The Money Economy
The third stage of economic development is reached when a medium of exchange is introduced. This is a far-reaching modification of the economic organization, and greatly increases the complexity of the economic process. Instead of one market transaction, exchange of goods (purchasing power) for goods (articles of consumption), we now have two separate transactions, exchange of goods (purchasing power) for money and exchange of money for goods (articles of consumption). It is clear, however, that the double transaction does not arrive at any different result; it merely reaches the same result by a more circuitous route.
This is typical of economic evolution in general. The fundamental objectives remain the same, but the process by which they are reached becomes more complex. As long as each person consumes that which he produces, economics is still in the amoeboid stage. But when specialization enters the scene it becomes necessary to introduce a process of exchange whereby the various kinds of goods desired for consumption can be obtained in return for the specialized goods that are produced. The simplest way of accomplishing this result is a direct exchange, but this process of barter is awkward and inconvenient, so for greater efficiency a system has been devised whereby the exchange is handled in two steps through the medium of money. When the two steps are complete, however, the final result is exactly the same as if the transactions had been carried out by means of barter. The goods have been exchanged, and nothing else of a significant nature has transpired. The money has not been altered in amount, and it is right back where it started from.
A useful analogy drawn from the physical world is the cooling of a gasoline engine. In this case the objective we wish to accomplish is to transfer heat from the engine cylinders to the surrounding air. We can do this in one step (analogous to barter) by direct contact, as in many aircraft engines and in some automobiles, but most automotive designers have found it convenient to use a transfer medium (analogous to money), which is usually water. The heat is first passed from the cylinders to the cooling water and then from the water to the air. The final result of this two-step process is exactly the same as when the cooling is accomplished by direct contact of air with the engine cylinders. The circulating medium has not been altered in any way, either in amount of in composition. Its only function has been to contribute to the efficiency and convenience of the primary process.
In both the engine cooling and the goods transaction a single operation has been carried out in two steps. The objective is not reached until both steps have been taken. Transfer of the engine heat to the cooling water is only half of the operation, and it accomplishes nothing by itself, as a motorist soon discovers if his radiator plugs up. The cooling system does not serve its purpose unless the second step is taken and the heat is transferred from the cooling water to the air. Similarly, exchange of goods for money is an incomplete transaction, only half of the total operation. The seller is not willing to stop here. He attaches no value to money per se; it has a value to him only as purchasing power by means of which he can buy goods. As in the case of the engine cooling, the transaction is not complete until the money proceeds of the original sale have been exchanged for other goods. The net effect of the transaction as a whole is therefore the same as that of direct barter. Goods (purchasing power) have been exchanged for goods (articles of consumption).
The general conclusions reached in this work by application of scientific methods and procedures are summed up in the form of a series of basic principles governing those aspects of production, exchange and consumption that are pertinent to the objectives of this work. These principles are the economic equivalent, in the area that they cover, of the laws of the physical sciences. They are independent of the particular forms of business and governmental institutions in vogue at the moment. They are as applicable to simple barter as to the most highly developed money and credit economy. They hold good under socialism, communism, fascism, or any other “ism” just as they do under the American individual enterprise system. The situations appropriate to some of these principles do not arise under the more primitive forms of economic organization, but whenever and wherever they do arise, these principles govern. It is not contended that the principles are usually valid or approximately correct, but that they are always valid and mathematically exact. The principles are simple, they are expressed in plain and unequivocal language, and their validity can easily be verified.
Furthermore, none of these principles is dependent in any way on the nature of human behavior. This assertion may be hard to accept after the way in which it has been drilled into us for decades that economics is a study of man’s actions and hence is essentially different in character from the physical sciences. But the truth is that applied science is also concerned primarily with human actions. Certainly the building of a bridge is the work of human beings. So is the design of an airplane, the synthesis of a new drug, the drilling of an oil well, or any other of the thousands of engineering and scientific tasks that might be mentioned. Science, pure and applied, deals with human actions, but not with the human aspect of those actions. The function of the physical sciences is to tell us what consequences will follow if specific actions are taken, or alternatively, what actions are necessary in order to achieve certain specific results. Economic science can do exactly the same thing. It cannot make our economic decisions for us any more than structural theory can decide whether we should build a new post office, or organic chemistry can decide whether we should make synthetic rubber. But it can tell us specifically and accurately, just as the physical sciences do in their respective spheres, what consequences will follow if we take certain actions, and it will thus enable us to adapt our economic actions to the results that we want to achieve.
The first of these principles that will be stated is the basic principle discussed in Chapter 3 that defines production as the only source of purchasing power.
Purchasing power is created solely by the production of transferable utilities, and it is not extinguished until those utilities are destroyed by consumption or otherwise.
The reason for specifying that the utilities must be transferable should be clear. Goods that have utility only to the producer or to their present owner have no status as purchasing power, regardless of the magnitude of that utility. A second hand watch possesses transferable utility and constitutes purchasing power, while a used dental plate does not, even though the latter may rank considerably higher in the esteem of the present owner.
In the barter stage of economic organization where goods are exchanged directly for other goods it is apparent that only goods can pay for goods. Now we see that the money economy does exactly the same thing, merely doing it indirectly rather than directly. Thus the same principle applies.
Only goods can pay for goods.
In earlier times, when this principle was emphasized in the economics textbooks, it was customary to add the qualification “in the long run.” Recognition of the incomplete status of the first step, the exchange of goods for money, makes this qualification unnecessary. Money is actually no more than a claim against the goods that have been produced, a claim that must ultimately be redeemed in goods of equal value. Of course, where money has an intrinsic value as goods, as in the case of the rare metals, that portion of the face value of the money that represents a value as goods is a partial payment.
Principles I and II are closely related. Since only goods can supply the ultimate purchasing power necessary to complete the two-step economic transaction, only the production of goods can create purchasing power. Whatever money purchasing power is obtained by any other means is only an additional claim against the same goods. It does not add to the total real purchasing power; it merely dilutes the value of the previously existing claims.
But even though the medium of exchange has no effect on the overall accomplishment of economic activity, it does play a very important part in the operation of the economic mechanism, and we will now want to give it some further consideration. The characteristics of money and money substitutes will be discussed at length later. The test of money is acceptance. If a commodity is accepted as a medium of exchange—that is, accepted not for its own utility, but as something that can be exchanged for other goods—then it is money; if not, it is not money. When we go a step farther and ask why certain commodities such as gold and silver are accepted as money whereas most goods are not, we find that there are a number of requirements, which a commodity must meet in order to be entirely suitable for use as a medium of exchange. The essential point is that variations in value must be minimized. This, in turn, means that the time and place utilities must be approximately constant. A circulating medium consisting of commodities of this nature, or credit instruments that have a similar acceptance as money, thus provides a means by which the full value of goods, including that of their highly perishable time and place utilities, can be transformed into a relatively permanent kind of value that can be used at the time and place most convenient for the possessor.
The only kinds of money accepted as such in the United States at present are the coins and currency issued by government agencies. The “money supply,” as defined by the economists, includes a number of other items, but unlike money, these items are not claims against goods, they are claims against certain specific quantities of money, and they have value only to the extent that such quantities of money actually exist, and are available. Bank deposits, for instance, the largest item in the so-called “money supply,” are claims against whatever money the bank may possess, the bank reserves, but these are much smaller than the total of the deposits. If the depositors write checks for a larger amount, the bank must arrange to obtain additional money from the Federal Reserve or some other outside source.
Gold and silver were once widely accepted as money, and gold still has this status to some extent. In the United States, however, the monetary metals must be sold, like other goods, to obtain money, and they do not add to the total money in use. The same is true of the various credit instruments classified as “near money.”
From the foregoing it can be seen that only the authorized government agencies can actually create money. It follows that the money in the economic system is conserved, and does not vary in total quantity except to the extent that it is created or retired by these agencies. (A small amount of destruction by fire, etc., occurs, but for analytical purposes we can consider the destructive forces as the equivalent of “authorized government agencies.”)
The difference between this view of the money situation and that found in the current literature of the economic profession is that present-day economic thinking does not distinguish clearly between that which has actual value and that which is merely a claim against values. Money is a claim against the goods that are produced. A quantity of the “bank money” or “near money” that the economists are including in their definition of the “money supply,” is only a claim against a claim. It does not add to the total of the claims against production, as a corresponding increase in the amount of money would do. Thus it has a much different effect on the streams of economic activity, as we will see later.
Because of the approximate constancy of value of the medium of exchange its introduction has done more than provide a common denominator to facilitate the exchange transaction. It has enabled storage of claims against goods independent of goods storage. This is a very significant point, but its major implications have been almost entirely overlooked by previous investigators because they have failed to appreciate the fundamental difference between drawing purchasing power from storage and creating it by production of goods. We will call the facilities for storage of money or goods reservoirs.
In the modern economies there are several different kinds of money reservoirs, but they all accomplish exactly the same result, a point that we will find very significant when we begin consideration of the methods that can be used for control of the reservoir transactions. The money storage may be done directly in a money reservoir, a bank, a pocketbook, or an old tin can, or government agencies may issue or retire money, or a nation’s currency may be acquired by foreign countries, which are then acting as reservoirs, so far as the domestic economy is concerned, or gold may be mined and used for money (not in the U. S. today). The activity in and out of these reservoirs is easily monitored, and the information required for control over the reservoir transactions is therefore readily available, if and when a decision is made to institute some kind of control.
Increases in the market prices of existing goods (particularly stocks, shares in the ownership of business enterprises) are often looked upon as sources of purchasing power. But these increases do not provide money purchasing power unless the goods are sold, and when the sale takes place it absorbs as much purchasing power from the buyer as it provides to the seller. Thus a transaction of this kind does not provide any more total purchasing power; it merely transfers purchasing power from one individual or group to another.
With the benefit of a realization that there are reservoirs in the circulating stream of money purchasing power that have a profound effect on the flow from production to the markets, it is now possible to return to the creation of purchasing power and to clear up another issue: the quantity that is created. Here, again, the facts are clear and unmistakable. Production of goods and creation of purchasing power are one and the same thing. That which we produce is purchasing power to us but goods (articles of consumption) to others. That which others produce is purchasing power to them but goods (articles of consumption) to us.
Purchasing power and goods are simply two aspects of the same thing, and they are produced at the same time, by the same act, and in the same quantity.
Production in excess of purchasing power is mathematically impossible. Nothing can exceed itself. It is immaterial whether the relative values of goods rise or fall; if the purchasing power of certain goods decreases because of a drop in relative value, the purchasing power required to buy those goods decreases by exactly the same amount.
This principle is not new. It was first stated by J. B. Say, one of the early French economists, and it is known as Say’s Law of Markets. To the economic profession it has been one of the great enigmas of their branch of knowledge. On the one hand, the “law” is so simple and logical that its validity is almost self-evident, but on the other hand, Say’s deduction from it, the seemingly obvious conclusion that the purchasing power available in the markets will always be sufficient to buy the full volume of production at the prevailing prices, is so completely at variance with actual market behavior that the law cannot command general acceptance either. The result is confusion.
An understanding of the role of the purchasing power reservoirs clears up the contradiction. We can now see that Say and his successors misjudged his finding. It is not a Law of Markets; it is a Law of Production. As such it stands solid and unshakable. Purchasing power is created in exactly the right quantity to buy the full volume of goods produced at the full production price. The availability of money purchasing power in the markets is an entirely different matter because of the presence of money reservoirs in the circulating stream.
The three fundamental principles that have been stated thus far make it clear that there is only one way in which the basic economic objective of increasing real purchasing power—ability to buy goods—can be attained. That is by increasing the production of goods, just as the only way by which we can increase the amount of heat transferred from the radiator of the automobile to the air (if we can think of any reason why we should want to do this) is by generating more heat in the cylinders. Real purchasing power (transfer of heat) cannot be increased by raising money wage rates (higher rates of water flow) or by cutting prices (lower rates of water flow) or by increasing the money supply (putting more water into the cooling system) or by shifting purchasing power from one group to another (stirring the cooling water) or by subsidizing some consumer group (which is just another way of accomplishing a transfer from one group to another) or by any of the other “something for nothing” schemes that are so plentiful in economics.
Further consideration will be given to each of these all too prevalent economic fallacies at appropriate points in the subsequent pages, but most of the obstacles that stand in the way of getting a clear view of the economic process can be avoided simply by keeping in mind that the whole object of any economic system—the sole reason for its existence—whether it is the simple barter economy of a savage tribe or the enormously complex mechanism that has been developed by the more advanced nations, is to provide a means whereby individuals may exchange the goods that they produce for the goods that they wish to consume, at the times that are convenient for them.
Another important result of the introduction of money into economic processes is that values are now customarily measured in terms of an arbitrary monetary unit whose relation to the true values (measured in terms of goods) is subject to continual variation. The true values, generally called “real” values, are widely used in economic discussions, but economic transactions in general are carried on in terms of monetary units—dollars, pounds, yen, etc. The ratio of real value to money value is the “value of money,” a quantity whose variations are responsible for many errors and misconceptions in economic thought, among economists as well as among laymen.
Most of the relations that will be developed in the subsequent discussion are just as valid in terms of money as in real terms, and the words “price” and “value” will normally be applied to both concepts without qualification. Where it becomes necessary to draw a distinction, such terms as “money value” and “real wages” will be used.
To illustrate what the word “value” means in their terminology, economists often make some such statement as this: “If one orange can be exchanged for two apples, then the value of one orange is two apples and the value of two apples is one orange.” Strictly on the basis of their definition of value as “exchange value,” this assertion is correct, but it gets us nowhere. It amounts to nothing more than a restatement of the definition in different words. However, the economist who makes this statement is doing something else with it; he is transferring conclusions reached on the basis of his own special definition of value to another totally different value concept. When he says that the value of one orange is two apples, he is not intending to convey the idea that this is true simply because he has set up his definition in this manner. He is implying that the orange is worth two apples; that is, he is using the word “value” in its ordinary everyday significance.
The difficulty here is that whereas the statement is true but meaningless as long as the economist stays with his own definition, the switch to a new definition in midstream has made it meaningful but untrue. Even a child in kindergarten knows that if he exchanges two apples for one orange, he cannot get the apples back unless he offers more than one orange. The exchange was made in the first place because the orange was worth more than the two apples to the original possessor of the apples, whereas it was worth less than the two apples to the original possessor of the orange. Both parties to the transaction thus experienced a gain in values as a result of the exchange, and if the transaction were reversed both would lose. Hence it cannot be reversed. Economic transactions are irreversible.
Here is the reason why it is essential to recognize the concept that we are calling “value” in this work, the amount that an individual is willing and able to pay for the goods in question. If we follow the example of the modern economist and attempt to carry out our analysis without the use of this concept, we not only have no explanation of this important fact that economic transactions are irreversible; we have nothing that explains why such transactions should take place at all. Present-day economic analyses take “demand” as their point of departure. “Let us start with demand,” says Samuelson, “Everyone has observed that how much people will buy at any one time depends on price.”44 But why should they buy this specific item at all? Why do they buy this at a high price rather than that at a low price? What are the limits on demand and price, and why do they exist? These are not trivial questions; they go to the heart of the economic process, and before we can accomplish our defined objectives we must put ourselves in a position to be able to answer them. As will be brought out in the pages that follow, lack of a clear understanding of the factors that determine the overall ability of the consumers to buy goods is responsible for some of the most serious errors in current economic thought and practice.
One of the important generalizations in the physical field is the Second Law of Thermodynamics. This law specifies that naturally occurring physical processes can move only in one direction: a direction that involves degradation of energy to a less available state. This degradation is measured quantitatively by an increase in a property known as entropy, and the Second Law can therefore be expressed concisely by the statement that naturally occurring processes always involve an increase in entropy. Value, as defined herein, plays the same kind of a role in economics that entropy does in physics. All voluntary economic transactions involve an increase in values. Hence goods can move only in one economic direction, gradually increasing in value as they approach the ultimate consumer, because of the continued additions of time and place utility.
If everyone had to go to the refinery to buy gasoline, the value of gasoline to the ordinary consumer would be low; it is only the omnipresence of the service station that makes gasoline powered transportation feasible on a large scale. So we have a whole series of values for gasoline, beginning relatively low at the refinery and increasing step by step until the ultimate consumer pays the retail price. But these values only hold good as long as the economic stream flows in the same direction, and no attempt is made to reverse any of the transactions that have taken place. If the automobile owner decides that he has bought too much gasoline and wants to convert some of it back into money, he finds that the value of gasoline has shrunk. He either has to accept a substantially lower price, or he has to spend time and effort in finding a retail buyer, which amounts to the same thing.
Gasoline therefore does not have a unique value that can be identified as “exchange value. ” At any specific time and place it has two values to anyone who appraises it: a downstream value in the direction of the consumer and an upstream value away from the consumer. A transaction, which involves movement of goods toward the consumer, increases the actual time and place utilities, whereas one in the opposite direction decreases the actual utility. Since this actual utility is one of the determinants of value, the change in utility also changes the value. The function of money, where it enters into the economic picture, is to provide a medium, which is independent of time and place, and therefore has equal value in both directions. This enables producers to convert the value of their products as objects of consumption, including the full value of the time and place utilities, into a form in which the value is invariable (ideally, at least).
The necessity for value differences to furnish the driving power for economic transactions, together with the irreversibility of these transactions because of the value differences, means that there is no such thing as a pure “exchange” in economic life, and expressions such as “exchange value,” or “stock exchange,” are to some extent misleading. A market transaction is an exchange, to be sure, but it is not merely an exchange; it is a dual process of sale and purchase. Aside from minor and incidental transactions, the original producer only sells, the ultimate consumer only purchases. Middlemen do both purchasing and selling, but they do not buy and sell at an “exchange price.” They buy at one price and sell at another. Even barter is not a pure exchange from an economic standpoint. What appears to be a simple exchange of wheat for fish, for example, is a dual economic process. The farmer is using excess wheat (purchasing power to him) to buy fish (goods to him), whereas the fisherman is using fish (purchasing power to him) to buy wheat (goods to him). The difference between this and a mere exchange quickly comes to light if one tries to reverse such a transaction. It then becomes apparent that the value of either commodity as purchasing power is considerably less than its value as goods.
It is quite possible that a decrease in value may take place at some point along the economic path where increasing value is the general rule, but such decreases do not take place by reason of economic transactions; they are the results of unilateral revaluation between transactions. A merchant may buy certain goods at a relatively high price and then find that he cannot sell them unless he reduces his selling price to a point below the original cost, so that he sustains a net loss, but this does not alter the fact that both of his transactions, purchase and sale, increased values at the time they occurred. The value of the goods to the merchant at the time of purchase exceeded the price that he had to pay; otherwise he would not have bought them. Their value to him at the time of sale was less than the selling price; otherwise he would not have sold them. Both transactions increased values, but between the time of purchase and the time of sale the merchant found that he had made a mistake, and he was forced to reduce his valuation of the goods.
The difference between the value to the buyer and the value to the seller can be compared to the physical concept that we call “force.” Where appropriate conditions exist in the physical field, an unbalanced force causes physical motion. Where appropriate conditions exist in the economic field, a difference in values causes economic motion; that is, an economic transaction.
Theoretically, any unbalanced physical force—a net excess in one direction or the other—will cause motion. In practice, however, this excess force must normally be great enough to overcome a certain amount of friction before movement is possible. Similarly, in the economic field there is economic friction to overcome, and transactions do not take place unless the difference in values is sufficient to overcome this friction. The market transaction is therefore a complex event involving a range of values whose significance cannot be accurately reflected by any single quantity such as the sales price, or “exchange value.”