July 28, 2017

Money: from silly stories to the true theory

Comment on Peter Cooper on ‘Short & Simple 11 ― Money as an IOU’


“… in fact he [Adam Smith] disliked whatever went beyond plain common sense. He never moved above the heads of even the dullest readers. He led them on gently, encouraging them by trivialities and homely observations, making them feel comfortable all along.” (Schumpeter)

Not much has changed in 200+ years. The homely stories about how money comes into the world go as follows:

(i) “Before money, …, we all had to barter for the goods we wanted. If I wanted wheat and had chickens, I needed to find someone who wanted chickens and had extra wheat. Money solves this ‘double coincidence’ problem by letting me sell my chickens to buy your wheat. If we didn’t have money we’d invent it immediately.” (Stray)

(ii) “To increase and facilitate trade, …, a paper currency was organized by the Restaurant and the Shop. The Shop bought food on behalf of the Restaurant with paper notes and the paper was accepted equally with the cigarettes in the Restaurant or Shop, and passed back to the Shop to purchase more food. The Shop acted as a bank of issue. The paper money was backed 100 percent by food; hence its name, the Bully Mark.” (Radford)

(iii) “Eventually some goldsmiths noticed that the paper receipts they gave to their customers to evidence the valuables left in storage began to circulate as currency alongside their countries’ coins. A shopkeeper accepting these receipts in payment knew that he could go to the goldsmith to redeem them for gold and silver, and also recognized that a paper receipt was more convenient to use as currency than were pieces of metal.” (Turk et al.)

(iv) “For example, perhaps your neighbor offers to tend to your garden while you are away on holiday. You write ‘IOU’ on a slip of paper and promise that you will accept the slip of paper back again in payment for a service to be performed on your return. Your neighbor knows and trusts you and so accepts this arrangement. On returning home, you wash your neighbor’s car and mend a fence, accepting back the IOU as payment.” (Cooper)

(v) “When government uses the currency to purchase goods and services, it promises to accept back its IOU in payment of obligations to it. These obligations mostly take the form of taxes.” (Cooper)

Whether these stories are historically true does not matter much. The fatal weakness of storytelling economics is the Fallacy of Insufficient Abstraction. The theory of money has to be developed within the framework of a ‘monetary theory of production’ (Keynes).

The pure consumption economy is for a start clearly defined by three macro axioms (Yw=WL, O=RL, C=PX), two conditions (X=O, C=Yw) and two definitions (Qm≡C-Yw, Sm≡Yw-C).

Money is needed by the business sector to pay the workers who receive the wage income Yw per period. The workers spend C per period. Given the two conditions, the market clearing price is given by P=W/R. So, the price is determined by the wage rate, which has to be fixed as a numéraire, and the productivity. From this follows the average stock of transaction money as M=kYw, with k determined by the payment pattern.

What is needed for a start is two things (i) a central bank which creates money on its balance sheet in the form of deposits = overdrafts, and (ii), a legal system which declares the central bank’s deposits as legal tender. Money comes into the world through the autonomous transactions between the business and the household sector and the transfer of deposits.

This is the fully specified analytical account that connects the measurable variables L, R, O, X, P, Yw, C, M of an elementary economy and explains how transaction money comes into the world. Note that the central bank is passive, it only carries out the autonomous transactions which, in turn, determine the average quantity of money M. There is no such thing as monetary policy. The acceptance of money is not brought about by state power or by personal trust but by enforceable law.

Egmont Kakarot-Handtke

Related 'How money emerges out of nothing ― the functional account' and 'The ultimate ― analytical ― origin of money' and 'What is MMT?' and 'MMT is dead'

REPLY to Calgacus on Jul 28

The history of money from the cowrie shell#1 to bullion to coins to notes and to the credit card shows a clear tendency of progressive abstraction. The conclusion of the history of money is that money is information and that the concrete forms of monies are nothing but different data carriers. The ultimate data carrier is the server at the central bank and the chip under your skin.

Again, the pathetic blunder of monetary theory is the Fallacy of Insufficient Abstraction. It is a bit stupid to get caught by the numerous outer forms of money. The abstract essence of the phenomenon is this: money = information.

In the ‘monetary theory of production’, things get started like this. The firm says to the worker we pay you one dollar per hour. At the end of the first day, the firm owes the worker $ 8. Money starts as a credit relationship with the firm as borrower and the worker as lender. Let this go on until mid-month. Then the firm’s IOU is $ 120.

Now the firm goes to the central bank and tells them to transfer $ 240 to the worker. The central bank makes a book entry: firm’s overdrafts $ 240 and worker’s deposits $ 240. The private IOU of the firm has become money. The worker owes the firm 120 working hours for the rest of the month. The underlying private borrower-lender relationship has flipped. Vis-a-vis the central bank, the firm is the borrower.

Now, $ 240 is a rather abstract thing until the worker goes shopping. We know from above that the price in the pure consumption economy with market clearing and budget balancing is P=W/R. This translates into the real wage W/P=R. The ‘real’ value of money or the purchasing power is determined by the productivity. This is how the arbitrary designation dollar (euro, yuan, ruble, etc.) becomes something very concrete, i.e. value of money = productivity. Money has NO intrinsic value.

By spending the money on the consumption good the credit relationship is resolved. This is the elementary cycle of money creation and destruction. It starts with zero and ends with zero.

Note that this analytical account deals exclusively with the measurable variables L, R, O, X, P, Yw, C, M of an elementary economy and leads to testable propositions. The economist’s job is to explain the ‘quantity of money’ M with the accuracy of two decimal places and its relationship with the price P. Note well that it is NOT the quantity of money that determines the price in the pure consumption economy. And this means that the commonplace Quantity Theory is dead. And the MMT story, too.

#1 “Shell money is a medium of exchange similar to money that was once commonly used in many parts of the world. Shell money usually consisted either of whole sea shells or pieces of them, which were often worked into beads or were otherwise artificially shaped. The use of shells in trade began as direct commodity exchange, the shells having value as body ornamentation.” (Wikipedia)

REPLY to Matt Franko on Jul 28

Nice try to start a futile semantic game. In every concrete historical situation, people know very well what money is. This, though, is a matter of indifference for the theory of money. What people think about the earth and the sun is irrelevant for astronomy, just as it is irrelevant for economics what storytellers tell about the historical emergence of money.

Money in the ‘monetary theory of production’ is in the most elementary case the stock of deposits at the central bank which is measurable with the accuracy of two decimal places. It is a matter of indifference whether it is called dollar, euro, yuan, or ruble. Take the world economy as one and define one currency and call it Bancor and all semantic variety disappears.

The point at issue is that MMT is provably false* and that Peter Cooper’s IOU story of money is beyond ridiculous. Just as your semantic crap. This is NOT a figure of speech.

* Refutation of MMT: all proofs and arguments you ever need

REPLY to Matt Franko on Jul 28

When social scientists (an oxymoron, not a metonymy) are at a loss they invoke complexity as an excuse. This does not work either.*

* Complexity and stupidity

REPLY to Matt Franko on Jul 28

The question on this thread is does Peter Cooper’s Short & Simple 11 – Money as an IOU hold water? And the answer is not one drop.

So MMT is refuted on all counts.*

Whether you understand the proof and its significance is your personal problem.

* For details see ‘Refutation of MMT: all proofs and arguments you ever need