Wednesday, June 30, 2010

Money is not a Neutral Veil

Neoclassical economics has the erroneous belief that money is neutral. Let’s start with some definitions of “neutral money.” First, a simple definition:
neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages and exchange rates but no effect on real (inflation-adjusted) variables, like employment, real GDP, and real consumption.
The macroeconomic theory called monetarism held that money is neutral “in the long run.” This essentially means that money is thought to have insignificant effects on real variables such as output, the level of employment and real GDP in the long term. The New Classical macroeconomics of Robert Lucas used rational expectations to argue that money is also neutral, both in the short and long run. According to this view, if the money supply is increased, then only nominal variables will be affected, rather than real variables like relative prices, output and employment, and prices and wages will simply adjust to their general equilibrium values (Horwitz 2000: 11). Austrians claim that they deny the neoclassical neutrality of money idea (Horwitz 2000: 11), but this is clearly disputable and Post Keynesians argue that in fact Austrian theory still relies on the neutral money axiom (Davidson 1989).

I want to focus here on a related idea: that money is just a veil over real activity.

Neoclassical analysis sees economic life in terms of a moneyless, ideal barter system. In this system, money exists but has been introduced merely to make trade easier. The exchange ratios between goods and services in bilateral transactions are still seen as fundamental. This means that economic life is just about the “real” exchange of goods and services: people produce commodities in order to exchange them for other commodities. In this view, all the important features of economics can be understood in terms of the barter exchange of goods and services. Money is just a thing that functions as a “neutral veil” that overcomes the inconveniences of direct barter. This emphasises money’s role as a “medium of exchange” and neglects its other functions.

However, this type of “real analysis” is fundamentally flawed: money is not just a veil over a barter system. Proper analysis of modern economic systems requires monetary analysis (Smithin 2003: 2). John Maynard Keynes’ General Theory of Employment, Interest and Money (1936) argued that modern capitalist economies are pre-dominantly monetary systems. The starting point for any sensible economic theory must recognise that monetary factors are crucial to modern economic activity. Indeed, Keynes produced a “monetary theory of production” which shows how crucial money and credit are to production of output:
The general idea of monetary production is that the economic system under which we live, variously described as capitalism or the market economy, and which has existed in one form or another since the industrial revolution is, in fact,
pre-eminently a monetary system.

Those responsible for setting production in train, whether they are entrepreneurs or corporations, must first acquire monetary resources by borrowing, selling equity, or previous (financial) accumulation before they can do so. The ultimate proceeds of productive activity from the subsequent sale of goods and services are also sums of money. Intuitively therefore in such an environment, and contrary to the point of view that money does not matter, the functioning of the monetary system takes on major significance. In particular, the ‘terms on which’ ... the monetary resources for production are obtainable (that is, the rate of interest) would seem to be of vital importance
(Smithin 2003: 3).
As a consequence of this, it can be also argued that, as long as resources are available for production of output in a way that does not cause inflation or significant inflation, then there is no need to “finance” investment for production out of loanable funds or a money supply where growth and availability of credit money is restricted by the supply of gold (or some other commodity).

The Rothbardian branch of the Austrian school which developed the ideas of Hayek and Mises vehemently rejects fiat money and “fiduciary media” un-backed by commodity money. But, as I have shown in a previous post (see What is Money? A Short Analysis), this view is utterly unconvincing, and in fact classical gold standard capitalism ended in 1913 with paper currency and bank deposits accounting for 90% of overall currency circulation in the world, and actual gold itself for not much more than 10% (Triffin 1985: 152). Gold standard capitalism had invented more fiduciary media to accommodate the demand for money, although it was no doubt restricted by the need for a monetary base of gold.

A fiat monetary system is superior to a commodity standard because it accommodates the endogenous growth in demand for credit. However, the crucial point is that fiat money also needs a financial system that is properly regulated to channel credit to productive lines of investment and to prevent asset bubbles. Keynesian demand management through fiscal and monetary policy and incomes policy (e.g., centralized wage bargaining or arbitration) prevent excessive inflation. When an economy has inflationary pressures Keynesian fiscal and monetary policies contract demand to smooth the process out. A recession may or may not result, but, if recession occurs, it will be brief and a new cycle of growth will soon resume through stimulus. The belief that investment needs to have “funded” by previous private saving is an utter myth that hinders economic growth and the full use of resources to maximise growth, wealth and employment.

Addendum: Money as a Measure of the Subjective Value of Labour?

Using a “subjective labour theory of value,” the blogger Cynicus Economicus argues that money has this function:
the underlying purpose of money is very clear. It should only act as a medium through which the value of labour might be accounted, and is always representative of a store of value of labour, with an underlying contract that it might, at some future point in time, be exchanged for the value of labour of others.
But the idea that money only acts as “a medium through which the value of labour might be accounted, and … always representative of a store of value of labour” appears to commit him to the view that money is also just a “veil” over a world of barter of subjective valuations of labour. This seems to commit the same error as the neoclassicals in thinking that money is just a veil over real activity, which it clearly is not.


Davidson, P. 1989. “The Economics of Ignorance or Ignorance of Economics?,” Critical Review 3.3/4: 467–487.

Horwitz, S. 2000. Microfoundations and Macroeconomics: An Austrian Perspective, Routledge, London and New York.

Smithin, J. 2003. Controversies in Monetary Economics, Edward Elgar, Cheltenham, UK and Northampton, MA.

Triffin, R. 1985. “Myth and Realities of the Gold Standard,” in B. Eichengreen and M. Flandreau (eds), The Gold Standard in Theory and History, Routledge, London and New York. 140–161.

The Utility of Money in Post Keynesianism

In the previous post, I described money as a possible factor of production, and I have also realised that the discussion of value there raises the question whether money has utility.

In its role as a medium of exchange, money functions as an intermediary unit of account (or numéraire) that facilitates the exchange of goods and services. From this derives the idea that money only has utility through its exchange value, a view which is held by the Austrians and neoclassicals. As the American neoclassical F. W. Taussig argued,
[t]he phrase “marginal utility of money” must … be used with caution. Money has utility in a different way from other things. It is valued not because it serves in itself to satisfy wants, but as a medium of exchange, having purchasing power over other things. Gold jewelry is subject to the law of diminishing utility precisely as other things are. But gold coin—money—is subject to it only in the sense that an individual buys first the things he prizes most, and then other things in the order of their less utility (Taussig 1911: 124).
Writing in 1911, Taussig here refers to commodity money (although it would appear that other neoclassicals admitted that commodity money like gold had utility in itself, but perhaps this is another issue).

But Post Keynesian economics shows us that money (even fiat money) does have utility:
In an uncertain world, the possession of money and other nonproducible liquid assets provides utility by protecting the holder from fear of being unable to meet future liabilities (Davidson 2003: 236).
The neoclassicals thought that only producible goods and services can provide utility. But money can have utility on its own account. So can liquid financial assets. The neoclassical view was that money has no utility, but only exchange value. The Austrian view also seems to be that money has no utility except for what can obtained in exchange for it. The idea that money has no utility in itself is part of the three fundamental neoclassical axioms that Keynes rejected. The following three fundamental axioms are the basis of neoclassical economics and of Say’s law:
(1) the neutral money axiom (i.e., holding money by itself provides no utility),
(2) the gross substitution axiom, and
(3) the ergodic axiom.
Post Keynesian economics requires the rejection of these axioms. In a fundamentally uncertain world, you have the problem of facing a possible lack of liquidity in the future (i.e., lack of money). This is why many people like to hold onto money, and precisely why money has utility – and in fact often has a great deal of utility.

In Keynes’ General Theory, an essential property of liquid assets (money being the most liquid asset) is that their “elasticity of production” is near or equal to zero. To say that financial assets and money have “a zero elasticity of production” means that commodity-producing businesses cannot engage in production of money or financial assets by hiring labour. If demand for liquidity in an economy increases, then producers of commodities cannot “produce” liquid assets by hiring workers. When the demand for non-reproducible assets as a “store” for money rises, this can induce unemployment. If there are assets in which money can be saved other than reproducible goods, then full equilibrium will not necessarily happen in a market economy: investment will not be sufficient to achieve full employment. This is why, even if wages and prices were perfectly flexible, we could still have involuntary unemployment.


Davidson, P. 2003. “Keynes’ General Theory,” in J. E. King, Elgar Companion to Post Keynesian Economics, Edward Elgar Publishing, Cheltenham, UK and Northampton, MA. 229–237.

Patinkin, D. and Steiger, O. 1989. “In Search of the ‘Veil of Money’ and the ‘Neutrality of Money’: A Note on the Origin of Terms,” Scandinavian Journal of Economics 91.1: 131–146.

Taussig, F. W. 1911. Principles of Economics, Volume 1. Macmillan Company, New York.

Monday, June 28, 2010

What is Economic Value?

I have posted on this subject before (see The Myth of the Labour Theory of Value), and wish to clarify some points.

First, we need to define the concept of value. I will summarise some of my earlier remarks. Value is the worth of something, however that is judged. Philosophers distinguish between extrinsic (= instrumental) and intrinsic value. The extrinsic value of something is its worth for the sake of something else, in the sense that it is valued because it will obtain, or allow you to achieve, some other thing or goal. The intrinsic value of something is its worth for its own sake. Yet another concept is intermediate value, which is when something has a combination of both extrinsic and intrinsic value. These concepts, however, are not what economists mean when they talk about value.

We can review the concepts of value as they are used in neoclassical and Marxist economics below:
(1) Neoclassical Economics:
Use value is purely subjective. Utility is the satisfaction or pleasure derived by an economic agent (a person or a firm) from consuming a good. Utility is the measure of value. This stems from a subjective valuation of the worth of the good by an economic agent. Thus the value placed on any good can, and often does, vary from person to person. Two people can derive completely different utilities from a good that costs them the same price. Also, utility can influence the price of a commodity.
Exchange value is the price that a good or service commands in the marketplace, although the price can also be affected by supply and demand. The utility of the good (and the individual subjective valuation of that good) can directly influence the price, particularly when aesthetic judgements are involved. In modern microeconomic analysis, price theory is the study of how prices are determined in individual markets. In neoclassical economics, there are two main factors affecting the price of a good: the demand side and the supply side. The demand side is essentially consumer behaviour involving individuals maximizing utility. The number of individuals who place a subjective value on a particular good can cause demand, and, along with supply, this influences the price of the good.

(2) Marxist Economics
Use value is the objective usefulness of a good and depends on the way in which the good is used by the buyer.
Exchange value is the power that something has in obtaining other goods in exchange, and it is completely independent of the use value.
In what follows, I accept the general neoclassical definitions of value, and reject the Marxist ones. Modern neoclassical economics has largely dispensed with “value theory.” As I. A. Kerr has pointed out,
[m]ore recently, the attitude of neoclassical economists to the value/price distinction has been one of indifference, rather than hostility … value theory is virtually synonymous with price theory and many economists would be hard pressed to explain the difference between the two. In fact, the two terms are widely conflated by neoclassical economists (Kerr 1999: 1218).
Post Keynesians, as far as I can tell, have not been concerned much with the general concept of “use value” in the subjective sense either (perhaps I am wrong), although Post Keynesian economics does have strong criticisms of the diminishing marginal utility theory (Keen 2001). Post Keynesianism departs from neoclassical theory in adopting a synthetic theory of prices that combines both classical cost of production ideas and neoclassical price theory (Kerr 1999: 1218). Thus Post Keynesian price theory is an essentially empirical discipline, and seeks to find the causes of price in analysis of modern economies and production.

If we are talking about “use value,” then the idea that the value placed on a commodity is fundamentally subjective seems reasonable to me. If value is subjective, then it does not always come from one specific or more objective and consistent sources (say, like labour).

In modern mainstream economics, “exchange value” is the price of the good or service in the market place. Supply and demand clearly do influence price. But there is clearly another factor that also fundamentally explains the average, long-run price of many goods. This is the total cost of factors of production, which are:
(1) natural resources, including land, raw materials, primary commodities, water, energy;
(2) labour;
(3) capital goods, and
(4) entrepreneurship (O’Connor and C. Faille 2000: 63).
Post Keynesian economics stresses that we live in a monetary production economy, so that credit money is also a fundamental prerequisite for production. Credit money could even be regarded as a factor of production, although I will put this point aside for the moment.

It is clear that the price of many goods sold for profit must be above the total costs of all these factor inputs. That is, the total costs of the factors of production plus the markup explains the general price. Of course, if there is no demand for the good or little demand, then that will influence the price too, but unless the producers of the commodity sell without profit, they must have a price above the total factor costs.

Addendum: A Subjective Labour Theory of Value?

The blogger Cynicus Economicus has proposed a novel theory of value that might be called a “subjective labour theory of value.”

He states
The first point to make is that all economic activity is rooted in the value of labour. A commodity such as gold only has value once labour has dug it from the ground, and labour has moved it to the surface. Once it arrives at the surface it will be some form of labour that is utilised to move it to where it is next utilised …. At the heart of all economic activity is human labour, and economics is the process of exchange of value of labour between individuals, organisations and other economic units. Within this system of exchange of value of labour, the underlying purpose of money is very clear. It should only act as a medium through which the value of labour might be accounted, and is always representative of a store of value of labour, with an underlying contract that it might, at some future point in time, be exchanged for the value of labour of others. Any system of money should seek to represent the value of labour in a way that is both fair and stable, such that the underlying contract is met regardless of elapsed time. Such a system implies that the value of money should be a neutral token to be used in the exchange of value of labour, such that it offers a fair exchange as determined by how individuals and organisations value the labour of each other. The purpose here is not to discuss the rights and wrongs of how one person’s labour might be valued against another, which is a debate about social justice, but rather to identify that all economic activity is the exchange of value of labour.
The idea that a person can in some cases subjectively value labour when buying a commodity is coherent and convincing. I do not question it.

However, the idea that all value judgements made by consumers when purchasing commodities are simply derived from a subjective valuation of labour does not follow.

One can also note that the very definition of value used above is not properly defined. It is “use value” or “exchange value”? (note that “use value” is not the “price” of a commodity).

If we assume that it is “use value,” then “use value” is the subjective worth of a commodity to an agent. The worth is measured by utility. The “utility” is the satisfaction or pleasure and the degree to which we are satisfied by the commodity. The source of how and to what extent we are satisfied by a commodity could come from one, two or multiple causes. A subjective theory of value commits you to the view that there is no universal objective source of “worth” or the way in which we measure worth.

If “use value” is the sense intended in “subjective labour theory of value”, then a serious problem is obvious: if I purchase a pearl at a market, I do so because I find the pearl aesthetically pleasing. I have no interest in the subjective value of the labour it took to bring the pearl to market (about which I know nothing anyway), and a subjective “labour valuation” is utterly irrelevant to the question whether I find it aesthetically pleasing or not. I purchase the pearl for subjective reasons other than a subjective valuation of labour.

A “subjective valuation of labour” simply does not occur in many purchases of commodities. You cannot claim that “use value” is subjective in the sense I have described above, and then claim that value nevertheless will only ever come from a subjective valuing of underlying labour.

Now we come to the definition of money in this “subjective labour theory of value”:
Within this system of exchange of value of labour, the underlying purpose of money is very clear. It should only act as a medium through which the value of labour might be accounted, and is always representative of a store of value of labour, with an underlying contract that it might, at some future point in time, be exchanged for the value of labour of others.
Since money can only act as “a medium through which the value of labour might be accounted” in the actual money price of commodities (or perhaps even assets) sold on the market, this requires a definition of value that equates value with the “money price a commodity obtains in the market place.” In other words, Cynicus is using the concept of “exchange value” here.

But it is simply not possible to argue that the “money price” of commodities is only derived from subjective valuation of the underlying labour. Demand (through subjective valuation) is only one side of price. As we have seen above, the average, long run price of a commodity tends to be also strongly related to the total costs of factors of production plus the mark-up. Labour is one factor of production. We cannot explain price by appealing to a “subjective labour theory of value.” It follows that the idea that money is only a “medium through which the value of labour might be accounted” is also wrong.


Keen, S. 2001. Debunking Economics: The Naked Emperor of the Social Sciences, Zed Books, London and New York.

Kerr, I. A. 1999. “Value foundation of Price,” in P. A. O’Hara (ed.), Encyclopedia of Political Economy, Routledge, London and New York. 1217–19.

Lowe, A. 1981. “Is Economic Value Still a Problem?,” Social Research 48.4: 786–815.

Sunday, June 27, 2010

What is Money? A Short Analysis

The subject of money seems to cause people a considerable amount of confusion. What it is and what it does can be difficult concepts for some people.

This is a very short analysis.

My view is that money can be best understood through these four propositions:
(1) Money is (a) a unit of account, (b) a medium of exchange and (c) a store of value;

(2) Money is a present and future potential claim on (a) commodities (goods and services), (b) assets (real or financial), and (c) foreign exchange (e.g., other currencies);

(3) Money’s role in proposition (2) can be foregone and money can be saved for a return for specific periods in whole (e.g., certificates of deposit, time deposits and other investments) or in part in a more flexible way (e.g., demand deposits or savings accounts) and lent out to other people;

(4) Money is also a thing that can be used to discharge one’s obligations (e.g., debt, taxes, fines, or compensation one might be obliged to provide).
In my view, propositions (1) to (4) are a good fundamental description of what money is and does. It is of course hardly complete or exhaustive. For example, some people choose to hold money in its own right (say, by hoarding it) rather than saving or investing it, or as a security against uncertainty in the future, or for the sake of status and the privileges that one can obtain by holding large amounts of money. Money can also be considered as the most liquid asset, and in this latter role demand for money itself can be an important factor in economic activity, as the liquidity preference theory of Keynes shows. Moreover, the theory of how money actually historically arose is still debated by neoclassical economists and chartalists/neo-chartalists (I am personally sympathetic to the chartalist theory on the origin of money).

As a supporter of Post Keynesianism, I advocate fiat money as preferable to commodity money, and view the modern money supply as essentially endogenous (in contrast to the “exogenous” money supply view). Furthermore, money is not some veil over an economy where economic activity is essentially barter: money has real effects on economic activity and is not neutral.
I will briefly examine each of my four propositions in more detail below.

I. (1) Money is (a) a unit of account, (b) a medium of exchange and (c) a store of value
These are money’s fundamental functions and the answer you usually get to the question of what money is.

As a unit of account, money is a thing by which we measure the value of another thing such as a commodity, asset or obligation. We can measure the relative values of one commodity/asset against another commodity/asset as well. Money is thus a common unit of measurement by which we establish value and compare it.

The medium of exchange function means that money is the intermediary instrument we use to buy, sell and trade commodities and assets. This avoids the highly inefficient system of bartering goods and services used in the past. The medium of exchange function makes market exchange much more efficient, rapid, and convenient. The neoclassical view is that the medium of exchange role arose as one commodity (usually gold or silver) become the most marketable good in the community. Chartalism, by contrast, emphasises the role of states in creating money by creating a “money thing” (often silver or other metal coins) that the government then demanded back as payment for taxes levied on the community. This had a fundamental role in creating the medium of exchange function of money.

The store of value function means that money has the power to store its value for a short or long time. With fiat money, the value of money essentially comes from its purchasing power (its power to buy a given quantity of commodities or assets). Inflation erodes this power, but since "store of value" is only one function of money one will have to decide whether the trade-off between the positive effects that inflation can have (or be an effect of) and the lower purchasing power for money that results is justified. If we avoid crippling debt deflation and productive borrowers benefit (at the expense of non-productive rentiers), then low and steady inflation can be fullly justified.

II. (2) Money is a present and future potential claim on (a) commodities (goods and services), (b) assets (real or financial), and (c) foreign exchange
Our money allows us to buy commodities (goods and services) and assets.
Some people might wonder why I have added a third item: foreign exchange.
Demand for foreign exchange is important: importers of foreign goods need it as well as domestic investors wishing to own foreign assets. The world’s reserve currency is the US dollar, which can be a potential claim on the commodities and assets in nearly all countries. There exists a precautionary demand for foreign currency too in trade, as well as a demand for it in financial markets. Foreign exchange allows a good many international financial transactions including speculation in financial assets and derivatives markets. A vast amount of economic activity involves “hot money” flowing in and out of nations and used in such financial transactions and often just moved around endlessly between nations for this purpose. I would consider the claim on foreign exchange to be a legitimate third claim that money has.

III. (3) Money foregone through saving
We can defer our purchasing of commodities and assets today, and instead obtain a return on money by lending it through saving. Very rich people in fact simply invest most of their wealth in this way. They have no interest in ever claiming output with all of it. Instead, they can get a good annual income through investing their excess savings and keeping that money invested for long periods (e.g., in perpetual trust funds).

IV. (4) Money is also a thing that can be used to discharge one’s obligations (e.g., debt, taxes, fines, or compensation one might be obliged to provide).
This is a very important function as people must pay taxes and debt. Historically, government taxes were a cause of the origin of money. As L. R. Wray has argued:
the evolution of money is linked to the needs of the state to increase its power to command resources through monetization of its spending and taxing power. Thus, money and monetary policy are intricately linked to political sovereignty and fiscal authority …. the critical point is that governments impose fees, fines, and taxes to move resources to the government sector, and that for many thousands of years, governments have imposed these liabilities in the form of a monetary liability. Originally, the money liability was always in terms of a unit of account as represented by a certain number of grains of wheat or barley … Once the state has imposed the tax liability, the taxed population has got to get hold of something the state will accept in payment of taxes. This can be anything the state wishes: It can be clay tablets, hazelwood tallies, iron bars, or precious metal coins. This, in turn, means the state can buy whatever is offered for sale merely by issuing that thing it accepts in payment of taxes. If the state issues a hazelwood tally, with a notch to indicate it is worth 20 pounds, then it will be worth 20 pounds in purchases made by the state so long as the state accepts that same hazelwood stick in payment of taxes at a value of 20 pounds. And that stick will circulate as a medium of exchange at a value of 20 pounds even among those with no tax liability so long others need it to pay taxes .... The modern Post Keynesian view of money is based on a neo-Chartalist, or state money, approach (Wray 2000).
If you look at a US one dollar bill, you will see the words “this note is legal tender for all debts, public and private.” Chartalists contend that it was this role created by government that is the key to money’s origin and development.

V. Commodity versus Fiat Money
Until the 1930s, commodity standards were a major form of money. A commodity money system is one where some commodity (e.g., gold or silver) is the basic form of money. It is “money proper.” “Money substitutes” are used in place of it, but must be convertible into the commodity at some fixed rate on demand.

Fiat money, by contrast, is money created by government acceptable for payment of taxes and debt through “legal tender” laws. Fiat money is not convertible into a commodity on demand at a fixed price and its supply is not limited. Fiat money has the advantage of freeing the monetary system from crippling unexpected deflation that causes debt deflation and has devastating effects on economic activity. I favour fiat money, with floating exchange rates (but where there is some scope for central bank intervention to prevent excessive appreciation or depreciation of the currency).

The classical gold standard was the most obvious example of a commodity standard. Yet as I have pointed in my previous post (see Fractional Reserve Banking: An Evil?), the gold standard imagined by some Austrian economists is a myth. In fact, by 1913 paper currency and bank deposits accounted for 90% of overall currency circulation in the world, and actual gold itself for not much more than 10% (Triffin 1985: 152). And this was the “classical” gold standard! It was a world where fiduciary media like credit money had become the major type of money in the broad money stock by the late 19th century. The reason is that, under the gold standard, there was a need for increasing creation of fiduciary media (a type of “money substitute”) like credit money, because not enough gold existed to meet the demands of the community for money. Fiduciary media are “money substitutes” in excess of the actual amount of commodity money (or “money proper”). Most “free banking” libertarians do not object to such “fiduciary media” per se, but the branch of Austrian economics influenced by Murray Rothbard does.

Modern Austrians and libertarians still debate the question whether increasing issues of fiduciary media (under a commodity system) were (1) unacceptable “created credit” (which allegedly causes “forced savings”) or (2) legitimate “transfer credit.” Ludwig von Mises’s view on fiduciary media, for example, was not wholly consistent. In his Theory of Money and Credit, Mises seems to suggest that increases in fiduciary media caused by a corresponding demand could be non-inflationary and presumably acceptable (Horwitz 2000: 78). In his later writings, however, he condemned the issue of fiduciary media uncovered or only partially covered by commodity money as a type of “created credit.” The “created credit” would increase the broad money stock, raising money prices and redistributing resources in favour of the first recipients of the money (Hülsmann 2007: 249).

As I have shown in the last post (see Fractional Reserve Banking: An Evil?), the Rothbardian view that fractional reserve banking and fiduciary media are immoral is utterly unconvincing.

As an advocate of Post Keynesian economics, I would also argue that the innovation by which investment could be increased beyond savings through fractional reserve banking and fiduciary media was a powerful method of increasing real economic growth through production of more goods and services and more productive investments.

That the “first recipients” of “created credit” were able to obtain a redistribution of resources in their favour was and is fully justified, if these people were engaged in productive investment that will benefit society as a whole and make it wealthier. And this just underscores the need for careful and effective financial regulation that can prevent asset bubbles and channel investment to productive uses.

The higher inflation that might (or might not even) happen is the trade-off you get from faster economic growth. And in fact as I show here (see The Austrian Theory of Inflation: Myths and Reality), the Austrians are committed to the view that changes in the level of prices depend very much on both real factors and monetary ones. In reality, whether inflation happens or not could be determined by real factors. Such real factors that can overwhelm monetary factors and keep inflation low include:
1. the falling prices of specific goods through increasing productivity or output;
2. low capacity utilization rates;
3. a rise in cheaper imports into a country;
4. falls in the prices of imported basic commodities that are factor inputs;
5. changes in the velocity of circulation of money, and
6. level of employment (= level of demand for goods and services).
Whether you get inflation or not when fiduciary media are issued (or, for that matter, fiat money) depends on the particular state of the economy at that time. I also see no argument against increasing credit money in line with the demand for it in a fiat currency system with effective financial regulation.

VI. Some Other Issues
The subject of money is frequently raised on the Cynicus Economicus blog by commentators.

Recently, one commentator has argued:
the prevailing theory here is that money is a representation of the value of goods and services currently exchanged within an economy.
But this is a definition of GDP, not money.
Also, another comment:
If money is created without a corresponding increase in goods and services then it naturally devalues what each note can buy. That’s inflation.
This assumes that the quantity theory of money – the idea that there is a direct, mechanistic relationship between the money supply and the inflation rate/price level. But the quantity theory makes assumptions that are either (1) fundamentally false or (2) untrue in recessions. The quantity theory assumes this:
1. a stable velocity of circulation;
2. an exogenous money supply, and
3. high capacity utilization/high employment.
In reality, we have an essentially endogenous money supply, so assumption (2) is wrong.

The velocity of money is unstable and subject to shocks and moves pro-cyclically (Leo 2005), and in a recession capacity utilization is low. The quantity theory also ignores imports in open economies, which can keep inflation low.

Another commentator called Sobers remarks:
Money is just a store of labour – a way of translating today’s production into tomorrow’s consumption with the maximum efficiency. I dig my neighbour’s garden, he gives me £20. I may put it in my bank and save it for a rainy day, or I may spend it down the pub immediately. It’s my choice. It was my labour.
This idea is based on the view that value can only come from a subjective valuation of the underlying labour used to produce something.

But this “subjective labour theory of value” is deeply flawed. When people buy commodities, they do not all simply “subjectively value labour.” The subjective decision to buy something could be based on one, two, or many factors that have nothing whatsoever to do with the subjective value of the underlying labour.

If you find even one instance of someone buying a commodity where his or her subjective decision had no role for a subjective valuing of labour, the theory would not work.

And, of course, in reality, many people do consume commodities without the slightest interest in the subjective value of the underlying labour.

If I purchase a pearl at a market, I do so because I find the pearl aesthetically pleasing. I have no interest in the subjective value of the labour it took to bring the pearl to market (about which I know nothing anyway), and a subjective “labour valuation” is utterly irrelevant to the question whether I find it aesthetically pleasing or not.

If the “subjective labour theory of value” collapses, then so too does the idea that money is just a store of labour.


Horwitz, S. 2000. Microfoundations and Macroeconomics: An Austrian Perspective, Routledge, London and New York.

Hülsmann, J. G. 2007. Mises: The Last Knight of Liberalism, Ludwig von Mises Institute.

Leo, P. 2005. “Why does the Velocity of Money move Pro-cyclically? International Review of Applied Economics 19.1: 119–135.

Triffin, R. 1985. “Myth and Realities of the Gold Standard,” in B. Eichengreen and M. Flandreau (eds), The Gold Standard in Theory and History, Routledge, London and New York. 140–161.

Wray, L. R. 2000. “The Neo-Chartalist Approach to Money,” Center for Full Employment and Price Stability

Saturday, June 26, 2010

Fractional Reserve Banking: An Evil?

Hostility to fractional reserve banking is ubiquitous. The Austrians hate it and regard it as a type of fraud. There are even a good many people on the left who despise fractional reserve banking as an evil institution. However, a careful look at fractional reserve banking suggests that it is not necessarily a problem with modern fiat money, a well-regulated financial system, deposit insurance and a central bank ready as the lender of last resort. Fractional reserve banking without these safeguards can be extremely destabilizing and has often led to disastrous bank collapses and depressions.

I have to admit that every time I hear some Austrian complain about fractional reserve banking I laugh. The Austrians are adamant that fractional reserve banking is an evil fraud, yet since the early 19th century this system was a fundamental characteristic of modern Western capitalism. Fractional reserve banking was a major invention of the free market. What government ever forced banks or the public to engage in the practice? For example, from 1836 until 1913, the US had no central bank, yet fractional reserve banking was the norm (see G. B. Grey, Federal Reserve System: Background, Analyses and Bibliography, p. 90). The practice has continued today, yet Austrians reject the idea and have proposed two alternative systems (with a return to the gold standard), as follows:
(1) Free banking. This was Ludwig von Mises’ suggestion. There would be no bank regulation, no central bank monopolies, no bank licensing, and no legal barriers to entry.

(2) 100% reserve banking. Banks would not be allowed to issue more receipts for gold or silver than they have on deposit. This was Murray Rothbard’s solution.
These ideas are of course justified by the idea that fractional reserve banking is fraud, a view held by Murray Rothbard and modern Austrians like Hans-Hermann Hoppe.

But the libertarian scholar Michael S. Rozeff (2010: 497–512) has clearly demonstrated that the Austrian view of fractional reserve banking as fraudulent is wrong. If you take a pro-free market, neoclassical, or libertarian view of economics, then in fact you have no good reasons to reject fractional reserve banking (and even those on the left can accept it, with the limits I described above).

The reasons are as follows. The Austrians have a false and indefensible view that bank deposits remain the property of the depositor. They fail to understand that, when a depositor places money in a factional reserve bank, the depositor has exchanged one set of property rights for another.

By contrast, if you put your money or gold into a warehouse, then the owners or managers of the warehouse have no property rights with respect to your money stored there (such money is legally known as a “depositum,” which means “something given or entrusted to another for safe-keeping”). The identical deposit must be returned to the owner or, in legal terms, it must be returned in specie (“in its own form”).

But when a modern fractional reserve bank takes money for a new deposit this is actually a personal loan to the bank, which is why the bank pays interest for it. The money in the deposit becomes the property of the bank. The money is a loan, or legally a “mutuum,” which means “a contract under which a thing is lent which is to be consumed and therefore is to be returned in kind” (the modern sense of the English word “deposit” is thus misleading when it refers to money in fractional reserve banking). The depositor who lends the money gets a credit (or IOU) from the bank and a promise to pay interest: “the very essence of banking is to receive money as a [m]utuum” (MacLeod 1902: 318). The money has been “sold” to the bank as a mutuum and is to be returned in genere (“in general form”), which means you do not necessarily get the same money back, but just an equivalent amount with interest.

In demand deposits, you have lost your absolute property rights to the money when you lent it to the bank, and instead have entered into a contract with the bank to allow them to use it, even though they are obliged to return to you on demand money to the same amount in whole or in part from their other reserves and deposits (MacLeod 1902: 324). This can also be expressed in this way:
“General deposits are obligations of the bank to pay money. They may be payable on demand or at a stated time in the future. The great bulk of commercial bank deposits are payable on demand. They create between the bank and the customer the relation of debtor and creditor, the title to the deposit passing to the bank, while the depositor acquires a right to receive a stated sum of money” (Johnson 1911: 117).
It is certainly true that many members of the public may be ignorant of these facts above. Yet it is also true that, if people did not understand the basic facts behind fractional reserve banking, there would be no such thing as a bank run. Yet bank runs were very frequent before the 1930s when modern fiat systems and deposit insurance generally became the norm. In order for such bank runs to have occurred many people must have understood at some level that the banks do not operate on a 100-percent-reserve basis. Perhaps a good many were ignorant of this, but the fact remains that modern fractional reserve banking required a legal contract between depositors and banks, specifying that the property rights to the money had passed to the bank and in return an IOU or credit had been granted to the depositor. This is not fraud. This is a free contract.

As Selgin and White argue, even if some members of the public do not understand that fractional reserve banks do not have 100% reserves,
“[i]f any person knowingly prefers to put money into an (interest-bearing) fractional-reserve account, rather than into a (storage-fee-charging) 100 percent reserve account, then a blanket prohibition on fractional-reserve banking by force of law is a binding legal restriction on freedom of contract in the market for banking services” (Selgin and White 1996: 88).
Furthermore, as long as members of the public were informed of the facts of fractional reserve banking and freely entered into the contract with the bank, then fractional reserve banking is not inherently fraudulent or immoral.

One can also make the point that, if people had really wanted to put their money into non-fractional reserve warehouses to keep their money completely safe, then one wonders why 19th and early 20th century capitalism never developed a large business sector providing just this service.

Fractional reserve banking before the 1930s thus allowed the creation of fiduciary media (a type of money substitute), including banknotes and bank deposits (which could be drawn on by check or withdrawn). It also allowed the creation of credit money in the form of bank deposits and banknotes. Mises defined fiduciary media as money substitutes where the issuer of the fiduciary media maintains less than 100% reserves in commodity money (gold or silver).

Modern Austrians reject fiduciary media that are not backed by commodity money.

Another libertarian scholar called George Selgin argues in response to this as follows:
“In a recent twist on the [fractional reserve] ... fraud argument, Hans-Hermann Hoppe and his co-authors … argue that holders of fiduciary media are, in fact, not victims of bank fraud at all but co-conspirators who assist bankers’ fraudulent undertakings by misrepresenting themselves “as the owners of a quantity of property that they do not own and that plainly does not exist” … Apart from begging the question of who are the victims, this novel fraud argument is based on a simple failure to recognize that redeemable banknotes and deposit credits are not “titles,” as Hoppe and his co-authors claim. They are instead IOUs, so there is nothing inherently fraudulent about there being more of them in existence at any moment than the total stock of what they promise to deliver. (If all IOUs had to represent existing property in order to be non fraudulent, most loan transactions would be fraudulent.) A person who deposits gold in a bank in exchange for a redeemable banknote does not retain ownership of the gold, but instead gives it up, albeit for an indefinite period of time … The bank, in issuing IOUs against itself, is not analogous to a counterfeiter, as Hoppe and his co-authors claim, for the simple reason that the bank acknowledges its own debts, whereas a counterfeiter issues IOUs with someone else’s name on them” (Selgin 2000: 93–100).
Banks keep reserves to meet their obligations to the depositors (the people to whom they are obliged to return money on demand). In ordinary circumstances, this system functioned adequately. But, if all depositors wanted to withdraw their deposits at the same time, the bank would experience a run and collapse, because a fractional reserve bank does not have enough reserves on hand to pay everyone.

This is because the banks were creating credit money (a type of fiduciary media) from deposits and the people to whom they loaned the money had used it.

Credit money was vitally necessary for investment and expansion of output. One can note that, even at the beginning of the 19th century, bills of exchange (a type of money substitute) constituted roughly 70% of the money in circulation. Only 30% consisted of banknotes and precious metals (see U. van Suntum, The Invisible Hand: Economic Thought Yesterday and Today, p. 74).

The truth is that, to see anything like a 100%-reserve-banking world, we would have to go back to the 16th to 18th centuries.

Once banks started to issue banknotes against gold deposits that were already used to back bills of exchange, the banks were creating new money (fiduciary media). Capitalism in the 19th century was based on fractional reserve banking and increasing use of fiduciary media.

Since the gold standard simply did not provide enough commodity money to meet the demand for credit in a growing economy, the 19th century was marked by deflationary periods (e.g., from 1873–1896). In particular, from 1814 to 1913, prices declined by 44% in the US, 44% in the UK, 22% in Germany, and 24% in France (Triffin 1985: 150–151).

In the face of rising demand for money, 19th century nations created credit money:
“[the] reconciliation of high rates of economic growth with exchange-rate and gold-price stability [in the 19th century] was made possible … by the rapid growth and proper management of bank money, and could hardly have been achieved under the purely, or predominantly, metallic systems of money creation characteristic of the previous centuries. Finally, the term ‘gold standard’ could hardly be applied to the period as a whole, in view of the overwhelming dominance of silver during its first decades, and of bank money during the latter ones. All in all, the nineteenth century could be far more accurately described as the century of an emerging and growing credit-money standard, and of the euthanasia of gold and silver moneys, rather than as the century of the gold standard.” (Triffin 1985: 153).
Triffin (1985: 152) estimates that in 1800 bank money or credit money probably constituted less than 33% of the money supply. But by 1913 paper currency and bank deposits accounted for 90% of overall currency circulation in the world, and actual gold itself for not much more than 10%.

Thus growth rates in the 19th century were only sustained by a massive expansion of credit money, and what economic growth that did occur was not achieved under the type of “pure” gold standard that existed in previous centuries.

The only way to have ended the fractional-reserve system that allowed this credit money creation would have been by government intervention. But that would have choked off economic growth.

Are there arguments against fractional reserve banking from the perspective of the left? Indeed there are. The 19th-century fractional reserve system was not usually regulated (or regulated very poorly), had no deposit insurance, and sometimes no central bank as a lender of last resort. This meant that the 19th century saw repeated and endemic financial crises and panics that set off severe recessions or depressions. Thus the 19th-century business cycle was frequently marked by speculative asset bubbles in boom times that collapsed in bank runs and crises setting off contractions in the real economy. Fractional reserve banking requires careful financial regulation, separation of commercial and investment banks, and a central bank. Without these interventions it is a potentially dangerous system.


Block, W. “Walter Block versus Bryan Caplan on Fractional Reserve Banking,”

Johnson, J. F. 1911. Banking Principles, Alexander Hamilton Institute, New York.

MacLeod, H. D. 1902. Theory and Practice of Banking (6th edn), Longmans, Green, Reader, & Dyer, London.

Rozeff, M. S. 2010. “Rothbard on Fractional Reserve Banking: A Critique,” Independent Review 14.4 (Spring): 497–512.

Selgin, G. 2000. “Should We Let Banks Create Money?” Independent Review 5.1 (Summer): 93–100.

Selgin, G. A., and White L. H. 1996. “In Defense of Fiduciary Media – or, We are Not Devo(lutionists), We are Misesians!,” Review of Austrian Economics 9.2: 83–107.

Triffin, R. 1985. “Myth and Realities of the Gold Standard,” in B. Eichengreen and M. Flandreau (eds), The Gold Standard in Theory and History, Routledge, London and New York. 140–161.

Friday, June 25, 2010

Rolling over Government Debt and Debt Monetization: A Ponzi Scheme?

The meme that government debt is just a Ponzi scheme seems to be an especial favourite of Austrians, libertarians and other free market supporters. I note that it often seduces people of different political persuasions too. I have also met it on the Cynicus Economicus blog.

Unfortunately, the idea that government debt is a Ponzi scheme, or that rolling over/monetizing government debt is a Ponzi scheme, collapses after some careful analysis.

Here is the definition of a Ponzi scheme from Wikipedia:

A Ponzi scheme is a fraudulent investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any actual profit earned. The Ponzi scheme usually entices new investors by offering returns other investments cannot guarantee, in the form of short-term returns that are either abnormally high or unusually consistent. The perpetuation of the returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors to keep the scheme going.

So a Ponzi scheme has these characteristics:
(1) The scheme requires new and greater amounts of private investors’ money perpetually to work. To be successful, the Ponzi schemer must go deeper and deeper into debt perpetually. He can never obtain the needed money from another source.

(2) The Ponzi criminal uses the money he obtains from investors for his or his criminal associates personal gain or to pay their investors’ returns.

(3) A Ponzi scheme is a fraud: investors do not know that the Ponzi schemer is paying them returns from their own money or money paid by subsequent investors. The Ponzi criminal is secretly and fraudulently conducting his operations by lying to his investors by claiming he is investing their money.

(4) The returns on a Ponzi scheme are usually abnormally high and short term, often 20% or higher.

(5) The Ponzi schemer has no significant actual profit or income from sources other than his investors’ money.
In light of all this, I wonder why people so readily think government borrowing is a Ponzi scheme.

There are five possible ways in which government debt or rolling over government debt might be considered a Ponzi scheme. However, when we examine these factors below comparing Ponzi schemes to government debt we can see that the Ponzi scheme analogy fails:
(1) The government has the power to roll over debt. This involves taking money from a new buyer of a bond and giving it to the previous owner. There is a general similarity here with the need of a Ponzi schemer to obtain new investors’ money to make his scheme work, but the similarities end here. The crucial fact people forget is that the government is the entity that has the power to create money. No Ponzi schemer has the power to create money. The Ponzi schemer goes deeper and deeper into debt perpetually, and can never obtain money from another source. But the government is not “financially” constrained (even though it faces real limits to the amount of money it can inject into the economy via deficits and retiring debt). Modern Monetary Theory (MMT) tells us that our government has no need for money borrowed from the markets to spend. It has the power of debt-free fiat money creation, and can do so whenever it wants. No private institution or individual has this power. A government that is sovereign in its own currency has obligations that are safe, precisely because its central bank has the power to buy back bonds from the secondary markets by creating new money or (if necessary) creating money for budget deficits. Creating “new” money this way is not debt at all. It is new fiat money (if inflation rises, that can be cured with budget surpluses or taxes). So the fundamental link between new sources of funding and debt (essential to a Ponzi scheme) is cut. Furthermore, history shows that, unless severe output or supply shocks happen (or other exceptional circumstances like reparations or sanctions), a country that returns to strong growth will see the government’s debt to GDP ratio fall and the possibility of unsustainable accumulation of debt disappear, unlike a Ponzi schemer who must continue to find private investors to make his fraud continue to work.

(2) The government does something extremely important with the money it borrows: it pays for public infrastructure, defense, social services, funding of R&D, education, and law and order. A Ponzi scheme fraudster does nothing of social value with his investors’ money (incidentally, if you know of a Ponzi schemer who donated his ill-gotten gains to charity, please do give me the details!). In contrast to the Ponzi scheme fraud, we enjoy fundamental benefits from government debt. In times of recession or depression government spending saves our economy from debt deflationary spirals and mass unemployment and collapses in output. No analogy with a Ponzi scheme here I am afraid.

(3) Government tells us precisely what it is spending our money on in the coming year’s budget, openly and in detail. A Ponzi schemer lies to you about what he does with your money. But there is no a secret about how the government will spend your money. You actually have influence over it. Furthermore, people vote governments in and out: so the voting population has a direct voice in determining what their money is spent on. We can vote for higher or lower taxes as well. If you are an investor wanting to buy government bonds, you will know exactly what the government is doing with your money in the budget. You are perfectly well aware that the government might roll over debt frequently. But it is your free choice to buy bonds. Many people do. In contrast to this, Ponzi schemers are by nature secretive fraudsters. There is no analogy here at all.

(4) Government bonds offer quite low returns (not ridiculously high ‘Ponzi’ style returns) compared to other investments, precisely because they are so safe. Your average Ponzi scheme offers a 20% return or higher. In contrast, US Treasury bills (T-bills) that mature in one year or less do not pay any interest directly. Rather, these Treasury bills are sold at a discount of their face value and give a return on maturity. At the end of June (2010) the average yield for one-year Treasury bills was 0.30%. The coupon rate on a new issue of 2 year US Treasury bills was 0.625%. The coupon rate on new five-year T-bills was 1.875%.
The yield on the benchmark 10 year US Treasury notes (which of course is a long term investment) has fallen from 3.14% to 3.07%. The government is not now and does not offer “Ponzi” style returns. No analogy to be found.

(5) Government does not always roll over debt, but pays back bonds with tax money, its real and guaranteed income, which is growing with the population and economy. The government therefore has a vast income which could be raised simply through increasing taxes. Ponzi schemers have no such income: they are just borrowing more money from private markets endlessly.
Look carefully at the points above. In four of the five points, there is no analogy.

Only if there were valid analogies in all of the points above, or at least in more than half (i.e., in three or four of them), could you seriously make the case that government debt is like a Ponzi scheme. In no sense can you make this case.

The conclusion must clearly be that government debt is not a Ponzi scheme.

In a very limited way in point (1) there is a similarity, but even that comparison is weak.

Why, then, do people persist in the idea?

The answer is simple: most people are simply committing the fallacy of composition.

This logical fallacy happens when someone concludes that what is true of one part (or parts) of a whole must therefore be true of the whole, even though there is no justification for the claim.

The reasoning of the “government debt is just a Ponzi scheme” argument is like this:

Argument 1:
1. Rolling over debt is analogous to the Ponzi scheme that pays investors back with newly invested money.
2. Government debt often relies on rolling over debt in a way analogous to the Ponzi scheme.
3. Therefore, government debt is a Ponzi scheme.

However, this syllogism is as flawed and unsound as this argument:

Argument 2
1. All atoms are invisible to the naked eye.
2. Cats are made up of atoms
3. Therefore, cats are invisible to the naked eye.

Anyone can see that this argument is unsound.

The formal reason is that both arguments commit the fallacy of composition, and argument (1) does so because it ignores points (2) to (5) made above where I compare government debt with a Ponzi scheme. In points (2) to (5), there is no analogy with a Ponzi scheme. And in even point (1) the analogy is very weak.

Anti-government ideologues and apologists for free market economics might like to subscribe to the “government debt is a Ponzi scheme” view, but there is no reason why the rest of us should accept such deeply-flawed and illogical thinking.


The commentator “George” on the Cynicus Economicus blog has also asked this question:

you fail to address some of my key points. Namely denying that your article comments on bank nationalization and government manipulation of bond [yields] read like a ‘Ponzi’ scheme of money creation.

A Ponzi scheme does not “create” money. The Ponzi schemer has no power to create money at all, but must obtain further money from investors. Since money creation is not a characteristic of a Ponzi scheme, even the definition of a “Ponzi scheme” here is confused.

Moreover, government intervention to control yields has nothing to do with a Ponzi scheme. The government offers quite low returns on its bonds. It can offer a coupon rate and then intervene to maintain the yields on bonds at this coupon rate or above it if it wishes. There is no fraud involved. The Ponzi scheme, by contrast, offers ridiculously high returns by secretive fraud. Bond investors can shun new purchases of government bonds if they wish to.

In a previous blog post I argued that

if my plan to nationalize the banks that accepted bailout money were implemented, then they could also purchase the issuance of new government bonds with the excess reserves they have at the Bank of England. This would help to keep yields down. The Bank of England’s £200 billion quantitative easing policy ended in February 2010, but there are still a lot of excess reserves in the system. These reserves are sufficient for new loans to be given to creditworthy borrowers as well as additional purchasing of government bonds when the private sector does not take them up.

The banks in the UK were on the verge of collapse in 2008. By their own stupidity, incompetence and the flawed regulatory system, they nearly destroyed the financial system and required billions of dollars in taxpayer money. We now read that the total cost of the UK financial interventions could be between £70 billion to £140 billion (see “Cost of UK financial sector bailout could hit £140 billion,” 3 March 2010).

I say that the banks pay the government back with interest. And they owe us much more for the lost employment, lost growth, foregone output and social misery their stupidity caused.

This would be my first option: the government can cut its budget deficit by taking excessive profits from the banks.

The second option (as I have described above) is for the banks to help keep yields down through more purchases of government debt.

In no sense is this a Ponzi scheme. It’s forcing the banks to give the public back something for the billions the public gave to the banks in the first place.

Tuesday, June 22, 2010

The Early British Industrial Revolution and Infant Industry Protectionism: The Case of Cotton Textiles

In recent posts on this blog, I have pointed to industrial policy as an important tool in economic development. I have promised further posts on the subject. This is the first of a number I wish to write on industrial policy both in theory and in practice.

There are many types of industrial policy. In the 18th and 19th centuries, industrial policy often took the form of “infant industry protectionism.” This idea was originally made by the first secretary of the US treasury Alexander Hamilton in 1790, and later by the German economist Friedrich List in 1841.

Infant industry protectionism is the use of selected tariffs on imports of high-value-added manufactured goods when domestic manufacturing is in its early stages of development, particularly where the creation of these industries gives increasing returns to scale, rather than dead-end “diminishing returns to scale.” The goal of protectionism is to allow an industry to develop until it is able to compete in international trade. Once the industry is competitive on global markets, you no longer need domestic tariffs and they can be removed.

An excellent overview of infant industry protectionism can be found in Ha-Joon Chang, Kicking Away the Ladder: Development Strategy in Historical Perspective (London, 2002).

It is often asserted that free-trade Britain shows that protectionism is false and unnecessary, since the UK industrialized without the need for tariffs or protectionism. But the fact is that the UK was a pioneer in many manufacturing industries and had no competitors: it is clearly a special case to some extent. Furthermore, the UK did have an extensive tariff regime until trade liberalization in 1846.

Moreover, the fact is that in the case of cotton textiles, one fundamental area of its early manufacturing sector, Britain is a classic example of the success of infant industry protectionism.

In 1750, India produced about 23% of world manufacturing output. China probably produced around 33% of global manufacturing, and Europe about 23% (Marks 2002: 97; Kennedy 1989: 149; Perlin 1983; the source of these figures is the French economic historian Paul Bairoch 1997).

Europe, China and India all accounted for about 80% of global manufacturing output (Marks 2002: 123). It has been estimated that the GDPs of China, India and Europe were roughly 23% each of global GDP in 1700 (see Philip S Golub, “All the Riches of the East Restored”). That is to say, their respective economies were about the same size.

Textiles were a significant part of India’s manufacturing base, and Indian textiles were exported to Europe, Africa, the Middle East, south-east Asia, and the Americas. It has been shown by economic historians that India had a comparative advantage in the production of textiles, namely cheap but high-quality calicoes, because of cheap labour (Marks 2002: 97; Parthasarathi 1998). (As an aside, one can note that P. Parthasarathi 1998 shows that, since food was comparatively cheap in India and agriculture was very productive, free artisans who produced textiles had reasonably good living standards.) Indian production for export was concentrated in four major centres in Gujarat, Bengal, Madras and the Punjab.

India dominated world cotton textile markets in 1750, and Indian calicoes had been popular in Britain since the late 17th century. Contemporary British manufacturers and politicians correctly complained that British labour was more expensive than Indian labour. Yet by 1830 British cotton textiles dominated the world market and the Indian cotton textile industry was in ruins. How did it happen? Was it by the unregulated free market and free trade?

In fact, it was by tariffs and protectionism. The earliest phase of the Industrial Revolution in Britain was founded on the cotton textile industry. It was here that Britain crossed the “threshold” of the industrial revolution (Landes 1969: 82). The second phase of the industrial revolution only started after the early 1800s with the invention of the railroad and the expansion of the coal, iron and steam power. Thus the importance of the cotton textile industry at Manchester in the early Industrial Revolution cannot be underestimated.

If we look at how Britain developed its first significant manufacturing industry which launched the industrial revolution, we find that it did so by severely violating all the modern doctrines of free trade and free market economics.

In the late 17th century and 18th century, cheap high-quality Indian textiles competed with the domestic wool, linen and silk textile industry in Britain. These woolen, silk and linen textile producers demanded and were given import relief from Indian goods by tariffs and sumptuary laws in the early 18th century.

These were some of laws passed to protect British industry:
1685 – 10% import tariff on Indian goods;

1690 – tariff doubled to 20%;

1701 – First Calico Act, legislation banning imports of dyed, painted or printed fabric;

1707 – British textiles manufacturers obtained further tariffs on Indian textiles;

1721 – Second Calico Act, which further banned imports of Indian textiles.
Britain’s textile industry was able to develop behind tariff barriers, and the home market started to develop a cotton textile industry. In fact, just before the industrial revolution, the tariff on Indian cotton goods imported into Britain had gone up to 50% (Alavi 1982: 56).

However, the early cotton industry in Britain could not match the quality of Indian textiles. In the early 18th century, Britain generally produced fustians (a mixture of linen and cotton/wool) and linen-cotton textiles, but not pure cotton goods.

Furthermore, the price of raw cotton imports rose in the 1770s and 1780s. It was only after the slave-based plantations of North America started to export to the UK that cotton imports started to fall in price.

I need hardly point out the paradox that the industrial revolution in Manchester through production of textile goods was itself dependent on, and effectively subsidized by, slave labour in the New World (see Pomeranz 2000: 277). How competitive would Manchester textiles have been, if production of cotton in the American south had been carried on by free laborers and farmers?

In the course of the 18th century, a number of technological innovations transformed the cottage industries of Britain into factory systems.

The most important inventions were as follows:
(1) Hargreaves’s spinning jenny (invented c. 1764; patented 1770), which was later made obsolete by 1800 by mules;

(2) Arkwright’s spinning frame, which was later developed into the water frame (patented 1769);

(3) Crompton’s mule (1779).
These technological innovations in textile manufacturing occurred and were applied to the infant industry in an environment of heavy protectionism.

According to the conventional view, the technological innovations made British textiles cheaper and able to compete with Indian textiles both in the UK and in the global markets in the late 18th century.

But this is not correct. The inventions of Kay, Hargreaves, and Arkwright did not make British textiles more competitive than Indian goods, and Indian goods were still of a finer quality. Even with the invention and gradual use of Crompton’s mule in the 1780s, British textiles still could not compete with Indian calicoes (Alavi 1982: 56).

The producers were protected with more tariffs, and by 1813 the import duty on Indian cotton goods stood at 85% (Alavi 1982: 56). As Alavi (1982: 56) argues:
“It was the wall of protection that made possible the survival and growth of the British cotton textile industry in the face of Indian competition and facilitated large capital investments in the industry. Without it, the English industry would have found it impossible to get a foothold in the home market, let alone abroad.”
It was not until the widespread adoption of the spinning mule and then the mechanized power loom invented by Edmund Cartwright in 1784 that English textiles gradually became more competitive in the early decades of the 19th century.

From 1797–1819 British cotton textile manufacturers were still unable to compete. In 1815, the value of all Indian cotton goods coming into England was 1.3 million pounds (from 1741–1750, it had stood at 1.2 million points annually, at a time when domestic cotton textile competition was still largely non-existent). British producers asked for and obtained tariff increases on Indian cottons on 7 separate occasions in the years from 1797–1819.

In fact, even with the technological innovations, by start of 19th century Indian silk and cotton goods
“could be sold in the British market at a price between 50% and 60% lower than those fabricated in England. It consequently became necessary to protect the latter by duties of 70% to 80% on their value” (Das 1946: 313, quoting Mukerjee 1967).
It was only the application of steam power in the period between 1815 to 1830 that allowed English textile goods to be competitive globally (Marks 2002: 100). The power loom, for instance, was initially limited by relying on water power, but by the beginning of the 19th century was able to use steam power (Moe 2007: 34).

The cost of British-made cotton cloth fell by 85%, but only from 1780 to 1850, and it was only in 1835 that steam power fueled 75% of the British cotton industry (Moe 2007: 35).

British textile goods probably became internationally competitive by the mid 1820s (when tariffs were still in place). The British protectionism that lasted until the 1820s allowed British goods to become competitive.

It is estimated that by 1820, 46% of Britain’s exports were cotton textile goods. These exports displaced India’s textile exports in world markets. Thus Britain itself had an “export-led” model of economic growth even in the early stages of the industrial revolution, by taking away the market share of India through technological innovation allowed by protectionism and tariffs.

Yet, according to classical free trade theory, the British should not have bothered to develop a textile manufacturing industry, if they were able get Indian cotton textile goods at a price 50 to 60% lower than domestic textiles. India did have a comparative advantage in production of cotton textiles even around 1810 when the British textile industry was developing. If real free trade had been implemented, the protective tariff would have been abolished and the market for British-made textiles at home would have collapsed. There would never have been a later opportunity to compete internationally.

Yet nobody can seriously deny that having a large productive textile industry was the foundation of Britain’s industrial revolution and in the long run good for the economy.

This is not the whole picture either, because from 1757 the British East India Company (EIC) won control of Bengal, the centre of Indian textile manufacturing.

The Indian states could not impose retaliatory tariffs on British goods in the early 19th century in response to British protectionism, because they were effectively ruled by Britain through the East India Company.

After the successful decades of tariff protection and shelter from competition, British goods succeeded in global markets at the expense of India’s exports. Bengal and the textile manufacturers were ruined and the resultant de-industrialization impoverished the previously prosperous towns.

Contemporary 19th-century British advocates of free trade actually noticed this state of affairs and criticised it. Robert Montgomery Martin was a historian of Irish descent and wrote about twenty-six books on history and the British empire (including a History of the British Colonies). In 1844 he was Treasurer of Hong Kong. He appears to have been a typical liberal and free trader. I quote from the Oxford Dictionary of National Biography:
Martin, Robert Montgomery (1800–1868), author and civil servant … His life was dominated by a self-appointed task—the study of the British empire, which Martin saw in terms of a vast free-trade area of new territories in allegiance to the British crown …. [sc. he wrote a] five-volume History of the British Colonies, followed by such related works as Statistics of the Colonies of the British Empire (1839)., accessed 16 Feb 2009.
Robert Montgomery Martin was called upon to give evidence in 1840 during a British parliamentary inquiry about India:
“[Before a British Parliamentary Committee in 1840] Montgomery Martin stated that he . . . was convinced that an outrage had been committed ‘by reason of the outcry for free trade on the part of England without permitting India a free trade herself.’ After supplying statistical data of Indian textile exports to Great Britain, he pointed out that between 1815–1832 prohibitive duties ranging from 10 to 20, 30, 50, 100 and 1,000 per cent were levied on articles from India. ... ‘Had this not been the case,’ wrote Horace Wilson in his 1826 History of British India, ‘the mills of Paisley and Manchester would have been stopped in their outset, and could scarcely have been again set in motion, even by the power of steam. They were created by the sacrifice of Indian manufacture. Had India been independent, she could have retaliated, would have imposed prohibitive duties on British goods and thus have preserved her own productive industry from annihilation. This act of self-defence was not permitted her’” (Clairmonte 1960: 86-87).
Thus near-contemporary British apostles of free trade were the first to notice the double standard. They were appalled at the hypocrisy of British protectionism and the destruction of India’s prosperous cities built on textile exports.

But they of course failed to notice that the protectionism had been a major cause of Britain’s industrial revolution and that, without it, the UK would have been much poorer. In other words, the success of the cotton textile industry in the early industrial revolution in Britain was an example of infant industry protectionism, or modern import substitution industrialization (ISI).


Alavi, H. 1982. “India: The Transition to Colonial Capitalism,” in H. Alavi et al. (eds), Capitalism and Colonial Production, Croom Helm, London.

Bairoch, P. 1997. Victoires et déboires: Histoire économique et sociale du monde du XVIe siècle à nos jours, Gallimard, Paris.

Chanda, N. 2007. Bound Together: How traders, preachers, Adventurers, and Warriors shaped Globalization, Yale University Press, New Haven.

Clairmonte, F. 1960. Economic Liberalism and Underdevelopment: Studies in the Disintegration of an Idea, Asia Publishing House, New York.

Das, T. 1946. Review of The Economic History of India: 1600–1800, American Historical Review 51.2 (January): 312–314.

Frank, A. G. 1998. ReOrient: Global Economy in the Asian Age, University of California Press, Berkeley.

Kennedy, P. 1989. The Rise and Fall of the Great Powers: Economic Change and Military Conflict from 1500 to 2000, HarperCollins, New York.

Landes, D. S. 1969. The Unbound Prometheus: Technological Change and Industrial Development in Western Europe from 1750 to the Present, Cambridge U.P., London.

Marks, R. 2002. The Origins of the Modern World: A Global and Ecological Narrative, Rowman & Littlefield, Lanham, MD.

Moe, E. 2007. Governance, Growth and Global Leadership: The Role of the State in Technological Progress, 1750–2000, Ashgate Publishing, Aldershot, UK.

Mukerjee, R. 1967. The Economic History of India: 1600–1800, Kitab Mahal, Allahabad.

Parthasarathi, P. 1998. “Rethinking Wages and Competitiveness in the Eighteenth Century: Britain and South India,” Past and Present 158 (February): 79–109.

Perlin, F. 1983. “Proto-industrialisation in Precolonial South Asia”, Past and Present 98: 30–95.

Pomeranz, K. 2000. The Great Divergence: Europe, China, and the Making of the Modern World Economy, Princeton University Press, Princeton, N.J.

UK Deficit Spending, QE and Inflation: A Short Analysis

A commentator called “George” on the Cynicus Economicus blog has asked some questions about an earlier post of mine called
“Projections of the UK’s Interest Burden on Gilts as a Percentage of GDP”.

He states:
You merely state a percentage of interest payment against government spending but fail to acknowledge that this becomes unaffordable when lenders demand higher interest rate for the increased risk.
In fact, I have pointed out in the previous post that yields are low now precisely because the government has the tools at its disposal to control yields and hence the cost of its additional borrowing. These tools are open market operations and regulation of the portfolios of banks.

Bill Mitchell of Billyblog has shown how in a fiat currency with a floating exchange rate, the government has the power to control the yield curve:
Bill Mitchell, “Operation Twist – Then and Now,” March 31st, 2010
My views are entirely in line with his. George asks what will happen when lenders want to charge governments higher interest rates. The answer is that governments can decide for themselves what the coupon rate and yield rate will be.
The new Tory-Liberal Democrat government might refuse to use these policy tools, and that would be a foolish mistake on their part, and, if yields surge to a problematic level, then they will be responsible for it. But then again their austerity might reassure the markets – so it is difficult to know what will happen. And only yesterday there are indications that the new government will still use loose monetary policy this year:
Alan Clarke, U.K. economist at BNP Paribas .... tipped the BOE to announce £25 billion of extra bond purchases in August, and a further £25 billion in November.

Natasha Brereton, U.K. budget measures point to loose policy, Wall Street Journal, June 22, 2010
Furthermore, if my plan to nationalize the banks that accepted bailout money were implemented, then they could also purchase the issuance of new government bonds with the excess reserves they have at the Bank of England. This would help to keep yields down. The Bank of Engand’s £200 billion quantitative easing policy ended in February 2010, but there are still a lot of excess reserves in the system. These reserves are sufficient for new loans to be given to creditworthy borrowers as well as additional purchasing of government bonds when the private sector does not take them up.

It should be noted that in May 2010 the total UK public sector net debt was £903 billion, or 62.2% of GDP.

Since the public sector debt is £771 billion or 54% per cent of GDP if we exclude the bailouts and financial interventions, then nationalizing banks will be a good way to bring down the debt as a percentage of GDP in the future.

For the figures on debt, see here:
UK National Debt
The commentator “George” also claims that I
“previously have stated that governments can print without limit.”
But this is entirely false. I have repeatedly stated that there are real limits to money creation and budget deficits.

The level of money creation and stimulus for one country will depend entirely on its particular available resources, capacity utilization, unemployment, credit growth, external balance, and inflation rate.

George then asks what is the limit of UK money printing before inflation kicks in.

Most deficit spending is naturally inflationary, so presumably George means what is the limit of UK money printing before serious and very high inflation kicks in.

In 2009/10 the budget deficit will be about £178 billion or 12.6% of GDP.

My guess is that if the deficit rises to 15% or even 20% of GDP without austerity but with more stimulus, then this would cause serious higher inflation, which might be problematic. In the Weimar Republic, it is estimated that budget deficits were 50% of GDP, and in an economy suffering severe output shocks and crippling reparations.

Yet it is obvious that the UK is nothing like Weimar Germany.

For excellent analysis of Weimar hyperinflation, see here:
The Richebächer Letter, Number 417 June 2009 (p. 3 following).
George refers to the term “money printing.” It should be noted that this could mean (1) more open market operations (or the radical version of this called quantitative easing) or (2) budget deficits indirectly funded through QE and borrowing from private markets.

The fact is that QE is not inherently inflationary since in the present environment most of the new money just goes back to the central bank in the form of excess reserves, as is shown here:
Bill Mitchell, “Building Bank Reserves is not Inflationary, December 14th, 2009
Since credit growth is weak, a highly inflationary injection of money by this route is unlikely.

Direct central bank creation of money used to fund a budget deficit is undoubtedly inflationary. But this is not happening in the UK. At most, you could say that QE allows indirect funding of deficits. But a significant amount of the government borrowing is coming from private markets too, so money is withdrawn to match the money spent in the latter case.

The inflation figures for May 2010 show disinflation in the UK: the inflation rate slowed from 3.7% in April to 3.4% in May.

So clearly deflationary forces are at work, despite the budget deficit.

The projection for 2009/10 is that the government needs to borrow £178 billion or 12.6% of GDP. But austerity will cause deflationary forces.

Monday, June 21, 2010

Industrial Policy: A Brief Comment

Most recently, I have debated the blogger Cynicus Economicus on Keynesianism and industrial policy in a very thoughtful debate from both sides here:
I have argued, in response to comments that seem to doubt not just the success of industrial policy but its very existence, that Cynicus’ blog has repeatedly described China’s industrial policy. He refers to it as “mercantilism.”

I asked him whether he denied the existence – and effectiveness – of this mercantilist industrial policy. Although I may be incorrect, and he has not said so directly in any of his comments, he seems to suggest that industrial policy can never work or has never been successfully done anywhere. I then posed the question: doesn’t China’s success with its particular type of industrial policy show such policy exists and can work?

In response, Cynicus states:
So what we are coming to is a belief that mercantilism might work for the developed world? Do I understand this correctly?
The anwser is “no”. I was simply asking whether Cynicus was willing to concede what he so frequently seems to say in other posts: that China’s mercantilism is an obvious example of the success of one kind of industrial policy. There are many kinds, of course.

Having one obvious example of the success of a type of industrial policy in China, one wonders why in other comments Cynicus seems to suggest that he knows of no example of industrial policy and thinks that the idea is “vaguely defined” or has never been implemented anywhere in real countries.

Yet the literature on economic history is filled with works on industrial policy in real countries, for example, post-WWII France, South Korea, Taiwan and Japan.

As I have said in other posts on the Cynicus Economicus blog, in the 19th century there was an early type of industrial policy that was called “infant industry protectionism” (usually involving tariffs) in countries like Germany or the US.

Note that this policy was not simply the adoption of tariffs on all imports or an endorsement of endless protectionism through tariffs, but selected tariffs on imports of high value added manufactured goods when domestic manufacturing was in its early stages of development, particularly where the creation of these industries gave increasing returns to scale, rather than dead-end “diminishing returns to scale.” Once these sectors became internationally competitive, it was possible to reduce or eliminate tariffs. Note also that this policy is perfectly compatible with the fact the other types of tariffs or poorly targeted tariffs can be harmful to economic development.

It should be noted that many apologists for free trade cannot – or refuse to – even properly understand the “infant industry” argument. Instead they present a caricature of it. Henry Hazlitt’s criticisms of protectionism in his book Economics in One Lesson are a good example of this.

I give a very brief sample of some specialist work on 19th-century infant industry protectionism below:
(1) Mark Bils, “Tariff Protection and Production in the Early U.S. Cotton Textile Industry,” Journal of Economic History 44 (December 1984): 1033–1045.

Mark Bils concludes:
Cotton textiles constituted nearly two-thirds of value added in large-scale manufacturing in New England in the 1830s. The removal of the tariff, according to my results, would have reduced value added in textiles by, at a minimum, three-quarters. The implication is that about half of the industrial sector of New England would have been bankrupted.
(2) Paul Bairoch, Economics and World History: Myths and Paradoxes, University of Chicago Press, Chicago, 1993, ch. 4.

(3) Antonio Tena, “Tariff Structure and Institutions in the Late 19th Century. New Perspectives on the Tariff Growth Paradox,”
Paper presented to the Seventh Conference of the European Historical Economics Society Lund, 29 June - 1 July 2007

Tena concludes:
We assume that high tariffs only have a positive relation with growth if they protect those sectors which generate positive externalities in the economy in general. So, in the relation between trade policy and growth what is significant is not just average tariffs, but the structure of tariffs. The causal mechanism between tariffs and growth is better explained by the structure of tariffs.
(4) Ha-Joon Chang, Kicking Away the Ladder: Development Strategy in Historical Perspective, London, 2002.
Ha-Joon Chang, Bad Samaritans: Rich Nations, Poor Policies, and the Threat to the Developing World, London, 2007.

Ha-Joon Chang demonstrates that many Western nations industrialized through infant industry protectionism. It is a complete myth that industrial development occurred through free trade and free markets in many Western countries.
In the era after WWII, infant-industry protectionism was replaced with a new, more radical form of industrial policy called import-substitution industrialization (ISI), which was now given a theoretical basis in development economics.

The east Asian states of Japan, South Korea, and Taiwan used a radical type of ISI to become economic giants. Access to the US market, a fundamental element of these countries export-led economic growth, is also a feature of China’s new model of industrial policy.

The classic policies of ISI were:
(1) policies to subsidize and create industries producing manufactured goods
(2) protective barriers to trade (e.g. tariffs or non-tariff barriers)
(3) an overvalued currency assisting manufacturers to import capital goods (heavy machinery), at least initially in industrial development.
In South Korea, Taiwan and Japan, there were also these additional elements of ISI:
(4) Export led growth = outward-oriented ISI
(5) direction of subsidies and investment to industries producing goods for export
(6) some use of an undervalued local currency to stimulate exports.
One can note that China certainly practises (1), (4), (5), and (6). (2) is also achieved by the undervalued currency. China is an exception to (3).

The conclusion is clear: China uses a similar type of industrial policy to that pursued earlier in Japan, South Korea and Taiwan.

I hope to address the issue of industrial policy soon on this blog and in more detail.

Sunday, June 20, 2010

Is National Debt Owed to Foreign Nations Simply a Claim on Domestic Output?

In a thought-provoking post criticizing Post Keynesianism, Cynicus Economicus argues that
The trick to understanding [sc. government debt] ... is not to think of government borrowing money, but of borrowing of resources. When a government borrows money from overseas, they are actually borrowing the output of that overseas country. For example, if borrowing from the Gulf states, it is the equivalent of borrowing oil .... All the time this consumption is taking place, there is an accumulation of an obligation to provide goods and services in the future to repay the loan of oil in the future. Those goods and services will necessarily require the consumption of resources (including oil) in the future to repay the loan of oil. If this is the case, then a percentage of the total resources of the US must be allocated to making this repayment.
In response to this, I made the point that foreign investors who either (1) fund a current account deficit through capital account surpluses, or (2) fund a government’s budget deficit by buying bonds are lending money, not output.

Money can be used to buy output or financial assets or real assets.

When you attract foreign exchange via a capital account surplus (“borrow” this money), the foreigners have bought a financial asset or real asset in your economy. They have an asset in exchange for their money and a return through interest payments, coupon rates or dividends and so on. They might sell this asset, exchange the domestic currency for foreign exchange (often US dollars) and then take their money to another country and buy a different asset. This type of activity happens all the time. And here is the fundamental point: no claim on the domestic output of the borrowing country necessarily happens. There simply isn’t an obligation to provide goods and services by the debtor country. There might be, but very frequently people are exchanging money for assets (real or financial) or vice versa.

A country pays for its excess imports (= current account deficits) through capital account surpluses. It gives foreigners financial assets and real assets in exchange for their money and a return on ownership of these assets. The foreign investors always want a return on their money, but there is no necessary claim on the output of the debtor country at all. Money can be taken out of the country by converting it into foreign exchange (often US dollars) and then the investor can buy another financial asset in a different country.

In fact, capital movements around the globe in the past 30 years have seen an explosion of speculative transactions, movements of “hot money,” and short term speculation on financial markets. People are investing money to make money and then to take it somewhere else and get further returns there through ownership of new assets.

We live in a world of current accounts (goods and services) and capital accounts (real and financial assets). A very great amount of money used to fund current account deficits or government deficits just gets moved around between financial and real assets between different countries – no claim on the actual output of the debtor country happens. Of course it could and often does, but this is very different from asserting that all or even most foreign debt must be paid back in the borrowing country’s output or saying that government debt is just borrowing overseas resources. Clearly, it is not.

In response to this criticism, Cynicus argues that I am “saying that lenders are lending with no expectation of interest in return. If this is the case, why lend?.

But I said no such thing, and have said quite clearly that foreigners obtain an asset in exchange for their money and a return (e.g., coupon payment on a government bond denominated in US dollars). Of course people get a return on their ownership of most assets. That return comes in the form of money. But then we are simply back to the truth that money can be a claim either on output or on financial/real assets.

Furthermore, Cynicus argues:
When a creditor lends a country money, they do so in the expectation that the money will be returned to a value that will allow them to purchase goods and services to a value equivalent at the time of the lending + interest. They do not want money, but the ability to purchase goods and services (or assets) in the country that is the destination of the lending.
They certainly want to get a return on their money and might want to use that money to consume goods and services to a value equivalent at the time of the lending plus interest. But in no sense is it the case that they will all demand such goods and services from the debtor country.

I can give a personal example. In the late 1990s, I was swept up in the tech bubble mania going on the US (yes, I was naive back then!). However, living outside the US, I exchanged my foreign dollars for US dollars and put that money into shares on the US stock market. Some time later I sold the stock at a higher price than what I paid for it and converted my US dollars back to my own domestic currency and make a tidy profit both in the rise in the value of the stock and the fact that the US dollar had risen in value. The US dollars I brought into my country could be used to claim the output of China, the UK, New Zealand or many other countries by the person or company that next used them. And as for me, I had no interest in consuming US output with the money earned. I used both the original investment and profit to consume my own country’s output. There must be millions of people like me who do the same thing. We are not interested in actually purchasing goods and services in the US. We just want a return in the form of money and then take that money overseas as US dollars and convert it back to our domestic currencies.

Strangely, Cynicus also states that
Alternatively, rather than use the money returned in repayment [sc. from the debtor country] to directly purchase output, they might decide to purchase the output indirectly by purchasing an asset. In doing so, they take greater risk for the potential reward of securing even more of the country's output.
But purchasing an asset in the debtor country is not simply “indirect” purchasing of that country’s output. The asset can be exchanged for money on a market but that money can be used to buy output or financial assets or real assets. There is no obligation on the debtor country to provide its output in exchange for the asset. That decision rests entirely with the creditor, many of whom shun output for financial assets or real assets, either in the debtor country or in someone else’s country.

For example, creditors who have bought US government bonds can just take their return (money from coupon payments) and the money from selling the bond, and then take their total US dollars (principal plus return) overseas and convert them into a local currency and buy further financial assets there.

And here is the fundamental reality: the US dollars they brought to the new country can be used to claim output from any country on earth and there is no necessary claim on US output at all. The alleged claim on the original debtor country’s output is severed. The US dollar is the world’s reserve currency. Most commodities in international markets are priced in US dollars. Those US dollars could circulate in international trade without ever being used to buy US output.