Let us review the chart we saw in Chapter V. This chart shows how a free market balances supply and demand for any commodity, supplying the greatest amount of that commodity for the lowest practical price, by which we mean the price that will cover all the costs of production and eliminate economic rent, that is, a profit higher than necessary to attract capital to that market. Thus, in theory, the free market will be the most economically efficient market possible. Of course, this chart represents an ideal, and we have already pointed out various pricing strategies that producers can use to collect an economic rent, that is, to defeat the chart. Nevertheless, it is a marvelous model, and where producers have no pricing power—and thus must take whatever the market gives them—it works very well indeed. However, we need to note that this model applies only to commodities, that is, reproducible, elastic objects and services that are made mainly to be exchanged in the marketplace.
Obviously, many things do not fall under the category of a commodity in that sense. The supply of rare wines and fine paintings is not affected by the price. Even when a Monet fetches $30 million, Mr. Monet will not supply the market with any new pictures. Now, the importance of Monets to the market is not very great, and we can ignore the impact, no matter how high the price. But there are three things of great importance to the market, which also have no equilibrium point; these things are money, nature, and man. Their price and quantity are not regulated by supply and demand, and they are not “manufactured” for the market. It may seem strange to say that of money (more about which in a moment) but clearly nature and man are prior to any markets. Neoclassical theory “commodifies” these by reducing nature to land and man to labor. But surely this is mere pretense; land is merely nature subdivided, while labor does not exist apart from the laborer.1 Land and persons have values other than market values, and when they are reduced to commodities, these other values get externalized. That is, when nature becomes the commodity “land,” we tend to ignore all the other values inherent in nature. We exploit nature to maximize profits, we abuse it to wring out the last penny. Nature—apart from “land”—only acquires a price when it enters a crisis: we value fresh air only when the air we have becomes too dangerous to breathe; nature only enters modern economics at the point where we are about to lose it. But this is economically inefficient, as is every externality; it would be cheaper to prevent a disaster than to clean up after one. And some disasters cannot actually be mitigated. If, as some climate scientists believe, the ice caps are melting and the sea levels are rising, then coastal cities like New York and Tokyo, and many productive coastal farm areas are likely to be swamped and uninhabitable. The losses would easily wipe out—many times over—the “gains” that were realized by commodifying nature.
As bad as commodification is for nature, it is even worse for man, because man is both the origin and end of all human values. By commodifying man as “labor,” the neoclassicals stand economics on its head. Instead of the economy serving the legitimate needs of man, man becomes a mere servant of an economy that has no purpose or point other than pointless wealth accumulation. Now, wealth accumulation is good, but not a good in itself. That is, it is a foundational good, not an excellent good. A foundational good is a good that we need in order to obtain another good, while an excellent good is one sought for its own sake.2 We need some wealth to provide for our families, but this wealth is most properly a means, not an end. The family is an end in itself, not sought for other reasons. We may incidentally derive further benefits and goods from excellent goods, such as when our pursuit of truth in education makes us more employable in the business world, but truth is nevertheless pursued for its own sake, and valuable even if we never realize any monetary value from it. The pursuit of at least some wealth is foundational to the success of the family, the community, and the nation, but to pursue it as a final end subordinates the family, the community, and the nation to the needs of the economy. In this distortion of means and ends, this confusion of foundational goods with excellent goods, can be located many of the failures of the family, and the cause of most of the wars in the world.
At this point, some economists at least will object that these are merely moral considerations, and that a discussion of the good, whether foundational or excellent, should not be part of the discussion about getting all the goodies we can. However, the moral is never just the moral; it is always the practical. Bad ethics equals bad economics. A particular businessman may gain great profit by breaking all the rules, but the economy as a whole will suffer. A bank robber may make great profits, but only because somebody else suffers great losses. We need to compare theory and practice to moral norms not so much for moral reasons, but for practical ones. If there appears to be a conflict between morality and the economy, then we can be sure that there is a misunderstanding of either the one or the other, and possibly of both. When we commodify things that are not commodities, we violate moral norms because we violate the nature of these things. This should be obvious in the case of nature and man (but we will delve into these questions in more detail in the next chapter). For now, let us look at the more difficult case, the case of money. We can start by looking at one particular aspect of money, the credit markets.
Credit and Equilibrium
It may sound strange to say that money is not a commodity, since money (unlike man and nature) has no meaning apart from the market. Nevertheless, it is clear that money is not made to be traded (although there is an incidental trade in currencies), but to serve as a medium of trade. That is, money, like nature and man, is prior to the market, not a result of it. It is true that you can have a market without money, that is, a barter economy, but such a market will be haphazard at best. This is because all trade depends on a double coincidence. If I am a fisherman who wants some shoes, I will take my fish to the market and hope to find somebody who has shoes but wants fish. In a barter economy, this is a chancy proposition at best. But money solves the problem; we may assume that there is always someone with money who wants our product and always somebody with the product we want who wants our money. Thus, the double coincidence always takes place.
There are many theories of money, many of which conflict with each other and all of which are beyond the scope of this book. Here we look at the market for credit. In standard economic theory, credit is a commodity like any other. The “price” of credit is the interest rate, and the interest rate adjusts supply and demand, just as in any other market. However, this is not correct. It is correct that as the price of credit, the interest rate, rises, the demand for credit falls, just as with any real commodity. However, so does the supply!3 The supply and demand curves for credit do not cross (as in the chart4) The demand curve looks like any other, but not the supply curve. Note how this chart varies from the standard supply and demand curve: The lines never cross, and there is no equilibrium point.
Why does the supply decline with the increase in the price? Because credit is not “sold,” it is rationed. Commodities are sold; anyone with the money may buy them, and the shopkeeper does not examine your credit or your planned use of the commodity. Bankers, on the other hand, lend only to those who are likely to pay them back, and this involves a judgment on the part of the loan officer. He examines both the credit history and the uses of the borrowed funds to determine if the bank is likely to get its money back. When interest rates are low, the bank has a lot of borrowers to choose from. But as the interest rate rises, the most reliable borrowers tend to exit the market. They rely on other sources or simply wait until credit conditions improve. The remaining borrowers are mostly those with weaker credit and less secure business plans. Hence the banks are more reluctant to lend the money and the supply declines along with the demand, the exact opposite of what happens in commodity markets.5 Shortages of credit are never about a shortage of money, but about a shortage of good uses for the money at the prevailing interest rate. Hence, there is no market-clearing price, nor is there any alternative to the administrative allocation of credit. Therefore, one of the foundations of neoclassical economics collapses both in the theory and in practice.
Money and Markets
Money is as essential to markets as gravity is to physics, and they perform almost the same function: the one explains the motions of the stars and the other the motions of the markets. So an understanding of money is essential to an understanding of markets. The problem is, nobody really understands it. Or rather, there are competing and incompatible understandings. This author will not claim to be smarter than anybody else in this regard. Nevertheless, when there is great confusion about a subject, it is best to start with the things about which everybody is agreed and with facts which no reasonable person can dispute.
The first fact that nobody will dispute is that money is a medium of exchange, used to solve the double coincidence problems of a barter economy. From this flows two conclusions. One, money is not wealth, and it is a grave mistake to confuse it with wealth. Wealth is the actual goods that we have and services we can perform. Rather, money is a claim on the circulating wealth, that is, the goods and services that are for sale at any given moment. A person with a dollar in his pocket can claim a dollar's worth of the goods and services that are for sale. The second conclusion flows from the first: there should be neither more nor less money in circulation than the total value of all the goods and services for sale. If there is more money in circulation than the value of the goods for sale, inflation is the result; if there is less, then deflation results. “Inflation” simply means that prices are rising, while “deflation” means that they are falling. Inflation penalizes savers (whose savings can purchase less) and helps borrowers (who pay back their loans in dollars worth less than the ones they borrowed); deflation does the reverse. The notion that inflation and deflation are caused only by changes in the money supply is known as monetarism, which is the dominant monetary fashion just now. In any case, the supply of money should expand (or contract) no faster than the increase (or decrease) in the supply of circulating goods and services.
This is where things begin to get sticky. Just how does one limit the money supply to the actual value of the actually circulating goods? When we actually examine the things we call “money,” what we see are scraps of paper and bits of base metals. The scraps of paper are called (in England and elsewhere) “banknotes.” We don't call them that in the United States, but if you look at the top of each dollar, you will see the words “Federal Reserve Note.” The Federal Reserve is the national bank, so these too are banknotes. Why should banknotes be “money,” how are they supplied to the market, and who manages the supply, if management is needed?
In that glorious age before bankers, money tended to be not bits of paper, but actual gold and silver coins. But gold and silver are difficult to store securely and dangerous to carry, so people often deposited their coin with goldsmiths who had safes in which to store the metals. The goldsmith would give the depositor a “note” of how much he had on deposit. If the goldsmith was of good reputation in the area, these notes could circulate as money, since buyers and sellers knew that they could get their gold from the smith if they really needed it, and they felt better with the paper than with the gold. The goldsmiths noticed, however, that they didn't actually need to hold all the gold, because it was unlikely that everybody would ask for their gold back at the same time. They only needed a small fraction of what they held, and could lend out the rest at interest. Indeed, they could lend it all, and lend it several times. So the goldsmith might give the depositor a note for his 1,000 gold ducats, and also lend the same 1,000 ducats to someone in the form of notes. In fact, he may have lent the same ducats many times over, in the form of notes. So long as they all didn't come looking for their gold at the same time, the goldsmith could become very wealthy very easily, and all with somebody else's money. This induced many of the smiths to abandon the forge completely and become full-time bankers.
It may seem like a very dangerous procedure to lend out the same ducat five or ten times, but actually, it could be very sound. If the borrowed money was used for productive purposes, if it was used to build a factory or a road or a ship, then the supply of goods and the supply of money increased at about the same rate. But if the money was used merely to finance consumption, then there was an expansion in the supply of money with no corresponding direct contribution to the expansion of production. In this case (called “usury”) the money supply grew faster than the supply of goods and inflation was the result. But whether for usury or for production, the banks were expanding the supply of money faster than the supply of gold on deposit. Hence “money” became not the gold on deposit that the notes were supposed to represent, but the notes themselves, mere scraps of paper.
This discussion may seem quaint and out-of-date, but in fact the exact same thing happens today. Banks create money through fractional reserve banking, which is a long word for the same process. You deposit $100,000 with the bank. The bank keeps $10,000 in its vaults as a reserve, and lends out $90,000. But the borrower doesn't spend this money all at once. Some portion remains with the bank (or with another bank, even if he does spend it). So now there is an additional $90,000 on deposit, of which the bank reserves $9,000 and lends out $81,000, etc. The original $100,000 deposit is quickly multiplied into loans of much greater than $100,000. Of course, the process is not really as “fast” as in this example. There is a lot of “leakage,” such as money paid in taxes. And the banks cannot always find enough sound borrowers to keep the new money working. Nevertheless, the principles are the same. We should note here several things. One, most money is created by private banks issuing debt against their deposits. Two, the money supply expands faster than the reserves, whether the reserves are in gold or in banknotes. And three, the expansion of the money supply can match the expansion in goods and services if the new money is lent to expand goods and services, but will be inflationary to the degree that it is usurious.
Governments also create money. They can print the money, creating it out of thin air. This is actually not a bad procedure if the new money is used solely for the purposes of expanding the public infrastructure, since this expands the productive capacity of the nation. This is not entirely inflation-free, since money is not wealth, but merely a claim on circulating wealth. You do not build roads and bridges out of money; you build them out of steel and concrete. Issuing new money merely redirects some of the concrete and steel away from the private sector and into the public sector. By increasing the demand for these commodities, it is likely also to increase the price. Nevertheless, this is still a cheaper way of financing the public infrastructure than either taxing or borrowing. Furthermore, such spending of new money can be used as a method to invigorate a faltering economy. When the economy is weak, the government can simply invest new money in worthwhile projects, and do so without either borrowing money or increasing taxes.
Note in all of this that there is no “natural,” free-market method to balance the supply and demand for money. The absence of such a method is characteristic of a fictitious commodity. We rely on the prudence of bankers to lend only for productive purposes, and so increase the money supply no faster than the productive capacity of the nation. However, the bankers cannot be perfectly prudent, because no one perfectly knows the future, and repayment is dependent on what happens in that unknown realm. Further, the banks find usury more profitable than investment. A good business plan might allow the payment of an interest rate of as much as10%, but credit cards can pay twice that, or better. Hence, there is a nearly irresistible temptation to divert credit away from productive uses to non-productive, usurious expenses.
There are those who believe that a return to the gold standard and the abolition of “paper” money would solve all of these problems; they believe that this would make money less of a fictitious commodity and more of a real one. This is problematic at best. In the first place, it ignores what the goldsmiths, and later the bankers, actually did. It was still “paper money” with only paper-thin reserves of gold. Further, a strict adherence to the gold standard was part of the economic orthodoxy of the 19th and early 20th centuries. It was a disaster, destabilizing economies all over the globe. All social classes came to reject it, and none more than the capitalist classes, whose businesses simply could not tolerate the wild fluctuations that resulted from a dogmatically applied gold standard. The plain fact is that no nation is likely to be able to expand its supply of gold as fast as it can expand its productive capacity. The gold standard then becomes a throttle on the expansion of the economy. As nice as the “real money” of gold sounds, there really is no way to make a fictitious commodity a real one. We can really go no farther than Aristotle did 2,500 years ago, when he declared that money is not a commodity, but exists only by law or custom. Money, then, is not an intrinsic power of some commodity, it is a necessary power of the community. As such, it will either be the democratic power of the whole community, or an oligarchic power of a few members of the community.
1K. Polanyi, The Great Transformation: The Political and Economic Origins of Our Time (Boston: Beacon Press, 1944), 75
2H.J. Alford, Managing As If Faith Mattered: Christian Social Principles in the Modern Organization (Notre Dame, Indiana: U. of Notre Dame Press, 2001), 42
3Hugh Stretton, Economics: A New Introduction (London and Stirling, Virginia: Pluto Press, 1999), 692.