Money: Internal & External Balances

MONEY This chapter examines the concept of money. The existence of money is what makes economics hard.

Understanding its influence on economic activity is the main source of disagreement among economists. This chapter seeks to outline the different perspectives and their implications while applying it to understand macroeconomic balances -- such as the budget and trade deficit -- that affect our lives. The discussion is necessarily abstract at points, because money is an abstraction, but the implications are real.

1.1 THREE FUNCTIONS OF MONEY Money is commonly thought to perform three functions: a medium of exchange, a store of value, and a unit of account. As a medium of exchange, money facilitates economic transactions.

Instead of directly exchanging the things we produce and consume, money acts as a common denominator of value that allows us to compare unlike things with the same metric. This is important when we want efficient transactions among anonymous individuals exchanging diverse products.

As a store of value, money allows us to separate the activities of production and consumption. We can work now (produce “value”) and spend the accumulated value of our work as we choose. Unlike other “value containers,” money is not subject to rust or rot (As the Romans observed, pecunia non olet [money does not stink]); it is not limited by its physical form. This is a key pillar of modern societies, whose significance will be explained more below.

Finally, as a unit of account, money acts as a scorecard that permits the valuing of intangible values or items that are not exchanged in markets. It serves an accounting function. For example, if one was conducting a cost-benefit analysis, one needs something commensurate to weight the costs and benefits of environmental destruction versus economic development. In addition, one may want to know the value of a property for the purposes of assessing taxes or as collateral for a home equity loan. Without money as a standard unit of account, these actions become difficult. The full implications and tensions of these functions will be explained in the balance of this chapter. For the moment, it is only important for the moment to know they exist.

1.2 COMMODITIES & ASSETS To organize the following discussion, a distinction will be made between two types of entities transacted in economic exchanges: assets and commodities. Simply, commodities are things. They have objective, defined, and homogeneous qualities. Two items of the same commodity are, for all intents and purposes, identical; the only consideration is quantity. In contrast, assets are notions. Their value is subjective, loosely defined, and often intangible and heterogeneous. Two individuals may ascribe the same asset a different value based on perceived qualitative differences.

Some examples of commodities include a bushel of apples, a gallon of gasoline, or sheets of paper. The key to identifying a commodity is that one can easily describe it with a scalar. We do not think that one ounce of gold is any better than another ounce of gold, but we do think that three ounces is three times more valuable than one ounce. In other words, we only care about quantity and quality differences are either small or non-existent or we are indifferent to them.

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Common examples of assets include publicly traded stocks, real estate, “brand name” merchandise, advice, religious salvation, currencies and relationships. The key to identifying an asset is that two people viewing the same item may hold different valuations of it. For example, two girls involved in the “boyfriend market” may place wildly divergent values on the same boy. For one, he may be a dreamboat; to the other, he may have “cooties.” However, the boy remains the same. The differences exist in the eyes of the beholder. The value of assets depends ultimately on subjective perceptions of value. These are perceptions are subject to revision and change, even if nothing has materially changed in the asset itself.

Why does this matter? First, markets, as described by economists, are good at handling commodities, but poor at assets. The conventional supply-and-demand chart has two axes labeled “price” and “quantity.” This presents no problem when describing the market for commodities because the key elements are price and quantity. However, when quality differences and subjective perceptions enter in, it is less suitable. Although some address this by noting the presence or absence of substitutes, preference changes, and expectations, these are still largely ad hoc gadgets to the core model. In short, the fair, competitive, and efficient market model implied by supply-and-demand analysis may work fine to describe the markets for raw materials and agricultural products (and to a lesser degree manufactured goods), but it may be ill-suited to describe economies dominated by financial asset transactions and the production of professional services.

Second, when economic analysis developed in the 19th century, it may have been an acceptable simplification to treat market transactions as commodity exchanges (barter) and money as simply another commodity in these transactions. However, this may not be apt in the modern economy, which is increasingly dominated by the exchange of assets. This may explain why economics has been largely unsuccessful in incorporating the activities of the financial sector in broader economic models. A few numbers to illustrate this point: the value of international merchandise trade of goods and services (commodities) has been $13 - $16 trillion in recent years, while the value of global financial assets has been estimated to be approximately $140 trillion. These assets rest on a relatively small foundation of goods and services. The chart shows how much of “asset” money rests on the narrow base of “commodity” money.

Third -- and perhaps most important for this chapter -- money, strictly speaking, is an asset; its value depends on the subjective perceptions of its users, but we often use AS IF it was a commodity, just like any other good and service. If you can grasp this intuition and understand the tensions it implies, you understand most of monetary economics, but it remains hard, nonetheless.

1.3 “FICTITIOUS” COMMODITIES Money is what economic historian Karl Polanyi called a “fictitious” commodity. By fictional, Polanyi did not mean that it is “false” or “untrue,” but that it is a human construct, like language and mathematics and not a natural element of every economy. Before continuing, it may be helpful to quote from Polanyi in full: . . . labor, land, and money are essential elements of industry; they also must be organized in markets; in fact, these markets form an absolutely vital part of the economic system. But labor, land, and money are obviously not commodities; the postulate that anything that is bought and sold must have been produced for sale is emphatically untrue in regard to them. In other words . . . they are not commodities. Labor is only another name for a human activity which goes with life itself., which in its turn is not produced for sale but for entirely different reasons, not can that activity be detached from

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the rest of life, be stored or mobilized; land is only another name for nature, which is not produced by man; actual money, finally, is merely a token of purchasing power which, as a rule, is not produced at all, but comes into being through the mechanism of banking or state finance. None of them is produced for sale. The commodity description of labor, land, and money is entirely fictitious.

Nevertheless, it is with the help of this fiction that the actual markets for labor, land, and money are organized; they are being actually bought and sold on the market; their demand and supply are real magnitudes; and any measure or policies that would inhibit the formation of such markets would ipso facto endanger the self-regulation of the system.

Polanyi’s point is threefold. First, labor, land, and money are not real and therefore evaluating them empirically is meaningless: they are fictions, social constructions. Second, these fictions are useful, even necessary, to have the modern economic system we have. Therefore, their existence should be evaluated instrumentally by what purposes they serve and how effectively they serve these purposes. Finally, he implies that there is a process of commodification through which entities which were not and were not considered commodities become to be treated AS IF they were. The completion of this process allows human societies to accomplish things that were impossible, even inconceivable, before. For example, before money is a commodity, the notion of lending it for interest makes no sense. If one cannot lend money, debt, credit, and other financial instruments are impossible.

1.3.1 LABOR Before examining money as a fictitious commodity, it may be helpful to consider the other two major fictitious commodities and how views have changed about them historically. First, labor. While you would not know it from reading or watching historical fiction, by far the most common employment relationship for most of human history was either serfdom or slavery. In other words, the idea that one’s labor -- and more specifically, one’s time -- was something that could be bought and sold to an employer would have struck most of our ancestors as quite odd. In part, this was due to technical limitations: you cannot sell your labor until it could be quantified in time, which required the existence of reliable, mechanical clocks, unavailable until the 17th/18th century. However, the bigger problem was conceptual: labor was not divisible from the laborer.

Therefore, you could only purchase the whole person, not just their labor.

This had important implications for certain occupations: doctors were often trained slaves owned wholly by their masters and required to provide medical care not only for their master, but all members of the household, including other slaves. Likewise, teachers, as we know them today, did not exist. Instead, wealthy individuals purchased tutors for their children, and, instead of paying them a salary, often just incorporated them into the household. The persistence of this mode of thinking can be seen in the nature of labor contracts as late as the 19th century. For example, if one engaged a labor contract for seven days, but was fired or quit on the sixth day, you did not receive 6/7ths of your wage: you were entitled to nothing because the labor contract (as a whole) had not been honored. Likewise, as Chapter 10 of Karl Marx’s Capital (“The Working Day”) suggests, once one had agreed to become employed, your employer had a claim to not some, but all, of your time, hence the fierce disputes over the length of the working day in the 19th century. It is not accidental that the rise of capitalism and the market economy accompanied the dissolution of feudal ties and the emancipation of slaves.

To this day, certain types of labor contracts are illegal, such as prostitution and organ sales, because they are legally indifferentiable from slavery.

1.3.2 LAND The second fictitious commodity is land. Land, and the natural resources in it, is not a commodity because it is not produced; it just is. Additionally, equal quantities of land do not share objective, defined or homogeneous characteristics: an acre does not equal an acre. An identical house in two different locations is likely to have a different price. Finally, one cannot uproot a unit of land, bring it to a market and exchange 3

it for other commodities. This intuition was commonplace among premodern societies, including Europe.

However, the best illustration may be the bemusement among the indigenous peoples of North America when European explorers and settlers offered to “buy” land -- such as the reputed purchase of Manhattan for $24 in trinkets -- or the purchase of Louisiana Territory by the American government from France. However, even if one was a European noble, one did not purchase (or sell) land. To the extent that Europeans had a notion of land ownership, it was the belief that land was nature, the handiwork of God, who had provisionally placed it in the stewardship of humans, beginning with the king, who distributed it among his vassals, and so forth, until it was finally distributed to serfs to till. At any time, someone higher in the feudal food chain could expropriate the land, or assert eminent domain, and reclaim title to it. Therefore, no one was able to buy and sell it to others as a commodity. This understanding is perhaps best exemplified in the “moral economy” practices of landlords. If a peasant experienced a poor harvest, it was customary for landlords to adjust the “rent” extracted from their tenants. Land did not exist as a resource to generate income, but existed primarily to provide the materials of sustenance for those occupying it.

In addition, much land was not the property of individuals, but held in common, especially grazing lands and woodlots. Although anyone could go into a forest and sell wood they felled (the “woodcutter” found in many fairytales), one could not exclude others from entering a forest and chopping the wood they needed to provide energy. The wood was a commodity; the forest was not. Similarly, shared grazing lands -- “the commons” -were a regular institution of agricultural settlements. The notion that one could assert ownership, and thereby, buy and sell property did not emerge until the Enclosure Movements during Tudor England. The popular literature of the time suggests how unnatural many found these developments: The law locks up the man or woman who steals the goose from off the common But lets the greater felon loose who steals the common from off the goose

Oliver Goldsmith’s poem The Deserted Village (1770) eulogizes the destruction of rural villages that resulted Ill fares the land, to hastening ills a prey, where wealth accumulates and men decay . . .

A time there was, ere England’s griefs began, when every rood of ground maintained its man For him light labor spread her wholesome store, just gave what life required, but gave no more . . .

But times are altered; trade’s unfeeling train usurp the land and dispossess the swain

Speaking from a later time, George Orwell summarized the process by which land was commodified Stop to consider how the so-called owners of the land got hold of it. They simply seized it by force, afterwards hiring lawyers to provide them with title-deeds. In the case of the enclosure of the common lands, which was going on from about 1600 to 1850, the land-grabbers did not even have the excuse of being foreign conquerors; they were quite frankly taking the heritage of their own countrymen, upon no sort of pretext except that they had the power to do so.

Recently, the Peruvian economist Hernando De Soto has argued that the failure to assign property rights through the commodification of land has been a major source of third world poverty. Reasonable people disagree about whether this has been a positive development or not. More will be written in the chapter on property rights. For our current purposes it is only necessary to recognize that it has been a change.

1.3.3 MONEY Money is a measure of economic value, just as an inch measures length. As a result, the practice of borrowing and lending money at interest confused many premodern thinkers: how could one buy and sell an inch? What was transacted was not an inch of something, but the inch itself. Anyone who made money from money was suspected of theft and fraud. The income they gained must be extracted from honest and productive labor.

During the Middle Ages, the sin of usury -- lending money at interest -- was enforced. The iniquity of usury was the foundation of many anti-Semitic canards, such as Shakespeare’s character of Shylock in The Merchant of Venice (an association that unfortunately has continued to present day). While the Dan Brown conspiracy theories of The DaVinci Code are overblown, the suppression of the Templars may have been due to their involvement in financial intermediation. Likewise, the Renaissance bankers, such as the Medicis and the 4

Fuggers, officially represented their activities as charges for providing foreign exchange to cloak their banking activities. Similar proscriptions existed in China and India as a result of the Confucian and Caste social systems. To this day, banks in the Muslim world are organized to avoid the Islamic religious ban on charging interest.

However, this is not simply a function of religious doctrines. There is a long political history in the United States of antipathy towards banks, from Jefferson-Jackson’s wars against the Banks of the United States, the Populist-Progressive crusades against the “Money Trust,” to the contemporary Occupy and Tea Party movements. The conviction that money is simply a veil for the exchange of other commodities and that it is sterile (unproductive) runs deep.

1.3.4 NEW FICTITIOUS COMMODITIES In recent years, a new form of fictitious commodity has arisen that can be loosely grouped as intellectual property rights (IPRs). The goal of this new breed of commodity is to make ideas ranging from creative works to the patenting of scientific research. Ordinarily, ideas are not commodities. If I share an idea with you, I can not make you “not think it.” Ideas, whether in the form of a new song or patented pharmaceutical, are not uniform, objective, and homogenous. The question of whether Paris Hilton should be able to copyright the phrase, “That’s Hot!” or whether the Disney Company should be able to legally bar individuals from using the likeness of Mickey Mouse created nearly a century ago is contested or be able to buy and sell the right to use these images and phrases is contested. In addition, as every student has experienced, what level of similarity in the arrangement of the written word constitutes plagiarism? The notion of plagiarism as an academic offense stems from the notion that the words constitute an idea that is the property of their author and must be fairly compensated in coin or credit. In addition, publishers sell editions of textbooks, long after the original author has ceased involvement in the writing and revisions, charging students exorbitant fees.

However, perhaps of greater concern is the commodification of emotion and genetic information. As sociologist Arlie Hochschild noted several decades ago, as our economies shifts toward larger numbers of service and professional jobs, emotions and personality become part of the labor contract. “Acting professionally” and suppressing emotions while doing work is more than simply your addition of labor to the final product, but is not explicitly compensated. Needless to say, emotions and personality are not commodities generated for the purposes of commerce. Another horizon on the field of fictitious commodities is genetic material now that the human genome has been coded. If a certain genetic sequence can be used to provide a desirable (or remove an undesirable) trait, who owns it and who can profit from its sale? It could belong to everyone, since the genome was coded using public money and we all participated in the process of genetic evolution, the physician who performs the procedure, or the individual(s) who own(s) the desirable genes.

2.0 THE ORIGINS OF MONEY We know that there was a time where money played a small role in the economy; we know that money is now indispensable to the operation of modern economies. This section looks at what changed and how economies changed. It presents two stylized “just so” stories of the emergence of money. The first focuses on the emergence of money exchanges out of barter; the second views money as a formalization of credit arrangements. Each emphasizes a different function of money. The “barter” story views money as simply another commodity, while the “credit” story focuses on money as a medium of exchange. Ironically, the “barter” story presents money as a commodity that solves an exchange problem, while the “credit” story underscores the exchanges in which money is the commodity! Neither narrative is important as history, but each can help illustrate dimensions of monetary exchanges in the present day. After detailing the “barter” and “credit” stories of money’s origins, a synthetic account will try to resolve the seeming tension between the two.

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2.1 BARTER The barter story about the origins of money start from a premise that there is natural inclination to trade in humans. The impetus for this assumption is Adam Smith’s The Wealth of Nations. In Book I, Chapter 2, Smith notes The division of labour . . . is the necessary, though very slow and gradual consequence of a certain propensity in human nature . . . the propensity to truck, barter, and exchange one thing for another.

It is common to all men, and to be found in no other race of animals, which seem to know neither this nor any other species of contracts . . . Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog. Nobody ever saw one animal by its gestures and natural cries signify to another, this is mine, that yours. I am willing to give this for that . . . it is by treaty, by barter, and by purchase that we obtain from one another the greater part of those mutual good offices which we stand in need of is this same trucking disposition which originally gives occasion to the division of labour.

As the father of modern economic thought, Adam Smith’s assertion of human’s instinct to trade has been taken as axiomatic and most economists go no farther than this. There is some anthropological and historical evidence that this is true. Archaeologists have found pottery and other artifacts spread over wide regions, suggesting trade or exchange well before the first coins and currencies can be found. There are some ethnographies of “primitive” peoples that suggest that barter, or at least gift-exchanges, are foundational to their common life. However, how does this explain the origins of money?

If there is a mutual coincidence of desires -- I have exactly what you want and you have exactly what I want -a simple bilateral exchange can occur. I have flints, you have cloth, let’s make a deal. Of course, this fortuitous circumstances does not occur automatically or proximately: there is no guarantee when I go to market that someone will want exactly what I have to sell. A&P sells tomatoes and grapes, but I cannot go into an A&P store with the tomatoes from my home garden to pay for my purchase of grapes. This problem can be solved if a third party can be found who is willing to buy and sell the items to facilitate the trade. Consider the diagram below.

We have three individuals -- Alex, Andrew and Anthony -- each comes to market wanting to sell a particular commodity and buy another. Alex wants to buy chickens and has grain to exchange. Andrew wants to buy cows and has chickens to sell. Anthony wishes to purchase grain and has brought his cows in exchange. For the moment, let us assume a fair exchange rate of 1 chicken = 4 grain and 1 cow = 7 grain. Our three individuals run into the first problem: there is no mutual coincidence of wants.

They want to sell grain, chickens, and cows and there are grain, chickens and cows for sale, but they do not match. Anthony wants grain -- and Alex has grain -but Alex only wants chickens and Anthony, cows.

Therefore, no one can simply swap mine for yours.

I am sure that you have arrived on the likely solution to this problem: Alex, Andrew and Anthony can satisfy their needs through two-stage swaps. For example, Alex can first swap 12 grain for 3 chickens with Andrew, and then Andrew can use the 12 grain to purchase a cow. While each person received some of what they wanted, they were not able to use all of their buying power. While Anthony received 7 grain, he still has two cows that he must take home and feed because he could not sell them. Although Alex bought 3 chickens he wanted, he has 3 grain that he must store. Despite gaining a cow, Andrew has 5 grain that he did not want and 2 unsold chickens. Since the commodities are not divisible (what is 1/100th of a cow), their transactions are inefficient.

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Inefficient transactions are bad not only because one did not receive the commodity you wanted, but because the commodity you wished to sell may keep its buying power. You may have to expend more resources to store your commodity, or as in this case, feed your animals, all which cost scarce resources.

2.1.1 MONEY & EFFICIENT TRANSACTIONS Imagine the same transaction by adding one commodity: money. Assume that $1 = 1 grain. Alex can now sell all 15 grain bushels for $15; Anthony can sell his cows for $21 dollars; Andrew can sell his chickens for $20.

They can use the proceeds to purchase 4 chickens, 2 cows, and 15 grain with $3, $6 and $6 left respectively.

Everyone was able to buy the maximum amount of commodities their purchasing power allowed and they avoid additional storage costs for unwanted commodities. In this set of exchanges, money acted as simply one additional commodity that everyone was willing to accept. However, what is this “magical” commodity?

The answer: money. However, what is significant about thinking of money as a commodity? If money is simply a commodity like all others with objective, defined and homogeneous characteristics, then money exchanges are not different than barter, just more efficient. Money exchanges exist only because they are more efficient by reducing transaction costs. Money is a “pass through” commodity (“veil”) for the underlying exchange of other commodities. This exchange from The Simpsons makes this point.

Homer: Homer’s Brain: Homer: Homer’s Brain:

Aw, twenty dollars? I wanted a peanut!

Twenty dollars can buy many peanuts.

Explain how!

Money can be exchanged for goods and services

2.1.2 COMMODITY MONEY CHARACTERISTICS Historically, we know that many things have been used as money: shells, cattle, iron nails, pigs, whale’s teeth, women (in gift-exchanges) and precious metals. A famous study (Radford 1945) of prison camps during WWII showed that POWs used cigarettes as a form of currency. An ideal currency has six characteristics: acceptability, divisibility, durability, limited supply, portability and uniformity. A currency does not need all characteristics, but the more of these six it has, the more likely a commodity is to supersede other commodities as the currency of exchange.

The previous example illustrated the value of acceptability, divisibility and durability. The problem Alex, Andrew, and Anthony faced was because some of them wanted certain commodities, while others wanted something else: there was nothing that everyone wanted. The remainders from the exchanges show the importance of divisibility: it is difficult (if not impossible) to trade 4/100th of a cow for 42/73rds of a chicken, etc. While one bushel of grain was equal to $1, grain is not as durable as common forms of currency. Limited supply -- scarcity -- is essential to maintain the rate of exchange. If money grew on trees, few would accept it as currency because it devalues commodities. The final two -- portability and uniformity -- simply facilitate exchanges by making it something that can be carried in large amounts and will be recognized as a currency.

2.2 CREDIT MONEY The barter version of money’s origins is a nice story, but it has one problem: there is little historical evidence that this happened. The main examples of barter occurred because money exchanges broke down, such as Radford’s example of the POW prisoner camp. When most households produced for their own consumption, exchange was not a major feature of economic life. However, we do find many examples of gift-exchanges or credit economies, which calls into question whether money must be a commodity. The proponents of the “credit” theory make one key insight: money is debt. Without debt, there is no real money.

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“Credit” comes from the word, “to believe” and this critical to understanding the difference between a simple commodity exchange and credit exchange. When commodities are bartered, there is no need for belief: the items exchanged are the evidence of the transaction; seeing is believing: I get this, you get that. In credit exchanges, one party gets a tangible commodity (and a debt), the other receives a credit. The creditor must believe that the debtor is willing and able to honor the obligation. Money is the marker of the obligation.

This may best understood as the practice of giving gifts. When we offer a gift, we do not expect something return. Gifts are a token of a relationship and what we expect is that our token will be reciprocated sometime in the future. We believe that our gift we be reciprocated, but we do not know. Failure to reciprocate is not a breach of contract, but the ending of relationship. The opening dialogue form the movie The Godfather illustrates the difference between a commodity exchange and gift-exchange.

Bonasera: I ask for justice . . . How much shall I pay you?

Don Corleone: Bonasera, Bonasera. What have I ever done to make you treat me so disrespectfully? If you'd come to me in friendship, then this scum that wounded your daughter would be suffering this very day. And if by chance an honest man like yourself should make enemies, then they would become my enemies. And then they would fear you.

Bonasera: Be my friend – Godfather.

Don Corleone: Good. Someday, and that day may never come, I'll call upon you to do a service for me.

But until that day – accept this justice as a gift on my daughter's wedding day.

Bonasera begins by treating it as a commodity exchange and asks the price of the commodity, “justice.” The offer of money insults Corleone, because he sees it as a gift exchange, premised on “friendship.” The commodity is free conditioned on friendship, but friendship is priceless.

The first exchanges were between bands of strangers. The offer of a gift sent the message: “I am friendly, I expect you to reciprocate.” This allowed for the mutually beneficial exchange to occur. Adam Smith -originator of the barter theory -- in his description of the market’s “invisible hand” notes that “. . . it is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner . . .” However, for those who rely on the credit theory, benevolence -- literally, good will -- is essential. Why? In gift exchanges, only one party receives something tangible, the other receives a promise -- an IOU -- to pay. Modern money is simply a sophisticated form of gift exchange. Cash money is ultimately government debt that private actors are willing to trade because it has the “full faith and credit” of the government. Money is simply trading the debt promises of sovereign governments in lieu of our own.

Two key conceptual differences in the operation of commodity money and credit must be noted. First, if money is a commodity, there is no problem with simply hoarding its value and keeping it out of the circulation. Trade will continue using whatever other commodities are available. However, if it is a credit/debt, then it must continually circulate to facilitate transactions. The decision to hoard precludes the transactions of others. In barter exchanges there is not relationship between buyer and seller; once the commodities change hands, the relationship ends. In credit exchanges, there is always a debt residual that implies an ongoing pledge to continue exchanges. Second, barter exchanges occur in only one time period, the present. Available stocks of commodities limit exchanges; short-term supply and demand and budget constraints govern the market. In credit exchanges, there is a present and a future, allowing individuals to “borrow” against their future and bring demand forward to buy goods and services in the present. The present is limited, the future is not. This is a sustainable “Ponzi scheme,” because tomorrow is a day that never comes.

2.2.1 THE KULA RING Bronislaw Malinowski’s famous ethnography of the Trobiand Islands, Argonauts of the Western Pacific, gives 8

an excellent case of how gift exchanges operated in the past, but also suggest how modern money works. The Trobiand Islanders faced a unique problem. They were a ring of islands -- the Kula Ring -- with no central location to serve as a physical market. They were limited to bilateral exchanges between neighboring islands on the island ring’s periphery.

The map to the right shows the geography of the islands and the lines show the trading circuit. As a result of their geography, they could not barter actual commodities in a physical market. However, there were able to engage in trade and develop a form of money. How? The Trobiand Islanders used totemic bracelets and necklaces (see below) as a form of currency. These bracelets and necklaces would circulate clockwise and counter-clockwise around the Kula Ring. At each island, they would be exchanged for whatever cargo the island could provide.

That island would then take the necklace or bracelet to the next island in exchange for their cargo. Eventually, they would complete the cycle. In doing so, the cargo also make its circuit around the islands even though no direct economic exchange occurred. There was no profit: the “gift” of the necklace or bracelet was equal to the cargo, regardless of quantity, so there was not underlying or implied “exchange rate” of the commodities transacted.

The mechanics of the Kula Ring parallels the “circular flow” model of the economy. In the circular flow model, goods and money circulate in opposite directions between households (consumers) and firms (producers).

Since every person’s income is also

2.2.2 CIRCULAR FLOW MODEL The mechanics of the Kula Ring parallels the “circular flow” model of the economy.

In the circular flow model, goods and money circulate in opposite directions between households (consumers) and firms (producers). Since every person’s income is another individual’s expenditure, the flow of money is equal to the value of goods. This model shows the principle of “no free lunch” at the economy level, because any decision to reduce purchases requires someone else to produce less. If the flow of money stops due to hoarding as a stock, it allows impedes the cycle of goods and services in the economy. Likewise, the hoarding of bracelets or necklaces in the Trobiand economy would bring economic activity to a screeching halt.

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2.2.3 KULA RING REDUX In the Trobiand Islands, all islands were both producers and consumers. Money exists, but no island controls the supply of money or supports itself by producing money. In modern economies, there are entities that produce and control the money supply -- namely banks and sovereign governments. What would the Kula Ring and the circular flow model look like if they included a financial sector (banks)? Before examining this problem step-by-step, let us look at a complete circular flow model. As you can see, government and financial institutions lie outside the simple circular flow of money, goods and services. This status is largely due to their shared ability to create money. Governments do so through seigniorage -- mint currency -- and issue debt against future tax receipts; banks via fractional reserve banking. This does not mean they wield unlimited powers, but it does make them fundamentally different than all other economic players.

Credit:

Nicholas Szabo, George Washington University

Shelling Out: The Origins of Money

http://szabo.best.vwh.net/shell.html

Let us return to the basic Kula Ring model where we have a flow of trade goods paralleled by two circuits of money -- necklaces and bracelets -- as shown on the left. Let us add in a “financial intermediary” (bank) “C” that transacts in money, but does not buy or sell goods and services. This is shown in the center diagram above.

“C” is willing to maintain the circuit, even though it has no interest in buying or selling any commodities, perhaps for a nominal transaction fee. Nominally, there is no difference between the economy show in the left and center diagrams. The other participants -- A, B, D & E -- experience no difference in their access to desired commodities, the ability to sell their wares, or make transactions.

The third diagram on the right, however, shows the key position held by financial intermediaries. They can go on a “capital strike” and refuse to make money available to the economy either by refusing to take deposits or make loans, preferring to hoard their money reserves. If money is viewed simply as one among many commodities, this strike is no different than any producer who refuses to sell to markets. However, if money is a “special” commodity necessary to facilitate all transactions, the circular flow of the economy shuts down if governments and financial intermediaries do not provide liquidity.

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2.3 HIGH & LOW MONEY: A SYNTHESIS The barter and credit accounts of money’s origins are both reasonable, but have strikingly different premises and conclusions about what money is and what its impact is. They exemplify the functions of money as a store of value and a medium of exchange respectively. How can they be reconciled?

One way is to think about the social structure of premodern, agricultural societies that existed prior to the Industrial Revolution. While there are variations from place to place, the diagram to the right is a good first approximation. On the eve of the Industrial Revolution, the great mass of individuals lived in small, selfcontained villages societies that produced most of their consumption -- food, clothing, shelter -- within the village unit. As a result, their engagement with markets was primarily barter exchanges within village communities. These village communities were economically and socially isolated: before the transportation revolutions, most settlements were “foot-scale” -- limited by the distance one could comfortably travel in a day, about 10-mile radius area (about the area of school district).

As tightly-knit communities, there was often implicit trust and therefore little need to formal credit exchange arrangements. To the extent they existed, they were revolving-credit associations or credit collectives, akin to the “microfinance” organizations such as Muhammad Yunus’ (Nobel Laureate) Grameen Bank. Money was not needed as a store of value -- surplus, if there was any, was consumed at harvest festivals, nor as a unit of account and of only limited use of it as a medium of exchange. Karl Marx, successful as a sociologist where he failed as revolutionary, describes the position of the 19th century peasantry The small-holding peasants form an enormous mass whose members live in similar conditions but without entering into manifold relations with each other. Their mode of production isolates them from one another instead of bringing them into mutual intercourse. The isolation is furthered by . . . poor means of communication and . . . poverty . . . Each individual peasant family is almost self-sufficient, directly produces most of its consumer needs, and thus acquires its means of life more through an exchange with nature than in intercourse with society. A small holding, the peasant and his family; beside it another small holding, another peasant and another family. A few score of these constitute a village, and a few score villages constitute a department. Thus the great mass of the . . . nation is formed by the simple addition of homologous magnitudes, much as potatoes in a sack form a sack of potatoes.

However, above the mass of peasants lay stratified social and occupational layers that needed money. Longdistance merchants required some form of money because they handled trade with diverse products at a distance and needed money as both a store of value and a unit of account. In addition, certain occupations, such as the nobility-warriors and clergy, required money to valorize their services. Security and salvation, as important as they maybe, are not barterable tangible commodities. The imposition of taxes and tithes, which must be paid in coined money, served the purpose of material support for these groups but also required a form of commodity money. A glimpse of this process can be found in the Christian New Testament in Jesus confrontation with the “money-changers.” The money-changers did not “change money,” but took the in kind donations (commodities) from peasants and gave them money in order to pay taxes to secular authorities or tithes to religious ones. The general antipathy to money-changers (and tax-collectors) is that they performed 11

these “services” at a considerable mark-up. If you think of the “fees” charged by your wireless phone or credit card company, you can appreciate the sentiment. The Ancient Greeks had a similar practices double-suing temples as treasures as in the case of the Delian League where the tribute paid to Athens were cloaked as religious offerings. Modern examples existed in Europe’s overseas colonies. The imposition of taxes on colonial subjects often precipitated the movement from subsistence agriculture (not traded or monetized) to the production of cash crops (traded and monetized) with deleterious social and environmental consequences. The American bimetallism (Gold vs. Silver) debates of the late 19th century also reflected this tension. The Populists, mostly workers and farmers, wanted a currency that served as a “medium of exchange,” while the Republicans and Bourbon Democrats, aligned with financial interests, valued currency mainly for its “store of value” and “unit of account” functions. Silver was superior as a medium of exchange; gold as a store of value and unit of account.

Historically, there were usually two monetary systems co-existing side-by-side: one whose principal goal was to serve as a medium of exchange, the other to act as a store of value. This Janus-faced system presented only minor problems when economic activity was primarily local with segmented markets. However, the emergence of national and international markets forced everyone to use the same currency form of money and the tensions manifested in debates over the proper form of money. Both the barter and credit accounts of money’s origins are true, but incomplete, explanations of money. The telling of stories reveals more about the narrator than the story’s subject. The choice of focusing on one version of the money story often shows “what side you are on.”

3.0 MONEY: STERILE OR FERTILE The appearance of money as a (“fictitious”) commodity is what makes capitalism possible. Slavery is an economic system premised on the control of labor; feudalism is a system founded on the control of land; the operation of Capitalism depends on the control of money. As unjust as slavery and feudalism were, it is not hard to understand why they could work: we can grasp why controlling people or land would be economically productive. Land produces food and natural resources; labor is synonymous with work. It is less clear why money is productive, whether green pieces of paper or coined precious metals. The dominant view was that money was sterile: it represented value, but could not generate value. This view originates in Aristotle The most hated sort (of wealth getting) and with the greatest reason, is usury, which makes a gain out of money itself and not from the natural object of it. For money was intended to be used in exchange but not to increase at interest. And this term interest (tokos), which means the birth of money from money is applied to the breeding of money because the offspring resembles the parent. Wherefore of all modes of getting wealth, this is the most unnatural.

Aristotle probably had in mind the debt peonage of Greek peasants precipitated by the advent of coinage and was a major impetus for the Solon’s reforms that created Athen’s democratic constitution. However, the notion that money is merely a veil for the exchange of commodities and cannot produce wealth (or impact economic activity) was influential into modern times and still influences economic theory. Contemporary concerns about “printing money” and the view of inflation as theft align with the view that changing the value of money is theft of the value of the commodities transacted. This section presents two views on the “sterility” and “fertility” of money. The first, associated with Marx, sees money as the instrument of exploitation that allows capitalists to extract value from workers. The second, associated with Hume, Simmel, most recently, Matt Ridley, argues that money and commerce promote peace, tolerance, and the growth of ideas, all which add value to money exchanges.

3.1 MARX & MONEY When interpreting Marx it can be difficult to parse when he is simply engaging in a reductio ad absurdum of Classical economic writers such as Adam Smith, David Ricardo and Jean-Baptiste Say (all proponents of a 12

barter-commodity theory of money) or he intends a serious empirical description of how economies actually function. As a result, it is not clear if his writings are to be taken literally or simply as means of showing how absurd Classical Economics is, even by their own assumptions. Therefore, caveat lector.

Marx begins by taking two elements of Classical Economics: Adam Smith’s “Labor Theory of Value” and JeanBaptiste Say’s “Say’s Law.” The first posits that the value of commodities ultimately derive from the labor input necessary to produce them. The second (although there are many versions of “Say’s Law”) argues that supply calls forth its own demand, implying that in the aggregate that the two sides of the exchange should be equal since one person’s income is another person’s expenditure. Marx then identifies two exchange circuits. The first, C1-M-C2, notes that individuals first produce commodities (C1), which they exchange for money (M), which they is used to purchase another commodity (C2). According to Say’s Law, C1 = M = C2. The use of money did not add anything to add or subtract from the value of the commodities.

The second, M-C-M*, begins with money instead of commodities. Money (M) is used to purchase a commodity (C) and the transformed back into money plus interest (M*). Where, Marx asks, does this increment of interest come from? Consider the second circuit as bank deposit. If I deposit money at a bank and they give me 2% interest on the deposit’s principal, where did the 2% come from? We know the bank probably took our deposit and made a loan (bought a commodity) and the borrower paid the bank interest, a portion of which was returned to us. Still, why would the money have increased in value? Why did the borrower have to purchase the right to make a transaction? And, why did we profit simply by entrusting our money in the bank’s care?

Marx returns to Smith’s Labor Theory of Value and its assertion that all economic value comes from labor. If the incremental value does not come from the transaction it must have been skimmed from the value of the commodity, or, taken from the source of value of the commodity: labor. The owner of capital (money) is able to siphon off the “surplus value” of labor and add it to his stock of capital (money). Contrary to the claim of the Classical Economists that both parties benefit equally from an exchange, Marx argued that one side (capital) systematically ripped the other (labor) off. This process of extracting surplus value through monetary exchanges is what Marx meant by “exploitation.” Exploitation is made possible by virtue of the money economy.

3.1.1 MARX & THE MARSHALL PLAN The classic example of an entity that “makes money from money” is a bank. While it is customary to think of a bank as a business with tellers that takes deposits and makes loans, it may be more useful to define banks functionally. A bank is an entity that has net long-term monetary assets and short-term monetary liabilities. With this definition, we may think of postwar US as a bank. Generally speaking, the US borrows “low” by issuing public and private debt (= bank deposits) to the world, and lending “high” by purchasing equity (= bank loans) in corporations from around the world. The difference is pocketed and a major source of American wealth. In essence, the American economy has become like Marx’s capitalist, able to “make money from money” and not “making things.” This development is tied to the twin processes of financialization and deindustrialization. As the chart to the left shows, in 1950, manufacturing and finance consisted of 29.3% and 10.9% of GDP respectively. By 2005, the shares had reversed.

Manufacturing produces only 12%, while finance occupies 20.4%. As a share of corporate profits, the trend is even more striking. In the early 1950s, manufacturing was the source of 60% of profits, while finance was less than 10%. By 2005, finance made 50% of corporate profits, while manufacturing dropped to nearly 5%.

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Marx’s CMC/MCM* framework can help us understand what happened in the American economy. Prior to World War II (really World War I), the US was a “CMC economy” organized to produce commodities for sale. London, not New York, was the world’s financial center, nor was the US dollar the world’s reserve currency. Then, from 1914-1945, the rest of the civilized world decided to blow itself up, destroying their productive capacity and borrowing large sums to finance their war efforts.

At the end of these three decades of conflict, the US found itself in a curious and envious position: it now controlled 80% ($26 Billion of $33 Billion) of the world’s gold stock, equivalent, at that time, to the world’s monetary base. The global economy would not be sustainable if the US hoarded its medium of exchange as a commodity. To its credit, the US embarked on a series of policies to redistribute the purchasing power by becoming “banker to the world” and transforming itself into a “MCM* economy” The US rebuilt Japan, recapitalized its European allies through the Marshall Plan and the World Bank, it established a network of foreign military bases ensuring that its resources would be spent abroad, it promoted consumerism and debt to spendthrift Americans, and established favorable terms for its trading partners through the Bretton Woods system that pegged the dollar to gold, but allowed other currencies to float against the dollar. The sum of these policies was that it made American banking more competitive and American industry less competitive relative to its economic counterparts. European and Japanese manufacturers took advantage of favorable exchange rates to export to American markets, while American manufacturers faced exchange-rate headwind. However, the strong US dollar made it easy for American banks to lend on favorable terms around the world and for Americans to purchase equity in foreign US as World’s Banker corporations. Not surprisingly, wages for Adapted from H. Schwartz workers in manufacturing stagnated, while compensation in the financial rose in the US. This process accelerated since the 1980s as financial deregulation, free trade, and liberalization of international capital markets allowed American bankers to take full advantage of their economic position.

3.2 INTEREST’S VALUE The economic argument for interest on money usually describe interest as the opportunity cost of money (although that implies that money is scarce, which it is not). Some argue that financial intermediaries create a more efficient allocation of capital by choosing which projects merit funding and the return is their share of this efficiency gain. Others would note that investment carries risk and the return is the reward for the willingness to shouldner risk. Since these points will be dealt with in greater detail elsewhere, it will suffice to simply list these explanations.

A second line of argument is that exchanges produce positive externalities for society and therefore the facilitators of these exchanges are entitled to a share of the social benefit. For example, there is a long standing argument that trade and commerce reduce conflict, if only because it is bad for business. Another argument is 14

that monetary exchanges promote tolerance, most commonly associated with sociologist Georg Simmel’s The Philosophy of Money. Credit exchanges imply a social relationship where some are trusted and others are not.

When becomes the basis for social interaction, the only color people see is green. Therefore, individuals from declasse minority groups can rise as long as they can show they can deliver the goods (make money). Simmel, writing at the beginning of the 20th century observed that Money expresses all qualitative differences of things in terms of ‘how much?’ Money, with all its colorlessness and indifference, becomes the common denominator of all values; irreparably it hollows out the core of things, their individuality, their specific value, and their incomparability. All things float with equal specific gravity in the constantly moving stream of money.

While there still may be things that money cannot buy, money, as a unit of account, permits the pricing of the priceless. The “value of a statistical life” (VSL) has been estimated by economists to be approximately $6.9 million. This concept is used by regulatory agencies to make cost-benefit analyses of safety precautions and environmental regulations. To the extent that tolerance and clear-thinking are social (and economic) goods, the providers of money may be entitled to a private share of the public gain.

3.2 SEX FOR IDEAS The explanations above all note an extant value that is monetized through interest charged on money, but they do show how money can create new value.

The monetary exchange still appears to be a zero-sum swap of two commodities as shown in the illustration to the right. In the beginning one person has a red apple, the other a green one; at the end, one person has a red apple, the other a green one: nothing has changed to the total value. However, this may be a narrow view of what occurred in this exchange. Recently, science writer Matt Ridley has suggested that ideas are shared when people trade material commodities. Unlike commodity swaps, swapping ideas is not zero-sum, but likely positive sum. When two person share ideas, as shown in the illustration to the left, neither loses their original idea and both gain another idea.

Ideas are not simply nebulous thoughts, but can be embodied in material commodities that people exchange. Ridley calls this process of exchange “sex for ideas” because the intercourse of ideas allows them to reproduce not as replicas, but as improved versions. For example, imagine two cooks charged with making chicken soup for each other. As accomplished chefs, they are perfectly capable of making good soup for themselves and have no need of trade.

However, if they do, they not only consume the soup, but encounter the “idea” -- the recipe -- of their counterpart, and thereby, improve their own production.

The notion that economic growth is fundamentally driven by the advancement of knowledge, ideas, and technology has not been lost on economists. “Endogenous growth theory” argues that growth is not fostered simply by greater inputs of factors of production -- land, labor, and capital -- but from technological progress, i.e., the growth of ideas. What cultivates economically useful ideas. Endogenous growth theorists believe that private investment in R&D is the main source of technological improvement. Alternatively, Schumpeterian economists point to entrepreneurs who produce the “creative destruction” that drives technical and economic change. Both hold that there must be proper incentives for individuals to innovate. In practice, this means to commodify ideas by strengthening protections of intellectual property rights through patents and copyrights.

In addition, they suggests that ideas come when individuals compete for the monetary advantages of first discovery, which often means secrecy and exclusive access. In this view, innovation is strictly a production function and not a result of the exchange of ideas.

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3.2.1 RED QUEENS Ridley presents a different view. Innovation is rooted in consumption, not production. It is the result of cooperation, not competition. Openness and sharing, rather than exclusivity and secrecy, is more likely to generate new ideas. Before looking at the full implications of Ridley’s argument and some noted examples, pro and con, consider Ridley’s main research background in the evolution (and superiority) of sexual reproduction in animals. In asexual reproduction (and monoculture and cloning), the offspring are replicas of their parents. Species with superior survival traits reproduce and populate the ecosystem. In sexual reproduction, offspring are similar, but not the same, to parents. As many children are acutely aware, they did not inherit just their parents high-quality DNA, but a lot of the “junk” DNA as well. Still, some evolutionary biologists hold that sexual reproduction provides evolutionary advantages: why?

Sexual reproduction, by scrambling the genetic material, fools parasites and predators, which are far more numerous than hosts. Long-term survival of species depends on not just being “best-adapted” in the short-term, but the ability to maintain the advantage in co-evolution of predator-prey (host-parasite) pairs. The reason that sexual reproduction has evolved to be pleasurable is that it grants an evolutionary advantage because it produces robust, not optimal, offspring. This process is known as the “Red Queen Hypothesis” after Alice in Wonderland’s Red Queen, who spoke the memorable line that “it takes all the running you can do, to keep in the same place.”

3.2.2 MONEY, CONSUMER CULTURE & INVENTION Let us pull some strands together. Money facilititates exchange and consumption. Consumption, not production, is the seedbed of invention. Ideas are embodied in material commodities. Through exchange the “small differences” in similar commodities are learned and recombined to produce new ideas. Therefore, the social process of shopping is critical to producing new ideas, technologies, and knowledge that are key to economic growth. As a result, commerce is not sterile, but fertile; it has the ability to create “new” value.

Producers do not simply develop new products that are then “evaluated” in markets by consumers; consumers through the “compare-and-contast” process of shopping may be generating new innovations.

We can broaden the point to human learning. It is common to think that knowledge precedes doing -- we cannot take action before knowing what to do -- but Ridley implies that the sequence is reversed. Consider language acquisition in young children. They do not learn to speak because they are explicitly taught, but by listening to adult conversations (consuming spoken language) and mimicking speech. Many individuals who would flunk grammar tests have a near perfect intuitive sense of the spoken grammar of their native language.

Many observe that the path to better writing is through reading (consuming written language) and practice by writing journals and multiple drafts (hint! hint! hint!). The writer George Orwell claimed to hone his writing craft by copying Henry James’ Tropic of Cancer in long-hand. One may also view teenage experimentation with different “identities” (manifested in hairstyles, wardrobe, musical and artistic tastes, etc.) as necessary samplings that serve as the prelude to “inventing” their adult selves. Some findings in cognitive science suggest that intelligence is really just the memorization (through experience) of diverse things. In economics, this process is known as “learning-by-doing” and is thought of a major source of endogenous growth. However, are there concrete economic examples that this is how innovation actually occurs?

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Some work in behavioral economics shows that, to promote creative work, the drives for autonomy, mastery, and purpose are more effective than material incentives. In fact, some studies evidence that greater material rewards induce worse performance. There is some evidence for this is the area of software design, where “open source” products such as Linux, Apache, Mozilla (Firefox), OpenOffice, Wikipedia, GNU compiler, GIMP, and Moodle, perform as well, at lower cost, and produce more “breakthroughs” than their proprietary counterparts. A comparative study of the technology clusters of Route 128 (Boston) and Silicon Valley found that cross-firm sharing of information and ideas was critical to Silicon Valley’s preeminence, despite Route 128’s initial advantages. Microsoft’s innovation strategy under CEO Steve Ballmer was to use its monetary advantages to “buy out” small innovators or beat its competitors to market. Arguably, this has been a failed strategy. Another key test of this idea is the competition between Google and Apple. Google has embraced open source platforms for smartphone and tablet “apps”, such as Android, and user-generated content, such as YouTube, while Apple has pushed for more uniformity and top-down control in its “App Store” and I-Tunes.

Finally, the future of net neutrality, which fostered the creation and dissemination of user-generated content, looms large on whether this innovative environment will continue.

In manufacturing, “flexible production” regimes, such as Italy’s “Third Italy” and Japan’s “Total Quality Control” put an emphasis on networked, horizontal organization and worker and consumer input into the design and production process. Arguably, they have been more creative and innovative than their conventional counterparts. In R&D, free, accesible research provided by university and government-sponsored research centers like the National Institutes of Health have been foundations for America’s innovative edge. Even in the private sector, research centers insulated from economic pressures, such as AT&T’s Bell Labs, IBM’s Watson Center, and Xerox’s PARC have been the engines for innovation.

Historically, nations that have shut themselves from commerce experience declines in innovation, even “forgetting” technologies. A main reason cited for the “Rise of the West” was European interstate competition and commerce that lead to the development of new technologies, allowing them to outpace far advanced civilizations in South and East Asia. Specifically, the Tokugawa decision to close Japan to foreigners and foreign trade and Ming-Qing Dynasty’s policies of limited contact with foreigners was a major reason for lack of technological progress during these periods.

Finally, consumer culture and consumerism with its penchant for variety and diversity may be essential to innovation along lines suggested by the “Red Queen Hypothesis.” Even “wrong” ideas are important, as J.S. Mill argued, because they clarify our understanding of what is right (and why it is right). The “marketplace for ideas” is important not only for the expression of opinions, but also for allowing the material products that embody these ideas to be shared. Insofar as money is a critical element of these processes, it may be a key part of economic development.

4.0 MONEY & BALANCES As a store of value, money allows individuals to transfer value across time and space. This property has many advantages: it separates the time-space link of production and consumption and allows us to allocate purchasing power over time and expands the extent of markets. However, it poses one big disadvantage. Once purchasing power can be distributed temporally and spatially, there is no guarantee that production and consumption, supply and demand will be balanced in the present. In short, the possibility of temporal imbalances (inflation & unemployment) and spatial imbalances (trade deficits and surpluses) can cause economic activity to be more unstable. This does not mean that they will be unbalanced -- they can be in balance dynamically -- but its makes is possible. Money is governed by two “prices”: the interest rate -- which orchestrates the aggregate balance of investment and consumption in the present and future -- and the exchange rate -- which influences the location of production and consumption.

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Although it is common to discuss the interest and exchange rate as the prices of money, they are not prices insofar as their level is NOT set in market (although there are implied prices in the level of the bond and foreign exchange markets). This is because money is not scarce by nature, but only scarce by choice. The quantity of money supplied is a choice made jointly by banks and governments. This does not mean that they should adjust the money supply at whim or without limit, but simply acknowleges that they can increase or decrease it supply if desirable.

The diagram above is a visual schema of the section’s topics. We will begin at the center with the circular flow model of an isolated, moneyless economy. It will present Say’s Law that states why production and consumption should be in balance. In addition, we will present the “quantity theory of money.” Next, we will look at the horizontal “temporal” flows of money and their “internal” balance. While this will describe the IS/LM model and debt-deflation, the details of fiscal and monetary policy will be discussed in another chapter.

In the next section, we will describe the vertical “spatial” flows of international trade and foreign exchange.

Finally, we will look at the model as a whole and interaction of the internal and external balances through the Mundell-Fleming (Trilemma) Model and Swan Diagrams.

4.1.1 SAY’S LAW Say’s Law --The Law of Markets -- is equally one of the most important and divisive concepts in economics, both technically and normatively. If you find it convincing, you likely hold conservative political views, find “supply-side” economics, “real business cycles,” and “structural” explanations of unemployment convincing, and believe that money is a neutral or irrelevant to explaining economic activity. In addition, you are likely to support a “commodity-barter” model of money. If you do not find it convincing you are likely political liberal, find demand-management and Keynesian economics convincing, and believe that money is central to understanding economic activity. Therefore, a neutral statement of Say’s Law is difficult.

For myself, I tend to fall on the liberal reception of Say’s Law, but I do think that Say wrote something 1) true, but also, 2) incomplete and 3) ambiguous. So, contextualizing Say’s argument is necessary to understanding.

In my view, two contexts are needed to understand Say’s Law on its own terms. First, that is was written to debunk the now long forgotten economic theory of Mercantilism. Second, it is best known as the foil to J.M. Keynes General Theory and Keynesian economics more generally. The Mercantilists argued that national 18

SAY’S “SEVEN” LAWS wealth increased through the accumulation of gold. Say, Adapted from William Baumol like other Classical economist such as Smith and Hume, wanted to emphasize the “real” productive capacity (the 1) Effective demand is limited by and equal to its output, “supply-side”) of the economy to show that hoarding gold because production provides the means to purchase output. and protectionst trade policies was not a path to greater 2) Expenditure increases when output rises national wealth. Later, during the second half of the 19th 3) Investment is more effective than an equal amount of century, Say’s ideas (and others) become fused with the consumption to raising the wealth fo a community doctrines of laissez-faire, Social Darwinism, and Victorian 4) Over time, communities will find demand for increased output morality that gave his economic ideas a different coloring. 5) Production of goods, not money supply, is the primary It was this later version of Say’s Law to which Keynes was determinant of demand. primarily responding with its opposition to government 6) Any excess of one good implies a deficit of another good intervention to ameliorate the economy, its misapplication 7) Supply and demand are always equated by a rapid and of Darwinian biology to social, political, and economic powerful equilibration mechanism. affairs, and the penchant to ascribe moral meanings to economic outcomes. Put in modern terms, Say’s Law argues that the best way to grow the economy is to increase productive capacity by encouraging investment, not stimulating consumption. Investment can be encouraged by lowering taxes on capital, reducing regulation, using or improving technology, increasing skills or education (human capital) or fostering entrepreneurship.

Economic problems stem from “real” (non-monetary) shocks or temporary mistakes that come from the misallocation of productive resources.

Simply put, Say’s Law argues that supply will create its own demand, an economic version of “if you build it, they will come.” We can work either to satisfy 1) our own needs or 2) the needs of others. If it is for our own needs, then it is not sold into the market and has no impact. However, if we work more than necessary to satisfy our own needs, it is due to the desire to finance the purchase of goods produced by another. If we increase our supply/production, we are also creating demand/consumption. In total, supply will equal to demand and real demand cannot exceed supply.

The intuition can be understood by imagining a glass filled with water.

The productive capacity of the economy is like the glass container; the liquid is akin to its purchasing power. One could fill the glass to the brim, but anymore would be pointless and wasteful. The only way to “grow” the economy is to make the glass larger (or fix some structural flaw -- a crack -- in the glass). This can only be accomplished by diverting some of current production into savings (investment) and away from current consumption. If we think of the economy as divided into many different sectors, each represented by a smaller glass, we can understand why there may be shortages or gluts of individual commodities. Expenditures on any commodity compete with expenditures on other commodities. There can be a misallocation, but not a general shortage. Money’s only function here is to facilitate commodity exchange, but it does not add or subtract from the value of the underlying commodities. Here is Say in his own words.

It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of creation of one product immediately opens a vent for other products . . . Money performs but a momentary function in this double exchange; and when the transaction is finally closed, it will always be found, that one kind of commodity has been exchanged for another.

The other implication of Say’s Law is that any unemployment of resources, including labor, is by choice. There is no, long-term voluntary unemployment. Individuals “choose” leisure, preferring the opportunity cost of their time over the income their labor would provide if employed.

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4.1.2 QUANTITY THEORY OF MONEY Another way to conceptualize Say’s Law is through the “quantity theory of money.” The quantity theory of money is a simple formula to analyze economic aggregates. It has four components: the quantity of money in circulation (M), velocity (turnover) of money (V), the price level (P) and the real value of goods produce (Q).

The equation sets the money stock and flow equal to the value of goods and services as follows.

M*V = P*Q The left side of the equation gives us aggregate demand or purchasing power in terms of money. The right side is equal to the aggregate production of the economy. We can determine the money supply by dividing production by the turnover rate, yielding the following equation.

M = P*Q V The velocity of money (V) is assumed to be constant and the real value of aggregate production is fixed in the short-term. As constants, they drop out of the equation, resulting in a direct, linear relationship between the money supply and the price level. If the money supply is increased, it will have a directly proportional impact on prices, causing them to rise (inflation). If more money chases the same aggregate of goods and services, the result will be higher prices all around, but no improvement in the real value of goods and services. This relationship is shown to the right. The increased money supply decreases the value of money and raises the price level.

4.2.1 INTERNAL BALANCES & TIME Money allows use to “store value,” allowing us to separate the activities of production and consumption. When we are hungry, we do not have to “produce” food, i.e., go out to our garden and harvest the produce, but can use money that we earned at an earlier time to buy it and “consume” it. Likewise, we are not limited in our consumption buy our current production. If I want to attend college, but, like most people, do not earn $100,000 per annum to pay for it, I can still “consume” the education now, and “produce” later by working and pay the tuition bill. This is only possible because we live in a money economy that lets us “store” the value from our productive time.

At any given time, there are some people who are producing more than they are consuming AND there are people who are consuming more than they are producing. This is not a problem because the first group -“savers” -- can lend their excess to the second group -- “borrowers”. Net savers are sending their present production forward to pay for future consumption, while net borrowers are pulling forward their future production to pay for current consumption. It becomes a problem when the flows of total saving and the flows of total borrowing do not produce a stock of purchasing power in the present that employs available resources.

If people, in aggregate, decide they would, on balance, rather spend money later than now, purchasing power in the present will be deficient. While it remains true that income = expenditure, if the outflow of expenditure (savings) to the future is greater than the inflows of expenditure from borrowing from the future (loans) and the stocks of past savings (returns on investments), we have an imbalance of production and consumption that will produce unemployment (consumption < production) in the present. Likewise, if the inflows to the present 20

exceed the outflows, then there is an imbalance of production and consumption in the present that will produce inflation (consumption > production). Maintaining a balance that reduces both unemployment and inflation is the “internal balance” of the economy.

Let us walk through this idea again with the help of a visual aid. Recall the analogy of Say’s Law as a glass that represented the productive capacity of the economy and the liquid representing the purchasing power. Instead of one glass, let us imagine three for the past, present, and future periods. When we save, we are “pouring” some of the liquid from the “present” into the “future,” leaving less purchasing power in the “present” to buy what is produced today.

PR

P AS T

ES

EN T

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Imbalance caused by saving

Another way to create an imbalance in the present is debt. Debt is borrowing come due and can be thought of as a payment from the present to the past. When we pay down our debts, we are not consuming current production. Although one person’s debt is another person’s credit, if a bank does not issue a new loan, and uses the revenue from incoming loans simply to repair a hole in their own balance sheet, it does not chase the current production of goods.

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Imbalance caused by debt

These imbalances have balancing counterparts. The counterpart to saving is borrowing, which allows the future to “pour” some of its purchasing power into the present. Similarly, the counterpart to debt is investment and savings. Savings we sent into the “future” arrive later as payments from the past into another present. The direction and magnitude of the flows is the short-term interest rate set by the open market activities of the Federal Reserve Bank and the long-term bond market in government securities for the long-term interest rate.

Other things equal, a high interest rate will encourage saving and discourage borrowing, causing a flow from the present to the future, while a lower interest rate will encourage borrowing and discourage saving causing a net reverse flow from the future to the present. In our glasses example, the interest rate is similar to the ange of tilt of the glasses. The greater the angle of tilt, the greater magnitude of the flow. Tilt toward the future, promote saving; tilt to the present, encourage savings. The goal is to have an interest rate that promotes the employment of productive resources (especially labor) and promotes real growth in the economy’s productive resources in the future.

4.3 THE IS/LM FRAMEWORK How does one strike the proper balance of consumption and production in the present and future? The Swedish economist Knut Wicksell coined the concept of a “natural rate of interest” that would be the interest 21

rate that would maintain the dynamic balance of money across periods of time. However, money, especially in the age of fiat money, is not a scarce resource: banks and governments can expand or contract the supply of money through their policy decisions. Therefore, money’s “price” cannot be determined by simply supply and demand considerations. At any given time, banks and governments can announce a short-term interest rate that is either above or below the hypothetical natural rate, creating too much or too little demand for produced goods and services.

Although money’s “price” (the interest rate) is not decided through a market mechanism, we can imagine a hypothetical market for money where the price is the equilibrium between the “demand” for money (investment-savings) and the “supply” of money (loans to finance consumption) and plot them on an ordinary supply and demand chart, where the interest rate is the price and the economy’s productive capacity is the relevant quantity. This chart -- IS/LM diagram -- is shown to the left. The “demand” for investment-savings (IS) slopes downward. At high interest rates, individuals are more willing to send money to the future via savings, making it unavailable to support present production of income. They want money, not goods and services.

However, at higher rates of interest, banks are more willing to make money available due to the higher return to their money stocks. As a result, they are more willing to supply money to the economy. There is a key difference here between the argument of Say’s Law and the IS/LM framework. In Say’s Law the size of the economy -- the volume of the glass container -- is set first by its productive capacity, which then dictates the amount of purchasing power. However, in the IS/LM model, the interest rate sets the availability of money, which then in turn, determines how much income will be generated in the present period.

4.3.1 LIQUIDITY PREFERENCE A key insight of the IS/LM framework is its explanation for why people might want to hold money or have cash balances. For Say, no one would want to hold money, preferring to trade it as quickly as possible for some desired commodity available in the market; money is given up like a “hot potato.” However, in the real world, we know that people do maintain cash balances with high liquidity such as checking or money market accounts. We also know that professional investors typically hold part of their portfolio in cash or forms of commodity money (gold). Why? We can begin to answer this question if we recall the various functions of money. The first is need for money for transaction -- money as a medium of exchange. This is the notion embraced by Say’s Law. We have a certain amount of things we wish to buy, which requires a certain amount of money. Therefore, as shown on the chart to your right, it is a near vertical (inelastic) demand curve. We want a certain quantity, any more would be pointless, any less would be perilous. As a result, we will also pay any price for base quantity of money as shown by individuals who go to loan-sharks or pay high interest-rate credit cards because not doing so would deprive one of some perceived necessity. Individuals do not contract punitive interest rates simply to look at green pieces of paper in their wallet. The second derives from money’s function as a store of value. When we produce goods and services, we could store our wealth in a variety of ways. For example, I may store my wealth in strawberries and hope that I can find a dentist with a taste for strawberries who is willing 22

to do root canals for strawberries. However, if I hold my wealth in money, I can be reasonably certain that most people will take it in return for their goods or services. Storing my money at a bank, even at a low rate of return, or paying a simple free for a credit/debit card is simply more convenient than carrying around bags of gold to pay. Like the transactions demand for money, this demand curve is vertical (inelastic), because the interest rate it is essentially a transactions plus storage fee. The third draws upon money’s function as a unit of account. In deflationary economic environments, when real prices of goods and services are dropping, one can speculate on the value of money being worth more in the future than it is now. If goods and services are cheaper in the future because prices are dropping, the same amount of money will purchase more in the future. This is the basis for those who invest in gold. Gold, they feel, will hold its value -- because it is used as a unit of account -- while other commodities and assets lose value. This purpose for holding onto cash balances is speculative. If ones sums these curves together to identify the total demand for money, on finds a “L-shaped” curve like the one shown above.

Liquidity preference -- the preference to hold a liquid asset like money over a more illiquid (and perhaps more valuable) asset -- is fundamentally forward looking. It is the comparison of the present over the future or vice versa. A key element of this calculation is uncertainty. Future prospects do not necessarily have to be bad for individuals to want to hold cash balances, they need only be uncertain. As a result, the perception of economic uncertainty or volatility in the future can have real impacts on the economy today

4.3.2 LIQUIDITY TRAPS The IS/LM framework also identifies the potential problem of liquidity traps. A liquidity trap is where increases in (money) supply will have no effect on the price of money and therefore cannot raise or lower the cost of savings or investment. Using ordinary monetary policy (the purchase and sale of securities), the interest rate cannot go below 0%, the “zero lower bound.” Therefore, after one has reached 0% interest, further increases in the supply of money will not lower the level of savings or raise the level of consumption. Individuals would rather hold onto money (savings), because holding a cash balance is worth more than a) spending money on goods or services now, because they are decreasing in value or b) investment opportunities with positive returns on investment.

We can think through this problem using the chart to the left. The dotted purple line is the level of output required for full employment. Reflecting the zero lower bound, the LM curve is flat at 0% interest. The intersection of the IS & LM curves is below the level of production needed for full employment. Increasing the money supply (moving the LM curve to the light blue line), does not change the point of intersection.

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4.3.3 INFLATION The previous discussion of liquidity preference focused primarily on situations and circumstances where demand is deficient due to a lack of purchasing power to buy current production. By reversing the flows, purchasing power could be greater than current production, which will drive up prices (inflation). However, inflation can be thought of as the reverse side of liquidity preference is inflation. If prices of real goods and services are rising quickly, money is losing value relative to them. One would prefer not to have a cash balance at all, because the balance would decline as money depreciated. At high levels of inflation, money even loses its function as a medium of exchange.

4.4 DEBT DEFLATION While liquidity preference is a forward looking problem with the internal balance, debt deflation is a backward looking balance issue. Debt are payments from the present to redeem liabilities incurred in the past. As a result, they compete with current consumption for purchasing power: If I am paying down my student loan, I am not purchasing a flat-screen TV with that purchasing power. While it is true that any person’s debt is someone else’s credit and so there is no net loss, simply a redistribution, of purchasing power, one can default on debts, retired debt does not necessarily produce new credit, and debt contracts (typically) are stated in nominal terms, but are paid with the proceeds of real goods and services.

The intuition of debt deflation can be understood by thinking of student loans. In 2004, roughly four years before the financial crisis, many high school seniors understood that their productivity (or at least earnings) would be enhanced by obtaining a college degree. However, the cost of a college degree was beyond what they could finance from their current income, so, not surprisingly, they took out loans (incurred debt) to finance their education. Many of these students graduated in 2008 into the worst labor market in a generation and were not able to repay their debt due to the lack of income. Many were locked out of the labor market by older workers delaying retirement due to their own accumulation of debt.

Moreover, many only found work in jobs that underused their human capital. As a result, demand for current production decreased, as debts were paid down, creating even less demand for current employment. The chart above shows the same dynamic graphically for the financing activities of firms. The impact of debt on consumer behavior was shown in recent years when the moratorium of foreclosures (and slowed the payment of debt) freed money for consumer purchases, spurring some increase in economic activity.

The economist Irving Fisher first proposed the idea of “debt-deflation” as an explanation for the Great Depression in the 1930s, but recently, this process has been termed a “balance sheet recession” to distinguish it from normal business cycle fluctuations. Instead of trying to employ all available economic resources, individuals and firms attempt to delever (reduce debt) and repair their balance sheets. Even as debts are paid down, there is no demand for new credit, shrinking demand in the economy and creating disinflationary pressures as individuals cut prices to raise revenues to pay debts. As a result, the real burden of the debt rises because the debt contract is stated in nominal terms, but the proceeds of good and services to service the debt shrink as prices decline. In addition, even as debts are paid down, the individuals and firms receiving the debt 24

may not have the same propensity to consume. A recent study of high and low debt countries in the United States showed that high debt counties had lower automobile sales and employment growth than comparable low debt counties. Studies by the IMF also support the importance of debt in explaining consumption loss. The below left chart shows that higher levels of debt correlates with greater consumption loss, country by country. The chart to the right shows that high debt nations have much greater consumption losses than low debt nations during recessions.

Employment Growth

Automobile Sales

In addition, once begun, this process can begin to feed upon itself as debt reduces the demand for money which then in turn reduces the demand for the current production of goods and services. In economics, this feedback process is known as a Kiyotaki-Moore credit cycle and is illustrated in the charts below.

5.0 EXTERNAL BALANCES The economist Charles Kindleberger once marked that anyone who spends too much time thinking about international money goes mad. Perhaps no economic topic provokes so many incorrect statements and prescriptions by so many otherwise intelligent people as the â&#x20AC;&#x153;external balanceâ&#x20AC;? between domestic and international money. When economics models were developed in the 19th century, foreign currencies were not traded; the international currency was gold because all major economic powers adhered to a gold standard, more or less. It was common to describe foreign trade as simply a form of barter: the US produced corn, Japan produced microchips and they traded corn for microchips. However, it is more accurate to say that the US produces corn (and dollars) and Japan produces microchips (and yen), and therefore, there is another market 25

that sets the “external” balance of dollars and yen.

Discussions of international economics often focus on international “competitiveness” and stress “real” factors -- labor costs, education levels, and the costs of international commodities -- while overlooking the monetary terms of trade. The critical balance is the balance of payments of which the trade balance is only one component. As the chart to your right illustrates, there are many different international monetary flows -many that have little to do with the exchange of goods and services (exports and imports) -- that can affect the international balance of payments. The thinking about international money parallel the previous section’s discussion of domestic money and its role in the creation of potential imbalances between consumption and production.

5.1 PRICE-SPECIE FLOW MECHANISM The original economic thinking on trade had a simple formula: exports good, imports bad. If exports exceeded imports, the balance was gold and accumulating gold was the same as accumulating wealth. No one thought that money stocks had any effect on real economic activity, but this position was criticized by David Hume who laid out the price-specie flow mechanism. The pricespecie flow mechanism can be thought of as Say’s Law or the “quantity theory of money” (Sections 4.1.1 & 4.1.2 above) applied to international trade.

The accumulation of money stocks (gold) by nations running trade surpluses, Hume argued, would raise domestic prices as more purchasing power chases the same stock of goods and services. In parallel, the outflow of money stocks from countries running trade deficits would lower prices as less purchasing power chased the same stocks of goods and services. This development would make goods and services produced in the trade surplus country more expensive to foreigners and foreign goods and services less expensive to domestic consumers. This would eventually rebalance trade and monetary flows. Trade posed no net loss in wealth: imports would eventually lead to more exports and exports financed the purchase of imports. What consumers lost in terms of income, they would regain in lower prices on imported goods and services. Therefore, the only real source of wealth were the stocks of real factors that nations competitive or not.

5.2 MUNDELL-FLEMING The fly in price-specie flow mechanism’s ointment is money. For Hume, international money could be reduced to flows of gold specie, but in the modern global economy, there are many national currencies whose supply is controlled by each nation’s central bank or government. Therefore, there is also a market setting the terms of exchange between various national currencies. In terms of international economic policy, each nation wants 26

three things: control of their domestic money supply, stable exchange rates, and access to capital markets. The problem they face, however, is that it is only possible to have two of these three options. You can have capital mobility and stable exchange rates, but only at the cost of impaired monetary and fiscal policy (Europe). You can have capital mobility and monetary policy, but only if you let your currency float (USA).

You can have stable exchange rates and effective monetary and fiscal policy, but only by reducing capital mobility (China). To understand why, we must add the foreign exchange rate to the domestic IS/LM model of money’s supply and demand. The foreign exchange rate can be thought of as the global interest rate and can be drawn as a horizontal line that intersects with the domestic IS and LM curves, as shown in the diagram to your right. If the domestic interest rate is below the global interest rate, savers would rather put their money in foreign financial institutions. For example, if the Bank of Japan offered 7% interest on deposits, while the US Federal Reserve only offered 4% interest, savings would gravitate toward the Bank of Japan and away from the US Federal Reserve. Conversely, if the domestic interest rate is higher than the global one, it would attract savings and investment. The IS (Capital Mobility), LM (Monetary & Fiscal Policy), and FE (Foreign Exchange) curves correspond to one of the three options of this trilemma. Economic policymakers can control the position of two of them, but not the third.

For example, if a central bank increases the money supply (lowers the interest rate) to stimulate the economy, it will shift the LM curve to the right. As a result, the IS and LM curves will intersect below the level of the prevailing exchange rate. Two things can happen. First, the exchange rate could fall to the level of the IS/LM intersection. If exchange rates are allowed to float, this will happen naturally, because increasing the money supply lowers the domestic currency’s value vis-avis foreign currencies. This will have the effect of increasing consumption (the rightward shift in the equilibrium) by shifting production from foreign to domestic production through the weakening of the exchange rate.

Second, the IS curve could shift outward to preserve the prevailing exchange rate, i.e., allow it to remain fixed.

If the exchange is fixed, this means that investment-savings (capital) will move abroad to seek higher returns.

While this would expand output, it might spark a “bank run” as investors pull out their capital out of domestic banks, contracting credit extended by banks. Only capital controls that impede the outflow of capital prevent this and so it sacrifices capital mobility.

Another adjustment scenario is an outward shift of the IS curve whether to attract foreign capital for investment or due to a foreign nation’s desire to depress their own currency by propping up your own currency in order to promote their exports. Once again, two things can happen.

First the exchange rate could rise to the level of the IS-LM intersection.

If exchange rates float, this will happen as the result of “market” forces, because inflows of foreign capital will increase the demand for the domestic currency relative to foreign currencies. This will increase consumption, but only partially, because it shifts production from domestic to foreign production by strengthening the exchange rate, but 27

depress consumption via a higher interest rate.

Second, the LM curve could shift outward to preserve the exchange rate at its previous level. If the exchange rate is fixed, this means that the money supply will expand to absorb the inflow of capital. This will drive up domestic prices as more money chases the same stock of goods and services. While this will increase asset values, such as home and equity prices, it will also create inflationary pressures on ordinary goods and services.

This could be prevented by “sterilizing” (keeping out of circulation) foreign capital inflows or lowering interest rates or government spending, but to do so would cede control over domestic monetary and fiscal policy.

5.3 TRILEMMA The Mundell-Fleming model shows what options are available for national governments in managing international money; it does not tell which sets of choices are the best. Different nations in different economic circumstances can reasonably choose different combinations of options. From the late 19th century until WWI -- the first age of globalization -- the major economies opted for a gold standard regime of fixed exchange rates and capital mobility and central banks were either non-existent or played passive roles. The borrowing costs of fighting the WWI rendered the gold standard impossible and contributed to the causes (hyperinflation and deflation) of the Great Depression. As a result, many nations desired more monetary autonomy to combat the vicissitudes of the business cycle. After WWII, the Bretton Woods System created a system of fixed exchange rates (pegged to the US dollar) and monetary autonomy throughout most the world. The American burden of maintaining this system became too much, and in the 1970s, it abandoned the gold standard and allowed the dollar to float. Since the 1990s, the reemergence of the gold standard economy through the adoption of the “Washington Consensus” policies of deregulation, capital market liberalization, free trade, property rights, and lower taxation in concert with the “second age of globalization” has appeared. The charts below show that developed countries’ policy choices have diverged, opting for greater capital mobility and currency stability, while allowing monetary autonomy to wither.

Conversely, policy choices in the developing world have converged to greater balance between the three.

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Some observers, such as Harvard economist Dani Rodrik, argue that the trilemma is not simply an economic choice, but has additional implications for the choice of political institutions. The gold standard system that prevailed before WWI and since the 1990s, has reinforced the economic status of nation-states, while permitting the integration of national economies. However, democratic control over these forces, as witnessed by the decline of labor unions and the insulation of economic decisionmaking from democratic oversight, has largely dissipated. The Bretton Woods system that reigned from the end of WWII to the 1970s, allowed the resurgence of democracy within the friendly confines of the nation-state (and insulated from international economic competition). In between, efforts at constructing global federations -- WTO, EU, G-7/G-20, UN, ILO & IMF -- deal with international issues from climate change to child labor to regulatory harmonization to international debt have been attempted. However, since they have often threatened the prerogatives of the nation-state (and powerful groups within nation-states), these organizations of international governance have been largely ineffective and not particularly democratic. The increasingly common sentiment that governments are no longer accountable or responsive to their citizens while battered by international forces such as globalization are consistent with the inadequacy of political institutions to grapple with the economic trilemma of international economic affairs.

6.0 INTERNAL & EXTERNAL BALANCES How can we resolve both the internal balance between inflation and unemployment and the external balance between trade surpluses and deficits? In the previous section, the trilemma laid out the potential choices facing economic policymakers, but did not indicate what choices were optimal; the best choices depends on the situation and circumstance. A Swan Diagram, named after the Australian economist Trevor Swan, provides a simple method of diagnosing one’s situation. The diagram puts the two balances on each of its axes. On the horizontal axis is the internal balance. The internal balance can be gauged in several ways. Essentially, it is the relationship of current consumption to current production. First, by the size of the public budget deficit. If the private sector is in balance, the source of the imbalance is public spending over public revenues (taxes) or the budget (fiscal) deficit. Alternatively, one could use excess unemployment.

Unemployment would suggest that spending (demand) is less than the economy’s productive capacity (supply). The external balance is on the vertical axis. This can be measured in several ways. Narrowly, it can be measured as the trade deficit -- the value of exports minus the value of imports. Broadly, it can be measured as the current account (balance of payments) deficit, which incorporates all international monetary flows.

The fiscal deficit divides the space into two zones. The northwest corner is the “unemployment zone,” created by insufficient spending. The southeast corner is the “inflation zone,” generated by too much spending.

Likewise, the trade deficit divides the space into two zones. The northeast corner is the trade/current account deficit zone created when imports exceed exports. The southwest corner is the trade/current account surplus zone made when exports exceed imports. Added together, these overlapping zones create four archetypal 29

problem areas: trade deficit + unemployment, trade deficit + inflation, trade surplus + unemployment, and trade surplus + inflation. The point where the two lines cross is the point where both the internal and external balances are in balance; all other points represent some type and magnitude of imbalance.

Where do contemporary countries fall on the Swan Diagram and what policies would this recommend to them to recover their internal and external balances? The illustration to your right is suggestive where several economies are currently located. Beginning in the north quadrant, we find the USA, with higher than normal unemployment and persistent trade deficits. In the south quadrant, we find America’s mirro image: China. China, for the past decade, has run large and persistent trade surpluses and experienced significant asset inflation, especially in housing and equity prices.

To the right, we find Greece, a country running trade deficits and experiencing high inflation.

Finally, Japan is low-inflation, low-unemployment country that runs persistent trade surpluses (at least with the USA), placing it in the lower left quadrant.

What policies should each of these countries take to rebalance their economies? For the USA, the policy mix should include increased government spending (fiscal policy) and currency devaluation. China, once again, as mirror image, should do the opposite. It should impose some austerity and allow its currency to appreciate.

Greece should impose some austerity and devalue its currency. Greece’s problem, however, is that it cannot devalue because it does not control its own currency (and it no longer controls its own monetary policy and it has lost access to capital markets). Japan should be increasing government spending and allow its currency to appreciate. However, each of these countries is now doing the opposite of what this model suggests. The USA maintains a strong dollar and has embarked on mild austerity measures. China has only recently allowed its currency to appreciate, but also has initiated a new raft of government spending measures. Japan’s yen has appreciated, despite the government’s efforts to prevent it, and its government spending has been fitful. Lack of its own currency has precluded the devaluation option for Greece, but it has been equally unsuccessful in reducing its high costs.

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