Economic and Financial Crises

A New Macroeconomic Analysis

A. Cencini, S. Rossi

• Publisher: Palgrave Macmillan
• Year: 2015
• Print ISBN:
  9781349690251
  9781137461896
• eBook ISBN:
  9781137461902
• Topic: Economics
• Subtopic: Accounting
• Index: Economics

This book deals with the structural origins of economic and financial crises. It explains that both economic theories and policies need to be grounded on a monetary macroeconomic analysis of the working of domestic and international economies. The volume outlines reform proposals to make sure that banking activities respect the nature of money.

Part I

Modern Principles of Monetary Macroeconomics

1

The Monetary Macroeconomics of Modern Economic Systems

What is money and how do banks issue it? How is it associated with physical output? Is it endowed with a positive value since its very creation, or does it acquire its purchasing power, and how? Is it necessary to distinguish between money proper and money income? If yes, what is their logical relationship? These are some of the questions dealt with in this chapter, where we endeavour to show that the specific nature of bank money remains, in part, a mystery and needs to be investigated starting from its bookkeeping origin. Too often identified with a commodity or an asset, money is mainly perceived as a stock that can circulate more or less rapidly within the economy and whose cost has a direct impact on production. Is this definition consistent with the way money enters those payments that banks carry out? A rigorous analysis based on double-entry bookkeeping shows that this is not the case, because money is intrinsically valueless and can only derive its value or purchasing power from production. The classical distinction between nominal and real money finds a new raison d’être in the distinction between money and income, where the latter is the result of a transaction through which money (a simple numerical form) integrates produced output as its real content. This new macroeconomic analysis of money and income leads to a fundamental dismissal of the old-fashioned idea that money creation is nothing less than a credit creation, or in other words that, by issuing money, banks originate credit, that is, a loan granted to the economy and financed by banks themselves. In fact, banks act as monetary as well as financial intermediaries, and credit is never financed through money creation.

Let us proceed step by step along a path that will lead us to discover the principles of modern monetary macroeconomics.

About money

Economists almost invariably begin their monetary writings by giving a wide and usually empirically based definition of money, which may correspond to the dictum that money is what money does, or may go as far as to identify money with a commodity, an asset, or a veil. Even the author of A Treatise on Money is no exception, for he starts his famous book by defining money through its functions.

Money itself, namely that by delivery of which debt contracts and price contracts are discharged, and in the shape of which a store of general purchasing power is held, derives its character from its relationship to the money of account, since the debts and prices must first have been expressed in terms of the latter.

(Keynes 1930/1971: 3)

The weakness of this approach is that it assumes that a conceptual definition may be made to coincide, a priori, with a nominal or with an axiomatic definition. Nominal definitions are arbitrary and say nothing about the nature of what is being thereby defined. The choice of a word to appose to an object is a clear example of nominal definition. Whatever word we choose to name a given object or concept, our understanding of its nature does not progress at all. To the extent that it does not increase our knowledge, an axiomatic definition is no more useful than a nominal one. Moreover, these two kinds of definition are quite different. Axiomatic definitions, in fact, are not arbitrary. As universally established principles, they are the result of a process of understanding, which transforms them into self-evident statements only a posteriori. A true axiom is a principle arrived at through analytical discovery. The fact that the Earth rotates around the Sun may be taken as an axiom today, but was certainly not considered as such before Copernicus. Finally, correct conceptual definitions are bound to become axioms. When this happens, they can be taken for granted and introduced as axiomatic definitions from the outset. What cannot be done is to assume the axiomatic character of a definition before having rigorously established it. A conceptual definition is indeed the arrival point of a process of understanding, and not its point of departure logically. As far as monetary analysis is concerned, we cannot start by axiomatically defining money, because the definition of money must be the end result of our conceptual enquiry.

The different forms that money is supposed to take on, and the different ways in which it is made to operate, are symptomatic of the lack of a clear understanding of what money really is. As claimed by Mishkin (2004: 44), ‘[e]conomists define money (also referred to as the money supply) as anything that is generally accepted in payment for goods or services or in the repayment of debts’. On top of being aprioristic, this definition is far too vague to be meaningful. As a matter of fact, anything can be accepted in repayment of debts, from banknotes and coins to checks, deposit certificates, securities, or even goods and services. The only apposite conclusion in this regard is therefore that ‘there is no single, precise definition of money or the money supply, even for economists’ (ibid.: 44).

In 1930, Keynes entitled Book I of his Treatise ‘The Nature of Money’ and Book II, ‘The Value of Money’. This is the logical succession that has to be followed if we are to avoid taking for granted any aprioristic conception of money. Claiming, as done by Mankiw (2007: 77), that ‘money is the stock of assets that can be readily used to make transactions’ is twice misleading, since it is at the same time too broad and too specific a definition. It is too broad because it encompasses every kind of assets, and too specific because it assumes that money is an asset. In reality, one cannot take for granted that money is an asset, even though historical observation seems to corroborate it. While it is undisputable that gold, silver, and other materials have been used in the past to represent money, it is no less certain that money cannot be identified with any of these materials. To describe the physical aspect of a coin, a banknote, or any other object is no contribution to understanding what money’s nature is.

In their explanation of money, economists almost invariably start from a brief analysis of the different forms taken up by what has historically been chosen to play the role of a standard. The passage from commodity money to bank money has marked a process of increasing dematerialization, which clearly shows how erroneous it would be to keep identifying money with its physical supports. Money is not gold, nor silver, nor an electric impulse; convertibility has long been abandoned; and central banks have given up the official link between money and their gold reserves. The recent evolution of payment systems towards the electronic use of book-entry money has clarified the terms of the problem, thus making it easier for researchers to avoid confusion. However, the main difficulty remains, namely that of explaining the nature of an entity that, although dematerialized, pertains to the realm of economics. Money is essentially a conceptual entity, which is not identifiable with any material or any object whatsoever, but is nevertheless strictly associated with or integrated to produced goods and services. Abstraction is not an easy way to follow. However, it is a necessary step, which has to be taken without falling into the trap of abandoning any reference to the real world. Money exists in the real world, but it cannot be physically defined or identified; this is why it has so imperfectly been understood so far. This explains also why it has generally been confused with a series of physical objects to which it was erroneously identified. Our problem is thus clearly stated: to determine the specificity of money irrespective of the device used to play its role.

The nature of nominal money

Let us start from the first function usually attributed to money, namely that of a unit of account. Economists are not unanimous when defining this function of money. For many of them, money acts as unit of account in that it is a measure or a standard of value. The ‘role of money is to provide a unit of account; that is, it is used to measure value in the economy’ (Mishkin 2004: 46). For others, money is a numerical unit used to express economic magnitudes such as prices, debt, income, capital, and so on. ‘As a unit of account, money provides the terms in which prices are quoted and debts are recorded’ (Mankiw 2007: 77). Now, to define money as a standard of value from the outset is logically unacceptable, since it would amount to suppose that money has a positive value, and that its value is of the same kind as (and therefore comparable with) that of the goods and services it is meant to measure. Such a procedure must be rejected, for the simple reason that, as intuited by Keynes (1930/1971), the nature of money must be explained first, before asking whether money has a value of its own or not. The numerical conception of money avoids this criticism and is far more promising to understand the working of our economic systems.

A unit of account is, first of all, a numerical standard used to count or to enumerate. Strictly speaking, it consists of numbers alone, and is therefore deprived of any intrinsic value. Numbers can be used to count a collection of homogeneous goods in order to ascertain their arithmetical sum. This is not, however, what a unit of account is supposed to do in economics, where produced goods and services are far from being homogeneous. In this framework, numbers are given the task of representing the means through which physically heterogeneous objects may be given a common numerical form. To introduce money as a unit of account has no other meaning than introducing numbers in the realm of economics.

The earlier statement may sound strange. Numbers are just here for us to use; why should we need money to introduce them into economics? The answer relates to our previous remark: goods and services are physically heterogeneous and cannot be summed up unless they are made commensurable. The existence of numbers is not enough to solve this problem. What is still needed is a way to integrate numbers and goods, which requires numbers to be made available through a specific economic operation.

Numbers have been part of economics since the introduction of money. However, it is only with the appearance of an exhaustive monetary system and through the generalized use of money that the integration of numbers has been achieved. The easiest way to understand the numerical nature of money is therefore that of analysing what allows banks to provide the economy with a unit of account.

The idea that banks create money is not new. Keynes (1930/1971) devotes the first section of his chapter on bank money to the ‘creation’ of bank money, and claims that ‘the bank may create a claim against itself in favour of a borrower, in return for his promise of subsequent reimbursement’ (Keynes 1930/1971: 21). It is by spontaneously issuing their own acknowledgement of debt that banks create money, and it is worth observing here that, correctly, Keynes does not confine the creation of money to the central bank. Any bank can issue money by creating a claim against itself. The question that has to be clarified at this stage is how it is possible for a bank to get spontaneously indebted, and how it is that, through its spontaneous acknowledgment of debt, numbers are introduced into economics.

The discovery of double-entry bookkeeping, which took place in thirteenth century’s Italy, is the event that marks the origin of banks. Double-entry bookkeeping was itself made possible by the previous (seventh century) discovery, attributed to the Indian mathematician Brahmagupta, of negative numbers, which, in its turn, is closely related to a new conception of the number zero. For a long time, zero was not considered a number in its own right: it was merely conceived as a symbol for an empty space in the system of numeration; it represented the absence of anything, the void, or the ‘nothing’. Since Brahmagupta, zero is known to have a definite numerical value of its own. More precisely, zero is the first number of the series of positive integers, the number that precedes one and that separates positive from negative numbers. Double-entry bookkeeping is an application of this distinction, which allows arriving at zero by adding negative to positive numbers.

The first meaning of bank money creation is the possibility given to banks by double-entry bookkeeping to issue simultaneously +x and −x units of money. Indeed, this is the only acceptable way of envisaging creation without recurring to metaphysics. Banks are human institutions, and as such they cannot create anything positive. The risk of running into metaphysics is avoided if what is created is at the same time positive and negative. This is what happens when banks get spontaneously indebted to a client who accepts to get indebted to them, that is, when a bank agrees to open a credit line to the benefit of one of its client, A. The double-entry representation of this contract is shown in Table 1.1.

Table 1.1 The opening of a line of credit

By entering A on the liabilities side of its ledger, bank B acknowledges its willingness to get indebted to its client A insofar as the latter is willing to become its debtor. Overdraft facilities pertain to this kind of transactions. They simply mean that the bank is prepared to carry out a payment on behalf of its client, and that its client will have to reimburse it. No payment has yet occurred, and the amount of money actually created is zero. However, the operation is not void and meaningless. The simultaneous creation of a positive and a negative amount of money to the benefit of A has no direct consequence for B and for A, but sets the conceptual and the practical framework for a payment system to exist. The signal given by banks to the economy is that they can provide the numerical vehicle required to convey a payment.

At this point a new question arises. If money is but a numerical vehicle with no value, and if banks by themselves can only issue zero units of money, how can any payment be carried out? The answer to this question leads us straightforward to consider the problem of money’s value.

The value of money

Apparently, the easiest way to attribute a positive value to money would be to define it as an asset. However, as we know, this is not a suitable solution, because bank money is almost completely dematerialized, and, even more important, because this definition cannot be introduced as an axiomatic assumption. An alternative solution is offered by the chartalist view that money in general may be accepted as a means of payment, as one of its components is State money. As a matter of fact, economists unanimously agree that the passage to inconvertibility has generalized the use of fiat money, that is, ‘paper currency decreed by governments as legal tender (meaning that legally it must be accepted as payment for debts)’ (Mishkin 2004: 48). A government decree would thus be at the origin of money’s general acceptance in payments. This is so much so as the government may impose different tax liabilities to the population and declare that it accepts State money as a means for discharging these liabilities. According to Smith (1776: 328), ‘[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’ (see also Mitchell Innes 1913: 398–9). Hence, the State can induce all taxpayers to accept these pieces of paper as money, because any non-bank agents know for sure that everyone who has to pay taxes will accept them in turn (Tobin and Golub 1998: 27).

Attractive as the chartalist view might seem at first, it takes us no nearer to a solution of the problem, for it rests on the arbitrary assumption that the government has the supernatural power to create a currency with a positive redeeming power. ‘[Fiat money] is manufactured by the government from thin air’ (Tobin 1965: 676). As already emphasized by von Mises (1912/1981), the chartalist theory of money does not provide any explanation of either prices or money’s value, and must be rejected as entirely useless. ‘The state theory is not a bad monetary theory; it is not a monetary theory at all’ (von Mises 1912/1981: 510).

A way out of this conundrum seems to be that of referring to social, general acceptance, that is, of maintaining that money’s redeeming power derives from ‘its general acceptability in the discharge of public and private transactions’ (Tobin 1965: 676). So, we are told that money has a positive value because we all accept it as a means of payment discharging debts. Money’s value would derive from social convention, in a similar way as in language the meaning of words is determined universally because everybody agrees about it.

As long as everyone continues to accept the paper bills in exchange, they will have value and serve as money. Thus, the system of commodity money evolves into a system of fiat money. Notice that in the end the use of money in exchange is a social convention: everyone values fiat money because they expect everyone else to value it.

(Mankiw 2007: 80)

Social, general agreement emerges as the cause of money’s value on top of government’s enforcement of paper currency as unique means of tax payments. Yet, a question arises almost spontaneously: for what reason should individuals agree on accepting a mere acknowledgment of debt in exchange for their goods and services? Bank money being deprived of any intrinsic value, its general acceptance should derive from the generalized belief that everybody is prepared to accept it as if it had a positive value. To put it bluntly, this amounts to saying that if we all accept to be dupe, no one of us will eventually be fooled. Needless to say, this is an odd way of making ends meet. Indeed, the whole argument is fallacious, and winds up in a vicious circle, money’s general acceptance being founded on the belief that everybody will accept it. Reality is much more straight and pragmatic: it is because money has a positive value (whose origin we still have to explain) that it is generally accepted, and not the other way around.

In most general terms, money’s value is identified with money’s purchasing power. What makes an individual to accept money in exchange for her/his goods and services is the certainty that the sum received will allow her/him to purchase other items of an equal value. The pertinent question to ask, therefore, is where does money’s purchasing power come from. To explain how money acquires a positive purchasing power is to explain how we can pass from nominal to real money, to put it in the language of classical economists, or, using today’s terminology, from money to income. ‘We mean by the purchasing power of money the power of money to buy the goods and services on the purchase of which for purposes of consumption a given community of individuals expend their money income’ (Keynes 1930/1971: 48). Let us address this issue in the next section.

The logical and factual distinction between money and income

As we noted in the p...

Table of contents

• Cover
• Title Page
• Copyright
• Contents
• List of Tables and Figures
• Acknowledgements
• Introduction
• Part I: Modern Principles of Monetary Macroeconomics
• Part II: Business Cycle and Crisis Theories: A Fundamental Critique
• Part III: The Monetary Macroeconomics of Crises
• Bibliography
• Author Index
• Subject Index