‘Money’s a matter of functions four,
A medium, a measure, a standard, a store.’
Nineteenth-century jingle
‘[Money] only exerts a distinct and independent influence of its own when it gets out of order.’
J. S. Mill, 18481
The story starts with the classical dichotomy: the division of economics into the theory of value and the theory of money. The dominant question in economics has been: why do things cost what they do? The first generation of scientific economists held that the price of things was determined by the number of hours’ work it took to produce a quantity of stuff. A later generation concluded that the price of goods is determined by their value to the consumer. The cost of labour adapts itself to the preferences of buyers. Value is simply market price. This is today’s theory. The point to note, for our purposes, is that neither of these explanations of value involves money. Goods cost goods: they are bartered for each other. Money, according to the classical story, plays no role in the determination of ‘barter’ prices, i.e. there is no desire for money as such.
The theory of money is concerned with something else: what determines the value or price of money, or its inverse, the general or average price level? The answer given by the elementary textbook is its quantity. The more money there is, the more goods as a whole will cost; the less there is, the lower the average price. The important claim of the theory of money is that the quantity of money makes no difference to the relative prices of goods and services. All it does is to explain the average price of all of them, and that affects nothing ‘real’.
So what is the role of money in this story? The answer is it ‘oils the wheels of trade’. It enables more trade to take place than otherwise would have. But it has no effect on the terms of trade. In Aristotelian terms, it is ‘barren’: it creates and destroys nothing. Today’s textbooks on banking and finance do little more than echo Aristotle. Banks simply ‘intermediate’ between buyers and sellers. This arcane phraseology serves the protective purpose of disguising the actual power of finance – and financiers – in the economy.
Philosophically, the underlying idea of the classical dichotomy goes back to Descartes’ famous distinction between appearance and reality, and his rejection of induction as the method of discovering truth. In medieval times, the general view was that the way things appear is the way they are: we observe God in nature. This was what Descartes rejected. Observation can reveal only how things appear to be; behind the appearance lies the reality. The task of science is to get ‘under the surface of things’. Adopting this standpoint, ‘scientific’ economics set itself the task of penetrating beyond the money values that we observe to the underlying world of real values. In the persistent language of economics, money is a ‘veil’ that hides from us the knowledge of real relationships. Economics must strip away the veil of money; or, more accurately, make the veil transparent, so we never confuse appearance and reality.2 The Cartesian distinction runs from David Hume to Milton Friedman, and underpins the axiomatic structure of mainstream economics.
In the 1930s, the economist John Maynard Keynes challenged the classical dichotomy with what he called ‘the monetary theory of production’. He wrote, in 1933:
[In the classical view] money . . . is not supposed to affect the essential nature of the transaction . . . between real things, or to modify the motives and decisions of the parties to it. Money, that is to say, is employed, but is treated as being in some sense neutral . . .
The theory which I desiderate would deal, in contradiction to this, with an economy in which money plays a part of its own and affects motives and decisions and is, in short, one of the operative factors in the situation, so that the course of events cannot be predicted . . . without a knowledge of the behaviour of money between the first state and the last. And it is this which we ought to mean when we talk of a monetary economy.3
In other words, we cannot separate the theory of value from the theory of money. Money enters into the ‘motives’ for trade. Goods cost money, not goods. So it is the ‘behaviour of money’ in the time between trades that we have to attend to. Money cannot be ‘neutral’, in the required sense that its value has no effect on the prices at which people want to trade, because the only prices people know are money prices. By the same token there is no such thing as a barter equilibrium – what goods would exchange for in the absence of money. There is only a monetary equilibrium.
So what affects the behaviour of money? This should be a key point of enquiry into the behaviour of a monetary economy. Why did money come to exist? What purpose does it serve?
No one knows exactly where, how or why money started, so people are free to invent stories. The main aim of the storytellers has been to elucidate, by reference to a hypothetical past, the nature of money in their own time. Two such stories have dominated the literature of money. Adam Smith’s eighteenth-century story tried to explain why money consisted of gold and silver. The chartalist theory, dating from the end of the nineteenth century, tried to explain why money consisted mainly of credit. We can call these the metallist theory and the credit theory.
Adam Smith’s story, which goes back to Aristotle, is still the textbook favourite. It is certainly the easiest story to understand, which accounts for its popularity. Before money, it is claimed, there was barter – direct exchange of goods for goods. But barter requires a ‘double-coincidence’ of wants. Both partners need to want what the other has, at the same time. So money was invented to enable one of the parties to pay the other in something which the other could use to buy something else. Adam Smith conjectured that the ‘something’ which became the ‘medium of exchange’ must have been ‘some one commodity . . . [which] few people would be likely to refuse in exchange for the produce of their industry’.4
Though cattle, salt, shells and the like were used, metals, and especially the precious metals gold and silver, came to be preferred, for their divisibility, but even more for their durability and scarcity. It was these qualities which fitted them to be the measure of perishable things.
At first ‘rude bars’ of iron, copper, gold and silver sufficed, because of their greater relative stability of value. To avoid having to weigh a lump of metal for each transaction, it became customary to affix a public stamp upon certain quantities of metals, certifying their weight and quality. ‘Hence the origin of coined money, and of those public offices called mints.’ The essence of this fable is that though it was convenient to make contracts in money, behind the veil of the contracts were real things being traded for each other at their real (i.e. barter) prices.
The theory of the bartering savage is heavily indebted to the classical anthropology of Adam Smith’s day, at the heart of which is the figure of homo economicus, who pursues his self-interest in isolation from society. That this still underlies neo-classical psychology is made clear in Paul Samuelson’s famous textbook, where we read: ‘A great debt of gratitude is owed to the first two ape-men who suddenly perceived that each could be made better off by giving up some of one good in exchange for some of another.’5 Most economists have favoured the bartering savage story, because it leaves out society and government.
By contrast, the credit story, which took root at the end of the 1800s, makes money start life as a debt contract – a promise to pay in the future for something bought today. The credibility of the promise depends on trust in the debtor. But trust is not bestowed on a stranger, so it is the existence of a social bond which makes money possible. The language of money is the language of promises: ‘my word is my bond’. As Alfred Innes writes: ‘By buying we become debtors and by selling we become creditors.’6 The credit theory of money does not automatically upset the classical dichotomy, if it is assumed that credit is simply an advance on money, which is itself an advance on goods. But it greatly weakens it by placing expectations at the centre of its account of ‘real’ transactions.
This seemingly recondite dispute about the origins of money reflects a deep divergence about the purpose of money. Was money to be thought of primarily as a means of effecting two transactions barely separated in time? Or was it also, and distinctively, to be seen as a link between the present and the future? The first led to the view that the only important demand for money was as a ‘means of payment’; the second that its significant economic role was as a ‘store of value’. It was the motives for holding money independently of the desire for goods – the positive preference for liquidity – which interested Keynes. The ‘fetish for liquidity’, he reasoned, could have only one cause: uncertainty about the future. For if everyone knew for certain what the morrow would bring, there would be no rational reason for hoarding lumps of metal or pieces of paper. In fact, there would be no need for money at all. So, the dispute about the origins of money was, at its heart, an epistemological one: how predictable were future events?
As one might suppose, the metallist and credit theories give different answers to the question of what gives money its value.
According to the metallist theory, the value of money inheres in the value of the thing of which it is composed, namely the metal. The ‘essential’ value of gold and silver is determined by properties intrinsic to them, such as their attractiveness, scarcity and durability. In the credit theory, money is simply a token of what is promised; its value is conferred by the degree of trust in the promise of its issuer.
The credit theory offers three possible issuers of money. By far the most important is the chartalist theory. This holds that the main issuer of money is the state. According to Georg Friedrich Knapp (1905) and Innes (1913), the state issues receipts (tokens of liability) for goods it commandeers. Coins (with the head of the ruler on them) are stamped tokens of state debt. These receipts circulate as currency, because the state’s ability to ensure that taxes are paid in the money it itself issues makes its ‘promises to pay’ uniquely reliable. Adam Smith acknowledged that:
A prince, who should enact that a certain proportion of his taxes should be paid in a paper money of a certain kind, might thereby give a certain value to this paper money; even though the term of its final discharge and redemption should depend altogether on the will of the prince.
Similarly, Innes argued that ‘the redemption of government debt by taxation is the basic law of coinage and of any issue of government “money” in whatever form’.7
The chartalist story reflects the fact that the earliest economies of which we have record – those of the Egyptian and Mesopotamian empires, a few thousand years before the birth of Christ – were tributary economies, economies in which the flow of goods and services was mainly between rulers and ruled. The subject owed the ruler tribute; the ruler owed the subject services in return. For example, in Egypt, a certain proportion of agricultural produce was delivered to the temple granaries, from which were paid the ‘wages’ of workers employed on public works, such as the building of pyramids and temples. One of the earliest purposes of money was to make it easier to ‘render tribute [taxes] unto Caesar’ (Matthew 22: 17–21). Reciprocal obligations could be discharged by tokens of purchasing power, rather than by actual transfers of physical goods, the tokens expressing customary valuations of the physical obligations. If this model of the earliest economies is accepted, the origin of money is related primarily to the operations of public finance, not of markets. Promises come before coins: coins are merely tokens of promises.
Neo-chartalists of ‘modern monetary theory’, such as Warren Mosler and Randall Wray, go further: the state doesn’t need to tax in order to spend; it needs to spend in order to tax. Neo-chartalists tantalize you with such questions as: how can you pay taxes if the government has not already spent the money? The state’s debts are the source of its revenue: the more it spends the more revenue it can collect. This is the simplest justification for deficit finance in a slump: the debt creates the revenue to discharge it.8 It is curiously blind to the thought that people may choose to withhold the taxes they owe the state if they disapprove of the purposes for which they are being raised.
The state is not the only possible issuer of debt. Any debt may serve as a means of payment if the security (trust) in the debtor’s promises is great enough. Privately created liabilities have always circulated alongside public liabilities. Of these by far the most important are the debts of banks. Banks would issue loans to borrowers in the form of promissory notes (notes promising to pay cash on demand) backed by their deposits. These notes could circulate as currency. However, the liabilities of banks were never as secure as those of the state, because of the danger of a run on the bank if the bank was seen to be over-indebted. The value of the notes, in short, depended on trust in the solvency of the bank.
Supporters of the credit theory, like Felix Martin, deny the state or banks an exclusive role in determining the value of money. Its value, they say, is negotiated between creditors and debtors, and determined by the balance of power between the two.9 Creditors can keep up the value of money if they are in a position to enforce full payment of the debts owing to them; debtors can reduce it by evading repayment.
The metallic or essentialist theory of money should not be dismissed too readily. Money may be a token of trust, but not all monies are equally trustworthy. Behind the supremacy of gold lies the fact that it can’t go bad. It is the ultimate guarantor of value. Since gold disappeared as money there has always been something unreliable about the currency.
Even when state money became paper, and therefore intrinsically worthless, it was thought desirable to maintain belief that government notes – promises to pay the bearer – were in fact debt certificates backed by gold. Until 1971, the value of the American dollar was widely believed to depend on its convertibility into gold, as though the value of gold guaranteed the value of paper dollars. After 1971, the central bank’s high-powered money was deemed ‘good as gold’. Monetary history is full of such fictions, but all fictions have their basis in experience and human psychology.
There has always been a tension between the convenience of having a fixed, unchangeable yardstick of value and the desire of creditors and debtors to have a money which suits their own interests. This is the class-struggle theory of money. In the industrial age, the conflict between capitalists and workers overlapped the older conflict between creditors and debtors without ever replacing it.
To historical sociologists like David Graeber, much of the history of the world can be interpreted in terms of the struggle between creditors and debtors. Whatever the loan or wage contract says, there is always a risk in an uncertain world that promises will be devalued or revalued; hence the intensity of the conflict to control the value of the promises.10
The state has only a limited incentive to guarantee the value of money. The reason is that it can always produce the money necessary to defray its expenses, either by debasing the coinage when money is metal or by printing more of it when it is paper. So, throughout history rulers have cheated on the amount of money they were manufacturing. While claiming to maintain the value of money, they have reduced the weight and fineness of the gold and silver in their coins, or issued too much paper. By imposing an ‘inflation tax’ they can get hold of extra real resources without openly raising taxes. ‘A government can live by this means’, wrote Keynes, ‘when it can live by no other. It is the form of taxation which the public find it hardest to evade and which even the weakest government can enforce, when it can enforce nothing else.’11
Throughout history too, reformers have directed their efforts to preventing the state from debasing the coinage: in Ricardo’s words, inflation ‘enriches . . . the idle and profligate debtor at the expense of the industrious and frugal creditor’.12 The main purpose of essentialist monetary thought was to stop the state from debasing the coinage. That is why it insisted that the value of money lay in the value of the metal in the coin.
A good example of this argument was the claim by the seventeenthcentury mercantilist William Petty that a reduction in the silver content of the coin was bound to be self-defeating. It would diminish the amount of goods people were willing to give up for it, except among ‘such Fools as take Money by its name, and not by its weight and fineness’.13 Petty was wrong. The debased coins issued by the royal mint continued to circulate at their face value. The key to their acceptability lay in the fact that they were the only legal tender. As Aquinas had realized four centuries before Petty, money was the ‘one thing by which everything should be measured . . . not by its nature, but because it has been made a measure by men’.14 The convenience of using the state’s money as a means of payment for goods and obligations outweighed the losses, actual and potential, suffered by creditors through debasement, unless the debasement was carried to extremes, at which point the state’s money ceased to be used for any purpose.
By the start of the nineteenth century it was realized that a stronger defence against ‘over-issue’ of money was needed. This could be secured by limiting the quantity of the state’s money to the quantity of gold bullion in the country – the subject of Chapter 2 – and placing strict limits on the operations of the state itself. If the state could be confined to a narrow range of activities, its incentive to expand the money supply would be correspondingly circumscribed. This was the main object of the Victorian fiscal constitution, which we describe in Chapter 4. The rule that the state’s spending should be annually balanced by taxation at the lowest possible level was designed precisely to limit the state’s ability to ‘debase the coinage’.
The other main danger to the value of money was the clamour of the debtor class to be relieved of its debts.
In Hamlet, Shakespeare has Polonius enjoin his son, Laertes:
Neither a borrower nor a lender be;
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.
Polonius’s advice, more recently echoed by Angela Merkel, has always been an old wives’ tale, if applied within a single jurisdiction. The chief way of starting or carrying on a business is by borrowing money, despite its fearful moral pitfalls. Polonius’s instruction makes a lot more sense if applied across country borders, because that raises much more acutely the question of the security of loans.
The age-old question for monetary policy was, whose interests should it protect? Those of lenders or borrowers, creditors or debtors? Creditors demanded of money above all that it keep its value between transactions. But debtors simply wanted to have enough money to enable them to carry on their business, and expected the state, the bank or the moneylender to produce it. These requirements were far from coinciding. Creditors are natural essentialists – they want principal and interest to be paid back in full-weight coin. Debtors are natural nominalists – they want to pay back less than they borrowed if they can.
Because of their importance in stabilizing expectations, promises need the support of both punishment and forgiveness.
Creditors assert a moral right to be repaid in money of equal value to that which they lent and a moral duty of the debtor to repay it, at whatever sacrifice. The root of credit is the Latin word credo, ‘I believe’. A lender is someone who trusts that the borrower will pay them back in money of equivalent value.15 Lenders assert that, without such trust, lending will cease, and trade will languish. To ensure the necessary trust, creditors have always created as many obstacles to default as government or convention allow. They have kept interest rates as high as possible against risk of default. They have imprisoned or enslaved defaulting debtors, or taken their property. They have invaded, or refused loans to, states that repudiate their debts. Economists talk of the ‘moral hazard’ of making life too easy for debtors. The more cynical see loans to impecunious debtors as a kind of asset-stripping, a substitute for armies to obtain land and resources.
However, the debtor position is not without moral support. All religions have supported ‘debt forgiveness’ and abhorred ‘debt-bondage’. It was customary for new rulers to declare a debt amnesty, as in the Jubilee law of the Babylonians, recorded in the Bible. Solon (c.638–558 bc) was the famed lawgiver who cancelled the debts of Athenian farmers. (Throughout history farmers have been the biggest debtor class, because of the seasonal character of their business and the unreliability of harvests.) The line in the Lord’s Prayer – ‘Forgive us our sins as we forgive those who have sinned against us’ – can be rendered: ‘Forgive us our debts, as we also forgive those in debt to us.’16 The recent bail-outs of bankrupt banks are examples of debt forgiveness.
Shakespeare vividly dramatized the moral resistance to the creditor who claims his ‘pound of flesh’ for failing to repay a loan. In The Merchant of Venice, the money-lender Shylock suggests as a ‘merry sport’ that, in the event of a default, the merchant-borrower Antonio must satisfy him with a pound of his own flesh, ‘to be cut off and taken in what part of your body pleaseth me’. Then the joke goes horribly wrong. Antonio’s ships carrying his goods for sale are wrecked; he cannot repay the loan on the appointed day, and Shylock claims his forfeit. Shylock’s downfall – he loses all his money – expresses the popular attitude towards the money-lender, who, in medieval Europe, was often a Jew. Anti-Semitism was part of a generalized debtor hostility to the rentier class – the class that lives off interest and rents.
The position of debtors was further strengthened by the Abrahamic-Christian prohibition of usury, or taking interest on the loan of money. Anti-usury laws ran from the earliest times until the nineteenth century (in Britain they were only abolished in 1835), and still exist in Islamic countries. Medieval folk believed usurers were prematurely carried off to hell, or that their money turned to withered leaves. They occupy the seventh circle of hell in Dante’s Divine Comedy.
Two moral considerations lay behind the anti-usury legislation. The first stemmed from the idea that a debt contract is a kind of unfair trade. Since the lender is nearly always in a stronger position than the borrower, it was felt that the borrower needed protection from the lender’s rapacity. Put simply, a farmer faced with a ruined harvest, or a trader with the loss of his goods, may have to borrow to stay alive, however high the interest he has to pay on the loan; a lender is under no compulsion to lend and, unchecked by law, may ask whatever interest he wants for loaning out his money. Therefore state and custom tried to keep the interest on lending money as low as possible.
But, secondly, there was also a long-standing moral hostility to ‘making money out of money’. This goes back to Aristotle’s view that money is, by its nature, ‘sterile’, so that interest on money rewarded no productive activity.
Scientific economics dropped the moral taboos and legal restrictions against taking interest. It treats interest as a justified payment for the cost of saving – denying oneself present consumption – and the risk of investment. If interest were denied or limited, there would be less incentive to save, and a disincentive to lend, therefore less investment and slower growth of wealth.
Modern developments have eased the intensity of the ancient struggle between creditors and debtors. Stock markets and limited liability have provided an alternative to bank borrowing for raising capital, and the penalties for default have been progressively relaxed. We no longer demand labour services of defaulting debtors, or send them to prison. Debt-bondage is a shadow of its old self.
With the rise of modern tax systems, the state’s need to issue debt to finance its expenditure has also declined. Its incentive to debase the coinage therefore decreased. Because governments had less recourse to their subjects for loans, people became much more willing to hold government debt. The nineteenth century was the golden age of the bondholder, with the state paying its debts in full-value money. This cosy world was horribly upset by the two world wars of the twentieth century and the triumph of democracy. The state became a huge net borrower for the first time since the Napoleonic wars, and the new voters came from the debtor, not creditor, class. Following the Second World War the debasement of money – inflation – was more or less continuous. But in the 1980s there came a reversal. Inflation was reined in, as the creditor class regained something of its old ascendancy. As unemployment rose and wages stagnated, loan sharks offering ‘pay day loans’ at usurious interest rates proliferated. In the Eurozone debt crisis of 2010–12, a ‘troika’ of creditors, in a return to nineteenth-century methods, demanded of Greece islands, gas extraction rights and museums – their ‘pound of flesh’ – as surety for loans they knew would never be repaid.
The truth is that any monetary policy will always produce winners and losers, depending on the terms of access to credit. The modern answer – placing monetary policy in the hands of an ‘independent’ central bank – does not make money ‘neutral’, because monetary policy is bound to have distributional effects.
The Quantity Theory of Money is more accurately termed the Quantity of Money Theory of Inflation, because it was invented to explain inflation, and (much later) became the basis of policy to prevent it. Although both inflation and deflation are consequences of having the wrong quantity of money, the quantity theory was never specifically aimed at explaining deflation, deflation being considered an inevitable consequence of the previous inflation. Therefore, if you could prevent inflation, you would automatically prevent the deflation that followed the pricking of the inflationary bubble. In our own day, this argument is associated with Friedrich Hayek.
It was the sixteenth-century French philosopher Jean Bodin who turned the common understanding of inflation as ‘too much money chasing too few goods’ into something like a theory, in order to explain the century-long rise in prices which, starting in the middle of the 1500s, ran parallel with the importation into Europe of newly discovered and mined silver from South America. The influx of silver from South America, which started in 1550, was the first great monetary disturbance of modern times, the price level in Spain doubling between 1550 and 1600.17 This unsettled all customary relations of the medieval world, and gave birth to speculation, both intellectual and financial.
In his Réponse aux paradoxes du M. de Malestroict (1568), Bodin wrote that ‘The principal & almost only [cause of rising prices] is the abundance of gold & silver, which is today much greater in this kingdom [France] than it was four hundred years ago.’18 This conjecture is said to be the start of the quantity theory of money.19 However, an early version of it may already have existed in China in the middle of the fourth century bc.20
Bodin’s conjecture seemed reasonable enough. If there is suddenly more money to spend on a fixed supply of goods it seems obvious that competition to buy them will force up their prices; the same competition with less money will cause their prices to fall.
This condition has been the basis of the quantity theory ever since. However, though in pre-industrial societies there was little economic growth, the supply of food would vary with the harvests. Prices of foodstuffs would go up and down without any prior impulse from money. It is true that more money would be needed to pay the higher prices. But it is precisely at this point that the role of money as credit enters the picture, as in the phrase ‘buying goods on tick’. Here money functions simply a means of account, without any physical substance. Medieval economies responded to the dearth of coin by expanding the supply of ‘tick money’. This then would be paid back in cash when prices came down.21
The invention – in fact rediscovery – of banking in northern Italy in late medieval times was key to making the supply of money more ‘elastic’, especially for rulers faced with rising costs and declining revenues. Banking started up in Florence around 1300, the era of Dante. This financial innovation was soon followed by banking crises – the Bank of Bardi and that of the Peruzzi family crashed in 1345. ‘Early banks’, explains Hicks, ‘were very unsound, over-anxious to accept deposits, and not yet conscious of the conditions under which alone it can be prudent to push such deposits to profitable use.’22 What’s changed?
The way modern banking grew up has been described by Nicholas Kaldor:
Originally goldsmiths (who possessed strong rooms for holding gold and other valuables) developed the facility of accepting gold for safekeeping and issued deposit certificates to the owners. The latter found it convenient to make payments by means of these certificates, thereby saving the time and trouble of taking gold coins out of the strong room only to have them re-deposited by the recipient of the payment, who was likely to have much the same incentive of [sic] keeping valuables deposited for safekeeping. The next step in the evolution towards a credit-money system was when the goldsmiths found it convenient to lend money as well as to accept it on deposit for safekeeping. For the purpose of lending they had to issue their own promissory notes to pay cash to the bearer (as distinct from a named depositor) on demand; with this latter development the goldsmith became bankers, i.e., financial intermediaries between lenders and borrowers.23
The language of banking – ‘taking’ deposits and then ‘lending’ them out – reflects the original function of banks as storehouses and intermediaries. But most ‘deposits’ today are created by the banks themselves when they make loans. These loans are often ‘unsecured’: made on trust in the borrower’s promise to repay. The loans, when spent, create fresh deposits, out of which new loans can be made. Unlike the quantity theory of money, which is a ‘supply of money’ story, the credit theory of money is a ‘demand for loans’ tale. The amount of money fluctuates with the demand for loans and the creditworthiness of borrowers; and both fluctuate with the state of business.
There has never been complete agreement about what constitutes the ‘money supply’. Today most money is credit, without physical existence: it is created by electronic transfer between deposits. The state’s paper money (‘cash’) is only a tiny fraction of a country’s payments system. Monetary economists distinguish between cash, whether held under the bed, in current accounts or by banks as reserves, and money loaned to customers by banks, held in deposit accounts. They call the first ‘high powered’ or ‘narrow’ money, and the second ‘broad’ money, and distinguish them by somewhat confusing and inconsistent acronyms: M0, M1, M2, M3, M4.24 To preserve the fiction that commercial banks cannot create money ‘out of nowhere’, orthodox theory posits a mathematical relationship between narrow and broad money, known as the ‘money multiplier’. This fiction persists to this day in mainstream academic economics, though central banks themselves have never paid much attention to it.25
Thus the question of whether the source of money is external to the economy (exogenous in economics-speak) or created and destroyed in the course of making transactions (endogenous) remains unsettled. A reasonable way of looking at the matter is to say that endogenous money is the rule, with exogenous money as a windfall – such as happened to Europe with the discovery of silver in South America.
The quantity theory of money ignored the possibility that people might want to hoard money. Economists say there is no ‘demand for money’ as such, only for consumables. They have usually treated the demand curve for money as the demand curve for goods and services. It slopes downwards, as the more of something one has, the less one is said to want it. Saving is construed as a demand, not for money but for future goods, with the rate of interest measuring the discounted present value of the future stream of anticipated utility.
But money, said the philosopher John Locke, thinking of gold and silver, ‘is a lasting thing a man may keep without spoiling’.26 By the same token, it can keep without spending. But why should anyone want to keep money? Gold and silver were used as stores of value (as well as signs of power, prestige and wealth) before they acquired their monetary use as means of exchange. King Midas of the ancient legend hungered after gold, not gold coins.27 Already in Roman times, India was seen as the ‘sink of the world’s gold’, much of it absorbed in jewellery and display. Its value, that is, was independent of its use as money.
But why should people wish to hoard money? Economists have associated the propensity to hoard money with periods of uncertainty and unsettlement. Thus J. B. Say – of the infamous Say’s Law, which says that supply creates its own demand – recognized that from time to time ‘capitals [may] quietly sleep in the pockets of their proprietors’.28 It was this propensity which led John Stuart Mill to consider Say’s Law an ‘unsettled question’ in his essay of 1829.29 Speculators, too, have always known that in disturbed times they can profit from being liquid. Increased propensity to hoard, what Keynes called the ‘speculative demand for money’, thus arises from increased uncertainty. It slows down the economy by slowing down the spending of money on currently produced goods and diverting it into financial operations.
Thus money earned in producing goods may be unavailable for spending on those goods, causing unemployment. If the government could ensure that all the money earned producing goods was spent on buying them, there need never be unemployment.
The central claim of the classical dichotomy is that the value of money (or average level of prices) makes no difference to the relative prices of goods and services. If all prices go up together, it makes no difference to the price ratios at which goods exchange. If this is so, attention to the quantity of money might seem redundant. However, experience showed that while the value of money or price level itself didn’t matter, changes in it did. Rising prices were associated with prosperity; falling prices with dearth. This correlation led a group of seventeenth-century thinkers called mercantilists to identify money with wealth. The more money a kingdom had, the wealthier it was; the less, the poorer. The mercantilists were the first to challenge the classical dichotomy – the absolute separation of money from the real economy.
The ‘scientific’ economists who followed the mercantilists pointed out the flaw in mercantilist reasoning. The association of money with wealth, they said, was the result of ‘money illusion’. As the economic historian Eli Heckscher put it: ‘Everyone under natural economy (barter) recognized that exchange was the more favourable the larger the amount of goods which could be got in exchange for one’s own. But then came the monetary system which drew a “veil of money” over the interconnected factors in exchange.’30 That money was a veil that obscured accurate knowledge of barter values became a standard trope in classical economics. To remove the veil (or equivalently, to make a money economy behave like a barter economy) was at the heart of the twentieth-century monetary reform movement.
The eighteenth-century philosopher David Hume gave the first precise rendering of the phenomenon of money illusion. It is inserted into his essay on the balance of trade.31 Here he considers the influential mercantilist argument that a country with no domestic sources of gold and silver needs to aim for a continuous trade surplus, if it is to have enough money to support a growing population. This required restricting imports, and therefore domestic consumption, and aggressively promoting exports, often through wars aimed at excluding competitors from domestic and foreign markets.32
Hume demonstrated that the mercantilist attention to the trade balance was fallacious. Trade between two countries, he says, automatically balances itself. This was a logical implication of the barter theory of trade: goods trade for goods. Money does not fundamentally alter the picture. A temporary imbalance between exports and imports produces countervailing gold flows, which, through their effects on price levels (up in the surplus country, down in the deficit country), restores the balance. This is his famous ‘price–specie–flow’ mechanism. Just as it is impossible to keep water flowing uphill, so ‘it is impossible to heap up money, more than any fluid, beyond its proper level’.33 Hume was the first clearly to identify a payments mechanism that ensured that trade would be balanced. This achievement was crucial to the free trade case developed by Smith and Ricardo.34
Hume, however, introduced a critical qualification: in the ‘shortrun’, an inflow of money could, by creating money illusion, stimulate business activity by increasing the rapidity, or velocity, of circulation.35 This insight made him the originator of the short-run Phillips Curve (see pp. 205–8), later taken up by Milton Friedman. Ever since Hume, economists have distinguished between the short-run and the long-run effects of economic change, including the effects of policy interventions. The distinction has served to protect the theory of equilibrium, by enabling it to be stated in a form which took some account of reality. In economics, the short-run now typically stands for the period during which a market (or an economy of markets) temporarily deviates from its long-term equilibrium position under the impact of some ‘shock’, like a pendulum temporarily dislodged from a position of rest. This way of thinking suggests that governments should leave it to markets to discover their natural equilibrium positions. Government interventions to ‘correct’ deviations will only add extra layers of delusion to the original one. That Hume’s distinction between the effects of short-run and long-run changes in the quantity of money destroys the practical utility of the theory for short-run stabilization policy was not realized until much later, and has still not been fully accepted by true believers.
Adam Smith also recognized that a growing economy required that the supply of money should increase roughly in line with demand, if ‘the average money price of corn’ was to stay the same. That is why he supported the issue of paper money as a supplement to gold money; paper would provide ‘a sort of waggon-way through the air, [which enables] the country to convert . . . a great part of its highways into good pastures and corn-fields, and thereby to increase very considerably the annual produce of its land and labour’.36 Later monetary theorists also recognized that gold money, whose increase depended on the discovery of new gold mines, could not guarantee the desirable stability of the price level. But they went further than Smith in arguing for cutting the link between money and gold completely.
The sketch above has revealed two contrasting patterns in the theory of money, which may be called the ‘hard’ and ‘soft’ money schools. They run through the history of monetary thought and policy to our own time.
Figure 1. Beliefs of the hard and soft money schools
The next two chapters will show how these contrasting clusters of thinking worked themselves out in the theory of monetary policy.