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.
http://en.wikipedia.org/wiki/Neutrality_of_money

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.
http://cynicuseconomicus.blogspot.com/2009/07/reforming-money-fixed-fiat-currency.html

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.


BIBLIOGRAPHY

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.

BIBLIOGRAPHY

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.