The Separate Personality of Money

Lecture 8

Prepared for Developments – Theories and Perspectives course

Reviewing ‘the Welfare State’ • Fearful that the socialists might win a majority

and change the existing order of power, Bismark in 1884 and 1887 introduced legislation to provide accident, sickness, old-age and disability insurance. He said – ‘My idea was to bribe the working classes, or shall I say, to win them over, to regard the state as a social institution existing for their sake and interested in their welfare.’

• However, in Britain, the welfare measures did not came because of the fear of revolution rather the conscientious and informed agitation of socially concerned men. The 1911 legislation provided sickness and invalidism insurance and also unemployment insurance. This was more comprehensive than Germany. Germany would introduce unemployment benefit in 1927.

… (cont.) • The classical economists were highly critical of

welfare policies - state intervention in social & economic affairs.

• Argument 1: if unemployment exists, it is due to frictional resistance that prevent appropriate wage and price adjustments.

• Argument 2: Marginal utility of money for the acquiring individual, unlike the marginal utility of individual goods, did not fall. It remained constant - more do not give any less satisfaction.

• Say there are two men. The law of diminishing marginal utility of a good will hold for both of them. But it is not possible to say that one with more goods had less satisfaction from an increment than one who had fewer. The feelings of different people were not comparable.

… (cont.)

• Arthur Pigou claimed that so long as total production was not reduced by the welfare actions, economic welfare – the sum total of satisfaction from the system – was enhanced by the transfer of spendable resources from the rich to the poor.

• Institutional economists argued in favor of welfare policies by extending the social contract theory - the legal and moral foundations of the relationship between citizen and state.

What is Money and How it is Created

Introduction • Monetarism – the role of money and its

management to increase economic output.

• In the beginning money was a commodity like any other. There are two characteristics of this commodity :

– The commodity is non-perishable and can be divided into parts of specified weight.

– It has to have high enough worth in small enough bulk.

• So, in early times with gold and silver coin, money was an intermediate step in barter exchange.

• It has another unique feature – money is a convenient way of holding wealth.

… (cont.) • Soon the rulers will resort unfair means

to take advantage of money in the effort to finance their increasing expenditure. … ‘a little of the metal could be shaved off the coin or a little of a lesser metal introduced into its manufacture – in the hope that this debased coin will pass as before and the metal saved could be used to produce more money.’

• Since then to now, no other economic practice was universally so condemned.

• Gresham's law : ‘Bad money drives out good’. Also by Nicole Oresme.

Origin of the separate identity of money• The separate identity of money was discovered

with the establishment of banks in Italy in the thirteenth century.

• At first bank was simply a place of deposit, the metal coins or honest metals was stored there on the depositor’s behalf. When he asked that the deposit be transferred to a creditor – as a means of payment – the coin was moved to the creditor’s place of storage. The total of the money available for transfer and payment thus did not exceed the amount of original deposit.

• Soon Banks start lending – men open accounts for borrowing and then depositing the proceeds. From this account, backed now not by a specific but by a general claim on the metal, they would make payments. And money had been created.

… (cont.) • In another development, some banks will

enable borrowers to take his loan in bank notes. The notes affirmed that he had the metal on deposit, and the receiver of the notes could then go to the bank and command it. Or, he could pass the notes on to yet another supplier or creditor. Meanwhile the original metal remained in the bank vaults and could also be lent. Again money had been created.

• So, total notes and deposits in checks were in excess of the value of the metal. This was entirely safe and acceptable for so long as everyone – original depositors, borrowers, note holders – did not come at the same time for the hard money.

… (cont.) • Given the profits possible from this manufacture

of money, it is natural that there is a temptation to overdo this. … ‘out of this temptation were born the central banks and much of the structure of modern bank regulation.’

• The Bank of England was established in 1694 – to regulate the lending and money creation of the lesser banks. And the central bank do this by forcing smaller banks to made payment their notes with metal and by enforcing minimum level of metal reserves against deposits.

• So, a mechanism is established through banks by which the supply of money could be increased or sharply diminished at will.

Money and Taxation • The final step in the discovery of the separate

personality of money was – the realization of prince and parliaments that the creation of money could be used as a substitute for taxes or as an alternative to borrowing.

• This discovery is not similar with the debasement of metal coins that were practiced by some prince. Now, the state acquired hard coin, store it in the state treasury and issued paper notes. Or, a bank did so on behalf of government. Again, the notes put in circulation would exceed the metal on which they are based. … ‘Need, not caution, would be the ruling force.’

… (cont.) • And when the volume of money could no longer be

sustained by the state from any available metal, conversion of the notes back into hard coin is devalued or in some few cases even suspended…. ‘They have gone off the gold standard.’

• This discovery has an important political consequence – continental notes by the Washington’s Armies, the assignats that helped finance the French Revolution, and the Greenbacks of the American Civil War were all issued by a future government to finance their expenses. None of them had central bank.

• Interestingly, economists celebrate these revolutions as the step toward capitalism but deplore the paper notes by which they are financed.

The key question of Monetarists• Scholars have come to agree that a moderate

issue of paper improve prices and stimulate economic activity.

• In agriculture: ‘Money created by banks could buy land, livestock and farm equipment; paper money also improve prices and ease debt repayment.’

• But the established centers of commerce and industry powerfully resisted such action – money should be kept scarce and valuable. This would be the case with rich even now. The classical economists would forcefully support this view.

• So, the question is - should money be called into service deliberately to affect prices and provide for capital needs?

The American Experience • After the civil war in USA, steps were taken in 1866

to retire Greenbacks in an orderly way – ten million in first six months, thereafter at a rate of four million a month. Finally in 1873 the country returned to the gold standard.

• But in these years farm prices were falling – from an index level of 162 in 1864 to 128 in 1869 to a withering 72 in 1879. In consequence came a highly charged debate over the role of money in setting price level. More greenbacks, it held, would put prices back up. This was the earliest manifestation of quantity theory of money.

• The debate resulted a new party named Greenback Party which elected 14 congressman – ‘never before in history had monetary policy brought forth such a political force’.

Quantity Theory of Money• In 1911, in The Purchasing Power of Money,

Irving Fisher published his quantity theory of money – ‘prices would vary with the volume of money in circulation, with due allowance for its velocity or rate of turnover and the total trade amount or number of total transactions.’

P = (MV+M`V`)/T

Here, P=price Level, M=quantity of money, V=velocity of circulation of M, M`=volume of credit money, V`= velocity of circulation of M`, and T = total volume of goods and Trade

• In the short run, the rate of the spending of money or the velocity of money is more or less constant and the volume of trade is relatively stable in the short run. So an increase in M and M` directly affects the level of prices.

… (cont.) • With this equation, the theoretical

apparatus of monetarism was born.

• This also generated two further questions –

– should money supply be equal to the increase of T, the volume of trade, to maintain price stability?

– Whether an attempt to increase or decrease the supply of money would instead have a powerfully adverse effect on T and thereby employment?

• These questions would be addressed in 1970s and 1980s.

Questions…