Money and Payments in Theory and Practice

Sergio Rossi

• Publisher: Routledge
• Year: 2007
• ISBN:
  9781134190782
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

International in scope and written by a leading young Post-Keynesian economist, this book focuses on the working of money and payments in a multi-bank settlement system within which banks and non-bank financial institutions have been expanding their operations outside their countries of incorporation.Departing from conventionally held beliefs, Serg

1 Money and credit

The nature and role of money and credit never cease to fascinate economists. In fact, a number of other scientists have also been attracted by the study of money, and of its essence in particular, as Ingham (2004) shows in painstaking detail with respect to sociology. Indeed, since the writings of Plato and Aristotle, money has been at centre stage of economic debate, and several controversies on its origins and functions have been animating the history of monetary thought (see e.g. Realfonzo 1998; also Smithin 2003). The principal questions that are still debated today go to the roots of money’s nature in modern economic systems (see Smithin (2000) for a survey). They ask notably: What is money? How is money created? Where does the value of money come from? The list of questions seems to be endless in this domain, if one merely browses the enormous monetary economics literature, just to remain within our profession.

To answer these and many other questions, one has to disentangle first the nature of money. In spite of its simplicity, this is in fact an extremely complex question, so much so that, as Schumpeter (1954/1994: 289) pinpointed, ‘views on money are as difficult to describe as are shifting clouds’. Despite 200 years of monetary economics, it is indeed no exaggeration to claim that ‘the definition of money can still be regarded as an almost unresolved issue’ (Bofinger 2001: 3).

Now, following Goodhart (2005: 817), one can distinguish two main theories about the nature of money: metallism and chartalism. Although the origins of both theories may be traced back to the work of Aristotle and Plato respectively, the labels metallism and chartalism were first used by Knapp in 1905 only (see Knapp 1924). As a matter of fact, metallism and chartalism are schools of thought that have been confronting since the inception of monetary analysis, whose origin may be found in the sixteenth century (see e.g. Goodhart 1998, Bell 2001). They led also to many debates between the banking and currency schools in the eighteenth and nineteenth centuries (see e.g. King 1804, Ricardo 1809/1951, Fullarton 1844, Mill 1844). Indeed, both metallism and chartalism aim to explain the origins, nature and value of money in a logical as well as historical framework, but according to different, and in many ways opposing, paradigms, as Schumpeter (quoted in Ellis 1934: 3) pointed out when he observed that ‘the commodity theory and the claim theory . . . are incompatible’.

The basic tenet of metallism, from which this theory takes its name, is that money is a commodity, often in the form of a precious metal. By way of contrast, the essence of chartalism is that money is a social relation independent of any material representation of it: ‘money is a “claim” or “credit” that is constituted by social relations that exist independently of the production and exchange of commodities’ (Ingham 2004: 12). Let us consider these two perspectives on money’s nature in turn.

The essence of money

The commodity theory of money: a critical appraisal

The definition of money that stems from metallism stipulates that ‘any commodity to be called “money” must be generally acceptable in exchange, and any commodity generally acceptable in exchange should be called money’ (Fisher 1911/1931: 2). More specifically, metallists consider money as ‘a creature of the market’, in the sense that it has been generated by a search process which agents spontaneously carried out to solve the problem of the so-called ‘double coincidence of wants’ existing in barter trade. As Jevons (1875: 3) noted in this respect, when two individuals meet, one not only has to have what the other wants but also has to want what the other has and wants to offer. This double coincidence of wants being difficult to observe in practice, the use of a medium of exchange arose from the market exchange process. ‘Think, indeed, of the peculiar difficulties obstructing the immediate barter of goods in those cases, where supply and demand do not quantitatively coincide; where, e.g. an indivisible commodity is to be exchanged for a variety of goods in the possession of different persons’ (Menger 1892: 242).

In minimizing their transactions costs, traders discovered that commodities have what Menger (1892: 242) dubs ‘different degrees of saleableness’. As commodities are more or less saleable in respect of the greater or less ease with which they can be disposed of at any convenient time and at current market prices, according to Menger (ibid.: 244–5) the market mechanism of supply and demand induced traders to identify a commodity generally accepted in exchange for all sorts of real goods, services and assets. This commodity then becomes a medium of exchange in the Friedman (1974: 8) sense that ‘[it] enables the act of purchase to be separated from the act of sale’. In this view, ‘a monetary system of exchange is one in which the vast majority of transactions involve money on one side’ (McCallum 2004: 81–2). To put it in the famous Clower (1967: 5) phrase, ‘money buys goods and goods buy money; but goods do not buy goods’.

Thus money exerts the function of an intermediary in the exchange of (nonmoney) goods, a definition that begs the question of money’s nature, as Clower (1967: 4) himself noted when he stated that ‘[we have] to express analytically what is meant when we assert that a certain commodity serves as a medium of exchange’. In fact, the economics profession has been defining money by its functions at least since Hicks (1967: 1) conventionally affirmed that ‘money is what money does’ (although see also Walker (1880: 1) for the same statement). Yet, as Bofinger (2001: 4) cogently noticed, this definition is prone to circularity, and is thus useless analytically: ‘If it is not clear what “money” is, it is also not possible to describe the functions of “money”.’

Neglecting or even ignoring this vicious circle in defining money by its functions, and although money might wield other functions as well, metallists consider that money is essentially a medium of exchange, which existed as a stock in a variety of forms such as rocks, leather, furs, spice, salt, tobacco, and even slaves or wives, and more recently in the form of precious metals (gold and, to a lesser extent, silver) owing to their intrinsic and, in fact, physical properties (the most important properties being their homogeneity, divisibility, portability and durability; see Clower 1967, Spindt 1985). In light of these characteristics of the most often and widely used media of exchange, metallists maintain that the advent of paper and bank monies further reduced transactions costs and those costly market ‘frictions’ that money would help ‘lubricate’ (on the concept of frictions in monetary economics see Niehans 1978: 16). In this view today, ‘probably the most prominent concern is that the continuing rapid development of information technology (IT) could lead to the disappearance of money as more IT-intensive methods for conducting transactions come to predominate’ (McCallum 2004: 81).

As a matter of fact, the Mengerian view of money as a commodity, or as a good that buys other (non-money) goods, has led economists to adopt an evolutionary approach to money’s nature, in which the very object of their analysis is bound to disappear in a not too distant future, owing to the full dematerialization of the money stuff driven by IT (see Dembinski and Perritaz 2000). Whether this destiny will provoke a revolution in the analysis of money is an open question that we cannot answer at the time of writing. Indeed, if the answer to this question were affirmative, the basis of mainstream teaching in any economics course on ‘money’ would (have to) change soon and radically (see Schmitz (2002) for a critique of Menger’s definition of money and of the neoclassical models currently based on it).

Indeed, the Menger approach to money’s nature and functions has been taken up by a number of neoclassical economists, led by authors such as Brunner and Meltzer (1971), Ostroy (1973), Jones (1976), Alchian (1977), and Kiyotaki and Wright (1989, 1991, 1993), the latter two authors developing a so-called search theory of money’s origin that is now the mainstream approach to monetary economics (see Gravelle 1996: 402, Goodhart 2005: 818). The challenge taken up by Kiyotaki and Wright, and also by their numerous followers (see e.g. Kehoe et al. 1993, Matsuyama et al. 1993, Williamson and Wright 1994), was to provide a logical answer to the crucial question as to why ‘every economic unit in a nation should be ready to exchange his goods for little metal disks apparently useless as such, or for documents representing the latter’ (Menger 1892: 239). As Niehans (1978: 14) puts it, ‘[t]he problem was to explain precisely why money stocks are useful. It is clear that, except perhaps for irrational misers, cash balances are not one of the genuine consumer goods appearing in consumer theory. . . . It is also clear that money is not one of the genuine producer goods, appearing in an ordinary production function.’ Clearly, neither a money-in-theutility- function approach nor a money-in-the-production-function approach can be helpful in order to understand and provide an answer to the rationale for the uses of money in both production and exchange (see Handa (2000: 56–67) for a survey of these two approaches, according to which money could be introduced indirectly in a utility or in a production function in light of the payment services that it provides – more on this in Chapter 2).

The metallists’ answer is that the value of commodity money derives from the value of the commodity used as a medium of exchange, such as gold. As to the value of paper money, they argue that it derives from the intrinsic value of its metal backing (Menger 1923). They want it for proof the fact that, in several countries, and particularly for monetary policy purposes, paper money has been de jure, but very often also de facto, convertible into a stock of precious metal at a fixed rate of exchange for quite a long historical period (see e.g. Morgan 1943: 138). To substantiate their view further, metallists argue that paper money is the ‘general equivalent’ of all real goods and services on sale. As Ingham (1996: 513) and Bell (2001: 153) notice in this respect, this argument stems from Walras’s (1954) general equilibrium analysis, according to which money is the numéraire against which all other non-money items (real goods, services and assets) are exchanged. Indeed, as Walras (ibid.: 188) claims, ‘[o]ur standard of measure must be a certain quantity of a given commodity’. This definition, as is well known and widely accepted, includes money in the set of commodities, and thus raises Ricardo’s (1817/1951) problem of finding an invariable measure of value in the actual set of commodities existing in the whole economy.

In fact, Ricardo’s (1951: 43) lifelong attempt at finding an ‘invariable standard measure of value, which should itself be subject to none of the fluctuations to which other commodities are exposed’, was bound to fail, as he was looking for a physical (be it material or immaterial) thing that does not and cannot exist in the real world. Indeed, according to Ricardo’s (ibid.: 361) definition of value:

The only qualities necessary to make a measure of value a perfect one are, that it should itself have value, and that that value should be itself invariable, in the same manner as in a perfect measure of length the measure should have length and that length should be neither liable to be increased or diminished; or in a measure of weight that it should have weight and that such weight should be constant.

In the real world, however, no commodity can have an invariable value, as commodities have to be produced by labour (and capital), and this occurs at variable costs owing to several factors, among which wages and technology are the most prominent factors (see Chapter 2 for analytical elaboration). Consider, for instance, a commodity such as a precious metal, say gold. As Ricardo (1816/1951: 55) himself noted in his Proposals for an Economical and Secure Currency, ‘[w]hile the precious metals continue to be the standard of our currency, money must necessarily undergo the same variations in value as those metals’. Clearly, the value of precious metals is subject to variation for a number of reasons (related to their production costs), which cannot make sure that a commodity like gold has invariable value, independently of the time horizon considered (from one business day to several centuries and beyond). Indeed, the problem highlighted by Ricardo has no logical solution because it is couched in a physical world, in which every thing, like a commodity, is a dimensional item and, as such, can be seized by several dimensional units of measurement in order to express its length, weight, density, brightness and so on. Essentially, as Keynes (1936/1973: 38) noted, all commodities are heterogeneous owing to their (multifaceted) dimensional nature. As such, they are incommensurable. If money is actually the standard of value, therefore, it has not to be itself a commodity, because otherwise it would itself need to be measured using another standard of value, in which case infinite recursivity makes this measurement logically impossible within the realm of physical magnitudes.

It is therefore necessary to consider the nature of money abstracting from the physical world, and its related dimensional units of measurement, to understand the peculiar as well as proper nature of money. Indeed, Smith (1776/1976) was well aware of the fact that money has not to be mixed up with a particular commodity. Although in his time money was reified into a precious metal, which blurred the distinction between money proper and money’s worth, he observed lucidly that ‘[t]he great wheel of circulation is altogether different from the goods which are circulated by means of it. The revenue of the society consists altogether in those goods, and not in the wheel which circulates them’ (Smith 1776/1976: 289). As he explains:

When, by any particular sum of money, we mean not only to express the amount of the metal pieces of which it is composed, but to include in its signification some obscure reference to the goods which can be had in exchange for them, the wealth or revenue which it in this case denotes, is equal only to one of the two values which are thus intimated somewhat ambiguously by the same word, and to the latter more properly than to the former, to the money’s worth more properly than to the money.

(ibid.: 290)

Having noted that money proper and money’s worth are two concepts that do not have to be mixed up, both analytically and in practice, however, Smith makes no attempt to define the nature of money. Indeed, this definition has been lacking at least since the commodity theory of money was put to the fore, because ‘the real problem is not one of classification but of a better analytical understanding of the functions of a medium of exchange’ (Niehans 1978: 16, fn. 39).

General equilibrium analysis provides some clues worth considering in this respect. In this analysis, money enters every monetary exchange as the general equivalent of any non-money good. As such, money ‘plays a distinctive asymmetric role as one side of virtually all transactions’ (Starr 1980: 263). Now, as Walras (1954: 188) argued, the numéraire, that is, money, should be understood for what it is essentially and not for what it is physically: ‘the word franc [meaning the standard of value] is the name of a thing which does not exist.’ Both Pigou (1949: 3) and Robinson (1956: 28) argued in the same vein, pointing out that money is not a physical thing. To put it clearly, two definitions of the numéraire exist in the history of monetary thinking: a physical and a numerical definition. In this respect, according to Pasinetti (1993: 63–4), there is

an important asymmetry between monetary regimes in which the numéraire of the price system is physical, and monetary regimes in which the numéraire of the price system is a purely nominal unit of account, not linked to any quantitative specification of any particular physical commodity.

In fact, it is well known that neoclassical economics, following Walras, considers the numéraire as a physical thing, namely, the nth commodity within a general equilibrium system encompassing n equations of supply and demand, one for each commodity. Therefore, in the words of Hicks (1967: 3),

although Walras does take one of his n commodities as numéraire (or unit of account) it is an essential part of his theory that the numéraire does not enter into the exchange in any different way from any other of the commodities.

As a matter of fact, in Walrasian economics

[t]he numéraire is not money; it is not even a partial money; it is not even assumed that it is used by the traders themselves as a unit of account. It is not more than a unit of account which the observing economist is using for his own purpose of explaining to himself what the traders are doing.

(ibid.: 3)

In short, in general equilibrium analysis money is inessential in the sense of Hahn (1973: 231): it is not necessary to consider money as a unit of account in order to determine the mathematical solution of a general equilibrium model (Rogers 1989: 63). As Fuerst (1994: 582, fn. 2) points out, ‘the Walrasian auctioneer obviates any need for a medium of exchange’, which amounts to saying that, apart from money, that is, the nth commodity taken as numéraire in general equilibrium analysis, ‘[a]ny of the other n–1 commodities might have been taken as numéraire’ (Hicks 1967: 3).

To obviate this internal critique, many neoclassical authors introduce some frictions that hinder the instantaneous (factors and/or goods) market clearing, and that money can help alleviate (see e.g. Brunner and Meltzer 1971, Grandmont and Younès 1972, Clower 1977, Starr 1989). If this strategy avoids the criticism of money not being essential in general equilibrium analysis since it averts the double-coincidence-of-wants problem, the problem remains that, according to this analysis, the nature of money is that of a commodity, which logically requires that its value be measured with a numerical unit of account, not to be included in the set of commodities. This takes us back to the Ricardo problem noted above.

In order to solve this problem, Debreu (1959) considers the numerical definition of the Walrasian numéraire, and assumes axiomatically – as he spells out in the subtitle of his major work – that ‘with each commodity, say the hth one, is associated a real number, its price, p_h’ (ibid.: 32). Now, while it is undisputable that money prices are real numbers, Debreu’s approach to the definition of money and prices does not really explain how it is possible to associate a real number with a particular real good, service or asset. As a matter of fact, this association being axiomatic in Debreu’s analysis, it stems from a convention that the author wants the economics profession to accept as such with no misgivings in order to pave the way for a mathematical treatment of macroeconomic magnitudes and phenomena. ‘The majority of economists seem to accept this procedure mainly because it allows them to reduce economics to a branch of mathematics’ (Cencini 2001: 21). Yet, ‘[t]o claim that goods are numbers because we need them to be numbers is scientifically unacceptable’ (ibid.: 21).

Indeed, monetary economics has to explain analytically why and how commodities can be replaced by real numbers, and particularly why the nature of money is numerical and not physical, as Walras’s general equilibrium analysi...