Reserve Currency, I: What is Money?

I'm not sure if Mr Greaney has finished his series on the Social Doctrine of His Holiness Pope John Paul I, but if he hasn't, I've caught up and there is no article to post today. So, here is an article on money, part of (I think!) a two part series.

From The Just Third Way

The other day we were deep in a discussion of bank reserves and the role of a reserve currency when someone asked why this was relevant to anything.  That was not in the sense of “Why are you wasting my time with this garbage?” but a genuine question, i.e., “Why is this subject worth discussing?”

That, in common with virtually all honest questions, is a good point.  It cannot, however, be answered very briefly, as the concept of a “reserve currency” on which the idea of bank reserves is based assumes a host of other concepts that must be explained before we can understand what reserves are and what they do.

Louis O. Kelso

The first concept we have to understand is money.  This is both much easier and much more difficult than many people believe.  That is because the concept itself has become so loaded down with cultural, religious, historical, and any other kind of baggage you can think of that getting to the essence of money becomes a very difficult task, indeed.

Nevertheless, we are going to try.  What is money?  Money is anything that can be accepted in settlement of a debt.  As Black’s Law Dictionary has it, money is “all things transferred in commerce.”

Knowing what something is called, however, doesn’t tell us what it is or how it functions.  To do that we need to know a little more.

A good place to start is with the description Louis Kelso used; we say “description” because we already defined money above.  As Kelso said,

Money is not a part of the visible sector of the economy; people do not consume money. Money is not a physical factor of production, but rather a yardstick for measuring economic input, economic outtake and the relative values of the real goods and services of the economic world. Money provides a method of measuring obligations, rights, powers and privileges. It provides a means whereby certain individuals can accumulate claims against others, or against the economy as a whole, or against many economies. It is a system of symbols that many economists substitute for the visible sector and its productive enterprises, goods and services, thereby losing sight of the fact that a monetary system is a part only of the invisible sector of the economy, and that its adequacy can only be measured by its effect upon the visible sector. (Louis O. Kelso and Patricia Hetter, Two-Factor Theory: The Economics of Reality. New York: Random House, 1967, 54.)

Adam Smith

This covers (very briefly) the definition of money, and what money does, but still leaves us somewhat in the dark.  At this point, then, it will be useful to know how money is created, at least in its essentials.

The idea of money is rooted in Adam Smith’s first principle of economics.  That does not mean, of course, that Adam Smith invented money, or even that he was the first to articulate this principle.  Rather, Smith was the first writer in the new science of political economy as far as we know to state as a first principle what others simply took for granted.

And what is that principle?  “Consumption is the sole end and purpose of all production” (Adam Smith, The Wealth of Nations, IV.8.49.)

From this first principle of economics, Jean-Baptiste Say derived “his” Law of Markets.  Again, Say did not really develop the Law of Markets.  It is implicit in every economic writer since Aristotle, and possibly earlier.  And what is “Say’s Law”?

Most simply (and misleadingly) put, Say’s Law is that production equals income, and therefore supply (production) generates its own demand (income), and demand (income) its own supply (production).

Jean-Baptiste Say

Elaborating on that, Absent theft, charity, or redistribution (or manna from heaven), there is only one way to consume, then, and that is to produce.  You must either produce everything that you and your dependents consume yourself, or you must produce something that you trade to another producer in exchange for what the other producer has produced.  Assuming that everyone who consumes, produces, and that everyone who produces consumes, and that only what is needed for consumption is produced, and all that is produced is consumed, production will equal consumption.  Supply will generate its own demand, and demand will generate its own supply — in aggregate.

Now, obviously this ideal scenario does not exist anywhere.  Infants, the elderly, the disabled, the unemployed, and so on, are often unable to produce anything because, unable to contribute to production through their labor, they have nothing to exchange for what they want to consume.  Say’s answer to that was to point out you contribute to production with your labor and your capital (he also mentioned land, which we include in capital as a non-human input to production).

Karl Marx

What Say left out, however, was how someone without capital who had only labor to sell is supposed to purchase capital in order to be able to produce enough to be able to consume.  This allowed people like David Ricardo, Thomas Malthus, Karl Marx, and John Maynard Keynes to reject Say’s Law on the grounds that since not everyone owned capital, labor is the sole input to production, and consumption and production are not in balance, Say’s Law obviously does not work.

Of course, the astute reader will immediately realize that Ricardo and company’s argument boils down to claiming that because Say’s Law is not working, it therefore cannot work . . . which is like saying that because your car cannot run without gas, it cannot run.  The response, of course, is that if your car needs gas to run, or Say’s Law needs capital ownership to work, then put some gas in the tank for the car to run or turn propertyless people into capital owners for Say’s Law to work!

So how do you turn propertyless people into capital owners?  That, while ultimately the most important economic issue, is not the one we’re looking at today, although we will address it in the conclusion.  What we are after in this discussion is a “pure theory” of money to understand the thing itself, not the admittedly crucial issue of how to get money to do its intended job.

So, taking into account Say’s Law, we discover that “money” is the means or medium by which people exchange what they produce; money is “the medium of exchange.”  As Say explained in his discussion of this subject with Malthus,

All those who, since Adam Smith, have turned their attention to Political Economy, agree that in reality we do not buy articles of consumption with money, the circulating medium with which we pay for them. We must in the first instance have bought this money itself by the sale of our produce.

Thomas Malthus

To a proprietor of a mine, the silver money is a produce with which he buys what he has occasion for. To all those through whose hands this silver afterwards passes, it is only the price of the produce which they themselves have raised by means of their property in land, their capitals, or their industry. In selling them they in the first place exchange them for money, and afterwards they exchange the money for articles of consumption. It is therefore really and absolutely with their produce that they make their purchases: therefore it is impossible for them to purchase any articles whatever, to a greater amount than those they have produced, either by themselves or through the means of their capital or their land.

From these premises I have drawn a conclusion which appears to me evident, but the consequences of which appear to have alarmed you. I had said — As no one can purchase the produce of another except with his own produce, as the amount for which we can buy is equal to that which we can produce, the more we can produce the more we can purchase. From whence proceeds this other conclusion, which you refuse to admit — That if certain commodities do not sell, it is because others are not produced, and that it is the raising produce alone which opens a market for the sale of produce. (Jean-Baptiste Say, “Letter 1,” Letters to Mr. Malthus, 1821.)

Although this is one of the best explanations of Say’s Law of Markets from the hand of Say himself, we immediately see a problem — aside from how propertyless people are supposed to become capital owners, that is!  At the beginning of this posting we defined “money” as “all things transferred in commerce.”  Yet here it sounds as though “money” is itself an article of commerce!  How do we resolve that seeming contradiction?

That is what we will address in the next posting in this series.