A discussion of money and the monetary policy from the perspectives of the classical economists

Transcription

1 A discussion of money and the monetary policy from the perspectives of the classical economists April 2012 Money and monetary policy have been in the centre of many debates long before Adam Smith developed a quasi-scientific, if not fully scientific, theoretical framework for the analysis of political economy. Ever since money replaced barter to facilitate exchange, there have been many different theories as to how this system of exchange should be handled, if it should be handled at all. With the rapid development of financial markets and the advents of the 2008 financial crisis and the 2011 Euro crisis, it is timely to reconsider the monetary system through historical perspective. This essay will focus on the discussion of ideas from the classical era of economics, closely following the writings of prominent scholars of political economy of the late 18 th and early 19 th centuries, and a modern approach will be used supplement and support the discussion where relevant. The essay will first reconsider the early, fundamental definitions of money, followed by a discussion of the Bullionist Controversy of the 19 th century and bullionism. Finally, the essay will attempt to apply the historical discussions to a basic analysis of the present-day lack of metallic standard and the US Federal Reserve s quantitative easing. Although this essay cannot fully examine the monetary system, it is still valuable to make some intriguing linkages between past insights and present-day phenomena. Before the discussion begins, a disclaimer must be made: the views of the classical economists are the very beginnings of economic analysis, and much of these views have been repeatedly challenged, if not scrutinised, and modern day economics have more sophisticated models which (make attempts) to explain current monetary phenomena. Hence, the purpose of this essay is simply to cast a different hue of light, and may not be absolutely correct, if such absoluteness even exists in the field of economics. The philosopher Adam Smith makes the concept of money emphatic in Book II of The Wealth of Nations. According to Smith (1994 [1776]), money resembles fixed capital, though he also admits that it is the ambiguity of language only which can make this proposition appear either doubtful or paradoxical (p. 314). Smith elaborates that the term is sometimes used to describe nothing but the metal pieces of which it is composed, and at other times some obscure reference to the goods which can be had in exchange for it (p. 315), clearly outlining the ambiguity of the term. Smith has also digressed on the importance of considering the circulation of money, because although the quantity of money is, to a certain extent, fixed, the revenue of the society is based on the number of transactions which occur, which is one of the reasons why solely the amount of money cannot determine wealth (pp ). Hence, Smith concludes that money is the great instrument of trade, [and] though it makes a very valuable part of the capital, makes PAGE 1 OF 7

2 no part of the revenue of the society to which it belongs (p. 317). An earlier, but similar, definition of money can also be found in David Hume s (1753) essay Of Money. Smith s comprehensive digression brings out an important concept of money: essentially, money denotes only the value of the goods for which it can be exchanged; inherently, money is but a facilitator of trade and does not have value of its own. This concept is essential because it argues that any measurements of wealth must ultimately depend on the quantity of real commodities produced by an economy, and this explanation can be extended to paper money, which is essentially a replacement of a very expensive instrument of commerce with one much less costly and sometimes equally convenient (Smith, 1994 [1776], p. 317). Friedman (1994) also candidly states that the monetary system is no more than a fiction (p. 10), as money is nothing more than a mutual agreement between all members of the society to place a fictitious value on money so that it can be used to trade goods. Although Smith has clearly stated that the value of money is determined ultimately by real goods, its value is remains fictitious and arbitrary. According to Smith (1994 [1776]), the value of goods can only be determined by their relative costs, and the monetary values of the respective goods only need to reflect such relative costs. From this, the classical economist David Ricardo attempted to develop of the labour theory of value, to distil the costs of production down to the cost of labour. However, Ricardo s theory was not nearly sufficient for explaining value, and modern day economics utilise a more comprehensive model of demand and supply to analyse aggregate price levels. Although these concepts of money are rudimentary and simple to understand, they are also the roots of problems associated with the monetary system. The complications in the mechanism of money remain a difficulty which resurfaces in the consideration of monetary policies. However, before such policies can be discussed, the history of the monetary system must be carefully examined. Theoretically, money can be represented by any commodity; however, money in 18 th century Europe was mostly metallic, commonly gold and silver. Smith gives a well-reasoned explanation for this phenomenon. To quote Smith (1994 [1776]): Metals can not only be kept with as little loss as any other commodity, scarce any thing being less perishable than they are, but they can be divided into any number of parts, as by fusion those parts can easily be re-united again; a quality which no other equally durable commodities possess, and which, more than any other quality, renders them fit to be the instruments of commerce and circulation. (pp ) Soon, however, bank notes were introduced: bank-issued papers which gave the bearer the right to withdraw the amount of metal specified. Therefore, bank notes were largely similar to metallic money, and PAGE 2 OF 7

3 were more convenient to manage and carry, which suited the purposes of merchants. The implementation of paper money meant that some form of regulation must be in place in order to standardise paper money. David Ricardo, in The High Price of Bullion, has brought up the fact that only one metal should be used as a standard because otherwise, the value of one metal will be affected by its price relative to that of the other metal (as cited in Friedman, 1994). However, this was not a main concern, because although Britain was officially on a bimetallic standard during the late 18 th and early 19 th centuries, they were on a de facto gold standard, and most of continental Europe adopted the silver standard. Nevertheless, the bank notes had given governments the ability to manipulate the provision of gold and silver, which ultimately resulted in the Bullionist Controversy. In light of the Napoleonic Wars of the early 19 th century, the British Parliament adopted the Bank Restriction Act of 1797, and banned the conversion of bank notes to gold. This is motivated by a political need to prevent mass conversion and leakage of bullion out to foreign countries. However, this also meant that British banks no longer had the need to maintain a certain stock of bullion in their vaults to match the number of notes issued. This sparked a number of debates between the bullionists who condemned the Act, and the anti-bullionists, who were in favour of the Act. Bullionists, such as David Ricardo, argued that there needed to be a limit on the quantity of money which can be issued. In The High Price of Bullion, Ricardo (1951 [ ]) states that by restricting the Bank from paying in specie, have enabled the conductors of that concern to increase or decrease at pleasure the quantity and amount of their notes (pp ), which meant that number of notes which could be issued were no longer limited by the scarcity of precious metals, and were instead left to the will of the note issuers. Ricardo has then extended the argument and reasons that the loosened restriction has caused the value of the bank notes to depreciate and inflation to occur. This is comprehensible, even when considering Smith s definition of money the increase in the number of bills do not affect the value of real goods of the economy because ultimately, value is determined by the relative prices, and not the nominal factors. This is based on David Hume s quantity theory of money in his essay Of Money. Hume (1753) proposed that in the long run, the greater or less plenty of money is of no consequence (p. 36). From a modern perspective, the quantity theory of money indicates that changes in money supply will be directly reflected by the changes in price level only and that inflation will be the ultimate consequence of manipulating bank notes (Friedman, 1994). This distinction between real and nominal variables is now known as the classical dichotomy. On the other hand, the anti-bullionists of the 19 th centuries adhere more closely to the real bills doctrine, based on Adam Smith s original reasoning. They did not agree that note issuers have the incentives to increase the amount of notes issued indefinitely. The concept of the real bills doctrine is that issuing notes will not be inflationary if the banks acquire assets of equal value as collateral. Smith (1994 [1776]) likens PAGE 3 OF 7

4 this concept to a water pond, which will always remain full as long as the inflow of water is equivalent to the outflow (p. 331). By exchanging bank notes with bills of exchange, merchants were obliged to repay the bank without question, thus they would only demand enough bank notes to support their mercantile trading. As such, banks will not over-issue notes (in the form of liabilities) and therefore, the non-convertibility issue was irrelevant and would not cause inflation. Ricardo, following his bullionist reasoning, decided to reinstate the gold standard by passing the Resumption Act in 1819 and by 1821 (two years earlier than planned), bank notes were once again subjected to full convertibility. However, as the Bank Restriction Act had been in place for almost two decades, and the money price of gold was much higher than mint prices. Therefore, Ricardo chose to deflate the economy during a post-war period of recession and worsened the economy. Ricardo s error has since been attributed to his hubris and ignorance of Hume s analysis of money which is that prices are sticky in the short-run, and thus the quantity theory of money does not hold and changing money supply has devastating effects on the real economy (Perlman, 1986). In fact, Hume has suggested that an expansion of the money stock has favourable effects on output and employment (Wennerlind, 2005). Furthermore, Hume s stance in monetary policies has been ambiguous and he has considered possible alternatives to the quantity theory of money (Wennerlind, 2005). The Bullionist Controversy has given insight into monetary systems and present-day issues concerning monetary policies are closely related to the 19 th century debates outlined previously. Although financial markets have undergone massive changes, the debates associated with the Bullionist Controversy are still as relevant as ever. The abandonment of convertibility and the gold standard in 1971 after the establishment of the Bretton Woods system was not dissimilar to the Bank Restriction Act of However, the Bretton Woods system made the fiat US dollar the world s reserve currency, and so the effects of non-convertibility are much more far-reaching than when non-convertibility had been introduced in the Those who wish to reconsider reinstating some form of metallic standard should, therefore, find the ideas discussed in the former section of this essay essential. Perhaps the most interesting aspect of money is that it is currently more fictitious than what Smith had first proposed; the monetary system today is mostly based on fiat money. By definition, this means that money is a government decree. Reconsidering the definition of money, namely a tool to facilitate trade with no value of its own, the concept of fiat money does not seem unreasonably far-fetched. However, there is at least one strong assumption behind fiat money which may be more unconventional than it first appears: the currency in question must be backed by a trustable government. In some countries such as Zimbabwe, a dysfunctional government has caused the entire monetary system of Zimbabwe to collapse. Fortunately, Zimbabwe s dysfunctional system has done little to impact the world economy. PAGE 4 OF 7

5 One must, however, also consider powerful governments, especially the Government of the United States of America. The US dollar is currently the reserve currency of other governments, which implies that central bank reserves depend heavily on the value of the US dollar, and few questioned the integrity of the US Government prior to the financial crisis of However, the US has the power to manipulate the global financial market because the Federal Reserve s control of the US dollar is almost absolute, and political factors in a globalised world only serve to further complicate the situation. Perhaps the most controversial monetary policy at the Federal Reserve s disposal is quantitative easing, which many would attribute to money-printing. This is possible because the US dollar is a fiat currency and there are no standards, metallic or otherwise, to limit its production. Therefore, according to the bullionist quantity theory of money, this can cause potential long-run inflation. Inflation, especially in the long run, is currently a major concern for the global economy, and the quantity theory of money firmly attributes this to excess money supply. Inflation has also been attributed to rising oil prices, although some believe that this does not convey the full picture: a comparison between oil and gold prices shows that the relative prices of these commodities have been constant, suggesting that the excess supply of fictitious fiat money (due to quantitative easing) is the true contributor of the high oil prices putting the quantity theory of money in a realistic perspective (Miller, 2011). In addition, Friedman (1994) argues that the lack of a gold standard has contributed to price instability. According to his regression analysis, prices should be more stable given that the gold standard was not abolished. However, the hubris of Ricardo serves as a reminder of the consequences of ignoring the short-term effects of price stickiness proposed by Hume (recall that Ricardo s plan to deflate the economy ultimately aggravated the post-napoleonic War recession). With high gold prices, it is, perhaps, unreasonable for the Federal Reserve to reinstate the metallic standard in the short run as it would involve the same deflationary procedure implemented by Ricardo in the Resumption Act. As such, some believe that quantitative easing is an acceptable method to stimulating the short-run economy; a modern version of the real bills doctrine may be adopted to justify quantitative easing, as the US dollars printed by the Federal Reserve is backed by treasury bills by buying bonds, the Federal Reserve has guaranteed inflow of cash. However, even supposing that the real bills doctrine holds, recall that whilst banks in the 18 th and 19 th centuries were backed by repayments of metal, the Federal Reserve is backed by the repayment of US dollars a fictitious asset which is created by the government. Clearly, the newly-issued currency are not backed by sound assets, which is of some concern as the excess credit from quantitative easing can cause mal-investments (Duncan, 2012). PAGE 5 OF 7

6 Nevertheless, it is argued that fiat money greatly increases flexibility of the monetary system, as it allows central banks to arbitrarily control the money supply. Some argue that the Federal Reserve s rounds of quantitative easing have helped reduce the impact of the 2008 financial crisis by greatly increasing money supply. The underlying principle is to increase the velocity of money by stimulating the investment and consumption components of aggregate demand, resulting in an increase in output. Empirical evidence suggests that the US economy is improving, with the decrease unemployment rate (Unemployment falls, 2012). However, note that it is difficult to conclude that quantitative easing is the main cause of this improvement. As a final remark, perhaps it is useful to also consider commodity money in real life, as a demonstration of a breakdown of fiat money. Examples of commodity money are rare, but recently, workers in North Korea are paid by Chocopie snacks instead of the North Korean Won (Ryall, 2011), which appears to function better than money, most likely due to the dysfunctional market system in North Korea, implying that people are better off receiving real, functional goods. However, one of the problems concerning Chocopies is that it is perishable; Smith (1994 [1776]) proposed that frugality and the accumulation of stock is the basis of the opulence of nations. Such accumulation cannot be done since Chocopies (the stock) have limited shelf life, though this is of little concern to North Koreans as savings cannot be created without a functional market system! In conclusion, it is important to recognise the fiction of money, and how the government is the sole basis of people s confidence in money. Therefore, money is but a tool and ultimately, any measurements of wealth must consider the real economy and the manipulation of money cannot be successful in the long run, as implied by the quantity theory of money and classical dichotomy. In light of this, the re-adoption of a metallic standard is, at least, worthy of consideration as it may eliminate price instability and lower the manipulative power of governments and central banks in the long run. PAGE 6 OF 7

7 References Duncan, R. (2012). The New Depression: The breakdown of the paper money economy. Singapore: John Wiley & Sons Singapore. Friedman, M. (1994). Money mischief: Episodes in monetary history. New York, NY: Harcourt Brace & Company. Hume, D. (1753). Essays and treatises on several subjects (Vol. 4). Edinburgh: printed for A. Kincaid, and A. Donaldson. Retrieved from Eighteenth Century Collections Online. Miller, J. E. (2011, October 20). Rethinking the Gold Bubble. Ludwig von Mises Institute. Retrieved from Perlman, M. (1986). The Bullionist Controversy Revisited. Journal of Political Economy, 94(4), Retrieved from Ricardo, D. (1951). The works and correspondence of David Ricardo. P. Sraffa, (Ed.). Cambridge, UK: Cambridge University Press. (Original work published in ) Ryall, J. (2011, November 23). Chocopie inflation in North Korea s Kaesong Industrial Park. The Telegraph. Retrieved from Koreas-Kaesong-Industrial-Park.html Smith, A. (1994). An inquiry into the nature and causes of the wealth of nations. E. Cannan, (Ed.). New York, NY: Modern Library. (Original work published in 1776). Unemployment falls in US to 8.3%. (2012, February 3). British Broadcasting Corporation. Retrieved from Wennerlind, C. (2005). David Hume s monetary theory revisited: Was he really a quantity theorist and an inflationist? Journal of Political Economy, 113(1), Retrieved from PAGE 7 OF 7