (1909). But the agreement always remains a fragile expectation equilibrium where changes of beliefs tend to exhibit a cumulative character (Dow and Smithin 1999). Accepting a fiat money note without intrinsic value as the ultimate equivalent for the disutility of work and for a definite delivery of resources amounts to a very demanding act of abstraction. The fundamental problems of low trust, which precluded the intertemporal barter solution to the organizational problem of coordinating activities in a market society, are concentrated on, and have to be solved by, the chosen money medium. This marks an enormous gain with respect to the economics of information, as individual agents are exempt from proving their own reputation in each transaction, but it creates a substantial task of establishing and preserving the reputation of a national currency. How does society learn to trust and accept its currency? This is where the bookkeeping idea appears to contribute to our understanding of money. To begin with, bookkeeping is no function of money; rather, it is an ascribed feature of the money medium in use, which is assumed to support the acceptance of that medium as a means of payment. The history and the theory of money know various mechanisms that have been applied or propagated in order to establish and preserve the acceptance and reputation of a money medium. A famous way of trying to make people believe in the value of money was the argument that it is ‘backed’ by some other valuable asset (De Grauwe 1996: 2). The bookkeeping approach lends support to this idea because its roots might be located in some sort of ‘labour metallism’. But money is not made of any ‘substance’, and it does not measure subjective inputs, although this opinion can be read off from Galiani’s work and from the somewhat romantic Historical School writings of Bendixen. Marx and General Equilibrium theory rightly emphasize that money measures the markets’ valuation of inputs, or equilibrium prices (in the appropriate sense of a sequential trading economy). A second possibility of enhancing the reputation of a currency might evolve from an approval of the macroeconomic results of the monetary process of production and distribution. The core of the bookkeeping idea consists of the argument that an agent is ‘justified’ to consume a certain amount of goods and services because he or she has correspondingly contributed to the overall welfare of the economy. Basically, this is a statement on a ‘fair’ real wage; its link to monetary theory is given by the additional hypothesis that money is a certificate of the agent’s (valued) contribution.

Money as a social bookkeeping device 161 But the use of money indicates a ‘fair’ trade only insofar as market agents obey their budget constraints and signal that they are willing to bear the cost of their purchases. This knowledge may help to maintain the social acceptance of the outcome of the process of income distribution. This hypothesis suggested by Luhmann (1996 [1988]) however is highly debatable. The acquisition of resources via money payments only means that agents behave according to the ‘rules of the game’, which of course does not imply that the game itself is approved by all of its participants. Moreover, there are numerous reasons to believe that competitive market forces do not always bring about an objective, i.e. impartial valuation of an agent’s supply of goods and services (Hayek 1969 [1967]: 122). The basic flaw of the bookkeeping idea, from the point of view of modern monetary theory, stems from its roots in the vision of a society where income is distributed in accordance with the decision of a collective body or a benevolent dictator. In this setting, the evaluation of any citizen’s contribution to the national product by means of record keeping at a central clearing-house is an obvious guide. But surely, things are fundamentally different in a market system where money symbolizes the decentralized pattern of the allocation of resources and income. Here, it seems odd to believe that a seller of resources accepts a money payment just because the buyer credibly assures to have earned these notes by hard work. Such an assurance stands for a backward-looking attempt of granting acceptance to a money medium. In a market economy, trust in a currency depends on a forward-looking reasoning. The decisive question is whether the disposition of money is supposed to entitle its bearer to obtain resources in the future. The above story of the two Robinsons does not invalidate this finding. In a way, this two-person economy exhibits elements of both the bureaucratic procedure of implementing a network of fair rewards and the competitive way of market exchange. Both members of the island society agree on the use of a ‘green stone’ in order to enforce their commitment in favour of a free and mutually advantageous trade. This money medium carries the information of each agent’s past work – this is the bookkeeping and fairness aspect – but much more important is the agreed-upon rule that entitles the bearer of the stone to receive the next dinner. This example-specific rule can be generalized and confirms the traditional goal of preserving the purchasing power of money. The acceptance of money rests on the expected future stability of the level of money prices. Bookkeeping does not enhance the acceptance of money because it does not support – and might even endanger – price stability on a macro-level: 1

2

People who trust in the stability of nominal prices know that this aim depends on the confidence of others. The rigidity of the price level – like the use of a currency itself – is built on mutual expectations. In this respect money is a public good (Grantham et al. 1977 and Luhmann 2000 [1968]: 90). As money also serves as a store of value, monetary stability is endangered if agents should start to convert their stock of holdings of financial assets into

162 H.-P. Spahn

3

4

goods. Even if money should have been issued strictly on account of the bookkeeping rule in the first place, inflation would undermine the quality of the currency, and interest rate policy is required in order to keep the agents’ money holdings ‘passively’ within the banking system. Money is not created by issuing certificates for hours worked, but originates endogenously from the extension of credit. It is essential for microeconomic efficiency and macroeconomic stability that the structure of credit is controlled by the commercial banking system, and its volume by refinancing and interest policies of the central bank.5 Any rule that links the creation of money to previous work or production of individual agents would resurrect the real bills fallacy again: the level of commodity prices becomes indeterminate as each nominal trade volume is being financed. The path of prices can no longer be controlled although banks confine themselves to discounting ‘solid’ trade bills. A correct measure of the value of an agent’s goods supply by money requires that any link between the production of these goods and the creation of money notes must be severed.6

A decisive distinction between a barter and a monetary economy is that money, considered as a medium facilitating the exchange, can become abundant vis-àvis the quantity of goods as a whole. Schumpeter (1970 [1930]: 219–25) noticed that the price level as such is an alien element in an accounting economy; its macroeconomic movement creates an order of its own; and some policy agency is required to define and preserve the stability of a ‘critical figure’ (in modern terms: a nominal anchor). Thus we finally arrive at the message that Wicksell (1965 [1898]) had spelled out earlier when he designed his vision of a paper money standard: because there is no firm endogenous nominal anchor in a monetary economy, the central bank ought to react with its interest rate to changes in the price level – a recommendation that now has become known as the Taylor rule.

Some final remarks Looking back it now appears as if the bookkeeping idea is nothing but a minor aberration in the history of economic thought, which had its roots in a romantic striving towards a ‘fair’ income distribution; in the quasi-metallist belief that money ought to comprise or present a ‘real’ substance, i.e. useful labour effort; and which implied some variant of the real bills fallacy when applied to practical monetary policy. But some elements of truth contained in the bookkeeping approach should not be ignored. These are, first, the principle of efficiently guided incentives in a society built on the division of labour; second, the necessity of money as a medium of payment, which results from a lack of information and mutual trust in large, anonymous societies; and third, a social mechanism or convention that ensures the overall acceptance of money. With regard to the last mentioned item, the idea that runs through from

Money as a social bookkeeping device 163 Galiani to modern General Equilibrium theory is the following: money is accepted because it signals that its bearer has taken upon himself some real cost that entitles him to demand a real equivalent in return. It comes as no surprise that (pre-)classical writers envisioned this real cost to consist of accomplished labour. From the point of view of modern monetary theory, it would be more obvious to take into account that all money is created in an act of credit. This implies that for each money unit in circulation some market agent pays, directly or indirectly, interest to the central bank (Riese 1995). Thus, in a monetary economy, it is interest costs and not labour costs that indicate the solidity of the currency and the degree of its scarcity vis-à-vis the supply of goods and services. For a seller of resources the knowledge that money in circulation is charged with interest costs generally signals that other market agents cannot live beyond their budget constraint. But strictly speaking, it is irrelevant for him whether the person opposite the counter has paid interest for the notes, which he plans to use in the act of purchase; what counts is the seller’s expectation that the central bank keeps the rate of interest high enough so that the stability of future prices appears to be ensured. That is why bookkeeping has turned into the widespread fashion of central bank watching.

Acknowlegements I am grateful to the participants of the Treviso conference and, in particular, to an anonymous referee, for providing critical and helpful remarks to a previous version of the chapter.

Notes 1 Walras misled his followers for more than a century to draw ‘economic laws’ from his auction model, which are valid only here, but not in a monetary market system. As a consequence, economic theory was set on a wrong track with regard to many issues; the notion of a real rate of interest is one of the most prominent examples (Spahn 2001: 25–32). 2 Schumpeter (1970 [1930]: 85) coined the phrase ‘transfer theory of money’ to characterize Bendixen’s approach. The opinion of Bendixen that money entitles its bearer to the consumption of goods, the value of which he himself has helped to produce, quite naturally made him succumb to the real bills doctrine. 3 ‘Monetary relations are trilateral. Monetary exchange . . . involves a third party of those authorities that may legitimately produce money’ (Ingham 2000: 23; see also Kiyotaki and Moore 2002). 4 See also Kiyotaki and Moore (2002). This conclusion drawn by neoclassical General Equilibrium theory was already known in sociology before: ‘Anybody who disposes of money does not need to trust others’ (Luhmann 1968: 66). The topic of trust is also dealt with in Simmel’s work; but he did not grasp clearly that money acts as a substitute for interpersonal confidence: ‘Without the general trust that people have in each other, society itself would disintegrate, . . . in the same way, money transactions would collapse without trust’ (Simmel 1907: 179). 5 Schumpeter (1970 [1930]: 210) addresses this topic by introducing two types of

164 H.-P. Spahn money: they both come in the form of current account balances and both represent a claim on the national product, but the first is considered to be a certificate of accomplished work, and the second is the mirror image of credit creation. But whereas the bookkeeping idea suggests a ‘natural’ restriction governing the quantity of the first type of money, the constraints on the second type remain somewhat obscure. 6 These problems are hidden in the above told story of the two Robinsons, because there were only two agents, two goods and the knowledge that there is only one ‘green stone’. The illegitimate manufacturing of a second money unit would immediately be detected. Therefore, in this example, the bookkeeping feature of money coincides with the expectation that the possession of money entitles to the pleasure of being served with another meal in the near future.

References Quotations from German texts have been translated by the author. Bendixen, F. (1908) Das Wesen des Geldes, München: Duncker & Humblot. —— (1922 [1920]) ´Zur Frage der Definition des Zahlungsmittels und der Werteinheit’, in F. Bendixen Geld und Kapital, 3rd edn, Jena: G. Fischer. De Grauwe, P. (1996) International Money, 2nd edn, Oxford: Oxford University Press. De Vroey, M. (1999) ‘The Marshallian Market and the Walrasian Economy: Two Incompatible Bedfellows’, Scottish Journal of Political Economy, 46: 319–38. Dow, S. C. and Smithin, J. (1999) ‘The Structure of Financial Markets and the ‘First Principles’ of Monetary Economics’, Scottish Journal of Political Economy, 46: 72–90. Gale, D. (1982) Money: In Equilibrium, Cambridge: Cambridge University Press. Galiani, F. (1999 [1751]) Über das Geld, reprint, ed. by W. Tabarelli, Düsseldorf: Wirtschaft & Finanzen. Grantham, G., Velk, T. and Fraas, A. (1977) ‘On the Microeconomics of the Supply of Money’, Oxford Economic Papers, 29: 339–56. Hahn, F. H. (1980) ‘General Equilibrium Theory’, Public Interest (Special Issue): 123–38. —— (2002) ‘The Dichotomy Once Again’, European Journal of the History of Economic Thought, 9: 260–7. Hahn, F. H. and Solow, R. M. (1995) A Critical Essay on Modern Macroeconomic Theory, Oxford: Blackwell. Hayek, F. A. von (1969 [1967]) ‘Grundsätze einer liberalen Gesellschaftsordnung’, in F. A. Hayek, Freiburger Studien, Tübingen: Mohr Siebeck. Hellwig, M. F. (1993) ‘The Challenge of Monetary Theory’, European Economic Review, 37: 215–42. Ingham, G. (2000) ‘“Babylonian Madnes”: On the Historical and Sociological Origins of Money’, in J. Smithin (ed.), What Is Money? London: Routledge. Keynes, J. M. (1930) A Treatise on Money, vol. I, London: Macmillan. —— (1933a) ‘A Monetary Theory of Production’, in G. Clausing (ed.) Der Stand und die nächste Zukunft der Konjunkturforschung, München: Duncker & Humblot. —— (1979 [1933b]) ‘The Distinction between a Co-operative Economy and an Entrepreneur Economy’, in The Collected Writings of John Maynard Keynes, vol. XXIX, ed. by D. E. Moggridge, London: Macmillan. —— (1973 [1936]) ‘The General Theory of Employment, Interest, and Money’, in The Collected Writings of John Maynard Keynes, vol. VII, ed. by D. E. Moggridge, London: Macmillan.

Money as a social bookkeeping device 165 Kiyotaki, N. and Moore, J. (2002) ‘Evil Is the Root of All Money’, American Economic Review, Papers and Proceedings, 92: 61–6. Knapp, G. F. (1909) ‘Geldtheorie, staatliche’, in Handwörterbuch der Staatswis senschaften, vol. 4, 3rd edn, Jena: G. Fischer. Kocherlakota, N. R. (1998) ‘Money Is Memory’, Journal of Economic Theory, 81: 232–51. Kregel, J. A. (1995) ‘Neoclassical Price Theory, Institutions, and the Evolution of Securities Market Organisation’, Economic Journal, 105: 459–70. —— (1998) ‘Aspects of a Post Keynesian Theory of Finance’, Journal of Post Keynesian Economics, 21: 111–33. Laidler, D. (1988) ‘Taking Money Seriously’, Canadian Journal of Economics, 21: 687–713. Locke, J. (1956 [1690]) Second Treatise on Government, reprint, Oxford: Blackwell. Luhmann, N. (2000 [1968]) Vertrauen: Ein Mechanismus der Reduktion sozialer Komplexität, Stuttgart: Lucius & Lucius. —— (1996 [1988]) Die Wirtschaft der Gesellschaft, Frankfurt: Suhrkamp. Marx, K. (1975 [1857–8]) Grundrisse der Kritik der politischen Ökonomie, Frankfurt: Europäische Verlagsanstalt. Menger, C. (1909) ‘Geld’, in Handwörterbuch der Staatswissenschaften, vol. IV, 3rd edn, Jena: G. Fischer. Ostroy, J. M. and Starr, R. M. (1990) The Transactions Role of Money’, in: B. M. Friedman and F. H. Hahn (eds) Handbook of Monetary Economics, vol. I, Amsterdam: North-Holland. Riese, H. (1995) ‘Geld: Das letzte Rätsel der Nationalökonomie’, in W. Schelkle and M. Nitsch (eds) Rätsel Geld: Annäherungen aus ökonomischer, soziologischer und historischer Sicht, Marburg: Metropolis. Schumpeter, J. A. (1917) ´Das Sozialprodukt und die Rechenpfennige’, Archiv für Sozialwissenschaft, 44: 627–715. —— (1970 [1930]) Das Wesen des Geldes, Göttingen: Vandenhoeck & Ruprecht. —— (1994 [1954]) History of Economic Analysis, reprint, London: Routledge. Simmel, G. (1982 [1907]) The Philosophy of Money, reprint, Boston: Routledge & Kegan Paul. Spahn, H.- P. (2001) From Gold to Euro: On Monetary Theory and the History of Currency Systems, Berlin: Springer. Wicksell, K. (1965 [1898]) Interest and Prices – A Study of the Causes Regulating the Value of Money, New York: A. M. Kelly.

11 Death in Venice – John Law Art collector, monetary theorist and corporate financier Antoin E. Murphy

Now the carnival is ended great numbers of strangers are leaving us every day . . . Mr. Law was taken ill here about nine days ago, and has been given over by his physicians eight and forty hours. He was first taken with a shivering cold fit which lasted him five or six hours, that was succeeded by a violent hot one, which has never intermitted but continued upon him ever since. I saw him for the last time the day before yesterday: he was then very sensible of the danger he was in, and, as he told me very desirous to die: believing his death would be of greater service to his family at this juncture than any other; because the cardinal has just now appointed three or four gentlemen to examine and state his accounts, and he thinks they will be more inclined to do him justice in France, when they shall know how poor he dies, and that he has nothing in any part of the world but in that country and in the King’s hands. He has ordered his son, who is here with him, to go to France.1 Mr. Law is dead, after struggling seven or eight and twenty days with his distemper, which was judged mortal by his physicians from the beginning. He died with great calmness and constancy, and is spoke of here with much esteem.2 he preserved his senses to the very last quarter of an hour, and did everything he could think of in order to facilitate our affairs.3

John Law died in Venice on 21 March 1729. Though a man of the eighteenth century, Law had the vision of a man of the twenty-first century. In this chapter it is intended to show aspects of this vision involving the world of art and monetary and finance theory. What has art to do with monetary and finance theory? Little or nothing. However, on both fronts Law was criticized by contemporaries and later generations of commentators on his life and works. If such commentators were to be believed Law was not only a poor monetary theorist, but, also, a neophyte in the area of art appreciation who was duped into purchasing a poor collection of art. Both these areas of Law’s activities deserve a reappraisal. In this chapter an outline of Law’s early career as a monetary theorist is initially presented. The narrative then switches to examine, against the backdrop of his life and death in Venice, his career as an art collector. The following section

Death in Venice – John Law 167 attempts to assess Law’s contributions to corporate finance through the development of the Mississippi System in France. It is concluded that both from the viewpoints of monetary and finance theory and art collecting that Law has claims to be regarded very much as a modernist, a man not just of the eighteenth century but also one of the twenty-first century.

Law the monetary theorist The great fascination about John Law’s work is that he was not only able to theorize about money and its role in the economy, but, that he was given the opportunity to implement his theories as policy in France. Few economists have been presented with such opportunities. Born in Edinburgh in Scotland in 1671 Law’s early life gave little indication as to the future career that he would lead. In his early sightings in London he was seen as a man about town interested in ladies and gambling. As Beau Law he was involved in a duel with another ‘beau’, Edward Wilson. Law killed the latter in a duel in Bloomsbury Square in 1694 and was sentenced to death for this killing. Escaping from prison, Law travelled to the Continent and became interested in the banking systems that had been established in Italy and Holland. Turning his back on his activities as a rake, Law became fascinated by the possibilities that money and banking presented. His writings show that he wanted to encourage policymakers to restructure radically their financial systems. To accomplish this he started, in the first decade of the eighteenth century, to send his monetary proposals to the governments of England, Scotland and France. His first known work Essay on a Land Bank (1994) was submitted in manuscript form to Lord Godolphin in 1704. In it Law recommended the establishment of a land bank in England. This manuscript shows that Law, by the age of 33, had developed a sophisticated approach to analysing money. He defined money as follows: Money is used as the measure by which goods are valued, as the value by which goods are exchanged and in which contracts are made payable. (Law 1994: 55) He would later re-emphasize this in Money and Trade (1705). Law’s insistence that money was the value by which goods were exchanged represented a massive break with the existing orthodoxy that defined money as the value for which goods were exchanged. Law’s replacement of the preposition ‘for’ with ‘by’ showed that he believed that money did not need to be intrinsically valuable. By decoupling money from intrinsic value he produced an alternative conceptualization to the metallist view of money. This decoupling involved a significant liberation in that instead of waiting for metallic money stocks to be changed by the vagaries of discoveries it was possible to take over a country’s monetary destiny through control of its banking system. If money was in short

168 A. E. Murphy supply the policymaker could arrange for the issue of more banknotes/bank credit to meet the shortage. Here Law believed that it was vital for the policymaker to have this type of power because he believed that money drove economic activity. If there was unemployment and underutilization of resources, money could and should be used to expand economic activity. The title of his book Money and Trade showed the symbiotic link that he believed to exist between money and trade with the latter representing at the time a synonym for economic activity. Law believed that without an adequate money supply a nation could not progress. It was not a matter of money endogenously responding to the needs of trade. It was necessary to have money ex ante in order to drive trade. In this he was proposing a money-in-advance argument. This may be seen in a memoir that he addressed to the French authorities in 1706: It will be asked if countries are well governed why they do not process their wool and other raw materials themselves, since, where money is rare, labourers work at cheap rates. The answer is that work cannot be made without money; and that where there is little, it scarcely meets the other needs of the country and one cannot employ the same coin in different places at the same time.4 In this passage Law was asserting that not only was money needed in advance in order to pay labour to produce goods and services but that waiting for ‘cheap labour’ to produce commodities was futile unless there was money to pay them. Law showed the importance of money in the economy by outlining a skeletal circular flow of income model where the creation of paper money facilitated the transformation from an agricultural-based barter economy to one incorporating an industrial sector. Implicitly he understood that in order to have the division and specialization of labour along with the increasing returns derived from growing the market it was necessary to have money. The freeing of money from its metallic shackles produced another benefit once banks were established. Law understood that there were two sides of a bank’s balance sheet to consider. On the liabilities side the new money, either in the form of banknotes or deposits, enabled transactors to perform exchange operations more easily than in a barter economy. Gold and silver could also be used as media of exchange, albeit with greater costs. What distinguished bank money from metallic money was the assets side of the bank’s balance sheet. Metallic money was uni-dimensional in that it could be used for exchange but nothing else. Bank money, on the other hand, created another group of transactors, namely borrowers. The magic of the new banking system was its duality in catering both for depositors and borrowers. Under a metallic monetary system the holder of specie could lend to a borrower, but, once this transaction was finalized, the specie holder no longer had the use of his specie money. With banks the depositor could still use his deposit, but the bank was also creating assets by lending out money deposited with them. The banks metamorphosed

Death in Venice – John Law 169 the process of savings and investment by enabling transactors that had hitherto been excluded from financing possibilities to borrow for investment purposes. Law saw the revolutionary possibilities for transforming an economy through the banking system. Banks could seek out entrepreneurs who would invest the money lent to them. Here there is a reciprocity of needs in that the banks need good borrowers and entrepreneurs need banks to finance them. Law’s proposals for banks, both in England and Scotland, were not accepted. It was not until 1716 that France’s regent, Philippe duc d’Orléans, gave his permission for Law to embark on his plans to start developing what would become known as Law’s System. These developments, which would ultimately end with the crash of the Mississippi System in 1720, are discussed below.

Law in Venice Because of the collapse of the Mississippi System, Law was forced to depart hastily from France in December 1720. He went to Italy, spending some time in both Rome and Venice. He was determined to return to France to have another attempt at introducing his monetary system. To accomplish this he travelled back to England on the fleet of Admiral Norris and lived in London. From there he was in frequent contact with the duc d’Orléans. Despite all the problems that the crash of the Mississippi System had engendered, the Regent still believed that Law was capable of redressing France’s financial problems. He was on the brink of inviting the Scotsman back to France so that by April 1723 the British embassy in Paris was discussing the possibility of a recall for Law. The Regent even sent his secretary, Jean François Melon, who would later write the Essai politique sur le commerce (1734), to negotiate with Law about the possibility of him returning and advising, once more, on the French financial situation. The death in November 1723 of Law’s arch-enemy, the Cardinal Dubois, who had strongly opposed any possibility of Law’s return, greatly increased the probability of Law’s return. The Marquis de Bully even wrote to Law requesting him to return without waiting for an ‘express order’ from the Regent. Unfortunately, for Law, the Regent suddenly died in December 1723 just at the time when he was to be recalled to Paris. The new Regent, the Duke of Bourbon, though he had benefited enormously from Law’s System, was hostile to Law – an antagonism stoked up by his mistress, Madame de Prie, a staunch friend of Law’s main opponents, the Pâris brothers. There was no further possibility of Law returning to France. With the door to Versailles shut Law decided to return once more to Venice. This was readily understandable for the attractions of Venice were considerable. It was a city bursting with artistic talent and bubbling with entertainment. Painters such as Canaletto, Rosalba Carriera, Guardi, Pellegrini, Ricci and Tiepolo lived there. The composer Vivaldi was the maestro di cappella of the Pietà, the orphanage for female foundlings. Venice appeared to thrive on its seasons of carnivals, with the intensity of these carnivals growing as the season of Lent approached. Beautifully dressed dancers, brilliantly masked, flitted to

170

A. E. Murphy

and from the balls in the many palaces of the city. There were of course also the ridotti where various types of gambling took place on a continuous basis. Law, bereft of outlets for his economic ideas, appears to have decided to immerse himself in the world of art and to finance his activities through his gambling skills. Perhaps Law even visited the neighbouring town of Treviso, a town with strong links to corporate finance, for it was here that the Treviso Arithmetic was published in 1478. Poitras (2000) recently dated the start of the early history of financial economics to the publication of this book. Law was a man of style so he needed suitable accommodation in which to present himself. He appears to have lived for at least part, if not all of the time, in the Palazzo Mocenigo in Venice for it was to there that his London banker George Middleton sent the correspondence relating to Law’s financial affairs.5 Overlooking the Grand Canal, the Palazzo Mocenigo was owned by the illustrious Mocenigo family who provided seven doges for Venice. In the eighteenth and nineteenth centuries it was a much sought after location for important visitors to Venice such as Casanova, Lady Mary Wortley Montagu and Lord Byron. The latter was so inspired by it that he hired the whole palace for 200 pounds a year. Apparently Byron, while there, armed with a knife threatened his housekeeper with whom he had an affair. The latter found it necessary to jump into the canal from a window to avoid Byron’s thrusts! Law, while in Venice, was also threatened with death by the de Longueville brothers who contended that his son William had received 100,000 livres in specie at a time when Law had introduced a prohibition on the holding of more than 500 livres in coin and bullion in France. They threatened to kill both Law and the son. For Law, the Palazzo, aside from its architectural beauty and splendid furnishings, was ideally placed as it was close to the Ridotto where he could attempt to re-build his fortunes by gambling. The paintings of Pietro Longhi and Francesco Guardi enable us to move back through time to catch the ambiance of the Ridotto. Longhi’s painting of a scene in the Ridotto in 1740 shows the entrance of masked ball revellers, covered by the bautta – the combination of mask, black cape and tricorn – while on the right of the scene cards spill over on the floor from what appears to be a drunken card game. Guardi’s magnificent painting of a later date shows a more settled scene with elegant well-dressed ladies and gentlemen conversing in the Ridotto, showing that it was not only a space for gambling but also an area in which wealthy Venetians and visitors to the city met and socialized. In John Law Economic Theorist and Policy-Maker (1997) I tried to show that the caricature of John Law the gambler needed to be re-assessed. He had a very quick mathematical mind and, rather than speculating, Law believed in using the laws of probability to his advantage. In gambling games such as faro he always acted as the banker where the odds were stacked in his favour. So to call Law a gambler is to do him an injustice. He was more an eighteenth-century bookmaker, one who ensured that the odds favoured him rather than relying on the goddess of chance. The caricature of Law the gambler has served as an easy way for economists to parallel Law’s career at the tables with his role as an economic

Death in Venice – John Law 171 policymaker. He has been deemed as someone who gambled with the French economy. But this is a false caricature. Law, let it be repeated, did not gamble with his money. It is more truthful to say that he invested his money in games where there was a very high probability of him winning. By the time he came to France in 1714 he had already made an immense fortune of around 1.6 million livres at gaming tables all over Europe including Venice. On his return to Venice in the 1720s his visits to the gaming tables were once again rewarding. The British resident in Venice, Colonel Elizeus Burges, confirmed his skill at making money: he [Law] had certainly won a good deal of money here: some of which he spent and he laid out a great part of the rest in pictures, some of which he sent to England before he died and the rest are still here. I think it is generally agreed he bought his pictures very ill and was horribly imposed on in every bargain he made. However, he thought otherwise himself and relied so much upon his own judgement that he advised with nobody and fared accordingly; for no man alive believes that his pictures, when they come to be sold will bring half the money they cost him.6 Burges’s letter shows that not only did Law make money in the Ridotto, but that he invested a substantial amount of it in art. While impressed by Law’s skills at the gaming tables, Burges was less impressed with his knowledge of art. In response to this, Law would probably have answered that (1) Burges was unaware of the extent of his art purchases and (2) many of the paintings that he purchased stood the test of time and would represent a fine collection by today’s standards of art scholarship. The inventory of his possessions, compiled after his death, revealed 81 boxes of paintings, sculptures, musical instruments and furniture that belonged to him.7 The inventory shows that Law possessed 488 paintings, alongside a collection of musical instruments and musical scores written by composers such as Antonio Vivaldi. So from the quantitative viewpoint Law had a considerable art collection, but what about its quality? Immediately on opening the first page of the inventory one finds the names of the great artists. This first page included a Titian, four paintings by Tintoretto, two by Veronese and a Paolo. Later on in the inventory the names of artists such as Correggio, Holbein, Michelangelo, Poussin and Leonardo da Vinci appear. There were also three Rubens! Care needs to be exercised here because, in some cases, Law could have been fooled by forgeries, copies and incorrect attributions. Furthermore many of these great paintings had not attained the dizzying valuations of modern times. These caveats aside the sheer quality of the names in the inventory encourages further investigation. The inventory had been compiled after Law’s death. By 6 August 1729 Law’s son, William, deposited the 81 boxes of Law’s art collection and the inventory with the French representative in Venice, Le Blond. The latter certified that these 81 boxes belonged to ‘Mylady Catherine Knowles’ and would be

172 A. E. Murphy sent to her on receipt of her instructions. On receipt of these he consigned the boxes to a ship sailing from Venice to Holland in late 1729. Unfortunately, for Law’s common law wife, Katherine Knowles, and family, the boat was caught in a storm and shipped water. The ship’s captain was obliged to return to Venice where it was discovered that many of the paintings had been damaged by coming into contact with the water. The subsequent discussions relating to insurance issues on the collection indicate that it was very valuable. Little is known about the fate of most of the paintings. One commentator, Armand Baschet (1875: 207), though giving no sources, maintained that the collection was sold in Holland in 1735. If this was the case the family still appears to have kept part of the collection, for 53 years after Law’s death, the London auctioneers Christie and Ansell announced an auction for Saturday, 16 February 1782 ‘A Catalogue of a few select first rate Pictures being the Reserved Collection of the celebrated Monsieur Laws, Well known for being the Planner of the Mississippi Scheme and Prime Minister to the Regent Duke of Orleans’ – see Appendix 1. It is possible that these were the paintings that Law sent to London prior to his death and so they therefore escaped from the damage that was the fate of the rest of the collection. The London catalogue included two portraits by the Venetian artist Rosalba Carriera (1675–1757) of both John Law and his son William. It is known that Rosalba Carriera, when visiting the financier Crozat in Paris in 1720, painted Law and it would be natural to expect that Law asked her to paint his son also. The portrait was described by the cataloguer ‘A high finished portrait of the celebrated Monsieur Laws, one of the best of the charming artist’ and that of William as ‘His son, equally fine’. I would surmise that these paintings were later inherited by Law’s daughter, Mary Katherine, who had married her cousin, William, Viscount Wallingford in 1740. As Law’s son, William, had earlier died in 1734 and his common law wife, Katherine Knowles, died in 1747, it is reasonable to suppose that the paintings had come into the possession of Law’s daughter, Mary Katherine. However, due to the fact that Law had never officially married Katherine Knowles and that there were continuing disputes with respect to his estate in France involving the French government, his creditors, and his brother, William, who wanted to claim Law’s estate on the grounds that his brother had never married Katherine Knowles, one can understand why there was a great deal of mystery relating to Law’s art collection. These legal wrangles may also explain why it took so long for paintings from this collection to be linked to his name when coming on the market. The collection of 75 paintings were sold by the auctioneers and the total amount raised a little over £690 sterling, an average price of just over £9 per painting, suggesting that Burges’s comments were correct and that Law had for the most part bought badly. This would be very much a short term view for if we consider a number of the paintings sold at this auction we can now see that they represent some great works of art that are currently housed in museums across the world. It is not possible to identify exactly all of the paintings, because, in many

Death in Venice – John Law 173 instances, the description of them is too general. However, in some cases, the titles of the paintings are sufficiently specific to provide tentative identifications. Paintings by Correggio, Domenico Fetti, Guercino, Raphael, Guido Reni, Sebastiano Ricci and Nicolas Poussin have been tentatively identified from the collection providing not only evidence of the soundness of Law’s art purchases but also providing further history on the provenance of these great paintings. Law’s apparent favourite in this collection was Correggio’s ‘Jupiter and Io’. This painting was highlighted by the auctioneers on the title page of the catalogue as deserving particular attention. It was described as ‘a Corregio from the Orléans collection’. Inside the cataloguers related how Law had saved this painting from the destructive hands of the Regent’s son: Jupiter and Io. We are told that this truly first rate picture was rescued from the destruction by Monsieur Laws, when he was Prime Minister to the Regent Duke of Orleans, whose son had ordered it to be cut to pieces; we shall content ourselves with observing, that from Law’s situation in France this account is extremely probable, and certain it is, that he valued this picture above all price; it’s rare merit will doubtless abundantly speak for itself.8 It is known that a sister painting to ‘Jupiter and Io’ by Correggio, ‘Leda and the Swan’, was mutilated by the Regent’s son, Louis, later to succeed his father as Duke of Orléans. Gould has provided the following account of Orléans’s attacks on Correggio’s art: The regent died in 1723 and was succeeded by his son, Louis, who, after the death of his wife in 1726, became mentally unstable. In the Charles Coypel sale catalogue, 1753 (lot 2), is a description of the mutilation of the Leda. According to this, the erotic character of the picture, of a copy of Correggio’s Io (later at Berlin; the original at Vienna) caused Duke Louis to cut out the heads of the principal figures in both. As he retired to the abbey of Ste Geneviève in 1731 the incident is likely to have occurred between 1726 and then. (Gould 1976: 194) The incident must have happened earlier than Gould has indicated because Law would not have been in a position to stop Louis d’Orléans from mutilating the paintings after December 1720. The most likely story is that Orléans, having mutilated ‘Leda and the Swan’, was about to tackle the second Correggio, ‘Jupiter and Io’, when Law stopped him. This would have meant that the incidents had occurred between 1716 and 1720. The painting’s erotic allusions with Jupiter disguised in a cloud placing his furtive hand around the naked body of Io may have offended the young man’s sensibilities in the same way that ‘Leda and the Swan’ did. Law, at the time, was sufficiently powerful to prevent the young Orléans from destroying the painting. It appears that the painting was not the original of Jupiter and Io but a copy by Correggio. Unfortunately, it was

174 A. E. Murphy destroyed in Berlin’s Kaiser Friedrich Museum during the Second World War. The painting obtained the second highest price at the Christie and Ansell auction – £40–19–0. Incidentally, its presence at the auction, along with the Rosalba portrait of Law, suggests that Law had been successful in spiriting it out of France as part of his art collection after his downfall. Law’s affection for Correggio is borne out by the presence of ‘a fine copy’ from ‘The marriage of St. Catherine’ by this artist in the auction catalogue and his earlier acquisition of ‘una donna nuda del Correggio’ for what appeared to be 3,000 livres9 – and a ‘Madona cum Bambino, del Coreggio’.10 The highest price of the collection was obtained for a naval battle between the English and the Dutch Fleets on 3 June 1665 by William Vandevelde. This picture had been painted for the celebrated diarist Samuel Pepys, who had been Secretary to the Navy. It was later purchased by Admiral Russell, Earl of Orford. It was sold for £76–13–0. Law appeared to like naval scenes for there were two other Vandeveldes in the auction, one of them representing ‘the Dutch squadron, commanded by De Ruyter, Van Tromp, etc, flying before the victorious English fleet’. The collection contained three paintings by Nicholas Poussin, one of which, ‘Bacchanalians’, obtained the third highest price of £39–18–0. This may be the painting that is now housed in the National Gallery in London. Another possible London based painting from the collection is Raphael’s ‘Cartoon for the Miraculous Draught of Fishes’. It was described as follows in the catalogue: ‘The miraculous draught of fishes, the evident variation in this little picture from the cartoon, induces us to conclude it to be a first design for that grand work’. This work, now regarded as a masterpiece, sold for a very modest £5–15–6. Another Raphael painting ‘Susannah and the Elders’ sold for £12–12–0. While there could be doubts about the Poussins and Raphaels as to whether they were copies of the originals, this would not be the case with respect to many of the others because the artists were regarded as lesser lights who would not have been copied because of their relative anonymity at the time. Thus one would be reasonably hopeful that Guercino’s ‘Ecce Homo’ now housed privately in Milan, Lanfranco’s ‘Moses and the Messengers from Canaan’ in the Getty Museum, and Guido Reni’s ‘Susannah and the Elders’ in the National Gallery in London, came from Law’s collection.

Law the modern economist and corporate financier Judging by the limited selection of his art collection that has been discussed we can confidently call Law a modernist. He could walk into many of the international galleries and museums today and inform the curators how he had bought various paintings hanging in them. But what about his economic ideas, can they, like the art he bought, transcend from the eighteenth to the twenty-first century? Law, it is believed, could easily move from the National Gallery in London, the Louvre in Paris or the Metropolitan in New York, and visit the London Stock Exchange, the Bourse or Wall Street and feel at home. Certainly

Death in Venice – John Law 175 from an architectural viewpoint the buildings housing these exchanges would be different from the narrow sinuous rue Quincampoix, where the Mississippi shares were traded in 1719–1720, or the coffee houses such as Jonathans and Garraways in Exchange Alley in London. He would, however, still be able to capture the same electric atmosphere there watching the interaction of money and capital markets, for this is the world of corporate finance at work. Looking at it Law would be able to identify some of his financial architecture. Indeed, given Law’s theoretical work and the way in which he attempted to implement it, his financial innovations with respect to money and the capital market, there is a case for calling John Law the father of corporate finance. Business schools the world over now devote a substantial part of their curricula to the study of corporate finance. It is an important area to study for, as its name implies, it analyses the financing of corporations. The external financing of corporations comes from two sources, banks and the capital market. The intensity with which banks and the capital market is studied in corporate finance classes is in marked contrast to the relative insouciance with which money, banks, credit, the stock exchange and financial innovation are treated in economics. Aside from perfunctory lectures defining money and showing the operations of banks, the subject is frequently vacuumed out of further courses under various rubrics such as money is a veil, money is neutral, and money is superneutral. Apart from Keynesianism, money is given a very limited short-term role to play in the economy by monetarism. In the case of new classical macroeconomics, both in its mark 1 and mark 2 formats, money has been pushed off stage. In brief, for many macroeconomists money is unimportant. Students are told to concentrate on the real side of the economy. Hence the paradox, why are banks and capital markets so important to corporate financiers and, apparently, of diminishing importance to economists? Law would not have agreed with such a separation because he did not believe that money was neutral. Furthermore he was a strong believer in the importance of developing financial markets so as to improve overall liquidity in the economy. In Figure 11.1 some aspects of Law’s basic financial architecture have been outlined. He believed that he faced dual crises in France, a monetary crisis due to the shortage of money, and a financial crisis due to the sizeable burden of the national debt. To address these crises Law’s financial architecture involved a twin tower approach. The first tower involved the establishment of the General Bank, later the Royal Bank, to create paper money and provide credit to the money market. He believed that the only way to alleviate the shortage of money was by substituting paper money for specie. He did this so successfully in the first stage of the system that a point came, in early 1720, when transactors favoured paper money more than specie. Admittedly, this period did not last very long but at least Law showed the possibility of the economy functioning just with a paper money system. The second financial tower that Law created was in the capital market. Through the establishment and development of the Company of the West in

176 A. E. Murphy

Monetary crisis

Financial crisis

General/Royal Bank

Company of the West/ Mississippi Company

Expansion of the money supply

Issues of shares

Low interest rate

Share support

Debt management

Development of trading companies

Merger of Royal Bank and the Mississippi Company

Figure 11.1 Law’s Financial System, 1716–1720.

1717, which later became the Company of the Indies and was popularly known as the Mississippi Company, Law showed the potential for a limited liability company to tap the capital market for finance. As it was initially set up the Company had two objectives: (1) the development of colonial trade through the expansion of the trading privileges that the Company possessed in French Louisiana and (2) the improved management of part of the national debt. While after August 1719 the emphasis of the Company’s activities tended to concentrate more on the debt management objective, it should be borne in mind that the Company financed the early development of French Louisiana sending out many thousands of colonizers there. As such, by tapping into new capital it was able to show how investment activity could be financed through the stock market. Law could not claim originality for this idea as the Dutch had financed many of their trading companies in this way in earlier centuries and the English had done likewise later with the East India Company, the Bank of England, the South Sea Company and the Royal African Company. Law could claim originality with respect to the extent to which he pushed this type of corporate financing. He used IPOs, mergers, takeovers, rights and options issues in a bid to produce a massive conglomerate handling all the trading companies, the national debt, the mint, the tax farms, etc. Law’s Mississippi Company issued 624,000 shares, which at one stage were valued at over 9,000 livres a share, placing an overall value on the Company of over 5.5 billion livres. The Company also issued 300,000 options entitling holders to take up shares at 10,000 livres a share. Given that the specie money supply was around 1.2 billion livres, Law had shown the ability of the market to tap sizeable sums of money.

Death in Venice – John Law 177 The problems for the System arose because of the excessively close interrelationship created between the two financial towers, the Bank and Company – see Figure 11.1. Initially the Bank lent money to transactors wishing to purchase shares. The Bank was then used to support the price of the shares through the creation of an agency to buy and sell shares – the ‘bureau d’achat et de vente’. Early in 1720 Law realized that the ‘bureau d’achat et de vente’ was creating excessive liquidity and, on 22 February, this agency was abolished and the shares were allowed to find their own price on the market. The ensuing sharp fall in the price of shares generated huge political pressures for Law to intervene and to arrest the downward movements in the share price. Law was forced to cede to these political pressures and on 5 March an arrêt du Conseil guaranteed the price of shares at 9,000 livres each. This action monetized the shares and this monetization created a financial circuit that was way out of line with the real economy. When Law attempted to cut back the size of the financial circuit on 21 May 1720 it was too late. Confidence was destroyed and the System started to collapse. It has been pointed out that this expansion of the Mississippi Company was greatly facilitated by the activities of the Royal Bank in lending money to finance the purchase of shares. Modern observers, analysing this development, may throw their hands in the air and ask how France’s Regent, Philippe duc d’Orléans, would have permitted this unholy alliance. Here it is germane to reflect a little on modern developments in this area. When, on Black Monday and Black Tuesday, in October 1987, Wall Street appeared to be in a meltdown mode the Federal Reserve stepped in to shore up the liquidity of the financial sector. More recently, after 9/11, the Fed stepped in again to provide liquidity to the market to assist it. The Federal Reserve Board chairman, Alan Greenspan, while preparing to tilt at the ‘irrational exuberance’ of the stock market, was also extremely diligent in ensuring that, through a policy of providing liquidity at low interest rates, investors were able to regain confidence and so stop the market from going into a free-fall when it was hit by exogenous shocks. In other words, Central Banks recognize the lessons distilled from the Great Depression that it is necessary to intervene in financial markets to provide liquidity in order to prevent panic and contagion spreading from the financial markets to the real economy. The links between modern Central Banks and stock markets may, at certain times, become very close. There were further implications for the world of corporate finance arising from Law’s activities. The British, fearing the success of Law’s System in France, decided to copy aspects of it in 1720, most notably through the use of the South Sea Company to take over a great part of the National Debt. This led to the South Sea Bubble of 1720 when London experienced wave after wave of new issues, not just of the South Sea Company, but, also, of a wide range of ‘bubble companies’ with activities ranging from insurance to the plainly bizarre such as a ‘project to be announced at a later date’. The intensity of the competition from these other bubble companies led to the South Sea Company persuading Parliament to introduce the ‘Bubble Act’. The objective of this act was to

178 A. E. Murphy prevent the incorporation of these other companies, established after 1718, because they were perceived as diverting public attention away from the South Sea Company to their activities. After the passing of the act the South Sea Company obtained a writ of scire facias against ‘those airy projects called bubbles’ to put them out of business. The result backfired. The Bubble Act brought down not only the bubble companies but also caused the share price of the South Sea to drop back from its high of over 900 to its early year price of around 120. The Bubble Act, which would effectively prevent the chartering of limited liability companies in Great Britain until its repeal in the 1825, stopped to a very significant extent corporate financing by the stock market for over a hundred years. Much the same happened in France though, the situation became even worse because the fall of the Mississippi Company also produced the collapse of the Royal Bank. In Great Britain, the Bank of England was able to escape from the downfall of the South Sea Company. In France, because of the dual failures of the Royal Bank and the Mississippi Company, the stock market and limited liability companies became taboo subjects along with banks, credit and financial innovation. It would take another eighty years before the creation of the Banque de France. Furthermore, chartering by limited liability companies was a near impossibility until the introduction of limited liability legislation in the 1860s. Law was both an economist and a corporate financier. In previous works I have shown Law’s contributions to economic theory in both his Essay on a Land Bank and Money and Trade. These contributions varied from his subjective value theory, his introduction of the concept of demand into economic analysis, his use of demand and supply theory to explain price movements, his conceptualization of the term the demand for money, his use of the interaction of the demand for money with the supply of money to show the sources of inflation, his analysis of the circular flow of income and the money-in-advance requirement, his account of the law of one price, etc – see Murphy (1997). These contributions were all part of a larger plan for Law wanted to use his theory to build up a financial structure in which money would be plentiful, interest rates low and capital markets strong. He recognized that investment required a financing structure. It was not just a matter of assuming that money suddenly appeared out of the air and automatically provided finance for borrowers. Structures needed to be put into place to ensure that investors were able to tap the financial system. These structures consisted of banks and a capital market. Ultimately, Law failed. However, he did show for a short period the vast potential of a corporate financial system involving banks and the stock market. In previous works I have criticized economists for their dismissal of Law because they perceived him as a failure and economists do not like any associations with failure. But the issue is deeper than this, for economists dismissed Law not only because they disliked the way he mismanaged the French economy, but, more importantly, because they believed his ideas on money were fundamentally wrong. Many economists presuppose that there is a type of linear progress from error to truth with theorists extirpating along the historical path

Death in Venice – John Law 179 the errors and honing in further on the truth. The assumption of a linear progression of ideas, with errors quickly detected and good ideas further polished and handed on to the next generation, is one that fits badly when it comes to assessing Law’s contributions and more importantly the discussion of their relevance for future generations. Raising the ghost of Law, he might produce a vehement attack on the interpretation of his ideas and their applicability. Instead of linear progress Law would see blockages, lack of comprehension and hostility towards his ideas. He would ask where did he go wrong? Was he not close to producing a modern version of the financial system a couple of hundred years prior to its eventual evolution? He would say that he showed how banks, paper money and credit creation could be set in place to develop the monetary system. And yet, he would say, that for over 250 years his ideas on the possibility of a specie-less system were systematically criticized by great economists from Cantillon to Hume to Turgot to Smith to Marx and to Marshall. Even Keynes refused to draw some obvious parallels between his writings and those of Law. Buried in the church of San Moisè in Venice, Law’s ideas live on.

Appendix 1 A CATALOGUE OF A FEW SELECT FIRST RATE PICTURES, being THE RESERVED COLLECTION of the celebrated MONSIEUR LAWS, well known for being the PLANNER of the Mississippi Scheme and PRIME MINISTER TO THE REGENT DUKE OF ORLEANS, consisting of the undoubted Works of the following great and admired Masters, viz. Raphael Ann.Carracci Lan. Franco Julio Romano Guido Sal. Rosa Guercino

Claude Dominichino Swanevelt Carlo Cignani Stella La Rosalba N. & G. Poussin

Paul Brill Vander Neer D. Teniers Van de Velde Rykaert, Rysdael G. Dow

The following, it is presumed will be found to deserve particular attention, a Corregio, from the ORLEANS Collection, a capital Picture by Parmegiano; two sea pieces by Vandevelde, of the first consequence, representing the two signal victories gained of the DUTCH FLEETS in 1665 and 1666, by the DUKE of YORK, the EARL of SANDWICH, &c. and a large and noble landscape and figures by Salvator Rosa: Which will be sold by auction, BY MESS. CHRISTIE AND ANSELL, At their Great Room, next Cumberland House, Pall Mall, On SATURDAY, FEBRUARY the 16th, 1782.

180 A. E. Murphy

Notes 1 London Public Records Office, State Papers 99/63, 91. E. Burges, Venice, 4 March N.S. 1729. 2 Ibid., 25 March 1729. 3 Maastricht, Rijksarchief in Limburg, Law 191. William Law, John Law’s son, writing to his mother about his father’s death. 4 Mémoire touchant les monoies et le commerce. Paris, Archives Nationales, G7 1468, Ms. 113, fo. 7. 5 Rijksarchief in Limburg, Maastricht, Papieren Law, 191. 6 Burges to Lord Londonderry, London, Public Records Office, State Papers 99. 7 Maastricht, Rijksarchief in Limburg, Papieren Law, V 673, inv. nr: 77. 8 Christie and Ansell’s Catalogue of a Few Select First Rate Pictures being the Reserved Collection of the celebrated Monsieur Laws. Auction, 16 February 1782. 9 Maastricht, loc. cit. Law, 160 10 Maastricht, Papieren Law, V 673, lot 322, inv. 77.

References Baschet, A. (1875) Histoire du dépôt des archives des Affaires Etrangères, Paris: Plon. Gould, C. (1976) The Paintings of Correggio, London: Faber. Law, J. (1705) Money and Trade Considered, Edinburgh: The Heirs and Successors of Andrew Anderson. Law, J. (1994) John Law’s Essay on a Land Bank, ed. by A. E. Murphy, Dublin: Aeon Publishing. Murphy, A. E. (1997) John Law Economic Theorist and Policy-Maker, Oxford: Clarendon Press. Poitras, G. (2000) The Early History of Financial Economics 1478–1776, Cheltenham, UK: Edward Elgar.

12 Paper money A reassessment of Adam Smith’s views Alberto Giacomin

Introduction In Scotland, at the time when Adam Smith was writing The Wealth of Nations, a monetary system was taking root in which, besides metallic money, convertible notes issued by private banks also circulated. In the same period, the English colonies of North America had embraced an even more revolutionary system, in which only unconvertible paper currency issued by the government or authorized public banks circulated. Though in his discourse on money Smith focuses attention on the first system, he does not fail to devote an accurate analysis to the second. It is presumable that he considered metallic money if not a relic of the past, an out-of-date device that was bound to bank safes in order to guarantee the public’s requests for conversion. On the contrary, he conceived the fiat money as a reaction to an extraordinary situation: namely, that of countries which, having no mines, were trying to save on a costly means of circulation such as gold and silver in order to fund the accumulation of capital in a phase of rapid economic growth. The scholars who have dealt with Smith’s theory of money have turned their attention mainly to the convertible paper money system, neglecting almost completely his analysis of the pure fiat money system, although it deserves consideration for its freshness and originality.1 In fact, this approach has compromised the chances of an homogeneous reconstruction of Smith’s thought, which relies on the contraposition between the traditional system based on a commodity money such as gold and silver and the new systems which, in different ways, made use of paper money. Such a contraposition assumes both a theoretical and a practical importance. On the one hand, it confirms Smith’s idea that money, as a medium of exchange, is submitted to an incessant process of innovation aimed at reducing the costs of commodity circulation; on the other, it provides support for his critique of the mercantilist theory, showing that gold and silver (commonly assimilated to wealth and reckoned to be the true goal of commercial policy) can be easily, and in some cases also advantageously, replaced by paper currency. In such a context this chapter pursues a twofold purpose. The first is to bring

182

A. Giacomin

out the central thread of the arguments which drove Smith to develop an analysis of the monetary systems introduced in Scotland and in the English colonies of North America. To this end, after pinning down the role he assigns to money in the working of a market economy, we will try to stress the link between his theory of money as a bookkeeping device and the search for technical innovations that help to reduce the costs of trade. The second purpose of this chapter is to provide a reconstruction of the pioneering analysis of the fiat money system advanced in The Wealth of Nations.

The role of money in a market economy The mercantilist bias According to Smith, the mercantilist thought rests on the idea that wealth consists in gold and silver2 and that a country lacking mines has to follow a set course in order to increase its wealth, i.e. to accumulate precious metals through a constant surplus on its balance of trade. In Book IV, Chapter I of The Wealth of Nations Smith puts forward several arguments aimed at denying this assumption. The principal one is based on the remark that money is dead capital and therefore that to attempt to increase the wealth of any country, either by introducing or by detaining in it an unnecessary quantity of gold and silver, is as absurd as it would be to attempt to increase the good cheer of private families, by obliging them to keep an unnecessary number of kitchen utensils. (Smith 1981: 440) On the other hand, when trade is free a country supplied with adequate means will be able to secure all the gold and silver it needs. And if even a country provided with the necessary means could not secure gold and silver, ‘there are more expedients’ – he observes – ‘for supplying their place, than that of any other commodity’: through barter, for example, though ‘with a good deal of inconveniency’; or by resorting to reciprocal credit deals and their compensation at a monthly or annual rate (in this case ‘with less inconveniency’); or, finally, through the introduction of paper money which, if ‘well regulated’, will be able to replace gold and silver ‘not only without any inconveniency, but, in some cases, with some advantages’ (Smith 1981: 437, passim). The last option, Smith observes, has been kept not only by Scotland, but also by the American colonies where, in his opinion, ‘it is not the poverty, but the enterprizing and projecting spirit of the people, their desire of employing all the stock which they can get as active and productive stock, which has occasioned this redundancy of paper money’ (Smith 1981: 941). The argument usually advanced by mercantilists in support of their view rests on the inconvenience of money shortage and the necessity of accumulating it in abundance in order to feed trade. Smith objects that there is no money shortage

Paper money – Adam Smith’s viewpoint 183 for the people who have the means to secure it or the guarantees to supply for borrowing. On the contrary, it follows very often from overtrading, that is from a decision of entrepreneurs to employ all the resources at their disposal in risky undertakings, together with the necessity of facing the payment claims from creditors before the sale proceeds have been cashed.3 Against those who maintained the usefulness of a treasure to finance the growth of the economy and the costs of war Smith argues that almost all the imports and military expenses are paid by the commodity exports, not by gold and silver accumulated. In his view, the mercantilist obsession with precious metals represents a bias that is theoretically unsubstantiated and is to be condemned. The only contribution gold and silver can give to the increase of wealth is connected with their role as medium of exchange, yet in this job they can be validly replaced, at least in domestic circulation, by banknotes or government paper currency. Money as capital In Book II, Chapter I of his Wealth of Nations, which is devoted to analysing the role performed by capital in the working of the economy, Smith includes money among the items of the circulating capital together with provisions, materials and finished products which are still in the hands of merchants or manufacturers and he states that it is thanks to money that ‘all the other three [parts of circulating capital] are circulated and distributed to their proper consumers’ (Smith 1981: 282). However, Smith observes, money closely resembles fixed capital whose aim is ‘to increase the productive powers of labour’ (Smith 1981: 287).4 He compares ‘the stock of money which circulates in any country’ to ‘those machines and instruments of trade’ which ‘require a certain expence, first to erect them, and afterwards to support them’ (Smith 1981: 288–9, passim) and adds that ‘every saving in the expence of erecting and supporting those machines’ can be assimilated to that realized ‘in the expence of collecting and supporting that part of the circulating capital which consists in money’. In effect, if such saving ‘does not diminish the productive powers of labour’, it causes ‘an improvement of the neat revenue of the society’ as it allows entrepreneurs to ‘increase the fund which puts industry into motion, and consequently the annual produce of land and labour’ (Smith 1981: 291–2, passim). The similarity between money and fixed capital is particularly relevant in Smith’s eyes as it supports his attempt to reconstruct the history of money as the incessant pursuit of technical solutions to increase the efficiency of the economic system by cutting trade costs. He believes that gold and silver are extremely expensive as a means of circulation and that the introduction of paper money helps to economize on precious resources that are allocated to increasing capital and production.5 However, there were those, like Hume, who, following the quantity theory of money, opposed the introduction of banks since they feared the inflationary

184

A. Giacomin

effects of credit. ‘It seems a maxim almost self-evident,’ – Hume observes – ‘that the prices of every thing depend on the proportion between commodities and money . . . Encrease the commodities, they become cheaper; encrease the money, they rise in their value’ (Hume 1955: 41–2). The introduction of banks, by increasing the quantity of circulating money, produces an increase in the prices of commodities, which makes him ‘entertain a doubt concerning the benefit of banks and paper-credit’ (Hume 1955: 35).6 The practical conclusion that he draws is that banks should by law only deal with deposits and custody and they should not be allowed to grant credit: ‘no bank could be more advantageous, than such a one as locked up all the money it received, and never augmented the circulating coin, as is usual, by returning part of its treasure into commerce’. ‘This is the case’ – he adds in note – ‘with the bank of Amsterdam’ (Hume 1955: 36, fn. 1). Smith disagrees with this opinion and intends to prove how economies where convertible banknotes circulate together with gold and silver – or even non convertible notes only – may well, with appropriate adjustments, replace economies based on metallic money.7 In other words, Smith believes that it is possible to obtain the advantages of using a cheap means of circulation such as paper money without necessarily violating the law of value on which exchange economies are based.8

Money as a social bookkeeping device At the beginning of Book IV, Chapter I of The Wealth of Nations Smith defines money as ‘the instrument of commerce’, namely the thing by means of which ‘we can more readily obtain whatever else we have occasion for, than by means of any other commodity’ (Smith 1981: 429). This definition places money at the core of the market system. In fact, the distinctive feature of that system is the chance individuals are given to have access to the product of the other members of society going beyond the bounds of an autarchic organization of the economy. The advantages afforded by a market economy follow from the push it is able to give to the division of labour. The more extensive the division of labour, the higher the level of social welfare. However, in order to get this result every individual must face a problem that does not arise in an autarchic economy, namely to find a purchaser for his own product and obtain in exchange what allows him to secure the goods and services he needs. Smith is well aware of both these aspects. He observes that as ‘we always find’, the ‘great affair . . . is to get money’. Money is what one obtains in exchange for the resources sold out to other individuals. Once money has been acquired, he continues, ‘there is no difficulty in making any subsequent purchase’ (Smith 1981: 429, passim). Actually, he points out elsewhere, a guinea may be considered as a bill for a certain quantity of necessaries and conveniences upon all the tradesmen in the neighbourhood. . . . If it could be

Paper money – Adam Smith’s viewpoint 185 exchanged for nothing, it would, like a bill upon a bankrupt, be of no more value than the most useless piece of paper. (Smith 1981: 290) The metaphor of the bill shows how Smith guessed the role of money as a social bookkeeping device, namely as an instrument which entitles the bearer to ‘draw’ from the market commodities having the same value as his contribution to the social product. Actually, only improperly can money be called a bill, provided that a bill incorporates the obligation of a private individual, while the monetary medium gives to its owner a power towards all the members of society. Since this power does not rely on any contract, it can only stem from a rule which every individual conforms with. In other words, Smith acknowledges that money is a social institution which is based on an implicit agreement among the members of society.9 It is this agreement which makes it possible to go beyond an autarchic economic organization and build an alternative economic order where everybody is ready to produce goods in excess of their needs, with reasonable confidence they can be exchanged with others’. Transactions demand for money Once acknowledged that money is the means which allows everybody to exchange his excess resources with others’, the convenience of forming and maintaining a reserve of this means becomes apparent. Smith himself draws attention to this point. Referring to the lack of coincidence of reciprocal wants which makes the resort to barter problematic, he observes that in order to avoid the inconveniency of such situations, every prudent man in every period of society, after the first establishment of the division of labour, must naturally have endeavoured to manage his affairs in such a manner, as to have at all times by him . . . a certain quantity of some one commodity or other, such as he imagined few people would be likely to refuse in exchange for the produce of their industry. (Smith 1981: 37–8) He repeatedly stresses that economic agents must be able to face in every moment the payment claims from their creditors and that, consequently, they need to hold a liquid reserve for this purpose.10 However, in the course of their business, besides contracting debts, they also get credits and hence, against money outlays, they also register money receipts. Assuming that outlays and receipts are equal and perfectly synchronized or that they could be rendered such, liquid reserves would become useless. Resting on these considerations, we can suppose that Smith had in mind an embryonic theory of the transactions demand for money, according to which money is held by economic agents to face the temporary excess of outlays over receipts. The holding of a liquid reserve raises two problems for economic operators.

186

A. Giacomin

The first, which affects the public authority, is the stability of the value of money and will be discussed later. By contrast, the second affects every individual and concerns the costs incurred by the very fact of holding such a reserve. Dealing with the advantages that ‘cash accounts’ (Smith 1981: 299), granted by Scottish – but not English – banks, ensure to merchants, Smith observes that an hypothetical London merchant must always keep by him a considerable sum of money, either in his own coffers, or in those of his banker, who gives him no interest for it, in order to answer the demands continually coming upon him for payment of the goods which he purchases upon credit. (Smith 1981: 300, emphasis added) Cash reserves entail a cost for the merchant as they force him to give up the profits or interests he could otherwise gain from the corresponding sum. Therefore, no individual will miss the opportunity of transforming totally or partially this ‘dead stock’ in an ‘active and productive stock’ (Smith 1981: 943), namely in materials, tools and livelihood for productive labourers. In a famous passage that Keynes considers a paradigm of the whole classical tradition,11 Smith assumes as a distinctive feature of individuals’ behaviour the prudent use of the disposable resources with a view to their aims.12 He observes that where there are conditions of safety for life and property ‘every man of common understanding will endeavour to employ whatever stock he can command in procuring either present enjoyment or future profit’. In the last case he will employ this stock as ‘fixed’ or ‘circulating capital’. A man, Smith continues, ‘must be perfectly crazy who, where there is tolerable security, does not employ all the stock which he commands, whether it be his own or borrowed of other people, in some one or other of those three ways’ (Smith 1981: 284–5, passim).13 Therefore, it is certain that every individual will try to reduce to a minimum the costs for holding a liquid reserve, and the introduction of banks represents, in Smith’s eyes, a great chance to achieve this result.

The convertible paper money system From gold to paper money According to Smith, at the beginning money consists of a commodity. He draws up a list of several commodities utilized for this purpose in different times and places, but he believed that ‘irresistible reasons’ of economic advantage had caused men ‘to give the preference . . . to metals above every other commodity’ as ‘the instruments of commerce and circulation’ (Smith 1981: 38–9, passim). The same reasons led, over time, to the substitution of iron with copper and then of copper with gold and silver. It is through the selection by traders and the subsequent intervention of the state through coinage14 that – according to Smith – metallic money has acquired

Paper money – Adam Smith’s viewpoint 187 ‘in all civilized nations’ its role of ‘universal instrument of commerce’ by means of which ‘goods of all kinds are bought and sold, or exchanged for one another’ (Smith 1981: 44). In such a context Smith introduces his considerations on paper money. He sees clearly the opportunities for economic growth that the new instrument is able to offer and develops an analysis of the experiments carried out by Scotland and the English colonies of North America during the eighteenth century. The aim he pursues is twofold: on the one hand, he intends to prove the inconsistency of the mercantilist theory, showing that the accumulation of precious metals is not only burdensome, as it raises the dead stock of the country to the detriment of the active and productive one, but also useless as gold and silver can be effectively replaced by paper money; on the other hand, he sets out to neutralize the critiques advanced by those who were opposed to its introduction, fearing the unlimited increase of a means of circulation without intrinsic value. Smith identifies accurately the advantages that entrepreneurs can obtain from paper currency. He starts from the idea that cash reserves represent a loss of capital entrepreneurs could avail themselves of in order to expand their business. This remark not only explains the circulation of convertible banknotes, but also accounts for the issue of unconvertible paper currency by government with the aim of saving gold and silver in a phase of rapid economic growth. The consequences of an excess issue of bills As stated, David Hume was sceptical about the introduction of banks since he feared the inflationary effects of credit on prices. Smith’s objection to this argument appeals to the actual working of two corrective mechanisms which come into play when currency exceeds public demand.15 The first one produces its effects when the new system is starting and causes the exportation of gold and silver in excess owing to the introduction of banknotes. The second, on the contrary, is set in motion when the new system is already underway and determines the presentation of excess notes to the banks for conversion into gold and silver. Let us examine these mechanisms separately, starting with the first. Smith begins his discourse with an accurate analysis of the behaviour of banks. He observes that they enjoy the public’s confidence, which allows them to circulate an amount of notes that greatly exceeds the gold and silver at their disposal.16 To give an example, he assumes that the currency, as a consequence of this fact, rises from one million to one million 800 pounds sterling. Since the early amount was enough to meet the public’s demand, the economic system comes to have an excess of currency which ‘cannot be employed at home’ (Smith 1981: 294). Yet, paper money cannot be accepted beyond the national boundaries. Gold and silver, therefore, will be sent abroad17 to purchase foreign goods which for the most part will be employed to add to the capital of the economy.18 Smith provides no explanation of the process through which gold and silver are exported. In particular, the lack of any reference to Hume’s price– specie–flow mechanism has puzzled many scholars,19 also considering that in his

188

A. Giacomin

Lectures on Jurisprudence (Report dated 1766) Smith defines ‘Hume’s reasoning’ as ‘exceedingly ingenious’. However, just afterwards he points out that the same author ‘seems . . . to have gone a little into the notion that public opulence consists in money’ (Smith 1982: 507). Probably, he is referring to the passage out of ‘Of money’ where Hume states that ‘though the high price of commodities be a necessary consequence of the increase of gold and silver, yet . . . some time is required before the money circulates through the whole state’ and that in the ‘interval . . . between the acquisition of money and rise of prices . . . the increasing quantity of gold and silver is favourable to industry’ (Hume 1955: 37–8, passim).20 Smith’s opinion on this point was completely at odds with Hume’s. It is not money but capital which, according to him, causes the wealth of nations. Money can make a direct contribution to the growth of economic activity only if it is transformed from a dead stock to an active and productive stock. Yet, one may ask, how can Smith dismiss the fact that the public’s increased purchasing power will not induce prices to rise in home market? A replay can be traced to the passage out of The Wealth of Nations where Smith states that the availability of every commodity ‘naturally regulates itself in every country according to the effectual demand’ (Smith 1981: 435).21 This, he adds, is especially true for gold and silver, because on account of the small bulk and of great value of those metals, no commodities can be more easily transported . . . from the places where they are cheap, to those where they are dear, from the places where they exceed, to those where they fall short of this effectual demand. (Smith 1981: 435) Consequently, if the quantity of gold and silver exceeds ‘effectual’ demand, the excess supply will be exported and ‘no vigilance of government can prevent their exportation’. If, on the contrary, their quantity falls short of ‘effectual’ demand, the excess demand will be imported and ‘the government would have no occasion to take any pain to import them’ (Smith 1981: 436, passim). Resting on the international prices of gold and silver assumed as given, Smith succeeds in identifying an alternative mechanism which in every country automatically adjusts the supply of those metals to demand, leaving unaltered the domestic prices of commodities.22 The process Smith seems to have in mind is the following: the surplus of metallic money due to the issue of banknotes flows back to the markets for gold and silver and lowers their domestic prices below the international level, making it attractive to holders to resort to exportation or the melting pot. Smith’s conclusion is that in a convertible paper currency system the prerequisites for an increase in prices do not exist because ‘the quantity of gold and silver, which is taken from the currency, is always equal to the quantity of paper which is added to it’ (Smith 1981: 324).23 Still, even if we were to admit that banknotes do not replace metallic money

Paper money – Adam Smith’s viewpoint 189 but add to it, it is possible, according to Smith, to reject Hume’s conclusion. It is sufficient for banks to be obliged to convert their banknotes into metallic money at the request of bearers. Convertibility anyway prevents banks from issuing an excessive amount of banknotes with respect to the demand of entrepreneurs, since they undergo that special process, whereby excess paper money would be used immediately by the public to reduce its indebtedness to the banking system or be converted into metallic money. It is the process which subsequently will be called the ‘law of reflux’. This phrase does not appear in The Wealth of Nations, yet Smith is well aware of the mechanism which it refers to. The mechanism is connected, in his view, with the convertibility and the transactions demand for money and helps prevent the inflationary effects of an excess issue of notes. In addition, Smith believed that competition in the credit market would discourage banks from issuing excess notes because they would have been promptly cashed by owners, and before them, by the other banks.24 However, although excluding the danger for inflation subsequent to the issuing of excess banknotes, Smith clearly understands the liquidity risk commercial banks have to face when granting credits to firms. In his view, the rule banks have to follow to avoid bankruptcy is to grant short-term loans upon submission of short-term bills issued by debtors of their clients or on real security. With this aim banks should be supplied with assets that can be liquidated easily in the event of a decrease in the demand for loans. They thus avoid losses during attempts to liquidate their own assets or borrow at high interest rates to satisfy requests for bill conversion. This is precisely the version of the real-bills doctrine adopted in The Wealth of Nations. In Smith’s view its prescriptions are aimed at securing the liquidity and solvency of an individual bank facing a diminishing demand for its notes by the public. This narrow version of the doctrine has nothing to do with the broad one which was first advanced by the antibullionists, after the suspension of the convertibility in 1797, to defend the Bank of England against the charge that it caused inflation. It is this version which is usually considered and justifiably criticized by most of the scholars, such as, for example, Thornton, Bagehot, Mints, O’Brien, Blaug and others.25 The broad version focuses on the entire banking system and states that inflationary overissue can be prevented as long as all banks advance their notes only upon the discount of sound, short-term commercial bills, i.e. drawn by merchants against commodity sales. This way, in fact, they merely respond to a demand for money stemming from the real needs of trade. There is no trace of that version of real-bills doctrine in The Wealth of Nations. Actually, according to Smith, inflation is kept under control by different factors, namely the convertibility of notes and the public’s transaction demand for money from which the law of reflux originates, on the one hand, and the competition among banks, on the other. Moreover, it should be recalled that Smith focuses mainly on the Scottish banking system in which, unlike in the English, bills of exchange had less importance than cash accounts.26 Ultimately, to avoid bankruptcy, banks must not grant medium- or long-term

190

A. Giacomin

loans, and this for two reasons. First, it would mean supplying capital to entrepreneurs without any, but who should acquire it by saving or resorting to loans secured by mortgages. Second, they might have to face liquidity problems while clients complete their production cycle or the amortization of equipment with a substantial increase in management costs. Smith condemns the idea of transforming Scottish banks ‘into a sort of general loan office for the whole country’ (Smith 1981: 316), that is into offices able to supply entrepreneurs with the capital they need to start business. In his opinion, that is what banks should never do, as It is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country. (Smith 1981: 320) The role of banks From the preceding observations it is easy to infer that, in Smith’s opinion, the benefit of paper money does not go beyond the chance offered to entrepreneurs of unfreezing a portion of their circulating capital and devoting it to an increase in production. Consequently, the only duty of banks is to provide liquidity for a short time to entrepreneurs (mainly merchants) who, having already started a business with their own funds and sold their products, are waiting to be paid by clients while having to answer unexpected demands. A bank, he notes, ‘ought to observe with great attention, whether in the course of some short period’, which can go from four to eight months, ‘the sum of the repayments which it commonly receives . . . is, or is not, fully equal to that of the advances it commonly makes’. Only in the first case can it ‘safely continue’ (Smith 1981: 304–5, passim) to lend money. These considerations explain Smith’s dislike of traders’ attempts to finance investment through bank credit. His argument applies not only to fixed capital but also to the circulating one, as ‘the whole of the returns is too distant from the whole of the outgoings’ and the intervals surpass ‘such moderate periods of time as suit the conveniency of a bank’. Smith’s opinion is that capital formation ought not to be financed by bank credit, but ought to be funded upon the ‘bond or mortgage’ of savers, i.e. ‘of such private people as propose to live upon the interest of their money, without taking the trouble themselves to employ the capital’ (Smith 1981: 307, passim). Actually – Smith observes – the claim of traders that banks ought to ‘provide them with all the capital’ they need to realize their production plans was not accepted. This was the reason why some of them ‘had recourse to an expedient’ which, ‘though at a much greater expence’, enabled them ‘for a time’ to obtain the desired borrowings. ‘This expedient’ – he points out – ‘was no other than the well-known shift of drawing and redrawing’ (Smith 1981: 308, passim). The negative judgement Smith gives on this practice is due to the fact that it

Paper money – Adam Smith’s viewpoint 191 succeeded, without the banks being aware of it, not only in substituting gold and silver money but in increasing the quantity of currency. In fact, ‘upon many occasions’, the paper money ‘issued upon those circulating bills of exchange’ amounted ‘to the whole fund destined for carrying on some vast and extensive project of agriculture, commerce or manufactures’ and not merely to ‘that part of it which, had there been no paper money, the projector would have been obliged to keep by him, unemployed and in ready money for answering occasional demands’. The final result – which Smith underlines once more – was that the excess paper money ‘immediately returned upon the banks in order to be exchanged for gold and silver’, and the banks had to honour their commitment ‘as they could’ (Smith 1981: 311, passim). Summing up his analysis, Smith calls the entrepreneurs who made recourse to this practice ‘projectors’ who ‘in their golden dreams’ had, no doubt, ‘the most distinct vision’ of the great profits they expected from their undertakings, yet ‘very seldom . . . had the good fortune to find’ (Smith 1981: 310, passim) them. Projectors’ idea of capitalism is the farthest from Smith’s view one could conceive. Though in a rough and early form, it had been stated at the beginning of the eighteenth century by a Scottish economist, John Law, who, during the regency of Louis d’Orléans, tried to introduce paper money in France. It is precisely Law’s theories which represent the target of Smith’s criticisms. At the end of his excursus on the Bank of Scotland’s experience, he explicitly recalls the opinion of his ‘famous’ fellow countryman (according to whom ‘the industry in Scotland languished for want of money to employ it’) and mentions his proposal ‘to remedy’ this want of money ‘by establishing a bank . . . which . . . might issue paper to the amount of the whole value of all the lands in the country’. He defines ‘splendid, but visionary’ the ideas expounded by Law and advances the hypothesis that they have, ‘perhaps, in part, contributed to that excess of banking, which has of late been complained of both in Scotland and in other places’ (Smith 1981: 317–18, passim). In the face of these ideas Smith reasserts his opinion on the role of bank credit as a means of converting idle capital into productive capital. He compares the ‘ready money’ that a dealer keeps by him ‘for answering occasional demands’ to ‘so much dead stock’ which ‘produces nothing either to him or to his country’. Such stock, by means of ‘judicious operations of banking’, can be converted into ‘active and productive stock’ (Smith 1981: 320, passim). In order to understand Law’s point of view, it might be helpful to remind that in an economic world which is ruled by the budget constraint, where every individual can spend only what he has previously earned, bank credit represents a sort of passkey by means of which firms are enabled to force their way into the market, i.e. to take goods and services without having capital at disposal, that is without first having to save. Smith rejects this interpretation of the role of banks. He believes that the creation of money by banks and the possibility given to entrepreneurs to invest without having first to save produce destruction rather than increase of social

192

A. Giacomin

capital.27 As a consequence, while clearly appreciating the role performed by cash in hand in the working of the economy and while outlining with great accuracy the circuit of paper money from the time it is issued by banks to its destruction when loans are reimbursed by entrepreneurs,28 he rejects the revolutionary implications of bank credit, i.e. the chances it offers to firms of getting capital without earning any income in advance. In Smith’s vision, capitalism is an economic system which is ruled by entrepreneurs who do not bet on the future with the money they have borrowed from the banks, yet they cut down to employ ‘the money borrowed’ from private individuals ‘in sober undertakings . . . proportioned to their capitals’, which, having ‘more of the solid and the profitable’, can repay ‘with a large profit’ (Smith 1981: 317)29 whatever has been laid upon them.

The pure fiat money system State money Promissory notes issued by the banks, however, did not constitute the only type of paper money circulating in the economy at the time of Smith. In order to find a remedy for the scarcity of gold and silver during the eighteenth century, the governments of the English colonies in North America had issued paper money in the form of notes, declaring them to be legal tender. Smith dedicates the final part of Chapter II, Book II of The Wealth of Nations to an analysis of this experience. He starts with the conclusion reached regarding the convertible paper money system, in which banknotes can be considered, in every respect, equal in value to gold or silver money when they can immediately and without any condition be converted into such money.30 On the contrary, Smith observes that a money which would not be convertible immediately and without any condition ‘would, no doubt, fall more or less below the value of gold and silver, . . . according to the greater or less distance of time at which payment was exigible’ (Smith 1981: 325). Smith gives some examples in support of his statement, one of which introduces the analysis of the inconvertible paper currency system: ‘The paper currencies of North America’ – he explains – ‘consisted, not in bank notes payable to the bearer on demand, but in a government paper, of which the payment was not exigible till several years after it was issued’ (Smith 1981: 326).31 Nonetheless, the governments of the colonies did not pay holders any interest and, moreover, imposed the legal tender of these banknotes for the full nominal value to which they were issued. The consequence of this decision was that sterling’s exchange rate increased in all the colonies, from a minimum of 130 to a maximum of 1,100 per cent depending on the case.32 Smith observes that the large differences in the value of the various colonies’ paper money with respect to sterling arose not only from the factors mentioned, but also ‘from the difference in the quantity of paper emitted in the different

Paper money – Adam Smith’s viewpoint 193 colonies’( Smith 1981: 327). The link between the quantity of paper money issued by the government and its value in gold and silver is reasserted immediately after in relation to Pennsylvania, which – he observes – ‘was always more moderate in its emissions of paper money than any other of our colonies’. This is precisely why, continues Smith, ‘its paper currency . . . is said never to have sunk below the value of the gold and silver which was current in the colony before the first emission of its paper money’ (Smith 1981: 327).33 However, moderation in issues was not the conclusive reason for Pennsylvania’s success. Smith calls attention to the fact that all the colonial governments accepted their own paper money ‘in the payment of the provincial taxes, for the full value for which it had been issued’, pointing out that ‘from this use’ paper money ‘necessarily derived . . . some additional value, over and above what it would have had, from the real or supposed distance of the term of its final discharge and redemption’ (Smith 1981: 328). The added value accruing to the colonies’ paper money was – according to Smith – ‘greater or less, according as the quantity of paper issued was more or less above what could be employed in the payment of the taxes of the particular colony which issued it’. In this case, the convertibility of notes into specie would lose importance completely and it would be possible to fix a premium on gold and silver, ‘if the bank which issued this paper was careful to keep the quantity of it always somewhat below what could easily be employed in this manner’ (Smith 1981: 328). Smith realizes that in a system in which the currency is purely a sign, the only way to preserve its value is to establish simultaneously a need and a shortage. A government with a monopoly of issues and the power to levy taxes can make paper money a necessity by announcing it will be accepted in payment of taxes, while at the same time it can use fiscal policy to ensure a shortage, by making expenditure, which decides the supply of notes, equal or lower with respect to taxation, which determines demand. The Pennsylvania case In Smith’s analysis of the fiat money system the case of Pennsylvania assumes a special importance, being the only colony where the introduction of an inconvertible currency was fully successful. Smith returns later to a discussion of this case in Chapter II, Book V of The Wealth of Nations, and furnishes additional information about the monetary system established in the colony. He first explains that the government’s objective was to provide ‘to its subjects’ a means of payment ‘without amassing any treasure’, then goes on to state that the method adopted was to set up local public banks with the task ‘of lending, not money indeed, but what is equivalent to money . . . By advancing to private people, at interest, and upon land security to double the value, paper bills of credit to be redeemed fifteen years after their date’ (Smith 1981: 820).34 Those bills of credit, Smith adds, were ‘in the mean time made transferable from hand to hand like bank notes’, and ‘declared by act of assembly to be a legal tender in

194

A. Giacomin

all payments from one inhabitant of the province to another’. From this operation, the government, which Smith defines as ‘frugal and orderly’, obtained a revenue ‘which went a considerable way towards defraying an annual expence of 4,500l.’ (Smith 1981: 820), i.e. the whole amount of its ordinary expenses. Smith ascribes the success of this measure to three factors. The first is the need ‘for some other instrument of commerce, besides gold and silver money’ (Smith 1981: 820), required to pay for imports from the motherland.35 The second is ‘the good credit of the government which made use of this expedient’ (Smith 1981: 820).36 The last is the moderation of issues, borne out by the fact that the quantity of paper money was barely above the amount needed to pay taxes, whereas in the other colonies it was ‘very much above what could be employed in this manner’ (Smith 1981: 328).37 Smith concludes his analysis of the pure fiat money system in Chapter III, Book V of The Wealth of Nations, with a synopsis. He rules out the possibility that the shortage of specie in the American colonies is ‘the effect of the poverty of that country, or of the inability of the people there to purchase those metals’, because the inhabitants of the colonies were not without the means to buy gold and silver ‘if it was either necessary or convenient for them to do so’ (Smith 1981: 940, passim). The true reason, according to Smith, lies elsewhere. It is a calculated decision based on the fact that: (1) paper money can perfectly replace gold and silver as a means of payment within a country, at least in times of peace, as the example of Scotland confirms;38 (2) this replacement is advantageous for the Americans because it allows them to avoid ‘the expence of so costly an instrument of commerce as gold and silver’ and to employ what they save ‘in purchasing, not dead stock, but active and productive stock’, namely ‘the instruments of trade, the materials of clothing, several parts of household furniture, and the ironwork necessary for building and extending their settlements and plantations’ (Smith 1981: 940). According to Smith, the abundance of paper money in the American colonies should be viewed as positive because, like the banknotes in Scotland, it is due to ‘their great demand for active and productive stock’, which ‘makes it convenient for them to have as little dead stock as possible’ (Smith 1981: 943). As a result gold and silver are used to pay for imports of goods destined for capital formation. Thus, Hume’s price–specie–flow mechanism is again rejected, as it had been by Smith in the case of the convertible paper money system.39 Smith’s considerations on the monetary experience of the English colonies of North America can be summarized as follows. A system of inconvertible paper money is the result of particular historical circumstances such as those that occurred in the English colonies of North America, namely the absence of gold and silver mines and the rapid economic growth that had to be matched by equally fast capital formation, and that made trade surpluses impossible. Whereas Scotland, in similar conditions, benefited from a stock of precious metals built up in earlier periods, the American colonies were forced to use all their gold and silver for foreign trade. This type of system can work if the government issuing the paper money

Paper money – Adam Smith’s viewpoint 195 declares it will accept it in payment of taxes and takes care constantly to adjust the stock in circulation according to the public’s demand. The method Smith suggests to achieve this result is to issue no more notes than are necessary to pay taxes. Careful management, designed to ensure that part of demand is not met, might even allow the paper money to appreciate against gold and silver. If the quantity of money depends on a decision of the government, the public’s attitude is bound to be affected by expectations regarding the future trend of the budget. Distrust of the government’s will or ability to maintain a balance between revenues and outlays over a period of time will prompt economic agents to get rid of paper money for fear of incurring losses. If these expectations spread, the fears will become reality and the currency will devalue. These observations show that Smith had in mind a particular version of quantity theory, which closely resembles the one advanced by some scholars for the purpose of salvaging that theory from several counter-examples signalled by monetary history. According to Sargent, in order to explain inflation what matters is not ‘the current government deficit but the present value of current and prospective future government deficits’. Indeed, he adds, the government can be viewed ‘like a firm whose prospective receipts’ are ‘its future tax collections’. In other words, ‘the public’s perception of the fiscal regime’ influences ‘the value of government debt through private agents’ expectations about the present value of the revenue streams backing that debt’ (Sargent 1982: 45–6, passim). Smith supposedly refers to that fact when citing among the causes of Pennsylvania’s success the low level of its public expense and the good reputation enjoyed by the government. He seems to think that Pennsylvania’s citizens had formed positive expectations regarding government’s will and ability to honour the commitments undertaken when issuing paper money. These considerations prompted Wray to claim that ‘Smith’s views of money . . . are quite similar’ to his own. In fact, the chartalist theory he advances seems consistent with Sargent’s approach. ‘Money’ – he states – ‘is a creature of the state’ and ‘fiscal policy would be used to increase stability of the value of the currency’ (Wray 1998: 18–19, passim). If government decisively pursues a balanced budget policy, economic operators will form no inflationary expectations as the actual value of future final balances will be close to zero.

Notes 1 The works which, to our knowledge, are devoted to Smith’s analysis of the unconvertible paper currency system are only two: Rosier (1996) and Wray (1998: 19–23). However, only the last one, tackles the theoretical problems raised by Smith. For a critique of Wray’s approach see ‘The Pennsylvania case’, below. 2 As Roncaglia (2003: 48, fn. 62) points out, Smith made a dummy polemical target for the purpose of criticizing mercantilist thought. In particular, he seems incapable of catching the principle of effective demand which is the heart of the doctrine of the favourable balance of trade. As the recent literature has explained (see, for instance, Perrotta 1991), the commercial policy suggested by this doctrine is not aimed at accumulating precious metals but at increasing the output and employment of the country. Actually, the mercantilist authors refer likewise to the balance of trade or to the

196 A. Giacomin

3 4

5

6 7 8

9

10 11 12

13 14 15 16 17

balance of labour. They start from the assumption that every country is characterized by an excess labour supply and suggest as a cure the employment of labourers for the production of commodities bound for foreign markets. The aim of overseas trade is to complement an insufficient domestic demand for goods with foreign demand. Smith rejects this assumption. In his view, there is no problem of effective demand, as the income of society is spent entirely on consumer goods or on means of production: see, on this point, Smith (1981: 337–8). See Smith (1981: 437–8). Smith’s remark can be perfectly understood if, instead of an individual firm, we consider the entire economy, as gold and silver even passing from an individual to another remain at the disposal of the system: see, on this point, Diatkine and Rosier (1998: 249–50). See Smith (1981: 292): ‘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’. See also, on this point, Hume (1955: 67–72). This idea is already clearly stated in his Lectures on Jurisprudence (Report dated 1766): see Smith (1982: 503–4). If an intrinsically worthless substitute for a commodity were to circulate, the valuecost law would be replaced by the value-scarcity law and it would be up to those issuing the substitute to apply the new law so that the supply of money would constantly adjust to demand. This is how Smith shifts from a commodity money theory to the quantity theory (see, on this point, ‘The consequences of an excess issue of bills’ and ‘state money’, below). Therefore, Smith seems to give up in The Wealth of Nations the stance adopted in his Lectures on Jurisprudence (Report of 1762–1763), where he criticized Locke’s opinion according to which the value of gold and silver ‘is . . . founded on an agreement of men to put it upon them’ and observed, on the contrary, that gold and silver ‘have what we may call a naturall value, and would bear a high [?one] considered merely as a commodity, tho not used as the instrument of exchange’ (Smith 1982: 370). However, it has to be remembered that Smith’s criticism rests on a misunderstanding since, in Locke’s opinion, the ‘general consent’ which gives to gold and silver the role of money is based on the ‘intrinsick Value’ of those metals namely on their ‘Quantity’ (Locke 1991: 233, passim). See, for example, the passage quoted below. See Keynes (1973: 115–16). Smith (1981: 422) observes that the transition from feudal to modern society was the work of ‘merchants’ and ‘artificers’, who, against the ‘most childish vanity . . . of the great proprietors’, acted ‘merely from a view to their own interest, and in pursuit of their own pedlar principle of turning a penny wherever a penny was to be got’. By chance, this passage shows that, in Smith’s eyes, money is a mere medium of exchange and his use as a store of wealth has no reason. In Smith’s opinion coinage represents only a means of certifying the quality and weight of metal in order to prevent misuse and fraud to the prejudice of creditors as this would discourage ‘all sorts of industry and commerce’ (Smith 1981: 40). Namely, the quantity needed for ‘circulating commodities’ (Smith 1981: 440). Actually, five times higher, since ‘the whole circulation may . . . be conducted with a fifth part only of the gold and silver which would otherwise have been requisite’ (Smith 1981: 293). See Smith (1981: 293–4). This idea can be traced in Smith’s Lectures on Jurisprudence (Report of 1762–3) where he observes that ‘the channel of circulation is always of itself sufficiently filled’ and that, ‘if it is too full, it must sink by exportation to foreign countries and the melting pot’ (Smith 1982: 391, passim).

Paper money – Adam Smith’s viewpoint 197 18 See Smith (1981: 295–7). 19 Namely, all those who share the quantity theory of money. This ‘anomaly’ was firstly noticed by Viner (1937: 87) who refers to it as to ‘one of the mysteries of the history of economic thought’. 20 This idea is reaffirmed in his essay ‘Of the balance of trade’: see Hume (1955: 68, fn. 1). Petrella (1968), who first drew attention to this point, provides further evidence of Hume’s ‘surrender’ to mercantilist thought. 21 Namely, he continues, ‘the demand of those who are willing to pay the whole rent, labour and profits which must be paid in order to prepare and bring it to market’. 22 According to some scholars (see Girton and Roper 1978: 615–18;, Laidler 1981: 188–92; Humphrey 1981; and Glasner 1989: 205–11), Smith’s explanation is very similar to the one provided by the monetary approach to the balance of payments whereby in a small-scale economy dealing with foreign markets under a fixed exchange rate system (as happens with a gold standard) the prices of tradable commodities are set at world level and must therefore be considered an exogenous variable. 23 He concludes his argument by stating that the increase in food prices in Scotland in 1751–1752, which Hume refers to, was probably due ‘to the badness of the seasons, and not to the multiplication of paper money’ (Smith 1981: 325). 24 See Smith (1981: 329): ‘The late multiplication of banking companies in both parts of the united kingdom . . . instead of diminishing, increases the security of the publick. It obliges all of them to be more circumspect in their conduct, and, by not extending their currency beyond its due proportion to their cash, to guard themselves against those malicious runs, which the rivalship of so many competitors is always ready to bring upon them’. 25 See, on this point, Humphrey (1982) and Glasner (1992). 26 See, on this point, Marcuzzo and Rosselli (1991: 30). 27 Commenting on the affairs of Ayr bank, whose avowed principle was ‘to advance, upon any reasonable security, the whole capital which was to be employed in those improvements of which the returns are the most slow and distant’ and which was obliged to close down its business after only two years, Smith (1981: 313 and 316–17, passim) observes: ‘though this operation had proved, not only practicable, but profitable to the bank as a mercantile company; yet the country could have derived no benefit from it; but, on the contrary, must have suffered a very considerable loss by it’. This because ‘the success of this operation . . . without increasing in the smallest degree the capital of the country, would only have transferred a great part of it from prudent and profitable, to imprudent and unprofitable undertakings’. 28 See Smith (1981: 299; 45: ls 10–18). 29 Here Smith resorts to a petitio principii in his attempt to bypass the problem of uncertainty which entrepreneurs and bankers are both obliged to face. 30 See Smith (1981: 324; 95: ls 1–6). 31 As Thayer (1953) explains, the paper currency circulating in the North American colonies was of two types. The first consisted in bills of credit that the governments issued for various maturities against future fiscal revenues and declared they would accept for payments. The second, on the other hand, consisted in notes issued by public land banks in connection with loans granted to private parties on the security of a real estate (land, farms, town houses, etc.). Unlike bills of credit, which were used to finance military or current spending, the notes issued by the land banks served the needs of private entrepreneurs. 32 See Smith (1981: 327; 100: ls 9–13). 33 What Smith wishes to emphasize is that the paper money that replaced specie in Pennsylvania kept the same value with respect to the pound sterling. In fact, whereas before the emission ‘a pound colony currency . . ., even when that currency was gold and silver, was more than thirty per cent. below the value of a pound sterling’, after

198 A. Giacomin

34

35

36

37

38 39

the emission the paper currency into which it had been turned ‘was seldom much more than thirty per cent. below that value’ (Smith 1981: 327, passim); see, on this point, McCusker (1978: 184–6) who provides the average annual exchange rate of Pennsylvania currency against English sterling during the years between 1723 and 1774 in which the colonial government issued paper money. According to documents relating to Pennsylvania, of 500 loans granted in 1744 over 75 per cent were to yeomen farmers, while most of the others went to mechanics. Farmers gave their farms as collateral, whereas mechanics offered their homes and land in Philadelphia and other colonial towns. Generally speaking, loans could not exceed 50 per cent of the value of the property given as collateral. However, this rule was not always observed and land did not always represent good collateral. A major exception was Pennsylvania, where the amount of loans was well below the legal limit and officials took great care not to overestimate the value of goods offered as collateral: see, on this point, Thayer (1953: 152–5). See, on this point, Smith (1981: 940): ‘The Americans . . . have no gold or silver money; . . . the gold and silver which occasionally come among them being all sent to Great Britain in return for the commodities which they receive from us’. Indeed, contemporary documents attest to the great need of businessmen for liquidity in a period of rapid economic growth of the colony. This requirement could not be satisfied in the usual way, that is through a trade surplus (there being no mines) because, as Brock (1975: 2–7) points out, Pennsylvania managed hardly to pay off its debt with Great Britain out of the revenue from exports to the West Indies. This point is also stressed by Galiani (1963: 267–8) who, referring to paper money circulating in the English colonies of North America, attributes the reliability of the Pennsylvania government to Quaker virtues. However, in his opinion, such virtues cannot be imitated by other Christian nations. When assessing the impact of issues on the value of the paper money it should be kept in mind that the North American colonies of the time also used other types of money. In addition to gold and silver, beaver fur, tobacco and rum, warehouse certificates and bills of exchange and finally books of credit also circulated, but only gold and silver coin or paper money could be used to settle debts. See Smith (1981: 940): ‘the domestick business of every country . . . may, at least in peaceable times, be transacted by means of a paper currency, with nearly the same degree of conveniency as by gold and silver money’. See Smith (1981: 941): ‘The redundancy of paper money necessarily banishes gold and silver from the domestick transactions of the colonies, for the same reason that it has banished those metals from the greater part of the domestick transactions in Scotland’.

References Brock, L. V. (1975) The currency of the American colonies, 1700–1764. A study in colonial finance and imperial relations, New York: Arno Press. Diatkine, S. and Rosier, M. (1998) ‘Systèmes bancaires et croissance chez Steuart and Smith’, Economies et Sociétés, ‘Oeconomia’, Série P.E., 27: 247–68. Galiani, F. (1963) Della moneta, Milan: Feltrinelli. Girton, L. and Roper, D. (1978) ‘J. Laurence Laughlin and the quantity theory of money’, Journal of Political Economy, 86: 599–625. Glasner, D. (1989) ‘On some classical monetary controversies’, History of Political Economy, 21: 201–29. Glasner, D. (1992) ‘The real-bills doctrine in the light of the law of reflux’, History of Political Economy, 24: 867–94.

Paper money – Adam Smith’s viewpoint 199 Hume, D. (1955) Writings on economics, Edinburgh: Nelson. Humphrey, T. M. (1981) ‘Adam Smith and the monetary approach to the balance of payments’, Federal Reserve Bank of Richmond Economic Review, 67: 3–10. Humphrey, T. M. (1982) ‘The real bills doctrine’, Federal Reserve Bank of Richmond Economic Review, 68: 3–13. Keynes, J. M. (1973) The collected writings. Volume XIV: The General Theory and after. Part II: defence and development, ed. by D. E. Moggridge, London: Macmillan and St. Martin Press for The Royal Society. Laidler, D. (1981) ‘Adam Smith as a monetary economist’, Canadian Journal of Economics, 14: 185–200. Locke, J. (1991) Locke on money, Oxford: Clarendon Press. Marcuzzo, M. C. and Rosselli, A. (1991) Ricardo and the gold standard. The foundations of the international monetary order, London: Macmillan. McCusker, J. J. (1978) Money and exchange in Europe and America, 1600–1775. A handbook, Chapel Hill: The University of North Carolina Press. Perrotta, C. (1991) ‘Is the mercantilist theory of the favorable balance of trade really erroneous?’, History of Political Economy, 23: 301–36. Petrella, F. (1968) ‘Adam Smith’s rejection of Hume’s price-specie-flow mechanism: a minor mystery resolved’, Southern Economic Journal, 34: 365–74. Roncaglia, A. (2003) La ricchezza delle idee. Storia del pensiero economico, Rome: Giuseppe Laterza & Figli spa. Rosier, M. (1996) ‘Adam Smith et la Pennsylvanie: la main invisible et les ailes dédaliennes du papier monnaie’, Cahiers d’Economie Politique, 27–8: 89–111. Sargent, T. J. (1982) ‘The ends of four big inflations’, in R. E. Hall (ed.) Inflation: causes and effects, Chicago: University of Chicago Press. Smith, A. (1981) An inquiry into the nature and causes of the wealth of nations, Indianapolis: Liberty Fund. Smith, A. (1982) Lectures on Jurisprudence, Indianapolis: Liberty Fund. Thayer, T. (1953) ‘The land-bank system in the American colonies’, The Journal of Economic History, 13: 145–59. Viner, J. (1937) Studies in the theory of international trade, New York: Harper & Brothers. Wray, L. R. (1998) Understanding modern money. The key to full employment and price stability, Cheltenham and Northampton, MA: Edward Elgar.

Part IV

Neglected contributions to monetary theory and policy

13 ‘Incalculability’ and the heterogeneity of agents in Frederick Lavington’s monetary theory of markets Cécile Dangel-Hagnauer and Alain Raybaut

Introduction Born in 1881, Frederick Lavington began a career in banking before becoming one of Keynes’s first students and taking his degree in 1911, after which he spent several years at the Board of Trade, returning to Cambridge as a lecturer only in 1918. He then devoted the last years of his life teaching relentlessly until his early death in 1927.1 According to Bridel (1987b), Lavington’s writings were seldom cited by his contemporaries, exceptions being Robertson and Hicks who were both early in recognizing his contribution to the theory of the demand for money.2 Lavington is partly responsible himself for the neglect his works suffered. According to Wright (1927: 504), ‘It’s all in Marshall, if you only take the trouble to dig it out’ was one of his favourite sayings. The heading introducing the notes to The English Capital Market (1921) and the preface of The Trade Cycle (1922) provide other examples of his modesty. Thus, Lavington presents his first book as merely ‘the development, right or wrong, of leading ideas’ laid down previously by Dr Marshall and Professor Pigou (Lavington 1921: 283). As for his second book, it is not, he writes, ‘the result of original research, but [is] only based . . . on the views of a comparatively small group of economists whose interpretations of . . . cyclical fluctuations seem . . . the most acceptable’ (Lavington 1922: 7). In his obituary, Wright (1927: 504) even suggests ‘he had something like an inferiority complex’. In contrast, for today’s reader Lavington’s writings stand out as anticipating some very modern developments. His professional experience in banking and at the Board of Trade was certainly crucial to the development of his approach to finance, where institutions play the leading role, and to his treatment of speculation that foreshadows modern approaches of the question. Lavington’s analysis of the demand for money is not dealt with here, as it has been previously accounted for by Bridel and Laidler.3 We insist instead on Lavington’s consistent overall conception of the market economy, one where money is present from the outset and agents have only a limited capacity to anticipate the future. Lavington places emphasis on risk and uncertainty, a subject on which his

204 C. Dangel-Hagnauer and A. Raybaut expertise was recognized in his day. Due to their ‘incalculability’, the outcomes of economic activity are perceived diversely by economic agents. Accordingly, entrepreneurs are considered as a heterogeneous group of agents with differing business and cognitive abilities, producing independently for the market conceived not as an abstract-like construction but as a gathering of bustling institutions. The chapter is organized as follows. The next section examines Lavington’s contribution to the analysis of risk and uncertainty and shows that it provides the basis for a theory of the entrepreneur. In the third section, entrepreneurs and speculators are examined from the viewpoint of their heterogeneity. This is a feature that is shared by the ‘agencies’ forming the ‘money market’ to which the fourth section is devoted. The limited capacity of agents to deal with risk and uncertainty, the ensuing errors they make, are what create, along with other market imperfections, the conditions for business confidence to fluctuate and trade cycles to appear, as is briefly shown in the fifth section. The sixth and final section contains a few concluding remarks.

The market economy: risk and uncertainty In writing The English Capital Market (ECM),4 Lavington’s aim is ‘to trace the nature of the economies which the market effects as part of the organisation of production, and to express these economies in terms of economic welfare’ (1921: VI). Thus, he analyses the market as an organizational method for adjusting resources to wants, noting however that there are two main obstacles to attaining this objective, i.e. ‘intractability’ of resources and ‘incalculability’ of outcomes of economic activity, both of which result in social losses. Society has, however, contrived means of limiting these losses. The main one consists in entrusting certain functions to a particular class of agent, the entrepreneur. Money, credit and the ‘money market’ Lavington’s starting point is the observation of the ‘unsurpassed efficiency’ of ‘modern industrial communities’ (1921: 1 and 275). This has been achieved, he argues, thanks to the division of labour in the form of the development of the ‘great branches of production’ and the ‘separation of processes’ (1921: 1). Lavington’s main purpose, however, is to show that to produce its effects, the division of labour requires the ‘transport of intelligence, of material things and of value’, which entails the ‘corresponding development of communications, by means of which the dissociated parts are co-ordinated and inter-connected’ (1921: 2). Then, in the same way as the telephone and the steamship allow the transport of ‘intelligence’ and material goods, it is the ‘money market’ that permits the transfer of value. This is accomplished through the provision of: (1) ‘means and facilities for making payments’ and (2) ‘facilities for effecting those particular payments by which capital is transferred from the control of one party to another’ (1921: 2–3). The supply of an adequate amount of currency and the

Frederick Lavington’s theory of markets 205 ‘transport of capital’ are thus the two services provided by the institutions that form the money market. Money is thus part of Lavington’s analytical framework from the very beginning. Accordingly, his first step in analysing the role of the capital market consists in sketching the main contours of his theory of money. Lavington introduces money initially as a medium of exchange, moving quickly to a more elaborate view where money is perceived as a means of payment and a store of value. Thus, depending on the ‘volume of payments, present and prospective’ they anticipate, agents hold a ‘fraction of their total resources [for] this particular use’ (1921: 60). It is then because money is a means of payment that it becomes ‘the general measure of value’ and thus ‘the unit in which undertakings to make future payments are expressed’ (1921: 61). Credit plays an important role with respect to the service provided by the money market institutions. It encompasses two aspects: (1) the ‘power of the business man to borrow’ and (2) the ‘confidence on the part of the investor’ (1921: 15). When confidence is at its ‘normal level’, credit itself is at its ‘normal’ level and the provision of the two services is facilitated. However, credit can cause disturbances and ‘abnormal’ credit will then participate in throwing the market into a state of abnormal activity, due to the development of excess business confidence, which is responsible for the cyclical behaviour of the economy. Risk and/or uncertainty? The second role of the money market, namely the ‘transport of capital’, concerns ‘the movement of capital into those uses in which it can be most effectively employed’ (1921: 71). For Lavington, this implies that agents postpone the consumption of part of their income. Saving is thus labelled ‘waiting’ and rewarded by the payment of interest in exchange for the utility to which it gives rise, in particular by enabling the adoption of production methods yielding greater productivity. However, ‘anyone who waits . . . must accept the risk of change’ to which is exposed the ‘value he carries through time’ (and be paid an additional income for providing that service) (1921: 82). Thus, the mere passage of time leads to a ‘continuous social loss’ whose amount ‘depends on three things: (1) the rate of social change, (2) the degree of imperfection of knowledge and (3) the extent to which resources are fixed and unadaptable, i.e. the immobility of invested resources’ (1921: 82–3). Little space is devoted to the first ‘thing’, Lavington insisting rather on the risks arising from imperfect knowledge, on the one hand, and immobility of invested resources, on the other hand. The issue of risk and uncertainty receives early attention in the first article published by Lavington in 1912. It is also given further attention in two articles that appeared in the Economic Journal in 1925 and 1926, thus after the publication of ECM, indicating that Lavington was seemingly dissatisfied with the way he had dealt with these notions in his book. Accordingly, whereas Lavington begins in his first article by building upon the notion of ‘uncertainty-bearing’ put

206 C. Dangel-Hagnauer and A. Raybaut forward by Pigou in Wealth and Welfare, 5 in Chapter 14 of ECM Lavington seeks to establish a distinction between risk and uncertainty. To do so he assumes first that perfect certainty prevails. Risk is then defined as the ‘unrelieved probability of loss’ attached, for instance, to holding risky securities. In the absence of uncertainty, there would then be times when security holders would receive a ‘bonus’ enabling the build-up of a ‘kind of amortization fund to cover loss in the past or future’ so that, in the long run, risky securities would pay on average the same return as perfectly safe ones (1921: 85). However, noting that risky investments offer over a long period a higher return than safe ones, Lavington draws the conclusion that ‘people dislike the uncertainty in the yield of risky investments’ (1921: 86, emphasis added) and require an extra payment for the ‘irregularity of return’ and the disutility it creates. Having made this distinction, Lavington encounters difficulties in sticking to it. Ironically this occurs when he sets out to propose what one would consider today a modern representation of risk in a chart (Figure 13.1),6 displaying the prospective net returns of a safe and a risky security. The diagram is akin to the one found in his 1912 article, itself ‘similar to the one used by Prof. Pigou’ to whom Lavington expresses his debt for permission to use it (1921: 399, fn 1). It resembles today’s textbook probability distribution of the returns of a risky asset, albeit with a skewed shape that gives it a rather modern-like flavour. In the diagram, MP is the ‘most frequent return’, M’P’ the ‘estimate actuarial value of the set of prospective returns’ (the mean return), M’P” the ‘net rate of interest’ (the riskless rate), whereas P’P” measures the ‘spread’, i.e. ‘the payment for bearing Uncertainty’ (1921: 87–8). Hence the distinction between risk and uncertainty has now become blurred, leading Lavington to observe that ‘the idea of Risk as a relieved probability of loss is now included as part of this more general conception, Uncertainty’ (1921: 89). This requires making a choice: The term Uncertainty is . . . both clumsy and unfamiliar, and it will be convenient to abandon its use in favour of the term Risk on the understanding that this term will in future be used with the wider and not the narrower meaning. (Lavington 1921: 89) Incalculability, risk, uncertainty and the entrepreneur In the 1925 and 1926 Economic Journal articles, Lavington returns to this subject and suggests an alternative distinction, that is, between ‘business risk’ and ‘uncertainty-bearing’. For that, Lavington begins by reminding us that his main concern consists in examining to what extent resources are used efficiently. There are, he notes, two obstacles to achieving efficiency: ‘intractability’ of resources and ‘incalculability’ of outcomes (1925: 186). To explain the effect of intractability, Lavington assumes first perfect calculability and defines intractability as resulting from the ‘resistance which the materials at our disposal

Frederick Lavington’s theory of markets 207 Y P

M MI

PI

Chances of each rate of return

PII

Safe security

0

4%

X

Rates of return

Chances of each rate of return

Y

⫺5%

Risky security P

MI MI

PII

0

PI

Rates of return

20%

X

Figure 13.1 The prospective net returns of a safe and a risky security (from Lavington 1921: 88).

oppose to their transformation into forms and places more to our liking’ (1925: 186). Thus, intractability is directly related to the immobility of resources, making it difficult for agents to cope with social change even when it ‘is fully foreseen’, as ‘our modes of production are not completely flexible’ (1925: 186–7). Turning next to ‘incalculability’, the author asserts it is due to the ‘complexity of the processes by which the future grows out to the present’.

208

C. Dangel-Hagnauer and A. Raybaut

Incalculability or the ‘obscurity of the conditions in which economic operations are conducted’ is then what generates risk and uncertainty (1925: 189). As in ECM risk is defined as an ‘unrelieved probability of loss’, although Lavington insists here on the ‘actual realised loss’ it generates, due to the maladjustment of resources to wants and the waste of productive capacity it involves through the joint effect of incalculability and imperfect flexibility. In fact, probability of loss does not necessarily imply an actual reduction in output, one of the many tasks of the entrepreneur being precisely to keep such losses at a minimum level. Basically, the entrepreneur is entrusted with the responsibilities of initiating, organizing and controlling production, by combining ‘the services of land, capital and labour with his own, and applying them to the productive uses in satisfaction of social wants’ (1921: 5 and 274). In addition, with regard to risk, the entrepreneur is considered as having developed a ‘specialised organising capacity’, a special skill that enables him to select and deal ‘with the risks associated with the conduct of productive operations’ and to continuously readjust resources to ‘imperfectly known and changing conditions’ (1925: 190 and 196). Doing so requires ‘initiative, special knowledge and . . . resources’ (1925: 190). At this stage, the entrepreneur faces a ‘technical problem’ (1926: 197). Thanks to his special ability in the ‘service of risk-bearing’, which is paid for in the form of an additional cost of production, he contributes to the greater efficiency of the market economy, as ‘the independent entrepreneur enlists very strong motives in the service of economical production, and tends steadily to select and develop the organising capacity by which Risks are destroyed’ (1925: 191). The modern form of industrial organization, ‘characterised by the presence of innumerable independent producing groups each in charge of an entrepreneur working for private reward’ contrasts with the system of ‘State Socialism’ (1925: 191). Hence, the entrepreneurs’ incentives to produce efficiently confer superiority to the market economy. The latter exhibits, nonetheless, a drawback in that entrepreneurs face a ‘commercial problem’ since they must sell what they produce independently (1926: 197). The ensuing uncertainty that they face is a shortcoming which is avoided in the socialist system where ‘individual purchasing power [would show] no appreciable variation from year to year’ (1925: 191). Instead the market coordinates activities imperfectly, causing individual incomes to fluctuate and to become ‘imperfectly calculable’ (1925: 192). Here again, the task of reducing such inefficiency falls to the entrepreneur, as he has developed ‘an additional organising ability’ enabling him to bear uncertainty and administer ‘an imperfectly calculable income’, in return for which he receives a compensation in the form of a profit (1925: 196). To sum up: (1) Risk is ‘associated with the realised loss in the form of reduced efficiency of production’ (in the form of wasted capacities) and (2) Uncertainty is ‘associated with realised loss’ in the form of irregularity of income (1925: 192). Another difference is that allowances, for instance in the form of reserves, can be made as a means of covering risk. In contrast, uncertainty is impossible to eliminate completely. Consequently, it requires making

Frederick Lavington’s theory of markets 209 forecasts that will inevitably lead to errors, a circumstance that plays an important role in the unfolding of the trade cycle.

The market economy: heterogeneous agents and market agencies As just highlighted, the entrepreneur plays a key role in Lavington’s construct. The organizational abilities of entrepreneurs are applied to the adjustment of means to ends and take on particular features in the context of risk and uncertainty in which they operate. Another important characteristic of entrepreneurs, namely their heterogeneity, is a trait that they share with another category of agents, speculators, an aspect that also participates in generating economic instability. Parties to production and market agencies Like the other agents, entrepreneurs form a social group. For Lavington, society is a living organism, made up of different ‘classes’ or ‘parties to production’ – ‘landowners’, ‘labour’, ‘capitalists’ and entrepreneurs – defined on the basis of the specific function they perform (1922: 274). Although Lavington uses the term ‘entrepreneur’ or ‘business man’ indifferently, his conception differs from Marshall’s insofar as he establishes a more clear-cut distinction between capitalists, ‘i.e. people with disposable resources’, and entrepreneurs – ‘the group of business men . . . who apply these resources in their various uses’ (1922: 19). When carrying out their activities, entrepreneurs rely on institutions or ‘market agencies’, among which Lavington lists: ‘Employment Exchanges, Trade Unions, newspapers and the more indefinite machinery of the labour market’ (1922: 275). These agencies are precisely instances of the means of communication that enable agents to interconnect and ensure the coordination of activities through the circulation of knowledge, products and value (1922: 2 and 5). Among these agencies, the main focus in both TC and ECM is on the agencies that form the money market. These are institutions that ‘lie between the group of capitalists and the group of business men’ (1922: 275). Heterogeneity of entrepreneurs ‘Business men’ or entrepreneurs come in many guises: private businessmen, partnerships and joint-stock companies rub shoulders with cooperative societies, municipalities, etc. Lavington insists neither on these different categories nor very much on the distinction between manufacturers, merchants and retailers. More meaningful to him are the differences in business and cognitive abilities. Business abilities are important insofar as they involve adjusting society’s productive resources to its needs, entrepreneurs being more or less willing to bear the risks this function implies. Thus, the manufacturer or employer shows more or less ‘willingness to produce’ and the merchant or the retailer shows more or

210 C. Dangel-Hagnauer and A. Raybaut less ‘willingness to buy’ (1922: 23). As for cognitive abilities, they are required for the appraisal of present and more remote market conditions whose estimation is the task of entrepreneurs considered as a group of interrelating individuals. So, whereas the individual entrepreneur seeks to make independent rational judgements and well-informed estimates, his judgement is ‘coloured by the business atmosphere’ (1922: 31). Interestingly, Lavington considers that for the individual entrepreneur to be affected by the general business outlook is not altogether irrational, so long as the process through which agents are mutually influenced remains ‘slight’. The problem is that the contagion that develops in this context can lead to herd behaviour and give rise to a cumulative process that will induce socially irrational conduct. Heterogeneity of entrepreneurs and change of composition of the group they form are the root causes of the process. Because risk and uncertainty characterize the context in which entrepreneurs exert their business abilities, they need to make forecasts that are ‘liable to error’ (1922: 26–7). The information on which forecasts are based originates in the minds of individual entrepreneurs and travels within the business community. However, in the same way as they are endowed with greater or lesser business ability, entrepreneurs are more or less capable of making correct estimates. To make things worse, apparently favourable conditions will induce individuals with low business and cognitive ability to be lured into the productive and trading sphere, and the increased size of the subclass of incompetent entrepreneurs leads to greater distortion in the information that spreads from one end of the market to the other. In brief, entrepreneurs form a heterogeneous class, not so much in that they operate within specialized industries, but rather because they differ from the standpoint of their business ability, their experience and in their aptitude to gather and process information. A similar form of heterogeneity characterizes speculators. Heterogeneity of speculators The speculator appears as a specific group of agent that overlaps the usual division of society between the providers of productive services, since speculators include capitalists, professionals working within the market agencies and entrepreneurs. The main realm of their activity is nonetheless the organized markets, such as the ‘produce exchanges’ and more especially the ‘stock exchanges’ (1921: 236). The function they perform is akin to that of traders, but whereas the latter take advantage of price differences among goods separated in space, the activity of speculators consists in carrying securities (or goods) ‘between two points of time with a view to profiting from a price difference between the two exchanges bounding his operation’ (1922: 235). The income this price difference generates is pocketed by the speculator in exchange for the service he provides in: (1) easing and quickening the transactions of the agents from whom he buys and to whom he sells and (2) bearing the risk resulting from the holding of the securities during the interval separating the ‘two points of time’. Most important of all, speculators contribute to market efficiency by driving security

Frederick Lavington’s theory of markets 211 prices towards their fundamental or ‘investment value’, through two channels: (1) by anticipating movements in fundamentals; (2) through their trading activity, which contributes to eliminating the spread between market prices and the underlying fundamentals.7 However, speculators form a heterogeneous group, with ‘expert’, ‘skilled’ or ‘professional’ speculators facing ‘unskilled’ speculators. Speculators differ according to the size of their wealth, the quality of both their knowledge and expertise, and their rationality. Accordingly, skilled speculators own sufficient resources, are well informed and are therefore able to make ‘intelligent’ estimates of future yields and prices of securities. They have expert knowledge of certain kinds of investments and relevant information concerning particular securities thanks to their ‘business of personal connexions’ (1921: 247). Hence the risk borne by skilled speculators is mitigated thanks to ‘the special information’ they have gathered and obtained ‘whether . . . by good fortune or hard work’ (1921: 247). This is what enables them to abstract wealth from other less well-informed agents, notably unskilled speculators, who are characterized by the opposite traits. Supported by limited and frequently borrowed resources, their decisions are governed by ‘emotion’ and ‘temperament’. Their behaviour is amateurish in that they ‘dabble’ in speculative securities and the operations they perform are ‘governed largely by irrational herd impulses, produce effects on prices which are wholly bad and lead to heavy social waste’ (1922: 256). Speculators also differ with regard to the timing of their operations. Skilled ones anticipate good news and ‘close their commitments when the good news arrives’, while the public at large engages in ‘speculative buying in the case of good news’ (1922: 246–7). Finally, there are differences in earnings. Whereas the amateur loses his ‘money by coming in too late’, the expert speculator can ‘transfer wealth to himself both from the investing and from the speculating public’ (1922: 247). This is particularly the case in the ‘aftermath of speculative buying’,8 which has forced the price of securities above their fundamental value, thereby offering the opportunity to the better informed professional to ‘undertake a bear position which yields him a further profit at the expense of the public’ (1921: 247).

The working of the money market The money market is composed of two compartments, the ‘inner market’, and the ‘outer market’, both of which are composed of specialized institutions. The former compartment includes banks, the market for negotiable securities, as well as trust and finance companies, whereas the latter one is formed by solicitors and the system of trade credit. Among this list of agencies, the author focuses more specifically on the banking system and on the market for stock exchange securities.

212 C. Dangel-Hagnauer and A. Raybaut The banking system: a source of both efficiency and instability Banks are specialized in the lending of capital for short periods of time. They provide the two money market services – the transport of capital and the manufacture of money – ‘in intimate connexion’ (1921: 177). Although these two services are ‘in essentials independent’, Lavington notes for instance that ‘the use of the cheque currency contributes directly to the efficiency of the work of transporting capital’ (1921: 177). However, to isolate the part played by banks in the transport of capital, the author starts by assuming that the economy has the exact amount of cheque currency needed to carry out the current volume of payments ‘at the normal level of prices’, that is when equilibrium prevails (1921: 177). In such ‘normal’ conditions, banks are mere ‘middlemen’. They perform the ‘collection and pooling of small items of capital’ in the form of deposits, or ‘lodgments’, in exchange for payment of interest or provision of cheque-making facilities. The funds they have collected are then invested in those ventures that yield the maximum return. How efficiently banks operate depends on: (1) social conditions, such as the willingness of individuals to entrust the banks with their savings; (2) more organizational factors, like the degree of centralization of the banking system and/or the development of branching and (3) informational aspects, such as reputation. On the whole the service of the manufacture of money rendered by banks is ‘unsurpassed in its efficiency as a means of effecting the kinds of payments which are most important in modern business conditions’ (1921: 147). Banks are particularly efficient in carrying out ‘marketing operations’ and promoting ‘business contact’ between supply and demand in the money market (1921: 112). Equilibrium may be upset by different causes, namely fluctuations in the external demand for gold, seasonal variations in domestic demand for currency, and most important of all, temporary alterations in the size of the money supply stemming from changes in the level of business confidence. The capacity of banks to create money can then become a cause of disturbance. This takes us back to Lavington’s conception of money as, first, a means of payment and, second, a unit of account. In an ideal world, banks would act so as to offset the disturbances that affect the purchasing power of the unit of account resulting from some ‘abnormal’ supply of currency. Among the causes that might adversely affect the money supply, one is directly connected with credit and banking. Thus, whereas the volume of bank loans is determined in the long run by both the amount of gold currency and the will of the public to transfer their savings to the control of the banking system, ‘during shorter periods of time it is governed by the will of the banks themselves’ (1921: 180). Variations in lending are in fact connected with the phases of the business cycle. Ironically, it is not so much the downward phase that retains the author’s attention, but rather the upward one: By far the most serious causes [tending to disturb the purchasing power of the sovereign] are those associated with the expansion of purchasing power

Frederick Lavington’s theory of markets 213 accompanying and reinforcing those changes in the level of confidence which are responsible for cyclical fluctuations . . . It is in the power of jointstock banks and very greatly to the social advantage for them to employ their control over the cheque currency to react against the expansion of purchasing power and destroy the artificial stimulus it gives to business activity. (Lavington 1921: 175–6) In other words, the banking system participates, along with the general conditions in which credit is granted, in intensifying the cyclical swings of economic activity, whereas Lavington considers it is in its power to check economic instability.9 The market for stock exchange securities: imperfect knowledge and asymmetric information The stock market and banks differ in that the former is specialized in the supply of long-term capital, but even more so in the way these institutions ‘relieve the investor of the work of management of his capital’ (1921: 121). Thus, banks ‘own the capital which they obtain from the public’ and take on complete responsibility for the risks they incur so that private and social interest coincide (1921: 121–2). In contrast, issue houses or company promoters, for example, ‘act more in an advisory or executive capacity’ (1921: 121). Hence their profits do not significantly depend on how effectively they distribute and invest the public’s savings, which raises the question as to the contribution of the market for securities in terms of social welfare. In principle, to the extent that they operate properly, the markets for ‘new’ and for ‘old’ securities should participate in lowering the supply price of capital, which is accomplished: (1) by setting security prices as closely as possible to their fundamental value and (2) by ‘marketing’ securities as ‘economically’ as feasible (1921: 190). However, this task requires ‘expert knowledge’, which is often lacking among security market agencies, in order to assess the ‘present and future circumstances’ that govern a borrower’s present and future earnings (1921: 190). An additional interesting problem from the viewpoint of the modern reader – whereas it does not seem to have attracted the attention of Lavington’s contemporaries – is that sellers and buyers differ from the informational standpoint: Sellers have a more intimate knowledge of the commodity in which they deal than buyers . . . In the market for new securities this condition enables the company promoter to sell worthless securities to the public; in that of old securities it enables the speculator with inside knowledge to draw abnormal profits by dealing with investors less well informed than himself. (Lavington 1921: 190) This problem is nonetheless partly avoided to the extent that vendors or security issuers have a reputation to preserve. Thus, in the market for ‘high-class

214 C. Dangel-Hagnauer and A. Raybaut securities’, the participation of institutions and agents of ‘high financial standing’ – the London issuing houses, the brokers and jobbers, as well as bankers and government representatives in the case of government issues –, their expert knowledge and great reputation are such that Lavington affirms that ‘there is little scope for abuse in the marketing of highly reputable stocks’ and ‘the sale of these securities on the London market is carried out with reasonable efficiency and economy’ (1921: 199). On the contrary, the market for ‘industrial securities’ is characterized by an extreme variety in the quality of issuers, many of which are ‘new companies exploiting doubtful opportunities’ (1921: 207). This makes the task of the individual investor extremely difficult, all the more as he simply does not have the knowledge needed to take part in the transaction, so that ‘the purchase is an act of faith rather than of judgement’(1921: 207). To make matters worse, the marketing of issues is accomplished by ‘company promoters’ who have no reputation to defend and whose profits derive from the margin between the price they pay the issuer and the price at which they sell to the public. There is, as a result, an overvaluation of securities, especially during phases of prosperity, due in particular to the promoter’s heavy marketing costs. Notwithstanding, several devices help protect the investor, for instance the prospectus issued by the company offering new securities for sale, as well as the advice provided in the financial press and by investment brokers. Finally, although Lavington deplores the laxness of English law in comparison with that of other countries, he considers that the market for new stock exchange securities ‘performs an important service in making capital available for risky commercial and industrial experiments at home and abroad’ (1921: 219). In conclusion, the institutions that make up the money market play an important role in facilitating the flow of funds between savers and lenders.10 However, the inefficiencies that result from both capitalists’ and entrepreneurs’ imperfect knowledge and information are only partly overcome. In particular, market agencies do little to prevent the development of waves of increasing and decreasing business confidence. By supplying a greater volume of money during the upward phase of the business cycle, banks actually contribute to providing an artificial stimulus to economic activity. Along with speculation in the market for stock exchange securities, their behaviour has the effect of amplifying instability.

The trade cycle Examining why ‘modern industrial communities’ are subject to instability is the subject of the small book Lavington published in 1922, where his aim is to provide a ‘brief account of the trade cycle’ (1922: 7). However briefly, in The Trade Cycle, Lavington endeavours to include all the main aspects that are characteristic of business fluctuations: the role of credit and banking, the process of adjustment between saving and investment, the role of capital goods, etc. This is hardly surprising, as he refers to the works of several economists, citing Mar-

Frederick Lavington’s theory of markets 215 shall, Pigou, Robertson, as well as Mitchell and Aftalion. Nevertheless, it is Pigou’s theory his own approach resembles most, an aspect that is underscored by Laidler (1999). As our goal here is not so much to show what Lavington borrows from these different authors, we focus instead on the role played by the heterogeneity of agents and the ‘incalculability’ of the outcomes of their activities in generating instability in the form of business cycles. The heterogeneous group of both independent and mutually interdependent entrepreneurs plays a key role within industrial societies. An important aspect not stressed up to now is that prices are the device through which market coordination, the main task entrusted to entrepreneurs, is achieved. Prices express effective demand and, along with costs of production, provide the entrepreneur – acting as ‘middleman operating between two sets of prices’ – with guiding incentives (1922: 89). Business activities, we know, are carried out within a context of risk and uncertainty. Furthermore, production takes time, particularly ‘in those industries which make constructional goods’ (1922: 21). As a result, entrepreneurs will need to spend much effort and ‘intelligence’ in making forecasts about future price levels. Quite naturally then, it is precisely through prices and entrepreneurs’ errors that disturbances will arise. Whereas the latter can originate either in the monetary system, in changes affecting the agricultural sector or in variations of profitability in certain industries, Lavington strongly insists, nonetheless, on there being definitely no reason why such disturbances should expose society to periodical oscillations in general business activity. For there to be cycles, an essential ingredient is required to reinforce the initial triggering disturbance, i.e. changes in the level of business confidence.11 Expansion (and decline) of confidence When making forecasts, entrepreneurs rely on whatever information they have. Thus, interdependence of firms will cause information, whether well grounded or not, to spread. Business confidence, once it is instilled, will tend then to increase cumulatively. Interestingly, no serious problem arises so long as the increase in confidence remains ‘slight’. Indeed: ‘If business judgements were purely rational, confidence in each trade would be a good reason for somewhat greater confidence in others’ (1922: 36). However, ‘business judgements will not remain purely rational’, as each judgement is ‘inevitably . . . further tinged with optimism’ (ibid.). In addition: ‘When markets are rapidly expanding and prices rising, the most inefficient entrepreneurs find business easy and profitable’ (ibid.). And, from this moment on, judgements become ‘infected by general error’ (1922: 37). Optimism becomes exaggerated and error spreads even more under the additional influence of the monetary factor and the disproportionate expansion of the supply of ‘effective purchasing power’ (1922: 41),12 itself a consequence of greater business confidence, inducing a more intensive use of bank deposits, a greater appeal to banks for bigger loans, greater withdrawals from savings accounts and increased speculation in the form of larger

216 C. Dangel-Hagnauer and A. Raybaut purchases of securities. The resulting excess volume of money, as compared with the volume of goods, produces an increase in the general level of prices, which in turn causes a transfer of wealth in the form of a ‘bounty’ for the entrepreneur. During the entire process, the general business outlook plays a key role in that merchants of good credit, and indeed many others of less solid reputation, . . . greatly expand the volume of their orders without any great fear that at the time of delivery they will be unable to obtain the money requisite for the payment of the unsold balance of their increased supplies of goods. (Lavington 1922: 46–7) However, credit expansion is limited by the size of banks’ reserves. So there comes a time when the entire process reverses: the decline in confidence leads to a contraction in the volume of effective purchasing power, as businessmen do their utmost to strengthen their financial position by granting less trade credit and issuing fewer cheques, while investors accumulate idle balances in place of security holdings. In the meantime, while the going is good, confidence and purchasing power rise concurrently, one giving further impetus to the other, as profits keep on accruing. Nourished by agents’ self-fulfilling expectations, the process persists: once it is believed that prices have entered upon their upward phase, no one can afford to wait, and every addition to the volume of buying, by its effect on prices, tends to justify the anticipations on which is was based. (Lavington 1922: 57) Thus, growing optimism boosts entrepreneurs’ willingness to produce in anticipation of demand’, which raises current output, general purchasing power, further strengthening the ‘rising tide of demand’ and accentuating the ‘rapidly growing profitableness of business’ (1922: 61). Hence, the rise in prices participates in creating and maintaining the conditions for increasing errors of optimism. The building up of ‘apprehension’ and depression Downplaying the ‘influences arising from the monetary system’, Lavington is adamant in finding the ‘real cause’ that prevents ‘marked business activity’ from going on ‘indefinitely’ (1922: 66 and 68). Indeed, sooner or later, excess accumulation, exaggerated reliance on both bank loans and indebtedness, and narrowing profit margins will lead to a ‘brief interlude of apprehension’ (1922: 14). Of moderate intensity in some cases, the turning point will generally take on the form of a crisis or a panic. Why it occurs is due to the decreasing returns that appear ‘as the boom proceeds’, owing to the drop in both ‘the quality of busi-

Frederick Lavington’s theory of markets 217 ness management and the efficiency of labour . . . with the result that increasing costs, coupled with the increasing supplies of equipment, make it impossible for capital to continue to earn a high return’ (1922: 75). This entails frustrated expectations when ‘the rate earned by capital declines and its growing supplies obtain a lower return than was anticipated’ (1922: 76). As a result, once ‘extravagant estimates’ become recognized as such, there is ‘the growing realization by the business community of errors committed and being committed’ (1922: 62 and 76). Subsequently, ‘failing confidence ripens into apprehension’, entrepreneurs become unwilling to assume risks, orders decline, and the ‘desire of each business man to “take in sail”’ induces a rise in the demand for money (1922: 77). During the depression we observe the same sequence of events as during the phase of prosperity, except that where there were formerly rises (in confidence, optimism and activity) we now have declines. For Lavington, however, depression comes to an end by the time activity has only fallen to the ‘relatively moderate limit of its ordinary course’ (1922: 87). This implies that depression is generally not very deep and that revival comes about endogenously, as soon as enough time has elapsed for risky ventures to close down and for the situation to become sounder. Disaster myopia and availability heuristic: prefigurations Interestingly, ‘in the search for a cause which would serve to rouse industry from its depression and quicken it into activity’, Lavington (1922: 54) excludes there being ‘a physical basis of explanation’, in the form of good harvests, important inventions or even ‘solar changes’, referring here indirectly to Jevons (1984). Lavington insists on this point, examining the effect, for instance, of an important innovation occurring in a world inhabited by rational agents alone. As he writes, The impulse would be cumulative in its effects, but the nature of its growth, surely, would be that of a convergent series, increasing in strength indefinitely, but increasing only up to a finite limit; and that limit would be not far from a normal business activity. (Lavington 1922: 59–60) Significantly, the professional speculator would have an active role to play in this case by exerting a steadying influence. How then does depression finally subside and revival step in? This occurs as a result of the fading out of the ‘feeling of mistrust accompanying the time of strain’, by ‘the oppressive memories of the past’ becoming fainter, and by the ‘knowledge that no business depression has yet been everlasting’ (1922: 54–5). Obviously the reorganization of business, the fall in wage rates, the improvement in workshop discipline, the reduction in the size of inventories, and the replenishment of banks’ reserves, all these factors contribute to setting the stage

218

C. Dangel-Hagnauer and A. Raybaut

for a specific category of businessmen – the ones who are ‘looking out eagerly for signs of improving trade’ – to enter the scene (1922: 56). However, psychological factors are decisive in creating the conditions for revival to take place. And, once ‘this slight expansion faintly colours the business atmosphere’, the process of growing prosperity will gradually gather speed (1922: 56). Thus, Lavington’s description of the unfolding of the trade cycle clearly foreshadows modern interpretations of the psychological mechanisms that underlie the behaviour of financial market participants.13

Concluding remarks Clearly, Lavington’s conception of the trade cycle owes much to the English political economy tradition, and particularly to the contributions of J. S. Mill (1965a and b) and Marshall (1881, 1919, 1920, 1923, 1992). However, the type of agent rationality at work in the writings of the three authors differs. In Mill, the trade cycle is caused by the speculative interaction between professional traders and rash speculators: the former are endowed with some superior knowledge, which does not prevent them from ‘overtrading’ and causing prices to diverge from their equilibrium level; the latter are responsible for the propagation of the ‘mania’; finally, professional traders act so as to put an end to the upswing that they know will not persist (Forget 1990). In Marshall’s writings, there is little emphasis on the ‘malignities’ of the professional speculator, except in the unpublished manuscript brought to light by Dardi and Gallegati (1992), so that it is rather the divergence between the real and the monetary rates of interest, under the effect of bank credit, that plays the leading role in the unfolding of the business cycle.14 This contrasts with the more ‘efficientist’ (to use the phrase coined by Dardi and Gallegati) approach of speculation in Lavington, for whom ‘the influence of the monetary system is to be regarded not as the primary, but as a reinforcing cause of business cycles’ (1922: 68). Already considered a specialist of risk in his day,15 Lavington provided an original and significant contribution in this area that is strongly reminiscent of Knight’s (1921). Both authors, it can be noted, establish a link between risk, uncertainty and entrepreneurship.16 Moreover, if ‘Marshall played the role of . . . trait d’union between the teachings of the old masters and the modern sensibility displayed by his unorthodox pupil’ (Dardi and Gallegati 1992: 572), namely Keynes, this also applies to Lavington. Many of the ingredients that Keynes would remix together appear in his writings.17 In particular, revisiting Lavington’s contribution is especially helpful in filling in some of the gaps that puzzle the reader of Keynes’s ‘Notes on the Trade Cycle’ (Chapter 22 of The General Theory), for instance his references to ‘psychology’, ‘misdirected investment’, ‘errors of pessimism’, ‘over-optimism’ and the role of confidence in general. When reading Lavington – and Pigou for that matter, as the two authors influenced each other – we soon understand why Keynes could be content with jotting down just a few ‘notes’, precisely because the notions he was referring to had been developed within the tradition that began with J. S. Mill, continued

Frederick Lavington’s theory of markets 219 with Bagehot (1873) and Marshall, and formed a set of ideas that were shared among the circle of economists to which he belonged.18 Until recently analyses of economic fluctuations that laid stress upon psychological causes were viewed with circumspection (when not with contempt).19 Today, phrases such as ‘psychological factors’ or ‘psychological causes’ no longer denote some kind of non-economic, hard to define, hotchpotch. Revisiting Lavington’s explanation of fluctuations shows in fact it is underpinned by a careful and detailed analysis of the relations between interacting agents, or groups of agents, characterized by the heterogeneity of their abilities and beliefs. These social and cognitive interactions create an alternation of collective waves of optimism and pessimism, which are at the root of the cyclical pattern of economic activity. In conclusion, the importance of money, credit and banking, along with the key role played by psychological factors in Lavington’s explanation of instability, anticipate Minsky’s (1986) analysis of financial instability and more modern conceptions of financial behaviour.

Acknowledgements The authors are thankful to Gordon Fletcher and to the anonymous referee for helpful suggestions. The usual disclaimer applies.

Notes 1 For details, see Wright (1927) and Bridel (1987b). 2 Among other exceptions, we find Pigou who refers, in the fourth edition of The Economics of Welfare (1932: 158), to the ‘excellent account of [capital market] agencies’ in The English Capital Market, of which there were further editions in 1929 and 1934. Another example is Allyn Young, who recommended the reading of The Trade Cycle (Laidler 1999: 198, fn 1). See also Schumpeter (1954: 895 and 1084). 3 Bridel (1987a: 96–100), and Laidler (1999: 97–9). 4 Although Lavington devotes more than half of The English Capital Market to the institutions that make up the ‘money market’, his ‘purpose is not one of description, but of interpretation’ (1921: VI). Accordingly, in Part I, the money market is interpreted as one of the economy’s organizational arrangements whose purpose is to make it more effective. It plays two roles. The first, the provision of means and facilities for making payments, is related to the functions of money that are analysed in Part II, where Lavington presents an ‘Outline of the Theory of Money’ and more particularly his theory of the demand for money. The money market’s second role, analysed in Part III, is the ‘transport of capital’; it consists in facilitating the flow of funds between savers and investors. Part V is then dedicated to the numerous institutions composing the capital market. 5 See ‘Note on Uncertainty-bearing as a factor of production’ in Pigou (1912: 95–103). 6 From Lavington (1921: 88). 7 See Lavington (1913) for an in-depth analysis of the extent to which speculation is advantageous to society. 8 H. Withers (1915: 291–2), quoted by Lavington, italic in the original. 9 This is of course the position of von Mises (1981) (whose contribution Lavington seems to ignore), as it will be the one defended by Robertson (see Laidler 1999: 99). It contrasts with Keynes (1971, vol. V: 261).

220 C. Dangel-Hagnauer and A. Raybaut 10 These institutions also play an important role in bringing into ‘rough unity’ short- and long-term rates of interest (Lavington 1924: 302). 11 This is probably where Lavington’s conception differs from Pigou’s which is more ‘eclectic’ (Laidler 1999: 87, fn 1). 12 Lavington prefers this phrase to the term ‘money’ which he considers ‘vague’. 13 See Guttentag and Herring (1986) and their reference to the notion of ‘availability heuristic’ developed by Tversky and Kahneman (1982). 14 See Bridel (1987a: 36–51) and Laidler (1999: 82–3). 15 See Knight (1921: 199–200, fn 1) and Batson (1930: 39). 16 See Schumpeter (1954: 895 fn), on this point. 17 It is, however, noteworthy that although Lavington’s analysis of the demand for money anticipates the liquidity preference theory, Lavington is never cited by Keynes. Nor, for that matter, does Lavington ever cite Keynes (Laidler 1999: 83 fn). 18 For a comparison between Lavington and Pigon’s contributions see Dangel-Hagnauer and Raybaut (2003). 19 See, for instance, Schumpeter (1954: 1132–4) and Haberler (1937: 142–3). Wright H. (1927) ‘Frederic Lavington’, Economic Journal, 37: 503–5.

References Bagehot, W. (1873) Lombard Street – A Description of the Money Market, London: John Murray. Batson, H. E. (1930) A Select Bibliography of Modern Economic Theory 1870–1929, London: George Routledge & Sons, reprinted (1967), London: Routledge & Kegan Paul. Bridel, P. (1987a) Cambridge Monetary Thought: The Development of Saving-Investment Analysis from Marshall to Keynes, London: Macmillan. —— (1987b) ‘Lavington, Frederick’, in J. Eatwell, M. Milgate and P. Newman (eds) The New Palgrave Dictionary of Economics, London: Macmillan. Dangel-Hagnauer, C. and Raybaut, A. (2003) ‘Trade Cycles in Cambridge: Agents and Their Beliefs’, European Society for the History of Economic Thought Seventh Annual Conference, Paris. Dardi, M. and Gallegati, M. (1992) ‘Alfred Marshall on Speculation’, History of Political Economy, 24: 571–94. Forget, E. L. (1990) ‘John Stuart Mill’s Business Cycle’, History of Political Economy, 22: 629–42. Guttentag, J. M. and Herring, R. (1986) Disaster Myopia in International Banking, Essays in International Finance, No. 164, International Finance Section, Princeton University. Haberler, G. von (1963) Prosperity and Depression, 4th edn, New York: Atheneum. Jevons, W. S. (1984) Investigations in Currency and Finance, London: Macmillan. Keynes, J. M. (1971) ‘A Treatise on Money’, 2 vols, in The Collected Writings of J. M. Keynes, vols 5–6, London: Macmillan. —— (1973) The General Theory of Employment, Interest and Money, in The Collected Writings of J. M. Keynes, vol. 7, London: Macmillan. Knight, F. (1921) Risk, Uncertainty and Profit, Boston, MA: Hart, Schaffner and Marx; Houghton Mifflin Company; reprinted (1971), Chicago: University of Chicago Press. Laidler D. (1999) Fabricating the Keynesian Revolution, Studies of the Inter-war Literature on Money, the Cycle and Unemployment, Cambridge: Cambridge University Press.

Frederick Lavington’s theory of markets 221 Lavington, F. (1912) ‘Uncertainty and Its Relation to the Rate of Interest’, Economic Journal, 22: 398–409. —— (1913) ‘The Social Interest in Speculation in the Stock Exchange’, Economic Journal, 23: 36–52. —— (1921) The English Capital Market, London: Methuen, reprinted (1968), New York: Augustus M. Kelley. —— (1922) The Trade Cycle – An Account of the Causes Producing Rhythmical Changes in the Activity of Business, London: P. S. King & Son. —— (1924) ‘Short and Long Rates of Interest’, Economica, 4: 291–303. —— (1925–1926) ‘An Approach to the Theory of Business Risks’, Economic Journal, 35:186–99 and 36:192–203. Marshall, A. (1919) Industry and Trade, London: Macmillan. —— (1920) Principles of Economics, 8th edn, London: Macmillan. —— (1923) Money, Credit and Commerce, London: Macmillan. —— (1992) ‘The Folly of Amateur Speculators Makes the Fortunes of Professionals. The Wiles of Some Professionals’, Marshall Library, University of Cambridge, first published in M. Dardi and M. Gallegati (1992). Marshall, A. and Marshall, M. P. (1881) Economics of Industry, 2nd edn, London: Macmillan. Mill, J. S. (1965a) ‘Paper Currency and Commercial Distress’, in The Collected Works of J. S. Mill, vol. 4, Toronto: University of Toronto Press. —— (1965b) ‘Principles of Political Economy’, in The Collected Works of J. S. Mill, vols 2–3, Toronto: University of Toronto Press. Minsky, H. P. (1986) Stabilizing an Unstable Economy, New Haven: Yale University Press. Mises, L. von (1981) The Theory of Money and Credit, Indianapolis: Liberty Press. Pigou, A. C. (1912) Wealth and Welfare, London: Macmillan. —— (1927) Industrial Fluctuations, London: Macmillan. —— (1932) The Economics of Welfare, 4th edn, London: Macmillan. Schumpeter, J. A. (1954) History of Economic Analysis, London: Allen & Unwin; reprinted, London: Routledge, 1994. Tversky, A. and Kahneman, D. (1982) ‘Availability: A Heuristic for Judging Frequencey and Probability’, in D. Kahneman, P. Slovic and A. Tversky (eds) Judgement Under Uncertainty: Heuristics and Biases, Cambridge, MA: Cambridge University Press. Withers H. (1915) Stocks and Shares, New York: Longmans, Green and Co. Wright H. (1927) ‘Frederic Lavington’, Economic Journal, 37: 503–5.

14 Profit rate, money and economic dynamics in Fanno’s thought Cristina Nardi Spiller and Mario Pomini

A dynamic and expanding economy will need a monetary policy flexible enough to give us a money supply commensurate with our growing productive potentialities. (Hansen 1949: 198)

Introduction Marco Fanno,1 although widely appreciated during his lifetime, subsequently fell into unjustified oblivion, after which his works were finally reappraised, to the extent that they became the subject of specific debate. His life2 spans three significant periods of the twentieth century: the age of Giolitti, Fascism and reconstruction; it is a period in which the theme of corporative economy3 is the subject of heated discussion, in which he sides with those who justify state intervention in economy. He points out the role of abnormal movements of capital,4 which express and add fuel to the crisis in progress; he offers a significant dynamized interpretation of the theorem of comparative costs;5 he analyses the economic development of modern capitalism, defends protectionism for countries undergoing industrialization and public regulation of the capital and employment market. After the Second World War, Fanno reassesses his stance on the action of the State in the economic field, but is not contrary to programming policies. He is in favour of the Vanoni’s Plan,6 as it conforms to the theory of economic development reflected in the connection between saving (voluntary and compulsory) and investment. Fanno reveals himself to be an attentive observer of monetary phenomena. In fact, the theme of money attracts Fanno from the start of his academic career. As early as 1912 he incorporates Wicksell’s theories on the links between prices, discount rate and interest (profit) (Fanno 1912: 186–379) into his theory of economic fluctuations, a theme he later returns to (1956a) when he, like Keynes (1930), investigates the relationship between the cost of investment and the flow of saving. Although Fanno includes money in his explanation of business cycles, his Teoria delle Fluttuazioni Economiche (Fanno 1956a) is an endogenous real model, a combination of cycle and trend.7 In the model, business cycles originate from profit rate changes rather than from the money market: so we see that

Profit, money and economy – Marco Fanno 223 Fanno rejects the monetary approaches of Hawtrey (1919) and von Mises (1928), and only partially endorses Fisher’s vision of cycles and crises, however significant. Fanno remains one of the principal Italian economists of the twentieth century, especially of the inter-war period. In this chapter we examine the importance of the profit rate and interest rate8 with regard to the cyclic trend illustrated by Fanno and to be extended to the dynamics of progressive economies. We then examine Fanno’s notable insights and pioneering approach: despite the fact that the author’s work reflects the institutional and historical background of the time, with its operational and analytical limits, Fanno endeavours to offer an overall view capable of shedding light on the distinctive features and the most significant distortions.

Elements of monetary theory in Fanno’s analysis Rejecting Fisher’s more recognized approach and making a choice which was to have a marked impact on his intellectual thought (Realfonzo 1992), Fanno retrieves Wicksell’s theory that if the rate of interest on bank loans is inferior to the normal rate of interest,9 the volume of credit and the circulating medium tend to expand and prices rise, and vice versa. It follows that ‘firstly if the rate of interest on loans is permanently below the normal rate, the price level will rise indefinitely; secondly the price level can only remain constant if the two rates are equal’ (Fanno 1935a: X, our trans.). As Fanno himself underlines, this approach was far from innovative, having already been discussed by Thornton (1802) and later thoroughly, albeit briefly, by Ricardo (1951). Nevertheless it continued to be attributed to Wicksell ‘partly due to mental inertia, but mainly with good reason; because it was he who, having rediscovered the theory, developed it’(Fanno 1935a: XI, emphasis added) although Fanno made it clear that the process of accumulation could only continue until equilibrium was reached, through adjustments in the quantity of credit (or money) created by the central bank.10 Fanno (1935a) acknowledges the limits of Wicksell’s model, despite its appeal: when the current rate of interest is constantly below the normal rate, a permanently rising price trend is the absurd result: the reaction of prices to the demand for loans influences interest rates, thereby nullifying existing differentials. Furthermore prices might not shift in the face of a temporary or unsubstantial change.11 Here we detect a remarkable similarity with the menu costs approach, in which prices remain constant when modest changes in the level of costs occur. From Wicksell’s analysis an inverse correlation between prices and the discount rate 12 emerges, which contrasts with the theories of Marshall (1961), Fisher (1961 and 1907), and also J. S. Mill (1948) who point to a direct link between price changes and the discount rate.13 Thanks to Fanno’s exposition this contrast appears more apparent than real, since the two approaches refer to different, but not mutually incompatible, cases. Indeed in Wicksell’s analysis the shock originates from the discount rate, so an inverse link between the discount

224 C. Nardi Spiller and M. Pomini rate and prices does indeed exist. In the approaches of Marshall and Fisher14 on the other hand, the shock originates from prices, the result being a direct interrelation between the discount rate and prices. Fanno does not simply justify the two ‘different’ stances; he amalgamates them and explains how they link. In Marshall’s and Fisher’s models, the direct link between prices and the discount rate is justified by the fact that as prices rise they pull up the current rate of interest. The possibility of quoting higher prices favours an increase in entrepreneurs’ profit in monetary terms and leads to an increase in the normal rate of interest. This rise in the normal rate of interest is substantially in line with the increase in prices; due to inertia the current rate of interest generally tends to go up by an inferior amount, and thus remains below the normal rate. Fundamentally, even in the case considered by Marshall and Fisher, Wicksell’s necessary condition is fulfilled since price increases continue once they have started. Thus the parallel movement of the current rate of interest and prices following a shock to one or the other conforms not only to the theory of MARSHALL and FISHER but also to WICKSELL’s theory; the two theories, which refer either to two different cases or to different aspects of the same case, far from conflicting actually coincide perfectly and can thus co-exist side by side. (Fanno 1935a: XIII) On the other hand, ‘in our work [Le banche e il mercato monetario] we have endeavoured to reconcile Wicksell’s theory not just with the Fisher equation but with all the other factors of monetary and credit equilibrium which till that time had been considered separately’ (Fanno 1931: 364, fn. 3). However, Fanno does not offer a systematic view with a plausible link between monetary and financial institutions and the real economy in terms of interest rates, returns on capital and the availability of credit. Nevertheless, to his credit Fanno ventures beyond Fisher’s analysis, clarifying the relationship between prices and interest rates. Fisher simply asserts that all prices implicitly contain an element of interest. Undoubtedly this affects price formation, but interest also influences the general price level, since in view of the alternative uses for goods to satisfy current and future needs, interest rates and the discount rate have an impact on the general price level: the former as an element of profit, the latter as an element of cost of the current consumption of goods with respect to the future consumption. (Vito 1954: 234, our trans.) Fanno (1954) thus illustrates how every price is the outcome of a set of factors, and how the discount rate plays a central role alongside the rate of profit. In Wicksell’s approach credit is used to manipulate the money stock to raise prices and achieve price stability. In fact if appropriate manipulation of the

Profit, money and economy – Marco Fanno 225 money stock enables economic crises to be overcome, price stability ensures that in the upward phase no further crises arise. Despite conceding that discount rate policies might be an effective way of influencing economic trends, Fanno stresses that such policies should be applied in a climate of positive expectations and not in the presence of turbulence or recession. Fanno reassesses the role of credit policies and endorses Keynes’ theory: it is expectations of profit which make the system function, regardless of credit policies. The enlightening example is the ineffective expansionary credit policies adopted in the USA from the autumn of 1931 to 1932: since spending was forced, the crisis was never overcome and no recovery was sparked. A crucial role is therefore played by the profit trend, as Fanno (1935a and 1956a) emphasizes, although, as he warns, prices are in any case subject to cyclical and long-term movements; unlike cyclical movements, long-term movements are slower and more limited.15 In fact price changes are closely linked to cyclical fluctuations in production, which in turn are linked to changes in the rate of profit and are beyond the absolute control of monetary authorities. Achievement of the stabilization of prices would require a rigid discipline centred on the monetary policy for internal and external targets. While such policies may be opportune when prices are rising (Fanno 1935a: X), in a downswing it is the lack of expected returns that dampens the animal spirits and fails to boost the economy, rather than the effects of a prudent monetary policy. On the other hand, price stabilization might be restricted to one economy or interest the whole world. If restricted to one country, while the other states allow prices to fluctuate freely, price stability becomes incompatible with exchange rate stability. If price stability is extended to other countries, it can only be achieved by means of international agreements between central banks.16 This message seems particularly relevant today: the Maastricht Agreement, based on a single currency and low inflation, sanctions the role of a common monetary policy and thus ratifies the end of independent monetary policies. Fanno’s argument, reflecting the majority stance at the time, hinges on the existence of a single bank which acts as a natural outlet for economic development rather than as a vehicle for strong state intervention, so that economic growth is promoted by the stability and practicality of the monetary system as a whole, by strategies which are systematic and central rather than fragmented and disjointed. As we explore Fanno’s thought, a contradiction emerges which – upon closer inspection – is actually quite evident. In their work on the role of speculation, Wicksell, Schumpeter, von Mises and Keynes consider the money stock essentially as a credit instrument and totally independent of its metallic base. This theory was to be undermined by Fanno’s distinction (1992, Ch. I, § I) between genuine bank deposits (the banking system acquires ‘fresh’ metallic currency) and deposit currency (the banking system makes ‘new’ types of money available to its customers).17 If money is strictly a form of credit, the only recognized form of deposit should be the deposit currency. Yet in his essays on monetary issues Fanno dwells on the distinction between the two types of deposit, a rather misleading distinction as Graziani (1992) points out; since Fanno always strives to

226 C. Nardi Spiller and M. Pomini reconcile his theories with reality he cannot disregard the historical and institutional background of his time, with multiple monetary systems (metallic money and money created by banks). This explains the rather subtle distinction. Leaving aside the issue of whether metallic money is the only true form of money, and hence returning to Wicksell’s theory, Fanno describes the circulation of money within an integrated system: firms obtain bank credit which they use to pay wages: thus the banks become creditors vis-à-vis the firms and debtors vis-à-vis the wage-earners. When payments are made, wage-earners place the money in bank deposits, creating money (via the bank deposit multiplier). This money is used to purchase goods and services or securities, and returns to the firms, who can extinguish their debts with the banks. Conversely, if deposit holders leave their excess liquidity in the form of bank deposits, the firms remain debtors to the banks. Fanno uses separate models of money circulation, all of which make explicit reference to the Wicksellian mechanism, ranging from a model with one firm to models with several firms producing different goods (Fanno 1956a: Chs VIII and IX). In describing the process of money circulation, Fanno highlights the specificity of the demand for loans18 and of excess liquidity. As Marget (1966: 407) acknowledges, Fanno (1912) anticipates Keynes in distinguishing between the commercial and financial circulation of money. Fanno goes a step further: his demand for loans bears a striking resemblance to Keynes’s new finance.19 The demand for loans by firms is linked to the duration of money circulation, from the moment when firms use the loan to the moment when wage-earners complete their purchases and exhaust their liquidity (Fanno 1931: 330 and 1956a: 215). The transition from a microeconomic to a macroeconomic viewpoint is fundamental: for firms the process of accumulation and expenditure of income is more important at an aggregate level than the production cycle, which is more important for individual firms. Only in the event of an increase in their liquidity preference would firms be unable to procure liquid funds and once again it is singular that Fanno (1992: Ch. II) observes how in a downswing speculators prefer to hold money: a precursor of the liquidity trap. Contrary to his earlier predictions20 Fanno thus illustrates the limits of the banking system, stemming from a lack of resources which undermines liquidity, rather than from an increase in running costs. He is also aware of the importance of international trade, and recognizes how transfers of currency result in changes in metallic reserves, to which the banks react. Hence discount rate policy plays a crucial role in international monetary equilibrium.

Rate of profit and business confidence Business confidence plays a fundamental role in Fanno’s analysis, given that ‘every time firms expect an increase in profits, an upward phase starts, and it starts as a result of the investments that their expectations tend to foster’ (Fanno 1956a: 251). Changes in the rate of profit are thus a very important element in Fanno’s

Profit, money and economy – Marco Fanno 227 analysis, the link between the theory of the money market and the theory of economic fluctuations.21 Upswings are characterized by an expected and actual rate of profit above the rate of interest (Fanno 1956a: Ch. X), the difference between the two rates being the vital condition for the cycle, as Fanno notes in 1912 and Keynes (1930) later emphasizes authoritatively,22 although in Fanno’s vision the upward phase is limited by the supply of credit,23 provided that the quantity of legal currency remains constant. If the annual percentage fall in the price level is lower than the real rate of profit and producers maintain a nominal profit margin, deflation is not detrimental: its repercussions consist of a gradual redistribution of wealth from creditors to debtors and from variable wage earners to fixed wage earners. If the fall in prices is proportionately higher than the change in the real rate of profit, after a certain time the nominal rate of profit will become negative, with a consequent drop in production. This view excludes any beneficial impact of the real balance effect, and is closer to the mechanism we can verify through the Fisher effect. This analysis based on the profit trend, rather than on other elements of equilibrium, allows us to determine the critical point of deflation.24 Shocks are almost always impossible to predict, making accurate forecasts impossible, and leading to lags and errors in adjusting output which, given the length of production processes,25 distort the business cycle curve. Fanno overlooks the fact that uncertainty does not only affect production processes, but involves the whole output structure in a vertical sense. Although in Fanno’s analysis time lags would accentuate the magnitude of exogenous changes, they nevertheless denote an exceptional conceptual modernity. It would appear reductive to hinge the whole theme of business cycles on the link between the discount rate and the rate of profit. Even when expectations of profit are considered the main lever in the system, the potential difference between the two rates is less important than access to credit, as the availability of loans becomes of the utmost importance,26 while investments are less sensitive to variations in the rate of interest. Undoubtedly in Fanno’s time the role of financial intermediaries is moderate:27 such reliance on bank credit and the discount rate trend is justified since ‘by raising the discount rate the volume of new loans contracts, and the upward phase comes to a halt’ (Fanno 1956a: 335). Regardless of the institutional framework of the economy, firms do not necessarily have to resort to the banking system; if we return to the pecking order of Keynesian new economics with asymmetric information, firms have the option of self-financing, with the advantage that any information dysfunctions are overcome. A further option is to issue bonds, which has its pros and cons. Fanno (1912 and 1931: 364, fn. 3) therefore succeeds in identifying a link between the theory of the discount rate and the quantity theory of money equation,28 but does not arrive at an organic vision of a plausible link between the monetary and financial institutions and the real economy via interest rates, returns on financial activities and the supply of credit.

228

C. Nardi Spiller and M. Pomini

Money and progressive economies After examining the central aspects of Fanno’s thought with regard to monetary subjects, we now deal with the problems connected with the economic cycle and economic growth. Fanno focuses his attention on economic growth after the Second World War in particular, although it was a salient feature of his thought since his early essays on the dynamic analysis of comparative costs. Fanno interprets economic growth not as a mechanical phenomenon, in the same way as changes in national income, but rather as the analysis of long-term trends in capitalist economies, his aim being to arrive at a unitary explanation of business cycles and trends. In keeping with his general approach, and thus with an eye to the workings of real economies rather than to abstract theoretical models, Fanno focuses, as we have seen, on monetary aspects in order to further his understanding of dynamic phenomena, evidence of his Wicksellian influence. After our preliminary examination of the role of money in long-term relationships, we now consider the value, equally significant albeit more traditional, which Fanno attributed to monetary and credit phenomena in economic fluctuations. Fanno emphasizes the concept of a progressive economy,29 in which we can distinguish three growth lines: the potential line, the secular line and finally the effective line. In the tradition of the Classical School, whose authors dedicated great attention to the factors which determine economic progress, Fanno demonstrates how the potential line essentially comes to depend upon three factors: population growth, technical progress and an increase in the propensity to save. This line shows the highest attainable level of growth in the system if all productive capacity is used to the full. The originality of Fanno’s thought is striking, even though the same concept resurfaces in later years, as Fanno himself asserts by drawing parallels with Hicks’ ceiling (1950) and Harrod’s natural rate of growth (1939 and 1948).30 In Fanno’s vision, which seems to endorse Keynes’s theory to the full, the potential line is a limit which the economy tends to approach, a limit which is never reached due to errors of judgement by firms and the institutional friction which has historically been a feature of economic systems. Fanno adds another line below the potential one: the secular line. Once again this concept is not new, indeed it is very similar to Harrod’s guaranteed growth line. At each point on the long-term growth line, the expectations of economic agents are fulfilled and spending on investment is equal to aggregate saving. In fact ‘as such it is none other than the long-term growth line of Keynesian type economies, namely the locus of successive equilibrium positions in an expanding Keynesian system’ (Fanno 1956b: 207). The principal characteristic of the secular line is that it is determined by the same elements as the potential growth line: in geometric terms the two lines (if we imagine two growth paths on a logarithmic scale) have the same gradient and are therefore parallel. In fact if the secular expansion line were steeper, the distance between the two would be reduced and the profit would also drop until the new investments were annulled. If vice versa it were less steep, then the increase

Profit, money and economy – Marco Fanno 229 in profits would lead to a considerable increase in the pace of investments. Also in this case the original distance would be re-established. According to Fanno, the secular line constitutes the economy’s dynamic gravitational centre, the trend around which the effective line must fluctuate (1956b: 438). The effective line is the path actually followed by the economy. The existence of factors boosting economic growth is not in itself sufficient for growth to occur: opportunities to make profit must be fulfilled by the productive activities of firms. The effective line, thanks to the combined effects of the accelerator and the multiplier, fluctuates around the secular line. Considering that, within the conceptual framework based on the potential and secular growth lines, the driving force behind the expansionary process are real factors such as population growth or technical progress, at first sight it would appear that monetary factors have no influence on the long-term trend. However, upon closer examination we see that this impression is misleading: money too has a role to play in long-term economic relationships. Fanno actually considers the issue of the need for money in a progressive economy at the end of the chapter devoted to a detailed account of the theory of the supply of money, once again inspired by the quantity theory of money (1956a: Ch. IX). It is interesting to note that this part was absent in the edition published ten years previously and therefore marks a further step forward in the reflection on the role of money begun by Fanno back in 1912. The starting point is Fisher’s traditional equation expressing the relationship between the volume of trade and the circulation of money i.e. B·k = p·R

(1)

where, using Fanno’s symbols, B represents the stock of money, k is the velocity of circulation, R is national income and p the general price level. Since by definition in progressive economies income varies at a constant rate, Fanno puts (1) directly in dynamic terms by transforming the identity in (1) into logarithms and deriving it with respect to time: B k p R ᎏᎏ + ᎏᎏ = ᎏᎏ + ᎏᎏ B k p R

(2)

On the basis of (2), an exogenous change in income due, for example, to technical progress can be accommodated by the following mechanisms: a change in the monetary base, a change in the velocity of circulation or a change in prices. Fanno is careful to identify two special cases: when the adjustment comes about through a variation in monetary variables or through a change in the price level. In progressive economies equilibrium in identity (2) can be maintained first of all by modifying one of the rates of the variables on the left side, through growth in the supply of money or an increase in the velocity of circulation. Fanno opts for the first mechanism since payment habits can only be partially and very gradually modified.31 The most appropriate instrument is undoubtedly a

230

C. Nardi Spiller and M. Pomini

percentage change in the quantity of the money stock. If the currency is metallic then it is necessary to increase imports of metal; in the case of paper currency, the monetary authorities intervene by issuing new paper money. The most relevant argument which emerges from these initial considerations is a reassertion of the traditional theory. Effectively, ‘if the two increasing ratios are equal and prices remain constant, the supply of money is neutral with respect to the secular expansion of the economies’ (Fanno 1956a: 232). This formulation changes drastically if the dynamic adjustment comes about through a change in prices. If the supply of money increases more than income, Fanno observes that prices tend to rise, with a positive impact on firms’ expectations of profit, leading to an increase in the volume of output. Conversely, negative expectations of profit lead to a drop in output, since high profits boost the rate of production while a fall in profits holds it back. Fanno observes: The high level of profits in the first case tends to accelerate the rhythm of production; the low level of profits in the second case tends to delay it. Therefore in the case of B R k ᎏᎏ ⫻ ᎏᎏ ⫺ ᎏᎏ B R k potential expansion and secular expansion tend to follow each other at a higher rhythm than they would have done with the concurrence of the known production factors only; in the opposite case they tend to follow each other at a lower rate. And in both cases therefore money, instead of remaining neutral, becomes a disturbing factor tending to modify the rhythm of secular expansion. (Fanno 1956a: 234) Far from being neutral, money becomes yet another factor which tends to modify the pace of long-term growth and can permanently depress or increase the growth rate of the economy. It is interesting to note how Fanno assumes that the parameters which determine the velocity of circulation of money are not constant but rather vary in the different phases of the business cycle. We therefore see that even in the case of the quantity theory of money Fanno adopts an eclectic stance, departing from an orthodox vision and making theoretical changes to suit his capitalist approach in terms of an economy in which full employment is never reached owing to misjudgement by firms. In the long term, in Fanno’s experience gained in the aftermath of the Great Depression, variations in the supply of money do not come up against the wall of inflation but rather contribute to the process of economic growth by creating new and unexpected opportunities for profit.

Profit, money and economy – Marco Fanno 231

Money and business cycles Fanno’s analysis of the relevance of monetary variables on business cycles is less innovative, following Wicksell’s vision which is based on the difference between the nominal rate of interest and the natural rate of interest. Fanno’s investigation of monetary phenomena is best expressed in his analysis of the duration of production cycles and the factors which impose effective limits on upswings and downswings (1956a: Ch. X). In our assessment of Fanno’s work we need to distinguish between two planes of analysis. The first is the analytical framework adopted by the author to formally determine fluctuations in economic variables, typical of business cycles. In this sense Fanno’s model is a reformulation of Samuelson (1939) whereby the dynamics of the system are the result of lags in variables. Indeed, ‘An economic system in which some variables depend on the previous value of other variables is destined to oscillate. Therefore the expansion movement, when it starts for reaching the potential secular development line, is transformed into an oscillating movement’ (Fanno 1952b: 556). Considering the structure of the model it is not surprising that the size of the swings depends on the value of the parameters underlying the accelerator and the multiplier. The original contribution is that the cyclical swings originate from a discrepancy between the demand for capital for long-term expansion and that of the previous year. This is what allows Fanno to claim to have identified a general dynamic theory capable of explaining both economic growth and business cycles. Upon this rather mechanistic analytical model Fanno superimposes his economic vision, based on the role played by changes in the distribution of income during the cycle as new opportunities for profit arise, which firms endeavour to exploit by increasing output.32 This vision is quite unlike previous theories, indeed the approaches of Harrod and Hicks are purely mechanical, in the sense that the role of profit in the process of expansion is not expressly taken into account. Profits in fact play a vital role, which is essential if we wish to determine the laws underlying the development of capitalist economies. The expansionary phase starts when there is a significant difference between the potential growth line and the long-term growth line, signalling to entrepreneurs the existence of new opportunities to make profit. Firms expand output capacity to cater for the excess demand for goods and the accelerator coefficient changes. Growing demand is countered by inelastic supply; the resulting price changes generate cyclical profits. The gap between investment and saving widens and real growth exceeds long-term growth. The upswing meets two barriers, one real and the other monetary. The real barrier is full employment: when the economy reaches the full employment ceiling, excess demand dries up, short-term profits are wiped out and investment comes to an end. A second, and in our opinion more significant, barrier exists, which the economy may come up against before full employment is reached, namely the availability of credit. Let’s follow Fanno’s reasoning: the upward phase takes off when profits start to

232 C. Nardi Spiller and M. Pomini rise. New investments are funded by credit, since in the expansionary phase of the cycle savings are not sufficient to satisfy firms’ demand for loans. During the cycle this situation tends to change. Credit cannot expand beyond a certain level without undermining the stability of the banking system; this level is determined by the institutional laws in force in all economies. What is particularly significant is that during the cycle income is redistributed from profit to wages, which tends to reduce the profitability of investment. In fact, late in the upward phase wages, which have been more or less steady for a long time, end up . . . rising. This rise comes, in part at least, at the expense of profits, and transfers part of the exceptional short-term earnings from the economic classes (entrepreneurs) with a high propensity to save to those (wage-earners) who are less able to save. (Fanno 1956a: 255) The end of the upswing is thus already in sight: on the one hand opportunities for making profit are running out while the cost of investment (the discount rate, to use Fanno’s term) is starting to creep up following the contraction in saving and the expansion of credit. When we return to the patently neoclassical condition of equality between the rate of profit and the discount rate, the economy reaches the peak of the expansionary phase and the downswing immediately starts. The decline in income is brought about mechanically by the very same factors that caused the upward phase, although from an economic standpoint it is significant that the ratio between the two rates has been reversed, the discount rate now being higher than the rate of profit. In a downswing the current rate and above all prospective rate of profit falls more, particularly in view of the expected fall in prices. Thus the discount rate remains above the rate of profit, and continues to do so however much output falls. (Fanno 1956a: 267) In Fanno, as we have already seen in Wicksell, the rate of interest cannot for structural motives remain below the rate of profit. The fact that banks need to maintain a certain level of reserves leads to an increase in the rate of interest. This increase also has a qualitative effect, since it is the banks that decide which investments deserve funding. In conclusion, the actual or cyclical dynamics of income are governed, in Fanno’s vision, by changes in the distribution of income, which ultimately derive from price changes. Following the classical approach, Fanno shares the view that it is opportunities to make profit which cause income to fluctuate around its long-term trend. Fanno focuses on the actual behaviour of economic agents, and indeed rejects a traditional view in which economic stagnation is the price to be paid for the optimum allocation of resources. The importance which Fanno attributes to progressive economies bears witness to his ability to interpret the situation of his day, a time of rapid and stable growth following the

Profit, money and economy – Marco Fanno 233 Second World War, when the theoretical interest of macroeconomists was rapidly shifting from business cycles towards growth theories. The cyclical approach returned to the macroeconomic scene in the 1980s with the real business cycle, and with it the idea that variations in income stem from changes in productivity and hence the opportunities for profit that technological change generates continually and in a totally unpredictable way.

Closing remarks Fanno is a ‘man of transition’, in the sense that he feels the need to go beyond the inadequacies he perceives in the neoclassical model, although in many ways his work remains ‘neoclassical’ (Bagiotti 1966: 24). In the spirit of renewal, he rationally and critically supports Wicksells’ theories, although his keen interest in development issues leads him to reject the money-prices approach and focus on the money-accumulation-growth relationship, without however arriving at a new, radical, comprehensive model of monetary theory. In Fanno’s view credit has a fundamental impact on the duration of cycles: it is the expansion of credit, limited by the size and behaviour of the internal banking system, as well as the workings of other related agents, which determines the sequence of negative reactions. Economic shocks originate outside the money market, and the money market adjusts passively except at the peak of the upswing, when it takes on a dominant role. At such a point the supply of credit is at its highest and the discount rate soars: this heralds the start of the downswing, and the money market returns to its traditional role.

Acknowledgements The authors would like to thank Prof. Anna Pellanda and Prof. Otto Steiger for their suggestions and helpful comments and an anonymous reviewer for his remarks.

Notes 1 Marco Fanno was born in Conegliano Veneto (Treviso, Italy) on 8 August 1878. He was appointed to his first academic position at the University of Sassari (Italy) in 1910. He was subsequently appointed to the Italian Universities of Cagliari (1911–1913) Messina (1914–1915) and Parma (1916–1919), always in Italy. Finally he was based in Padua until retirement age. In this last University, he taught Public Finance and Financial Law and Political Economy. Fanno’s academic career was interrupted between 1939 and 1944 because of fascist racial law. His publications are varied and numerous, almost 30 books and more than 60 essays in Italian, German, French and English reviews. He was member of the Accademia dei Lincei, of the Econometric Society and of local Academies in Padua and Venice. He died on 14 January 1965 in Padua. 2 A careful examination of Fanno’s contribution, reflected also in the cultural context of the age, is carried out by Magliulo (1998). 3 For a general interpretative view of corporativism, see, among others, Mancini, Perillo and Zagari (1982).

234 C. Nardi Spiller and M. Pomini 4 Fanno (1935b) explains with great clarity the principal motives leading to flows of capital. Both normal and abnormal flows exist: the former arise from the differences in current net interest rates between countries (i.e. without the effects of risk premiums), whilst the latter have various causes and depend on a number of conditions, the most common being: (a) payment of reparations or extinction foreign debts contracted in times of war; (b) a tax burden greatly in excess of that in other countries; (c) forecasts concerning fears of an increase in the tax burden; (d) political or social motives; (e) lack of confidence in national banks; (f) fears of devaluation or devaluation of the internal currency. Flows of type (a) are generally initiated by State authorities on the basis of detailed programmes; the others – more irregular and unpredictable – are the result of individual behaviour. In this view, the abnormal transfers are the result of exogenous shocks, so ‘We have here the basic outlines of an exogenous business cycle theory’ (Arena 1998: 117). 5 On this subject, see Fanno (1952a) and, for a detailed analysis, Manfredini Gasparetto (1987). 6 The Plan, officially known as Schema di sviluppo, dell’occupazione e del reddito in Italia (Scheme for the Development of Employment and Income in Italy), in the decade 1955–1964, identifies the economic policy lines designed to coordinate public action directly and private action indirectly in order to solve crucial problems, such as the North–South gap, reorganization of distribution of the work force and equalization of the balance of payments. Despite the public obstacles and the lack of embodiment in a law in the formal and substantive sense, the Plan achieved some important successes: increase in income, achievement of full employment and favourable trend of the balance of payments. 7 See Marrama (1974), Magliulo (1990, 1992 and 1998) and Nardi Spiller (1993a, 1993b and 2000). 8 Fanno prefers to use the term discount rate rather than interest rate when he wishes to underline explicitly the rate of interest paid on loans obtained from banks by discounting bills not yet unexpired. 9 At the basis of Wicksell’s analysis, the banks must fix a monetar (nominal) interest rate at a level equal to the natural one. The latter measures the return obtained from the production process when the available savings are invested (see Wicksell 1907: 214 and 216 and 1928: 220). 10 For a critical appraisal of Wicksell’s and Fanno’s contributions, see Morishima (1996). 11 While Wicksell (1907) asserts that prices tend to change as soon as the discount rate moves away from the interest rate, Fanno underlines certain cases in which prices may remain steady in the face of temporary shocks despite differences between the discount rate, the rate of profit and the rate of interest. In an expanding economy, a steady price level means that the discount rate must be below the interest rate. Hence Wicksell’s approach does not apply to an expanding economy. 12 In the context of analysing economic fluctuations, the link between the discount rate, profit and prices allows us to include the theory of the money market in general equilibrium theory, in order to identify possible cyclical distortions. Opinions vary on this issue, considering the conflicting positions of von Mises (1912) and von Hayek (1929). 13 Some interesting distinctions come to light. In fact, ‘Securities yield a profit, which we can call interest; producer goods yield earnings which we can call profit; consumer goods can be enjoyed by the purchaser today compared to goods which will be available for consumption only in the future. To obtain a loan there is a price to pay; this price is the discount rate’ (Vito 1954: 226, our trans.). 14 Nevertheless Fisher (1911) emphasizes time lags concerning the interest rate and prices, which bring about inflation or deflation. In this scenario, expectations play a crucial role.

Profit, money and economy – Marco Fanno 235 15 Long-term movements, according to Fanno (1935a: XVII), depend on differences between changes in the volume of trading, disparities in gold available for monetary purposes, and differences in the factors in the exchange equation. 16 This issue is discussed in Nardi Spiller (1992). 17 Deposit currency is defined by Fanno (1992 [1932–1934]: 8) as the share of total deposits upon which holders can draw cheques, and represents a new form of currency, corresponding to the supply of bank currency, with possible implications for the bank multiplier. In the model, the coefficients are behavioural parameters, hence neither theoretical nor institutional. This is why they may change according to the strategy adopted by the bank as part of its business. 18 It depends on the volume of business, and hence on the level of output and prices. 19 See Keynes (1937). 20 See Fanno (1912). For a discussion of this book by Fanno, see Del Vecchio (1913). 21 Fanno’s link is the same as Schumpeter’s. See Schumpeter (1912 and 1939) and Fanno (1956a). 22 For an analysis of Keynesian thought revised by Fanno see Manfredini Gasparetto (1984: 241). 23 Distancing himself from Wicksell, Fanno (1992: Ch. I) asserts that the expansion of credit is limited by the size currency reserves and the rising cost trend. Furthermore, when considering a system based not only on bank deposits but also on a legal currency, Fanno initially considers the money stock endogenous, as in Wicksell’s model, but subsequently considers it exogenous, along the lines of Fisher. 24 See Fanno (1933) and Fisher (1933). 25 As Fanno (1931) demonstrates, the notion of absolute length of the production cycle used to investigate certain technical peculiarities of the capitalist system is ‘useless when we wish to determine the degree of capital intensity of a productive process’ (Vito 1954: 250, our trans.). 26 As already pointed out by Roosa (1951a and 1951b) and in Commission on Money and Credit (1961). 27 Today, the development of new markets and the proliferation of intermediaries makes it increasingly possible for debtors to obtain finance directly. Banks are bound to become less important as intermediaries for saving. 28 For further analysis see Manfredini Gasparetto (1984: 241). 29 By progressive economy, Fanno means an economy in which output and income tend to grow at a rate which, for ease of analysis, is assumed to be constant. 30 Fanno observes: ‘Our long-term growth curve corresponds in terms of income to Harrod’s natural growth rate and Hick’s ceiling, since all three are full employment curves and therefore all three represent the upper limit of explosive upswings’ (1956c: 214). 31 Hardly an innovative consideration, being part of Fisher’s exchange equation (Fisher 1911) and the Cambridge School approach. 32 Fanno observes A comprehensive theory of economic development and economic fluctuation can be constructed only by abandoning the exclusively mechanistic approach, to take account also of the human factor, which is the true driving force of systems . . . In capitalistic economies, in fact, increase in production takes place mainly due to the initiative of private enterprises, whenever they deem it expedient, i.e. when they forecast high future profits. (1952b: 555)

236 C. Nardi Spiller and M. Pomini

References Arena, R. (1998) ‘Marco Fanno’, in F. Meacci (ed.) Economists of the 20th Century, Cheltenham UK: Edward Elgar. Bagiotti, T. (1966) ‘Marco Fanno: un curricolo neoclassico’, Giornale degli Economisti e Annali di Economia, 25: 24–55. Commission on Money and Credit (1961) Report on Money and Credit, their Influence on Jobs, Prices and Growth, New York: Prentice-Hall and Englewood Cliffs. Del Vecchio, G. (1913) ‘La teoria economica del credito. A proposito del libro del prof. Fanno sul mercato monetario’, Giornale degli Economisti e Rivista di Statistica, 46: 200–13. Fanno, M. (1912) Le banche e il mercato monetario, Rome: Athenaeum. —— (1931) ‘Cicli di produzione, cicli del credito e fluttuazioni industriali’, Giornale degli Economisti e Rivista di Statistica, 71: 329–70. —— (1933) ‘Il punto critico della deflazione’, in AA.VV. Economic Essays in Honour of Gustav Cassel, London: Allen & Unwin; reprinted in M. Fanno (1954).Scritti vari di economia e finanza, Padua: CEDAM. —— (1935a) ‘Introduzione’, in G. U. Papi (ed.) Mercato monetario, vol. VIII, Turin: UTET. —— (1935b) I trasferimenti anormali dei capitali e le crisi, Turin: Giulio Einaudi Editore —— (1952a) La teoria economica della colonizzazione, Turin: Einaudi. —— (1952b) ‘Le teorie delle fluttuazioni economiche’, Giornale degli Economisti e Annali di Economia, 11: 533–70. —— (1954) Scritti vari di economia e finanza, Padua: CEDAM. —— (1956a) La teoria delle fluttuazioni economiche, 2nd edn, Turin: UTET. —— (1956b) ‘Considerazione sullo sviluppo dei sistemi economici’, Giornale degli Economisti e Annali di Economia, 15: 199–217. —— (1956c) ‘Lineamenti di una teoria dell’espansione delle economie progressive’, Economia Internazionale, 9: 212–29, 438–58 and 609–26. —— (1992 [1932–1934]) Teoria del credito e della circolazione, ed. by R. Realfonzo and A. Graziani, Naples: ESI. Fisher, I. (1907) The Rate of Interest, New York: Macmillan. —— (1911) The Purchasing Power of Money, New York: Macmillan. —— (1933) ‘The Debt-Deflation Theory of Great Depression’, Econometrica, I: 337–57. —— (1961) Appreciation and Interest, New York: Augustus M. Kelley. Graziani A. (1992) ‘La “Teoria del credito e della circolazione” ’, in M. Fanno (1992 [1932–1934]). Harrod, R. F. (1939) ‘An Essay in Dynamic Theory’, The Economic Journal, 49: 14–33. —— (1948) Towards a Dynamic Economy, London: Macmillan. Hawtrey, R. G. (1919) Currency and Credit, London: Macmillan. Hayek von, F. A. (1929) Geldtheorie und Konjunturtheorie, Wien: Hölder, Pichler and Tempsky. Hicks, J. A. (1950) Contribution to the Theory of the Trade Cycle, Oxford: Clarendon Press. Keynes, J. M. (1930) A Treatise on Money (2 vols), London: Macmillan. —— (1937) Alternative Theories of the Rate of Interest, The Economic Journal, 47: 241–52. Magliulo, A. (1990) ‘Marco Fanno nel dibattito sul ciclo economico degli anni Trenta’, Quaderni di storia dell’economia politica, 2–3: 131–45. ——(1992) ‘La teoria del ciclo economico e la spiegazione della Grande Crisi. Il contrib-

Profit, money and economy – Marco Fanno 237 uto di Marco Fanno’, in M. L. Manfredini Gasparetto (ed.) Marco Fanno, l’uomo e l’economista, Padua: CEDAM. —— (1998) Marco Fanno e la cultura economica del Novecento, Florence: Edizioni Polistampa. Mancini, O., Perillo, F. and Zagari, E. (eds) (1982) La teoria economica del corporativismo, Naples: ESI. Manfredini Gasparetto, M. L. (1984) ‘Keynes nell’interpretazione di Marco Fanno’, in AA.VV., Keynes in Italia, Milan: Ipsoa. —— (1987) Il commercio internazionale secondo la teoria dinamizzata dei costi comparati, Padua: CEDAM. Marget, A. W. (1966) The Theory of Prices, New York: Augustus M. Kelley. Marrama, V. (1974) Economia politica, vol. II: Statica e dinamica del reddito, Turin: UTET. Marshall, A. (1961) Principles of Economics (2 vols), ed. by C. W. Guillebaud, London: Macmillan Mill, J. S. (1848) Principles of Political Economy, London: G. W. Parker. Mises von, L. (1912) Teorie des Geldes und der Unlaufsmittel, Jena: Gustav Fischer. —— (1928) Geldwertstabilisierung und Konjunkturpolitk, Jena: Gustav Fischer. Morishima, M. (1996), ‘Prefazione. Parte II: Fanno e Wicksell’, in D. Cantarelli (ed.) Il magistero scientifico di Marco Fanno tra passato e futuro, Padua: CEDAM. Nardi Spiller, C. (1992) ‘L’andamento del corso dei cambi e la dinamica inflativa nell’analisi di Marco Fanno’, in M. L. Manfredini Gasparetto (ed.), Marco Fanno, l’uomo e l’economista, Padua: CEDAM. —— (1993a) ‘Une Analyse Interprétative du Modèle Cyclique de Fanno’, Rivista Internazionale di Scienze Economiche e Commerciali, 40: 397–410. —— (1993b) ‘Le fluttuazioni economiche: punti convergenti e divergenti tra l’apporto di Fanno e il contributo di altri studiosi’, Associazione Borsisti ‘Marco Fanno’, Mediocredito Centrale: Rome: 43–54. —— (2000) ‘Affinità e distinguo nell’analisi sulle fluttuazioni cicliche tra Fanno e Hayek’, Nuova Economia e Storia, 6: 73–94. Realfonzo, R. (1992) ‘La teoria monetaria di Fanno nel dibattito del tempo’, in M. Fanno (1992 [1932–1934]). Ricardo, D. (1951) ‘On the Principles of Political Economy and Taxation’, in Works and Correspondence, vol. I, ed. by P. Sraffa with the collaboration of M. H. Dobb, Cambridge: Cambridge University Press. Roosa, R. V. (1951a) ‘The Revival of Monetary Policy’, The Review of Economics and Statistics, 33: 37–55. —— (1951b) ‘Interest Rates and the Central Bank’, in R. V. Roosa (ed.) Money, Trade and Economic Growth: Essays in Honour of John Henry Williams, New York: Macmillan. Samuelson, P. A. (1939) ‘Interaction between the Multiplier Analysis and the Principle of Acceleration’, Review of Economic Statistics, 21: 75–8. Schumpeter, J. A. (1912) Theorie der Wirtschaftsentwicklung, Leipzig: Dunker & Hamblot. —— (1939) Business Cycles, New York: McGraw Hill. Thornton, H. (1802) An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, London: Hatchard. Vito, F. (1954) Le fluttuazioni cicliche, Milan: Vita e Pensiero. Wicksell, K. (1907) ‘Influence of the Rate of Interest on Prices’, The Economic Journal, 17: 213–20. —— (1928) Vorlesungen über Nationalökonomie, vol. II, Jena: Gustav Fischer.

15 Money and usury in the economics of Ezra Pound Meghnad Desai

Ezra Pound whose views on money I shall discuss below died in Venice in 1972. He lived in the San Gregorio area of Venice in his last years, near the end of the Grand Canal. Italy had been his home since 1924 (except for the 13 years from 1945 to 1958 when he was arrested and indicted for treason against the USA and though not convicted was incarcerated in an asylum – St Elizabeth’s in Washington, DC), in Rapallo and then in Venice. He was of course a Fascist and an anti-Semite. Yet Pound’s writings on money offer us insights which stand independently of his Fascism and anti-Semitism. Later I shall put his ideas about money and usury in a broader context of economics and attitudes to usury derived from religion. Pound wrote a lot about money and banking. His diatribes against usury read positively like the warnings of Old Testament Prophets. Indeed he wrote more economics than any other major English language writer with the exception of Bernard Shaw. He met Major Douglas soon after the First World War and was convinced by his theories. He reviewed Douglas’s book on Social Credit when it came out,1 but apart from that he did not immediately write on economics. His economic writings start in the early 1930s and are concerned with seeking a cure for unemployment. In his first and longest piece of writing The ABC of Economics all his ideas come together.2 He starts by saying that money is generalised tokens of gold, leather; paper inscribed with a ‘value’ as of 16 ounces of copper; metal by weight; cheques with fantastic figures; all serve to shift wealth, wheat and beer from one place to another or to move wool cloth from Flanders to Italy. (Pound 1973: 236) But soon he asks, ‘Can we say that perfect money consists in true certificates of goods extant?’ (ibid.). However, there are too many goods and not enough certificates extant to buy all the goods. The key is unemployment, which by 1932 had become the biggest problem. So he comes around to his central idea about money: ‘Counting money as certificates of work done, the simplest means of keeping money distributed (in legal-tender credit-slips) is to keep work distributed’ (Pound 1973: 241).

Money and usury – Ezra Pound 239 So the root cause for the high unemployment was a shortage of money whose supply was monopolized by bankers. [T]he place of control is a dark room back of bank, hung with deep purple curtains So if money is to be released from bankers’ control, the State has to issue lots of it. I take it that in the perfect economic state the cost of money is reduced to almost nothing, to something like the mere cost of postage, and this is the cost borne by the state, i.e. distributed so as to be a burden on no one in particular. (Pound 1973: 237 and 254) Thus Ezra Pound saw money as connected with work performed, but being in short supply if bankers controlled it. Hence the key was to reduce interest rate to zero by issuing lots of currency so as to ensure full employment. Although his position was a maverick one in the 1930s, it anticipates the way in which postwar governments took control over the issue of currency, by nationalizing the Bank of England for instance or making the Federal Reserve subject to a full employment target. But Pound is also to be noticed for having advocated zero interest rates in a way which is different from Keynes’s ‘euthanasia of rentiers’, Pound’s bête noire is not the rentier but the banker. He slid into a paranoia about bankers and in particular about the Bank of England over the next decade and a half after his ABC of Economics. At first he differentiates between banks which are solidly based on land or real production as their assets and other banks. He thought that the Monte dei Paschi was the only sound bank in the world. Indeed, he says, ‘Two kinds of banks have existed: The MONTE DEI PASCHI and the devils. Banks built for beneficence, for reconstruction; banks created to prey on people’ (1973: 270). He goes on to tell how Cosimo de’ Medici ‘guaranteed the capital of the Monte, taking as security the one living property of Siena, and a certain amount of unhandy collateral’(Ibid.). He explains that Cosimo pledged the grazing lands of Sienna as his collateral to underwrite a capital of 200,000 ducats for the Monte. Shareholders were to be paid 5 per cent and borrowers were charged 5
 per cent and all profits were donated to the community. This act of Cosimo is exemplary banking as far as Pound is concerned, ‘And the lesson is the very basis of solid banking. The CREDIT rests in ultimate on the ABUNDANCE OF NATURE, on the growing grass that can nourish the living sheep’ (ibid.). The basis of good credit then is that it is rooted in the productivity of nature, the growth of grass and of sheep. The interest charged is then paid out of biological growth which yields a surplus. Pound contrasts this sort of banking with the traditional sort: ‘The hell banks have, from as far as the record takes us, started as gangs of creditors, associated to strangle the last ounce of profit out of their debtors’ (ibid.).3

240

M. Desai

One example of this is the Genoese Banca San Gregorio, which had its asset base on the monopoly of import tax collection. Much more of Pound’s anger was focused on the Bank of England, which he thought was a pure bankers’ racket for making a large return from the monopoly of note issue. Pound repeatedly cited a sentence from the Prospectus for the Bank written by William Paterson: ‘FIRST, Paterson, the founder of the Bank of England, told his shareholders that they would profit because “the bank hath profit on the interest of all the moneys which it creates out of nothing” ’ (1973: 290).4 This then is the other story in contrast to the Monte dei Paschi. One bases its credit on nature and its products while the speculator-banker creates money and credit out of nothing. This for Pound is anathema. It is in this essay written in 1939 that he ventures into a denunciation of bankers as usurers. The perspective of the damned nineteenth century shows little else than the violation of these principles [principles of property ownership which respect the rights of all property owners: MD] by demoliberal usurocracy. The doctrine of Capital, in short, has shown itself as little else than the idea that unprincipled thieves and anti-social groups should be allowed to gnaw into the rights of ownership. This tendency ‘to gnaw into’ has been recognised and stigmatised from the time of the laws of Moses and he called it neschek. And nothing differs more from this gnawing or corrosive than the rights to share out the fruits of a common co-operative labour. (Pound 1973: 298) Pound then goes on to quote Lenin’s pamphlet on Imperialism which quotes Hobson denouncing rentiers. He follows this up by quoting Hitler on ‘the struggle against international finance and loan capital’ (1973: 299) By 1939 when he wrote the essay from which I cite this passage, Pound’s vision had become much darker. He ends the essay as follows: ‘USURY is the cancer of the world, which only the surgeon’s knife of Fascism can cut out of the life of nations’(1973: 300). But later as war approached, his general position against usury and bankers took him into anti-Semitism and from there into antiAmerican propaganda in the form of pamphlets and radio talks during the Second World War. The pamphlets were written in Italian rather than English since Pound saw Italian Fascism as the wave of the future. The talks were a mixture of economic homilies about money and usury, diatribes against bankers and Jews and then against Roosevelt and his betrayal of the American Constitution. One particular example of his wartime economic writing may be cited here. A Visiting Card was written in Italian in 1942 and issued after the war as a pamphlet in English.5 This is a long (30 pages) essay, meandering over historical episodes, citing often obscure authors and telling of past events from a perspective of a man who thinks money is the key to all troubles. But the themes of money and credit now take on a dark colouring with Pound seeing conspiracy

Money and usury – Ezra Pound 241 everywhere. His previous dislike of the Bank of England now takes on sinister proportions. Thus he says: The war in which brave men are being killed and wounded our own war here and now, began – or rather the phase we are now fighting began – in 1694, with the foundation of the Bank of England. (Pound 1973: 308) Said Paterson in his manifesto addressed to prospective shareholders, ‘the bank hath benefit of the interest on all moneys which it creates out of nothing’(quoted in Pound 1973: 290). This swindle, calculated to yield interest at the usurious rate of 60 per cent, was impartial. It hit friends and enemies alike. In the past, the quantity of money in circulation was regulated, as Lord Overstone (Samuel Loyd) has said ‘to meet the real wants of commerce, and to discount commercial bills arising out of legitimate transactions’(quoted in Adams 1943: 309). But after Waterloo, Brooks Adams saw that ‘nature herself was favouring the usurers’ (ibid.). For more than a century after Waterloo, no force stood up to the ‘monopoly of money’ (ibid.). Brooks Adams, a descendant of the second American President John Adams and his son, who also became President, John Quincy Adams, wrote the book The Law of Civilisation and Decay which Pound cites here. It is a favourite of the money cranks since it views human history as a battle against usury.6 Pound’s pamphlet covers a wide range of topics and authors. Pound was influenced by Major Douglas and he says of Douglas’s theory of Social Credit in the pamphlet that it ‘was the doorway through which I came to economic curiosity’. But Pound goes beyond Douglas’s theory. Social Credit for him is the power to issue currency, i.e. interest-free debt, which has to be the prerogative of the State since money is certificates for work. The State generates employment by issuing enough certificates so that everyone who wants to work can be employed. In producing these metallic discs, or pieces of paper, which serve as a means and a measure of exchange, the state is doing work; and it would be perfectly just that employees and officials of the state were remunerated for doing work rather than that the state should collect taxes on the products of other people’s work. (Adams 1943: 329) Though Pound did not pursue this idea much more, it is quite a radical one in which the state does not tax its citizens but finances all its expenditure by printing money! He did however approve of Silvio Gesell’s idea of stamp money. Thus, he frequently cites the experiment in Worgl in the Tyrol, where a Gesell scheme was adopted. As Pound describes this short-lived experiment All went well until an ill-starred Worgl note was presented at the counter of an Innsbruck bank. It was noticed, all right – no doubt about that! The

242

M. Desai Judaic-plutocratic monopoly had been infringed. Threats, fulminations, anathema! The burgomaster was deprived of his office, but the ideological war had been won. (Pound 1973: 314)

Pound continued in this dark vein right up to the end of the War. In 1944, he defected to Mussolini’s Republic of Salò in Northern Italy and to the end went on writing about the evils of usury. Thus in Gold and Work written in Italian again in 1944, he returns to his theme.7 He rewrites much of American history as a struggle between finance and politics. Thus, The struggle between the financial interests and the people was continued in the battle between Jefferson and Hamilton, and still more openly when the people were led by Jackson and Van Buren. The decade between 1830 and 1840 has practically disappeared from the school-books. The economic facts behind the American Civil War are extremely interesting. After the Napoleonic wars, after the ‘Civil’ one, after Versailles, the same phenomena may be observed. Usurocracy makes wars in succession. It makes them according to a preestablished plan for the purpose of creating debts. For every debt incurred when a bushel of grain is worth a certain sum of money, repayment is demanded when it requires five bushels or more to raise the same sum. This is accompanied by much talk of devaluation, inflation, revaluation, deflation and a return to gold. By returning to gold, Mr. Churchill forced the Indian peasant to pay two bushels of grain in taxes and interest which a short time before he had been able to pay with one only. (Pound 1973: 338) What we have here is acute paranoia and a lack of coherence in one who was one of the finest writers of the twentieth century. But starting with a perfectly simple though radical position that enough money should be printed until full employment is guaranteed, Pound wanders off into the wilder shores of antiusury paranoia. In 1932 and his ABC of Economics, he treats money as a token and analyses the problem of work creation. The monopoly over money creation then exercised by banks irritates him and he recommends interest-free debt creation by the State. As such, this should not involve him with the debate on usury at all. But as the war approaches and his writing is ignored in America as elsewhere, he gets into the downward spiral of blaming usurocracy for everything. His descent into this spiral drove him to speak on radio against the American war effort. He ended up after the war being indicted for treason and only his evident lack of sanity saved him from being hanged.8 But the real significance of Pound’s writings on money is that it echoes with a lot of writing since time immemorial about the nature of money in social relations. There is a perennial hostility about money in the social imagination. At best money – filthy lucre – is thought of as a necessary evil. If only society

Money and usury – Ezra Pound 243 could do without the distorting effect of money on social relations, we often hear, the world would be better. Socialists would abolish money in their utopia. The three Abrahamic religions – Judaism, Christianity and Islam – have injunctions against usury. Aristotle also could not see why money should bear fruit in the form of interest since it was barren. Money, Aristotle thought, should facilitate exchange and help trade but not become an object by itself for making more money, i.e. amass wealth. Wealth came from nature, from natural growth. Money not being part of nature was incapable of growth and hence should not bear interest. The whole idea of evaluating things, and even worse, relations in monetary terms is anathema. The Global Justice Movement is the vanguard of antiglobalization protests about the dominance of banks and the burden of debt (Desai and Said 2001). Many believe that once upon a time money did not exist and the world was based on barter, that there were direct unmediated exchange relations in primitive societies, that the entry of money rather like the Biblical serpent poisoned relations for ever. Most of these beliefs are historically false, but that is another matter (Parry and Bloch 1989). Yet through history, there has also been a strong antipathy for too little money as for too much money. Of course there has always been a division of classes and groups as to who is on what side. Thus producers – farmers, industrialists, merchants – who are most likely to be borrowers complain about lack of ready money. This in turn has been reflected in political rhetoric at times of severe deflation. Hence William Jennings Bryan and the Cross of Gold, hence Churchill’s statement ‘I would rather see Finance less proud and Industry more content’ (Skidelsky 1992: 198), hence Jefferson against Hamilton, hence Cobbett on Old Corruption and so on. The bankers and lenders prefer sound money and prudent banking. Farmers and industrialists like loose money and plenty of credit at low rates of interest. In the west and south west of the USA you even today encounter people who think banking is a species of fraud. This dislike of bankers chimes well with the old doctrine of usury as a moral sin. It is this link to bankers which we shall revisit when we come to Pound. But the old attitude against interest rates persists in some odd places. Take, for example, Samuelson’s classic article on overlapping generations, which purports to provide a theory of the interest rate.9 Here we have a world without ‘the social contrivance of money’ (1958: 467) and bankers, but with interest rates. The real significance of Samuelson’s theory for our purpose is that in his example it is not necessary to impose or actually collect any interest rate. This is because as long as each generation fulfils its intergenerational obligation, there is no need for the older generation actually to save and collect interest rates. This is because in Samuelson’s world we have the analogue of the world of the Old Testament in which one should not impose usury on one’s brother. In the Samuelson intergenerational model, one does not charge usury to one’s son. This is a generic result. In closely knit communities, one can abide by the Biblical injunction. If there is trust, we do not need money or even monetary relations. In Samuelson’s world of overlapping generations, interest need not be

244

M. Desai

paid because of the strength of the intergenerational Social Contract. Yet interest rate is not zero. There are other examples in economic theory which justify a zero interest rate. Thus, Schumpeter in his Theory of Economic Development describes a stationary state in which the circular flow of income is endlessly repeated and in analogy with Marx’s Scheme of Simple Reproduction, there is zero surplus and hence zero rate of interest.10 A zero interest rate is thus optimal for a stagnant society with zero surplus. Therefore, it may be that the underlying economic rationale for the ban on usury in Abrahamic religions was the lack of any surplus-generating activity in the arid region where these religions first arose. This is speculation of course, not a detailed historical argument. But for societies which have a surplus-generating capacity and are indeed capitalist, a zero interest rate is difficult to sustain. As the Scholastics found out by painstaking practice, rationales can be found for charging interest rates if the money is engaged in surplus-creating activities, i.e. if the world is a M-C-M’ world rather than a C-M-C’ world.11 Thus the rate of surplus or more concretely the rate of profit will determine the rate of interest in equilibrium or in normal times. But in the short run or out of equilibrium, interest rate can exceed the rate of profit (Wicksell’s natural rate). The Great Depression was the last cataclysmic crisis of capitalism and it was initiated by a failure of large banks in Europe, which in its turn caused failure of banks in America and general shortage of money with consequent bankruptcy of farmers and businesses. Social imagination therefore saw money as pivotal to the economy and its lack at that juncture created the biggest challenges to liberal capitalism and the rise of anti-market ideologies such as Fascism. It is at this juncture of the deep crisis of capitalism that Ezra Pound begins his engagement with economics. He had come across Douglas’s views at a previous critical period in the history of capitalism. The First World War ended the nineteenth-century phase of globalization with its Gold Standard, free movement of labour and capital, and a relatively passport-free travel across the North Atlantic countries. Douglas had posed the question in the immediate period as to how money could be found during the War to provide more than full employment, but not when Peace was restored. He had located the answer in a shortage of credit caused by the bankers’ monopoly over credit supply. Thus he advocated social control over credit rather than private-bankers’ control.12 What was happening was that indeed the rate of profitability had collapsed in the inter-war years and the world could not get back to the old Gold Standard days, however much the bankers wished. But they kept interest rates artificially high and, as profitability had not recovered, there was Depression. This meant that the optimal height of the rate of interest rate was determined not by saving propensities and such like but by the rate of profit. Keynes provided simultaneously an answer for raising the rate of profits and for undermining the grasp of the bankers over the rate of interest. Neither Douglas nor Ezra Pound could see this. But they had the right instinct in blaming the shortage of credit as the cause of the Depression.

Money and usury – Ezra Pound 245

Conclusion Ezra Pound’s economic writing is prolix and uneven. It is repetitive and in later years turns somewhat paranoid. But he grasps some basic truths. His theory of money chimes with Aristotle’s views though he does not explicitly say so. He believes in Nature as the source of growth and hence interest rate as justified only if it encourages natural growth. This is why he approves of Cosimo de’ Medici and his role in the creation of Monte dei Paschi. It is in his views on credit that Pound is more innovative. His idea that the State should issue as much currency as is required to provide full employment has Keynesian undertones though Pound loathed Keynes. It is also in his fulminations about bankers and debts which are crippling that he may yet inspire some modern debates about debt forgiveness for the poor countries.

Notes 1 See Pound (1920). 2 ABC of Economics is reprinted in Pound (1973). In what follows, I quote from this essay but put a more logical structure on Pound’s thoughts than would be found there at first sight. 3 All these quotations are from Social Credit: an impact which Pound wrote in 1935 but was not widely available until 1951. This excerpt is taken from an extract entitled Banks, published in Pound (1973: 270–1). 4 What is Money For?, in Pound (1973: 290–302). I should add that I have been unable to trace this quotation in any of the sources cited by Pound. 5 See Pound (1973: 306–35). 6 See Adams (1943). 7 See Pound (1973: 336–51). 8 I discuss this in some detail in Desai (2006). 9 Samuelson says early in his article ‘Now I should like to give a complete general equilibrium solution to the determination of the time shape of interest rates’ (1958: 467). 10 See Schumpeter (1934). 11 See Noonan (1957). 12 What is most remembered about Douglas is his fallacious A + B theorem which is a misunderstanding of gross value and value added. But there was a lot more to him than that.

References Adams, B. (1943) The Laws of Civilization and Decay, New York: Alfred Knopf. Desai, M. (2006) The Route to All Evil: The Political Economy of Ezra Pound, London: Faber & Faber. Desai, M. and Said, Yahya (2001) ‘The New Anti-Capitalist Movement: Money and Global Civil Society’, in H. Anheier, G. Marlies and M. Kaldor (eds) Global civil society, Oxford: Oxford University Press. Noonan, J.T., Jr. (1957) The Scholastic Analysis of Usury, Cambridge, MA: Harvard University Press Parry, J. and Bloch, M. (1989) Money and the Morality of Exchange, Cambridge: Cambridge University Press.

246 M. Desai Pound, E. (1920) ‘Probari Ratio’, The Athaneum, 2 April. Pound, E. (1973) Selected Prose 1909 –1965, New York: New Directions. Samuelson, P. A. (1958) ‘An Exact Consumption-Loans Model of Interest with or without the Social Contrivance of Money’, Journal of Political Economy, 66: 467–82. Schumpeter, J. A. (1934) The Theory of Economic Development, Cambridge, MA: Harvard University Press. Skidelsky, R. (1992) John Maynard Keynes. II. The Economist as Saviour, London: Macmillan.

Index

accountability 23–4 accounting: economy 156; in low-trust societies 156–9 Adams, B.: The Law of Civilisation and Decay 241 adaptive expectations 17–18 agent: as a term 34–5 agent-based computational economics (ACE) 34–5 agent-based modeling approach: and Sonnenschein–Mantel–Debreu (SMD) theory 31–3; source 30 Akerlof, G. A. 17 Alchian, A. A. 71 ancien régime: economy of 10–11 Andrewes, A. 74n3 Arestis, P. 135, 138, 147n2 Aristotle 243; Nicomachean Ethics 1; Politics 1 Arrow, K. 32 Arrow–Debreu equilibrium 52, 54, 82, 89, 156 art collection: of John Law 171–4, 179–80 Ayr bank 197n27 Bagehot, W. 68, 69 bancor 98, 100, 101–2, 104, 111–12 bank credit 190–2, 212–13 bank deposits: and deposit currency 225–6 bankers 158, 243 banking systems 211–13 banknotes 66, 67, 69 Bank of England 177, 239, 240, 241 banks: Hume on 183–4; liquidity risk 189; role of 190–2; Smith on 186, 187 barter exchange 60, 155 Baschet, A. 172 Bendixen, F. 154–5 Bethell, T. 74n4 Binmore, K. 53

Black Monday and Tuesday (October 1987) 177 Bloch, M. 74n3 Bodin, J. 3, 135–47; Discours 135, 137, 145; Les six livres de la République 135, 137, 145; Methodus 135; Response to the Paradoxes of Malestroit 135, 145 Bodin–Malestroit controversy 135 bookkeeping approach 150–63, 184–6 Borel, E. 48 Bouterouë, C. 147n11 Bretton Woods conference 96 Bridel, P. 203 Brouwer’s fixed point theorem 52 Bubble Act 178 ‘bubble companies’ 178 Burges, E. 171 business confidence 226–7 business cycles 227, 231–3 business risk: and uncertainty-bearing 206–9 Byron, Lord 170 Calvo pricing mechanisms 17 Cantillon, R. 10–11; Essai sur la nature du commerce en général 90 Cantillon–Smith market price theory 80–1, 90, 91–2 capital: demand for 124; flows 222; formation 190 capitalism 59, 192 cash-in-advance constraint 89, 91 Central Bank 16 central banking 67–8 C-form theory 24 Chicago school of urban sociology 39 circulation: of money 226 classical economists 2, 60, 66; maximization 51 Clower, R. 17, 89

248 Index Coase, R. H. 70 coined money 62, 140–7, 186–7; see also metallic money collateral 64, 68, 69–70, 72, 73 collective intentionality theory 44 commodity: as a term 66 commodity market 72 common property 66; rights 71 communism: collapse of 25 Company of the West 176–8 competitive equilibrium theory 50–1, 80, 83 complete financial markets: assumption of 18–20 complexity theory network approach: network models 36–8; and SMD theory 31–3; social ties analysis 38–40; source 30; and the Walrasian auctioneer 34–5 Continuous Linked Settlement (CLS) 110–11 contract theory 72 convertible paper money system 186–92 cooperative approach 52–3; vision 84–6 ‘cooperative economy’ 10 corporate finance 175–9 counterfeiting 141–2 credit 205, 227, 231–2; contracts 64–5; market 72–3; problem, ICB (International Clearing Bank) 100–3; rationing school 72–3 cry-ups 136, 137, 139, 141 currency/country link 22 Dalton, G. 61 Dardi, M 218 Davidson, P. 112n4 Davies, G. 5 debasement 139, 140, 141–3 debasement-proof monetary system 144–6 Debreu, G. 52, 66, 83; Theory of Value 52 Defalvard, H. 52 deflation 9, 115, 116–18, 121, 125 degredations 141–2 delivery-versus-payment mechanism 105–6, 110–12 Demsetz, H. 59, 70, 71 deposit currency: and bank deposits 225–6 discount rate 234n8; policies 225 Douglas, C. H. 238, 241, 244 Dubey, P. 21 dynamic theories 126 economic anthropologists 59, 60 economic anthropology 73n1

economic growth: Fanno 228–30 ‘The Economics of Community Public Finance, Reports and Studies’ 23 Edgeworth–Uzawa process 84, 85, 86 elasticity of expectation 123 endogenous-money perspective 96, 162 English colonies: in North America 181, 187, 192–4 Engster, D. 135 ‘entrepreneur economy’ 10 entrepreneurs 208–10 equilibrium existence theorem 52 euro-system 22–4 excess issue: of bills 187–90 exchange rates 111–12 expansionary credit policies: USA 225 false money 136, 140–1, 142 Fanno, M.: business confidence 226–7; business cycles 231–3; capital flows 222; career 233n1; deposit currency 225–6; economic growth 228–30; interest rate 223–5; money circulation 226; overview 222–3; price stability 224–5; progressive economy 228–30; rate of profit 226–7; Teoria delle Fluttuazioni Economiche 222 Fascism 240, 244 feudal seigniories 63 financial risk 21–2 Fisher, F. 85 Fisher, I. 66, 115, 116–18, 223, 224; DebtDeflation Theory of the Great Depressions 116 foreign exchange markets 96–7 Franklin, J. H. 135 Frazer, J. G.: The Golden Bough 74n2 frequentist approach 49 Furubotn, E. G. 72 Galiani, F. 151–3; Della Moneta 151 Gallegati, M. 218 game theory 9, 32, 48–55, 90 Garegnani, P. 124 Garrault, F. 146 Geanakoplos, J. D. 21 general equilibrium theory 30, 31–3, 48, 50 Genoese Banca San Gregorio 240 Gesell, S. 241 ‘global interaction’ models 33 Global Justice Movement 243 global stability: of market processes 81–2, 84, 87, 88

Index 249 gold 1–2, 6, 69, 97, 98, 136, 137, 138–46, 182, 188–9; standard system 98 Goodfellow, D. M. 61 Gould, C. 174 government: interventionist policies 2; role of 22–6 Granovetter, M. 31, 38–40 gravitation 81 Graziani A. 225 Great Depression 244 Greenspan, A. 177 Grierson, P. 4 Haberler, G. von 125, 126 Hahn, F. 82, 87–8 Hahn–Negishi market process 87–8 Harrod’s natural rate of growth 228 Hart, O. 75n12 Harvard Business School 123 Hassett, K. A. 128n13 Hawtrey, R. 68, 69, 74n7 Heinsohn, G. 62, 74n9 heterogeneous agents 209–11 Hicks, J. 75n13, 122, 123 Hicks’ ceiling 228 Howells, P. 135, 138, 147n2 Hubbard, R. G. 128n13 Hume, D. 184, 187, 188 Humphreys, S. 62 ‘hydraulic’ economies 7 impossibility theorem 32 income distribution 153 inflation 189; targetry 17 information flows 39–40 Innes, A. M. 5 interest 64, 68; costs 163; elasticity of investment 124, 125; rate 117–19, 223–5, 239, 243; rate setting 16–17; real rate of 163n1 International Bank for Reconstruction and Development 96 International Clearing Bank (ICB) 100–10 International Clearing Union (ICU) 97–100 International Monetary Fund (IMF) 96 international monetary system 7 International Money Clearing Unit (IMCU) 112n4 investment function 123–4 Jevons, W. S. 217 Kakutani, S. 52

Kalecki, M. 10, 111, 129n15, 129n19 Keynes, J. M.: deflation 115, 116–18, 121; General Theory 115, 117, 118, 120; ICU (International Clearing Union) 97–103; and Lavington 218; macroeconomic use of money 154; monetary theory of production 155; money as a link 159; money of account 74n9; money–wage flexibility 118–21; rate of interest 244; theory of effective demand 10; Tract on Monetary Reform 116, 117; A Treatise on Money 74n9, 82; upswings 227 Keynes effect 116, 118, 125, 127n2 King, M. 17 Kirman, A. 30–1, 31–3, 36–7, 40–1 Kiyotaki, N. 24 Knapp, G. F. 154 Knight, F. 218 Knowles, K. 172 Krugman, P. R. 127n1 labour-certificating currency 152–3 labour value theory 79 Laidler D. 203 Lange, O. 128n10 La Porta et al 25 Lavington, F.: banking systems 211–13; credit 205; The English Capital Market 203, 204; general 203–4; heterogeneous agents 209–11; money market 204–5; risk and uncertainty 205–9; stock market 213–14; trade cycle 214–18; The Trade Cycle 214–18 Law, J.: art collection 171–4, 179–80; corporate finance 175–9; Essay on a Land Bank 167, 178; financial system 169, 175–6, 178; gambling 170–1; monetary theories 166–9; Money and Trade 167, 178; Smith on 191; system of 169, 175-6, 178; in Venice 169–71 law of reflux 189 Lectures on Jurisprudence 188 Leonard, R. J. 50, 53 liquidity 91, 120–2, 177; premium 64; risk 189; trap 122 LM curve 16 ‘local interaction’ models 33 Locke, J. 151, 196n9 low-trust societies 156–9 Lucas, R. 33; revolution 15–16, 20, 21, 26; theoreticians 18 Lucretius 62 Luhmann, N. 161

250 Index Lutz, F. A. 101 Lyapunov function 84 Madden, P. 85 Malestroit, J. Ch. de 135, 136–7, 139; Paradoxes 135, 136 Malinowski, B. 61 Marget, A. W. 226 market: alternate views of 7, 11–12 market economies: features of 7–8 market equilibrium: and money 3–4 market mechanism: as a synthesis 88–93 market prices 80–1, 90 market process: models 81–2, 83–7; theory 79 market society 63 Marseille fish market: 36–7 Marshall, A. 69, 154, 203, 223, 224 Marx, K. 66, 80, 153–4, 244 Medici, C. de’ 239 medium of exchange 152–3, 155 Melon, J. F.: Essai politique sur le commerce 169 Meltzer, A.: A History of the Federal Reserve 26 Menger, C. 24, 89, 155 mercantilism 1, 79, 182–3 metallic money 6, 168–9, 181, 186–7, 188–9, 225–6; see also coined money metallism 136, 139, 145–6, 151, 154 methodological individualism 50, 51, 52, 53 M-form theory 24 micro-foundations 15 Mill, J. S. 129n20, 218, 223 Mises, L. von 219n9 Mississippi System 169, 176–8 Modigliani, F. 122, 123, 124, 126 monetary approach 89–93, 197n2 monetary policies: and accountability 23–4; and Fanno 225; and fiscal policies 22–3; theory and reality 16–18 monetary sovereignty 136 monetary systems: convertible paper 186–92; debasement proof 144–6; eurosystem 22–4; gold standard 98; Law’s 169, 175–6; pure fiat 192–5 money: of account 65, 152; alternative conceptions 1–4, 150; as capital 183–4; Ezra Pound on 238–9; fiat system of 192–5; in history 4–7; international 96; origins 24; and property 62; and social relations 242–5; stamp 241–2; state money 192–3; transfer theory of 154–5, 163n2

money circulation 226 money-in-advance argument 168 money market 204–5, 211–14 money–wage flexibility 118–27 Montchrétien, A. de. 147 Monte dei Paschi bank 239 Morgenstern, O. 48, 49–54 multilateral clearing 103–4 Mussa, M. 22 Nash equilibrium 33, 51, 54 national currency 96, 98–9, 160–1 natural prices 80 Negishi process 86–7, 87–8 neoclassical theory 9, 60, 66, 79, 124, 155 neo-Walrasian theory of market 83–7 netting systems 101–2, 112n7 network models 40–1 Neumann, J. von 48, 49–55; Theory of Games and Economic Behaviour 49, 51 new classical macroeconomics 175 new institutional economics 70–2 New Keynesianism 72–3 non-tâtonnement model 79, 80, 81, 83 North, D. C. 70, 71 O’Brien, D. P. 135, 138–9, 144 optimal currency area theory (OCA) 22 Osborne, M. J. 50–1 Ostroy, J. M. 83, 157 Ostroy and Starr’s rule 83–4, 88 overdraft principle 103 Oxford Economists’ Research Group 123 Palazzo Mocenigo 170 paper currency 7, 69, 181, 182–3; convertible system 186–92; inconvertible system 192–4 Paterson, W. 240, 241 Patinkin, D. 125, 126, 128n8 payment: notion of 158 payment society 159 Pennsylvania 192–4 Pigou, A. C. 203, 206, 215 ‘Pigou effect’ 125–6, 126 Pipes, R. 74n4 Polanyi, K. 60, 61–2 Polemarchakis, H. M. 21 possessors: possession rights 66, 71; possessory rule 63 Pound, E. 238–45; The ABC of Economics 238–9 power: exercise of 8; structure of the economy 10–12

Index 251 precious metals 1–2, 6, 69, 97, 138–46, 182, 188–9 pre-classical economic theory 66 prices: determination 88–9; and discount rate 223–5; flexibility 128n11; levels 227; parametric 80, 83; rises 136–7; stability 9, 17, 225 price theory 79–80, 82 price/wage stickiness 17 the ‘Prince’ 3, 136, 140, 141, 144–6 private property 3, 60, 62, 66; rights 71 promissory notes 158 property: economics 59–60, 62–5; premium 63–4; rights 63, 66, 70–2; rights system 59; title collateral 62 psychologistic approach 49 quantity theory of money 136, 138, 139, 230 rate of interest 16–17, 117–19, 122, 223–5, 239, 243; real 163n1 rate of profit 226–7 rational expectations assumptions 19–20 rationalist approach 49–50 real-bills doctrine 189 realisation: of transactions 83, 88–9, 91 rationality: individual 50 representative consumers 20, 32 ‘reverse Pigou effect’ 125–6 Ricardo, D. 68, 69 Richter, R. 72 Ridotto 170 risk 73, 205–9; assessment 20 Robertson, D. 128n9 Roncaglia, A. 195n2 Royal Bank (France) 177, 178 Rubinstein, A 50–1 Rueff, J. 96 Saari, D. 81 Sahlins, M. 73n1 Samuelson, P. A. 50, 124, 231, 243 Sargent, T. J. 147n9, 195 Say, J.-B. 68, 69 Scheme of Simple Reproduction 244 Schumacher, E. F. 101, 102, 103, 111, 112n6 Schumpeter, J. 69, 70, 139, 155–6, 162, 163n5; Theory of Economic Development 244 Scottish banking 181, 182, 189–90 Sen, A. 44 sequential trading: model of 156–7

Shapley–Shubik’s rule 90 Shleifer, A. 25 shubati tablets 5–6 Shubik, M. 20, 21, 27, 49 silver 1–2, 6, 69, 136, 137, 138–46, 182, 188–9 Simmel, G. 158, 163n4 Simon, C. 81 slavery 74n6 Smith, A.: barter exchange 60; mercantilist bias 182–3; money as capital 183–4; paper money system 186–92; price theory 80, 90; property 66; social bookkeeping 184–6; The Wealth of Nations 90, 182, 183, 184, 188, 189, 192–4 social accounting 3 social atomism 50 social bookkeeping approach 150–63, 184–6 social credit 241 social embeddedness 41–5 social relations: and money 242–5 social ties analysis 38–41 Sonnenschein–Mantel–Debreu (SMD) theory 30, 31–3 Soto, H. de 74n4 South Sea Bubble 178 sovereignty 3, 136, 140, 142, 146 speculators 210–11 Sraffa, P. 124 Stability and Growth pact 23 Stamp, M. 108–9 standards of value 4–5 Starr, C. G. 62, 157 Starr, R. M. 83 Steiger, O. 74n9 Steuart, J. 66–8 Stigler, G. J. 19 Stiglitz, J. 72, 73 stock market 213–14 Streissler, E. 24 strength of weak ties (SWT) hypothesis 31, 38–41 structural basis: macro-models 16–22 substantivist–formalist exchanges 61 Sunirand, T. 21 tallies 4, 5 tâtonnement model 79, 80, 81, 84 Taylor rule 162 Tesfatsion, L. 30–1, 34–5, 37–8, 40–1 Thayer, T. 197n31 Thornton, H. 21, 68, 69

252 Index Tobin, J. 124, 125–6 trade cycle 214–18 transactions: behaviour 82; demand 185–6; realisation 83, 88–9, 90, 91 Tsomocos, D. 21 Turquam, T. 146 uncertainty 205–9, 227 unemployment 238–9 usurocracy 242 usury 6, 238, 240–1, 242

Walras, L. 80, 89; agent 51; auctioneer 30, 34–5, 43, 81, 154, 156, 159; theory 52 Weiss, A. 72 wergeld 4 Wicksell, K. 69, 162; Fanno on 223–4 Williamson, O. E. 72 Wirth, L. 39 Woodford, M.: Interest and Prices 17 Wright, H. 203 Wright, R. 24 Yellen, J. 17

value theory 79–80 Vanoni’s Plan 222 Velde, F. R. 147n9 Viner, J. 197n19 Vito, F. 224

Zermelo, E. 48