Money, Credit and the Role of the State: Essays in Honour of Augusto Graziani (Alternative Voices in Contemporary Economics)

MONEY CREDIT AND THE ROLE OF THE STATE

Money Credit and the Role of the State Essays in honour of Augusto Graziani

RICHARD ARENA AND NERI SALVADORI

Ashgate

Aldershot • Burlington • Singapore • Sydney

 Richard Arena and Neri Salvadori 2003 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior permission of the publisher. Published by Ashgate Publishing Limited Gower House Croft Road Aldershot Hants GU11 3HR England Ashgate Publishing Company 131 Main Street Burlington, VT 05401-5600 USA

British Library Cataloguing in Publication Data

Library of Congress Cataloging-in-Publication Data

ISBN

Contents

List of Figures List of Tables List of Contributors Introduction by Richard Arena and Neri Salvadori

x xi xiii xv

PART I: MONEY AND ECONOMIC ACTIVITY 1 2 3

4

5

Money in Wieser’s Social Economics Richard Arena

1

Money, Saving and Intertemporal Resource Allocation Lilia Costabile

19

Monetary Stability and Heterodoxy: A History of Economic Thought Perspective Ghislain Deleplace

45

Labour Market Deregulation and Unemployment in a Monetary Economy Guglielmo Forges Davanzati and Riccardo Realfonzo

63

Effective Demand and Cash Flow Requirements in a Monetary Economy Bruno Trezza

73

PART II: CREDIT AND BANKS 6

7

‘As if its body were by love possessed’. Abstract Labour and the Monetary Circuit: a Macro-Social Reading of Marx’s Labour Theory of Value Riccardo Bellofiore Liquidity Constraints and Small Firms’ Growth: The Case of Southern Italy Adriano Giannola

87

113

viii

8

9

10

11

Money Credit and the Role of the State

Weaving Cloth from Graziani’s Thread. Endogenous Money in a Simple (but Complete) Keynesian Model Wynne Godley

125

Circuit and Coherent Stock-flow Accounting Marc Lavoie

134

The Monetary Circuit and Income Distribution: Bankers as Landlords? Giorgio Lunghini and Carluccio Bianchi

150

Credit and Money in Schumpeter’s Theory Marcello Messori

173

PART III: KEYNES, KEYNESIAN ECONOMICS, AND BEYOND 12

13

14

15

16

17

Budgetary Constraints, Stocks and Flows in a Monetary Economy: Keynes’s Economics Once More Jean Cartelier

201

Krugman on the Liquidity Trap: Why Inflation Will not Bring Recovery in Japan Jan Kregel

223

Saving and Investment: Keynes Revisited Basil Moore

237

The Solution of the Paradox of Profits Alain Parguez

255

Some Notes on Post-Classical Macroeconomics Alessandro Roncaglia

269

Aspects of a New Conceptual Integration of Keynes’s Treatise on Money and the General Theory: Logical Time Units and Macroeconomic Price Formation Mario Seccareccia

283

PART IV: PRODUCTION AND INCOME DISTRIBUTION 18

The Democratic Firm as a Public Good Bruno Jossa

311

Contents

19

20

21

ix

Rent, Technology, and the Environment Alberto Quadrio Curzio and Fausta Pellizzari

333

Is Ricardian Extensive Rent a Nash Equilibrium? Neri Salvadori

347

Vertical Integration in the Changing Economy Ian Steedman

359

PART V: THE ROLE OF THE STATE 22

23

24

25

26

27

Financial Sector Reforms in Developing Countries with Special Reference to Egypt Philip Arestis

371

The European UMTS Licences Allocation: Why Economic Theory Has not Worked Alfredo Del Monte

391

From Corporative ‘Programmed Economy’ to Post-war Planning: Some Notes on the Debate Among Italian Economists Riccardo Faucci

411

The Economic Role of the State as a Factor of Production Domenicantonio Fausto

429

Central Bank Independence and Democracy: A Historical Perspective Carlo Panico and Maria Olivella Rizza

445

Updated Liberalism Vs. Neo-Liberalism: Policy Paradigms and the Structural Evolution of Western Industrial Economies after World War II Alessandro Vercelli

466

List of Figures

2.1

Induced saving and the equilibrium interest rate

38

4.1

Deregulation, aggregate demand and unemployment

69

10.1

The Ricardian solution

166

10.2

The basic Keynesian solution

168

10.3

The extended Keynesian solution

169

11.1

Schumpeter’s two-phase cycle: (a) the aggregate output; (b) the aggregate prices

190

12.1

Competitive Keynesian equilibria

212

12.2

Solow’s and Keynes’s steady states

214

12.3

Dynamic properties of Keynes’s steady-state

220

17.1

Effect of income inflation on the oscillatory movement of prices

291

17.2

Initial time path of prices and employment

295

17.3

Evolution of consumer prices and the composition of employment

296

17.4

Cyclical movement of PC over a complete credit cycle

299

17.5

Logical time constructs and cyclical movement in capital stock

301

23.1

UMTS bidding using a simultaneous English auction

394

23.2

The relations between the Herfindhal index and the cost of licences per head of population

404

The relations between the Herfindhal index and the cost of 1MHz per GSM user

404

The relation between the percentage change in carriers’ market capitalization and L/A (the ratio between the money spent on licences and the value of assets)

407

23.3 23.4

List of Tables

7.1a

Performance and structural ratios (median values)

115

7.1b

Performance and structural ratios. by dimensional classes (median values)

116

7.2

Fixed investments (per cent on sales)

117

7.3

Sources of company finance (per cent)

118

7.4

Debt and liquidity ratios

120

7.5

Debt and liquidity ratios for size classes

121

8.1

Model transaction matrix

126

9.1

Transaction matrix with private debt

138

9.2

The monetary circuit with private money

140

9.3

Transaction matrix with government debt

143

9.4

The monetary circuit with a government deficit

145

9.5

The monetary circuit in an overdraft system

146

20.1

The processes of production

349

22.1

Costs of resolving banking sector crises amounting to more than 10 per cent of GDP

374

22.2a Emerging and South East Asian economies: real GDP growth (percentage change on previous year)

376

22.2b South East Asian economies: overall costs of financial crisis (output gaps)

376

22.3

Spreads between lending and deposit rates in selected countries

384

22.4

Selected banking system indicators (in billions of Egyptian pounds, unless otherwise indicated)

384

23.1

Status of 3G mobile licensing

400

23.2

Cost of UMTS licences and index of concentration in GSM markets in European countries that used, in 2000, auction as a method to allocate spectrum

401

xii

23.3

23.4 23.5

Money Credit and the Role of the State

Cost of UMTS licences and index of concentration in GSM markets in European countries that used beauty contest as a method to allocate spectrum

402

Distribution of UMTS licences between incumbents and new entrants

405

Debt, market capitalization and ratings in European telecommunications companies

407

List of Contributors

Arena, Richard (LATAPSES-DEMOS, CNRS/Université de Nice-Sophia Antipolis) Arestis, Philip (The Levy Economics Institute of Bard College, New York) Bellofiore, Riccardo (University of Bergamo) Bianchi, Carluccio (University of Pavia) Cartelier Jean (University of Paris-X-Nanterre) Costabile, Lilia (University of Naples Federico II) Del Monte, Alfredo (University of Naples Federico II) Deleplace, Ghislain (University of Paris 8) Faucci, Riccardo (University of Pisa) Fausto, Domenicantonio (University of Naples Federico II) Forges Davanzati, Guglielmo (University of Lecce) Giannola, Adriano (University of Naples Federico II) Godley, Wynne (University of Cambridge) Jossa, Bruno (University of Naples Federico II) Kregel, Jan A. (United Nations Conference on Trade and Development) Lavoie, Marc (University of Ottawa) Lunghini, Giorgio (University of Pavia) Messori, Marcello (University of Rome Tor Vergata) Moore, Basil (Wesleyan University) Panico, Carlo (University of Naples Federico II) Parguez, Alain (University of Franche-Comté, Besançon, France, and University of Ottawa) Pellizzari, Fausta (Università Cattolica del Sacro Cuore) Quadrio Curzio, Alberto (Università Cattolica del Sacro Cuore) Realfonzo, Riccardo (University of Sannio) Rizza, Maria Olivella (University of Salerno) Roncaglia, Alessandro (University of Rome La Sapienza) Salvadori, Neri (University of Pisa) Seccareccia, Mario (University of Ottawa) Steedman, Ian (Manchester Metropolitan University) Trezza, Bruno (University of Rome La Sapienza) Vercelli, Alessandro (University of Siena)

Introduction Richard Arena and Neri Salvadori

The contributions gathered in this volume are dedicated to Augusto Graziani on the occasion of his seventieth birthday. They take up the concerns that have been central to Graziani’s work over the years, reflecting the importance and relevance of his contribution to economic theory as well as making an attempt to develop some of his main arguments, applying them to new questions and diverse theoretical contexts. The first theme addressed by a number of articles in this volume is Graziani’s contribution to the “monetary theory of production” (Graziani 1989a, 1994a and 2003). The point of departure of this theory is the appraisal of the main characteristics of a ‘monetary economy’: i) since money cannot be a commodity, it can only be a token money; ii) the use of money must give rise to an immediate and final payment and not a simple commitment to make a payment in the future; and iii) the use of money must be so regulated as to give no privilege of seignoriage to any agent (Graziani, 2003, p. 60; see also Graziani, 1988, p. xiv)

Furthermore, in the perspective of this approach, macroeconomic analysis cannot be derived from microeconomic foundation through aggregation. Instead, the construction of macroeconomic models must start from its own independent assumptions, and in particular the identification of social groups that constitute the community, their conditions of reproduction and preservation: any theory based on an individualistic approach is necessarily confined to microeconomics and is unable to build a true macroeconomic analysis (Graziani, 2003, p. 18)

For modern capitalist economies, two main social groups have to be taken into account. Entrepreneurs are the only agents who have access to bank credit. Therefore, they can borrow a potentially unlimited amount of means of payment; they are only constrained by their profit expectations. In monetary economies, entrepreneurs are not of the Walrasian type: They do not combine various productive factors, based on the relative prices of those factors, in order to obtain final products. Rather , they borrow money in order to increase the amount of money they own, that is, in order to earn net monetary profits. On the contrary,

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wage-earners do not have access to bank credit. They receive money wages from entrepreneurs for the supply of their labour-power. Therefore, they only have at their disposal as much monetary purchasing power as they have earned. The banking system plays an important role in that it is placed both at the starting as well as the end point of the monetary circuit. In any period, it first creates and then destroys the total amount of bank money. This organisation of monetary circulation among social groups implies that, since production takes time and wage-earners have to be paid before sales are made by firms, entrepreneurs need loans before work can commence, and this simultaneously creates credit money. When sales occur, entrepreneurs charge prices which generate a profit for each of them and also make it possible to repay the loan, with interest determined by a bargaining process between banks and firms. At this point, the credit money originally created ceases to exist and the monetary circuit is complete. Hence, what one is looking at is essentially a single chain of transactions each involving no more than one entrepreneur at a time; and whose length is identical with the production period that can vary. Although the clarity and elegant simplicity of this analysis are perfectly compatible with Keynes’s analysis of the finance motive, a number of limiting assumptions need to be introduced. Some of the contributions to this volume aim to provide a generalization of Graziani’s version of the circuit scheme or some complements to that analysis (see, for instance, Chapters 5, 6, 8, 9, and 15). In principle, several extensions of this scheme are possible (see also Graziani, 2003, on ‘The role of financial markets’ and ‘Implications for monetary policy’, respectively), three of which are considered in this volume. The requirements for positive cash flows, worked out in the framework of a monetary economy (see Chapter 5), are used to complement the Graziani-type circuit scheme. This analysis sheds some light on the conditions at which the circuit can close enabling firms to pay back their loans to banks and so being in the condition to open up the circuit again for the next turn. These conditions bear directly on the organization of monetary circulation which is why circuit theorists regard them as at least as important as those that must be satisfied for global demand and supply to be equal and, at the same time, for the money market to be in equilibrium. The second limiting assumption underlying Graziani’s approach is that of the existence of a single chain of transactions (‘Graziani’s thread’ in Godley’s words). Some contributions to this volume (see Chapters 8 and 9) try to avoid this rather restrictive assumption by introducing an infinite number of such chains to form a transaction matrix, and by allowing for the variation in inventories and in the length of production periods, measured by a sequence of fixed accounting periods. Finally, some authors in this volume (see Chapter 10) turn their attention to the price theory adopted by monetary circuit theorists. The monetary circuit scheme can be interpreted in two alternative ways, namely as a single period book-keeping scheme or as a scheme of reproduction. In the first case, prices stem from the

Introduction

xvii

combination of a short-run competitive equilibrium on the consumer goods market and an accounting definition of the investment goods market. In the second case, prices can be interpreted as natural or long-run prices determined by technical conditions of production. Obviously, the choice of a specific price theory within the circuit approach also implies different possible views on income distribution and distributional conflict. Similarly, such divergence in views will furthermore depend on the type of theory of production adopted and, in particular, the role attributed to wages (see chapter 4). The second broad field investigated in the contributions to this volume is the history of economic thought. From the perspective adopted in this volume, the history of economic thought is much more than simply a cultural appendix used by economists to highlight their intellectual origins. Rather, history of thought matters because, as Graziani has often stressed, the knowledge of past theoretical debates and influences can help to develop a heterodox view on modern economic problems. If all economists were broadly satisfied with the state of contemporary economics, history of economic thought could hardly play any crucial role for the advancement of our discipline. The present state of economics would represent the latest result of analytical progress and it would be pointless to spend too much time on past more primitive or even mistaken theoretical developments. However, if some economists are not satisfied with the contemporary state of economics and think it necessary to construct alternatives to mainstream theory (see chapter 2) – such as the approach to which Graziani’s work has made an important contribution – reconsidering the messages of past economists becomes a worthwhile enterprise. If such messages have often fallen into oblivion, this has not always been because they were logically inconsistent but rather because they were not compatible with the foundations of mainstream economics. Thus, it makes sense to consider past contributions with an open mind. Graziani has always insisted on the singularity of his views in the field of history of economic thought (see, for instance, Graziani 1985a, pp. 17–18). On the one hand, he maintains a sort of prudent skepticism visà-vis dominant interpretations of the history of economic thought (ibid., p. 18). On the other, he considers that the main line of distinction in the field is between the acceptance and the rejection of an ‘individualistic conception of society’ (ibid.). In accordance with Graziani’s views, one of the threads running through the contributions to this volume is an emphasis on the usefulness of the history of economic thought for modern economic theorists (see also Graziani 1983, 1989b). First, it comes as no surprise that various contributions to this volume (see Chapters 12, 14, 15, 16, and 17) discuss the relation between Graziani’s approach and the different existing interpretations of Keynes’s theory, some of which have influenced Graziani while others have been received more critically (see Graziani, 1991a, 1996a). For instance, Graziani rejects the simultaneous treatment of stocks and flows as it appears in some macroeconomic models of the IS/LM type. By contrast, Graziani’s approach shares some of the essential assumptions of cash-inadvance models à la Clower and of constrained finance models à la Tsiang (see Chapter 12). It is possible to see Graziani’s model as a beginning-of-period model

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in which money is prevalently a means of payment (also for investment purposes, see Chapter 2). To the extent that this is the case, it clearly supports Keynes’s interest and money theories, better suited to a beginning-of-period approach than to a traditional end-of-period view. The market mechanisms that support this type of approach are described in the Treatise on Money. The relation between the Treatise and the General Theory has been extensively discussed by historians of economic thought (including Graziani; see Graziani, 1981). Some contributions (Chapter 17) to this volume provide new material for this debate. Another example of the use made of the history of economic thought in this volume is provided by Classical Political Economy (see, for instance, Chapter 3), even though the focus here is more on a possible methodological comparison between circuit theory and classical political economy. While there can be no doubt that Graziani rejects certain classical analytical developments, such as Say’s law or the emphasis on the ‘real’ aspects of economic activity that are clearly incompatible with a Keynesian framework, it is also clear that his approach shares the key role given to social groups by old and modern classical economists. It also favours a concept of economic period characterized by a sequence of phases including the process of expectations formation, the production process and the phase of market exchanges, as was the case in the classical tradition (see Graziani, 1994b, 1996b). This is why some of the contributions in this volume analyse old and modern interpretations of the classical message on the relationship between production and income distribution (see Chapters 19, 20, 21). The same perspective is extended to Marxian approaches and the book considers the relation between Marx and the circuit analysis of national income circulation and distribution (see Chapter 6). The last example that we will refer to here is provided by the Austrian tradition in economics. Reference to this tradition may appear to contradict the strong Keynesian nature of Graziani’s approach since the Austrian view of the dynamics of monetary production economies is often considered an alternative to the approach of Keynes and Keynesians (see Graziani, 1996c). However, it can be argued that, within the Austrian tradition, we can find one variant, associated with Wieser and Schumpeter, that is fairly close to the circuit approach. This is the reason why the book discusses the monetary theory that emerges from Wieser’s Theory of Social Economy and shows that it exhibits some of the major features of Keynes’s analysis in the Treatise on Money, namely the existence of an endogenous money supply, the dominant role of the banking system in the process of money creation, the distinction between the circulation of national income and of capital, and the role of individual and social beliefs in the explanation of the levels of economic variables (see Chapter 1). A similar view is shared by Schumpeter who re-defined the foundations of monetary theory, replacing the traditional view of money as a “veil” that only facilitates exchanges, with the concept of money as capital that acts as an essential premise for the starting of new production processes (see Chapter 11). These foundations contributed to build the so-called ‘credit theory of money’, as opposed to the ‘monetary theory of credit’.

Introduction

xix

This credit theory of money is obviously close to Keynes’s theory of ‘bank money’, as it appears in the Treatise as well as in the papers on the finance motive, and as it has been revived by Graziani (1984, 1985b, 1987). This volume also addresses questions related to applied economics and economic policy, another of Graziani’s important, long-standing interests (see, for instance, Graziani, 1993a, 2000, 2002). We will briefly mention four examples here. One such question concerns the problem of labour market regulation and unemployment in a monetary economy (see Chapter 4). Monetary circuit theory does not deal with this problem in terms of a conventional labour market characterized by rational individual agents who supply and demand labour services according to the level and flexibility of the real wage rate. The monetary wage rate is the relevant variable and its level is the result of a social bargaining process taking place at the beginning of each production period before the current prices of consumption goods have been determined. Entrepreneurs and wage-earners must form expectations about the level of these prices but they do not know ex ante the level of the real wage rate. The level of the monetary wage rate is therefore reviewed periodically. If the level of unemployment and the profitability of firms exert some influence on the bargaining process, it does not follow however that this influence is direct and mechanical. Other factors such as the degree of organization of entrepreneurs and workers, their respective bargaining power, the institutional set-up and the role of the state greatly matter and influence the collective beliefs of the bargainers. This approach takes account of historical pathdependence and of the variety of industrial relations regimes. The type of employment policies implied by this approach to wage determination therefore strongly differs from the conventional approach and its focus on labour market flexibility. Another example is the conduct of monetary policy and the related problem of Central Bank independence (see Graziani, 1998; 2003, chapter 3). Central to the monetary circuit approach is an explicit consideration of the relationship between the monetary authorities, the state and social groups, as well as the requirement that these be compatible with principles of representative democracy. The importance given to social groups by this approach underlines the need for multidisciplinary cooperation between economists and other social scientists. Certain contributions to this volume (see Chapter 26) show that, since the 1980s, standard economic theory has limited the analysis of this type of interaction to the problem of the organization of state institutions in terms of its own monodisciplinary approach, focusing on the search for an optimal configuration between society and the state. This is why mainstream theory faces an analytical problem. Its simplistic representation of the relationship between society and the state leads to a contradiction between Central Bank independence and democracy. The analytical flexibility of the Keynesian circuit approach and its ability to integrate the advances of other social disciplines leaves the door open to a more sophisticated representation of the relationship between the state and the society.

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Such representation could provide the basis for a more convincing legitimisation of Central Bank independence in a democratic society. From this perspective, a contradiction between Central Bank independence and democratic legitimacy is by no means inevitable. This problem of the compatibility between the organisation of the economic system and the requirements of a democratic state is also extended to other domains. An interesting example is the theory of the firm: How can a democratic share-holder model of the firm be reconciled with a notion of social efficiency? The book suggests some tentative answers to this question, developing the notion of a ‘democratic firm’ as a merit good (see Chapter 18). Other themes reflecting this broad policy-oriented concern with forms of governance and economic organization include market and financial regulation in advanced as well as developing economies (see Chapters 22 and 23). Of a more theoretical nature is the related discussion of recent changes undergone by the notion of ‘liberalism’: The central argument made maintains that while Keynes’s and Pigou’s version of liberalism remains compatible with the classical version of A. Smith and J.S. Mill, the so-called neo-liberalism of Coase and Friedman is, in fact, inconsistent with basic tenets of the liberal tradition (see Chapter 27). Counter-cyclical economic policies are also considered. Using the example of the current problems of the Japanese economy, the book contrasts recent interpretations of the liquidity trap, such as that provided by Krugman, with Keynes’s original approach in the General Theory (see Chapter 13). The former leaves no space for any hope that Japan could escape from the liquidity trap and recover from the current depression, not least because its interpretation of Keynes is questionable. Finally, the book also covers themes concerning the Italian economy, and especially that of southern Italy (see Chapter 7), as well as the analysis of the debate among Italian economists and in particular within the Italian tradition of public finance (see Chapters 24 and 25). Both are, in fact, among Graziani’s prime interests (see, for instance, Graziani, 1975, 1978, 1991b, 1993b, and his many contributions to the economic policy debate since the 1960s). The contributions to this volume that cover the three main areas of research discussed here are organized in five parts. Part I is concerned with the basic concepts underlying Graziani’s approach to monetary production economies, combining economic theory and history of economic thought. Part II analyses the fundamental role given to banks in the process of money creation and justifies why the monetary theory of production generates a credit theory of money, making use of Keynesian but also of Marxian and Schumpeterian thought. Part III investigates the Keynesian origins from which the theory of monetary circuit is derived. This theory is compared to the various modern interpretations of Keynesian legacy, including the standard neo-classical synthesis, cash-in-advance models, postclassical macroeconomics and, obviously, post-Keynesian theory. Part IV focuses on production and income distribution, emphasizing modern Classical theory with which circuit theory has an ambiguous relationship. Finally, part V analyses

Introduction

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important questions relating to the role of the state, one of the future intellectual challenges for monetary circuit theory. Taken together, the contributions to this volume explain why the monetary theory of production developed by Augusto Graziani can be considered a new paradigm under construction potentially capable of providing a better understanding of real-world economic problems, based on a modernized Keynesian perspective.

References Graziani, A. (1975), ‘Rapporto sullo stato degli studi di economia’, in A. Graziani e S. Lombardini (eds), Gli studi di economia in Italia, Milano: Edizioni di Comunità, pp. 1339. Graziani, A. (1978), ‘The Mezzogiorno in the Italian economy’, Cambridge Journal of Economics, 2, pp. 355–72. Graziani A. (1981), ‘Keynes e il Trattato sulla moneta’ in A. Graziani, C. Imbriani and B. Jossa, Studi di economia keynesiana, Naples: Liguori Editore. Graziani, A. (1983), ‘The macroeconomic theory of Vera C. Lutz’, Banca Nazionale del Lavoro Quarterly Review, 36, pp. 3–27. Graziani, A. (1984), ‘The debate on Keynes’ finance motive’, Economic Notes, 13, pp. 5– 34. Graziani, A. (1985a), ‘Deux perspectives pour introduire un débat – II’ in R. Arena, A. Graziani and J. Kregel (eds.), Production, circulation et monnaie, Paris : Presses Universitaires de France. Graziani, A. (1985b), ‘Le debat sur le “motif de financement” de J.M. Keynes’, Economie Appliquee, 38, pp. 159–75. Graziani, A. (1987), ‘Keynes’ finance motive’, Economies et Societes, 21(9), pp. 23–42. Graziani, A. (1988), ‘Il circuito monetario’, in A. Graziani e M. Messori (ed.), Moneta e produzione, Turin: Einaudi. Graziani, A. (1989a), The Theory of the Monetary Circuit, Thames Papers in Political Economy, London. Graziani, A. (1989b), ‘Money and finance in Joan Robinson’s works’, in G.R. Feiwel (ed.), The Economics of Imperfect Competition and Employment: Joan Robinson and Beyond, New York: New York University Press, pp. 613–30. Graziani, A. (1991a), ‘La theorie keynesienne de la monnaie et le financement de l’economie’, Economie Appliquee, 44, pp. 25–41. Graziani, A. (1991b), ‘The Italian economic journals and some major turning-points in economic theory’, Economic Notes, 20, pp. 117–34. Graziani, A. (1993a), ‘Domestic and international economic changes. Embarrassing correspondences’, International Review of Applied Economics, 7, pp. 253–66. Graziani, A. (1993b), ‘M. Fanno’s “Production Cycles, Credit Cycles, and Industrial Fluctuations”: an introduction’, Structural Change and Economic Dynamics, 4, pp. 393– 402.

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Graziani, A. (1994a), La teoria monetaria della produzione, Arezzo: Banca Popolare dell’Etruria. Graziani, A. (1994b), ‘Real wages and the loans-deposits controversy’, Economie Appliquee, 47, pp. 31–46. Graziani, A. (1996a), ‘Money as purchasing power and money as a stock of wealth in Keynesian economic thought’, in G. Deleplace and E.J. Nell (eds), Money in Motion: The Post Keynesian and Circulation Approaches, pp. 139–54, New York: St. Martin’s Press; London: Macmillan Press. Graziani, A. (1996b), ‘Piero Sraffa’s vision of the capitalist process’, in P. Zarembka and A. Sinha (eds), Latest Developments in Marxist Theory, pp. 291–98, Greenwich, Conn. and London: JAI Press. Graziani A., 1996c, L’equilibrio fra risparmi e investimenti secondo Keynes e Hayek, Rivista Italiana degli Economisti, 1, pp. 325-65. Graziani, A. (1998), ‘The independence of central banks: the case of Italy’, in Ph. Arestis and M.C. Sawyer (eds), The Political Economy of Central Banking, Cheltenham: Edward Elgar, pp. 169–79. Graziani, A. (2000), Lo sviluppo dell’economia italiana, Turin: Bollati-Boringhieri, 2nd edition. Graziani, A. (2002), ‘The Euro: an Italian perspective’, International Review of Applied Economics, 16, pp. 97–105. Graziani, A. (2003), The Monetary Theory of Production, Federico Caffè Lectures, Cambridge: Cambridge University Press.

PART I MONEY AND ECONOMIC ACTIVITY

Chapter 1

Money in Wieser’s Social Economics Richard Arena

1.1

Introduction

Der natürliche Wert (Natural Value, in English) and the Theorie der gesellschaftlichen Wirtschaft (Social Economics, in English) which are certainly the most famous of Friedrich von Wieser’s works, seem to contain two different fundamental analytical messages. In the first book (Wieser, 1889–1893), individuals are supposed to live in a ‘communist State’. They have analogous natural endowments and abilities, as well as identical consumers preferences and the same marginal utility of income. They are characterized as utility maximizers but, if they do not really differ from their walrasian cousins, Wieser’s ‘natural state’ is, however, clearly distinct from Walras’s pure exchange economy. Exchange, as well as money, are actually absent and a central authority directs national economic activity and, especially, the distribution of wealth among agents. Natural value is determined by marginal utility and is not disturbed by ‘human imperfection’, ‘error, fraude, force, chance’, ‘order of society’, ‘private property’ or distributional factors (Wieser, 1893, pp. 61–2). Moreover, individual agents do not belong to social classes, they are not constrained by institutions and they cannot exert (or suffer) power effects on (or from) other individuals. In other words, Der natürliche Wert offers a theory of what Streissler called ‘this most unnatural of all imaginable states of nature, i.e., with perfect competition and equal incomes for all’ (Streissler, 1986, pp.88–9). To put it in different terms, in spite of the differences between his approach and the walraso-paretian one, in Natural Value, Wieser seems to accept the idea that the explanation of the working of the economic system first requires the construction of a basic model which offers a simplified broad view of the main analytical components of the real world, namely, a theory of income distribution based on imputation and on marginal utilities and productivities. The common point with Walras and Pareto is that this basic model is a real and natural economy from which money is entirely excluded. Therefore, Natural Value seems to belong to the tradition of economics which began with Adam Smith and corresponds to the Keynesian definition of a ‘real exchange economy’, often emphasised by Augusto Graziani: according to this tradition, money does not matter and the foundations of economic analysis are purely real.

2

Money Credit and the Role of the State

The second book (Wieser, 1914–1927) first describes a ‘simple economy’ which resembles but is not completely analogous to a ‘natural state’. In Volume I of Social Economics (called ‘the theory of the simple economy’), for instance, individuals are again supposed to express identical preferences and incomes. Therefore, according to Wieser, they can easily be replaced by a single economizing individual who, however, cannot be assimilated to a Robinson Crusoe. ‘Millions of person’ are replaced by a ‘masses unit’, which presents holistic features (p. 9). As Wieser wrote; In the theory of the simple economy we shall examine only the effects of economic purposes on economic processes. We shall not consider the conditions that accompany the formation of the socio-economic powers except to remark the condition of fatigue that attends the expenditure of personal energy. The simple economy (...) is the economy of a single subject. Here one does not find the contrast that are manifest in the social formation of forces. But we do not have in mind the scant economy of an isolated householder. Rather we envisage an economy that has the breadth of a national economy with all its wealth, technical knowledge and problems of economic calculus. But this broad economic is guided by a simple mind (Wieser, 1927, p. 19).

Quite logically, exchange and money are still absent in those ‘simple economies’. However, there is another more radical difference between ‘natural states’ and ‘simple economies’. In Social Economics, the theory of a ‘simple economy’ is not a subject for studies per se but only a logical step in the construction of a ‘social economy’. To put it differently, ‘simple economies’ refer to what Wieser calls ‘ the most abstract isolating and idealizing assumptions’ (Wieser, 1927, p. 6). Therefore, they are only introduced to define, by contrast, ‘social economies’ which appear to correspond to a ‘decreasing abstraction to conditions of reality’ (Wieser, 1927, p. 9). Now, contrarily to ‘natural states’, in social economies, individuals cease to have analogous natural abilities and identical endowments. They belong to social classes, are constrained by institutions and especially by money and credit, and can exert (or suffer) power effects on (or from) other individuals. Therefore, individual decisions do no longer reflect the ‘forces of freedom’; they also depend on social inequalities and constraints. They contribute however, to institutional changes, even if it is in an unintended way and if these changes effect, in turn, subsequent economic behaviours. Thus, in Social Economics, a simple economy does no longer play the role of a real exchange economy as it is defined by Keynes and as it was the case for natural states. It is only a preliminary and pedagogical step towards monetary economies which constitute the very topic of economic analysis: in Social Economics, Wieser is certainly more Wicksellian than Walrasian. This apparent divergence between the messages of Wieser’s two main books is certainly the result of the evolution of his own thought. It has, however, the merit

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of showing, that Wieser’s final conception consisted in taking money seriously into account and giving up the idea that the model of a ‘real economy’ was able to capture the main features of the economic system. If our interpretation is right, Wieser’s theory of money and credit thus appears to be crucial. Few historians of economic thought paid indeed attention to it. It is certainly a pity, however, that these developments were not better known since they provide one of the first formulations of the Austrian theory of money and credit. Now, the purpose of our contribution is precisely to characterise this formulation and show that it belongs to the tradition of those economists who thought that money matters.

1.2

Wieser on Institutions

Wieser’s approach to institutions derives from his position on the problem of individualism. Now, in Social Economics and in contrast with Natural Value, the author’s Austrian subjectivism does not imply a social representation in which equal, free and autonomous individuals would generate economic institutions by their mere interaction. Wieser’s moderate individualism provides the key for understanding the transition from his ‘simple’ to his ‘social economy’, that is from a Robinson Crusoe to a monetary economy. The framework of social economies permits, in turn, the emergence of money as an institution. Money implies credit and credit helps to the implementation of production activities. Finally, the investigation of the theory of Wieser’s ‘money and credit economy’ allows to distinguish different monetary circular flows according to the functional role they play in the working of the economic system taken as a whole. Social economies do not only take into account a part of the individual determinants of economic behaviours, namely the ‘forces of freedom’ (‘Freiheitsmächte’).1 They also refer to the ‘forces of compulsion’ related to the existence of power in economics. This view implies various consequences. On the one hand, Wieser did not consider that exchange relations were independent from the existence of an autonomous social power As in all other activity, so in the negociation of economic contracts, the average man is governed by the social power of the associative principe. In his individual dealings he uses the type of contract that has been generally developed. As a rule he adds nothing more to this form than a specification of the particular persons and values involved (...). If one looks more closely, one finds that as a rule even in the selection of persons and the specification of consideration he is governed by class and social powers; and his legal freedom of contract as matter of fact shrinks into an extremely limited freedom of choice. If one points to private contract as the unifying medium of the national economy, and if one seeks to faithfully reproduce actual conditions, one must add that the private contracts are themselves governed by class and social powers (Wieser, 1927, p.162).

4

Money Credit and the Role of the State

On the other hand, Wieser considered that individuals were generally unequal and that ‘compulsion’ reduced their degree of freedom and autonomy. That is why he attributed to classical economists the ‘error’ of having given ‘too much room for the play of personal freedom’ (Wieser, 1927, p. 53). ‘ His nation, his class and his profession’ – these are the main social stratifications which Wieser associated to any single individual. For him, it was thus necessary to take into account the ‘horizontal division of economic society’ (i.e. the distinction between producers belonging to different activities) as well as the ‘vertical’ one (i.e., the distinction between classes, or leaders and masses) (Wieser, 1927, p. 158). National, vertical and horizontal stratifications formed what Wieser calls the ‘social order’ (Wieser, 1927, p. 161). In order to understand why, for Wieser, money is an institution, it is first necessary to focus on one of these ‘vertical’ social stratifications, namely the distinction between ‘leaders’ and ‘masses’. It emerges within ‘social economies’ since ‘simple economies’ only relate equal individuals. Therefore, the distinction is not provisional or casual. It presupposes a national community in which agents are fundamentally unequal: ‘Leadership is impossible without some inequality’ (Wieser, 1927, p.157). ‘Social economies’ are more complex than ‘simple’ ones since, within them, ‘individual units meet from all all directions’ and ‘clash with great forces’ (Wieser, 1927, p.153). This complexity, according to Wieser, implies a necessary coordination which is ensured by social power. Thanks to it, ‘The individual search of whom independently follows his own law, are held to a common purpose and enabled to work to a single end’ (Wieser, 1927, p.152). Wieser indeed considers that ‘masses’ are unable to generate a spontaneous coordination and therefore, that they have to be directed and controlled by ‘leaders’: Even in those cases of social intercourse where a legal right of self-determination is preserved to the individual and in which leadership plays no part, leadership and the accompanying power of leadership do develop. Even in their personal affairs, the mass of individuals are too weak to rely upon themselves alone. (...) Everything that man has accomplished whether in spiritual or physical evolution, has been attained only through social relations, in that the best leadership has furnished the example, the advice and the knowledge; and that others were induced to follow them because of the success which these leaders have attained’ (Wieser, 1927, p.156).

In this representation of the social economy, leaders are autonomous and their energy permits them to behave according to their individual aims. However, masses are not passive. They may accept or reject what leaders decided and their decision and reaction are essential. If masses agree with the actions and innovations of the leaders, they are lead to copy them. Therefore,

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Through the initiative of leaders and through initiative acceptance by the masses, society develops certain institutions serving the common needs so well as to seem like the creation of an organized social will. Money, markets, division of labour, the social economy itself are such creation (Mitchell, 1917, p. 104).

Wieser introduces here two different behaviours. One is innovative. It corresponds to leaders decisions. The other one is imitative. It refers to the attitude of masses. This distinction obviously inspired the one pointed out by Schumpeter in the first German edition of his Theory of Economic Development, when he contrasted what he called ‘energetic’ and ‘hedonistic’ economic behaviours. The mechanisms of innovation in the subsequent editions of the book are also an echo of this opposition, since new products of new techniques are introduced and diffused within the economy through a combination of innovative and initiative behavioural patterns. The intervention of masses cannot be interpreted however as a pure act of recognition of the social utility of leaders decisions. It generally transforms an individual invention into a real social device. Therefore, masses tend to create a final rule ‘far beyond [leaders] expectations’ (Wieser, 1927, p.165). This is the meaning Wieser attributes to Menger’s idea according to which economic institutions are the ‘unintended social results of individual teleological tendencies’ (Wieser, 1927, p. 165). Two cases may be faced according to the interests privileged by leaders. Wieser indeed observes that powerful persons are merely in a position, in building up the economic organization, to carry through their personal interests rather than the general interest. Thus they are able, at those points which they regard as critical, to replace the social mind by their own. By this means the social consciousness is falsified and made to appear contradictory (Wieser, 1927, p. XVII).

In this case, Wieser observes that the intervention of the State (p. XVII) or of the masses is necessary. If this intervention does not occur and if, on the contrary, masses approve, this proves that leaders are defending some general interest. Social classes, for instance, derive from a systematic and permanent leadership. They are acceptable if they do not ‘lead to the oppression of the masses’ (Wieser, 1927, p. 157). But money too derives from another type of leadership.

1.3

From Simple to Social Economies

Money precisely provides a positive example in which institutions serve the general interest:

6

Money Credit and the Role of the State The enormous advantage offered by money in the community of exchange is explained solely from the fact that it dissolves the entire turnover into links of such individual transactions of one exchanging couple each. The effect of it is, that men, in their acquisitions are never tied down to the one contracting party with whom they have just dealt. They are altogether turn to any other man who may have the stock required (Wieser, 1927, p. 169).

But money is not present in all economies. We already saw that its emergence is related to the process of transition from simple to social economies described in volume II of Social Economics (‘The Theory of the Social Economy’). Noticeable for us, exchange and money finally appear: The second section, the theory of exchange, presupposes a social economy, unhampered by interferences on the part of the state. The theory of the simple economy having shown in what manner a single subject manages and calculates his economic affairs, we now show the numerous juridical subjects, who meet in the course of exchange, as they seek their economic advantage, determine prices and thus erect the structure of a social economy (Wieser, 1927, p. 10).

Wieser assigns to social as well as to simple economies the same fundamental objective, which is strictly analogous to the one that the Classical School defined for the first time in the history of economic thought. This objective is economic self-reproduction and it reflects what Wieser calls ‘the law of the unity of the economy’ (Wieser, 1927, p. 68). In compliance with the classical tradition, simple and social economies must ensure, with or without any exchange process, that a net product is created: An economy aspiring to enduring service must distinguish between gross-yields and net-yields. It must lay aside: sufficient reserves to entirely renew its capital, treating only the residue as net-yield (...). Net-yield may be defined as the residue left after deducting reversal-costs from the gross-yield (Wieser, 1927, p. 131).

This stress on self-reproduction is increased by the transition process from simple to social economies and explains the first ‘typical’ feature which permits to distinguish between both types of economy. Streissler indeed emphasized the importance given by Wieser to production within social economies: It is also correct that [Wieser] also had a strong inclination for the production side of the economic process. And that made him the only truly neo-classical author in the first two generations of the Austrian school and together with Fritz Machlup one of only two neoclassical authors in the school altogether. He thereby also provided a link with Anglo-American economic thought, particularly with Alfred Marshall, with whom he had the strongest affinity and who also appreciated him most. His strong ‘neo-classical’

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bent of thought (in the narrower sense) can best be seen in the disposition of his material in The Theory of Social Economics. It reflects John Stuart Mill’s Principles: the analysis of the factors of production is placed nearly at the beginning, distribution, on the other hand, is treated, as in Mill, much later, in the case of Wieser nearly at the end. The classical vein runs very strong in Wieser: in his habilitation thesis he gives Ricardo, Marx, Engels, Jevons and Menger as his authorities; and in the text-book of his maturity Ricardo out-distances Menger in text references by 25 to 18 and Marx is the author most frequently quoted in footnotes, four times among only twelve footnotes in all (Streissler, 1986, p. 96).

More precisely, Wieser dedicates an entire paragraph of his Social Economics (Book I, §10) to what he calls the ‘unity of the economy’. Among the three determinants of this unity -money, market, production- the first two only unify the economy ‘externally’ (p. 49) but the fundamental ‘internal’ link which allows to define the economy ‘as a whole’ is production’: However, despite its extreme differentiation and manifold contrasts, the economic process of today is actually a whole. It is not a unit in the truer sense of the term; and yet it functions with an all-embracing homogeneity which may be idealized and represented as unity. This condition is founded in production. All productive stems are related to one another (Wieser, 1927, p. 50).

More fundamentally, production is, in turn, based on the existence of a process of division of labour which exhibits two dimensions. The first, horizontal, was already emphasised by the classical school, according to smithian lines. The second one, vertical, refers to the division of social classes. Wieser considers its importance is not inferior to the one related to horizontal division of labour (Wieser, 1927, p. 310). Now, money did not generate division of labour but is only its ‘concomitant’ (p. 170). This is probably the reason why it only unifies economy ‘externally’. The existence of a vertical division of labour provides one of the main foundations of what Wieser calls social stratification namely, the second typical feature of social economics. As we already noticed, stratification implies both the division between and the division within social classes. These divisions exert various and substantial effects on the economic activity. They do not only concern production but also exchange. For instance, in a social economy, prices are also stratified, reflecting the evolution of the different types of goods in relation with the social groups which consume them. Thus, the existence of three classes implies that the group of ‘mass-commodities’ has to be evaluated by the marginal utility of the poor: the set of ‘intermediate goods’, by the preferences of the middle classes and the group of ‘luxury goods’, by the valuations of rich people (Wieser, 1927, pp. 157–8). Social stratification also appears through the social role played by entrepreneurs: ‘The legally independent acquisite entreprises are instruments of a

8

Money Credit and the Role of the State

great social productive and acquisitive process following a division of labor’ (Wieser, 1927, p. 151). This process allows entrepreneurs to act frequently as ‘leaders’, not only because ‘commodities, as things, are controlled by the owners’ (p. 42) but also because the institution of enterprise is the organ of the modern economic stratification (...). In its simple forms, it invests the entrepreneur merely with personal superiority; later, when large enterprises develop, it gives him a degree of power that finally swells to capitalist supremacy (...) He is not merely the legal head; he is also at all times the economic leader. His legal power of disposition reaches its full significance in securing to him complete freedom of economic management. His economic leadership commences with the establishment of the enterprise; he supplies not only the necessary capital but originates the idea, elaborates and puts into operation the plan, and engages collaborators (Wieser, 1927, p. 324).

Firms are not the only institutions in social economies. We already notices how the were generated by the interaction between leaders and masses. We have also to recall that this interaction is only understandable in a permanent process. Leaders create social devices which correspond to their needs and aims. Masses imitate leaders and, therefore, transform those devices into social rules or institutions. These institutional patterns then become constraints for further individual behaviours. The aggregate results of the various agents decisions change, in turn, and contribute to institutional change etc... This approach, therefore, introduces a process of institutional change able to imply feed-back effects on the economic sphere. This kind of process occurs in historical time and, therefore, it has to be considered step by step. From this standpoint, institutional impulses ‘are entirely dependent, [for the average man] upon the practice of his time and environment for their direction and their strength’ (Wieser, 1927, p. 159). The emergence of new leaders can, however, change institutions, if they are allowed by masses. One of the main institutions of a social economy is market or, to be more precise, markets, since Wieser refers to ‘institutions of exchange’ (Wieser, 1927, p. 150). Wieser’s view of exchange substantially differs from Walras’s one. Wieser does not consider indeed that the scheme of pure bilateral exchange offers a kind of universal foundation for any economic system. Quite the contrary, he stresses that the mutual wills of individual economic agents do not provide the only determinant factors of exchange: The exchange contract (...), although it is made as a rule only between two parties, has manifested itself the coordinating instrument that binds the individual economies into

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the rational economy (...) our main task is to describe the institutions of exchange and erection of the national economic body that is brought about by these (Wieser, 1927, p. 150).

In this context, ‘the market is a social institution, where the freedom of exchange operates as a freedom of choice’ (p. 172). The existence of markets is implied by the coexistence of private property and (both horizontal and vertical) division of labour. Production is indeed implemented by ‘legally independent’ individual ‘ producers’, helped by ‘workers’ (p. 150). Now, ‘in a fully developed money economy, in which individual self-sufficiency disappears, all households must finally turn to the market for a satisfaction of their needs’ (Wieser, 1927, p. 150). In other terms, markets are fundamentally monetary. They form what Wieser called ‘the great circulation of the national economy’ (Wieser, 1927, p. 151). On one side, households demand consumption goods to firm and they are then ‘faced with the necessity of securing a monetary income’ (p. 150). This income is a money wage paid by producers. Money holding is, therefore, a prerequisite of demand for wage-earners. They are submitted to a kind of clowerian liquidity constraint. They cannot buy directly goods through barter with their labour. On the other side, for firms, money holding is a prerequisite of production. Firms must hold the amount of money due to wage-earners and, therefore, they also demand liquid resources. Contrarily to a simple economy, they are now structurally parted from households. Again, Wieser’s conception of market is entirely different from Walras’s one. While Walras starts from a basic scheme of market economy based on barter between two commodities and then generalizes it progressively to general pure exchange, production, capitalization, and in the end, money and credit, Wieser considers that there is no market without money. To use Hicks’s modern words, his theory of markets is a money theory of markets, since, for Wieser, markets are logically unconceivable if money as an institution is not presupposed. But Walras’s and Wieser’s conceptions of market do not only differ according to the part they attribute to money within the exchange process. On his side, Walras stresses the universal character of pure exchange economies as a general logical device on which it is necessary to build the whole edifice of general economic equilibrium. On the contrary, Wieser does not emphasize the homogeneity of concrete markets but their heterogeneity. This attitude is not surprising. Wieser first considers markets as an institution: ‘The market is a social institution, where the freedom of exchange operates as a freedom of choice’ (Wieser, 1927, p. 172). Considering market as an institution, Wieser notices that it is necessary to distinguish warious ‘nstitutions of exchange’ and he dedicates the whole part II of Book II of his Social Economics to their study. Markets must therefore be distinguished according to their specific institutional set-up or, to use Wieser’s (but also Marshall’s) own words, to their proper ‘organizations of markets’. Market organization is indeed central in Wieser’s approach, as it was in Menger’s one. The formation of prices does not follow the

10

Money Credit and the Role of the State

same rules, according to the fact that the market is organized or ‘disorganized’ (Wieser, 1927, p. 195). Markets might be characterized, however, by a common feature but also by their diversity. The common feature of markets is the predominant part played by producers and supply within the working of exchanges. On one side, the freedom of exchange is indeed counterbalanced, at least partially, by the forces of compulsion. Wieser observes that, often, in the process of exchange, agents have not their ‘full economic strength ’(p. 168) and therefore, as in the contracts of ‘labour’ or ‘usurious loan’, an asymetry exists among the parties. Producers may, therefore, profit from compulsion and they are also able to impose their ‘supply prices’ (p. 175) as a prerequisite imposed by producers to consumers (p. 175). Markets, however, are not identical. They are all different: ‘Theoretically, we have to distinguish in the universal economic market as many varieties of partial markets as there are varieties of market-indices’ (Wieser, 1927, p. 175). This stress on the diversity of markets was not introduced by Wieser, but by Menger, within the Austrian Tradition (Arena, 1999). As we pointed out earlier, it first refers to what Wieser calls ‘the stratification of prices’ (Wieser, 1927, p. 186). In other words, markets are not all accessible by any type of agents. Thus, the quantities of ‘mass-commodities’ brought to markets depend on the volume of consumption needs of all social strata which are expected to consume these goods. Therefore, in mass-commodities markets, prices are determined by the poorest agents and only by their marginal utilities. On luxury goods markets, on the contrary, ‘prices are offered according to a standard induced by the purchasers ability of members of the higher and highest income-strata who are bent on excluding the competition of all other rivals’ (p. 187). Finally in intermediate goods markets, prices are determined according to the purchasing power of the middle classes. Therefore, markets are socially stratified according to the diversity of consumers purchasing-power. Markets are also differentiated according to their organization. Here the mengerian influence is direct. Several causes might be related to: degree of speculation (p. 173), type of competition (pp. 173–4), distance to the final consumer (p. 176), mechanisms of bids (pp.174–6) or quality of organization (p. 195). These causes permit to distinguish a set of main markets. The labour market is the first described by Wieser, who notices that ‘labour is not a product’ (p. 176). Markets products are differentiated according to their modes of exchange: natural barter (p. 174) or monetary exchange (p. 175). Money markets include the loan and the stock markets; they do not allow product exchanges; they permit to satisfy investment needs (p. 176). Finally, the price variations on the ‘market of agricultural or urban real estate’ often follow the price variations of the money market (p. 176). Last but not least, then comes money as a distinct feature of social economics. If we combine it with production, we obtain the two most distinctive typical

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features of a modern economy. That is why we may credit Wieser, without any kind of hesitation, of having built a theory of monetary production economies within the Austrian tradition. It is now time to focus on money as such.

1.4

Wieser on Money and Credit

Wieser clearly considers money as one of the founding institutions of social economy: For complicated social institutions the historical explanation requires further refinement. We shall show this by the classic illustration of money, whose unknown origin has provoked almost as much interest among men as the origin of the state or of speech. But we must also show that the more subtle explanation at which one finally arrives, necessarily involves a reduction of individualistic stress. The long series of writes who sought to explain money as an individualistic institution, ends with Menger’s penetrating investigation. He uses the phenomenon of money as a paradigm by which he assumes to show that all social institutions of the economy are nothing more than ‘unintended social results of individual-teleological factors’ (Unter Suchungen, pp.171–87) (Wieser, 1927, p. 163).

The reference to Menger is obviously essential. For our purpose, it is not however necessary to remind here Menger’s conception at length. We shall confine ourselves to two substantial quotations taken respectively from Menger’s Principles of Economics and Problems of Economics and Sociology: Money is not the product of an agreement on the part of economizing men nor the product of legislative acts. No one invented it. As economizing individuals in social situations became increasingly aware of their economic interest, they everywhere attained the simple knowledge that surrendering less saleable commodities for others of greater saleability brings them substantially closer to the attainment of their specific economic purposes. Thus, with the progressive development of social economy, money came to exist in numerous centers of civilization independently. But precisely because money is a natural product of human economy, the specific forms in which it has appeared were everywhere and at all times the result of specific and changing economic situations. Among the same people at different times, and among different people at the same time, different goods have attained the special position in trade described above (Menger, 1871, pp. 262–3). It is clear (...) that the origin of money can truly be brought to our full understanding only by our learning to understand the social institution discussed here as the unintended result, as the unplanned outcome of specifically individual efforts of members of a society (Menger, 1883, p. 155).

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Money Credit and the Role of the State

These two quotations provide a significant outlook of Menger’s theory of money. Wieser accepted it only partially. He indeed considered that money is something more than this ‘intended result’ (p. 165). To put it briefly, for Wieser, Menger’s story is substantially correct if we interpret ‘individual efforts’ as the efforts of the ‘leaders’. In other words, Wieser implanted his theory of the interaction between leaders and masses within Menger’s approach. According to him, within the market process, the members of the society who had in charge the organization of exchanges very quickly realized the importance of the drawbacks implied by a barter economy. These drawbacks -which are familiar to economistsconvinced ‘leaders’ to introduce a simpler system which would have avoided the necessity of multiplying indirect and costly exchanges. Through a process of learning, little by little, they created several means of substitution according to their historical and cultural environment. Therefore those leaders, who had only in mind their own interests, indeed contributed to create a true unintended new monetary system. But, in Wieser’s conception, these means only formed a system when masses approved them by imitating leaders, in other words, when everyone, in the least exchange processes, used the means introduced by the main participants to the market. The function of the masses consists in the case of money as in all other social activity in that their imitation establishes the universal practice which gives to a rule its binding force and social power (Wieser, 1927, p. 104).

Money is therefore an institution which is not understandable with the only help of an individualistic approach. Wieser, however, did not only pay attention to the problem of the origin of money. He also faced the main questions of monetary theory. We shall not consider here those related to the value of money. Wieser’s only innovation is related to the link he sets up between the value and the utility of money, in contradiction with the usual original quantity of money theory. We shall not consider either the problem of a monetary system based on a metallic commodity. We shall rather stress the different forms of money distinguished by Wieser which correspond, in modern terms, to the various types of liquid assets. The first one is ‘money-capital’. Money-capital includes not only cash reserves but also those much large sums which are held in other liquid form, especially those already invested at interest during the process of accumulation, provided that they may be cashed or transferred on short notice (Wieser, 1927, p. 293).

Therefore, it is easy to understand why ‘the formation of money-capital is accomplished by saving or by laying aside money’ (Wieser, 1927, p. 300). ‘Money-capital’ indeed corresponds to Keynes’s Treatise ‘saving deposits’, namely, to firms monetary saving.

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Money-capital has to be distinguished from loan-capital: All capital lent, that is not money-capital is loan capital, from short term business credits to long-term or perpetual mortgage loans and annuities which are usually spoken of as capital investments (Wieser, 1927, p. 294).

Loan capital corresponds to the bank or money deposits firms obtained by the means of short term or long term credit. It is therefore analogous to Keynes’s ‘finance’ and ‘business deposits’. ‘Entrepreneur’s capital’ is, then, the sum of ‘liquid cash items which are to cover payments of wages and other current operating expenses, that part outstanding as loan capital and also the remainder which has been transformed into natural capital and further the enterprise as such’ (p. 294). ‘It means the entire capital which has been invested and is actively used in the enterprise’ (p. 294). It corresponds to the classical volume of ‘advances’. Finally, ‘the ready money of the household’ ‘is to be used directly to cover domestic needs’ (Wieser, 1927, p. 293). It therefore corresponds to Keynes’s Treatise income deposits. When consumers form saving deposits, the usual language avoids to call them money-capital but, however, land or housing acquisitions by households have to be included within national saving (Wieser, 1927, pp. 295 and 300). What is striking here is obviously the analogy between Wieser’s and Keynes’s classification. It reveals a connection related to the will of describing the same reality which is a monetary production economy. This parallel goes on with the introduction of credit: The establishment of the credit system did not introduce a fundamentally new set of conditions; it is not even desirable to speak of a special credit economy. What men refer to as the credit economy is merely an extension of the money economy; it might be called the credit-and-money economy (Wieser, 1927, p. 261).

A ‘credit-and-money economy’ is therefore nothing else than the modern form of an exchange economy. In other words, credit and money institutions correspond to the contemporary stage of the process of emergence of money market economies: ‘the development is within the money economy; credit transactions are an institution of exchange’ (Wieser, 1927, p. 238). The introduction of credit within money market economies facilitates the activities of production and this is the reason why ‘leaders’ created it and ‘masses’ accepted it. It strongly increases the performances of the economy: By means of loans and credits in their various forms individuals other than those owning property are given control of the property. In particular the group of entrepreneurs is renewed. By means of payment by credit the form of money is expanded; developing natural values offer a commercial security and themselves furnish the means of payment

14

Money Credit and the Role of the State which facilitate their sale. Thus the avenues of production are enlarged. These are great results but they rest on a monetary economy within which they function (Wieser, 1927, p. 261).

Credit, therefore, appears to be both the modern form of exchange and facilitator of production. However, these two roles are not so distinct, they merge into the assertion, that, in a credit-and-money economy, credit supplies entrepreneurs with the liquidity they need to organize production. Anticipating Keynes’s finance motive, Wieser shows that bank money or credit provides the very condition of production within a money market economy. In this prospect, Wieser indeed remarks that, thanks to credit, the entrepreneur (and not the capitalist !). ‘.. is enabled for the entire period to continue an economic process which, in the absence of the loan, he could not have begun or continued (Wieser, 1927, p. 240). Credit takes a variety of forms in the real life. We shall not enter, however, here into the description by Wieser of the different concrete types of credit since it only presents an historical interest. We shall rather consider the economic principles according to which the credit system is organized. The foundation of this organization is the Fullarton’s principle which assumes the strict necessity of the periodical reflux of credit creation: Notes which are paid out in discounting loans are subject to a law which has been called after its discoverer, ‘Fullerton’s law’. When the credit granted by the bank expires the bank either receives its note or, if repayment is made in cash, an amount of cash which covers the note remaining in circulation. The notes which the bank issues in discounting commercial paper are no longer lived than the draft of acceptance itself. (...) They come into existence when the draft is discounted; they die when the draft is honored (Wieser, 1927, p. 245).

In compliance with the Banking School approach, the adoption of the Fullarton’s principle obviously implies a distinction between credit defined as a temporary means of payment and money defined as a definitive one. Wieser states it: Finally commercial paper is a means of only provisional payment. Notes [of the Central Bank -stressed by me R.A.] are a means of final and conclusive payment just as is money (Wieser, 1927, pp.245–6).

It is then natural that Wieser conceives bank money supply as endogeneous: The amount of the unsecured balances, to the extent of which money does double work, fluctuates as elastically with the monetary requirements of trade as does the amount of unsecured notes. In periods with large financial requirements, the bank will increase its loans. As the requirements drop off, there takes place a return flow of bank funds which is quite analogous to that described by the law of the return of bank notes (Wieser, 1927, pp.248–9).

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15

Within the theoretical framework that we have just described, the fulfillment of the Fullarton’s principle and the respect of the rule of endogeneity of bank money imply a strict equality between the money values of supply and demand. This equality ensures, in its turn, that the values which finally prevail on the market as well as in the production sphere, are natural: It is his personal loss, when one of the contracting parties errs and surrenders a greater value in the one form than he receives in the other. The equation of values in the total, however, is not affected by this error, for what he overpaid becomes the gain of the other party to the contract (Wieser, 1927, p. 256).

1.5

Money and Circulations

As some of the economists of the beginning of the XXth century interested by the field of monetary theory, Wieser describes the national economy as a ‘community of payment’. This community which derives from the existence of money and credit involves two different types of circulation. The first circulation might be called the income circulation. It is described by Wieser as ‘the exchange of natural values for money’ (Wieser, 1927, p. 250). It is the circulation which, according to the prevailing form of the division of labour, allows households and firms to buy the different consumers and capital goods with the incomes they earned in the process of production and exchange. Wieser describes this circulation as a means for society to attribute social utility to produced goods. There is certainly here a possible parallel with Marx. Marx characterized exchange as the process of transformation of concrete labours into parts of the social abstract labour. Therefore, exchange was a means of confirming the social utility of goods which, earlier produced in a purely private sphere. Now, Wieser writes: In disposing of his products for money, the producer effects a transition from the narrow field of his particular process -a limitation imposed by the division of labor- to the entire wealth of values in the market. He surrenders the natural form of a specially conditioned product for which the market possesses only a limited capacity of acceptance. In return he receives money, the general medium of exchange, which enjoys a mass-habit of acceptance and by which he is left to a greater or less degree master of the market. He may now come forward in the market with his demand. It is this shift from a restricted to a general command of the market that is significant in the concept of payment. In this sense payment is a monetary performance in exchange (Wieser, 1927, p. 251).

Through exchange, ‘natural values’ are therefore becoming ‘social values’, as ‘concrete labour’ used to become ‘abstract labour’ in Marx. Therefore, the income circulation is not only the means to ensure the renewal of production in a social economy involving private property and division of labour. It is also a social set-up

16

Money Credit and the Role of the State

which permits society to include (or exclude) private productions within (or from) the set of the national product. Wieser also admits the existence of a second type of circulation. He indeed uses the word ‘original’ to specify the natural income. But this original income does not sum up the whole economic activity. Besides ‘price payments’ which characterize the circulation of income, Wieser also defines ‘payment by assignment’, ‘which are made under any title outside the market of natural values’ (Wieser, 1927, p.253). These payments are rather heterogeneous. They refer to transactions related to changes of ownership, as it is the case when a financial asset (a share or a bond) is transferred to another agent. Payments to banks or to creditors are also included in ‘payments by assignment’ because ‘the party paying as the assignor (...) surrenders a certain general market control, considered as money, to an assignee’ (Wieser, 1927, p. 253). This category also entails gifts or tax payments. The incomes to which these ‘payments by assignment’ give birth, form what Wieser calls the ‘derived income’. Within the sphere of the derived income a specific mention must be put on the capital market (p. 303). This market is subdivided into the ‘money’ and the ‘investment markets’ (p. 303). The money market is the liquidity market. It allows banks and firms to meet and determine the conditions of short term production credits. It provides the means which permits markets economies to organize their system of credit. The investment market ensures the funding of investment by saving. Capitalgoods and unsold commodities are assumed to form a part of firms saving, while sold commodities appear as monetary balances within firms endowments (Wieser, 1927, pp. 295–6). The investment market involves the market of stocks and bonds, on the one hand, and the real estate market, on the other hand. This view of ‘investment market’ may present some resemblances with Keynes’s ‘financial circulation’ but they are only superficial: no real Keynesian speculative motive is assumed to exist in Wieser’s theory.2 The money and investment markets ‘are mutually connected’ (Wieser, 1927, p. 304). Therefore, one could expect for the emergence of a single long-run rate of interest, as the result of ‘equalizing movements’ (p. 304). But, in practice, this is not the case: Even with complete security on the loans, the interests of the different groups composing the supply and the demand are too diverse as regards the period of the loan and a number of other conditions for a central market to form in which the law of the unity of price might prevail (Wieser, 1927, p. 304).

The rate of interest on the money market is ‘more mobile’ than the ‘steadier’ investment market interest rate (p. 304).

Wieser on Money and Social Economics

1.6

17

Concluding Remarks

The investigation of monetary themes in Wieser’s contribution to economics finally reveals an original reflection. From this point of view, three final remarks might be formulated. It is first clear that Wieser’s contribution to the Austrian tradition is highly valuable. On the one hand, Wieser completes and extends, in his own way, Menger’s theoretical results. On the other hand, paradoxically, he proposes the foundations of a theory of money strongly related to the wicksellian approach and anticipating Keynes’s Treatise on Money. It is striking to note the analogies between Wieser’s theory and some aspects of the classical tradition. On one side, the stress put by Wieser on production and natural positions is not so far from the Ricardian approach. On the other side, the Banking School exerted substantial influences on Wieser’s theory of money. Is is finally worth to stress the distance between Wieser’s and Walras’s views on money. Although both authors are often considered as promoters of the socalled ‘Marginal Revolution’, their theories have very little in common. This only proves how Jaffé was right when he emphasized the necessity of ‘deshomogeneisation’ of this ‘Revolution’ (Jaffé, 1976).

Notes 1 2

A. Ford Hinnichs’ English translation (Wieser, 1927) used the word ‘natural controls’ (see Translator’s note n. 1, p. 154 of Wieser, 1927). We prefer the literal translation accepted by Mitchell (1917, p. 104). Wieser describes speculation but does not see the importance of its financial dimension (Wieser, 1927, pp. 363–7).

References Jaffe, W. (1976), ‘ Menger, Jevous and Walras de-homogeneized ’, Economic Inquity, 14. Keynes, J.M. (1930), A Treatise on Money - The pure theory of money, Vol. V des Collected Writings of John Maynard Keynes, London: MacMillan, Cambridge University Press, 1971. Menger, C. [1871](1950), Grundsätze der Volkswirtschaftslehre. English translation: Principles of Economics, Glencoe, Illinois: The Free Press. Menger, C. [1883] (1963), Untersuchungen über die Methode der Sozialwissenschaft und der Politischen Oekonomie insbesondere. English translation: Problems of economics and sociology, Urbana. University of Illinois Press. Mitchell, W.C. (1927), Foreword to Social Economics, pp. IX–XII.

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Streissler, E. (1986), ‚Arma Virumque Cano: Friedrich von Wieser, The Bard as Economist’, in N. Leser (ed.): Die Wiener Schule der Nationalökonomie, Vienna: Herman Böhlau. Von Wieser, F. (1893), Natural Value, [reprinted by M. Kelley Publishers in 1956], English translation of Der natürliche Werth, 1889. Von Wieser F. (1927), Social Economics, New York: Adelphi Company [reprinted by M. Kelley Publishers in 1967], English translation of Theorie der Gesellschaftlichen Wirtschaft, 1914.

Chapter 2

Money, Saving and Intertemporal Resource Allocation *

Lilia Costabile

2.1.

Introduction

There are two main issues connected with the influence of monetary factors on economic dynamics. The first is the question whether, and to what extent, these factors are an important causal factor in the genesis of economic fluctuations, or rather a purely passive, or, at most, a complicating factor; and whether the control of monetary factors would suffice to stabilise the economy in the short run. The second issue is whether, and to what extent, monetary and financial factors may exert an influence on the economy’s growth: whether they can affect the time profiles of economic variables in the long run and, if so, which variables are affected, and through which channels. The two problems are obviously related at a logical level, as indeed they are in the history of economic thought and debates. Some authors have regarded monetary factors as responsible for short run fluctuations in economic activity, but ineffective as determinants of long run trends. Others have attributed to monetary factors a more lasting effect, and have argued that monetary and financial policies and institutions can affect the pattern of economic growth. According to those who hold the first point of view, money does not need to be neutral, but monetary forces merely generate short-run imbalances in the structure of production. Since the latter are bound – by their very nature of ‘maladjustments’ – to be reverted in the course of the re-equilibrating process, monetary forces produce mere swings in economic activity. What is behind the underlying concept of equilibrium are the real forces of technology and consumers’ preferences: an allocation of resources – and a structure of relative prices – is defined as an equilibrium if it reflects the operation of these two forces. In this approach, monetary impulses may cause distortions in the – actual or perceived – structure of relative prices (mainly the rate of interest and the wage rate) which, in turn, elicit demand and supply responses, thus generating the business cycle. However, these responses are ‘mistakes’, inasmuch as they are triggered by spurious price signals, not justified by changes in the underlying real forces. The resulting allocation of resources is bound to be nullified by the reaction of economic agents, when, eventually, they recognise the underlying real situation. Ludwig Von Mises,

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Money Credit and the Role of the State

Friedrich Von Hayek, Milton Friedman and many Monetarists, as well as the New Classical Macroeconomists1, are examples of this line of thought. By contrast, the alternative view can be stated as follows: monetary factors and policies contribute, together with the real forces mentioned above, to determine the economy’s equilibrium, even in the long run. They do so by altering the data of the economic agents’ maximising problem, in such a way that their re-equilibrating strategies are not aimed at restoring the original equilibrium, but, rather, at achieving a new equilibrium state. Dennis Robertson, Robert Mundell, James Tobin, are in this line of thought. One further specification of these two alternative approaches is made possible by the introduction of the concept of a ‘vertical’, as opposed to a ‘horizontal’, structure of production. Following Haberler (1939, p. 30), the ‘vertical’ equilibrium structure of production is defined by the circumstance that ‘the allocation of the factors of production to various employments corresponds to the distribution of the money flow – i.e. the monetary demand for the products of the different branches of industries’, as determined by the decisions of the population on spending and saving. If the structure of production does not correspond to these decisions, ‘we have a vertical maladjustment – vertical because the industries which are not harmoniously developed are related to each other in a vertical order, as cost and product’. In the light of these definitions, the difference between the two points of view can be stated as follows. According to the first point of view, the equilibrium vertical structure of production is determined by ‘productivity and thrift’, i.e. technology and consumers’ intertemporal preferences. By contrast, in the alternative view, the vertical structure of production can be influenced by monetary factors as well as by saving behaviour and technology. For purposes of identification, these two alternative views are labelled here the ‘Neutrality View’ and the ‘Non-Neutrality View’ respectively. However, it should be noticed that these are very broad labels indeed, as each of them covers a great variety of theories, which are by no means completely homogeneous within themselves. This chapter, in sections 2.2 to 2.4, illustrates the main developments within the former approach, while the Neutrality View is considered mainly for its criticisms of it. It will be shown that the Non-neutrality View has gradually evolved, at first within the forced saving approach, then into the equilibrium approach, probably as a consequence of criticisms from authors belonging to the other tradition. The equilibrium approach is immune from most criticisms raised against the forced saving doctrine, for it derives its Non-neutrality results from full consideration of agents’ maximising strategies. For this reason, the models of Mundell (1963) and Tobin (1965) are unchallenged pieces of economic analysis. However, there are circumstances in which the ‘Tobin-Mundell effect’ may not be in operation, as empirical evidence on savers’ portfolio choices during some inflationary experiences seems to show. The second part of this chapter (sections 2.5 to 2.7) argues that, in all circumstances where the Tobin-Mundell effect is not in operation, another mechanism comes into action, based upon individuals’

Money, Saving and Intertemporal Resource Allocation

21

saving-and-consumption choices in the face of inflation, which still leads to Nonneutrality. In order to illustrate the operation of this consequence of monetary expansion, a very simple model, based on Modigliani-Brumberg (1954 and 1979) and incorporating the ‘induced saving’ effect, is presented. A brief conclusion (section 2.8) summarises the argument.

2.2

The Non-Neutrality View: the Common Root

The question is the old one whether a country (or the world as a whole) can increase its wealth through monetary expansions. Economists have always understood that, for monetary variables to have any effect on real variables, these must occur through their distributional effects. The common root among Nonneutrality doctrines is the idea that a change in the quantity of money and the price level and, a fortiori, a change in their growth rates, in the absence of instantaneous adjustments in all nominal variables, do have distributional effects among agents in the economy. These are: (i) a redistribution in the ‘circulating medium’ among private agents, which is accompanied by a redistribution of income and wealth, and consequently affects aggregate saving and investment. This happens because some contracts are fixed in nominal terms, and lag behind the price level; (ii) the inflation tax, whereby governments, by keeping the nominal rate on their monetary liabilities fixed, gain at the expenses of their creditors, i.e. the private sector. This effect implies that there is a cost associated with the holding of real balances, which enters private agents’ saving and portfolio decisions. If neither of these effects is allowed to operate, money is neutral. In other words, if all incomes are fully indexed, no distributional effect occurs. In particular, if all contracts between private agents incorporate escalator clauses, distributional effects within the private sector are not set in motion. Similarly, if the new money balances are distributed to private agents exactly in proportion to their existing money holdings, distributional effects between the government and its creditors are ruled out by assumption (this hypothesis amounts to assuming that the private sector is paid a nominal interest rate on its monetary assets equal to the inflation rate). The common root, then, is the idea that money affects the economy via distributional effects, and that these in turn affect the rate of capital formation and the equilibrium real interest rate. Differences between the two approaches to Non-neutrality arise, as we will show, depending on whether the focus is on redistribution within the private sector (generally associated with unanticipated inflation) or between this sector and the government.

22

2.3

Money Credit and the Role of the State

Inflation, ‘Forced Saving’, and Capital Formation

The distinguishing feature of the forced saving approach is the notion that monetary policy can positively affect capital formation by forcing a redistribution of resources away from consumption and in favour of investment. The implication is that, although the resulting allocation of resources between consumption and investment does not reflect some agents’ saving and consumption plans, and indeed frustrates these plans, nevertheless monetary policy can permanently raise the economy’s capital stock. The early development of the doctrine of forced saving was due to Thornton, Bentham and Malthus.2 The (indisputable) idea underlying this doctrine was that those agents, groups or social classes whose nominal incomes (including interest on monetary assets) fail to adjust to the price level, see the purchasing power of their incomes reduced, and thus forcedly release real resources, either in favour of the government or in favour of agents whose incomes rise with the price level. 3 From this basic idea the proposition was derived that, provided the recipients of these additional resources are prepared to employ them – directly or indirectly – for purposes of capital accumulation, a monetary expansion has the effect of raising the economy’s propensity to save and of increasing national capital. Consequently, a nation could ‘add to the mass of its future wealth’ via a monetary expansion and the channelling of additional real resources into investment, at the expense of consumption. Although subsequently the doctrine of forced saving evolved to incorporate other effects, this is its essential proposition, the one which characterises it and that it has always retained. In the early formulations of the doctrine, monetary expansions were regarded as likely to favour the manufacturing classes, ‘capitalists’, at the expense of workers and other fixed-incomists. Underlying this idea was the generally accepted view that money would normally enter the economic circuit at a particular point, by accruing into the hands of the ‘productive classes’, either by way of loans from the banking sector, or by way of payments for goods sold by the manufacturers to the government. Hence monetary expansions would favour capital formation, even though public investment, i.e. investment undertaken directly by the government, was not regarded as either likely, or advisable. The basic message of these early formulations is that a monetary expansion raises the economy’s saving/income and investment/income ratios as a consequence of the redistribution of income between wages and profits which it inevitably induces, owing to the ‘wage lag’.4 In addition to the distributional effects between wages and profits, another channel of monetary influence was later incorporated in models of forced saving. This is the idea, originally proposed by Wicksell, but anticipated by Thornton (Hayek, 1932), that monetary policy may cause the money rate of interest to diverge from the ‘natural rate’, i.e. that rate which would equalise the demand for, and the supply of, capital if these two variables met in their natural, real form.

Money, Saving and Intertemporal Resource Allocation

23

In these models, investment is no longer considered as an exogenous variable. Monetary policy positively affects investment decisions if it succeeds in lowering the money rate below its natural level. Induced investment generates forced saving, since the economy thus diverts more resources into capital formation than consumers had intended to do, via their individual decisions to abstain from consumption. This version of the doctrine of forced saving, incorporating the Wicksellian relationship between the two interest rates, was at the centre of economic debates on money, fluctuations and growth in the 1920s and early 1930s: Robertson and Keynes in the 1930s were among the Cambridge adherents to this version, which was then incorporated, in the 1960s and 1970s, into the ‘Keynes-Wicksell’ growth models (e. g. Stein, 1969; see also Deaton, 1977).

2.4

The Neutrality View

Proponents of the Neutrality View have criticised the doctrine of forced saving, on the grounds that it implies incompatibility with the concept of equilibrium and with agents’ maximising strategies. There are two versions of this critique. The first was formulated before the role of price expectations became one of the central concerns of economic theory, and therefore does not rely on this factor; the second one does. Both versions are based on the notion that the equilibrium capital stock depends upon agents’ intertemporal preferences, under the only constraints of the available resources and their physical productivity. Growth, in this theoretical framework, can only be generated by one of the following factors: an increase in the original factors of production (generally represented by an exogenous population growth), technical progress, and changes in consumers’ intertemporal preferences.5 The first version of this Neutrality argument was formulated by Mises (1971) [1924], and, after him, by Hayek (1931, 1932). They argued that any addition to the capital stock generated out of forced saving cannot be maintained, since it is not compatible with agents’ rational choices: consumers’ reaction to the disequilibrium situation which they face will restore equilibrium. Very briefly, this position can be stated as follows: some incomes exhibit a lag behind prices,6 and this is why forced saving occurs; but these incomes eventually catch up with the rate of price increases, because the new money injections are, sooner or later, paid out by firms to the original factors, which are supposedly fully employed. When this happens, agents will try and restore their original equilibrium, i.e. their original consumption/income ratio. By so doing, they will also restore the original ratio between the relative prices of ‘present’ and ‘future’ consumption goods, i.e. the original real interest rate. Since the demand price of investment goods now falls again relative to the demand price of consumption goods, the production of capital goods becomes unprofitable. The original equilibrium will thus be restored, but the re-equilibrating process will be marked by a crisis. ‘Neutrality’ means that the equilibrium intertemporal resource allocation is not affected by monetary

24

Money Credit and the Role of the State

factors, although the re-equilibrating process may involve the cost of capital disruptions and crises. As we have already mentioned, this view (or the argument that distributional effects can be totally assumed away), is the common root of all Neutrality arguments. However, this conclusion is only granted if some assumptions are made. In particular, the following assumptions are implicit in Mises’s and Hayek’s formulations. First, firms do not retain ‘corporate profits’, and therefore all gains ultimately accrue to the ‘original factors of production’. Since the propensity of the factors’ owners to save is invariant to monetary expansions, the production decisions stimulated by monetary policy cannot be confirmed by consumers’ choices. However, some alternative theoretical approaches, based on the notion of a class division between capitalists and workers, assume that corporate profits are either retained by firms’ managers for investment purposes, or distributed to firms’ owners, who are supposed to have a higher propensity to save and invest than workers. It follows that the inflation-induced redistribution of income in favour of profits is permanent, and this is what may make the equilibrium capital stock independent of wage earners’ and, more generally, fixed-incomists’ intertemporal preferences. Therefore this alternative assumption opens the way to a theory where forced savings are the source of permanent additions to the economy’s capital stock, as in Robertson (1926), Keynes (1930), and in the post-Keynesian growth models. Robertson’s 1934 article is an interesting attempt to integrate cyclical changes in income distribution in this alternative theoretical approach to growth (Costabile, 1993 and 1997). The second assumption implicitly made by Mises and Hayek is that the economy’s intertemporal equilibrium is unique and stable. As has been shown by Leontieff (1948), if different assumptions are made, a multiple solution obtains and, consequently, a deliberate policy aimed at promoting growth through forced saving may be effective. For this possibility to occur, however, it is necessary that monetary policies are effective in altering the distribution of income, at least in the interval before new capacity is generated. And this possibility, as we have just seen, was recognised in Mises’s and Hayek’s version of the Neutrality View. If, on the contrary, it is assumed that all factors’ nominal incomes immediately adjust and rise in the same proportion as the price level, distributional effects are not at work. This is the essence of the second version of the Neutrality View, which maintains that the stickiness of wages and other incomes in the face of persistent inflation either implies irrational behaviour, or some kind of deviation from the hypothesis of perfect competition (Johnson, 1963, p. 122). Having discarded the notion that some deviation from perfectly free competition may occur, this criticism has focused on the ‘rational behaviour’ argument. This alternative version of the Neutrality View, which focuses on the role of price expectations, is even more radical than the previous one, as it denies that a change in money supply generates distributional effects within the private sector, even as a short run phenomenon. Since rational agents incorporate the rate of

Money, Saving and Intertemporal Resource Allocation

25

inflation in their expectations (if monetary policy is systematic), it follows that both the real wage rate and the real interest rate are set at their natural levels. This is because neither workers, in the labour market, nor lenders, in the capital market, will let their nominal incomes be eroded by expected inflation. With adaptive expectations, a lag in nominal incomes behind prices may still exist in the short run, due to a lag in the expected rate of inflation behind the actual rate (Friedman 1968). However, if expectations are rational, real incomes are invariant to the systematic part of the money supply (Lucas, 1972; Sargent, 1973; Sargent and Wallace, 1975). This amounts to assuming that the coefficient relating the rate of change of nominal incomes to the rate of change of prices is unity and, consequently, that an anticipated monetary expansion does not redistribute incomes among private agents. This critique was reinforced by the contention that, empirically, there was no evidence of systematic lags in wages or any other nominal remuneration behind prices (Cagan and Lipsey, 1978, p. 3; Fisher and Modigliani, 1978, p. 823). However, one may notice that other historical episodes (such as the current Italian experience) confirm that such lags may well be in operation. At first sight, it seems that very little in the notion of forced saving survives to this critique, since distributional effects within the private sector seem to be incompatible with anticipated inflation. However, this is not so, as one example of forced saving in the context of anticipated inflation will suffice to show. This example derives from a criticism of the analysis developed by Cagan (1969), and shows that, even with anticipated inflation, a redistribution of income within the private sector could still occur in a pure credit economy. Cagan’s argument is based on the notion that, even with anticipated inflation, when prices rise those who issue money reap the revenue from money creation at the expense of the holders of money balances. Assume a pure credit economy, where deposits are the only money and investment is financed out of bank loans. Suppose banks are able to expand the money supply (i.e. add to the supply of loanable funds) at some given real interest rate, and to accumulate earning assets (the borrowers’, presumably firms’, liabilities) at this rate. With anticipated inflation, the nominal interest rate is adjusted to cover the expected rate of price change, and this implies that the revenue from the inflation tax accrues to the banks. There is a redistribution of income in favour of the banks. 7 However, once again, the rate of capital accumulation is not affected, if distributional effects are assumed away, as Cagan does in his model: if the banks distribute the proceeds from money creation to their stockholders and depositors, whose desired wealth/consumption ratio is a given constant, savings out of anticipated revenues from the ‘tax’ will fall, and neutralise the banks’ additions to loanable funds. The capital stock will not be increased, in these circumstances, as a consequence of credit creation. This is Cagan’s conclusion. However, it could be argued that, contrary to this conclusion, if the increase in loanable funds occurs at the instigation of certain agents (e.g. the stockholders or bank managers) who wish to own the increased

26

Money Credit and the Role of the State

capital stock, the effect on capital formation is permanent. Under this hypothesis, the monetary expansion would not appear to be the banks’ aimless initiative, as, on consideration, it is in Cagan’s model, but the means rationally used by the banks’ managers or stockholders for achieving an intended increase in the capital stock at the expense of depositors. Banks’ stockholders and/or managers willingly own the additions to the capital stock, whose property they indirectly acquire in the form of firms’ liabilities. This discussion of Cagan’s model is a good introduction to the second approach to the non neutrality of money in the long run, because it is based on the notion that, even when anticipated, inflation imposes a tax on money holdings. This tax, and the adjustment process of those who bear its cost, are the starting point of the second approach to the Non-neutrality View.

2.5

Inflation, Portfolio Choices, and Capital Formation

The Non-neutrality View argues that, even in a fully indexed economy, monetary policy influences capital formation. A fully indexed economy is one in which all debt instruments (except currency) and contracts are indexed, and no other source of monetary Non-neutrality (such as those deriving from a non indexed tax system) is allowed to operate (Fisher and Modigliani, 1978). In the indexed economy, inflation, even when anticipated, imposes a tax upon the holders of money balances. Such a tax would disappear only in the event that either desired money balances were reduced to zero, or that, alternatively, that a nominal interest rate equal to the inflation rate were paid on money balances. Since even the most extreme supporters of the Neutrality View would not make either of these assumptions, it follows that the inflation tax acts as a channel of monetary effects on real variables, even in this type of economy. As we will see, the portfolio approach is immune from all criticisms raised against the forced saving doctrine, because it derives its Non-neutrality results from thorough consideration of the public’s reactions to anticipated inflation: no role is assigned to the unintended outcomes of individual plans. In other words, growth, in this approach, meets the requirements of neoclassical equilibrium methodology. For growth to be an equilibrium process, it is necessary that investment be equal to savers’ supply of capital. Therefore, the possibility for monetary policy to influence capital formation ultimately rests on its effects on this supply. In the models of both Mundell (1963) and Tobin (1965) the channel of monetary effects on this supply is portfolio choice. In Mundell’s model, an increase in the rate of growth of the money supply generates a rise in the anticipated rate of inflation, which lowers the real rate of return on money balances, thereby reducing the real demand for this asset (since agents substitute goods for money). Prices then rise more than in direct proportion to the increase in the money stock, and therefore the private sector’s net wealth

Money, Saving and Intertemporal Resource Allocation

27

falls, thereby generating a negative real balance effect on consumption, and a corresponding increase in saving. Given that the commodity market was originally in equilibrium, the real interest rate falls to re-equilibrate this market. In this model, substitutability is between money and goods in general. A different line of argument, based on the substitutability of money and capital as alternative stores of value, was developed by Tobin (1965) (Johnson, 1967 and Levhari and Patinkin, 1968 reformulated the argument). Here monetary policy may not affect total private saving decisions, but it does affect the relative attractiveness of money and capital as alternative outlets for a given flow of private saving. With money of the outside variety (i.e. government debt), alternative expected rates of inflation imply corresponding rates of depreciation of monetary assets. This depreciation amounts to a fall in the real rate of return on money balances which, given that their nominal rate of return is institutionally fixed, is inversely related to the inflation rate. Thus, if the anticipated rate of inflation rises, capital goods and equities are substituted for money in agents’ portfolios: a larger fraction of the private sector’s saving flow is channelled to capital accumulation, and a smaller fraction to the accumulation of real balances. In the context of a growing economy, this implies that, if the inflation rate is higher, the equilibrium capital/labour ratio will be higher too; consequently, the equilibrium real interest rate is inversely related to the inflation rate, because of the assumed decreasing marginal productivity of capital. The Mundell-Tobin approach to money and growth is immune from all criticisms of the ‘irrationality’ kind; it applies to anticipated inflation, respects all ‘neoclassical’ maximisation rules, and is logically coherent. Therefore, it is generally accepted (even by some new classical macroeconomists) and lies at the root of the accepted view that money is neutral, but not superneutral. 8 The TobinMundell effect stands as an unchallenged piece of economic analysis. Although the mechanics of Non-superneutrality in the models of Tobin and Mundell are not identical, they share a common critical assumption, i.e. that anticipated inflation reduces the demand for money and, in general, for assets whose value is fixed in nominal terms, while it raises the relative attractiveness of real assets and equities. This was the ‘standard theory’ in the 1960s and 1970s. But the inflationary experiences, which most Western countries underwent in the Sixties and Seventies, shook confidence in this notion.9 For instance, Cagan and Lipsey, in their comprehensive, authoritative study on ‘The financial effects of inflation’ (1978), reported that in the United States ‘households did not invest more in real assets when inflation accelerated in 1965. In fact they tended to reduce the share of income devoted to the acquisition of housing and common stock, assets that might have been expected to be the object of inflation-induced saving (...). Flows increased into saving deposits (...)’. This trend continued during the 1970s, confirming ‘the anomaly during inflation, so far as the standard theory of its effects is concerned, of household additions to holdings of the very assets that are subject to depreciation in purchasing power by inflation’. It should be noticed that this seemingly paradoxical change in households’ portfolio

28

Money Credit and the Role of the State

composition was not due to the public’s failure to anticipate inflation; in fact, as a study of a cross section of households by Taylor, reported by Cagan and Lipsey shows, ‘the typical expected rates of inflation among the households in the samples were quite close to actual rates’. Nor did these portfolio choices reflect an insensitivity of households to interest rates differentials. The explanation suggested by Cagan and Lipsey for this behaviour of households, is that inflation, even if anticipated, generates uncertainty relative to the future, thus raising the desire for liquidity. Under these circumstances, no irrational behaviour is implied by the relative increase in currency and deposit holdings, which may rationally be regarded as safer stores of value than market securities (whose value declines when nominal interest rates adjust to inflation). Equities and market securities are risky assets, in which households do not normally invest heavily. Consequently, contrary to what the ‘standard theory’ predicted, ‘households have continued to invest heavily in fixed-dollar assets because of the limitations of real property and the safety of deposits and short term assets’ (Cagan and Lipsey, 1978, pp. 36–7 and pp. 42–8). Similar developments were recorded for some European countries. In Italy, for instance, in the 1970s high rates of inflation coexisted with a high, increasing demand for deposits and other assets fixed in nominal value, such as short term government bonds, although their real value was eroded by inflation.10 Although these developments cannot be generalised, since they only refer to the experience of two inflationary decades, it is interesting in our present perspective to ask whether, in the absence of a Tobin-Mundell effect, anticipated inflation would cease to have any effect on capital formation. In the remaining part of this chapter, this question will be addressed on the basis of a simple model. For the argument’s sake, it is assumed that money is the only store of value and, consequently, there is no portfolio choice at all. Arbitrary as this assumption may appear at first sight, it may well be appropriate to insulate the effects of anticipated inflation on the private sector’s total saving decisions, as opposed to its portfolio choices. As in Tobin’s and in Mundell’s models, it is assumed that the money supply is of the outside variety. This implies that the revenue from money creation accrues to the government. As in some models of money and capital accumulation different from Mundell’s and Tobin’s (e.g. Fisher, 1979), any increase in the money stock here occurs via government purchases from, rather than via lumpsum transfers to, the private sector. A stationary economy is assumed as the basic model. The response of this economy both to a once-and-for-all change in the money supply, and to a change in the rate of monetary expansion, will illustrate the result of Non-neutrality. We will show that, under plausible assumptions on households’ behaviour in an inflationary situation, what happens is an increase in total saving. Thus it is suggested that, if the Tobin-Mundell effect is allowed to operate, anticipated inflation favours capital formation via a substitution of real capital for money in savers’ portfolios. If, by contrast, this portfolio effect is not operative, inflationary

Money, Saving and Intertemporal Resource Allocation

29

policies may still be conducive to capital formation via their effects on households’ total saving. It should be noted that the argument presented in what follows includes consideration of households’ reactions to anticipated inflation, and does not rely on mistakes and/or irrational behaviour. 2.6

The Basic One-Asset Model

Our starting point is a ‘Modigliani-Brumberg’ (1954 and 1979) life-cycle model without bequests, with the addition of a public sector. The economy is originally in a stationary state equilibrium. Population is constant: T is the number of agents at each calendar year, and each generation is constituted by one agent only. Each agent lives for T years, works for L years and his/her retirement period lasts for N years. This economy reproduces, in each calendar year, the life of the individual agent, in the sense that, just as for one agent total life T = L + N, for the economy as a whole in every year total population T is the sum of L workers and N retired agents, or pensioners, the ‘old’. In each period, total output is Q = λL

(2.1)

where L is the number of workers and λ the marginal and average productivity of labour.11 Output is a non storable good. Each agents gets a real wage w = λ. Consequently, aggregate income is equal to total output: Y = wL = Q. Each worker expects his/her yearly real income w with certainty for each working year. The government collects a constant fraction θ οf real income. Consequently, individual real disposable income is:

ytd = w(1 − θ)

(2.2)

where the subscript t indicates the working year when this income is earned. The assumption of no bequests implies that saving during individual working life is motivated only by the agent’s desire to provide for consumption after retirement. We add some standard assumptions: i) the utility function of each agent is homogeneous of any degree in c1... cT, where c is his/her yearly consumption and the subscript denotes the appropriate time period. ii) the real and nominal interest rate are arbitrarily fixed at zero in the original equilibrium (the following analysis would not be substantially altered if it were fixed as a positive level). This means that there are no interest-yielding loans either within the private sector, or between the latter and the government. Consequently, the only store of value is money, a non-interest bearing asset, which is assumed to be government debt (introduced in the economy at some date in the past, for purposes outside the scope of the present analysis). Money also works as the numeraire and as the medium of exchange.

30

Money Credit and the Role of the State

iii) each agent plans to distribute consumption over his lifetime in such a way as to achieve an even flow of consumption throughout his/her life horizon; hence c1 = c2 = ... = cT = c . iv) finally, the economy is stationary, and the current and anticipated price level is stable and set equal to one, so that, in the basic model, the same notation can be used for real and nominal variables. Under these assumptions, individual planned values of the relevant variables are derived in equations (2.3) to (2.6). cT = Lw(1 − θ) st =

N w(1 − θ) T

at = (t − 1) at = L

N w(1 − θ) T

T +1− t w(1 − θ) T

(2.3) t = 1 ... T

(2.4)

t = 1 ... L

(2.5)

t=L+1…T

(2.6)

where s is the individual planned saving in each working year, at is the stock of real wealth with which each agent plans to begin year t. Given our simplifying assumptions concerning the economy’s demographic structure, we can easily derive from these individual variables the corresponding aggregates in equations (2.7) to (2.12). CP= Lw (1 – θ) L

AL = ∑ (t − 1) t =1

N w(1 − ϑ) T

L N AL = ∑ (t − 1) d TL Y t =1

AN =

AL + AN = A =

α=

N L   w(1 − θ)  N 2 − ∑ (t − 1)  T t =1  

N L 1   w(1 − θ) ∑ (t − 1) N + L  N 2 − ∑ (t − 1)   T t =1    t =1

A 1 L  2 N  = ∑ (t − 1) N + L  N − ∑ (t − 1)  D Y LT  t =1 t =1  

(2.7) (2.8)

(2.9)

(2.10)

(2.11)

(2.12)

Money, Saving and Intertemporal Resource Allocation

31

where CP is the aggregate private consumption in each calendar year and is equal to the year’s private disposable income; AL is the worker’s aggregate wealth, Yd is worker’s current income in each calendar year; AN is pensioners’ aggregate wealth in each calendar year; A is the private total wealth, and α is the desired aggregate wealth to income ratio. We assume the following form of the equation of exchange: M(1 – h)v = PQ, where M is the total stock of money; h is the percentage of this stock which is witheld from circulation in the circulating period (the year); M(1 – h) is active money,12 v is its velocity of circulation; as already mentioned, P is assumed for simplicity to be unity in the stationary state. The assumed stability of prices in the stationary state guarantees that private agents’ decisions to save (during their working life), and dissave (during their retirement period) enable them to realise the desired flow of consumption in each year of their life: In other words, these plans are just adequate to give each agent enough purchasing power to realise the desired flow of consumption in each remaining year of his life. To see this, let zt be the agent’s resources in year t. Then: N  t = 1 ... L (2.13) zt = w(1 − θ)  ( L − t + 1) + (t − 1)  T  zt =

T − t +1 Lw(1 − θ) T

t = L ... T

(2.14)

These resources are just adequate to guarantee the agent the planned level of consumption in the remaining years of his life, since zt L = w(1 − θ) T − t +1 T The government budget constraint balances. Hence, in each year: g

C = θ Lw = θ Q

(2.15)

From this condition, together with (2.1) and (2.7), it follows that in each year aggregate production is entirely consumed, partly by the private sector and partly by the government, i.e.: g p (2.16) Q=C +C Given these basic characteristics of the model, let us analyse the consequences of a government policy, aimed at promoting capital accumulation. In order to avoid complications, it is assumed that the government decides to undertake the investment policy directly, without the intermediation of private parties. This policy consists of government purchases of goods (in addition to usual government

32

Money Credit and the Role of the State

consumption) for investment purposes, whose fruits in terms of an increase in productive capacity will only be available T + 1 years from now. The government finances these purchases through the printing press. The present model shows that the private sector’s saving and consumption choices are modified by the policy under examination, and consequently adapt to it. The argument is developed in two stages. First, we will develop the case where the policy consists of an announced once-and-for-all increase in the money supply, and a corresponding once-and for-all deficit-financed purchase of goods; this case is interesting for illustrative purposes, since it allows us to show in detail how the private sector reacts to this policy, and what the consequences are for the levels of saving, private consumption, and the price level. Secondly, we will develop the more relevant case where the announced policy entails a permanent increase in the growth rate of the money supply, to finance a permanent deficit-financed increase in the government share of the national product.

2.7

A Once-and-for-all Change in the Money Supply and its Effects on Savings

Suppose that, in year t, the Government finances an amount of current purchases of goods from the private sector, in addition to the usual tax-financed purchase θQ, by an increase in the money supply ∆M. The Government now competes with private agents on the market for products. Consequently, given our assumptions, an ‘inflationary gap’ is created, which will result in an increase in the level of prices. I assume that the price level now established is expected to be permanent. Workers receive the money flow ∆M from the government, in payment for the goods which they sell.13 Therefore the purchasing power of their current income is not affected, since it rises at the same rate as the price level (it is as if this income were fully indexed). On the contrary, the real value of their accumulated wealth is not invariant to the change in the price level. Except for the new-born generation, the purchasing power of accumulated assets is eroded. Let the real value of this loss, for the agent in the tth year of his/her life, be lit: lit =

π N (t − 1) w(1 − θ) T 1+ π

t = 1... L

(2.17)

where π = Pt − Pt −1 Pt −1 is the rate of change in the price level. The inflation loss is given by the difference between the new real purchasing power of accumulated assets, and their original purchasing power. The inflation loss for the pensioner is derived from equation (2.6), and is given by the following expression: lit =

π L (T − t + 1) w(1 − θ) T 1+ π

t = L + 1, ... N (2.18)

Money, Saving and Intertemporal Resource Allocation

33

Finally, from (2.8), (2.10) and (2.11), the private sector’s aggregate inflation loss is: N L π 1   w(1 − θ) ∑ (t − 1) N + L  N 2 − ∑ (t − 1)   (2.19) Λ= 1+ π T t =1    t =1 Private agents expect the real value of their wealth to fall by this amount. What are the consequences of this expectation on their intertemporal decisions? Let us look separately at the different generations. As already mentioned, the new born does not expect to experience any change in lifetime resources, since he/she has no accumulated wealth, and his/her current income rises in proportion to the price level. Consequently, equations (2.3), (2.4) and (2.5) still express his/her intertemporal budget constraint and choices. With this exception, all the remaining generations experience a fall in the real value of their resources. For the worker in year t, the new expected value is: 1 N   ztπ = w(1 − θ) ( L − t + 1) + (t − 1)  1 T + π  

t = 1 ... L

(2.20)

These resources, eroded by the price increase, are not sufficient to keep the planned flow of yearly consumption. Given our hypothesis that every agent wishes to keep an even flow of consumption during his remaining life, his/her new planned yearly consumption is: ctπ =

  π ztπ w(1 − θ)  L  = + L −   (t − 1) T − t +1 T − t +1   1 + π (1 + π)T  

t = 1 ... L (2.21)

This means that the worker will uniformly distribute the inflation loss over the T–t+1 remaining years of his/her life, in order to keep the desired time shape of consumption unchanged. To this purpose, in addition to previously planned saving (equation 2.4), a new amount of saving will be performed in the current year: stπ = ct − ctπ =

π N t −1 w(1 − θ) 1+ π T T − t +1

t = 1 ... L

(2.22)

This amount is termed here ‘induced saving’ ( stπ ), because (as Robertson noticed) it is induced by the expected increase in the price level. This kind of saving is of a different nature from ‘forced saving’ because it is the result of consumers’ maximising strategies, rather than the unintended outcome of an unanticipated increase in the money supply (Robertson, 1926; Friedman, 1953; Modigliani and Brumberg, 1979).14 Let us now consider the pensioner’s ‘induced saving’. This agent will not perform saving in the exact sense of abstaining from consuming part of his/her current income, since, ex hypothesis, he/she no longer earns an income, and finances current consumption out of assets accumulated by the date of retirement.

34

Money Credit and the Role of the State

Still, planned consumption will be reduced, in order to distribute the loss evenly over all the remaining years. For a retired agent, the new plan of current consumption is: ctπ =

1 L w(1 − θ) 1+ π T

t = L + 1 ... T

(2.23)

and the planned cut in current consumption, which, in order to preserve the analogy with the worker’s case, we define as the pensioner’s ‘induced saving’, is: stπ = ct − ctπ =

π L w(1 − θ) 1+ π T

t = L + 1 ... T

(2.24)

The revision of individual plans illustrated above has relevant macroeconomic effects. Private saving rises from zero to a positive value, due to induced saving. From (2.4), (2.23) and (2.24), private saving is now S π , which is given by the sum S L + S Lπ − CNπ , i.e.: Sπ =

π N  w(1 − θ)  L + 1+ π T 

L

t −1 

∑ T − t + 1

(2.25)

t =1

Since the private sector’s real disposable income has not changed, its propensity to save correspondingly rises from zero to the value: L π 1 Sπ t −1  L+∑ =  d 1+ π L  Τ − t +1  Y t =1

(2.26)

Private consumption is correspondingly reduced to:  π N t −1   + L  C π = w(1 − θ) L −  w(1 − θ)  ∑  T − t +1  1 + π T

(2.27)

This value is obviously given by the original level of consumption, as defined by equation (2.7), minus private saving as defined by equation (2.25). The argument thus far could be summarised by saying that the increase in the price level generates a negative wealth effect on consumption.15 It is worth noting that induced saving is the force which, together with the government’s expenditure decisions, allows the inflationary gap to be closed. 16 Let us look at this point in detail. The share of real output accruing to the government rises with the private sector’s saving decision, i.e. of the whole value of induced saving. Hence its new level is: C g π = θ Lw + S π

(2.28)

Money, Saving and Intertemporal Resource Allocation

35

Induced saving, as we have seen, is of the voluntary type, since it reflects the private sector’s revised intertemporal plans. This implies that the government does not subtract resources from private agents mainly via ‘forced saving’ (that is, an unexpected fall in the real value of private expenditures), although this force is also in operation (pensioners in the last year of their lifetime perfome ‘forced saving’ only); rather, it commands these resources via the change in private intertemporal plans, induced through its monetary policy. The private sector adapts to public decisions. There is no conflict left open between the private and public sectors over the distribution of real income and, consequently, the allocation of resources between saving and consumption fully reflects private intertemporal choices. All adjustments have occurred, and the goods market is in equilibrium. The argument above can also be clarified by considering the monetary counterpart of the revision in private intertemporal decisions. All pensioners obtain the desired cut in present consumption by keeping their monetary expenditures unchanged, and let their real purchasing power be eroded by the rise in the price level. This erosion is just equal to the desired cut in their consumption level (as defined by equation 2.25), both being equal to: π L Nw(1 − θ) 1+ π T As far as workers are concerned, we have seen that their desired saving/income ratio rises. Since their nominal income rises proportionally to the rise in the price level, it follows that their monetary expenditure rises less than proportionally to the rise in the price level. As a consequence of these revised decisions, aggregate monetary expenditures rise by a factor less than (1 + Œ LHOHVVWKDQLQSURSRUWLRQWRWKHULVHLQQRPLQDO income.17 This amounts to a fall in the velocity of circulation of money relative to income, a fall explained by workers’ induced saving. Thus, the private sector reacts to the Government’s ‘act of inflation’ by exerting a downward pressure on the level of prices which, consequently, rises less than it would in the absence of induced saving. This can be seen by considering the equilibrium condition in the product market. This condition implies that the sum of government plus private expenditure must be equal to the money value of the national product, which is equal to wL ( 1 + Œ  *RYHUQPHQW H[SHQGLWXUH KDV ULVHQ WR wL θ (1 + g) where g wL θ = ∆Μ, and 0 < g < 1. The private sector’s new monetary expenditure is obtained from equation (2.28), by multiplying C π by the factor (1 + Œ 7KXVWKH equilibrium condition is:   π N  wLθ(1 + g ) +  w(1 − θ) L −  w (1 − θ) h   (1 + π) = wL(1 + π) 1 + π T  

(2.29)

36

Money Credit and the Role of the State

t −1 +L. t =1 T − t + 1 6ROYLQJWKLVHTXDOLW\IRUŒZHJHW L

where h = ∑

π=

θg N h(1 − θ) + θ TL

ZKLFKLPSOLHVWKDWŒ < g θ < g θ v, where the last term is the rate of inflation which would obtain, in the absence of induced saving.

2.8

A Permanent Rise in the Growth Rate of the Money Supply

In this case, it is assumed that, starting from the stationary state described in the basic model, the Government announces a permanent increase in the rate of growth of the money supply, to be started this year (t), for the purpose of financing a permanent increase in its share of the national product, above the usual taxfinanced share. The public expects a permanent positive rate of inflation. As a consequence, each generation expects a corresponding positive rate of depreciation of its accumulated wealth, both now and in the future. The expected loss on accumulated assets is equivalent to an anticipated fall in the real interest on these assets. Since these are assumed to yield a nominal interest institutionally fixed at zero, the real expected interest rate falls from zero to –Œ*LYHQWKDWLQWKLV model there are no alternative stores of value, each worker expects to earn this negative rate not merely on past accumulated savings, but also on any amount of savings it decides to perform in the present and in the future.18 All the retired generations know that their accumulated assets will depreciate at the rate –Œ Whether the economy will perform induced saving depends on the relative strength of the wealth effect and the ‘total interest rate’ effect of anticipated inflation. Let us look at these effects in details. The wealth effect is unambiguously negative, exactly as illustrated in the previous section: the current rise in the price level imposes an inflation loss on all generations, except for the new-born, and accordingly negatively affects their consumption decisions. As far as the wealth effect is concerned, as already stated, the new-born’s decisions are unaffected. The interest rate effect concerns all generations except for the oldest one, which does not have a future planning horizon. This effect corresponds to the ‘total price effect’ of standard consumer theory, since the expected fall in the real interest rate is in fact a change in the relative prices of present and future consumption. Therefore, the interest rate effect has to be broken down into an income effect and a substitution effect. The income effect on consumption is negative, for the following reason: the fall in the real interest rate implies a fall in

Money, Saving and Intertemporal Resource Allocation

37

the agent’s real income, in the sense that the expected reward for a given amount of present saving falls; in other words, it takes a greater amount of present saving to transfer a given purchasing power into the future. Since all private agents in this model are creditors, it follows that the sign of the income effect on aggregate consumption is unambiguously negative. On the contrary, the substitution effect on consumption is positive, since future consumption becomes more costly in terms of present consumption. Summing up, the following forces are at work on aggregate consumption: (a) the automatic cut in the oldest generation’s consumption, due to the fall in the real purchasing power of their accumulated assets, which they simply give up inelastically; this generation performs forced saving. (b) a revised intertemporal consumption decision for all other agents, which is the outcome of the following effects: 1) a negative wealth effect, resulting from the erosion of the real value of savings accumulated in the past; 2) negative income effect; 3) a positive substitution effect. Effects (b2) and (b3) concern both current and future savings. The condition for saving to rise above its stationary state level is that the sum of the effects (a), (b1) and (b2) is greater than effect (b3). Empirically many estimates show that the interest-elasticity of saving is negligible (Carlino, 1982). Considering that, moreover, only one effect, i.e. (b.3), works in the direction of reducing saving, while three effects work in the opposite direction, there is a presumption in favour of the hypothesis that induced saving will take place as a consequence of anticipated inflation. The following analysis rests on this presumption. Under this hypothesis, the private sector adjusts its saving decisions, i.e. its net demand for the outside financial assets (money), to the expected rate of inflation. Once this intertemporal decision is made, the private sector will perform ‘induced saving’ in the face of inflation, i.e. it will reduce present consumption in order to make up for the expected inflation loss. The consequences of induced saving for the equilibrium value of the real interest rate are worth noticing. This rate, as we have mentioned, falls from 0 to –Œ when inflation sets in. The important point to stress is that this is no a disequilibrium value for the interest rate, but its new equilibrium value, which corresponds to the private sector’s new, greater saving decisions. In this model, the same process which establishes the new price level in the commodity market (i.e. the interactions between the private sector’s and the government’s expenditure decisions) also establishes the equilibrium interest rate. The non invariance of the equilibrium real interest rate results from a distributional effect between the private sector and the public sector, which in turn derives from the existence of a nonindexed government debt (Patinkin, 1965, pp. 288–94). Once again, superneutrality could easily be re-established by assuming this distributional effect away: for example, if taxes were cut to compensate taxpayers for the inflation loss, and they foresaw this cut.

38

Money Credit and the Role of the State

The effect of deficit financing of public expenditures on the equilibrium real interest rate (r*) is illustrated in Figure 2.1. In part (a), the straight line at 45° from the origin illustrates the equilibrium condition on the commodity market: this is that the public deficit, in real terms (i.e. the government’s deficit-financed real purchases of goods), be equal to private induced-saving (i.e. the amount of goods that the private sector voluntarily abstains from consuming, as a consequence of the inflationary process). In part (b) the relationship between induced saving and inflation is illustrated. This relationship is positive because, the higher the inflation rate, the higher the erosion in the real value of accumulated assets, and consequently (under the assumption made above about the relative strength of the various effects of inflation), the higher induced saving. Part (c) illustrates the inverse relationship between the inflation rate and the equilibrium real interest rate; since the nominal interest rate is zero, this relationship is illustrated by a negatively sloped straight line at 45° through the origin. π

π

r*

S

(b)

(c)

Def.

Def.

45º S

(a)

r*

(d)

Figure 2.1 Induced saving and the equilibrium interest rate To illustrate the relationship between monetary financing of public deficits, let us start from part (a). Here, for each level of government purchases of goods, we read the required level of induced saving. In part (b) we read the corresponding required inflation rate, i.e. the rate of inflation which stimulates the required amount of induced saving. In part (c) we read the equilibrium real interest rate corresponding to this amount of saving. Thus we obtain a pair of values (Def., r*) for the real deficit and the equilibrium real interest rate, which we can use, in part

Money, Saving and Intertemporal Resource Allocation

39

(d) of the diagram, to obtain the locus of equilibrium combinations (Def., r*). As can be seen from this part of the diagram, the relationship between alternative values of the real deficit and the equilibrium real interest rate is negative: with zero deficit, the real interest rate is zero, as in the basic model. As higher values of deficit-financed public expenditures are reached, the equilibrium real interest rate falls. The slope of the Def. –r* line depends upon the sensitivity of private agents’ saving decisions to the inflation rate: the higher this sensitivity, the lower the equilibrium real interest rate corresponding to each level of the public deficit. Summing up: monetary financing of government deficits generates, through its inflationary effects, the required level of ‘induced saving’, and this in turn exerts a depressing effect on the equilibrium real interest rate. This conclusion illustrates the non superneutrality of money in a model where (as in the experience of some western countries illustrated above) savers keep the bulk of their wealth in the form of monetary assets, i.e. assets whose yield is not adjusted for inflation, and there is limited scope for portfolio substitution between money and ‘real’ stores of value, such as equities and shares. This model may be considered as complementary to those of Tobin and Mundell, since it shows that, even if the effects contemplated in their portfolio models were not in operation, there would still be grounds for the view that changes in the rate of monetary expansion do not leave the equilibrium values of the real variables (savings, the interest rate) unaffected.

2.9

Conclusions

This chapter has been concerned mainly with the analytical foundations of the ‘Non-neutrality View’, i.e. the view that monetary factors can exert a permanent influence on the vertical structure of production. The first part of the chapter traced the gradual evolution of the Non-neutrality View, first within the ‘forced saving’ approach, then into the modern ‘equilibrium approach’ of Mundell and Tobin, which predicts a flight out of money and into real assets in the face of inflation, with a consequent rise in the capital-labour ratio and a corresponding fall in the interest rate. While the forced saving approach has been criticised widely by supporters of the Neutrality View, the approach of Mundell and Tobin is provided with sound microeconomic foundations, and therefore stands, at a theoretical level, as an unchallenged piece of economic analysis. However, some major facts during the inflationary experiences of the 1960s and 1970s seem to have cast some doubt on the empirical relevance of the Tobin-Mundell effect. The second part of the chapter presented a model aimed at illustrating the operation of a different effect, complementary to that of Mundell and Tobin, which may come in operation whenever the latter effect is not at work, as during the inflationary periods referred to above. This argument is based on the notion that a monetary expansion induces an increment in private agents’ voluntary saving. This

40

Money Credit and the Role of the State

effect was called here, after Robertson, ‘induced saving’, and was illustrated with the aid of a modified Modigliani-Brumberg life cycle model, with the addition of a public sector. We have thus shown that, under plausible circumstances, the ‘inflationary finance’ of investment may generate the required amount of saving, thus reinforcing the Non-neutrality result. Notes *

1 2 3 4

5

6 7

8

9

My interest in monetary economics and in the history of monetary theory was initially stimulated by the Seminar initiated and directed by Augusto Graziani in the Seventies at the Centro di Specializzazione e Ricerche di Portici, University of Naples. His approach to these subjects can be found in Graziani, 1981, 1994. Attending the Seminar was a very important intellectual experience for many of us – certainly for me: not merely for the many aspects of theory and doctrine which I learnt but, most importantly, because I was exposed to the clarity of Augusto’s mind and the rigour of his thought. I wish to thank him for this. But some New Classical Macroeconomists (e.g. Lucas, 1979, p. 185) contemplate sources of permanent monetary Non-neutrality in their models. On the relationships between the cycle models by Mises, Hayek, Friedman and Lucas see Costabile (1998). The development of the doctrine of forced saving in the Eighteen, Nineteenth and early Twentieth centuries is traced in Hayek (1931, chap. 1; 1932; 1935, chap. 1). On Malthus’s treatment of this issue, see also Costabile (1983). As we will see, subsequent criticisms did not dispute this basic idea, but other aspects of the doctrine. This basic mechanism, although already at work in pre-Keynesian thought, subsequently came to be considered as a distinguishing feature of the Keynesian and post-Keynesian models of inflation, distribution, growth and development. These all rely – sometimes implicitly – on monetary accommodation to investment decisions, and on forced saving. The main works in the list are Keynes (1971) [1930], Kaldor (19551956), J. Robinson (1956), Maynard (1962). Robertson’s contribution (Robertson, 1926) to this stream of thought has been explored, among others, by Fellner (1952), Hicks (1963), E.A.G. Robinson (1978), Danes (1979), Wilson (1980), Graziani (1981), Costabile (1985, 1993, 1997). This approach to economic growth is to be found in Hayek (1941, pp. 222 and 233), Leontieff (1948, pp. 106–107), Hirshleifer (1970, p. 172). The father of this theoretical approach, as well as of this graphical apparatus, is Irving Fisher (1907 and 1930). For a discussion see, Costabile (1984). Hicks (1967), proposed a reformulation of what he defined ‘the Hayek story’, which, admittedly, does not account for Hayek’s analysis of forced saving. As is well known, for a given level of output, the inflation tax is given by the product of real money holdings (the tax base) times the rate of inflation (the tax rate). With real money holdings fully adjusted to expected inflation, the revenue from the tax is constant. However, in some models money does not affect capital accumulation in steady states, if households have infinite time horizons (Sidrausky, 1967). Money is neutral if real variables are invariant, in equilibrium, to a once-and-for-all change in money supply. Superneutrality means that the equilibrium values of real variables are invariant to a change in the rate of growth of the money supply. Owen (1986, particularly chap. 3) may still be useful to consult for a review of the literature on the financial effects of inflation.

Money, Saving and Intertemporal Resource Allocation

41

10 In the Italian case portfolio shifts in favour of real assets were also prevented by some institutional features of the relevant markets, including: (i) the underdevelopment of the Italian stock exchange, which made equities very risky and, consequently, particularly unsuitable as a recipient for households’ saving; (ii) the almost total absence of a developed mortgage system, which made the minimum wealth requirement for acquiring real property very high. 11 Q could be considered as the vector q1... qL, where qi = λi li, i = 1 ... L; L is the number of workers and number of products, λi is the marginal and average product of the i-th worker, and li is the number of work hours for each worker. However, nothing essential derives from disaggregation, and reference is made to aggregate production only. 12 As defined, among others, by Angell (1941, pp. 133–4), from whose analysis this form of the equation of exchange is derived. 13 The assumption that money is introduced in payment for goods produced by workers, i.e. ‘young’ generations, obviously implies that, in this model, changes in the quantity of money have distributional effects within the private sector, in addition to those between the latter and the government. The present article focuses mainly on the latter type of distributional effect. See also Fisher and Modigliani (1978). 14 While the analysis developed in the text has been inspired mainly by Robertson’s work, it differs from the latter at least in one respect: here the process which establishes the new price level involves simultaneity between the government’s ‘act of inflation’ and the revision of private consumption decisions; in Robertson’s work, on the contrary, this process is a sequential one (Robertson, 1926, Appendix to chapter V). 15 Any ‘interest rate effect’ of the type to be considered in the next section is ruled out by the assumption of unit elasticity of expectations: next year’s price level is expected to change as this year’s price level is changing and, consequently, the relative price of ‘present goods’ in terms of ‘future goods’ is not altered. 16 This point has been made before (see Keynes, 1973 p. 36, letter to Robertson of 31 May 1925); here Keynes used the expression ‘act of inflation’, which is adopted in the present text. See also Friedman (1953). π 17 The worker’s desired level of consumption ctL , as defined by (2.22), requires a monetary expenditure w(1 − θ)

L T

(1 + π) − w(1 − θ)

= w(1 − θ)

π 1+ π

(1 + π)

N

t −1

T T − t +1

=

L t −1 L t − 1   −π 1+ π −  π   T T T − t + 1    T − t +1

Since π

t −1 Τ − t +1

>π

t −1

L

Τ − t +1 Τ

it follows that the new monetary expenditure, corresponding to the desired level of π consumption ctL , is given by the old level of monetary expenditure multiplied by a factor less than (1 + Œ  6XPPLQJ RYHU ZRUNHUV ZH JHW WKHLU QHZ DJJUHJDWH PRQHWDU\ expenditure, which is as follows: L

∑c t =1

π tL

 

(1 + π) = w(1 − θ) L + w(1 − θ) Lπ −  π w(1 − θ)

N

L

t −1 

∑ T − t + 1  T t =1

42

Money Credit and the Role of the State

18 If storable goods, real capital and equities were alternative stores of value, the expectation of a negative real interest on money might induce people to shift partly from money into capital (provided they were willing to hold these more risky assets, as explained above, p. 31–32). In this case, in addition the Tobin-Mundell effect agents will perform some ‘induced lacking’ to the purpose of restoring the real value of their wealth.

References Angell, J.W. (1941), Investment and Business Cycles, New York and London: McGrawHill. Cagan, P.(1969),’The non neutrality of money in the long-run’, Journal of Money, Credit and Banking, 1(2), May. Cagan, P. and R.E. Lipsey (1978), The Financial Effects of Inflation, National Bureau of Economic Research, New York: Ballinger. Carlino, G.A. (1982), ‘Interest rate effects and intertemporal consumption’, Journal of Monetary Economics, March. Costabile, L. (1983), ‘Natural prices, market prices and effective demand in Malthus’, Australian Economic Papers, June. Costabile, L. (1984), ‘Preferenze intertemporali, risparmi e investimenti. Note su due approcci alternativi’, Economia Politica, 1(3). Costabile, L. (1985), ‘Credit creation, capital formation and abstinence in the approach of D.H. Robertson’, in R. Arena, A. Graziani and J. Kregel (eds), Monnaie, Financement et Production, Paris: Presses Universitaires de France (also printed as Research Paper Series no. 32, Faculty of Economics and Politics, Cambridge). Costabile, L. (1989), ‘Politica, monetaria, debito pubblico e tasso d'interesse’, Note Economiche, 1. Costabile, L. (1993), ‘Introduzione’, in L. Costabile (ed.), Politica bancaria e livello dei prezzi. Con altri scritti sulla moneta, (Italian translation of Robertson, 1926, with other of his essays on money). Costabile, L. (1997), ‘Robertson and the post-Keynesian approach to growth and cycles’ in P. Arestis, G. Palma and M. Sawyer (eds.), Capital Controversy, Post-Keynesian Economics and the History of Economics. Essays in Honour of Geoff Harcourt, London: Routledge, vol. 1. Costabile, L. (1998), L’analisi delle fluttuazioni cicliche prima della rivoluzione Keynesiana, Quaderni del Dipartimento di Scienze Economiche e Sociali, n. 13, December. Danes, M.J. (1979), Dennis Robertson and the Construction of Aggregative Theory, unpublished Ph.D. dissertation, London: the London School of Economics. Deaton, A. (1977), ‘Involuntary saving through unanticipated inflation’, American Economic Review, 67. Fellner, W.J. (1952), ‘The Robertsonian evolution’, American Economic Review, 42(3). Fisher, I. (1907), The Rate of Interest, New York: MacMillan.

Money, Saving and Intertemporal Resource Allocation

43

Fisher, I. (1930), The Theory of Interest, New York: MacMillan. Fisher, S. (1979), ‘Anticipations and the non-neutrality of money’, Journal of Political Economy, 87(2). Fisher, S. and F. Modigliani (1978), ‘Towards an understanding of the real effects and costs of inflation’, Weltwirtschaftliches Archiv, 114. Friedman, M. (1953), ‘Discussion of the inflationary gap’, in M. Friedman, Essays in Positive Economics, Chicago: The University of Chicago Press, (revised version); originally in The American Economic Review, 32, June 1942. Friedman, M.(1968), ‘The role of monetary policy’, American Economic Review, 58(1). Graziani, A. (1981), Teoria economica. Macroeconomia, Napoli: Edizioni Scientifiche Italiane. Graziani, A.(1994), La teoria monetaria della produzione, Arezzo: Banca Popolare dell’Etruria e del Lazio/Studi e ricerche. Haberler, G. (1939), Prosperity and Depression. A Theoretical Analysis of the Cyclical Movements, Geneva: League of Nations. Hayek, F.A. (1931), Prices and Production, First Edition, London: Routledge & Kegan Paul; and (1935); second edition, (revised and enlarged), London: Routledge & Kegan Paul. Hayek, F.A. (1932), ‘The development of the doctrine of forced saving’, Quarterly Journal of Economics, 47, November. Hayek, F.A. (1941), The Pure Theory of Capital, London: MacMillan. Hicks, J.R. (1963), ‘Dennis Holme Robertson, 1890–1963’, Proceedings of the British Academy, 50, London: Oxford University Press. Hicks, J. R. (1967), ‘The Hayek story’, in J.R. Hicks, Critical Essays in Monetary Theory, Oxford: Clarendon Press. Hirshleifer, J. (1970), Investment, Interest and Capital, Englewood Cliff, N.J., Prentice Hall. Johnson, H.G. (1963), ‘A survey of theories of inflation’, Indian Economic Review, 6(4). Johnson, H.G. (1967), ‘The neo-classical one-sector growth model: a geometrical exposition and extension to a monetary economy’, Economica, 33(131) (and revised version in H.G. Johnson, Selected Essays in Monetary Theory, London, G. Allen & Unwin, 1978). Kaldor, N. (1955–56), ‘Alternative theories of distribution’, Review of Economic Studies, 23(61). Keynes, J.M. (1971) [1930], A Treatise on Money, 1. The Pure Theory of Money, in The Collected Writings of John Maynard Keynes (henceforth JMK), edited by D. Moggridge, London: MacMillan for The Royal Economic Society, vol. V. Keynes, J.M. (1973), The General Theory and After. Part I: Preparation, JMK, vol. XIII. Leontieff, W. (1948), ‘Theoretical note on time preference, productivity of capital, stagnation and economic growth’, The American Economic Review, 48(1). Levhari, D. and D. Patinkin (1968), ‘The role of money in a simple growth model’, American Economic Review, 58. Lucas, R.E. (1972), ‘Expectations and the neutrality of money’, Journal of Economic Theory, 4(2).

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Lucas, R.E. (1979), ‘An equilibrium model of the business cycle’, Journal of Political Economy, 83, December; as reprinted in R.E. Lucas, Studies in Business-Cycle Theory, Cambridge: The MIT Press, 1983. Maynard, G. (1962), Economic Development and the Price Level, London: MacMillan. Mises, L. (1971) [1924], The Theory of Money and Credit, Irvington-on-Hudson, New York: The Foundation for Economic Education. Modigliani, F. (1980), The Collected Papers, ed. by A. Abel, vol. II, The Life Cycle Hypothesis of Saving, Cambridge, Mass.: MIT Press. Modigliani, F. and R. Brumberg (1954), ‘Utility analysis and the consumption function: an interpretation of cross-section data’, in K.K. Kurihara (ed.), Post-Keynesian Economics, pp. 388–436, now in Modigliani (1980), pp. 79–127. Modigliani, F. and R. Brumberg (1979), ‘Utility analysis and aggregate consumption functions: an attempt at integration’, now in Modigliani (1980), pp. 128–97. Mundell, R. (1963), ‘Inflation and real interest, Journal of Political Economy, 71(3). Owen, D. (1986), Money, wealth and expenditure: integrated modelling of consumption and portfolio behaviour, Cambridge: Cambridge University Press. Patinkin, D. (1965), Money, Interest and Prices, New York: Harper & Row. Robertson, D.H. (1926), Banking Policy and the Price Level, London: Staples Press. Robertson, D.H. (1934), ‘Industrial fluctuations and the natural rate of interest’, Economic Journal, 44(176). Robinson, E.A.G. (1978), ‘Keynes and his Cambridge colleagues’, in D. Patinkin and J.C. Leith (eds), Keynes, Cambridge and ‘The General Theory’, Toronto: University of Toronto Press and London: MacMillan. Robinson, J. (1956), The Accumulation of Capital, London: MacMillan. Sargent,T.J. (1973),’Rational expectations, the real rate of interest, and the natural rate of unemployment’, Brookings Papers on Economic Activity, 2. Sargent, T.J. and N. Wallace (1975), ‘Rational' expectations, the optimal monetary instrument and the optimal money supply rule’, Journal of Political Economy, 83(2). Sidrauski, M. (1967), ‘Rational choices and patterns of growth in a monetary economy’, American Economic Review, 57, Papers and Proceedings. Stein, J.L. (1969), ‘Neoclassical and Keynes-Wicksell monetary growth models’, Journal of Money, Credit and Banking, 1(2). Tobin, J. (1965), ‘Money and economic growth’, Econometrica, 33, October. Wilson, T. (1980), ‘Robertson, money and monetarism’, Journal of Economic Literature, 18(4).

Chapter 3

Monetary Stability and Heterodoxy: A History of Economic Thought Perspective Ghislain Deleplace

3.1

Introduction

According to Karl Marx, ‘economists, who are thoroughly agreed as to labour-time being the measure of the magnitude of value, have the most strange and contradictory ideas of money, the perfected form of the general equivalent. This is seen in a striking manner when they treat of banking, where the commonplace definitions of money will no longer hold water’ (Marx, 1867, p. 81 n.). Nearly one century later, Joseph Schumpeter metaphorically substituted the sky for the sea, and he was no less severe with the fickleness of monetary thought: ‘views on money are as difficult to describe as are shifting clouds’ (Schumpeter, 1954, p. 289). Daring to place money at the centre of a scholar’s approach may then look reckless, and holding consistent ideas on it out of reach. However, through his whole work, Augusto Graziani did both, blending continuous originality with coherent reasoning. The issue of monetary stability is a good example of these qualities. Although this issue is generally addressed by the literature in the framework of monetary orthodoxy, Graziani has been able to settle it in the heterodox circulation approach, thanks to his continuous focus on the double character of money, general purchasing power and stock of wealth (Graziani, 1996). This achievement is not only important for modern monetary theory; from the point of view of the history of economic thought, it suggests that there is probably a mistake to consider the concern for monetary stability as a proof of economic orthodoxy, leaving to other issues – such as full employment or social justice – the task of revealing less conservative approaches. Regarding money, non-standard economists have at least in common to refuse to analyse it in a functional way – as a tool performing technical functions in the economic machinery – and to stress its role as a social link. If money is what allows people to form a permanent community, its stability is not only a matter of preserving constant proportions between economic magnitudes, but also a condition of avoiding the disruption of social relations.

46

Money Credit and the Role of the State

It may then be worthwhile to inquire about the debates which took place in the history of economic thought about the issue of monetary stability. The aim of the present chapter is to contribute to that inquiry, focusing on the period when monetary stability was not viewed simply as the antithesis of full employment. Two main points will be stressed here. Firstly, I shall suggest that during the first half of the nineteenth century, the issue of monetary stability gave to some great economists the opportunity to develop unorthodox ideas. Secondly, it is interesting to notice that these ideas appeared around the analytical link between domestic and international monetary stability. This issue appears then as an illustration of how the knowledge of past theoretical debates may nourish a heterodox view on modern economic problems – the kind of approach Augusto Graziani’s works have exemplified most. The chapter is organised as follows. Section 3.2 settles the issue of monetary stability in the light of the opposition between orthodoxy and heterodoxy. Sections 3.3 to 3.5 illustrate my two points – the opportunity of unorthodox ideas and the analytical link between the domestic and international aspects – with three authors: Henry Thornton (1802), David Ricardo (1816), and Thomas Tooke (1844). Section 3.6 draws some conclusions about the relevance of past monetary debates for modern analysis.

3.2

Monetary Stability and Heterodoxy

The analysis of monetary stability combined very early two types of adjustment, a market one and a macroeconomic one: David Hume’s ‘price-specie flow mechanism’ mixed in 1752 market phenomena (arbitrage between the foreign exchange market and the market for precious metals) and macroeconomic ones (the influence of the aggregate quantity of money on its value), two decades before The Wealth of Nations, and nearly two centuries before Keynes. One should nevertheless refrain from linking these two aspects – ambivalence and precocity – and inferring that the first one is a negative outcome of the second. The historical precedence of monetary theory upon value theory – hence on market theory – is well-known. The recurrence of a logical difficulty to integrate monetary theory into value theory, once the latter was constituted, – whether by Ricardo, Marx, Walras, Keynes or Arrow-Debreu – is also well-established. This does not mean that monetary analysis is a kind of holdall, whose precocious emergence was motivated by practical reasons, and which is stubborn to any somewhat rigorous theoretical elaboration. Another explanation of the precocity and the ambivalence of the issue of monetary stability in the history of economic thought may be found in the fact that it exemplarily illustrates the fundamental question raised by political economy – what kind of a relation between the merchants and the state? – and it relies on analytical tools which proved to be relevant – arbitrage as a crucial feature of the market activity, and the unit of account as the expression of the social totality.

Monetary Stability and Heterodoxy: A History of Economic Thought Perspective 47

From the very beginning, the issue of monetary stability has been addressed in the following way: is the continuity of the unit of account decreed by the state consistent with the arbitrage activities of the merchants? One should add a third dimension to the precocity and the ambivalence of that issue: it is essentially concerned with international problems. It is so because the arbitrages of the merchants have an international character, and because the unit of account decreed by the state rivals the other national ones. To put it another way: from the very beginning, the issue of monetary stability is not dissociated from the issue of exchange stability. This link appears in the various definitions of monetary stability: either the stability of the purchasing power of money on goods, measured by the average price of a complex of goods (the general price level); or the stability of the purchasing power of money on debts, reflected in a complex of the various rates of interest current for debts of different maturities; or the stability of the purchasing power of money on other monies, expressed by the average exchange rate of a complex of foreign currencies. Although the first two definitions refer to domestic monetary stability and the third one to external monetary stability, their interdependence is not only a matter of applied economics. At the most abstract level, all three definitions are on the same footing inasmuch they face a common difficulty: monetary stability is equated to the stability of prices which are determined on markets (for goods, debts, or foreign exchange). Now, in a monetary economy, those prices are themselves measured in money (of account). As a consequence, the stability of money as a means of payment endowed with a general purchasing power (whether internal or external) may only be conceived if an intangible unit of account is given. Because a unit of account is a social fact, it is to be given as the result of a social process. During centuries, this process has been the adoption of a monetary standard, the unit of account being legally defined as a particular weight of this standard (alternatively, this amounted to give a legal price in money to the weightunit of the standard). Such a particular weight was declared in each territory endowed with a legal monetary authority, and official exchange rates between national currencies ensued, although no supranational body was (until the last avatar of the gold standard under Bretton Woods) empowered with the right to have them maintained. One could think that the issue of monetary stability has been addressed in a completely new way since August 15, 1971, and that everything written before – i.e. a great part of what the history of economic thought is concerned with – only remains archaeological. Fortunately it is not so: the questions raised in a monetary economy without any monetary standard are rooted in the analysis of a monetary economy with a monetary standard. Why? Because decreeing legally a particular definition of the monetary unit is not enough to make it socially operative. As early as the sixteenth century, one observed that gold and silver coins commonly circulated at ‘voluntary’ prices in terms of the agreed unit of account, at variance with their legal values (Boyer-Xambeu, Deleplace, Gillard, 1994, chapter

48

Money Credit and the Role of the State

6). This meant that there was a divergence between the legal price and the many commercial prices of the minted metal, or, to put it in another way, that the definition of the monetary unit varied from place to place in the kingdom, although everybody used the same (legal) name to call it. The monetary debates of the time precisely dealt with the causes and consequences of that monetary instability. In the second half of the 17th century and the first half of the 18th century, the development of organised markets for gold and silver switched the attention to the divergence between the legal price of the minted metal and the market price of the unminted one (gold or silver in bullion as distinct from coins). This new manifestation of monetary instability was the focus of much agitation during more than a century, from Locke to the Bullion controversy. Finally, in the last quarter of the 19th century and the first quarter of the 20th century, the concept of ‘the value of money’ underwent an evolution which made it independent of the monetary standard, although this evolution started at the very moment when the gold standard dogma generalised and went on while the majority of economists still believed in that dogma (Deleplace, 1996). Following Jevons and his ‘tabular standard’, Wicksell, Fisher, Hawtrey, and the Keynes of the Treatise, broached upon the relation between the rate of interest and inflation, with a common concern originating in Ricardo: the convertibility of bank notes in gold at a fixed legal price was not enough to guarantee monetary stability. The two questions of convertibility and the foreign balance jointly create a link between the three definitions of monetary stability mentioned above, and give to this issue a theoretical specificity, as compared with the issue of economic stability in general. Now it is time to explore that link more precisely, from a history of economic thought perspective.

3.3

From the Orthodox Doctrine of David Hume to the Dissenting Henry Thornton

The publication in 1802 of Henry Thornton’s An Enquiry into the Nature and Effects of the Paper Credit of Great Britain was not only the first theoretical act of the Bullion controversy; it was also a change in the way monetary issues had been dealt with by the literature in the second half of the eighteenth century. This literature was dominated by David Hume’s theory, which required to be adapted to two evolutions in the English monetary system. Firstly, while Hume was reasoning in terms of a metallic currency, the multiplication of banks imposed to take into account the variety of the medium of circulation, which included also bank notes, exchequer bills, checks, book transfers and bills of exchange. Secondly, while the extension by Adam Smith of Hume’s theory to banks of issue was concerned by the analysis of notes convertible in specie, the suspension of convertibility decided in 1797 (and which would continue in England during twenty-four years) called for an analysis of this unprecedented inconvertibility. Not only Thornton addressed

Monetary Stability and Heterodoxy: A History of Economic Thought Perspective 49

these two issues, but his book marked a significant departure from Hume’s doctrine, which had been fundamentally left unchanged by Adam Smith. This orthodox doctrine rested on two pillars: the Quantity Theory of money for the analysis of domestic circulation and the price-specie flow mechanism for the link between the domestic circulation and the foreign balance. The following excerpt from Hume’s essay Of the Balance of Trade (1752) sums up the adjustment mechanism which ensures internal and external monetary stability: Suppose four-fifths of all the money in Great Britain to be annihilated in one night, and the nation reduced to the same condition, with regard to specie, as in the reigns of the Harrys and Edwards, what would be the consequence? Must not the price of all labour and commodities sink in proportion, and every thing be sold as cheap as they were in those ages? What nation could then dispute with us in any foreign market, or pretend to navigate or to sell manufactures at the same price, which to us would afford sufficient profit? In how little time, therefore, must this bring back the money which we had lost, and raise us to the level of all the neighbouring nations? Where, after we have arrived, we immediately lose the advantage of the cheapness of labour and commodities; and the farther flowing in of money is stopped by our fullness and repletion. […] Now, it is evident, that the same causes, which would correct these exorbitant inequalities, were they to happen miraculously, must prevent their happening in the common course of nature, and must for ever, in all neighbouring nations, preserve money nearly proportionable to the art and industry of each nation. All water, wherever it communicates, remains always at a level. (Hume, 1752, pp. 311-2)

This hydraulic conception introduced in the literature an interdependency between the internal value of money (inversely related to its quantity) and its external one (determined by the foreign balance of trade). Because of this interdependency, the same stabilising mechanism, which relied on a quantity adjustment of the domestic monetary circulation and a price adjustment of exports and imports, operated in any circumstance, whether ‘exorbitant’ or ‘common’, and for whatever cause of disequilibrium, domestic (e.g. an abnormal increase or decline in the quantity of money) or external (e.g. a sudden negative or positive foreign balance). A first contribution of Thornton was to make a distinction between various cases, which required different analyses. One should avoid to confuse an external shock, disturbing foreign economic relations, and a domestic one, due to a defect in the working of the monetary system. Moreover, one should separate normal times, in which the adjustments operated mechanically, and special circumstances, which might justify active interventions. These distinctions were introduced by Thornton in a theoretical framework which has a distinctly anti-Humean flavour, for both pillars of the orthodox doctrine. On the one hand, an excess supply of money does induce an increase in prices, but not in the quantitativist way: because the price of a commodity is determined by the behaviour of sellers and buyers, which is itself influenced by the degree of liquidity in the economy, there is no

50

Money Credit and the Role of the State

reason why this behaviour should be the same in every market, and the price increase will not be equiproportionate: Let us, now, trace carefully the steps by which an encrease of paper serves to lift up the price of articles. Let us suppose, for example, an encreased number of Bank of England notes to be issued. In such case the traders in the metropolis discover that there is more than usual facility of obtaining notes at the bank by giving bills for them, and that they may, therefore, rely on finding easy means of performing any pecuniary engagements into which they may enter. Every trader is encouraged by the knowledge of this facility of borrowing, a little to enlarge his speculations; he is rendered, by the plenty of money, somewhat more ready to buy, and rather less eager to sell; […] Thus an inclination to buy is created in all quarters, and an indisposition to sell. Now, since the cost of articles depends on the issue of that general conflict between the buyers and sellers, which was spoken of, it follows, that any circumstance which serves to communicate a greater degree of eagerness to the mind of the one party than to that of the other, will have an influence on price (Thornton, 1802, p. 195).

On the other hand, an imbalance in foreign trade is not corrected by the pricespecie flow mechanism, but through income effects: If therefore, through any unfortunate circumstance, if through war, scarcity, or any other extensive calamity, the value of the annual income of the inhabitants of a country is diminished, either new economy on the one hand, or new exertions of individual industry on the other, fail not, after a certain time, in some measure, to restore the balance. And this equality between private expenditures and private incomes tends ultimately to produce equality between the commercial exports and imports (ibid., pp. 142-43).

Two main sources of monetary instability may be distinguished in Thornton, and each one requires an appropriate treatment. One is an exogenous disequilibrium, originating domestically (e.g. a bad harvest), in foreign relations (e.g. a war), or at either level (e.g. a panic, provoked by a mistrust in a local bank or a fear of an invasion). The problem is then to avoid a cumulative instability, and to minimise the effects of the shock until new exogenous circumstances make it disappear. Active interventions are then required: ‘To understand how to provide against this pressure, and how to encounter it, is a great part of the wisdom of a commercial state’ (ibid., p. 143). Two elements point to the right direction, one internal and the other external. Firstly, a contraction of the domestic circulation should be avoided, because it would impair the capacity of the exporting industries to restore the balance of trade, when better times have returned. As a consequence, ‘the bank ought to avoid too contracted an issue of bank notes’ (ibid., p. 153), even though its gold reserves are diminishing because of the distress, and precisely to compensate the shortage of liquidity induced by the export of the metallic

Monetary Stability and Heterodoxy: A History of Economic Thought Perspective 51

currency. Here lies the foundation of lending of last resort, which would be advocated by Walter Bagehot seventy years later: For this reason, it may be the true policy and duty of the bank [of England] to permit, for a time, and to a certain extent, the continuance of that unfavourable exchange, which causes gold to leave the country, and to be drawn out of its own coffers: and it must, in that case, necessarily encrease its loans to the same extent to which its gold is diminished (ibid., p. 152).

Secondly, the depressive impact, on the exchange, of a trade deficit or of transfers abroad may be counteracted by capital inflows generated by foreign speculators who anticipate the return of the sterling to its previous parity and want to acquire positions in that currency while it is temporarily weak. The importance of that speculation – hence of the brake it puts on the decline of the exchange and the export of gold – depends on two factors: the interest-rate differential between England and abroad (which is affected by the legislation on the maximum rate of interest), and the length of the period anticipated by foreigners for the return to parity. Here lies the foundation of uncovered interest parity (Boyer-Xambeu, 1994), which is part of modern common knowledge in international finance: The exchange is, in some degree, sustained for a time, which is thought likely to be short, through the readiness of foreigners to speculate in it; but protracted speculations of this sort do not equally answer, unless the fluctuation in the exchange is very considerable. [When interest is at 5% in England and below 11% abroad] if a variation of three per cent [in the exchange] is supposed necessary to induce foreigners to speculate for a period which is expected to end in six months, a variation of no less than twelve per cent would be necessary to induce them to speculate for a period which is expected to end in two years. The improvement of our exchange with Europe having been delayed through a second bad harvest, it is not surprising that the expectation of its recovery within a short time should have been weakened in the mind of foreigners (Thornton, 1802., p. 157).

A completely different situation arises when the disequilibrium is endogenous to the domestic monetary system, for example in the case of an excess supply of bank notes. Now the threat to monetary stability is no longer an exogenous shock beyond the control of a ‘commercial state’, whose ‘wisdom’ may only help to react to it. The aim is to improve the monetary system, in order to prevent the endogenous depreciation from appearing. The solution has then to be found elsewhere, but again two elements may help, one internal, the other external. Firstly, in a system where the volume of bank notes issued was endogenously driven by the demand for them, which depended itself on the difference between the expected return on investment and the interest rate at which one could borrow from the bank, overbanking might be avoided if the Bank of England was allowed to increase its discount rate as much as necessary (which required to repeal the

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Usury laws), and strongly induced to do so (which justified a controlled monopoly of issue). Secondly, the external constraint imposed by gold bullion being ‘the larger article serving for the commerce of the world’ provided a criterion to judge whether bank notes were or not in excess. In a domestic monetary system where convertibility ensures that gold coins and bank notes are ‘interchangeable’, any excess supply of bank notes which depresses their value in terms of goods also depresses the value of the coin. If the purchasing power of bullion abroad remains unchanged – hence its purchasing power in England, which cannot depart from its world one, because of international arbitrage – the double value of gold (lower in coin than in bullion) is reflected in its double money price in sterling (the market price of bullion being higher than the mint price). Coins are melted into bullion, which is exported: If, then, this paper [the bank note] is by any means rendered cheap, and if the paper so rendered cheap is currently interchanged for one sort of gold, namely, for gold which has been coined, then the coined gold partake in the cheapness of the paper; that is, it will buy, when in the shape of coin, a smaller quantity of goods than it will purchase when in the form of bullion. In other words, an ounce of gold coming from the mint in the shape of guineas, and making 3l. 17s. 10 1/2d. (for that is the sum into which an ounce always is coined at the mint), will be worth less than the same ounce of gold was worth before it went to the mint, and less than it would again be worth if converted back into bullion. There arises, therefore, a temptation to convert back into bullion, and then to export […] In proportion as the difficulty of collecting, melting, and sending abroad the gold coin is augmented (ant it encreases as the quantity of coin diminishes), the difference between the mint and market price of bullion will become more considerable, supposing the demand for gold in foreign countries to continue. Thus it is through the interchangeableness of gold coin with paper, that gold coin is made cheap in England; or, in other words, that goods, in comparison with gold coin, are made dear. The goods which are dear remain, therefore, in England; and the gold coin, which is cheap (for the bank is indisposed to buy it, on account of the loss sustained on each coinage), goes abroad (ibid., pp. 149-50).

By reducing the metallic circulation, this export of gold compensated the excess quantity of bank notes; hence it was a factor of monetary stabilisation (at the domestic level it depressed the market price of bullion and at the foreign one it rectified the exchange), unless the Bank increased its issues. Although the absolute level of these issues was impossible to determine, the excess of the market price of bullion over the mint price then provided a criterion for their required variation: they should be reduced whenever this divergence became abnormal. An analytical conclusion emerges from the distinction between exogenous and endogenous sources of monetary instability. If both cases call for the repeal of the legislation imposing a maximum to the interest rate, they differ diametrically about the expected behaviour of the central bank: an exogenous shock may lead to lending of last resort, while an endogenous depreciation requires contracting the

Monetary Stability and Heterodoxy: A History of Economic Thought Perspective 53

issue. To see that there is no contradiction in that, one needs to put the international determinants of monetary stability into the picture.

3.4

A False Orthodox: David Ricardo

By contrast with the anti-Humian approach of Thornton, the generally accepted view of Ricardo’s monetary theory is that of a super-Hume. He is presented as adopting the Quantity theory of money ‘in [a] strict sense’ (Schumpeter, 1954, p. 703), ‘espousing a hard-line version’ of it (Blaug, 1995, p. 31), and just defending ‘a little more flexibly’ an ‘extreme bullionist’ position (Laidler, 1987, p. 290). His belief in the causal relation between the quantity of money and its value is not doubtful: The only use of a standard is to regulate the quantity, and by the quantity the value of the currency […] without a standard it would be exposed to all the fluctuations to which the ignorance or the interests of the issuers might subject it (Ricardo, 1816, p. 59).

However, as early as 1811, in the Appendix to the fourth edition of his pamphlet The High Price of Bullion, A Proof of the Depreciation of Bank Notes (first edition: 1810), Ricardo introduced an innovation which qualified the convertibility principle, and was not logically implied by this causal relation: the convertibility of notes in bullion instead of specie. The ‘benefits to the public’ of this innovation, he contended, was that ‘the same security against the depreciation of the currency can be obtained by more gentle means’ than through the pre-1797 formula (Ricardo, 1811, p. 124). This idea was expanded in Ricardo’s Proposals for an Economical and Secure Currency (1816), included (through a quotation from this pamphlet) in chapter 27 of On the Principles of Political Economy and Taxation (1817), and defended in 1819 during Ricardo’s depositions before the Committees of the Houses of Commons and of Lords on the Resumption of Cash Payments. It is known in the literature as the ‘ingot principle’, after the name of the ingots which should have been cast to constitute the gold reserves of the Bank of England. Ricardo’s plan also included three proposals which the preceding debates during the Bullion controversy or the later ones around the Currency principle make sound more familiar to an historian of monetary thought. One may be called a ‘management principle’: the Bank of England was expected to regulate the amount of its issues according to the market price of gold (restricting them when it went above the mint price and increasing them when it fell below), instead of leaving them to the discretion of the Directors of the Bank, as before. This principle, which constituted a ‘judicious management of the quantity’ of paper money (Ricardo, 1816, p. 57) was, as we saw in section 3.3, already to be found in Thornton (which does not mean that its theoretical foundation was the same). But one should observe that it would not be revived later on by the Currency principle, which on the contrary would insist on a rule strictly proportioning new issues to an

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increase in the gold reserves of the Bank; this latter rule was embodied in the Bank charter Act of 1844. The second proposal – which was new and would be pushed into the same Act nearly thirty years later – could be called the ‘Bank buying principle’; it compelled the Bank of England to purchase gold against notes at a fixed price, set a little below the mint price. Combined with the ‘ingot principle’ – which would not find its way in the Currency principle, and compelled the Bank to sell gold bullion at the mint price – this rule ensured that, by arbitrage, the market price of the standard (gold) would be stabilised at its mint legal level. The purpose of the plan was then: to prevent the value of money from varying from the value of bullion more than the trifling difference between the prices at which the bank should buy and sell, and which would be an approximation to that uniformity in its value which is acknowledged to be so desirable (ibid., p. 67).

The third proposal had already been advocated by Thornton: it stated that ‘the most perfect liberty should be given […] to export or import every description of bullion’ (ibid., p. 67). The heterogeneity in the fate of the components of Ricardo’s plan not only questions the filiation between Ricardo and the Currency school; it also casts a doubt upon his supposed strict monetary orthodoxy. Keynes himself was more shrewd when he wrote: ‘If Ricardo had had his way with his ingot proposals, commodity money would never have been restored, and a pure managed money would have come into force in England in 1819’ (Keynes, 1930, p. 14). The history of monetary regimes is another clue to the resistance which was opposed by orthodoxy to Ricardo’s ideas: although the ‘ingot principle’ was adopted by Parliament in 1819 as the basis for the future return to convertibility, it was dropped when cash payments at the Bank were legally resumed in 1821, and it would wait for another post-war restoration of the gold standard in England to be implemented, in … 1925. Is it enough to claim that the ‘ingot principle’ is an ‘heterodox component in Ricardo’s theory of money’ (Deleplace, 2001, p. 343)? One might simply understand Ricardo’s proposals as technical improvements of the convertibility rule, changing nothing important in substance. Firstly, a legal Bank buying price of gold would prevent its market price to fall too much in case of a sudden influx of bullion, then protecting the interests of the London bullion brokers, whose activity would still be facilitated by the freedom to export or import the metal. Such a vindication did apply in 1828, when the Bank of England, under the pressure of Rothschild, committed itself to buy any quantity of gold at £ 3. 17. 9, only one penny and a half under the mint price; this price was legally confirmed by the Bank charter Act of 1844. But the same N.M. Rothschild, who was at the time of Ricardo one of the two major bullion brokers in London, had strongly opposed Ricardo’s plan in his deposition before the House of Commons’ Committee on the

Monetary Stability and Heterodoxy: A History of Economic Thought Perspective 55

8th of March, 1819 (see Sraffa, 1952, p. 357); this seems enough to discard Ricardo’s personal interest in his defence of that rule. Secondly, the combination of the ‘Bank buying principle’ and of the ‘management principle’ might be justified by the desire to make the Bank of England more reactive to any disturbance of domestic or foreign origin. The purpose would be simply to speed up the adjustment of the quantity of notes, in order to stabilise money more quickly, in accordance with the strict quantitativist analysis which also pleaded in favour of free international movements of bullion (along the line of Hume’s price-specie flow mechanism). But, then, technically speaking, the ‘ingot principle’ pulled in the opposite direction: by imposing a quantitative lower limit for the transactions on gold with the Bank (Ricardo suggested 20 ounces, corresponding to the large sums of 77 £ 17 s. 6 d. for the sale by the Bank and 77 £ for the purchase), it hampered the working of this adjustment process, as if it threw sand in the convertibility mechanism. The intellectual rigour generally attributed to Ricardo excludes that he could not have been conscious of this contradiction. If monetary orthodoxy cannot vindicate the ‘ingot principle’, one could suggest that its rationale was in fact different from the one of the three other proposals. The following quotation suggests such an explanation: To secure the public against any other variations in the value of the currency than those to which the standard itself is subject, and, at the same time, to carry on the circulation with a medium the least expensive, is to attain the most perfect state to which a currency can be brought (Ricardo, 1816, p. 66).

As summed up in the title of the pamphlet, the ingot proposal would then convey an ‘economical’ character to the currency, while the task of ensuring its ‘secure’ one would be left to the three other proposals. It is easy to see where the ‘economy’ lies: by redeeming its notes in bullion instead of specie, the Bank of England would contribute to the disuse of metallic coins in domestic circulation and their replacement by paper money, which was more ‘economical’ to fabricate. As David Laidler puts it: One practical advantage of this scheme was that by economizing on gold, it would put little upward pressure on its value when it was implemented, and Ricardo pointed out this advantage. He mainly justified his [ingot] proposal in more general terms, though, stressing the desirability per se of economizing on scarce precious metals when paper would serve equally well as currency, an argument which harked back to Adam Smith’s defence of paper money in the Wealth of Nations (Laidler, 1987, p. 293).

If so, Ricardo’s ingot proposal was simply an adaptation of an old Smithian idea, juxtaposed for technical reasons (the economy in producing money) to the other proposals theoretically founded in quantitativist principles. Ricardo would then be rescued from contradiction: ‘economy’ and ‘security’ simply stand side by side,

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even if the former somewhat reduces the latter. He would be granted for putting some water in the wine of his ‘hard-line version’ of the Quantity theory of money, balancing the economy provided by the institution of paper money and the security guaranteed by the strict enforcing of the quantity adjustment mechanism. Of course, this mixture of pragmatism and orthodoxy would have a price: the lack of any theoretical originality… Another interpretation of the ‘ingot principle’ may be offered: this principle is the one which, combined with the three other proposals, is expected by Ricardo to provide monetary ‘security’, in an unorthodox way. Ricardo’s plan was a true revolution in the theoretical foundation of a monetary system: it aimed at demonetising gold in domestic circulation, the metal remaining the standard of money but no longer itself money (the ultimate medium of circulation). Three farreaching implications of the plan justify this interpretation; they all connect the internal and external levels. The first one is that it limited to external drain the pressure on the Bank of England to sustain convertibility of its notes. In a regime of convertibility in specie, two reasons may lead holders of notes to demand their conversion: the belief that they will be unable to retain the same purchasing power as coins in domestic circulation, and the desire to obtain gold to hoard or export it. As, according to Ricardo, no regime may protect against a panic resulting in hoarding (‘Against such panics, Banks have no security, on any system; from their very nature they are subject to them’; Ricardo, 1816, p. 68), one should concentrate on circulation and export only. In the first case, coined metal is looked for, because notes are no longer trusted as perfect substitutes for coins; this leads to an internal drain of Bank reserves. In the second case, unminted metal is looked for, and specie is only demanded to be melted and exported as bullion; this leads to an external drain of Bank reserves. Now, with the ingot principle, the internal drain disappears, since the abolition of specie eliminates any possible demand for convertibility aimed at replacing the notes in domestic circulation, since bullion has no legal tender. Of course, a drain of Bank reserves may still occur, but it may only be external. The second implication of Ricardo’s plan is that it allowed to uncouple in a certain measure the circulation of the domestic currency (bank notes) and the trade of the international means of settlement (gold bullion). This advantage was clearly seen by Keynes, who credited Ricardo for the paternity of the Gold-Exchange Standard: A system closely resembling the gold-exchange standard was actually employed during the second half of the eighteenth century for regulating the exchange between London and Edinburgh. Its theoretical advantages were first set forth by Ricardo at the time of the bullionist controversy. He laid it down that a currency is in its most perfect state when it consists of a cheap material, but having an equal value with the gold it professes to represent; and he suggested that convertibility for the purposes of the foreign exchanges should be ensured by the tendering on demand of gold bars (not coin) in

Monetary Stability and Heterodoxy: A History of Economic Thought Perspective 57 exchange for notes – so that gold might be available for purposes of export only, and would be prevented from entering into the internal circulation of the country (Keynes, 1913, p. 22).

The third implication of Ricardo’s plan is that it alleviated the external constraint on the market price of bullion in London (hence on the circulating value of the English currency), by reducing the influence on it of the world supply and demand of gold as a commodity. This advantage was already noted by Ricardo in the 1811 Appendix: On just principles, we should possess the most economical and the most invariable currency in the world. The variations in the price of bullion, whatever demand there might be for it on the continent, or whatever supply might be poured in from the mines in America, would be confined within the prices at which the Bank bought bullion, and the mint price at which they sold it (Ricardo, 1811, p. 127).

How was it possible? The capacity of the Bank of England to stabilise the market price of bullion in London depended on two factors. When it purchased gold, it suffered a loss from keeping a non profitable asset; nevertheless, there was no limit to this purchase, provided the loss could be partly compensated by the spread between the fixed buying and selling prices. When the Bank sold gold, it was constrained by the size of its metallic reserve; hence a situation could occur, in which the drying-up of that reserve compelled the Bank to suspend convertibility and to let the market price of bullion increase above the mint price without limit. To what extent convertibility in bullion could avoid a situation which had impeded the return to convertibility in specie during more than twenty years? Two factors could help, one internal, the other external. Firstly, the demonetisation of gold in domestic circulation structurally increased Bank reserves, holders of coins wanting to get rid of them and selling them to the Bank when the increased supply of metal drove its market price down to the Bank buying price. Of course, the quantity of circulating notes increased in proportion, but, as seen above, not the potential demand for convertibility: the holders of notes for domestic circulation were not a source of drain. Bank reserves then increased while the risk of conversion did not, and the capacity of the Bank to face an external drain was reinforced. Secondly, by concentrating in its vaults the major part of gold in England, and by being the sole purchaser of gold for monetary use (as reserve), the Bank of England became the regulator of the London market for bullion, and, in the circumstances of the time, the centrepiece of its world market. This central position was favourable to increase the ‘security’ of the monetary system (on the international adjustment process, see Deleplace, 2001, pp. 339-43). Keynes’s judgement was right: if Ricardo’s plan had not been dropped, ‘commodity money would never have been restored’ in England. And here again, the defence of unorthodox views bore on the understanding of the analytical link between domestic and international monetary stability.

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3.5

Money Credit and the Role of the State

A Forerunner of the Art of Central Banking: Thomas Tooke

The theoretical framework of Tooke’s monetary analysis differs from Ricardo’s one on many aspects. One is its conception of the domestic ‘circulating medium’: Tooke refused to draw a dividing line between specie and bank notes on the one hand, other means of settlement on the other hand, and he considered the circulating medium as constituted by a continuity of instruments of payment, which could easily be substituted for one another. A second aspect is his theory of the rate of interest: breaking with a real approach going back to David Hume and Adam Smith, in which the main determinant of the rate of interest was the rate of profit on real capital, Tooke insisted on its determination by the supply and demand of ‘monied capital’, in which liquidity played a crucial role. A third aspect is the influence of money on prices, which is the central theme of his monumental History of Prices in six volumes (the last two with W. Newmarch), published between 1838 and 1857. As in Thornton, money influenced prices in a nonhomothetical way, through its impact on the demand for commodities (which varied with the state of liquidity) and on their supply (the rate of interest being part of the cost of production). As for the general price level, its variation did not depend upon that of the quantity of money (however defined), but on the contrary it was a cause of changes in the amount of the circulating medium. This theoretical framework led Tooke to adopt unconventional positions on the two interconnected issues which attracted the attention during the Bullion controversy and later the Currency versus Banking controversy – the regulation of the banking system and the link between the domestic value of money and the exchange rate. The money rate of interest held a pivotal role in the internal and external stability of the monetary system: [The conclusions are… ] 15. That it is only through the rate of interest and the state of credit, that the Bank of England can exercise a direct influence on the foreign exchanges. 16. That the greater or less liability to variation in the rate of interest constitutes, in the next degree only to the preservation of the convertibility of the paper and the solvency of banks, the most important consideration in the regulation of our banking system (Tooke, 1844, p. 124).

In domestic circulation, the level of the rate of interest and the corresponding state of credit were of crucial importance for economic activity, and sudden variations in them could jeopardise the banking and financial conditions of its operation. Moreover, the rate of interest influenced international capital movements, which prevented the price-specie flow mechanism from adjusting the foreign balance automatically: The doctrine by which it is maintained that every export or import of bullion in a metallic circulation must entail a corresponding diminution of, or addition to, the

Monetary Stability and Heterodoxy: A History of Economic Thought Perspective 59 quantity of money in circulation, and thus cause a fall or rise of general prices, is essentially incorrect and unsound (ibid., p. 121).

Two factors of disconnection impeded the adjustment mechanism advocated by the Currency school: a) domestic circulation, where substitution could operate between various instruments, was largely disconnected from foreign payments: an external drain of bullion did not automatically set in motion correcting monetary forces; b) the foreign exchange market, where each exchange rate between two currencies was determined by the bilateral balance (including capital movements) between the two relevant countries, was largely disconnected from the bullion market, which depended upon the aggregate balance with all foreign countries. Tooke’s opposition to the Bank charter Act of 1844 was developed in An Inquiry into the Currency Principle, which he published the same year. He blamed the separation between the Issue department and the Banking department, and the rationing of the note issue by metallic reserves which was its justification, for being ineffective (for its purpose) and harmful (because of indirect consequences). No automatic monetary contraction or expansion could be achieved in a system where various circulating media could rightly accommodate the needs of trade, so that ‘it is equally an error to suppose that the Bank of England can exercise a direct power over the exchanges, through the medium of its circulation’ (ibid., pp. 122-3; Tooke’s italics). The only effect which could be expected was ‘more abrupt transitions in the rate of interest, and in the state of credit’ (ibid., p. 124), with all the injurious consequences on the solidity of the banking system and the strength of economic activity which he had denounced. The positive counterpart of this critique of the Currency principle is scattered in the applied economics of volumes II to IV of his History of Prices. Although the price-specie flow mechanism to which the Currency principle harked back was ‘incorrect and unsound’, this did not mean that no international adjustment mechanism existed. But it was of another type, and the two factors of disconnection pointed above called for a policy to complement it. The clue to understand it lied in the observation that international gold flows were not part of an hydraulics of money, but a form, among others, of arbitrage and speculation on capital. The domestic and foreign markets for ‘monied capital’ were therefore the centrepiece of the international adjustment mechanism, in connection with the bullion and exchange markets (Gillard, 1994). Suppose the occurrence of an adverse foreign balance, which, in the general conditions of the British economy, may only be circumstantial and transitory. The exchange is lowered and the ensuing export of capital (in whatever form: bullion or foreign credit) necessary to settle the balance reduces the supply of liquidity in the London short-term capital market; consequently, the market discount rate is pushed upwards. When it reaches the Bank of England discount rate (which in ordinary times is above the market rate), paper is discounted at the Bank, and a new issue of notes replenishes the circulating medium. Hence the domestic effects of the external drain are softened. Meanwhile, the rise in the discount rate attracts

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foreign capital in London, through two channels: the existence of an interest differential in favour of London, which generates an influx of short-term capital by arbitrage; and the downward movement in stock market prices, consecutive to the rising discount rate, which makes financial assets more attractive to foreign speculation. Both channels contribute to reversing the adverse exchange, which allows to overcome the initial imbalance. It is easy to see how the Bank of England may fit into the picture. If, as in the Bank charter Act, a rigid rationing rule prevents the Bank from accommodating its note issue, domestic liquidity will remain squeezed, and ‘abrupt transitions in the state of credit’ will hurt the economy, without any benefit for the international adjustment. Conversely, the Bank of England may respond to the internal drain it suffers in its metallic reserves and / or to the rise in the market discount rate it observes (if and only if it is the consequence of the adverse foreign balance) by raising its discount rate, without rationing the note issue. The capital inflows will then play their correcting role more completely and more rapidly than if the market for ‘monied capital’ is left alone working. This discretionary discount policy oriented to the defence of the exchange rate was summed up in conclusion 15 quoted above. The way the crisis of 1847 was handled, with the suspension of the issuance rule of the Bank charter Act and the rise of the Bank rate to 8 per cent, confirmed Tooke’s view, which was later illustrated by the popular maxim ‘7 percent will draw gold from the moon’ and became an essential element of the art of central banking. It is not surprising that, Tooke’s theoretical framework being much different from Ricardo’s one, he ended up with a different view of the role of a central bank: the regulation of the short-term capital market instead of the gold market. The understanding of the international adjustment mechanism was accordingly different, relying on movements of capital instead of bullion. But, when one focuses on the international dimension of monetary stability, something appears as central in the analyses of both authors: the attempt at alleviating the foreign constraint on the economy, by introducing an institutional separation between domestic monetary circulation and international payments.

3.6

Some Conclusions

The study of stability in the framework of a metallic monetary and exchange regime sheds some light on the significance of the external constraint. An additional peculiarity of the monetary standard – gold, to put it shortly – enters here the picture. Not only, as seen above, did it have a double price: as the standard, a legal one; as a commodity, a market one. But also, as a commodity, it was usually not produced in the countries which dominated the economic world and where the economic ideas were framed, first of all in Britain. This aspect meant that the market for the commodity acting as the monetary standard might only be supplied in two ways: either by extracting gold from the domestic

Monetary Stability and Heterodoxy: A History of Economic Thought Perspective 61

monetary circulation (through the melting of the circulating coins or the conversion of the convertible bank notes), or by importing it from countries having to discharge foreign balances. The first way implied that monetary stability depended on the organisation of the domestic system of payments: the quality of the circulating coins, the legal statute of the issuing banks, the managing rules of the deposit and discount banks, all that mattered, because it influenced the convertibility of the various means of payment in the standard metal. The second way implied that domestic monetary stability depended on economic relations with abroad; this is why the issue of external monetary stability (or, more broadly, of international monetary stability) was from the outset part of the debates, as a theoretical problem, not only an applied one. Of course one could say that the sterility of the British soil for the production of gold was a contingent phenomenon, which has no theoretical implication. What would have happened if a gold mine had been discovered in the courtyard of the Bank of England, as Ricardo put it ironically, and, in addition, if it had been operated with constant returns to scale? Probably neither the Bullion controversy nor the Currency versus Banking controversy would have existed, and modern monetary theory would be very poor. The reason is that the necessity in Britain to import gold from abroad was all but contingent; it was the specific manifestation, in the framework of a metallic monetary and exchange regime, of the fact that the monetary issue was constrained, and that this constraint was external, i.e. beyond the control of any national institutional body. Now, if one believes that to-day, inconvertibility and independence have freed the central banks from any domestic constraint on their issues, and that monetary integration and financial globalisation have eliminated any distinction between internal and external forces, the theoretical debates of the gold-standard age remain only interesting for economic archaeology. But if one thinks that the external constraint still matters for monetary stability, old masters are still worthwhile reading, and the history of monetary thought may still be useful for economists, whether orthodox or heterodox.

References Blaug, M. (1995), ‘Why is the quantity theory of money the oldest surviving theory in economics?’, in M. Blaug and alii, The Quantity Theory of Money. From Locke to Keynes and Friedman, Aldershot: Edward Elgar, pp. 27–49. Boyer-Xambeu, M.-T. (1994), ‘Henry Thornton et la Bullion Controversy. Au-delà des bornes, il n’y a plus de limites’, Revue économique, 45 (5), septembre, pp. 1215–26. Boyer-Xambeu, M.-T., Deleplace, G. and Gillard, L. (1994), Private Money and Public Currencies. The 16th Century Challenge, Armonk (NY): M.E. Sharpe. Deleplace, G. (1996), ‘Does circulation need a monetary standard?’, in G. Deleplace, and E.J. Nell (eds), Money in Motion. The Post Keynesian and Circulation Approaches, London: Macmillan, pp. 305–29.

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Deleplace, G. (2001), ‘Does Ricardo’s theory of money belong to the classical canon?’, in E.L. Forget and S. Peart (eds), Reflections on the Classical Canon in Economics. Essays in Honor of Samuel Hollander, London: Routledge, pp. 331–45. Gillard, L. (1994), ‘Change, métal précieux et conventions monétaires dans l’Histoire des prix de Thomas Tooke’, Revue économique, 45 (5), septembre, pp. 1289–311. Graziani, A. (1996), ‘Money as purchasing power and money as a stock of wealth in Keynesian economic thought’, in G. Deleplace and E.J. Nell (eds), Money in Motion. The Post Keynesian and Circulation Approaches, London: Macmillan, pp. 139–54. Hume, D. (1752), ‘Political discourses: of the balance of trade’, in E. Miller (ed.), David Hume: Essays, Moral, Political, and Literary, Indianapolis: Liberty Fund, 1985. Keynes, J.M. (1913), Indian Currency and Finance, in The Collected Writings of John Maynard Keynes, London: Macmillan, vol. I, 1971. Keynes, J.M. (1930), A Treatise on Money. 1. The Pure Theory of Money, in The Collected Writings of John Maynard Keynes, London: Macmillan, vol. V, 1971. Laidler, D. (1987), ‘Bullionist controversy’, in J. Eatwell, M. Milgate, P. Newman (eds), The New Palgrave. A Dictionary of Economics, London: Macmillan, vol. I, pp. 289–94. Marx, K. (1867), Capital. A Critical Analysis of Capitalist Production, vol. 1, New York: International Publishers, 1967. Ricardo, D. (1811), ‘Appendix’ to the fourth edition of The High Price of Bullion, A Proof of the Depreciation of Bank Notes, in P. Sraffa (ed.), The Works and Correspondence of David Ricardo, Cambridge: Cambridge University Press, vol. III, 1951, pp. 99–127. Ricardo, D. (1816), ‘Proposals for an economical and secure currency’, in P. Sraffa (ed.), The Works and Correspondence of David Ricardo, Cambridge: Cambridge University Press, vol. IV, 1951, pp. 49–141. Schumpeter, J.A. (1954), History of Economic Analysis, New York: Oxford University Press. Sraffa, P. (1952), ‘Notes on the evidence on the resumption of cash payments’, in P. Sraffa, (ed.), The Works and Correspondence of David Ricardo, Cambridge: Cambridge University Press, vol. V, pp. 350–70. Thornton, H. (1802), An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, Fairfield: Augustus M. Kelley, 1991. Tooke, T. (1838–1857), A History of Prices and of the State of Circulation, London: Johnson, 1972. Tooke, T. (1844), An Inquiry into the Currency Principle, London: Routledge, 1996.

Chapter 4

Labour Market Deregulation and Unemployment in a Monetary Economy Guglielmo Forges Davanzati and Riccardo Realfonzo

4.1

Introduction

In the present debate over labour market flexibility, it is an almost unchallenged view that firms’ freedom to fire has a positive effect on employment. This standard dominant thesis is based on the simple microeconomic argument that freedom to fire works as an incentive to hire, or, in other words, that firms’ availability to hire is basically dependent on their capability to fire (see, among others, Layard, Nickell and Jackman, 1994; OECD, 1994). The aim of this chapter is to show that deregulation may not increase employment, provided that the macroeconomic effects of deregulation itself are taken into consideration.1 To be specific, on the one hand, deregulation increases workers’ uncertainty on their future consumption, and, on the other hand, it works as a discipline device inside the production process, and consequently one expects that the more labour relationships are deregulated: a) the more workers tend to reduce their propensity to consume (so aggregate demand would decrease); b) the more workers tend to increase their effort and, thus, labour productivity (so aggregate supply would increase). The model presented below aims at finding the equilibrium employment resulting from this double assumption. In this respect, it has Keynesian and Institutionalist elements. It is a Keynesian model in the sense that – as shown below – it is based on the description of the functioning of a capitalist monetary economy driven by Keynes’s Treatise on Money and re-presented by the contemporary so-called ‘circuitist approach’, or ‘monetary theory of production’ (see Graziani, 1994; Lavoie, 1992; Realfonzo, 1998). Furthermore, it contains Institutionalist features, particularly the idea that due to their dissatisfaction in the particular institutional context where they work and live, workers tend to behave non-cooperatively in the workplace, and thus capitalists are engaged in finding the most effective strategies to keep labour intensity at its maximum level (Bowles, 1985; Wilkinson, 1998. A

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detailed description of the paradigm of ‘Keynesian Institutionalism’ has been recently provided by Bortis, 1998). The chapter is organized as follows. In section 4.2, the theoretical framework of our analysis of the effects of deregulation will be presented; in section 4.3, the equilibrium employment under deregulation will be determined, given the assumptions a) and b) above; and in section 4.4 our concluding remarks will be provided.

4.2

The Theoretical Framework: the Monetary Theory of Production

The monetary theory of production describes the working of the capitalist economy as a monetary, sequential process in which three macro agents are involved: banks, firms and workers. Macro agents have different functions within the economic process: the banking system produces money and selects creditworthy firms; firms, thanks to the access to bank money, buy inputs and produce commodities; workers supply labour power. The economic process can be described as the succession of the following phases: 1) the process starts with the bargaining in the money market between banks and firms. Banks supply firms with initial finance; firms need money in order to buy labour power and to start production; 2) in the next phase, firms use bank finance to purchase labour power; firms give each worker the previously agreed money wage; 3) once firms have acquired a labour force, there is the production phase where firms carry out their production plans; 4) after production, there is the phase of circulation. Firms offer the goods for sale to the workers. If workers’ propensity to consume is equal to one, firms get back all of the money they laid out to pay wages and so can pay off their debt to the banks (except for interest). If workers’ propensity to consume is less than one, firms try to recuperate the unspent money by selling securities in the financial market. Hence, firms get the final finance from both the commodity market and the financial market; 5) the monetary circuit is closed by the repayment of the initial finance to banks and, thus, by the destruction of the money originally created. Let us stress some elements of the above description. According to the monetary theory of production, money is a pure symbol, a mere bank liability. In this context, loans make deposits and the money supply is fully endogenous (not only in the sense that the banking system could in theory create money endlessly but also in the sense that the influx of money into circulation is demand driven). The amount of initial finance (i.e. the creation of money) is equal to the money wage bill (under the assumption that firms have not

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previously set aside money stocks and, for this reason, cannot resort to selffinancing). In this Keynesian analytical context aggregate demand determines aggregate supply: firms choose the number of workers to employ in order to satisfy the expected level of aggregate demand (given the technical production function). In the labour market, workers bargain for the money wage, given their expectations about the price level: the real wage will be known only ex post, in the market for goods, once the production processes are over. This means that the expected real wage could be lower or higher than the actual real wage. If the actual real wage is lower than the expected one (forced saving) it is reasonable to expect that workers will react to the failure of their expectations, and an inflationary process of increase in prices and wages and/or a decrease in labour productivity could follow (see Forges Davanzati and Realfonzo, 2000). However, in equilibrium the expected real wage will be equal to the actual real wage (i.e. the workers correctly foresee the price level). In this theoretical framework, under the assumption of non-competitive markets, firms are generally assumed to be price and wage makers.2 They determine the price by adding a margin of profit, q > o, to the average cost per unit of product, w/π (where π is average labour productivity): p = w/π (1 + q). The mark-up is determined by the degree of monopoly which is a function of the industrial concentration ratio (Dutt, 1987; Lavoie, 1992). If a state sector is considered in the model, and a deficit expenditure (for example, the payment of pensions) financed by money issued by the central bank is assumed, it is of relevance that public expenditure acts as a new source of finance for firms: it will increase the final finance (the amount of money spent in order to buy goods and securities). It is interesting to point out – at least with reference to the share of state expenditure that increases firms’ returns in the goods market – that this is free finance for firms: it is not a consequence of a firm’s debt towards commercial banks but of a state debt towards the central bank. It is also worthwhile stressing that the increase in inflow of money into circulation due to state deficit expenditure could also give firms a chance to reimburse (the totality or a share of) bank interest in money terms. In fact, if we do not consider any creation of money out of the firms’ borrowing, we must conclude that firms cannot reimburse interest to banks in money terms: they can just repay interest in kind or postpone the payment. For the sake of simplicity, in the next two sections we will concentrate on macroequilibrium points of our monetary economy. Let us stress that the monetary circuit closes in equilibrium when the expected real wage is equal to the actual real wage (workers’ expectations about the price level are confirmed) and firms repay banks for the initial finance, including interest.3 This means that the definition of the equilibrium position of a monetary economy of production is compatible with unemployment and with the deficit of just one agent, the State.

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4.3

Deregulated Labour Relationships and the Effects on Equilibrium Employment

Given the general framework described above, the following assumptions will be made: A. Technology and firms’ pricing 1) the aggregate technical production function is Q = π N, where Q is output in real terms and π labour productivity. Firms produce homogeneous goods and are profit-maximizers. Firms operate in a non-competitive market for goods, setting the price by adding a mark-up to the average production cost, i.e. p = ( w/ π ) ( 1 + q ) , where q is the rate of profit. B. Aggregate demand 2) the average propensity to consume c decreases as the exogenous probability of being sacked (α) increases. Since workers are homogeneous, α is equal for all workers; 3) public expenditure G is assumed as an exogenous given, entirely devoted to paying pensions; 4) expectations by all agents are assumed to be adaptive. C. Workers and the labour market 5) labour supply increases as the unitary money wage increases, given workers expectations on the price level;4 6) labour productivity increases as α increases; 7) the unitary unemployment benefit is assumed to be nil. D. The money market 8) firms and banks negotiate over a money interest rate (i). Here, it is assumed as a given and it is included in the price of goods, so that p= ( w/ π ) ( 1 + q ) ( 1 + i) ; 9) firms’ decision on the initial finance to be required (F) on the basis of the expected aggregate demand. Assumptions 2 and 7 are worth noting for the purposes of the model. Assumption 2 relies on the idea that – as the degree of deregulation increases – worker uncertainty on their future level of income increases and thus in order to keep the level of consumption almost constant over time the plausible reaction to deregulation should be to increase the present propensity to save. Note that this applies to all workers: certainly to the employed, but also to the ones firms will eventually hire, because they too will be subject to the threat of dismissal.

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Assumption 7 can be justified on the grounds that deregulation in labour relationships makes the threat of dismissal by firms effective and credible and, as a result, worker’s tendency to ‘shirk’ diminishes (in a sense, this can be conceived as a firm’s discipline device). 4.3.1

The Economy at the Beginning of the Circuit

The starting point of the analysis is the following simplified picture of the beginning of the circuit (t0): a.

all workers are employed for an actual real wage equal to that expected (monetary equilibrium); b. G allows firms to obtain their target rate of profits plus the money interests bill they must reimburse to banks (say G*). In order to determine the equilibrium employment, consider the macroeconomic equilibrium resulting from the equality between aggregate demand and aggregate supply (AD = AS), in view of the assumption that firms are price-makers. Thus, AD =

c(α) wN + c(α)G * p

(4.1)

is the aggregate demand, which – in to, by assumption – guarantees firms a price level including their target rate of profit and the interest rate, and allows workers to obtain real wages consistent with their expectation. In view of assumption 9 – which gives rise to equation (2) – the level of aggregate demand solely affects the volume of production and employment. p=

w(1 + q )(1 + i ) π(α)

(4.2)

By substituting (4.2) into (4.1), one obtains the level of aggregate demand consistent with firms’ aims and constraints (i.e.: q and i), (say AD o ) that is: AD o =

c(α)π(α)( wN + G ) w(1 + q )(1 + i )

(4.3)

which, in view of the causal link AD : AS, determines a level of production (or aggregate supply) ASo = π(α)N. In view of equation (4.3), a policy of labour market deregulation generates the following main effects: 1. as c decreases, so does AD and therefore Qo, since firms are now in a position to produce less to buy all goods while obtaining the same rates of profits and interests. 2. As Qo decreases, and π increases, firms need a lower number of employees to satisfy the new (lower) demand for goods.5

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These conclusions are the result of two events, described in the following sequences: The rationale which leads firms to call for deregulation is described in sequence 1. SEQUENCE 1. 9 α :9 π :; p : 9ADie : 9Pie where α is an index of the degree of flexibility, p is the price, ADie is the expected demand for the individual firm and Pie its expected profits. The increase in flexibility allows firms to reduce prices (because of the increase in productivity), without reducing the mark-up and the rate of interest. The individual firm finds it convenient to do, so as to keep market shares (ADie) away from its competitors and to increase its profits (Pie). However, if firms are homogeneous in the sense that they all start at the same moment, the overall effect is solely a decrease in the price level. The overall effect of the individual firms’ behaviour is in sequence 2. SEQUENCE 2. 9 α : ;AD and ;ADe :; F : ;w and ;NG In other words, once firms have seen from experience that deregulation (α) reduces aggregate demand (AD), since the expected aggregate demand (ADe) equals that of the present circuit, in the following rounds they will reduce the initial finance (F) and, therefore, both the unitary money wage (w) and employment (N). Equation (4.3) results in the following implications. The equilibrium employment is greater: i) the greater c G /p is; ii) the lower π is, i.e. the lower the probability of being sacked is; iii) the greater c is (the lower the propensity to save s is), i.e. the lower the probability of being sacked is; iv) the greater w/p is. Let us now comment on these results. The first conclusion is fully consistent with the standard Keynesian model, where public expenditure allows the economy to reach full employment equilibrium. The second conclusion can be justified with the argument that – as labour productivity increases – firms need a lower number of workers to obtain the level of production determined by the aggregate demand. The third and the fourth conclusions reflect the idea that as the propensity to consume (for a given average real wage) or the average real wage increases (for a given propensity to consume), aggregate demand increases too, and so does employment. It is obvious from equation (4.3) that an increase in the exogenous probability of being sacked (α) reduces equilibrium employment since it – at the same time – increases labour productivity (π) and decreases the propensity to consume (c).

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Furthermore, in view of equation 1, note that an increase in firms’ monopoly power – as a result of an increase in the industrial concentration ratio – reduces equilibrium employment. Thus, a policy of regulation of the goods market, by stimulating competition, is a further means of increasing employment. Figure 4.1 shows the mechanism implied by equation (4.3). In the north-east panel, the aggregate supply curve (AS) and the aggregate demand curve (AD) are depicted. AS is horizontal, due to the assumptions that firms are price-makers and they operate with constant returns to scale, while AD is the standard downward sloped aggregate demand curve. The south-east panel transfers the value of output (Y) in the area N–Y, where the aggregate production function is represented.6 In the south-west panel, the labour market is depicted: labour supply (Ns) increases as the money wage increases, for given expectations on the price level. The curves MWB are rectangular hyperbola and reflect the money wage bills. p AS

A P°

a) C

P*

B AS'

AD

c)

AD' Y

Y

AS ' = π(α ') N

Y

AS = π(α ') N

45°

N

Y w

b)

Ns( p e ) MBW''

d)

MBW'° MBW' N'' N'

No

Figure 4.1 Deregulation, aggregate demand and unemployment

N

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Starting from a given price level (po), the intersection between AS and AD determines the level of output (point A) and, hence, the level of employment No. As deregulation occurs, due to the increase in labour productivity, the price level falls to p* along the AS curve (which shifts downward to AS′). Since firms have not experienced the decline in demand yet, they continue producing the same level of output (point B), but – because of the increase in labour productivity – they need fewer workers. Therefore, the production function shifts upward and employment falls to N′. However, at the new price, they are unable to sell all the goods produced, and the segment BC represents the unsold goods. At the same time, the propensity to consume declines, determining the shift (and the change in elasticity Due to the change in the propensity to consume) of the AD curve, to AD′. A new equilibrium is reached with a lower level of output, employment (N′′) and money wage. The money wage bill curve shifts to MWB′′. At this point, a relevant question needs to be answered. Why do firms advocate a policy of deregulation? To understand this point let us separate the analysis of the single firm from the analysis of firms as a whole. The single firm – say firm A, while B are all the other firms – aims at increasing its market share in order to increase profits. For this reason, it finds it profitable to increase deregulation (α). In fact, an increase in the deregulation of labour relationships within firm A, will increase the labour productivity of its workers (an increase in πA); the consequent reduction in production costs will lead to a reduction in prices (a decrease in pA), an increase in A’s money revenues and profits. This sequence provides an explanation for the individual firm’s desire for labour relationship deregulation. Let us now look at the big picture. Assuming homogeneous firms, we have an increase in α (by all firms, at the same moment, to the same degree). In this case we have an increase in the labour productivity of firms A (πA) and B (πB); as a consequence we will have a reduction in production costs and in prices (pA and pB) of all firms so that market shares will not change. Moreover, the increased uncertainty on workers’ future level of income will decrease the worker propensity to consume, aggregate money expenditure, money revenues (of A and B) and aggregate profits. In conclusion, overall, both the increase in labour productivity and the decrease in the propensity to consume due to deregulation will lead to a decrease in employment.

4.4

Concluding Remarks

This chapter dealt with the effects of labour market deregulation on employment, in a monetary theory of production approach. The starting point of the research is that while the standard neoclassical argument pro flexibility (i.e. the less costly it is for firms to fire, the more they tend to hire), could be plausible on the micro level, it is questionable on the macroeconomic plane. In order to show the macroeconomic effects of deregulation, two basic assumptions have been superimposed on the standard model of the monetary theory of production: (a)

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deregulation increases uncertainty and therefore reduces the present propensity to consume and (b) it works as a discipline device, in that – due to the credibility of the threat of dismissal – worker effort, and thus labour productivity, increase. The overall effect of labour market deregulation is the reduction in equilibrium employment, due both to the fall of aggregate demand and to the increase in labour productivity. It has also been shown that a policy devoted to increasing the degree of competition in the market for goods – in that it reduces the price level and, therefore, increases demand – is a further means of increasing employment.

Notes 1

2 3

4 5

6

In this respect, our analysis differs from most of the theories criticizing the standard view on flexibility, in that they mainly develop further microeconomic arguments. See Williamson (1975), Boyer (1988), Mardsen (1997). A different approach is advanced by ILO (1996). They are wage makers in the sense that – while the money wage is settled by competition – firms can fix the price level: hence, they are wage-makers, in the sense that they ultimately determine the real wage. At the present moment we exclude the effects of workers’ money savings on the price of securities and firms’ ability to recuperate unspent money in the financial market: we simply assume that – thanks to state expenditure – firms ‘collect’ on the market for goods the amount of money necessary to reimburse banks for the initial finance (including interest). For a discussion on the way the actual real wage is fixed in a model of the monetary theory of production see Forges Davanzati and Realfonzo (2000). However, it may happen that deregulation improves firms´ expectations on future profits, therefore it may determine an increase in investment and in employment. This should be regarded as a possible counterbalancing effect, in the sense that the decrease in employment, due to the decrease in the propensity to consume and the increase in labour productivity, might be lower than what would result from equation 4.3. Note that, in this framework, it is necessary to distinguish between a technical production function and an endogenous production function, where the latter depends not only on technology, but above all on workers´ effort. See Forges Davanzati and Realfonzo (2000).

References Bortis, H. (1998), ‘A Note on Keynesian long-run period’, History of Economic Ideas, 6(3), pp. 7–33. Boyer, R. (1988), The Search for Labour Market Flexibility: The European Economies in Transition, Oxford: Clarendon Press. Bowles, S. (1985), ‘The production process in a competitive economy: Walrasian, neoHobbesian and Marxian models’, American Economic Review, 1. Dutt, A.K. (1987), ‘Competition, monopoly power and the uniform rate of profit’, Rewiev of Radical Political Economics, 4, 55–72.

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Forges Davanzati, G. and R. Realfonzo (2000), ‘Wages, labour productivity and unemployment in a model of the monetary theory of production’, Economie appliquée, 4. Graziani, A. (1994), La teoria monetaria della produzione., Arezzo: Banca popolare dell’Etruria e del Lazio. ILO (1996), World Employment - National Policies in a Global Context, Ginevra: ILO. Lavoie, M. (1992), Foundations of Post-Keynesian Economic Analysis, Aldershot: Edward Elgar. Layard, R., S. Nickell. And R. Jackman (1994), The Unemployment Crisis, Oxford: Oxford University Press. OECD (1994), The OECD Job Study, Paris: OECD. Realfonzo, R. (1998), Money and Banking. Theory and Debate (1900–940), Chelthenham: Edward Elgar. Mardsen, D. (1997), ‘Regulation vs. deregulation. which route for Europe’s labour markets’, in J. Philpott (ed.), Working for Full Employment, London: Routledge. Williamson, O. (1975), Markets and Hierarchies: Analysis and Antitrust Implications. London: MacMillan. Wilkinson, F. (1998), ‘Co-operation, the organization of work and competitiveness’, University of Cambridge – working paper no. 85.

Chapter 5

Effective Demand and Cash Flow Requirements in a Monetary Economy Bruno Trezza

5.1

Foreword

The basic reason for using and holding money was clearly stated by Pigou as early as 1917 when he wrote ‘In the ordinary course of life, people are continually needing to make payments in discharge of obligations contracted in terms of legal tender money…. The obligations and the claims that become due at any moment seldom exactly cancel one another and the difference has to be met by transfer of titles to legal tender. Under this name I include actual legal tender, bank notes and bank balances against which checks can be drawn’ (Pigou, 1917, p. 38). People have to use money since money has the legal and recognized capacity to extinguish obligations, while other assets cannot do so: ‘the property of money is that it is accepted as a medium of exchange’ (Modigliani, 1944, p. 235). The question remains open of why people should hold money. This question has been considered the central issue in the pure theory of money; as Hicks (1935, p. 18) puts it: ‘the critical question arises when we look for an explanation of the preference of holding money rather than capital goods. For capital goods will ordinarily yield a positive rate of return, which money does not’. The answer is again given by the fact that ‘the imperfect moneyness of those bills that are not money is due to their lack of general acceptability which causes the trouble of investing in them’ (Hicks, 1946, p. 166). On this line of thought Keynes (1936, chap. 13 section 2; 1937) reached in the end the conclusion that the rate of interest could be determined in relation to the relative convenience between holding money and buying an asset. In this way securities are a close substitute for money as an asset, but not for money as medium of exchange (Modigliani, 1944, p. 235). Hence people need to have money to meet cash payments due both to a lack of synchronization between flows of receipts and flows of payments and to contingencies requiring sudden expenditures or unforeseen opportunities (Keynes, 1936, p. 171 and pp. 195–7). These are the well-known transactions and precautionary motives to which Keynes also added the speculative one. Economic theory in general and monetary theory in particular has spent considerable effort and time in exploring reasons and causes of holding money. Hardly any attention has been given to the restraints and conditions linked to the

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fact that to buy goods people and firms must use money. As the interest focused on the demand for money the need to use money for transactions was considered only as a source for transaction balances. The composition of these balances then became the central issue (see Tobin, 1958, p. 66); from this same point of view emerged the subsequent development of post-Keynesian demand for money represented by the theory of portfolio selection. Paraphrasing Robertson, we may say that economists became ‘so taken up with the fact that people sometimes acquire money to hold it that they have apparently all but entirely forgotten the more familiar fact that they often acquire it in order to use it’ (Robertson, 1966, p. 161). What this path of thinking has left out is by no means of secondary importance but is, in many respects, even more crucial to understand the working of the economic system, especially monetary circulation. Let us start from a very simple observation. In any moment of time people may decide on a plan that implies the change of some real or financial assets into others; that is G1 ⇒ G2 . In order to do so, if money is the medium of exchange, two exchanges must take place in sequence: G1 → M and M → G2 ; hence the real plan is G1 → M → G2 . The first of these two transactions may be the sale of some goods or of promissory notes of any type to borrow the required money for the subsequent deal. After all, this is simply another way to assess the transaction motive to acquire money and must be expressed in some constraint at each and every point of time to prevent goods or one’s own credit from becoming the source of effective demand for other goods. (Clower, 1967, p. 3) Any trade of the type G1 ⇒ G2 can be either envisaged as an ex ante target or seen as an ex post result. However to be factual it must include the necessary chain G1 → M → G2 . This brings into the picture an extremely important element of uncertainty that in no way can be eliminated without transforming a monetary economy in a barter economy. Indeed, in a monetary economy the demand for the good G2 can turn up only after and if the sale of G1 for money has taken place. Hence point-in-time restraints characterizing a monetary economy must always be taken explicitly into account or else the working of a monetary economy and the circulation of money cannot likewise be effectively investigated. A second problem, strictly linked to the previous one, is given by the fact that any analysis of the economic system must consider average conditions; that is conditions that can be maintained or recurring over time. Clearly exceptional situations must also be taken into account but they cannot be used as the basis of a theory seeking to understand and explain how the economy works. In a monetary economy, for all point-in-time restraints to be satisfied, it is crucial to ensure that all cash flows are at least non-negative or made so as to enable people to carry out their economic plans. Keynes’s conceptual journey from the Treatise on Money to the General Theory may possibly be described in the following way. In the Treatise Keynes explores the relationships between the monetary demand, as a flow, for consumption and investment goods and the production of these goods; the

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equilibrium conditions will set the monetary prices (Keynes, 1930, chap. 10). In that analysis the main equilibrium condition is given by the equality between the production cost of new investment goods, the amount of savings and the value demand for investment goods (Keynes, 1930, p. 149, see also chap. 11); in this case however it is also possible to obtain an equation similar to Fisher’s quantitative monetary theory showing the existing connection between the monetary price level, total output and total amount of deposits (Keynes, 1930, p. 150). Here the main focus is on how total monetary demand for goods splits between consumption and investment goods so as to determine prices in each of the two sectors. Once money prices are given, or somehow determined, it may then seem natural to use a condition of this type to establish the level of output on the basis of the splitting of demand between consumption and investment goods. Hence total demand in money terms, and its splitting between consumption and investment, sets the level of production; as investments are financed out of global savings, the equality between supply of and demand for money as a stock may then be used to determine the interest rate. The well-known basic Keynesian model is so attained. However in the preparatory works for the General Theory, Keynes played with a different idea much more akin to a cash flow concept: the difference ( M '− M ) . This is the difference between money inflow and money outflow resulting from the process of production and sales by firms as a whole. Marx deems the inequality ( M '− M ) > 0 to be the basic condition for the economic system to work as it ensures firms have a positive inflow of money allowing plus value to be converted into profits (Marx, 1887, vol. I, chap. IV, section c). Keynes distinguishes three types of economic systems: the cooperative, the neutral and the entrepreneurial economies (Keynes, 1987, p. 76 ff.). The entrepreneurial economy, the one corresponding to the real state of affairs, is based on a sequence of the type M → B → M ′ . Entrepreneurs are not interested in the amount of output but in the amount of money so that they will expand production if they expect to increase monetary profits (Keynes, 1987, pp. 81–2). Although Keynes assumes the same sequence as does Marx, he never considers the condition ( M ′ − M ) > 0 as a important one but seems to think ( M ′ − M ) ≥ 0 sufficient. In this way the direct link between the Treatise and the General Theory is re-established and whatever concept relating to cash flows is removed. However, Marx made explicit the difference ( M ′ − M ) as a flow by referring to labor time, that is the time in which profits are generated; Keynes seems instead to link the difference to time generating interest. This different approach is probably behind the two different conditions as assumed by Marx and Keynes. For clarity’s sake things, from now on we shall simply refer ( M ′ − M ) to firms’ income generating time period as defined in usual accounting practice. The equality between global demand and supply does not imply that all relevant cash flows are positive or at least non-negative. In effect this equality is only a way to clear the market and entails nothing specific on monetary flows. Cash flow conditions for firms and families have to be explicitly investigated to

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clarify what can be a viable and possibly recurring condition for the economic system; in this way also some important aspects of monetary circulation can be clarified. In what follows we shall first indicate the characteristics of a monetary economy and then we shall investigate the conditions for all relevant cash flows to be such to configure a viable condition for firms and families and so for the economic system as a whole. We then suggest how an alternative model may be devised.

5.2

The Characteristics of a Monetary Economy

A monetary economy can be defined as a system in which goods are exchanged for money, money for goods but no good can be traded for another good. In this sense all types of credits, with the exceptions of bank deposits, must be considered as goods. This simple definition has some very important consequences that have in general passed unnoticed in theory but are crucial for understanding money circulation in the economy (see Trezza, 1978 and 1975). In a monetary economy markets can be simply defined by the goods that are changed for money so that in any economy there are as many markets as there are goods; let there be n markets and n goods including all financial markets, each related to a specific financial instrument, plus money. In each market the demand for the quantity of a good multiplied by its price is always exactly equal to the supply of money for that good; that is Dxi pi ≡ Omi . Any individual willing to buy something must give in exchange a sum of money equal to the value of the goods in question. Similarly we may write Oxi pi ≡ Dmi , which says that any individual willing to sell something must ask in exchange a sum of money equal to the quantity of the good times its price. Defining Exi ≡ Dxi − Oxi and Emi ≡ Dmi − Omi we have Exi pi ≡ Emi for i = 1, ..., n . These n identities imply that in any market, and for all markets, the excess demand in value is equal to the excess supply of money on that very market. Clearly ∑ i Exi pi ≡ −∑ i Emi ≡ − Em , which is Walras’ identity. This identity states that the sum of all excess demand for goods in value must be equal to the excess supply of money. Therefore in analyzing any market we may consider the real side and the monetary side of it. The real side shows quantities and prices of goods traded and the money side how much money flows in exchange. Moreover, a monetary economy requires a cash constraint to be added to the usual budget constraint for any single subject; in fact it must be assured that no good can be bought without having the required amount of money: that is ∑ i Dxij pi ≤ M j , where j designates the subject and i the goods. Buying on credit can be easily dealt with by considering two transactions in sequence, the first in which a promissory note is sold for money and a second in

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which the obtained money is used to buy something. In doing so great care is to be used to avoid generating the conditions of a barter economy in disguise.

5.3

Cash Flow Implications of the Keynesian Basic Equation

Keynes’s basic equation states that Y = I + C + G , where Y is income, I investments, C consumption and G public expenditure. The usual hypothesis that C is a function of income leads to the well-known multiplier equation Y = ( I + G ) /(1 − c) where c is the propensity to consume out of income. We must now bring to light the cash flow implications hidden behind the above equation and never taken into proper consideration by the theory. Let us write P + W = Y = I + C + G , where P are total profits and W total wages; this equality simply states how income is distributed between profits and wages on one side and how it is used for investments, consumption and public needs on the other. Let us assume C = c p P + cwW ; as usual both cw and cp are between zero and one. However cp must be considered as the propensity to consume out of distributed profits; that is c p = cˆ p d where d is the percentage of profits distributed to shareholders and cˆ p the usual propensity to consume. Let us define b ' = I (1 − d ) P , so that b = b '(1 − d ) = I / P . For the moment we shall give no special meaning to b; however, b′, c 'p and d are all between zero and one. By substitution the following is obtained:

P(1 − c p − b) = −(1 − cw )W + G This equation shows the net cash flow of the whole system of firms acting in the economy. For the firms’ system as whole (SF) the only outflow of money is given by wages paid to workers and money inflow is given by what workers spend plus public expenditure. It is very important to note that public expenditure, up to now, has been equal to public deficit, as there are no taxes. In what follows what is said for the SF can be said for a representative firm and viceversa, with due attention to some details. The other side of the equation simply shows the net cash flow emerging from the firms’ balance sheet: the positive cash flow for the firm is given by profit and it is utilized to buy consumption and investment goods; if expenditures are less than profits then the cash flow is positive, otherwise negative. If we define the firm’s money outflow at the beginning of the period as M and the money inflow at the end as M′, we have ( M ′ − M ) = P(1 − c p − b) = −(1 − cw )W + G . It is important to underline the relation: ( M ′ − M ) = P(1 − c p − b) ≥ 0 ⇔ G ≥ (1 − cw )W

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An initial result is that if there is no public expenditure, or if it is too small, the firms’ cash flow is necessarily negative. Thus the usual Keynes equation Y = ( I + G ) /(1 − c) does not ensure any type of equilibrium from the firms’ standpoint as it says nothing on the firm’s cash flow that may be either in the red or black. Clearly in any single moment of time cash flows may go any way D + T but if we consider average conditions, that more or less fulfill expectations and therefore can be reiterated over time, then cash flows must be positive or at least nonnegative. As a consequence a positive economic activity necessarily requires a public balance deficit and firms and workers alone cannot keep the system going.

5.4

Introducing Taxation and External Trade

We must now turn our attention to the case where taxes are explicitly considered. Let us define disposable profits and wages as P′ = (1 − t p ) and W ′ = (1 − tw ) , where tp and tw are the tax rates on profits and wages respectively; let b* = I / P ′ . Consumption becomes C = c p P′ + cwW ′ , as usual. Public deficit can be defined as D = G − (t p P + twW ) ; therefore the basic equality P + W = Y = C + I + G can be written in the form: P + W = c p P′ + cwW ′ + b * P ′ + D + (t p P + twW ) So that our basic equation becomes:

( M ′ − M ) = P′(1 − c p − b*) = −(1 − cw )W ′ + D And also ( M ′ − M ) = P '(1 − c p − b*) ≥ 0 ⇔ D ≥ (1 − cw )W ′ For the time being the conclusion has been reached that there is a net positive cash flow for the firm only if there is enough public deficit. The amount of the deficit required to generate a non-negative cash flow wholly depends on the propensity to consume out of wages. The reason for that is clearly understood if one considers that wages’ monetary savings are financed by firms so that firms must have revenues that cover wages’ financed saving as well as firms’ monetary needs. From now on we shall drop the apex so that P and W will stand for disposable profits and wages respectively. In an open economy we have P + W = C + I + D + T , where T = X − E stands for external trade surplus equal to the difference between exports and imports; hence P(1 − c p − b) = −(1 − cw )W + D + T so that D and T are equivalent in determining firms’ cash flow. From now on we shall indicate with A the sum D + T , that is the expenditure in goods coming from outside the firms’ system.

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5.5

79

Credit, Wealth and the Stock Exchange

The introduction of credit makes things more complex. Let us consider workers and firms individually. Having introduced credit and considering average conditions, to satisfy the cash constraint, we must introduce the requirement that net cash flows for workers and firms, CFw and CFp, must be greater than, or equal to, zero. Obviously in any single moment these items may be negative, but this implies that the money stock of the subject is being reduced, a situation that cannot continue over time as there is a bottom line given by zero money stock. The net cash flow for workers is given by CFw = W (1 − cw ) − qBw + ∆Bw ≥ 0 , where q is the service and repayment rate on existing debt, Bw, and ∆Bw the new borrowing. In principle, with credit, cw may assume any value, even greater than one, but for cw ≥ 1 we have ∆Bw ≥ qBw implying that workers use new borrowing to service and repay the outstanding debt and to finance new expenditures. This situation may also be considered transitory and in general we may fall back on the usual assumption that cw < 1 ; in this case ∆Bw < qBw so that at least part of the service and restitution of the outstanding debt is paid out of current incomes. To find out firms net cash flow let us start from the equality

Y = P + W = cwW + A + P(b + c p ) , from which we obtain

P = −(1 − cw )W + A + P(b + c p ) . Therefore CFnp = P(1 − b − c p ) = −(1 − cw )W + A is the net cash flow coming in from productions and sales, and the global cash flow is given by CFp = P(1− b − c p ) − qB p + ∆B p = −(1− cw )W + A − qB p + ∆Bp (the assumption here that q is the same for firm and workers is of no relevance). Consider now the firms’ balance sheet: ∆K o + ∆B p = ∆K f + ∆K w ; that is the increase of owned capital plus the increase of debts must be equal to the increases of fixed and working capital. However ∆K o = P(1 − c p ) − qB p and ∆K f = I = bP , so that by substitution P(1 − b − c p ) − qB p + ∆B p = ∆K w ; we may then write P(1 − b − c p ) − qB p + ∆B p = ∆K w and finally: M ′ − M = ∆K w ≥ 0 ⇔ A ≥ (1 − cw )W − qB p + ∆B p Hence firm’s working capital may increase, remain constant or decrease according to the difference between external expenditure and the net money outflow connected with firms’ expenditure in wages. If external expenditure is not sufficient, firms will not have internal resources to finance the required increase in working capital and have to turn to banks. Also in this case external expenditure must be positive to ensure an average condition of healthy business for firms. There might be periods in which the credit

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increase has to compensate for insufficient external expenditure; in any case easing credit may really help in low demand situations. Let us introduce variations in wealth, H, within the cash flows of firms and workers. By itself a variation in the level of wealth of workers cannot give rise to more spending as it provides no money, but workers can always borrow from banks giving part of the increased wealth as a guarantee and so increase their spending. Let g w ∆H w be the percentage of net wealth increase used to get money for spending. In this case the net workers’ cash flow becomes CFw = W (1 − cw ) − qBw + ∆Bw + g w ∆H w ≥ 0 . In this way cw ≥ 1 implies ∆Bw + g w ∆H w ≥ qBw ; this last condition is perfectly sound as to the normal borrowing, usually repaid out of future incomes; workers may add extra borrowing guaranteed by the increase in the value of their wealth. This may happen both in the form of direct borrowing or in the form of somebody buying and borrowing to finance this purchase. The extra spending caused in this way may reach very high levels if there is a consolidated trend in wealth increase as in the stock exchange boom periods in which people may enjoy very substantial gains by generalized increases in stock values. For firms we have CFp = P(1 − b − c p ) − qB p + ∆B p + g p ∆H p ≥ 0 ; if CFp is greater than zero then the variation in the money stock held by the firm is positive. In this case g p ∆H p mainly stands for new issued stock sold on the market; on some occasions it may reflect the case of increases in real estate values on which money is borrowed from the bank. The above inequality implies that firms may finance spending not only from the operating cash flow and borrowing on future earnings but also with the money obtained by selling newly issued stocks or using newly prized real estates as guarantee. In both cases firms are using their increased patrimonial value to pursue investment and expansion plans to grow faster and to make the most of all market opportunities. We also have ∆K w = −(1 − cw )W + A + g p ∆H p so that we do no longer need A > (1 − cw )W to obtain ∆K w > 0 as cw may be greater than one and such to make the whole expression on the left negative. In this case ∆K w > 0 is consistent with A < 0 . Firms may finance increases in fixed or variable capital with the extra sources provided by newly issued stocks in addition to the finance linked to discounted forecasted future earnings. All this may cause extra growth, enhanced opportunities and hence additional development in a reinforcing loop that can be viewed as a virtuous cycle, also enabling public budgets to be adjusted. However a negative trend in stock values may, especially if persistent, create real and heavy problems.

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5.6

81

Exploring b

So far nothing has been said on cp and b as we have focused on the demand side. Depending on distributed profits, cp is a variable entirely within firms’ control; instead b is a crucial variable for firms’ well-being. To make this point clear let us suppose that production is set independently of demand. In this case firms will set all the variables in relation to some expected values of the demand for goods; among these variables they will also determine the desired cash flow, CFpd , and with it ∆B pd and bd (we assume for simplicity cp = 0; that is no profit distribution). In relation to the level of the effective demand for goods, sales may be higher, equal or lower than foreseen and the CFpd will accordingly differ from the CFp . If CFpd > CFp then firms will find b higher than bd as they are accumulating unintended investments in the form of an increase in inventories; the extent of changes in b depends on accounting rules that allow for profits to be accounted for. If firms want to keep CFp equal to CFpd then ∆B p must be greater than ∆B pd . The opposite holds if CFpd < CFp . With m standing for the ratio between firms’ debt and owned capital we have bd ≥ b ⇔ I d ≥ I and b ≥ 1 + m if and only if either CFp ≤ CFpd or ∆B p ≥ ∆B pd . The reason for this is simply given by the fact that lower sales imply a smaller than predicted inflow of money; the difference in the two items, being equal to the unintended increase in inventories, compels firms to increase the money inflow by borrowing. From CFp = P(1 − b − c p ) − qB p + ∆B p , assuming cp equal to zero, we may write P(1 + m − b) − (1 + m)qB p = ∆K w ; therefore b ≤ 1 + m has to be considered as a condition strictly required for firms to be viable; that is a situation that can be maintained and reiterated over time such as to represent the average condition for the SF. Thus a more precise content is given to the relation between credit needs and firms’ activity. It should be clear now that the basic point to be considered is not how to finance initial investments as suggested by Keynes (Keynes, 4) but how to ensure that the firms’ system considered as a whole acquires enough money from the production process. The importance of this emerges from firms’ money outflow and consequent negative change in firms’ cash balances due to wage payments and savings out of them (Graziani, 1994, p. 79; Davidson, 1978; Trezza, 1975). It seems then that the analysis of the requirements for firms to recreate their working capital may give substantial insights also in explaining monetary circulation.

5.7

An Alternative Model

Now we may finally propose an alternative and simple model; let us start with the simplest one with no credits and banks. Families’ income generated by production activities is supposed equal to total wages plus distributed profits; that is W + hP , where h (0 ≤ h ≤ 1) is the

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percentage of profits distributed to shareholders; clearly we are still talking about disposable wages and profits as before. If a percentage cf of that income is spent then the families’ expenditure, Ff, is given by Ff = c f (W + hP) . P(1 − h) being retained profits, firms’ expenditure, equal to investments, may be written as Ff = nP(1 − h) ; 0 ≤ n . Clearly ch = c p and n(1 − h) = b ; cp and b having the same meaning as in the previous analysis. Total demand for goods is then given by: Dg = F f + FI = c(W + hP) + nP(1 − h) + A where A, as above, represents any expenditure not coming from the production process as government deficit and, in an open economy, external trade surplus. If π is the share of profits in total income, P = π(W + P) = πY , then Dg = Y [c(1 − π + hπ) + nπ(1 − h)] + D and Y=

A = Dg 1− γ

where γ = [c(1 − π + hπ) + nπ(1 − h)]  belongs to the interval [0, 1] and equals 1 if c = 1 and either h = 1 or n = 1 . This result is very similar to the usual multiplier, Y = I /(1 − c) , but there are several significant differences. First, and most important, A cannot be equal to I, second γ is not equal to c. These differences reflect the importance, for the determination of a global demand consistent with economic and financial needs of the firms’ system, of the distinction between demand linked to the production process and other sources of expenditure. In this restricted sense, and only in this, the word autonomous expenditure may be used. It may be hence said that Keynes’s intuition was quite right but autonomous expenditure has to be properly defined, otherwise firms’ cash flows do not work and equilibrium conditions do not represent a situation that can be maintained and reiterated over time and hence an average condition for the economic system to be in. Introducing credit and banks does not change the overall picture although the model requires some more attention. In this case A may also comprise some expenditure by workers and firms; however this part of A, say gA, (0 ≤ g ≤ 1) , must be financed by borrowing from the banking system. In this way gA is made dependent also on credit conditions, interest rates, credit supply, etc.; we may eventually assume that the demand for borrowing depends somehow on the rate of interest, that is gA = f (r ), f ' < 0 . Also central banks may easily influence this type of expense acting on the supply of credits offered by banks; restrictive measures may well be much more effective than expansive ones. As stated above, in some particular circumstances, cw and n may be greater than one. Clearly this may happen any time, but in general it should be considered as a short run situation to be changed over time to restore more normal conditions. In a viable situation cw or n greater than one should reflect some positive occurrence, like an increase in stock values, to maintain present and forecasted cash flows in a healthy condition. The best way then to ensure a viable condition is

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always to assume n < 1 , implying b < 1 . This condition is quite sufficient as h is in the firms’ decisional domain so that it will be determined in relation to global financial conditions.

5.8

Conclusions

Economic theory has always explained the demand for money starting from it being the medium of exchange; even Keynes’s liquidity preference is based on the fact that money can be exchanged for any other good while any other asset has first to be changed into money to be expendable. However money cannot be medium of exchanges without imposing some point-in-time constraints to people’s choices and, even more important, without having a number of balance sheet relations that apply to each market and to the economy as a whole. These constraints and relations have to be taken into account any time the economic system is investigated, especially when money circulation is considered. Once this is done cash flows become crucial as they hinder people’s capability to take action in the market and therefore they represent a basic element for the demand to come into being. Marx’ emphasis on the conversion of surplus-value into profits clearly reflects the role of money as a medium of exchange, the importance of monetary circulation and the necessary passage of capital through its abstract form as money (see Marx, 1887, vol. I, chap. IV and p. 564). In this sense Keynes’s effective demand theory may be considered as a theory claiming to elucidate the general conditions into which this conversion may take place, what Marx omitted to do. However, Keynes did not focus on cash flows requirements as critical factors for monetary circulation and in particular for firms to recreate their working capital, but only suggested the need to find credit to finance initial investments; subsequent literature on the matter, following Keynes’s lead, only considered firms’ demand for credit and the relations between firms and financial institutions. Once the requirements for a monetary circulation are explicitly brought into play, it may be shown that Keynes’s effective demand theory entails being extended with the explicit consideration of the features pertaining to a monetary economy and, accordingly, of the cash flow requirements underlying monetary circulation. In the simple model without credit, cash flow requirements imply that the sum of public deficit and balance of trade to be positive; this is a very important and direct result that, as should be expected, cannot be maintained when credit is introduced. In this case, working capital can be regenerated by recourse to credit, provided firms’ owned capital suitably increases; the connection between firms’ needs and the sum of public deficit and trade balance becomes more complex as it depends on a number of factors. Restrictive monetary policies seem to have substantial impacts on the economy by making borrowing more difficult and expensive and thus precluding firms from

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acquiring the necessary liquidity to attain the right amount of working capital; in this case firms’ condition becomes weaker and risky such that they have to cut down investments and production. In the same way monetary policy may oppose and even overturn a strong increase in stock values so cutting down global demand. On the other hand, monetary policy not seem to have any effect in fostering the economic system as low interest rates and easier credit conditions should not induce firms to increase fixed and working capital beyond the appropriate amount. Of still greater importance is the fact that fiscal policy and monetary policy seem not to be substitutes but complementary as the former mainly impacts on the demand for goods and the latter on firms’ financial conditions.

References Clower, R.W. (1967), ‘A reconsideration of the microfoundations of monetary theory’. Western Economic Journal, June, pp. 1–9. Davidson, P. (1978), Money and the Real World, MacMillan. Graziani, A. (1994), ‘La teoria monetaria della produzione’, Banca popolare dell’Etruria e del Lazio, Arezzo. Hicks, J.R. (1935), ‘A suggestion for simplifying the theory of money’, Economica, February, pp. 1–19. Hicks, J.R. (1946), Value and Capital, Oxford: Clarendon Press. Keynes, J.M. (1930), A Treatise on Money, London: MacMillan. Keynes, J.M. (1936), The General Theory of Employment, Interest and Money, London: Harcourt, Brace and World. Keynes, J.M. (1937), ‘Alternative theories of the rate of interest’, Economic Journal, 47, pp. 241–52. Keynes, J.M. (1987), Collected Writings. The General Theory and After, A Supplement, Vol. XXIX, Cambridge: Cambridge University Press. Marx, K. (1887), Capital, Edited by F. Engels, London: Swan Sonneschein Lowrey. Modigliani, F. (1944), ‘Liquidity preference and the theory of interest and money’. Econometrica, December, pp. 45–88. Reprinted in Readings in Monetary Theory, London: G. Allen and Unwin. Pigou, A.C. (1917), ‘The value of money’, The Quarterly Journal of Economics, 32, pp. 36– 65. Robertson, D. (1966), ‘Mr Keynes and the rate of interest’, in Essays in Money and Interest, London: Fontana Library. Tobin, J. (1958), ‘Liquidity preference as behaviour towards risk’, Review of Economic Studies, 25, pp. 65–86. Trezza, B. (1975), Economia e Moneta, Bologna: Il Mulino. Trezza, B. (1978), ‘On the concept of the monetary economy’, in T. Bagiotti and G. Franco (eds), Pioneering Economic: International Essays in Honour of Giovanni Demaria, Milano: Cedam, pp. 991–1004.

PART II CREDIT AND BANKS

Chapter 6

‘As if its body were by love possessed’. Abstract Labour and the Monetary Circuit: a Macro-social Reading of Marx’s Labour Theory of Value Riccardo Bellofiore

Surplus value and profit can only derive from a relation between the two classes, but the exchange of commodities is quite a different thing inasmuch as it is a phenomenon within the class of capitalists. […] It is therefore wrong to say, as is often done, that the Marxist theory of value founders on the attempt to explain prices. In fact, Marx’s theory of value has nothing to say directly about the phenomenon of prices, since there is no problem of valorisation to analyse in it (Augusto Graziani, ‘Let’s Rehabilitate the Theory of Value’, in Bellofiore, 1997, p. 25).

6.1

Introduction

Since the 1970s, Marxian theory of value has come to be once more at the centre of criticism, revisions and reassertions1. The following pages shall look briefly at the interpretation that was dominant in the 1960s and the reasons why it is not acceptable, with particular reference to its inadequate reading of abstract labour. In the 1980s and the early ‘90s, new interpretations came on stream, where money took centre stage and new, more promising perspectives were advanced for the socalled ‘transformation of values into the prices of production’. Nevertheless, these new perspectives spring from accounts of Marx’s method and of his view of exploitation in a capitalist economy that do not seem entirely convincing. The aim of this work is to assess how the Marxian vision of exploitation can be expressed within a picture of capitalism as a truly ‘monetary production economy’, and how the ‘monetary circuit’ of capitalist production and circulation is just the other side of the sequential nature of the notion of abstract labour as depicted by Marx. In the following reconstruction of the Marxian critical political economy, one of the most fundamental sources of inspiration has been given by some pioneering contributions given by Augusto Graziani of the early 1980s (and now available in English: see Graziani, 1997a and 1997b).

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Occasional references will be made to some discussions about Marx in recent decades, but no pretension is made to offering a complete review of the issue. References to the secondary literature are to be taken solely as marking the development of the author’s personal opinion, in the hope to clarify the direction taken.

6.2

Traditional Marxism

A good starting point is the interpretation of abstract labour that was dominant at the beginning of the 1960s. At that time, abstract labour was taken to be essentially a mental generalisation. In Paul Sweezy’s words, abstract labour was ‘equivalent to “labour in general” ’, ‘what is common to all productive human activity’, and then ‘abstract only in the quite straightforward sense that all special characteristics which differentiate one kind of labour from another are ignored’ (Sweezy, 1942, p. 30). It is not, however, an arbitrary abstraction that is attributable to the whim of the researcher. Rather, the abstraction of labour is precisely referred to what actually happens in a capitalist economy, where there is a historically unprecedented degree of labour mobility. This qualitative notion, which makes up the substance of value, is, in Sweezy’s view, the true foundation of Marx’s quantitative analysis. All commodities are a frozen quota of the abstract labour spent by the overall labour force of the society. Therefore, they are value before any specific actual exchange relation with other commodities is set up. Hence, the theory of value is not merely aimed at discovering the laws governing the long-period, or equilibrium, relative prices. Above all, it investigates the laws ruling the allocation of the labour force among the various branches of a commodity producing society. A very similar interpretation is that given by Maurice Dobb in his Political Economy and Capitalism (Dobb, 1940) and in many articles that followed it. More explicitly than Sweezy, Dobb seeks to justify why Marx determines commodities’ exchange ratios starting from their ‘magnitudes of value’ – namely, the sum of labour directly and indirectly put into the production of the various commodities. The explanation lies in Marx’s adoption of a method of successive approximations. In Dobb’s view, Marx was of course fully aware that, under conditions of free competition, ruling relative prices have to include an average rate of profits. Consequently, they must diverge from ‘exchange values’ – that is, from the ratio between the magnitudes of value of the commodities exchanged – since the proportion of past to direct labour is different in the various industries. Yet, Marx’s approach is to investigate the question of the production of surplus value allowing, in the first stage of the argument, that commodities exchange at the ‘exchange values’ proportional to the labour embodied in the commodities involved, though this implies an unequal rate of profits. This happens, according to Dobb, because in this first step of the inquiry Marx is interested exclusively in the most general features of the capitalist mode of production. Therefore, the argument so far

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concerns only the macroscopic level of the theoretical investigation. By its nature, it does not tackle the individual situations and competition among industries, but only the ‘social relations of production’, which are the determinant of the division of the output between the two fundamental classes. This is, indeed, the subject of the First Volume of Capital. It is not until the Third Volume, in the second stage of the argument, that Marx moves to the microscopic analysis, in which he fills in the details of the picture and takes into account the differences influencing the competitive relations among the various industries. The first approximation corresponds to the system of ‘[exchange] values’, while the second approximation corresponds to the system of ‘prices of production’. The obvious difficulty arising at this point is the following. Once the second approximation, that of the determination of the prices of production in Volume III, has been reached, what is left of the first approximation in the Volume I, the analysis of the formation of surplus value? The same Dobb asks what point was there in speaking of two levels of approximation, or two stages of analysis, if the second could not be derived (given the additional data introduced at this second stage) from the first (Dobb, 1967). Dobb’s answer is that the debate about the derivation of the prices of production starting from Bortkiewicz’s ‘correction’ of Marx’s failure to specify the transformation of the inputs, is resolved by Seton’s 1957 article (Seton, 1957) and Sraffa’s 1960 book (Sraffa, 1960). Prices of production are then assumed to be determined by: (i) the ‘methods of production’, that means, by the description of the technical configuration of production with the commodities employed (inputs) and the commodities produced (outputs) taken as givens, and both measured in terms of their embodied labour; (ii) the ‘rate of exploitation’, read as the ratio between gross profits and wages, again measured in embodied labour. Thorough critics, as Claudio Napoleoni, soon pointed out that Dobb’s interpretation did not merely amounted to a distinction between a first step of the analysis, looking at the formation of the surplus value in the production process, and a second step fixing the capitalist prices for individual commodities (Napoleoni, 1972b). There was more. Though not conclusive for the determination of the prices of production and so, in a certain sense, incomplete, this reading had indeed to maintain that the results of the first approximation in terms of ‘exchange values’ are to be viewed as a fully adequate account of the social distribution of the commodity output between classes. That is, these results have not to be modified by the second approximation in terms of production prices.

6.3

The Rediscovery of Abstract Labour

The account of the labour theory of value that traditional Marxism had offered is not, however, a satisfactory one. This section offers some reasons against the interpretations about abstract labour given by Sweezy and Dobb.

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As already shown, according to those two authors the abstraction of labour is to be understood as a merely mental generalisation. Rather, as Lucio Colletti definitely clarified at the end of the 1960s (Colletti, 1972, Colletti, 1979), it is a real process that takes place concretely within the objectivity of everyday capitalist reality. The notion of a ‘real abstraction’ of labour is anything but obvious and deserves a closer look, also because it takes on different meanings as the Marxian system moves forward. Firstly, the abstraction of labour refers to the fact that, under capitalism, the various labours are carried out privately and independently of each other. They then become social only through the external, thing-based, ‘mediation’ of the exchange on the market and the metamorphosis against money. It is at this stage that fetishism arises. When they are exchanged on the market, the products of human labour are treated as quantitatively equal with each other: i.e., human beings abstract from the different use values pertaining to the various commodities. But in doing so, they also and simultaneously abstract from the differences distinguishing the many concrete labours that went into making them, labours which are now objectified and dead within the commodity output to be sold on the market. The process of abstraction of labour, as it is going on in the sphere of exchange is thus nothing but an expression of an alienation from subjectivity. The fact that the abstract labour – seen from the point of view of the analysis of market exchange – is nothing but alienated labour has a precise meaning and important consequences for the strictly economic theory of capitalism. It means that in the world of commodities private labours are quantitatively equalised through a real separation of labour from the individuals who perform it. This may be more precisely expressed as follows. The use of the labour power – namely, labour properly speaking – which is a property or predicate of the concrete individual, comes to be separated from him or her and becomes a true independent subject and, as such, ‘abstract’. The ‘value’ of things, resulting from this kind of labour, dominates over human beings. Here we have clearly an inversion of subject and predicate of the sort characteristic in Hegelian logic, a logic that is the true logic of the bourgeois-capitalist society, understood as an inverted, upside-down reality. An often-overlooked quantitative corollary of this argument helps reconnect the discussion so far with the shortcomings of the Sweezy-Dobb line. The fact that human energy spent in the period is ‘fixed’ on the market in a crystal of frozen human labour, namely the ‘values’ of commodities, means that these latter express nothing but a certain quantity of (abstract) labour in a generalised exchange society. The abstraction of labour seen as the alienation of subjectivity within exchange together with the resulting fetishism of the world of commodities, on the one hand; the categories of the ‘substance’ and ‘magnitude’ of value, on the other: they are two sides of the same coin. For Marx, then, the qualitative derivation of abstract labour is at the same time a quantitative and an exhaustive determination of ‘value’, in a single theoretical move.

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A point, however, has to be stressed carefully to fully understand this reasoning: the ‘generalised exchange society’ is identical, for Marx, with capitalism. Against the longstanding tradition set on foot by Engels (see for criticism, Arthur, 1998), the opening chapters of Capital do not describe a ‘simple commodity society’ of independent producers, who are owners of the means of production and who exchange the products of their labour on the market. On the contrary, occasional exchange becomes generalised only when labour power becomes itself a commodity. Of course, the inquiry of the commodity has a priority over the inquiry of capital. There is an historical priority of the isolated exchange of commodities relative to developed capital. And there is a logical priority of the commodity over capital because the production of surplus value and capital follows from the purchase of labour power as a (very special) ‘commodity’ on the labour market. However, it is equally true that capital is the precondition of the generalisation of the market, and that, in this respect, capital is antecedent to the systematic exchange of commodities. Within this line of thought, the two approximations offered by Sweezy and Dobb are no longer called for. ‘Value’ – as the theoretical notion enlightening the analysis of capitalist exchange (and production) – is sufficient unto itself and stands in need of no further ‘approximation’. The desire to have ‘abstract labour’ without the ‘substance of value’ is the impossible dream to have the quality without the quantity. From the point of view of the abstraction of labour on the market, with the implied alienation of the producers’ subjectivity, commodities have to be seen as a peculiar social form of labour, congealed in a crystal of a determinate entity. As such, commodities have an absolute or intrinsic value, which cannot but take a monetary ‘value form’, and then immediately have a ‘price’. As a consequence, through the mediation of money, exchange ratios between commodities’ absolute values are established on the market, giving rise to a system of relative ‘[exchange] values’, expressing nothing but the ratio between the quantities of labour ‘embodied’ (or ‘congealed’) in them. Once again, the desire to have ‘absolute’ value without ‘exchange value’ is an unfulfillable desire, as was that to have abstract labour as pure quality without the substance of labour with a given determinate magnitude. The inseparability of the notions of ‘absolute value’ and ‘exchange value’ was a leitmotiv in the interventions that Claudio Napoleoni made in the debate: both in the 1960s and in the second half of the 1970s, when he was a critic of Marx, and in the early 1970s, when he was a non-dogmatic supporter of the scientific soundness of the abstract labour theory of value (for a discussion in-depth of Napoleoni’s thought, see Bellofiore, 1991). This however raises a major problem. The system of ‘values’ is one where profits in proportion to the capital advanced are unequally distributed across the various sectors of production. Napoleoni holds that for Marx ‘exchange values’, as ratios between embodied labours, are the unavoidable intermediary link between ‘absolute values’ (the labour magnitudes expressed in money form within the market relation) and ‘prices of production’ (corresponding to the competitive situation with an average rate of profits). It follows, then, that

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the essentiality of the notion of ‘exchange value’ in the ‘transformation from values into prices of production’ is a necessary condition for the theory to avoid internal incoherence. In other words, if exchange values are shown to be redundant in the ‘transformation’, the entire theoretical building seems to collapse. Before developing this point, some subsequent developments of the account of abstract labour formulated by Lucio Colletti, and still implicit, have to be introduced into the picture. Which is what is done in the next section.

6.4

Abstract Labour ‘in Motion’

The first point to be stressed is that in Marxian theory abstract labour and money are categories that cannot be separated. Money is the very result of capitalist production. It is the general purchasing power embodying abstract, generic wealth as such. The labour that produces some aliquot share of this generic wealth – that is, of the ‘new value’ or ‘value added’ whose necessary form of expression is monetary – itself takes on the same quality, namely its ‘genericness’. Hence, the monetary nature of the capitalist output is already ‘ideally’ implied in the production process, inasmuch as the production of commodities has yet to be made actual in the metamorphosis into money on the market. Money is precisely that value that has made itself autonomous in exchange, separated from commodities and existing alongside them. Considered as ‘absolute values’, the commodities produced are then ideal money already before ‘final’ exchange on the commodity market. As the unique ‘external’ measure of value, real money is the necessary phenomenal form that must be taken on by the ‘immanent’ measure of value, which is abstract labour time. The ‘leap’ of commodities from mere ideal money to actual real money cannot, however, be taken for granted. Therefore, the law of value is not just a law of equilibrium, it is also a law of non-equilibrium: that is, it shows how equilibrium or disequilibrium comes into being starting from the ‘formation’ of economic magnitudes: without presupposing either that these latter are already given or the working of some kind of Say’s Law. In any case, it should be borne in mind that capitalism is not the systematic production of the commodity output taking the form of money as the general equivalent, unless money as capital equally systematically purchases labour power on the labour market at the beginning of the economic circuit. Hence, capitalism is a monetary production economy in which the relation between the two basic classes comes about in a sequence of phases, moving from (i) the purchase of labour power by money capital on the initial labour market; through (ii) the exploitation of labour power by productive capital within the capitalist labour process as the core of the valorisation process, bringing into existence commodity capital; to (iii) the eventual sale of commodities against money on the final so-called goods market. Just as capital has to pass through the monetary circuit in order to be valorised, so labour, which is the ‘substance’ of commodities’ value, has itself to pass

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through a sequential process. There is here a second peculiar characteristic of Marx’s notion of abstract labour. As seen, the abstraction of labour within exchange refers to the alienation of the subjectivity: this notion is looking at the result of human activity, it is referring then to the labour already objectified or dead in the product. But it has been also seen that commodity exchange is general only when it is the upshot of capitalist production. Indeed, in the Grundrisse, Marx arrives at abstract labour with a double theoretical deduction, that is not only starting from the analysis of market generalised commodity exchange, but also from that of the capitalist production process. From this latter perspective, the living labour of the wage worker is shown to be the abstract labour ‘in becoming’. Here the core of the matter is labour as activity – namely, the actuality of labour: living labour extorted from labour power which in its objectification embodies ‘potential’ value and surplus value. That is, the heart of the theoretical building is abstract labour ‘in motion’. Within the capitalistic production process, living labour is the only element that is neither commodity nor value. Since labour power is the only external purchase of the capitalist class, its use is the only possible source of value and surplus value. It should be borne in mind that the ‘translation’ of labour power as potential labour effort into the effective extraction of living labour is as uncertain as the ‘realisation’ of the dead labour contained in the commodity output into money as the ‘general equivalent’. This is another reason why the Marxian theory of value cannot be reduced to an instance of the so-called equilibrium paradigm in economic theory. It might be asked whether the inversion of subject and predicate affects only the labour which is ‘dead’ in the commodity output, or also the categories of labour ‘power’ (in the social relation going on in the exchange on the labour market) and that of ‘living’ labour (in the social relation going on within the capitalist production process). The answer is positive. This is a third meaning to attach to the abstraction of labour. Take the worker’s sale of his/her labour power. In the exchange on the labour market, as in any other sale, the seller passes over to the buyer the right to exploit the use value of the commodity which has been sold. But there are two pecularities of this transaction that should not be ignored. One is the well-known fact that the capitalist has been lucky enough to find on the market a commodity whose use value is itself labour ‘in action’, which is the very source of the substance of value. He can therefore extract from the worker more labour than its reproduction costs (setting aside the part coming from ‘domestic’ labour). Though less often pointed out, the second peculiarity is no less important. Once again, the point was stressed by Claudio Napoleoni: The commodity in question is very special because, instead of being an object that the worker owns, it is constituted of the worker herself, under a very particular aspect, namely as labour power (Napoleoni, 1972a, p. 55).

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This means that the worker who is bought by ‘money as capital’ is really separated from his/her own labour, that is, from his/her own subjectivity. The capability to work is no longer an attribute of the individual, as might seem natural; rather, it is the labour power, considered as a commodity, which is a particular feature of the individual, that becomes the subject of which the single worker, the individual of flesh and bone, is now just an appendix. But there is a problem here. Despite this real separation of the workers from their own labour, labour power and the living labour that it performs cannot be fully separated from the human beings who are its bearers. It is from this consideration that derives the thesis that the capitalist relation is marked by a real contradiction (a point that cannot be developed here). Let us now take abstract labour ‘in becoming’, or living labour. It is Marx’s explicit view that when the labour process become the means to the valorisation process, a genuinely capitalistic mode of production comes to life. Within it, living labour loses all its own specific qualities. What’s going on is precisely the fact that the concrete characteristics and abilities of labour have come to be functions of how it is incorporated into capital (Napoleoni, 1976, pp. 76–7). This is the way how labour comes to be ‘part’ of the ‘technical’ configuration of production – that is, this is how the ‘matter’ of human activity becomes the adequate ‘content’ of the valorisation process, under the drive of value turned into capital as the dominant social ‘form’ which has conquered the labour process. The knowledge and will that govern the technical determination of the productive process are now ‘alien’ to the worker. The labour power is not only subject to capital in being compelled to perform living labour in excess of the ‘necessary labour’, and thus to produce a surplus of value. In this respect, the living labour of the wage worker is, as Marx puts it, forced labour (of free individuals: a novel, unprecedented historical situation). There is more. Capitalist labour is also labour that is ‘other-directed’, in the sense that its features are increasingly determined ‘from without’. These two aspects of fully capitalist labour interact, because the compulsion to work is now the result of the fact that – with machinofacture and automation, and then with the complete development of the capitalist social relation – the concrete determination of labour springs from technical progress driven by the end of valorisation. The hypostatisation of labour reaches the point at which, through its materialisation as ‘fixed capital’, abstract labour becomes the true subject of which the concrete wage workers appear merely as its living extensions. These further determinations of the abstraction of labour as a process involve three layers, going progressively deeper in the apprehension of capitalist reality. First, the commodity market: here labour is ‘objectified’, or ‘dead’ labour, and abstract labour refers to alienation in exchange. Then, the labour market: here labour is labour ‘power’, and the process of the real hypostatisation affects the wage workers who are selling themselves as single representatives of society’s entire labour power. Finally, the ‘immediate’ production process: here labour is the ‘living’ labour of the wage workers; the hypostatisation process affects workers whose activity is ‘other-directed’, and who has now become a predicate of abstract

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labour considered as ‘value in process’. After passing through these three stages, it is crystal clear that the foundation of the abstraction of labour is nothing but the same real subsumption of labour into capital, which is the result of the development of capital itself. Two important consequences for the notion of exploitation follow from this view of abstract labour. The first is that, for Marx, if exploitation has to do with the appropriation of a surplus product, behind which there is a surplus labour, it is more fundamentally grounded in the compulsion and the other-directedness that afflict the whole of the labour performed (Bellofiore and Finelli, 1998, pp. 59–63). Exploitation is not merely a matter of distribution: and it makes little difference here whether the contest is about the shares of the net product (as in NeoRicardianism) or of the labour expended (as in most Marxisms). Rather, it is a matter of the capitalist nature of labour: in other words, abstraction and exploitation are coextensive categories. There is nothing awkward about, since ‘exploiting’ wage workers in fact means to use their labour power. Of course, it is possible to keep on speaking about exploitation as the extraction of surplus labour and as the attainment of surplus value, since that indeed is the ultimate purpose of the exploitation of labour properly understood as the abstraction of the whole of labour. Yet, it must always be remembered that this more common way of referring to exploitation follows from the other, more basic, sense. The second consequence of this understanding of abstract labour is that, since it is a notion that applies only within capitalism, then it is possible to speak about exploitation in the narrower sense only within the capitalistic mode of production. It is only by way of a different chain of reasoning that it makes sense to refer to slavery or feudal labour as exploited, since in precapitalist societies the product and surplus product cannot be rigorously reduced to labour and surplus labour (see Bellofiore, 1998b, pp. 21–3).

6. 5

The New Interpretations

We have set out two main lines of interpretation of the theory of value, that of the ‘two approximations’ and that of ‘abstract labour as a process’, that is abstract labour as labour that is alienated within exchange and really subsumed by capital within production: a theory which has as its core abstract labour ‘in motion’. As it is well known, both run into serious difficulties as putative versions of Marxism as sound economic theory. Those that afflict the traditional Marxism of Sweezy and Dobb exploded a few years after the publication of Sraffa’s Production of Commodities by Means of Commodities (Sraffa, 1960). This book was bound to put under severe pressure their idea that ‘exchange values’ and ‘prices of production’ make up distinct price systems appropriate to successive stages of the analysis. The kernel of the book lies, after all, in the immediate and simultaneous determination of ‘natural’ prices and the distribution of income. For that determination, there is no need whatever to

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begin with ‘values’, go to ‘exchange values’, and then transform them into ‘prices of production’. The connecting link between value and price of production, namely exchange value, is then wholly inessential. On the basis of this result, some commentators began to suspect, and many became certain, that the dimension of value and the move through exchange values were ‘redundant’, and, so, that Marx’s successivist method was ungrounded. In this connection, the standard reference is to Ian Steedman’s book of 1977 (Steedman, 1977). The derivability in Sraffa of prices of production from simple knowledge of the methods of production and real wages, both specified in physical terms, were used as a criticism directed explicitly against Marx, because the data of the determination of prices are the same needed to compute the data in the usual ‘transformation problem’. Far from resolving the ‘transformation problem’, as Dobb had thought, Sraffa if anything shows that there is nothing to transform. Furthermore, if, following Sraffa, wages are understood as a share of the surplus to be distributed at the end of the period – ‘after the harvest’, as he wrote – they must either be taken externally as an independent variable, sociologically determined ‘outside’ the economic core (say, by distributional struggles), or be derived, together with prices, as a dependent variable after that the profit rate is known (say, in consequence of Central Bank’s monetary policy fixing the money rate of interest, or derived from a target growth rate). If, on the other hand, wages are thought to be given in real terms, they are ‘resolved’ in a subsistence basket of commodities, each item of which is multiplied for its price, with the net product going entirely into gross profits. Whatever line is taken, the distribution of national income between classes cannot but be modified by the so-called ‘second approximation’. Hence, it seems crumbling also the second pillar of the DobbSweezy reading of Marxism, the idea that the ‘first approximation’ of value holds good on the level of macroeconomics and not modified by the moving to the microeconomics of prices. The difficulties of understanding the category of abstract labour can be seen more clearly by considering approaches that lay particular stress on the idea that Marxian ‘value’ is constituted in the unity of production and monetary circulation. This is the line taken, for instance, by the school of the ‘value form’ and also in the writings of Benetti and Cartelier (1998). Now, it is clear that the view in question can not only be found in Marx, but is decisive and distinguishes Marx from Classical-Ricardian and Neoclassical-Walrasian ‘real’ economics. But it is equally clear that this Marxian perspective goes hand in hand with another, according to which labour ‘exploitation’ begins in production and congeals in an ‘absolute’ value that is potentially already there before circulation. This latter view is foreign to the ‘value form’ approach and to the French circulationist school. If ‘value’ is a category whose existence, and not simply actual measurability, comes about precisely in the same act of exchange, ‘exploitation’ must be identified with the subtraction from the wage workers’ earnings of a part of the net product, for whatever reason. In this case, there will be no chance of setting up an explanatory hierarchy of the sort that Marx offers, where the ‘totality’ of production and

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circulation has its dominant centre in the capitalist form stamped on the labour process. Moreover, it is lost that quantitative aspect of the analysis of the First Volume of Capital, according to which the production of value and surplus value is investigated prior to the determination of competitive prices with a given average rate of profits. Marx’s view of capitalist production is that ‘the fundamental relation is that between capital and that which is its other and has to be subdued by it’, a relation where capital is constituted as self-valorising value as a result of the exploitation of labour and rewarded accordingly, prior to any analysis of capitalist pricing and redistribution of the surplus; only afterwards, ‘a different relation intervenes, that between capitals themselves’, with each capital now being rewarded with a profit in proportion to the advance of money (Arthur, 1999, p. 161; see also Bellofiore, 1999, pp. 61–2). Instead, in the more recent ‘circulationist approaches’ Marx’s theory slides into the limbo of purely qualitative analyses. Thus, both Sraffa’s followers and ‘value form’ theorists end up doing away with the quantitative aspect of Marx’s theory as a theory of exploitation in production. Some writers have regarded these conclusions as wholly destructive, and they have given rise, by way of reaction, to new interpretations of the Marxian theory of value and of the ‘transformation’. What holds these new interpretations together is the fact that they take seriously the connection between value and money, and the claim that capitalist price determination does not ‘dissolve’ the reference to the labour spent in production. Of the new interpretations, the most rigorous is the one put forward in the 1980s by Duménil, Foley and Lipietz (see: Duménil, 1980, 1983–1984; Foley, 1982, 1986; Lipietz, 1982; for an almost complete and general survey, see Foley, 2000; see also Bellofiore, 2002). For the sake of brevity, and because it is the best known and most frequently cited, Foley’s version will be taken here as representative of this view. In its most basic terms, the reading that these authors give of the ‘transformation’ can be summarised as follows. Marx starts with the postulate that at the aggregate level, the (new) value exchanged on the market is a translation into monetary form of the direct labour that took place within the whole of the various production processes. This they call the law of value: the identity between, on the one hand, the social product minus the non-wage costs both expressed in ‘values’ and, on the other, the same aggregate expressed in ‘prices’. By definition, each of the two quantities is equal to the national income distributed between wages and profit. Since it is assumed that behind the ‘value added’, which is an immediately monetary quantity, what is represented is nothing but labour, the question arises: how much labour is ‘represented’ by a given unit of money? The answer is the value of money: the ratio of the total amount of direct labour expended in production over the ‘value added’ by living labour in the period and having a monetary form of appearance. The value of money thus expresses the amount of labour that a monetary unit is able to buy or ‘command’ on the market. It is the inverse of the monetary expression of labour, or, in other words, it is the inverse of the share of the money value added that – thanks to the ‘law of value’ –

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can be attributed to each labour unit employed in the economy. In what follows, ‘represented’ labour shall be understood as the fraction of social labour that each commodity gets through the amount of money against which it is exchanged. This may also be interpreted as that fraction of social labour that the commodity take over in virtue of the ruling price regime, of which ‘exchange values’ and ‘prices of production’ are just two instances. The ‘postulate’ implies that, when the law of exchange – that is, the price regime: relative prices proportional to embodied labours, as in Volume I of Capital; or prices that diverge systematically from these latter, as the prices of production in Volume III of Capital – varies, the only thing that really changes is the allocation between the various commodities of the overall given sum of the (indirectly social) living labour. So long as prices are proportional to the ratios between embodied labours, and thus continue to be regulated by the ‘exchange values’, then each commodity will be able to command in exchange that amount of money that represents a quantity of labour which is exactly equal to the labour ‘congealed’ in the commodity itself. But if prices diverges from ‘exchange values’, then the amount of money each commodity gains on the market represents a quantity of labour which is higher or lower relative to the labour embodied. The next move on this account is to define the value of labour power no longer as the labour ‘congealed’ in the subsistence basket that the wage workers buy, but as the labour ‘represented’ in the money wage. Multiplying the money wage (or the overall wage bill) that each single worker (or the whole employed workforce) is paid by the ‘value of money’ the amount of social labour that ‘returns’, so to say, to the wage worker(s) is calculated. This is the labour represented in the money wage (or within the wage bill), which can differ from the amount of labour incorporated in the commodities that the wage worker comes to possess. The value of labour power multiplied by the value of money is thus, of course, the wages as a share of national income. A set-up of this sort allows results similar to Marx’s to be reached. By substituting Marx’s equality between the total of values and the total of prices with the equality between the money ‘value added’ expressed in ‘values’ and in ‘prices of production’, and by holding constant in the ‘transformation’ not the real wage but the value of labour power as defined above, then Marx’s other equality, that between the sum of gross money profits and the sum of surplus values, is confirmed. Indeed, the total surplus value is by definition the new value produced in the period minus the variable capital which has been advanced. But the new value has been set equal to the money wage bill plus gross money profits, and it has been stipulated that the labour represented by the money spent out of the national income expresses nothing but the labour required for its production. In other words, for the aggregate in question, the labour ‘commanded’ in exchange is by definition equal to the labour ‘embodied’ in production. What is subtracted from this – the variable capital – expresses nothing but the amount of labour represented by the money wage bill. It comes as no surprise that what we get – total surplus value – must be equal to the proportion of money income which does

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not return to wage workers: it must, that is, be equal to the labour represented in gross money profits. The aggregate equivalence between total profits and total surplus value is then implicit in the definitional premises. This, indeed, is a matter that Duménil and Foley have themselves stressed many times. Going further along the same path, some contributors have sought to satisfy both of Marx’s equivalences. In the light of the rereading of variable capital, constant capital can also be interpreted as the quantity of labour that is represented in the part of money capital buying the means of production, and not as the labour required for their production. Albeit with differing emphases, this is what is done by Wolff, Roberts and Callari (1984) and Moseley (1993a): they add constant capital to both sides of the equation – that is, the value added expressed in ‘values’ and the value added value expressed in prices prices of production. This will turn it into the equality between the sum of values and the sum of prices. Thereby, every point in Marx’s transformation seems to be brought back to life intact. All the parts into which the total value produced is divided – constant capital, variable capital and surplus value – are now interpreted as the labour represented in the three monetary segments into which the given monetary total is resolved. On Duménil and Foley’s account, the rate of surplus value is defined as the (gross) money profits over the money wages, and is understood in terms of represented labour. This of course means that it, in general, diverges from the rate of surplus value interpreted as the ratio between the labour ‘congealed’ in the commodities bought by gross money profits and the labour ‘congealed’ in the commodities bought by the money wage bill. But for them the ‘value’ and the ‘price’ rate of profits continue to differ, as in Neo-Ricardian writers. For Wolff, Roberts, Callari and Moseley, the two are again one and the same.

6.6

Some Sympathetic Criticisms

Unlike the Dobb and Sweezy Marxism’s, these approaches exclude all talk of two approximations to capitalistic prices, first the ‘exchange values’ and then the ‘prices of production’. What we have is, on the one hand, the dimension of ‘value’, which follows directly from the ‘postulate’ saying that all the ‘value added’, or money income, originates from living labour. On the other, there is the dimension of ‘price’, which is defined once the rule of distribution of the capitalist surplus value is chosen. ‘Exchange values’ and ‘prices of production’ are thus seen as alternative exchange norms. The overcoming of the method of successive approximations is here based on the elision of ‘exchange values’ as the link connecting values and prices. A view of this sort presents itself as capable of answering the criticisms that, on the basis of Sraffa, were commonly made of Marx in the 1970s. For just this reason, it is interesting that, in the early years of that decade, the Italian NeoRicardian Fernando Vianello put forward a very similar articulation of the relations between ‘value’ and ‘price’ in several contributions (Vianello, 1970, 1973).

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On Vianello’s account, commodities are objectivisation of abstract labour. Hence, whatever might be the relative price system, the social product can always be traced back to total labour, the part that returns to the workers can be defined as ‘necessary labour’, and the remainder as surplus value. The only difference in emphasis from the new approaches – on a matter on which, as we shall see, Vianello seems to be correct – is that on his account variable capital is calculated on the basis of a real wage that is defined in terms of commodities. The vision of capitalism that emerges from all these interpretations is clearly Smithian: given that labour is what naturally produces, the presence of a gross profit is a sign of a deduction from the product belonging to labour. But it has been shown in previous sections that in Marx, rather than being a ‘postulate’, the identity between new value and living labour is the result of an argument; indeed, it is, both logically and historically, a presupposition-posit. And it has been shown too that that identity holds only for capitalism. It must be noted that Duménil’s book in French stresses much more than Foley’s contributions the methodological complexity of Marx’s approach: though I cannot tell whether Duménil would approve my way of grounding the new value-living labour identity. Unlike Duménil and Wolff, Roberts and Callari, both Moseley and Foley place a heavy stress on the monetary nature of the economy and on the fact that the Marxian method is a macrofoundation of the microeconomic determination of prices. I agree on both issues, but submit that either author has not worked through fully these quite proper observations. It is likely that the main obstacle has been the failure to connect the two in such a way as to show that they boil down to a single thesis. A macroeconomic analysis of the capitalist social relation, like that offered by Marx in Volume I of Capital, involves looking at the various branches of production as they were a single entity, and this is an analytical move that is not consistently found in the new interpretations. Moreover, putting the category of the capitalist monetary cycle at the centre of a genuinely macroeconomic conceptual scheme, which is what Foley wants to do, requires the question about the channels through which money comes into the economic circuit, and the finance to capitalist production is granted, to be asked. As Augusto Graziani in his writings (see Graziani, 1989a, 1992, 1996, and especially Graziani, 1994a; for a very condensed summary of the theory of the monetary circuit, see Bellofiore and Seccareccia, 1999) has showed, to give a satisfactory answer to that question there is a need to move towards a model on which the banking sector is distinct from the industrial sector, and where money is fully endogenous, being in the first instance thought as ‘initial’ finance for firms. Of course, this leads to reconstruct the Marxian ‘cycle of monetary capital’ along the lines offered by the theory of the monetary circuit. On the contrary, the stress in the new interpretations is rather on the need for commodities to be realised at the end of the period on the market, in the metamorphosis with money as the general equivalent. Indeed, it is only to allow the translation of ‘constant capital’ (looked at as a money magnitude) and of ‘variable capital’ (looked at as a money magnitude) into the terms of the ‘represented’ labour that the advancing of money capital appears in the argument.

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Indeed, the magnitude of ‘constant’ and ‘variable’ capital so interpreted depends on the ‘value of money’, which in its turn is fixed at the end of the capitalist monetary circuit. In this way, the new interpretations slide towards the ‘value form’ approach, from which often they want to distance themselves. An instance of this would be Foley’s account of the value of money. He is perfectly clear that this is an ex post category: it is direct labour divided by the money national income. This means that commodities have been realised in money terms before that the Marxian categories and the ‘transformation’ can be fully spelt out. This is not merely coherent with, but actually follows from, the idea that abstract labour exists only in the unity of production and circulation. For Moseley, the picture is rather different. Here, value has a place prior to, and independent from, exchange, but simply because he assumes that the value of money is known at the beginning of the economic circuit and is identical to what issues at the end. At least until some account will be given of this assumption, it must be regarded as ad hoc. On this point Duménil is again the odd man out. In his view, the metric of production prices continues to be in labour and not in money, a point which, mutatis mutandis, holds also for Wolff, Roberts and Callari. Duménil’s conclusions are rigorous, but the centrality for Marx of money both before and after production is lost. The last comment is about the new approaches’ handling of the ‘value of labour power’. Though the wage is paid in the capitalist process after labour has been performed, the new interpretations stress that it is anticipated in money on the labour market, before the production process is completed and, in particular, before it is translated into use values by the wage workers’ expenditure as consumption. Thus, the real wage depends on the prices that are fixed on the commodity market. This is a further point on which I fully agree. It is certainly correct to say that the amount of money purchasing labour power, and then becoming the income that the wage workers can spend on the market, will be realised as use values on the commodity market only at the end of the period. As it is correct the observation that this is one of the features that distinguishes labour power as a commodity from all others. But, contrary to what Mohun claims (see Mohun, 1994), it does not follow that the value of labour power is directly identical with the labour represented in the money wage. If this were so, once the (ultimately arbitrary) hypothesis of ‘equal exchange’- namely, of relative prices proportional to exchange values – is abandoned, Marx’s other definition in Volume I of Capital, according to which the value of labour power is given by the labour ‘congealed’ in the subsistence basket, would lose all meaning: and it would be difficult to understand why this other definition has been introduced from the start. A different perspective can be set out briefly. Following Graziani (in the papers quoted above, and in Graziani, 1994b), let us assume that the real supply of consumer goods made available to the working class as a whole (‘wage goods’) depends on the autonomous decisions of the firms’ sector, that is of all industrial capitalists grouped together. Pure ‘market’ mechanisms do nothing to stop the capitalist class from bringing to the market a quantity of wage goods that is

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different from, and specifically lower than, the quantity that would be regarded as sufficient for (historical and moral) ‘subsistence’ in a given period. However, Marx prefers to assume from the start that the workers are paid what they are correct in expecting in the given historical circumstances. In this way, he eliminates the suspicion that the extraction of surplus value is attributable to some injustice inflicted on the workers; for, that is a suspicion as alien to Marx as any. Moreover, in the three Volumes of Capital Marx stipulates that all the ‘potential’ value coming out from production will find an outlet on the market – which is tantamount to saying that short-term firms’ expectations about effective demand are always fulfilled. It is in this situation, which may be called ‘neutral’, that Marx aims to show that the capitalist surplus derives from the exploitation of living labour within production. Of course, wage workers may influence the real wage indirectly, by means of control over their working efforts and through conflict at the site of production, or through political action. One last point, looking in more detail at how Duménil sets the question up. He observes that, since the total amount of the living labour expended in the period must be given, the effect of expressing the value of labour power either as the labour ‘congealed’ in the real ‘subsistence’ basket, which gives its evaluation in ‘exchange values’, or as the labour represented in the money wage, which gives its evaluation in ‘production prices’, means a change in the quantitative magnitude of surplus value. Duménil regards the former of these definitions as an a posteriori measurement and the latter as an a priori one. The reason behind this statement is that for him the commodity basket that the wage worker effectively purchases can only be known ex post, once their consumption choices have been carried out. But this can be contested. Though what Duménil argues might be an appropriate observation in an enquiry focused on individual behaviour, things are quite different within a macro-monetary and class analysis. Again following Graziani, the total of the commodities made available to wage workers for consumption results from the capitalist-entrepreneurs’ choices about the composition of output and about investment demand. In other words, thanks to the monetary financing of production, firms taken as a whole have the power to allocate the total labour power between the sector producing ‘wage goods’ and the sector producing ‘profit goods’. As an aggregate and relative to their access to bank finance, firms may fix their own demand in real terms independently of the fluctuations of prices. Conversely, wage workers can fix their own demand only in nominal terms: and there is an inverse relation between, on the one hand, the purchasing power of their money wage bill, which is limited by the income they obtained in return for labour power, and, on the other, price increases. Here – as Graziani (1979) has convincingly argued – there is a point of contact between Marxian theory and the conclusions arrived at by theoreticians such as the Keynes of the Treatise on Money and the 1937–1939 writings on finance, by Schumpeter, or by Kalecki and Joan Robinson (see Graziani, 1984, 1988, 1989a, 1989b; see also Bellofiore, 1985, 1992). In the light of this line of thought, far from being inadequate, the assumption that the amount of the ‘wage goods’ available to the

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working class is to be regarded as given in ‘physical’ terms seems to be the only one that goes to the heart of the capitalist process. In the next section, I set out briefly the outline of the Marxian theory of exploitation in a monetary economy. I’ll pick up some earlier thoughts about abstract labour, which make up my own rereading of Marx developing suggestions made some time ago by Colletti and Napoleoni (see Bellofiore, 1989, Bellofiore and Finelli, 1998, Bellofiore, 2001), and try to bring them together with a reinterpretation of the Marxian cycle of money capital in terms of Graziani’s theory of the monetary circuit (see Bellofiore and Realfonzo, 1997, Bellofiore, Forges Davanzati and Realfonzo, 2000).

6.7

Exploitation Within the Monetary Circuit

Marxian value theory and the transformation of values into prices of production have often been discussed as if what were at issue was the correctness of the results that Marx reached in the Third Volume of Capital. Thus, at least some interpreters have sought to show that ‘the books balance’. But the real problem is quite different: what do the new interpretations leave of the First Volume? After all, it was the only one of the three that was seen through press by the author himself. Therefore, the onus is on any reading of Marx to justify the argument put forward in Volume I. And this means, of course, to show the necessity of moving from the First Volume to the Third. In my view, the value theory that Marx employs in the Volume I serves as a theoretical explanation of the origin of surplus value. That is, it explains how capital is produced, without at the same time placing capital as it own presupposition. The real question is not how capital produces but, rather, how is capital produced. Marx’s method compels him to two choices. The first is to pursue his reasoning at the level of capital in general, where each individual capital is regarded in terms of the determinations that are common to all capital. The other is to begin the examination of capital in general from a situation in which there is a confrontation between, on the one hand, total capital, which is to say the purchasers of labour power taken as a whole, and, on the other, the ensemble of potential wage workers. It is in this that the analytic priority of macroeconomic analysis relative to a microeconomic approach consists. The firms taken as a whole have to make just one external purchase, that of labour power, because they own fixed capital bought from previous periods, and because within the period they produce and exchange among themselves both intermediate and new capital goods. At the outset of the capitalist circuit, therefore, the sum of the firms will need an initial financing, which will be supplied by monetary capitalists and will be equal to the money wage bill. The exchange on the labour market, in which capital advances a money value in order to obtain its valorisation, contains potentially within itself – ‘embodied’, as it were, in firms’ expectations – the successive sequence given by the

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production process and the sale of products, which generate profits and allow the repayment of the debt. Once this first phase of the capitalist process is over, capital still has to ensure that, in the second phase, that of the immediate production process, wage workers really perform the working time of the length established by contract and of an intensity that is at least normal. In previous sections I’ve shown how peculiar is labour power as a commodity, and how the translation of labour power into actual living labour cannot be taken for granted. Rather, it requires an act of compulsion on the part of capital, either by direct control over workers and/or by the indirect means of technical change. Industrial capital can ‘command’ labour only by means of an initial exchange that is predicated on access by entrepreneurial capitalists to monetary capital: but that monetary advance is a forerunner of real choices and behaviours in the sphere of production. Capital’s ‘consumption’ of labour power consists in extending the labour process beyond the limits of the labour necessary to produce the commodities going back to wage workers as real wage. It consists, that is, in the extortion of a surplus labour, which gives way to the production of a surplus value. As Marx wrote in the Results of the Immediate Process of Production, quoting from Goethe’s Faust: ‘By incorporating living-labour power into the material constituents of capital, the latter becomes an animated monster and it starts to act ‘as if its body were by love possessed’ (Marx, 1976, p. 1006). Let us go back to what has been argued before in this chapter. Marx’s hypothesis is that wage workers taken as a whole are paid the ‘subsistence’ wage. This amounts to supposing that the amount of ‘necessary labour’ is putatively known before the production process is under way, already during the exchange on the labour market. Marx also establishes that the real subsumption of labour to capital creates a material mode of production in which human activity is itself made abstract, with a view to the exchange of its output on the market, and in which the specific skills of individual workers become generic and negligible. It follows, then, that the time of living labour spent in production is itself to be regarded as homogeneous, in its social quality of labour time ‘commanded’ by capital. This ‘command’, or social power, over labour as such is the upshot of the articulation of two moments: the ‘initial’ exchange on the labour market and the exploitation going on within direct production, the ‘core’ of the capitalist process. It is, in short, the outcome of both circulation and production, which together tend to produce a social homogenisation of labour before the ‘final’ exchange on the commodity market. This social homogenisation could not be understood outside a theoretical perspective stressing the monetary nature of the capitalist production process, and the key role of the initial finance lent by money capital in favour of industrial capital. Thanks to this social homogeneisation, it is quite proper to subtract from the living labour, extorted from the wage workers taken as a whole, the ‘necessary labour’ that is returned to them in the wage goods. And it is proper to do so even before the sale of the output on the ‘final’ commodity market. Thus, the surplus value can be fixed, and with it the rate of surplus value understood as

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the ratio between the quantity of labour ‘congealed’ in the ‘profit goods’ and the quantity of labour ‘congealed’ in the ‘wage goods’. These conclusions hold good independently of the way in which relative exchange ratios are determined. What comes about within firms is a social prevalidation of ‘private’ labours (Bidet, 1986 and Reuten and Williams, 1989; the point was already implicit in the chapter on Marx in Napoleoni, 1975). This prevalidation is itself anticipated by the initial bargaining between firms and wage workers on the labour market, and between industrial capitalists and monetary capitalists about initial finance (its amount and the corresponding loan rate of interest). The monetary capitalists can nowadays be identified with the banks financing capitalist production: otherwise, as Graziani shows, it would not be possible to understand how the capitalist process could even get under way. As a consequence, it is a mistake to relegate into the realm of the ‘technological’ what happens before the ‘final’ exchange on the commodity market, and therefore to interpret only as concrete labour the working time spent by workers within the capitalist labour process. One point in the preceding line of thought should be further clarified. Production is made up of two main categories of commodities. On the one hand, there are those that the industrial capitalists place at the disposal of the wage workers on the commodity market, selling against the money wage bill what previously has been called the ‘wage goods’. These goods make-up the real wage corresponding to the ‘subsistence basket’ for the working class. On the other hand, there are all the other final commodities that do not return to the wage workers. These are the goods which has been called ‘profit goods’. They may be either capital goods or luxury goods. With a given number of wage workers employed and a given level of productive power in each sector, the composition of output between the two kind of commodities derives from the choices about the allocation of labour made by firms. The ‘command’ over living labour that industrial capital enjoys because of its privileged access to monetary capital in the relation between banks and firms is the root of the power asymmetry between the two classes. Wage workers get money only after they have sold their commodity, which is labour power, and they can only choose whether to spend all or only some of their total money wage bill. On the contrary, because of their privileged relation with the banks, firms are able to decide about where and how wage workers are to be employed. As a class, therefore, firms taken together can be thought to have fixed the level and structure of real production even before the analysis reaches the commodity market. Of course, firms do encounter the social constraints set by class conflict with wage workers. But the crucial point is that wage workers cannot make their voice heard within the sphere of market bargaining. The working class cannot but obtain as real wage the commodities offered on the commodity markets as a result of firms’ autonomous decisions. Seen in this light, as Benetti-Cartelier 1980 would say, the ‘wage relation’ must be understood as a relation of monetary subjection.

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As previously stated when talking about Duménil’s account of the value of labour power, in a genuinely macro-monetary model the composition of production must then be regarded as given a priori and not a posteriori. The value of labour power amounts to the labour ‘congealed’ in the ‘wage goods’, and the rate of surplus value amounts to the labour ‘congealed’ in the ‘profit goods’ relative to the labour ‘congealed’ in the ‘wage goods’. That value of labour power and that rate of surplus value will obviously be expressed into a money wage bill and into a ratio between (gross) money profits and the sum of money wages. The monetary representation of these magnitudes will change with any variation in the price rule that is adopted, if the real amount of profit goods and wage goods is taken as constant. For sure, in a less aggregated model, in which firms are not treated all at once as a single subject, the total of the wage goods consumed by wage workers will come to depend on demand. But the demand which matters is ultimately that of the firms and not that of the wage workers themselves, since investment demand lead effective demand, and thereby production for the market. The analytic results are fundamentally identical to those in the aggregated model. Look at this picture from another angle, once the ‘transformation’ has been effected. In the capitalist process, constant capital and variable capital are advanced in money. They must be thought as equal, respectively, to the means of production and the wage goods – namely, the material ‘elements’, or constituents, of constant and variable capital – both evaluated at their prices of production. The output has also to be evaluated in prices of production. Nevertheless, national income originates only from living labour, being nothing but the new ‘value added’ expressed in money. And whatever is the price expression of the value of labour power, this latter is fixed for the entire working class as a given basket of commodities according to firms’ choices. The rate of surplus value in labour embodied terms – namely, in values – is then invariant in the ‘transformation’, and the ‘exchange value’ notion is far from irrelevant. Appeal to ‘values’ appears to be the only meaningful approach to the macrosocial analysis of the capitalist relation as a relation of exploitation. The very object of the analysis in Capital, Volume I, so to speak, dictates the reasoning in terms of ‘values’. Since capital is not yet being regarded in terms of its subdivision into distinct branches, there is no reason not to evaluate the ‘net product’ in this way. But there is more. On closer inspection, we see that the only relative price that counts in the distribution of the new value between the classes – which is known once the length of the social working day and total employment are both given – is the exchange ratio set on the labour market, namely, the value of labour power. Of course it is true that changes in ‘prices of production’ relative to ‘exchange values’ will change not only the money wage bill but also the ratio between (gross) money profits and money wages, and the average rate of profits. But none of these changes can affect the relation between the two classes as that is set up in the Marxian scheme of Capital I. There are only two ‘quantities’ that are important in the relation between total capital (firms taken as a whole) and the working class (wage workers taken as a

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whole) from this point of view. The first is living labour, whose quantity and intensity is the object of class struggle in production. The other is the use values that are bought by workers through the expenditure of their wage. With given methods of production, these define the necessary labour, which is the labour expended by workers for their own reproduction. On the one hand, these two quantities define the position that wage earners occupy as workers and as consumers. On the other, they define the (maximum) rate of capital accumulation. They embody at once the point of view of the working class and the point of view of capital as a whole, as value valorising itself through living labour and taking into account some social norm of reproduction. Though they take on different forms in the passage from ‘exchange values’ to ‘prices of production’, neither the value of labour power nor the rate of surplus value in labour embodied terms can be cancelled from Marx’s argument; rather, they persist as the essential underlying reality of the phenomenal world of prices. More than likely, we should be ready to hear in this an echo of the thoroughly Hegelian concept of mediation, which we find in the Encyclopedia, 18, §12: ‘mediation is the principle and the passage to a second term, in which this second is only insofar as it as been arrived at from something that is different from it’. I can now return to the other theme raised at the beginning of this section. It was noted that the theory of value in Volume I aims at uncovering the origin of the capitalist surplus without presupposing capital as prior to itself. To do so, Marx begins by examining the production of value and of surplus value on the hypothesis that the ‘inputs’, above all labour power, cannot yet be theorised as capitalistically priced commoditites. The inquiry has then to imagine that they are purchased at prices that correspond to their ‘value’. The prolongation of living labour beyond necessary labour creates a surplus. Marx here uses what Rubin called the method of comparison, and initially evaluates the output in ‘values’ (see Rubin, 1973, pp. 221–57: the theme of a comparison made on a ‘counterfactual’ was also Croce’s, and it is taken up again, in a different way from Croce and Rubin, in Bellofiore and Finelli, 1998 and Bellofiore, 2002). The emergence of gross money profits for the ensemble of the capitalist class calls for the introduction of the category of the average rate of profits, which at first cannot but be computed as Marx does in Volume III, in ‘value’ terms. But once the rate of profits has been introduced, capitalist ‘prices of production’ for the output, divergent from ‘exchange values’, must be calculated – that is, commodities are now to be seen as the result of capital and not as its presupposition. In the first phases of the reasoning, there is a before and an after. The before is labour; and the after is capital. In other words, there is a linear movement from labour to capital. It is a movement that every capital whatever and under every guise must repeat in order to give rise to new surplus value and then profits. But, once the origins of capital have been explained, we must work backwards and include labour power, along with the other inputs, in the circularity of capital. In reproduction equilibrium, the same price must be applied to the same commodity appearing both among the inputs and among the outputs. As a consequence, also

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the inputs and not only the outputs will have to be re-evaluated. The consequence is well known: there will be a change in the surface appearance of the value of labour power, of surplus value, of the rate of surplus value and of the rate of profits. Far from being a limitation of Marx’s theory, when carried to its logical extreme, this appears to be a further point of continuity between Marx and Hegel: it shows that the process by which prices of production are determined by capital is an instrument for hiding its origin in labour. Let us draw to a close. ‘Value’, as the principle according to which commodities are just expression of abstract labour, is not a ‘first approximation’ to determining the capitalist exchange ratios. Rather, it is the only abstraction appropriate for understanding the origin of the capitalist surplus. Therefore, ‘exchange value’ – which figures prominently in Marx’s Capital, Volume I – is not a price rule among many others which may be chosen, as a function of the preferred criteria for the distribution of the surplus, and alternative to ‘production price’. This ‘dualism’ cannot work as a meaningful approach to capitalism, which is a mode of production where there is a market for ‘labour’, where the surplus is not in kind but is realised on the commodity market, and where ‘static’ competition creates a tendency pushing towards an average rate of profits (though this tendency, of course, is counteracted by ‘dynamic’ competition for gaining extraprofits). The three observations together would compel the theory to assume from the start the ‘price of production’ system as regulating exchanges on all markets. Rather, ‘value’ is an essential category because it allows – before the inquiry of capitalist pricing, and then before that the exchanges among capitals are taken into account – the theoretical investigation of the very special ‘exchange’ on which the capitalist social relation is founded. That ‘exchange’ is the one between the working class and capital as whole, an exchange which encompasses both a circulation moment (corresponding to the opening phase of the monetary circuit, where labour power is bought and sold) and production (the central phase where living labour is extracted). As a consequence, to understand ‘valorisation’ the only relevant exchange ratio to be considered is the one regulating this ‘exchange’, without at first introducing the exchanges among capitalits, and then the rules of competition (‘analysed a thousand and one times from the general equilibrium of Walras to Sraffa’s theory of prices’: Graziani, 1997a). This reading of Marxian labour theory of value is quite natural for those who acknowledge the priority and autonomy of macroeconomic analysis relative to the study of individual behaviour. From this perspective, the value of labour power – expressing the labour ‘congealed’ in the ‘wage goods’ – together with the identity between money income as the new value, on the one hand, and the whole length of the social working day, on the other – are the variables needed for the determination of that rate of surplus value which remains invariant whatever the price rule. And from this perspective, a class perspective, gross money profits for capitalists are born solely from the use of labour power: that is, from exploitation.

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Note 1

I wish to thank Chris Arthur, Suzanne de Brunhoff, Martha Campbell, Jean Cartelier, Ghislain Deleplace, Gerard Duménil, Marcello Messori, Patrick Murray, Fred Moseley, Jean Pîerre Potier, Riccardo Realfonzo, Geert Reuten, Tony Smith, Nicola Taylor, for comments on this paper and related topics. Though I would like they bear some responsibility for the many remaining errors, they are all mine, and the usual caveats apply.

References Arthur, C.J. (1997), Engels, Logic and History, in Bellofiore (1998), vol. I, pp. 3–15. Arthur, C.J. (1999), ‘Napoleoni on labour and exploitation’, in Baldassarri and Bellofiore (1999), pp. 141–63. Baldassarri, M. and Bellofiore, R. (1999), Classical and Marxian Political Economy: A Debate on Claudio Napoleoni’s Views, special issue of Rivista di Politica Economica, 89(April-May). Bellofiore, R. (1985), ‘Money and development in Schumpeter’, Review of Radical Political Economic, 17(1-2), pp. 21–40. Also in J.C. Wood (ed.), Joseph Alois Schumpeter: Critical Assessments, vol. IV, Routledge, 1991, pp. 371–94. Bellofiore, R. (1989), ‘A monetary labor theory of value’, Review of Radical Political Economics, 21(1-2), pp. 1–26. Bellofiore, R. (1991), La passione della ragione. Scienza economica e teoria critica in Claudio Napoleoni, Milano: Unicopli. Bellofiore, R. (1992), ‘Monetary macroeconomics before the General Theory. The circuit theory of money in Wicksell, Schumpeter and Keynes’, Social Concept, 2, pp. 47–89. Bellofiore, R. (ed.), (1997), Marxian Theory: The Italian Debate, special issue of the International Journal of Political Economy, 27(2).. Bellofiore R. (ed.), (1998a), Marxian Economics: A Centenary Appraisal, 2 vols., Basingstoke: Macmillan. Bellofiore, R. (1998b), ‘The concept of labour in Marx’, International Journal of Political Economy, 28(Fall), pp. 4–34 (Italian original, 1978). Bellofiore, R. (1999), ‘The value of value. The Italian debate on Marx: 1968–1976’, in Baldassarri and Bellofiore (1999), pp. 31–69. Bellofiore, R. (2001), ‘Marxian economic thought’, International Encyclopedia of the Social & Behavioral Sciences, edited by N.J. Smelser and P.B. Baltes, Oxford: Pergamon, pp. 9286-92. Bellofiore, R. (2002), ‘ “Transformation” and the monetary circuit: Marx as a monetary theorist of production’, in Campbell and Reuten (2002), pp. 102–127. Bellofiore, R. and R. Realfonzo (1996), ‘Finance and the labour theory of value. Towards a macroeconomic theory of distribution in a monetary perspective’, in Bellofiore (1997), pp. 97–118. Bellofiore R. and R. Finelli (1998), ‘Capital, labour and time. The Marxian monetary labour theory of value as a theory of exploitation’, in Bellofiore (1998a), pp. 48–74.

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Bellofiore, R. and M. Seccareccia (1999), ‘Monetary circuit’, Encyclopedia of Political Economy, Routledge, London, pp. 753–6. Bellofiore, R., G. Forges Davanzati and R. Realfonzo (2000), ‘Marx inside the circuit. Discipline device, wage bargaining and unemployment in a sequential monetary economy’, Review of Political Economy, 12(4), pp. 403–17 Benetti, C. and J. Cartelier (1980), Marchands, salariat et capitalistes, Paris: Maspero. Benetti, C. and J. Cartelier (1997), ‘Money, form and the determination of labour’, in Bellofiore (1998a), pp. 157–71. Bidet, J. (1986), ‘Socialisation et abstraction; lecture de l’ouvrage: Un échiquier centenaire: théorie de la valeur et formation des prix’, Cahiers d’économie politique, 12, pp. 175– 82. Campbell, M. and G. Reute (eds), (2002), The Culmination of Capital: Essays on Volume Three of Marx’s Capital, Basingstoke: Palgrave. Colletti, L. (1972), From Rousseau to Lenin, London: New Left Books (Italian edition, 1968). Colletti, L. (1979), Marxism and Hegel, London: New Left Books (Italian edition, 1969). Dobb, M.H. (19402), Political Economy and Capitalism. Essays in Economic Tradition, London: Routledge. Dobb, M.H. (1967), ‘Marx’s capital and its place in economic thought’, Science and Society, 31, pp. 527–35. Duménil G. (1980), De la valeur aux prix de production, Paris: Economica. Duménil, G. (1983–1984), ‘Beyond the transformation riddle: A labor theory of value’, Science and Society, 47(44), pp. 427–50. Foley, D. (1982), ‘The value of money, the value of labor power, and the Marxian trasformation problem’, Review of Radical Political Economics, 14(2), pp. 37–47. Foley, D. (1986), Understanding Capital. Marx’s Economic Theory, Cambridge, Mass.: Harvard University Press. Foley, D. (2000), ‘Recent Developments in the labor theory of value’, Review of Radical Political Economics, 32, pp. 1–39. Graziani, A. (1979), ‘L’analisi marxista e la struttura del capitalismo contemporaneo’, in Storia del Marxismo, vol IV: Il marxismo oggi, Torino: Einaudi. Graziani, A. (1984), ‘The debate on Keynes’s finance motive’ Monte dei Paschi di Siena Economic Notes, 1, pp. 5–33. Graziani, A. (1988), ‘The financement of economic activity in Keyne’s thought’, in H. Hagemann and O. Steiger (eds), Keynes’s General Theory nach fünfzig Jahren, Duncker & Humblot, Berlin. Graziani, A. (1989a), ‘The theory of the monetary circuit’, Thames Papers in Political Economy, Spring. Also in: Économies et Sociétés, 24(June), pp. 7-36. And in: M. Musella and C. Panico (eds) The Money Supply in the Economic Process: A Post Keynesian Perspective, Aldershot: Edward Elgar, 1995, pp. 516–41. Graziani, A. (1989b), ‘Schumpeter and Italian economic thought in the inter-war period’, in Studi economici, 1, pp. 41–83.

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Graziani, A. (1989c), ‘Money and finance in Joan Robinson’s works’, in G.R. Feiwel (ed.), The Economics of Imperfect Competition and Employment, Basingstoke: Macmillan, 1989, pp. 615–30. Graziani, A. (1992), ‘Production and Distribution in a Monetare Economy’, in H. Brink (ed.), Themes in Modern Macroeconomics, Basingstoke: Macmillan, 1992. Graziani, A. (1994a), La teoria monetaria della produzione, Arezzo: Banca Popolare dell’Etruria/Studi e Ricerche. Graziani, A. (1994b), ‘Real Wages and the Loan-Deposits Controversy’, Economie Appliquee. Graziani, A. (1996), ‘Money as purchasing power and money as a stock of wealth in Keynesian economic thought’, in E. Nell and G. Delaplace (eds), Money in Motion, Basingstoke: Macmillan, pp. 139–54. Graziani, A. (1997a), ‘Let’s rehabilitate the theory of value’, in Bellofiore (1997), pp. 21–5. Graziani, A. (1997b), ‘The Marxist theory of money’, in Bellofiore (1997), pp. 26–50. Hegel, G.W.F. (1975), Enciclopedia delle scienze filosofiche in compendio, 2 voll., RomaBari: Laterza. Lipietz, A. (1982), ‘The so-called “transformation problem” revisited’, Journal of Economic Theory, 26, 1, pp. 59–88. Marx, K. (1976), Results of the Immediate Process of Production, Appendix to Capital, volume I, London: Penguin, pp. 948–1084. Mohun, S. (1994), ‘A re(in)statement of the labour theory of value’, Cambridge Journal of Economics, 18(4), pp. 391–412. Moseley, F. (1993a), ‘Marx’s logical method and the transformation problem’, in Moseley (1993b), pp. 157–83. Moseley, F. (ed.), (1993b), Marx’s Method in Capital: A Reexamination, Atlantic Highlands, New Jersey: Humanities. Napoleoni, C. (1972a), ‘Interventi’, in Il Marxismo italiano degli anni sessanta e la formazione teorico-politica delle nuove generazioni, Roma: Editori Riuniti, pp. 184–93; pp. 433–35. Napoleoni, C. (1972b), Lezioni sul capitolo sesto inedito di Marx, Torino: Boringhieri. Napoleoni, C. (1975), Smith, Ricardo, Marx, Oxford: Blackwell. Napoleoni, C (1976), Valore, Milano: Isedi. Reuten, G. and M. Williams (1989), Value-Form and the State: The Tendencies of Accumulation and the Determination of Economic Policy in Capitalist Society, London: Routledge. Rubin, I.I. (1973), Essays on Marx’s Theory of Value, Montreal: Black Rose Books (Russian edition, 1928). Seton, Francis (1957), ‘The transformation problem’, Review of Economic Studies, 24(June), pp. 149–60. Sraffa, P. (1960), Production of Commodities by Means of Commodities, Cambridge: Cambridge University Press. Steedman, I. (1977), Marx after Sraffa, London: New Left Books. Sweezy, P.M. (1942), The Theory of Capitalist Development, New York: Monthly Review Press.

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Vianello, F. (1970), Valore, prezzi e distribuzione del reddito. Un riesame critico delle tesi di Ricardo e Marx, Roma: Edizioni dell’Ateneo. Vianello, F. (1973), ‘Pluslavoro e profitto nell’analisi di Marx’, in P. Sylos Labini (ed.), Prezzi relativi e distribuzione del reddito, Torino: Boringhieri, pp. 75–117. Wolff, R.D., B. Roberts and A. Callari (1982), ‘Marx’s (not Ricardo’s) “transformation problem”: a radical reconceptualization’, History of Political Economy, 14(4), pp. 564– 82.

Chapter 7

Liquidity Constraints and Small Firms’ Growth: The Case of Southern Italy Adriano Giannola

7.1

Introduction

There is general agreement on the difference, in terms of efficiency, between small firms in southern and northern Italy (see Prosperetti and Varetto, 1991; Giannola and Sarno, 1996; Giannola, Papagni and Sarno, 1998; Sarno, 1999). As far as technical efficiency is concerned (that is the ability to generate output from a given amount of factors of production) there appears, over the years, a persistent, huge differential (around 30 per cent) in favour of Northern firms. These findings (Giannola and Sarno, 1996; Giannola, Sarno and Papagni, 1998) show that Southern firms are not in a position to exploit economies of scale as northern firms do. The fact that firms’ size in the Mezzogiorno, for different size classes, is systematically smaller than in the rest of Italy, is a particular feature that seems to have major consequences. When the analysis shifts from technical to economic efficiency (i.e., the ability to combine the factors of production so as to equalize the weighted marginal productivity of factors), the gap between southern and northern firms in the level of production costs is dramatically reduced (ranging from 6 to 10 per cent). These results suggest that the North-South gap is not so much related to a specific inefficiency, but to the smaller size of southern firms that does not allow them to profit from returns to scale to the same extent. A possible conclusion (with relevant policy implications) is that the root of many problems of southern firms lies in the obstacles that prevent them from growing to reach an adequate operating size. A related implication is that the southern industrial structure, due to its size characteristics, is more easily affected by monetary policy and the economic cycle (Gertler and Gilchrist, 1991; 1993) The difficulties faced by southern firms become evident if we look at the evolution of the Italian manufacturing industry during the 1990s. For this purpose, we can proceed by considering a sample of firms which is representative of the entire population from a sectoral, dimensional and geographical standpoint. During the 1990s there was an overall decline in average firm size in Italian across all size classes. This is particularly marked for southern firms, in which firms’ size in 1990 was already significantly below average; by 1994 this character was considerably

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accentuated and was confirmed in 1997; by contrast, average northern Italian firm size showed a major increase in 1997. Moreover, the less pronounced and less persistent decline of the average size did not prevent Northern firms from expanding sales in the period in hand; this is due to the rapid growth of exports that followed the 1992 devaluation of the Italian lira. In the same period, in the Mezzogiorno, sales of local firms show a persistent and significant decline. As a consequence, the dynamics of the productivity of labour was negative (or stagnant) in the South, while it steadily grew in the rest of the country. Southern firms, while experiencing at the end of the period some significant progress in penetrating foreign markets, faced increased competition on the domestic market due to the contraction in aggregate demand, severely affected by the restrictive stance of the macroeconomic policy. All in all, these data illustrate the weakness (if not the worsening) of the competitive position of manufacturing firms in the South.

7.2

Productive and Financial Performance, the Pace of Capital Accumulation and the Emergence of Financial Constraints

The problems of southern firms are clearly expressed by their relative performance (tables 1a and 1b; notice that in the following analysis all the data are drawn from Medio Credito Centrale, 1999). Profitability ratios, such as ROE and ROI, show a negative evolution after 1992. This evolution has both a real and a financial explanation. We notice the relative decline in factor productivity that accompanies the reduction in the operative scale of the firms. This trend can be seen (in general and especially by firm size) considering several ratios like the per capita value added; fixed assets per employee, sales/fixed assets ratios. At the same time, there is a sharp increase in financial costs or, in general, a problematic adjustment of the ‘‘financial framework’’ that emerges from the inspection of other ratios like total financial debt/sales; the burden of debt/value added and burden of debt/ gross operating margin. Also in this case the firms with fewer than 50 employees show the most problematic performance. Looking at the real factors, both northern and southern firms show a decline in the value added as a share of sales and an increase in the labour cost/value added ratio. The labour cost per employee is stable in the South, while it is slightly increasing for northern firms. Therefore the increasing weight of the labour cost per unit of value added recorded in the South is due to the inadequate dynamics of value added as well as to the decline in sales. These compound ‘scale effects’ negatively affect the gross margin of these firms, which suffers a further reduction due to the increased financial costs. For this last aspect – which will be analyzed in greater detail below – it must be said that increasing costs go hand-in-hand with a recovery of investment activity. Therefore the worsening of the financial situation

Liquidity Constraints and Small Firms’ Growth: The Case of Southern Italy

115

might be described as temporary, inasmuch as it is the necessary condition for implementing a strategy aimed to recover competitiveness. However, it must also be said that – per se – the decline in sales and size is a powerful factor in determining, ceteris paribus, an increasing financial burden for southern firms. In this case the concern of maintaining the financial equilibrium may actually offset crucial investment processes (and this seems to apply particularly to smaller firms). Table 7.1a

Performance and structural ratios (median values) b MEZZOGIORNO 1992

1994

1995

1996

1997

ROE

4.2

4.2

4.4

4.9

ROI

9.6

7.8

9.4

9.8

8.0

OF/DFT

17.8

13.8

14.1

13.2

11.3

OF/MOL

41.8

29.7

37.9

36.4

31.6

OF/VA

16.7

12.1

14.2

13.6

11.7

VA/FATT

32.6

32.8

25,9

26.5

27,1

W/VA

63.7

66.6

59.2

61.7

63.7

VA/ADD

57.0

52.9

67.7

64.8

65.8

379.6

368.

408.2

394.1

394.4

IMM/ADD

53.2

49.6

67.8

65.1

66,5

W/ADD

35,9

34,2

39.7

39.6

41,9

DFT/FAT

27.7

22.8

18,6

19.7

21.6

FATT/IMM

4.8

CENTER NORTH 1992

1994

1995

1996

1997

ROE

5.7

13.0

17.4

13.8

12,2

ROI

11.1

13.7

19.0

16.3

13,4

OF/DFT

18.2

13.8

15.6

13.7

10.9

OF/MOL

45.6

28.4

29.0

30.7

27.7

OF/VA

14.2

9.9

11.4

10.6

9,1

VA/FATT

33.3

33.6

27.8

28.4

28,4

W/VA

69.4

66.6

59.2

64,1

66,2

VA/ADD

67.1

72.9

86.6

79,0

81,0

FATT/IMM

553.

606.4

678.4

648,7

651.0

IMM/ADD

37.1

38.1

7.1

45,0

47.8

W/ADD

46.4

48.5

50.6

50,4

52.9

DFT/FAT

23.2

18.3

15.0

13,7

15.0

b

See Legenda

Source: Mediocredito Centrale

116

Money Credit and the Role of the State

Table 7.1b

Performance and structural ratios. by dimensional classes (median values) b MEZZOGIORNO < 50 1992

51-250

251-500

1995

1997

1992

1995

1997

1992

1995

1997 6.3

ROE

5.7

3.9

4.7

0.7

4.6

4.9

0.4

7.4

ROI

11.2

10.1

8.4

5.5

8.5

6.8

5.1

7.3

6,6

VA/FATT

33.5

23.4

25.9

33,2

28.4

29.4

31,2

33,7

27.1

MOL/VA

35.2

44.5

38.6

32.4

35,4

31,4

28.5

40.0

31.0

OF/VA

14.8

15.9

12.3

15,7

13.2

10.7

11.3

16.0

10.6

OF/MOL

32.4

39.7

33.3

47,0

34.0

30.7

42.3

54.4

30.4

DFT/FATT

14.9

17.3

20.1

32.1

20,5

22.1

32.1

32.7

31.3

VA/ADD

47.8

71.9

65.5

57.7

61.4

65.7

74.9

67.7

68.5

W/ADD

31.0

38.7

40.3

38.0

39.7

45.5

43.2

44.4

52.4

CENTER NORTH < 50

51-250

1992

1995

1997

ROE

10.2

18.7

ROI

18.4

23.6

VA/FATT

34.2

251-500

1992

1995

1997

1992

1995

1997

13.0

6.0

16.3

11.2

4.0

16.3

12.0

16.1

11.4

16.4

10.6

7.9

12.7

9.9

24.4

26.2

35.5

31.7

31,6

33.9

31.7

31.2 33.6

MOL/VA

35.6

44.2

34.7

30.8

37.3

32.6

30.9

37.4

OF/VA

12.3

12.2

9,5

12.7

10.7

8.6

14.6

10.8

8.3

OF/MOL

35.4

30.1

28.9

40,0

26.8

26,7

47.9

31.8

26.4

DFT/FATT

12.0

10.4

8.3

24.2

20.3

23.2

32.0

23.6

25.5

VA/ADD

61.6

89.2

77.0

70.7

83.6

84.5

74.2

89.9

91.5

W/ADD

41.1

48.5

49.8

49.1

52.5

56.3

50.3

56.7

61.8

b

See Legenda

Source: Mediocredito Centrale

7.3

Financing Investments

Faced by increasing difficulties, southern firms showed an interesting reaction which led to a recovery of the pace of investment in the last three years analysed (1995-97) (Table 7.2). 57 per cent of these investments are in innovative equipment (against 36 per cent in the North).

Liquidity Constraints and Small Firms’ Growth: The Case of Southern Italy

Table 7.2

117

Fixed investments (per cent on sales) SOUTH

NORTH

1992

1993

1994

1992

1993

< 50 employees

3,3

2,8

2,9

4,0

12,2

1994 4,9

51-250 employees

5,6

6,5

6,2

3,5

4,3

2,7

251-500 employees

4,2

4,3

2,7

4,3

3,6

3,6

TOTAL

5.9

5,4

4,8

3,9

5,1

3,2

1995

1996

1997

1995

1996

1997

< 50 employees

9.0

5.9

9.4

10.8

11,2

11.1

51-250 employees

4.6

5.1

6,9

4.8

4,6

4.6

251-500 employees

4.5

5.4

6.2

4,5

4.0

3.8

TOTAL

5.8

5,4

7.4

6.2

6.0

6.0

Source: Mediocredito Centrale

It is worth pointing out two key aspects in this process. While in the period 1992–94, capital accumulation is mainly concentrated in the firms belonging to the 51–250 class of employees, and is particularly weak for firms with fewer than 51 employees, in the last period (1995–97) small firms show significant activism nationwide. As far as southern firms are concerned, both innovation and investment are concentrated in non-exporting firms, i.e., those that have been most affected by increasing competition in the domestic market. In terms of the source of finance for investments, Table 7.3 gives such information as well as (last row) information on the share of firms rationed on the credit market. Considering all firms, we see that in the 1992–1994 period, internal contribution, via retained profits, and additional equity capital are far less substantial sources of finance in the South (46 per cent) than in the North (64 per cent). Public subsidies (capital grants) and subsidized medium long term loans, instead, account for 18 and 21 per cent respectively in the South, against the 2 and 12 per cent in the North. On the contrary, non-subsidized loans (ordinary credit) contribute much less (5 per cent against 11 per cent) as well as other financial instruments like leasing (5 per cent against 8 per cent). Interestingly enough, these general characteristics do not apply in that period to southern firms with fewer than 51 employees, or – for relevant aspects – to the class of 51-250 employees. In fact, for smaller firms the main source of finance is represented by self-finance (54 per cent), quite unlike the situation in the North (26 per cent). As regards the contribution of equity capital, we end up with 56 per cent in the South and 27 per cent in the North. In addition, subsidized medium long terms loans are a more substantial source of finance for northern firms up to 250 employees.1 As for the percentage of rationed firms, this is at least double in the South for each size class.

118

Table 7.3

Money Credit and the Role of the State

Sources of company finance (per cent) < 50 SOUTH

Venture capital Self-financing Ordinary loans Special loans Public subsidies Leasing Tax concessions Other TOTAL Rationed firms (%)

51-250

NORTH

SOUTH

Special loans Public subsidies Leasing Other TOTAL Rationed firms (%)

NORTH

SOUTH

NORTH

1.8 53.7 1.2

0.7 25.8 3.8

0.3 47.1 3.5

2.2 57.3 10.0

0.2 45.8 2.2

2.7 63.7 12.9

5.3

7.6

18.5

19.2

28.3

11.1

19.1 18.2 0.5 0.4 100.0 10.5

0.8 60.3 0.9 0.1 100.0 5.4

20.8 6.7 1.6 1.5 100.0 10.6

2.0 7.1 1.5 0.7 100.0 4.3

16.8 5.3 1.3 0.1 100.0 7.2

2.6 2.8 0.7 3.5 100.0 4.9

< 50

Venture capital Self-financing Ordinary loans

251-500

51-250

251-500

SOUTH

NORTH

SOUTH

1.0 21.3 5.3

0.4 67.3 12.1

1.7 53.3 7.5

NORTH 2.6 41.3 19.1

SOUTH 11.1 51.3 5.9

NORTH 1.6 58.2 22.0

4.9

4.1

5.0

7.8

11.1

3.7

12.2 51.2 0.1 100.0 10.5

1.5 9.3 2.0 100.0 5.4

13.9 14.6 0.4 100.0 10.6

4.7 7.8 1.9 100.0 4.3

18.2 1.6 0.5 100.0 7.2

1.4 2.1 3.2 100.0 4.9

In the 1995–1997 period smaller firms are most dynamic (especially in the North) in terms of investment. The share of equity and retained profits is confirmed as the main source of finance in the North especially for smaller firms. In the South, this source is confirmed as the most important only for firms with over 50 employees; the second most important source of finance consists of grants, fiscal and interest incentives. Smaller firms are not in a position to meet the need to finance a larger investment by retained profits. This source is much less important than in the past in this period and more limited in absolute terms. southern firms with under 51 employees find their main source of finance in instruments – like leasing – that at the same time do not dramatically affect their liquidity position and do not entail a need for an ‘excessive’ increase in the amount of bank credit. In this respect the marginal role of ordinary credit in the South is confirmed in general and especially for smaller firms; the opposite occurs in the rest of the country.

Liquidity Constraints and Small Firms’ Growth: The Case of Southern Italy

7.4

119

Characteristics of the Financial Constraint

This evidence suggests that binding financial constraints may considerably affect investment performance of southern firms with fewer than 51 employees. In particular, further inspection of the data seems to support the idea that such firms face an atypical liquidity constraint, which limits an adequate flow of working capital and hence expansion even in a profitable business environment (as in the period from 1995–1997). Vice versa, in the next size class (51-250 employees) the financial constraint takes the more traditional form of a difficulty in funding fixed capital investment. In general, for all firms, the persistence of a more severe financial constraint in the Mezzogiorno than in the rest of Italy is confirmed. Table 7.1 shows that the debt/sales ratio is substantially higher in the South and is increasing markedly in small firms. The same is true for the ratio between financial costs (interest costs) and gross operating margin. These results are connected to the pronounced restriction of the operative scale of southern firms (Iuzzolino, 1999). In the same period the share of bank loans on total sales is falling. Within the total of bank loans, the share of short term loans is also falling, at a rate that is particularly evident in southern Italy. Taking into account the size of firms (Table 7.5), the increase in the debt burden affects mainly the first two size classes. Small firms try with some success to reduce the share of bank loans on sales, but they are much less successful in reducing short term bank debt. For medium sized firms, instead, the growth of the financial debt is accompanied by a more stable share of bank loans on total debt and by a substantial reduction of its short term component. But the worst signs for small southern firms are represented by the explosion of two crucial indicators such as total financial debt / sales, and burden of debt / value added ratios. For northern firms the increase in total debt is much less pronounced; the share of bank debt remains almost stable and all major financial ratios are under control. The common tendency in the South is debt restructuring which – especially for small and medium sized firms - aims to reduce financial needs arising from the production process: a target that small firms seem to achieve with increasing difficulty and that – as will be argued in the next section – sets the pace of their activity. To confirm this conjecture, this trend is accompanied by a greater attention of small southern firms to their liquidity position (Table 7.4 shows how the current assets / sales and current assets / current liabilities ratios are, in the Mezzogiorno, higher than in the North). This suggests that, in the period considered, the difficulty coping with increasing competition compels Southern firms to control their financial equilibrium. Greater concern with company liquidity is combined with an effort to reduce dependence on the banking system. The adjustment of the debt structure, that follows the decline of the operative scale, delivers some short term results in tackling the growth of the financial burden. However, it poses further constraints on firms’ ability to grow and to

120

Money Credit and the Role of the State

Table 7.4

Debt and liquidity ratiosb SOUTH 1992

1994

1995

1996

1997

DFT/CAP

79.4

57.0

65.3

63.0

DFT/FATT

27.7

22.8

18.6

19.7

21.6

BNCB/BNC

92.3

95.1

85.8

77.1

80.6

OF/DFT

61.6

20.3

17.5

15.4

15,4

14,0

124.9

121.5

124.9

123.8

127.3

OF/VA

16.7

12.1

14.2

13.6

11.7

ATTC/FATT

70.5

70.1

66.1

65.7

67,5

LIQUIDC

NORTH 1992

1994

1995

1996

1997

DFT/CAP

112.9

91.7

87.7

68.4

DFT/FATT

23.2

18.3

15.0

13.7

15.0

BNCB/BNC

91.4

94.6

90.9

89.2

86.8

OF/DFT LIQUIDC

74.1

21.4

16.0

17.3

15.6

12.6

122.7

120.7

118.8

117.7

117.7

OF/VA

14.2

9.9

11.4

10.6

9.1

ATTC/FATT

61.2

61.0

55.9

54.7

57.3

b

See following LEGENDA

Source: Mediocredito Centrale data

pursue a suitable investment policy. In this perspective, decline in competitiveness and financial fragility become strictly interconnected and self-maintaining phenomena. Moreover, there is also a negative effect on the perceived riskiness of the firms, with the result of making the flow of short term funds more uncertain, and making rationing of long term finance more likely to happen. Hence, firms – especially small ones – are increasingly concerned with liquidity constraints and are more compelled (often unsuccessfully) to resort to retained profits to meet their financial needs.

7.5

The Financial-Liquidity Constraint; a Simple Model and Some Macroeconomic Implications

It is now possible to propose a very simple framework which suggests how decisive the liquidity constraint may be in directly conditioning firms’ production decisions as well as – in turn – the process of investment.

Liquidity Constraints and Small Firms’ Growth: The Case of Southern Italy

Table 7.5

121

Debt and liquidity ratios for size classesb SOUTH < 50 1990

1992

51-250 1994

1990

1992

251-500 1994

1990

1992

1994

OF/MOL

42,8

50,0

56,6

18,7

21,6

17,9

10,7

21,4

8,7

DFT/CAP

87,1

93,8

101,9

98,1

94,3

100,4

83,7

138,4

108,7

DFT/FATT

27,0

27,7

32,0

34,4

38,5

39,2

27,2

40,0

37,2

BNC/DFT

94,7

94,7

82,6

93,6

81,8

79,9

86,0

82,1

84,9

BNCB/BNC

97,1

97,8

93,4

94,2

85,9

82,9

97,6

69,6

81,3

1,3

1,3

1,2

1,4

1,4

1,3

1,9

1,9

1,7

ATTC/FATT

60,3

64,7

69,2

69,4

80,6

75,0

85,8

86,8

88,8

GESTFIN

23,9

10,5

–16,9

23,9

–10,0

-83,1

31,3

5,0

8,4

LIQUIDC

NORTH < 50 1990

1992

51-250 1994

1990

1992

251-500 1994

1990

1992

1994

OF/MOL

36,6

49,9

32,5

40,3

55,9

36,6

43,2

60,7

DFT/CAP

108,7

123,9

124,9

118,9

114,9

116,1

115,6

131,0

40,8 110,7

DFT/FATT

21,5

26,6

25,5

27,5

29,0

26,7

26,4

34,7

28,7

BNC/DFT

93,7

88,2

92,4

87,1

85,1

84,6

83,8

74,9

79,4

BNCB/BNC

98,9

94,2

92,4

90,8

90,8

90,0

85,5

80,4

83,4

LIQUIDC

1,3

1,2

1,3

1,3

1,2

1,2

1,2

1,1

1,2

ATTC/FATT

58,1

61,1

60,7

64,7

66,3

63,1

60,3

73,9

72,4

GESTFIN

23,4

4,2

20,9

20,3

–1,1

21,5

25,9

-8,6

5,2

b

See following LEGENDA

Source: Elaborations on Mediocredito Centrale’s data

Let us assume that a firm resorts to debt, d, to finance its activity, y, according to a fixed proportion α. Let δ be the planned rate of growth of production. The demand for debt per unit of time will be: ∆d = δd–1 =αδy–1

(5.1)

Assume that the supply of debt follows the rule: ∆d = δd–1 – f

(5.2)

122

Money Credit and the Role of the State

where f represents a function that takes into account the risk level of the firm. For the sake of simplicity, suppose f is a function of the total amount of a firm’s debt d and of the ‘own – capital’ E (equity) that plays the role of a sort of collateral in order to moderate the firm’s risk. We therefore define µE as a bonus whose value is a direct proportion of the level of firms’ capital E and (through the value of 0 < µ < 1 exogenously determined) inversely related to the general conditions of risk (of the sector, the environment, etc.). The specific risk of the firm is relate to d and to the parameter γ. The structure of f is therefore defined by f = –µE + γd

(5.3)

This expression defines a critical level of d as a function of µ and γ and E, d* = µE/γ, for which f = 0. For d ≤ µE/γ, then, f ≤ 0 and the supply of loans is equal to, or greater than the demand. In this case the firm does not face a liquidity constraint; the planned growth of production is compatible with the available financial resources. In the opposite case (when d > d*), the availability of external resources falls progressively as d increases. In this case the available resources are less than the amount needed to finance the planned growth. Substituting (5.3) in (5.2) we have a first order difference equation: µE  1+ δ  d −  d -1 = 1 + γ + γ 1  

(5.4)

For given initial conditions and with γ ≠ δ, the solution will be: µE  d − µE   1 + δ  dt =  0 1+ γ  + γ − δ γ − δ    t

The debt grows over time in proportion that depends on h = (1 + δ)/(1 + γ). When δ < γ, h < 1, d converges to µE/(γ − δ); credit rationing prevails. The greater the difference between δ and γ, the faster is the convergence. If δ > γ; h > 1; the liquidity constraint may or may not limit the desired growth according to the size of firms’ capital E. When E > d0 [(1 + δ)t (1 + γ)t –1]/(γ − δ)/µ there is no constraint in financing the planned growth of production. Since we assumed a constant relationship between d and y, the growth profile of y coincides with that of d. When δ < γ, y converges to the equilibrium value µE/α(γ − δ) which is inversely related to α which, in turn, represents the measure of the dependence of firm production from external finance.

7.6

Conclusions

In my opinion this simple model sheds some light on the nature of the financial constraint which is particularly relevant to the idiosyncratic position of southern

Liquidity Constraints and Small Firms’ Growth: The Case of Southern Italy

123

Italian firms. But, apart from the Italian Mezzogiorno, this simple framework may apply to a more general perspective (Whited, 1992). The idea is that, rather than the lack of finance for investment projects (the main interest of the ‘rationing literature’ (Fazzari, Hubbard and Petersen, 1980; Bond, Meghir, 1994) it is worth investigating a hierarchical and – in my opinion – more severe constraint. This deals with the delicate phase represented by the opening of the monetary circuit. And, since it negatively affects the possibility to provide the necessary working capital, it also affects current production, firms’ size and – in perspective – investment decisions. As for the Italian Mezzogiorno, the microstructural features outlined above lead to some major macroeconomic implications. The fact that the effective d values are conditioned by a liquidity constraint, combined with the assumed relationship between debt and the level of sales, indicates that, at the aggregate level, national income will also be constrained. More specifically, even if the liquidity constraint does not affect the rate of growth, it will certainly affect the level of the national product.

APPENDIX LEGENDA: RATIOS OF/DFT OF/MOL OF/VA VA/FATT VA/ADD W/VA MOL/VA W/ADD IMM/ADD

Burden of debt/Total financial debt Burden of debt/Gross operating margin Burden of debt/Value added Value added/Sales Value added/Employees Labour cost/Employees Gross operating margin/Value added Labour cost/Employees Fixed assets/Employees

ROI ROE

Return on investment Return on equity

DFT/CAP DFT/FATT

Total financial debt/Equity Total financial debt/Sales

BNCB/BNC

Short-term bank debt/Total bank debt

LIQUIDIC

Current assets/Current liabilities

GESTFIN

Net income/Gross operating income

124

Money Credit and the Role of the State

Note 1

In the period under consideration, capital grants are still reserved by law almost exclusively for the realization of investment projects in southern Italian regions. Since 1994, under the new regional policy regime (Law 488), investment projects realised in several northern areas are also eligible for capital grants.

References Bagella, M., L. Becchetti and A. Caggese (2001), ‘Financial constraints on investments: A three-pillar approach’, Research in Economics, 55. Bianco, M. (1997), ‘Vincoli finanziari e scelte reali delle imprese italiane: gli effetti di una relazione stabile con una banca’, in I. Angeloni, V. Conti, F. Passacantando (ed.), Le banche ed il finanziamento delle imprese, Bologna: Il Mulino. Bond, S. and C. Meghir (1994), Financial Constraints and Company Investment, Fiscal Studies, 2, pp. 1–18. Fazzari, S.M., R.G. Hubbard and B.G. Petersen. (1988), ‘Financing Constraints and corporate investment’, Brooking Paper on Economic Activity, 4, pp. 141–206. Gertler, M. and S. Gilchrist (1991), ‘Monetary policy, business cycles and the behavior of small manufacturing firms, NBER Working Paper, no. 3892. Gertler, M. and S. Gilchrist (1993), ‘The cyclical behavior of short-term business lending. Implication for financial propagation mechanism’, European Economic Review, 2–3, pp. 623–31. Giannola, A. and D. Sarno (1996), L’analisi comparata dell’efficienza e della performance dell’impresa meridionale, Quaderno di politica industriale del Mediocredito Centrale, n. 10. Giannola, A., E. Papagni and D. Sarno (1998), Le imprese del Mezzogiorno negli anni Novanta. Caratteristiche strutturali, capacità innovativa e competitività, equilibrio produttivo-finanziario e vincoli all’attività ed alla crescita, Quaderno di politica industriale del Mediocredito Centrale, n. 24. Iuzzolino, G. (1999), ‘La struttura finanziaria delle imprese manifatturiere campane: domanda di credito, razionamento e premio di rischio’, in A. Giannola (ed.), Mezzogiorno tra Stato e Mercato, Bologna: Il Mulino, pp. 323–50. Kaplan, S.N. and L. Zingales (1997), ‘Do investment-cash flow sensitivities provide useful measures of financing constraints?’, The Quarterly Journal of Economics, 1, pp. 169– 213; Prosperetti, L. and F. Varetto (eds), (1991), I differenziali di produttività Nord – Sud nel settore manifatturiero, Bologna: Il Mulino. Sarno, D. (1999), ‘I differenziali di efficienza economica dell’impresa meridionale’, in A. Giannola (ed.), Mezzogiorno tra Stato e Mercato, Bologna: Il Mulino, pp. 143–68. Whited, T.M. (1992), ‘Debt, liquidity constraints and corporate investment: evidence from panel data’, The Journal of Finance, 47, pp. 1425–60.

Chapter 8

Weaving Cloth from Graziani’s Thread. Endogenous Money in a Simple (but Complete) Keynesian Model *

Wynne Godley

8.1

Graziani’s Thread

One of Graziani’s main themes runs as follows. In order to finance production, the entrepreneur must obtain the funds necessary to pay his workforce in advance of sales taking place. Starting from scratch, he must borrow from banks, at the beginning of each production cycle, the sum which is needed in order to pay wages, creating a debt for the entrepreneur and, thereby, an equivalent amount of credit money, which sits initially in the hands of the labour force. Production now takes place and the produced good is sold at a price which enables the debt to be repaid inclusive of interest, while hopefully generating a surplus – that is, a profit – for the entrepreneur. When the debt is repaid, the money originally created is extinguished. An entire monetary circuit is now complete. This account of the monetary circuit has a number of extremely important and distinctive features. It emphasises, in particular, that a) there is a gap in (historical) time between production and sales which generates a systemic need for finance; b) bank money is endogenously determined by the flow of credit and c) total real income must be considered to be divided into three parts – that received by entrepreneurs, that received by labour and that received by banks. We have already travelled an infinite distance from the (yes, silly) neo-classical world where production is (must be) instantaneous, where money must be exogenous and fixed and has no counterpart liability, and where the distribution of income is determined by the marginal products of labour and capital – a construction which depends entirely on the assumption that all firms sit perennially on a single aggregate neoclassical production function frontier.

8.2

Weaving Cloth from this Thread

In what follows there is not one breath of criticism of the Graziani construct, which is at once simple, elegant and fruitful. What I propose to do here is adapt the

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Money Credit and the Role of the State

model so that the main insights (as I understand them) are carried across into a world where aggregate production is a continuous set of overlapping individual processes and in which the production period can vary. I shall fill out a whole macroeconomic framework where, in a number of sequences, various stock variables (money, debt and inventories) generate and are generated by flows (incomes and expenditures). All of Graziani’s insights are retained. Table 8.1

Model transaction matrix and glossary Households

Consumption (=Sales)

Firms Current

–C

+S

+WB

–WB

Firms’ interest payments +F

Bank profits

+Fb

Change in stocks of: Money Loans Σ

Capital

–∆I

0 +rL–1

0

–Fb

0

–F

0

–∆M 0

0



0

–rL–1

Firms’ profits

Current

0

+∆I

Inventory investment Wages

Banks

Capital

+∆L 0

0

+∆M

0

–∆L 0

0

C, c = consumption F = firms’ profits

M, m = credit money n = employment

S, s U

Fb

= banks’profits

p

W

I, i k

= inventories = opening volume of inventories as proportion of sales volume = bank loans

pr r

= price of goods = productivity = nominal rate of interest

WB YD, yd

= wage bill = personal income

= real rate of interest

y

= output

L

rr

= sales = unit wage cost = wage rate

Upper case denotes values, lower case volumes. The star (*) denotes a desired quantity. Subscripts s and d denote supply and demand; h means (money) ‘held’.

I start with a transactions matrix which defines all the current price flows (occurring in some given period of time) to be used in the model and which describes the accounting relationships between them. I must make it clear that this model is far too simple to be realistic. There is, for instance, no international trade, no government, no financial asset other than credit money and no fixed investment. I am making the smallest possible model capable of embodying the

Weaving Cloth from Graziani’s Thread

127

key features I wish to illustrate. It is always possible to add more and more realistic features, but at the cost of dramatically increasing variables and equations; but this would not advance my present purpose. The matrix (see Table 8.1), following the methodology advocated by Backus, Brainard, Smith and Tobin (1980), reveals the accounting structure of the model. Its key feature is that all columns and all rows sum to zero thereby enforcing the fundamental principle that all balances between income and expenditure generate equivalent changes in stocks of financial assets and liabilities and, more generally, that ‘everything comes from somewhere and everything goes somewhere’. Without a comprehensive accounting framework of this kind, the system properties of macroeconomic models can never be securely tied down. This framework makes it mandatory, for instance, to make it explicit how investment is financed – a key process which is systematically ignored in most conventional macroeconomics. For a more elaborate case where firms undertake fixed investment as well as inventory investment, and this is financed, not just by bank loans but also by undistributed profits and issues of equity, see Godley (1996). In the following I first give the whole model written out formally and then rapidly run through it (the glossary is in Table 8.1): y = s + ∆i

(8.1)

s=c

(8.2)

∆i = γ1 (i * −i−1 )

(8.3)

i* = γs

(8.4)

y pr

(8.5)

n=

WB = Wn

(8.6)

U=

WB y

(8.7)

k=

i−1 s

(8.8)

p = (1 + λ ) U (1 − k ) + k (1 + r )U −1 

(8.9)

S = sp

(8.10)

F = S − WB + ∆I − rI −1

(8.11)

I = iU

(8.12)

Ld = I

(8.13)

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Money Credit and the Role of the State

Ls = Ld

(8.14)

M s = Ls

(8.15)

Fb = rL−1

(8.16)

YD = F + Fb + WB

(8.17)

YD ∆p m−1 − p p

(8.18)

yd =

M h = M h −1 + YD − C

(8.19)

C = cp

(8.20)

c = a0 + a1 yd + a2 m−1

(8.21)

m=

Mh p

 U  r = (1 + rr )   −1  U −1 

(8.22)

(8.23)

The production decision, provisionally assuming perfect foresight, is based on sales (entirely taking the form of consumption) plus the change in inventories, (8.1) and (8.2). Inventories are assumed to move towards some desired ratio to sales, (8.3) and (8.4). Employment is determined by output and productivity, (8.5), the wage bill by employment times the wage rate, (8.6), and unit labour costs by the wage bill divided by output, (8.7). The only tricky bit of the story concerns (8.9), the way in which prices distribute the value of sales proceeds between profits and costs. The process needs a short section to itself, which follows. Of the physical objects sold this period (s), a certain proportion, k, were made last period (8.8); the rest were made this period. The objects made, but not sold, last period (ks) constitute the stocks with which firms start the period and the unit wage cost of production of these stocks was U–1, while the unit wage cost of objects made this period ((1 – k) s) is U. It is a fundamental set of assumptions, (8.13)–(8.15), that inventories, since they involve outlays by firms in advance of sales, are always financed by loans which are extinguished when sales are made; also that there is a counterpart to every loan in the form of credit (or bank) money. Firms had loans outstanding at the beginning of the period equal to inventories valued at cost, so they have to pay interest on these loans to the banks. The total historic cost (HC), including interest, of producing what was sold this period may therefore be written H C = (1 − k ) sU + ksU −1 + rksU −1

(8.24)

Weaving Cloth from Graziani’s Thread

129

Firms’ profits are equal to the value of what they sell less the historic cost of production F = S − HC which may be written using a mark-up S = (1 + λ) H C

(8.25)

Then from (8.24), (8.25) and (8.10) we have a key identity which describes how the price implies (or is implied by) the profit mark-up on historic unit costs, i.e. equation (8.9). For the rest, the value of sales, inventories and consumption are given by (8.10), (8.12) and (8.20) while, given the price decision, profits are given by (8.11) – the residual item in column 2 of the transactions matrix. Banks are assumed to charge interest on loans outstanding, (8.16), but not to pay interest on money and this is how banks’profits are generated. Banks’profits, like firms’ profits, are all distributed to households and these receipts together with the wage bill make up nominal personal disposable income, (8.17). Real disposable income, as defined in (8.18) above, is always equal to real consumption plus the change in the real stock of money (8.22) – the only form of wealth in this model. To spell this out, note first the identity (8.19) which says that nominal money held at the end of each period is equal to the opening stock of money plus nominal disposable income less nominal consumption. Next, noting that changes in the nominal stock of money, like changes in the value of any stock variable, can be decomposed into prices and quantities, we can write ∆M = M − M −1 = mp − m−1 p−1 = ∆mp + ∆pm−1 Hence , using (8.19) and (8.20), we obtain ∆m =

YD ∆pm−1 − −c p p

The consumption function (8.21) makes consumption depend on real income and the opening stock of money (the only form of wealth in this model) plus an exogenous component. Note that since real income is defined as above the consumption function can be alternatively written as a wealth adjustment function  a  ∆m = a2  − 0 + a3 yd − m−1   a2  where a3 = (1 − a1 ) a2 , implying a long run wealth target (achieved when ∆m = 0) m* = −

a0 + a3 yd a2

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Money Credit and the Role of the State

Finally banks are assumed to adjust nominal loan rates so as to maintain real interest rates at some given level, (8.23). The model is now complete. Treating as exogenous the variables a0, rr, W, pr, and λ we have an equation in every variable – all stocks and all flows, both real and nominal. The model may be solved (given initial conditions) as a fully interdependent dynamic system evolving in a determinate way though real time. And conditional on any given configuration of exogenous variables it will reach a full steady state when the real wealth target is met (m = m*). The full steady state for output is given by y* =

a0 1 − a1 − a4

where a4 =

8.3

a0 γ

(1 + λ )(1 + γrr )

.

Some Major Implications

One conclusion of central importance may be indicated via re-perusal of the equations of the formal model, where we have one equation in the money supply generated by loans to firms, (8.15), and another in the money which households find themselves holding, (8.19) – yet there is no equation which brings the two into equivalence with one another. This equivalence is invariably and exactly guaranteed, however, by the system properties of the model taken as a whole. The use of a comprehensive double entry system, and the combination of national income concepts with flow of funds concepts, guarantees that every row and every column sum to zero (see Table 8.1). From this it follows ineluctably that as soon as every variable except one is determined, that last variable must be determined as well. And that is the position we now find ourselves in. Every row and every column is indeed determined in the model as summing to zero except row 7, which shows the supply of money and money holdings, each determined by a different process. Yet because all other rows and columns sum to zero, it follows that there is neither need nor place for an equation to make these two numbers equal to one another; the system ensures that this is invariably and exactly true. This conclusion confirms the view reiterated endlessly by (for instance) Kaldor, Wray and Moore. The necessary equivalence of money created with money held gains a new dimension, augmenting the theoretical foundations of monetary theory in a very fundamental way, when expectations are introduced into the story. Suppose that (as in reality) firms do not know exactly what their sales are going to be, and that therefore they base their production decision on expected sales and intended inventory changes. To the extent that sales expectations are not fulfilled,

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131

inventories will take the rap – they will differ from their intended values to the extent that realised sales differ from expected sales, and the amount of loan finance will be comparably different as well. Then next period, starting from a position in which inventories are out of kilter, too high or too low, the production decision will be modified to take account of this. The firm will thus be responding to quantity signals when making its key decisions, not price signals. No elaborate theory of expectations is needed to underpin this account, as mistakes are quickly remedied as a result of the palpable fact that inventories have turned out to be excessive or inadequate. A very similar story may be told about the consumption and the implied intended end-of-period money holdings by households. The consumption decision has to be taken in partial ignorance of what real income is going to be. If income turns out to be different from what was expected, then the accumulation of money (wealth) will be different from what was intended to an equal extent. It is the unexpected accumulation or depletion of the stock of money (perhaps a letter from the bank manager) which gives a quantity signal to the household that it must modify its consumption behaviour. Note that in each case (that of producers and that of consumers) we have, by introducing the notion of unintended stocks, abolished the need for the equilibrium conditions (or disequilibrium conditions) which are so fundamental to the traditional neo-classical theory. Producers themselves set prices; they do not need to know a hypothetical price which will bring aggregate demand into equivalence with aggregate supply. And households will invariably be found to be holding that amount of money which is created by the need for business finance. As already mentioned, there is neither need nor place for an equilibrium condition which makes the ‘demand’ for money (whatever that may mean) equal to the supply, and which determines the rate of interest in the process. And while, in this model, expectations take on a centrally important theoretical function, their practical importance is not very great because mistakes are easy to rectify. The destruction of the key equilibrium condition used by neo-classical authors by including inventory investment in the demand/supply equation was emphasised by Hicks (1989). A second major implication of the equations in this model is that with only a small number of further steps we may derive an expression which precisely describes the distribution of the real national income between the three major sectors. First define the rate of cost inflation, πw =

U −1 U −1

and the real rate of interest defined with respect to cost inflation

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Money Credit and the Role of the State

rr =

1+ r −1 1 + πw

These two equations may be substituted in the price equation (8.9) to obtain p = (1 + λ )(1 + krr )U

We may now divide by p and multiply by y, real output, to obtain an expression which precisely decribes the division of real output (or income) between real profits, the real wage bill (wb = WB/p) and the real income of banks, the creditors of the system – all in one single period of time y = (1 + λ )(1 + krr ) wb

This equation, although in itself nothing more than an accounting identity, is extremely useful when it comes to analysing the distribution of income, both empirically and theoretically. No one of these shares can change without the sum of the other two changing by an equal amount; and no pair of shares can change without there being a precise implication for the third. If the profit mark-up could be fixed, rather as an indirect tax rate can be fixed, and if banks could adjust the nominal rate of interest on loans so that the real rate (as defined here) remained fixed, it would follow that the nominal wage bargain is completely impotent as a means of changing real wages; the real wage bill would simply be a residual. Alternatively if the profit mark-up had to be adjusted in such a way that prices remain constant, as a result, say, of foreign competition, then we have a way of gauging the effect of nominal wage changes both on real wages and on real profits. This description of income distribution may also be useful for the analysis to which Graziani has given considerable amount of thought (see Graziani, 1985) of the interaction between the aspirations of the three sectors to collar various shares of real income and the way in which inflation resolves conflicts between them.

8.4

Conclusion

In this chapter, starting from the ‘monetary circuit’ theory of how and why credit money is generated, I have taken a single step towards the incorporation of its insights into the simplest imaginable macro-economic model which is yet complete in the important sense that all rows and all columns of the transactions matrix sum to zero. One important conclusion is that it is impossible for the supply of money to differ from the amount of money which people want to hold, or find themselves holding, without either the need or the place for any mechanism to bring this about.

Weaving Cloth from Graziani’s Thread

133

Note *

I am grateful to Ken Coutts, Carluccio Bianchi, Marc Lavoie and Gennaro Zezza for comments on an earlier draft.

References Backus, B. and T. Smith (1980), ‘A model of US financial and non-financial economic behaviour’ Journal of Money Credit and Banking, 12. Godley, W. (1996), ‘Money, finance and national income determination: An integrated approach’, Working Paper No.167, Levy Institute Graziani, A. (1985), ‘Interet monétaire et interet réel’ in Production, circulation et monnaie Paris: Presses Universitaires de France Hicks, J.R. (1989), A Market Theory of Money, Oxford: Clarendon Press.

Chapter 9

Circuit and Coherent Stock-flow Accounting Marc Lavoie

9.1

Introduction

I saw and heard Augusto Graziani for the first time at the Trieste Summer School, where he lectured in 1984. I was then shocked to discover that economists from outside France also held ideas that were closely related to those presented by the various schools of the monetary circuit in France, usually associated then with the names of Alain Parguez, Frédéric Poulon, and Bernard Schmitt. Others before me had made a similar observation, since Graziani, along with many of his younger colleagues and students, had participated in a conference organized in early 1984 at the University of Nice (Arena and Graziani, 1985). This conference was devoted to the circulation approach to money, which the circuitistes and other heterodox economists, from Nice and inspired by the classical tradition in particular, were putting forth as an alternative monetary economics. Indirectly, this conference eventually led to another, similar conference, at the Jerome Levy Economics Institute in 1991, where the circulation approach was confronted with its sister Post-Keynesian view of money, thus giving rise to Money in Motion (Deleplace and Nell, 1996), of which Graziani (1996) was a contributor. At the time where I first met him, Augusto Graziani was engaged into a debate on the appropriate definition of the finance motive. Graziani (1984) made the point that the finance motive applied to all production, and not just investment expenditures, and that the finance motive was relevant to the value of production, and not just to a change in the value of production. This is in contrast to what Keynes himself said in his first article on the finance motive and it also contradicts the usual post-Keynesian interpretation of the finance motive, as can be found for instance in the writings of Paul Davidson.1 In a sense, one can say that the finance motive is the topic of the present chapter. My main goal is to show how money creation arises when there is some new economic activity, following Graziani’s description of this process. The monetary circuit put forth by Graziani will be described and formalized by making use of a method which has been advocated by Wynne Godley (1996, 1999), based on a matrix presentation of the transaction flows and financial stocks. Although Godley himself never attempted to describe the monetary circuit by

Circuit and Coherent Stock-flow Accounting

135

making use of his matrices, he is fully aware that his matrix approach is consistent with the monetary circuit approach developed by Graziani and the French circuitistes. Indeed, Godley presented three lectures on time and credit money, in 1988, at the University of Naples, at the invitation of Augusto Graziani (Godley, 1993, p. 79). There is a clear interaction between these two authors: Godley (1999, p. 404) uses the work of Graziani (1990), and Graziani (2001, p. 11) refers to Godley and Cripps (1983). The outline of the chapter is the following. In the next section, the monetary circuit as outlined by Graziani will be recalled, and the principles of the framework put forth by Godley are being presented. In the third section, a simple example, without government debt but with private money, is being discussed. This will be closest to the Wicksellian pure credit economy that Graziani himself focused upon. In the fourth section, government debt is introduced, first without banks, then within the context of the overdraft economy. Some implications regarding some post-Keynesian controversies are drawn as we move along.

9.2 9.2.1

The Monetary Circuit and the Stock-flow Approach The Monetary Circuit

Graziani’s theory of the monetary circuit, although officially presented in Graziani (1989, 1990), was already clearly outlined in his 1984 finance paper (Graziani, 1984). There, Graziani (1984, p. 7) makes clear that a pure credit economy should be analysed with the help of three sectors: firms, households, and the banking system. These are the three sectors that we shall use in our first matrix. For Graziani (1984, p. 9), ‘the economic process gets started as the banking sector grants credit to firms’. This Graziani calls financement to distinguish the initial credit finance of production from the end-of-period final finance, which corresponds to the placements of the savings of households – as Joan Robinson (1956, p. 8) used to call them – and to the retained earnings of the firms. The initial financement is also called construction finance by Paul Davidson (1982, pp. 48–9), while the end-of-period final finance is called investment funding. For Graziani, the initial liquidity arising from the financement must cover ‘total production costs, namely the costs of producing both consumption and capital goods’. As a result, ‘consumption and investment are equal, the production of both requiring an amount of initial finance such as to cover total money costs’. This initial finance is the additional bank debt that production firms must take on. We shall see that this first stage of the monetary circuit – the money-creation stage or the flux stage – can be formalized with the help of Godley’s matrices. The second stage of the monetary circuit is the money-destruction stage, or the reflux stage. This is where final finance, or investment funding is involved. In this second stage, households spend their income on consumption goods and purchase securities on the financial markets. These two money flows allow production firms

136

Money Credit and the Role of the State

to repay part of their bank debt. As Graziani (1992, p. 218) says, ‘clearly at this point the role of financial market is not one of collecting savings in order finance investment, but rather one of making it possible for firms to repay their bank debts’. It should be noted that production firms will be unable to repay the entire amount of their new bank debt as long as households decide to increase their money balances. Graziani (1992, p. 218) is crystal clear on this issue: ‘It is the decision of savers to keep part of their savings in money form that forces firms to ask for bank credit. In other words, the demand for deposits gives rise to a demand for loans. This result contrasts with the conventional presentation according to which deposits do not act on the demand side, but rather increase the potential supply of loans on the part of the banks’. This means that, at the beginning of the monetary circuit, the production decisions of firms lead to the creation of a flow of money balances: credit makes deposits. ‘The decision of a bank to grant a loan gives rise to the simultaneous appearance of a deposit.... Banks...do not, and could not, collect deposits without having previously granted loans’ (Graziani, 1992, p. 218). However, at the end of the period, it is the portfolio decisions of the households that set the existing amount of money in the system. The causality becomes reversed. The stock demand for deposits determines the amount of outstanding loans. The more deposits households wish to hold, the more firms will be unable to repay their bank debt, being forced to ask the banks for a renewal of the additional loans that were initially consented to them. As Graziani (1984, p. 10) points out, an important time interval will occur between the first and the second stage of the monetary circuit. Between the time money is created and destroyed, various operations will be performed. In fact, between the beginning of the period (year) and the end of the period (year), production, payments, and sales will occur. ‘This implies the existence of a certain amount of idle liquidity somewhere in the circuit’. To this idle liquidity will correspond the inventories, which on average, remain on hand. 9.2.2

The Stock-flow Approach

A clear implication of Graziani’s monetary circuit is that money is endogenous and cannot be exogenous. The very same claim arises from Godley’s analysis of a monetary economy. This conclusion arises from a fully coherent accounting framework, to which are superposed behavioural equations that get the models running. A key factor is that Godley’s accounting framework provides a general fully-coherent tool, which takes into consideration the various interdependences that link income flows to changes in financial assets. Godley’s monetary economics enlighten the so-called circulation approach to money that has been advocated by Graziani, his students and the French circuitistes (Graziani, 1990).

Circuit and Coherent Stock-flow Accounting

137

Godley’s (1996, 1999) monetary approach, which complements the circuit approach, is based on a transactions flow matrix that has the following key features. All the rows must sum to zero: they represent the flows of transactions for each asset or for each kind of flows; in addition, all the columns, each representing a sector, must sum to zero as well: they represent the budget constraint of each sector. Within this framework, the budget constraints for each sector describe how the balance between flows of expenditure, factor income and transfers generate counterpart changes in stocks of assets and liabilities. These accounts are comprehensive in the sense that everything comes from somewhere and everything goes somewhere. Without this armature, accounting errors may pass unnoticed and unacceptable implications may be ignored. With this framework, ‘there are no black holes’ (Godley, 1996, p. 7).2 Now a feature of the transactions stock matrix used by Godley, and first proposed by Backus et alii (1980), is that if there are N rows, then there are only N – 1 independent equations. This means that the Nth equation can be left out of the analysis. This is highly reminiscent of Walras’s Law, and indeed some authors present this feature in light of Walras’s Law. Within standard models, it is usually ascertained that the bond market (or the equity market) will be left out, and that the search for supply and demand equilibrium will be conducted in the money market. This choice is not without consequences. What the money market stands for is not always clear. For instance, when money is assumed to be bank deposits, what is the supply function for deposits, i.e., ‘in what manner do banks supply demand deposits?’ (Goodhart, 1984, p. 268). In what manner can we say that the supply for and the demand of bank deposits are different from each other? It seems clear that it is much more sensible to leave out the so-called money market, and to speak of a demand and supply on the securities market, or to speak of demand and supply on the equities market, assuming equilibria on these markets are reached quasiinstantaneously by fluctuations in asset prices.

9.3 9.3.1

A Simple Model with Private Money The Transactions Flow Matrix

Take as a first example the transactions flow matrix of Table 9.1. This matrix can be found in Lavoie and Godley (2001-2002) where it describes the accounting of a growth model. There is no government sector and no central bank, as in the Wicksellian pure credit model favoured by Graziani. Here the banking sector has been restricted to its most simple form: it is assumed that the banking sector makes no profit whatsoever. This implies that the rates of interest on loans and deposits are the same, or it implies that the profits made by the banks are entirely redistributed to the households (although banks do not issue equity!). The production sector is more realistic: it has undistributed profits and it issues shares. Households receive wages, dividends and interest payments, which they can either

138

Money Credit and the Role of the State

consume or use to purchase new assets. As in all such transactions flow matrices, all rows and all columns sum to zero. The rows describe the nominal amounts which are being exchanged from one sector to another. Similarly, the columns sum to zero and represent the budget constraint that each of the sectors must respect. Table 9.1

Transaction matrix with private debt Firms

Households

Current Consumption

C

Investment

+I +W

W

Net Profits

+ FD

 (FU + FD)

Current

I

in loans

0

+ FU

0 + rlL(–1)

0

 rmM(–1)

0

+ L  M

Issue of equities

 epe 0

 L

0

+ M

0

+ epe 0



0

+ rmM(–1)

in money

Capital

0

 rlL(–1)

Interest on loans



Capital

+C

Wages

Interest on deposits

Banks

0

0 0

0

0

Take the perhaps less obvious case of the production sector. This sector is subdivided into a current account and a capital account. Both accounts must sum to zero. All variables with a plus sign represent a source of funds; all variables associated with a negative sign represent the use of funds. In the current account, the flows of funds arising from the sales of consumption goods and of investment goods must equate the payments on wages, interests and dividends, plus the sums that the corporations can set aside for themselves – the undistributed profit. In the capital account, the additions to the stock of capital, fixed capital and inventories, must be financed by undistributed profit, share issues, and new borrowing from the banks. The matrix serves to illustrate some well-known claims by some postKeynesians and circuitistes such as Graziani regarding credit and money. The first claim is that the demand for and the supply of money are necessarily equal; the second claim is that the amount of loans supplied by banks to firms must necessarily be equal to the amount of deposits held by households (in a simple model). The matrix of Table 9.1 clearly shows that this cannot be otherwise. The question is, what is the mechanism that will allow such an equality? This question has puzzled various authors (e.g., Goodhart, 1984, pp. 232–3) for some time now, for apparently the demand for money and the supply of credit are determined by two independent mechanisms. In the Lavoie and Godley (2001-

Circuit and Coherent Stock-flow Accounting

139

2002) model for instance, the demand for credit, at the end of the period, depends on the part of investment expenditures which has not been financed by retained earnings and new equity issues. On the other hand, the demand for money deposits is determined by a Tobin-like portfolio mechanism, where the demand for money and the demand for equities depend on a given proportion of expected wealth, modulated by expected income, the rate of interest set by banks, and past rates of return on equities.3 In obvious notations, the equations are as follows: *

Md Yhr* * = − λ + λ − λ + λ (1 ) r r 0 1 m 2 e 3 V* V* ( pe .ed )* Y* = λ 0 − λ1rm + λ 2 re* − λ 3 hr* * V V

The notations are the following: pe is the price of equities, ed is the unit number of equities which are demanded; Yhr* is the expected regular income, V* the expected wealth, rm is the rate of interest on money deposits – set at the start of the period, and re* is the expected rate of return on equities – which includes both the dividend yield and the capital gain; the ’s are parameters, with 0 representing the share wealth that households would like to hold in the form of equities if the rates of return and the income level played no role. The fact that these mechanisms appear to be totally independent has led some authors to claim that there could be a discrepancy between the amount of loans supplied by banks to firms and the amount of bank deposits demanded by households. This view of the money creation process is however erroneous. It omits the fact that while the credit supply process and the money holding process are apparently independent, they actually are not, due to the constraints of coherent macroeconomic accounting. In other words, the decision by households to hold on to more or less money balances has an equivalent compensatory impact on the loans that remain outstanding on the production side. 9.3.2

The Matrix and the Monetary Circuit

The transactions flow matrix will help to understand how exactly the monetary circuit functions. Suppose, as we did in our model, that firms distribute wages in line with production, that dividends are distributed according to past profits, and that interest payments, as shown here, depends on the past stock of deposits and on a rate of interest administered by the banking system. Suppose further, as was explained in the first section, that firms borrow, at the beginning of the production period, the amount needed to pay the wages of the current period. This is, as the Graziani and the circuitistes say, the first step of the monetary circuit (Lavoie, 1992, p. 153). Note that it does not matter whether the payments are made for consumption or investment goods.

140

Money Credit and the Role of the State

Thus in the first step of the circuit, both the loans and the deposits newly created by the banking system belong to the production sector. This situation however, can only last for some split moments. Firms only draw on their lines of credit when they are required to make payments. Very soon, the deposits of the firms are transferred by cheques or electronic payment to the workers who provided their labour to the firms. The moment these funds are transferred, they constitute households’ income. Before a single unit is spent on consumer goods, the entire amount of the bank deposits constitutes savings by households. This is all shown in Table 9.2. The matrix requirement that all rows and columns must sum to zero makes clear the requirements of first step of this monetary circuit. The unsold production – the increase in inventories – must necessarily rise by an amount equal to the production costs, the wages paid W.4 This means that investment (in inventories) in the current account of firms is equal to the value of wages. On the side of the capital account, it is clear that the value of this investment in inventories must be financed by the new loans initially fetched for. Table 9.2, contrasted with Table 9.1, helps to understand the distinction between initial and final finance which has been so clearly underlined by Graziani (1984). Table 9.2

The monetary circuit with private money Firms

Households

Banks

Current

Capital

+I

I

Current

Capital

Consumption

0

Investment Wages



+W

0

W

0

Net Profits

0

Interest on loans

0

Interest on deposits

0

in loans in money

+ L  M

 L

0

+ M

0

Issue of equities 

0 0

0

0

0

0

0

Table 9.2 also spells out the triangular relationship between firms, banks and households at the very moment money is being created to pay out wages, as it has been emphasized by some circuitistes (Gnos and Rasera, 1985, p. 50, but also Parguez and Seccareccia, 2000, p. 101). As Graziani (1992, p. 218) points out, ‘The moment a firm makes its first payment (for instance the payment of wages), money is created as the simultaneous debt of the firm towards the bank (bank

Circuit and Coherent Stock-flow Accounting

141

deposit). Typically, a monetary payment gives rise to a triangular debt and credit relationship among agents (the bank, the payer and the payee), while it does not create any direct relationship between the two non-banking agents’. The transition from Table 9.2, which represents the first step of the circuit, to Table 9.1, which represents the second and last step of the monetary circuit, is accomplished by households getting rid of the money balances acquired through wages, and the additional money balances received on account on their dividend and interest payments. As the households get rid of their money balances, firms gradually recover theirs, allowing them to reimburse the additional loans that had been initially granted to them, at the beginning of the period. Firms decide on the amount of new equities they will issue, es, but they cannot decide on the price pe that these new issues and the existing ones will carry. This will be decided by the confrontation, on the market for equities, between the total supply (old and new) of equities and the demand for such equities arising from the proportion of their expected wealth that households would like to keep in the form of equities. The key factor is that, as households increase their consumption, their money balances fall and so do the outstanding amount of loans owed by the firms. Similarly, as households get rid of their money balances to purchase newly-issued equities by firms, the latter are again able to reduce their outstanding loans. In other words, at the start of the circuit, the new loans required by the firms are exactly equal to the new deposits obtained by households. Then, as households decide to get rid of their money balances, the outstanding loans of firms diminish pari passu.5 Although determined by apparently independent mechanisms, the supply of loans to firms and the holdings of deposits by households cannot but be equal. 9.3.3

Credit Rationing and the Principle of Increasing Risk

The comparison of Tables 9.1 and 9.2 and the fundamental distinction between initial finance and final funding also allows to clear up another debate within postKeynesian theory. Various authors have claimed that the circuitistes and some theorists of endogenous money (the so-called Horizontalists à la Moore and Kaldor) have tended to ignore the issues raised by credit rationing or credit constraints imposed by banks.6 An excellent presentation of a post-Keynesian view of credit rationing, compatible with the present arguments, has been provided by Wolfson (1996). Wolfson points out that banks face a notional demand for credit. Banks however are only concerned with credit-worthy customers. They will grant credit to all credit-worthy borrowers. The demand for credit of these credit-worthy customers constitutes the effective demand for credit (Lavoie, 1992, p. 177; 1996, p. 207). The production that will actually be carried in Table 9.2 depends on the credit-worthy status of the producers. They will be able to go ahead with their production plans only insofar as they are credit-worthy, and in the case of the production of investment goods, only insofar as the customers who have ordered

142

Money Credit and the Role of the State

these goods can provide financial guarantees that they will be able to honour their orders. Credit constraints thus appear at the stage of initial finance (as in Table 9.2), not at the stage of final funding (as in Table 9.1). The credit constraints will imply a restrained level of production. In a growth model, they will imply a restricted amount of capital accumulation by entrepreneurs, and hence credit restraint is incorporated within the investment function, with the later being sensitive to debt ratios or the weight of debt payments for instance. This justifies the assumption, made for instance in Lavoie and Godley (2001-2002), that the credit requirements of firms, as they appear at the end of the period, as shown in Table 9.1, are always fulfilled by banks. In other words, as pointed out by Godley (1996, p. 8), the change in bank loans are the residual source of finance. Bank finance is a buffer. The initial finance provided by banks to allow production, as in Table 9.2, is in all cases larger than the final funding requirements of firms at the end of the period, as described by Table 9.1. If finance has been granted to start the production process, problems of credit restraints cannot arise at the end of the accounting period. 7 Credit rationing can only arise at the beginning of the next period. And indeed, this is how it appears in the Lavoie and Godley (2001-2002) model. If households decide to hold a larger proportion of their wealth in the form of money deposits, the debt ratio of firms will be larger and this will slow down the rate of accumulation, either because of borrower’s risk or because of lender’s risk. Thus, as Graziani (1992, p. 220) correctly points out: ‘Money as a form of wealth becomes relevant when the determination of aggregate demand is considered. Here Keynesian analysis is crucial in that any accumulation of idle balances, by increasing the debt of firms towards the banks, may cause a decline in demand’. An additional mechanism could be incorporated within the model, whereby the interest rate on loans is raised whenever the debt ratio of firms rises. But this mechanism, in line with Kalecki’s principle of increasing risk, would not necessarily generate the expected results at the macroeconomic level. This is because the model shows that faster growth does not necessarily induce higher debt ratios. There are thus very close links between the theory of credit rationing espoused by Wolfson (1996) and the insights that arise from the theory of the monetary circuit. Wolfson (1996, p. 451) makes very clear that a theory of credit rationing based on Keynesian uncertainty relies on asymmetric expectations between lenders and borrowers, i.e., between banks and production firms. But Graziani (1990, p. 30) is just as clear and is of the same opinion: ‘In the General Theory it is in fact implicit that banks and firms share the same short-term expectations regarding aggregate demand.... Such similarity of expectations between banks and firms is unknown to the theory of the circuit. The theory revives instead the role of the Schumpeterian banker, on whose evaluations the destinies of the firm depend’.

Circuit and Coherent Stock-flow Accounting

9.4 9.4.1

143

A Model with Government Money A Two-Asset Model

We now consider another simplified economy, based on a service economy, with no investment by firms. The production sector does not go into debt and consequently there are no private banks. There is however a government sector, with a central bank. When government must finance its deficit, it issues Treasury bills B, short-term assets the price of which is assumed to be fixed to unity, and which convey an interest payment of rb. These bills are purchased by the central bank and by the public, i.e., the households. The public has the choice between holding government notes, i.e., (high powered) money H issued by the central bank, or interest-earning assets – the Treasury bills. Once again the national accounting of the transaction flows is provided within the framework of a matrix, given by Table 9.3, where all rows sum to zero and where all columns do likewise.8 It can be seen in particular, that since the central bank is collecting interest payments on its stock of bills, while paying out no interest on the notes that it issues, it will be making profits. It is assumed, in line with current practice, that the profits realized by the central bank are being reverted to the government sector. Table 9.3

Transaction matrix with government debt Households

Firms

Government

Central bank Current

Consumption

C

Government expenditures GDP (wages and profits of firms) Interest payments

+Y + rBh–1 T

Change in money

 H

Change in bills

 Bh



0

0 G

0

Y

Central bank profits Taxes

Capital

+C +G

0 rB–1

+ rBcb–1

0

+ rBcb–1

 rBcb–1

0

+T

0 + H

+ B 0



0

0

0

 Bcb

0

0

0

In the model developed by Godley, the central bank sets the rate of interest rb of its choice on Treasury bills. On the basis of this rate, households decide of the proportion of their wealth which they wish to hold in the form of bills and in the form of cash money, with the help of Tobin-like portfolio equations similar to those of the previous section.

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Money Credit and the Role of the State

How is it that the central bank is able to sustain a fixed rate of interest, whatever the demand for securities of the public, and whatever the fluctuations in the government deficit? The answer lies in the accounting constraints of a fully coherent macroeconomic model and in the assumed behaviour of the central bank. If the households now desire that a larger proportion of their wealth be held in the form of bills, the central bank will restrict its own demand for bills or even will sell the demanded bills on the open market. Reciprocally, if households have high liquidity preference and wish to get rid of their bills holdings, the central bank will purchase the offered bills. In other words, the central bank clears the market at the price of its choice, by providing an endogenous demand for bills, which is equal to the difference between the supply of bills resulting from past government deficits and the demand for bills arising from the household sector. In net terms, as Godley puts it, i.e, when the central bank is integrated to the government sector, the supply of bills by the integrated government sector is endogenous and equal to the demand of the public. As in the previous model, when the adequate behavioural equations have been added, there is no need for any equation requiring that Hd = Hs. Once the bill market has been taken into consideration, the so-called money market drops out of the picture. In the computer model, introducing this equation would make the model over-determined, and the model could not solve. There just cannot be any excess supply of money. This contrasts with the standard view, where the bill rate is endogenous and the money supply exogenous. In the standard story – as told for instance by Tobin (1982, p. 182) and Backus et alii (1980, p. 267) but also by heterodox authors Franke and Semmler (1991, p. 340) – the central bank (or government) decides arbitrarily on the proportion of the deficit that will be financed by bill issues and by the creation of high powered money. In the models of these authors, this proportion is an exogenous variable. This is the crucial difference between the circulationist view and the neoclassical one. In the circulationist or post-Keynesian view, cash is provided to the public on demand. The government, or the central bank, does not decide in advance on the proportion of the deficit that will be ‘monetized’. This proportion depends on the portfolio decisions of the households, at the rate of interest set from the onset by the monetary authorities. 9.4.2

The Monetary Circuit Again

The steps of the monetary circuit can once again be used to help understand how money creation and government deficits are being related to each other. At the beginning of the circuit, the government orders the production of some goods to the private production sector. Once these goods have been produced, they must be purchased by government. To do so, the government issues new bills, which are purchased by the central bank. The counterpart of these securities, in the books of the central bank, is the amount of high powered money credited to the government account. This money will circulate, first to pay the firms, which will in turn pay

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145

wages to their workers and remunerate their owners. The money balances so created will thus wind up in the deposit accounts of households.9 All this is illustrated with Table 9.4. Once again, all rows and columns must sum to zero. Before households decide what to do with their newly acquired money balances, spending them on consumption or acquiring interest-earning assets, all accounts must balance. As a consequence, the deficit cannot but be ‘monetized’ initially, in line with what neo-chartalist post-Keynesians have been recently arguing (Wray, 1998, ch. 4-5; Mosler and Forstater, 1999). Once households revise their demand for bills, in line with their new expectations with regards to income and wealth, and in line with the rate of interest on bills set by the monetary authorities, the additional demand for bills by households must be accommodated by the central bank, if the central bank is to keep the interest rate at its target level. The central bank must sell to the households the securities that they lurk for, and by so doing, the central bank will absorb the money balances that households do not wish to hold. Table 9.4

The monetary circuit with a government deficit Households

Firms

Government

Central bank Current



Capital

Consumption Government expenditures GDP (wages and profits of firms)

+G +Y

G

0

Y

0

Interest payments Central bank profits Taxes Change in money

 H

Change in bills 

9.4.3

0

0

+ H

0

+ B

 Bcb

0

0

0

0

The Monetary Circuit in an Overdraft Economy

The model discussed above is illustrative of an asset-based financial system, which can be found in its purest form in Anglo-saxon countries. Most financial systems in the rest of the world, however, are instead overdraft financial systems, where commercial banks are often in debt vis-à-vis the central bank, being forced to ask for advances from the central bank. The impact of government expenditures can also be assessed in such an overdraft system. Table 9.5 provides such an illustration. Here, commercial banks have been reintroduced, along with the central bank. For simplification, only the relevant rows and columns have been included. For instance the current accounts of banks and the central bank have been omitted.

146

Money Credit and the Role of the State

The overdraft economy shown here may also have some relevance to the situation of national governments within the European Monetary Union. In Europe, the private banking sector overall is indebted vis-à-vis the central banks. In addition, the prevailing rules forbid national central banks and the European Central Bank (ECB) from directly financing the expenditures of central governments. As a result, at least when they run deficits, central governments must either sell securities to private financial institutions or they must obtain loans from commercial banks (Lavoie, 1992, p. 167). In Table 9.5, it has been assumed that banks grant loans to governments when they make their expenditures. Table 9.5

The monetary circuit in an overdraft system Households

Govt. exp. GDP

+Y

Deposits

- M

Cash

- H

Firms

Government

+G

-G

0

+ M

0 + H

Advances 0

*

0

+ L

0

Central bank

-Y

Loans

*

Banks

0

- L

0 0

+ A

- A

0

0

0

0

As in Table 9.4, Table 9.5 illustrates the initial impact of government expenditures from a monetary circuit point of view. As can be seen in the Government column, G = L, meaning that the entire expenditure is financed by a bank-issued loan. Firms get paid for providing the services to government, and the flow of revenue reverts to households G = Y. Before households decide to consume their income, it is assumed here that they split their money income into money deposits M and cash money (government banknotes) H. As a result, commercial banks must obtain banknotes from the central bank, to provide the households with the banknotes that they wish to hold. To do so, banks ask for advances from the central bank, A = H. Commercial banks are thus in debt visà-vis the central bank.

9.5

Conclusion

The purpose of the present chapter was to show that the systematic use of transactions-flow matrices, which insure that nothing has been left out hanging in the air and that all interdependences have been taken into account, a method advocated by Wynne Godley, provides coherence and formalism to the theory of the monetary circuit, espoused by Augusto Graziani. Taken by itself, the

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transactions flow matrix tells us what results occur by the end of the period. The theory of the monetary circuit allows to tell a causal story: it helps us to understand how economic activity arises, and how it is financed at the beginning of the period. There are great advantages, I believe, in combining the two methods, as it has been attempted here. Many questions which have been of concern to circuitistes and to post-Keynesians, for instance the role of bank profits and the impact of interest rates on money creation, most probably can be answered by using this framework.

Notes 1

2 3 4 5 6 7 8 9

For a recent assessment of the finance motive, see Rochon (1997). See also Rochon (1999), Parguez and Seccareccia (2000), and Figuera (2001) for a more general assessment of circuit theory and Graziani’s view of it. Bossone (2001) provides an analysis of the monetary circuit for a more mainstream audience. Similarly, the better-known balance-sheet matrix may also be put in place, although, the zero-sum requirement is replaced by the requirement that the total of the rows and the total of the columns sum to the value of tangible capital. The adding up constraint in this case is that the sum of money and equities ought to equal wealth. Note that it is assumed as well that the new fixed investment goods have not yet been sold to the corporations which ordered them. There is some resemblance with Moore’s (1997, p. 426) point that ‘depositors can only «supply» banks with deposits if they have somehow previously acquired them’. I have presented a brief rebuttal of these assertions (Lavoie, 1996), and Bertocco (2001) shows in great detail that Kaldor took credit rationing into account. A similar argument was already made in Lavoie (1985, p. 76), but without the strength of the matrix approach advocated here. The model of Table 9.4 is basically Model 2 of Godley (2000), with the explicit addition of a central bank. If some income tax were payable at the source, only a net amount of money balances would remain. In other words, under these conditions, only the deficit, rather than the entire government expenditure, would be initially financed by money creation.

References Arena, R. and A. Graziani (eds), (1985), Production, circulation et monnaie, Paris: Presses Universitaires de France. Backus, D., W.C. Brainard, G. Smith and J. Tobin (1980), ‘A model of U.S. financial and nonfinancial economic behavior’, Journal of Money, Credit, and Banking, 12(2), May, pp. 259–93. Bertocco, G. (2001), ‘Is Kaldor’s theory of money supply endogeneity still relevant?’, Metroeconomica, 52(1), pp. 95–120. Davidson, P. (1982), International Money and the Real World. London: Macmillan. Deleplace, G. and E.J. Nell (eds), (1996), Money in Motion: The Post Keynesian and the Circulationist Approaches, London: Macmillan.

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Figuera, S. (2001), Théorie monétaire dans l’économie capitaliste, Paris: L’Harmattan. Franke, R. and W. Semmler (1991), ‘A dynamical macroeconomic growth model with external financing of firms: A numerical stability analysis’, in E.J. Nell and W. Semmler (eds), Nicholas Kaldor and Mainstream Economics: Confrontation or Convergence?. London: Macmillan, pp. 335–59. Gnos, C. and J.B. Rasera (1985), ‘Circuit et circulation: une fausse analogie’, Cahier de la Revue d’économie politique, pp. 41–57. Godley, W. (1993), ‘Time, increasing returns and institutions in macroeconomics’, in S. Biasco, A. Roncaglia and M. Salvati (eds), Market and Institutions in Economic Development: Essays in Honour of Paolo Sylos Labini. New York: St. Martin’s Press, pp. 59–82. Godley, W. (1996), ‘Money, finance and national income determination: An integrated approach’, Jerome Levy Economics Institute of Bard College, WP No. 167. Godley, W. (1999), ‘Money and credit in a Keynesian model of income determination’ Cambridge Journal of Economics, 23(2), pp. 393–411. Godley, W. (2000), Monetary Economics, Draft of a manuscript, Jerome Levy Economics Institute, Bard College, February. Godley, W., and Cripps, F. (1983), Macroeconomics, London: Fontana. Goodhart, C.A.E. (1984), Monetary Theory and Practice: The UK Experience, London: Macmillan. Graziani, A. (1984), ‘The debate on Keynes’s finance motive’, Monte dei Paschi di Siena Economic Notes, 1, pp. 5–33. Graziani, A. (1990), ‘The theory of the monetary circuit’, Économies et Sociétés, 24(6), June, pp. 7–36. Previously published with the same title in Thames Papers in Political Economy, Spring 1989. Graziani, A. (1992), ‘Augusto Graziani (born 1933)’, in P. Arestis and M. Sawyer (eds), A Biographical Dictionary of Dissenting Economists, Aldershot: Edward Elgar, pp. 215– 23. Graziani, A. (1996), ‘Money as purchasing power and money as a stock of wealth in Keynesian economic thought’, in G. Deleplace and E. Nell (eds), Money in Motion: The Post Keynesian and the Circulationist Approaches, London: Macmillan, pp. 139–54. Graziani, A. (2001), ‘Endogenous money in the circulation approach’, paper presented at the Frei Universtität Berlin conference, March. Lavoie, M. (1985), ‘Credit and money: The dynamic circuit, overdraft economics, and Post Keynesian Economics’, in M. Jarsulic (ed.), Money and Macro Policy, Boston: KluwerNijhoff, pp. 63–84. Lavoie, M. (1992) Foundations of Post-Keynesian Economic Analysis, Aldershot: Edward Elgar. Lavoie, M. (1996), ‘Horizontalism, structuralism, liquidity preference and the principle of increasing risk’, Scottish Journal of Political Economy, 43(3), August, pp. 275–300. Lavoie, M. and W. Godley (2001-2002), ‘Kaleckian models of growth in a coherent stockflow monetary framework: A Kaldorian view’, Journal of Post Keynesian Economics, 24(2), pp. 277–311.

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Moore, B.J. (1997), ‘Reconciliation of the supply and demand for endogenous money’, Journal of Post Keynesian Economics, 19(3), pp. 423–28. Mosler, W. and M. Forstater (1998), ‘A general framework for the analysis of currencies and commodities’, in P. Davidson and J. Kregel (eds), Full Employment and Price Stability in a Global Economy, Cheltenham: Edward Elgar, pp. 166–77. Parguez, A. and M. Seccareccia (2000), ‘The credit theory of money: The monetary circuit approach’, in J. Smithin (ed.), What is Money?, London: Routledge, pp. 101–23. Robinson, J. (1956), The Accumulation of Capital, London: Macmillan. Rochon, L.-P. (1997), ‘Keynes’s finance motive: a reassessment. Credit, liquidity preference and the rate of interest’, Review of Political Economy, 9(3), pp. 277–94. Rochon, L.-P. (1999), ‘The creation and circulation of endogenous money: A circuit dynamique approach’, Journal of Economic Issues, 33(1), pp. 1–22. Tobin, J. (1982) ‘Money and finance in the macroeconomic process’, Journal of Money, Credit, and Banking, 14(2), pp. 171–204. Wolfson, M.H. (1996), ‘A Post Keynesian theory of credit rationing’, Journal of Post Keynesian Economics, 18(3), pp. 443–70. Wray, L.R. (1998), Understanding Modern Money, Cheltenham: Edward Elgar.

Chapter 10

The Monetary Circuit and Income Distribution: Bankers as Landlords? Giorgio Lunghini and Carluccio Bianchi

Lord, I knew thee that thou art a hard man, reaping where thou hast not sown, and gathering where thou hast not strewed. Matthew, 25, 24

10.1

A Foreword

Mainstream economics is characterized by a general lack of interest in the topic of the distribution of income between classes. Considering the increasing importance of finance and banks in contemporary economic systems, it may be worthwhile to look at this problem from the point of view of the so-called monetary circuit theory, to which Augusto Graziani made several important contributions. The monetary circuit is neither a theory nor a model, it is a scheme as Quesnay’s Tableau économique (which is the proper reference, since in the monetary circuit scheme there is a time sequence), Marx’s reproduction schemes, and Sraffa’s equations in Production of commodities. These are schemes defining the reproduction conditions of a given system, schemes whose analytical power also depends on the fact that they do not contemplate behavioral functions. The monetary circuit, in particular, can be interpreted as an integration of the Marxian schemes of reproduction and as a possible ‘closure’ of the Ricardian-Sraffian scheme. Just as in the Marxian schemes of reproduction, and in Kalecki’s theory of distribution, in the monetary circuit scheme the level and composition of output and therefore of employment are exogenously given. To a certain extent this also determines the distribution of income between classes. The monetary circuit scheme considers three classes: industrial capitalists, workers, and bankers. In order to set the production process in motion capitalists must obtain an initial loan from bankers in order to buy the labor force they have decided to hire at the money wage negotiated on the labor market and on the basis of their decisions concerning the production of consumer and capital goods. At the end of the production process, and if surplus is realized, capitalists will have to give back the initial loan to the bankers with an added interest. This process can be analyzed from two

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151

points of view, which must be kept separate: from a single-period bookkeeping standpoint or with the perspective of defining the necessary conditions for a reproduction of the whole process. The process described by the monetary circuit scheme is the same one outlined by Marx: In the first introductory act the lender gives his capital to the borrower. In the supplemental and closing act the borrower returns the capital to the lender. [...] In the actual movement of capital its return is a phase in the process of circulation. The money is first converted into means of production; production transforms them into commodities; through sale of the commodities they are reconverted into money and return in this form into the hands of the capitalist who had originally advanced the capital in the form of money. But in the case of interest-bearing capital, the return, like alienation, is the result of a legal transaction between the owner of the capital and a second party. We see only the alienation and the return payment. Whatever passes in the interim is obliterated. But since money advanced as capital has the property of returning to the person who advanced it, to the one who expended it as capital, and since M – C – M’ is the immanent form of the movement of capital, the owner of the money can, for this very reason, loan it out as capital, as something that has the property of returning to its point of departure, of preserving, and increasing, its value in the course of its movement. [...] The lender expends his money as capital; the amount of value, which he relinquishes to another, is capital, and consequently returns to him. But the mere return of it would not be the reflux of the loaned sum of value as capital, but merely the return of a loaned sum of value. To return as capital, the advanced sum of value must not only be preserved in the movement but must also expand, must increase in value, i.e., must return with a surplus-value, as M + ¨M, the latter being interest or a portion of the average profit, which does not remain in the hands of the operating capitalist, but falls to the share of the money-capitalist (Marx, 1998, pp. 346–9).

As we shall see, when a reproduction perspective is taken, in the monetary circuit scheme the surplus rate (in this case the sum of the rate of net profits and of the rate of interest) depends on the same circumstances pointed out by Ricardo for his corn rate of profits: the technical conditions of production and – according to an inverse relationship – the real wage. Therefore the distribution of the social product between capitalists, workers and bankers will depend mainly on these same circumstances. As far as the share of bankers is concerned, in the monetary circuit scheme interests substantially play the same role that rent does in Ricardo’s theory of distribution (and thus in the process of capital accumulation). As a sign of homage, in what follows we will use the simplest and clearest of the monetary circuit schemes, which is the one suggested by Augusto Graziani in his 1984 article; but also in a series of letters going back twenty years between Augusto Graziani and one of the authors.

152

10.2

Money Credit and the Role of the State

A Three-Class, Two-Sector Scheme

In the standard version of this scheme there are three classes (Bankers, Capitalists and Workers) and two sectors (Consumption and Investment goods). Firms decide the amount of consumer goods C = πC N C and investment goods I = π I N I to be produced, where Œ represents output per worker, while NC and N I are the number of workers employed in the two sectors. As in the Marxian schemes of reproduction, nothing guarantees that N C + N I = N * , where N * represents the available labor force. We also suppose that in the production process there is no constant capital, or rather that there is no depreciation. Therefore, in a Ricardian fashion, the capital advanced by industrial capitalists amounts to the money needed to pay for workers’ wages only. The initial amount of money that firms have to get from banks is F = wN , so at the end of the period they will have to repay a sum equal to F ' = wN (1 + i ) , where w is the uniform money wage negotiated on the labor market, and paid in advance, and i is the interest rate. Workers allocate their monetary income wN between consumption and saving, so that the demand for consumer goods will be CpC = (1 − s) wN , where pC is the price of these goods and s is the proportion of income that is saved. From here on we will distinguish between a single-period accounting approach and an analysis of the reproduction conditions of the system. In a single-period accounting approach, where the market for consumer goods behaves like Marshall’s fish market, and where the supply C is determined by accident by firms, then the market price of consumer goods will be given by: pC = (1 − s )

w N w = (1 − s) πC N C πC

 NI  1 +   NC 

(10.1)

while the demand price of a capital good (which we suppose to last indefinitely) will be obtained by discounting the perpetual expected revenue R at the current interest rate i: pI =

R i

(10.2)

The gross profits of the two sectors (with interests included) will be what is left to the capitalists once they have paid the wages, namely: N   PCG = pC C − wN C = wN (1 − s ) − C  N  

(10.3)

PIG = ( π I pI − w ) N I

(10.4)

and

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Total gross profits will be equal to:

P G = pC C + pI I − wN = pI I − swN

(10.5)

while total net profits (i.e. profits net of interests) will be equal to: P = pI I − ( s + i ) wN

(10.6)

(If workers spend what they earn on consumer goods, then gross profits will be equal, as in Kalecki’s scheme, to investment.)

10.3

The Rates of Profit

In this economy the (net) rates of profit in the two sectors are: rC =

πC pC − w(1 + i ) w

(10.7)

rI =

π I pI − w(1 + i) w

(10.8)

and

while the average (net) rate of profit is NC N   π p + π I pI I  − w(1 + i ) (CpC + IpI ) − F '  C C N N  = r= F w

10.4

(10.9)

The Monetary Circuit Scheme in a Single-Period Competitive Framework with Profit Equalization

Since this expression of the profit rate is a purely bookkeeping definition, it is always true. A different interpretation of it can be given according to the price theory adopted, being well aware that each price theory implies a different vision of the working of the economic system. In the basic monetary circuit scheme, as we already mentioned, supplies are given and the consumer goods price is determined in a competitive way. The system, then, assumes a well-defined causal structure. First of all, given the shortrun equilibrium value of the consumer goods price, the corresponding equilibrium value of the profit rate is immediately determined. In fact, by substituting equation (10.1) into equation (10.7), one gets:

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rC = (1 − s )

N − (1 + i ) NC

(10.10)

where, as it may be noticed, and in a quite peculiar way, rC is completely independent of the wage rate. If the profit rates are to be equal between sectors, then the same expression must hold true for the investment goods as well, so that equation (10.10) also defines the equilibrium value of the profit rate prevailing in the whole economic system. This value can then be used, in an accounting framework, in order to derive the price of investment goods compatible with profit uniformity. In fact, by equalizing equations (10.10) and (10.8) one gets: pI =

w N (1 − s) NC πI

(10.11)

Finally this price can be used to find the unique value of capitalists’ expected revenues from investment compatible with it, by substituting equation (10.11) into equation (10.2). This approach, however, has logical and analytical faults. In the first place it is not clear, apart from accounting requirements, what is the economic mechanism capable of assuring the assumed profit equalization. In fact the common profit rate is derived from a competitive equilibrium condition of the consumer goods market, simply extended to the investment goods market by definition; and this also requires capitalists to revise endogenously their investment expectations by the exact necessary amount. However, expected returns from investment are, so to speak, in the back of the capitalists’ mind, so that it is quite difficult to see how this well defined numerical revision can be brought about. Also the demand and supply conditions of investment goods are never explicitly stated, in a quite asymmetric way with respect to consumer goods, and do not play any role in price determination. In a more fundamental manner, nothing in the scheme assures that the rate of profit is always positive. In fact, according to equation (10), one can easily ascertain that the profit rate is positive if, and only if, the following condition holds: N I / N C > ( s + i ) /(1 − s) . The economic interpretation of this condition stems from the fundamental role played in the scheme by the consumer goods market and the assumed competitive determination of its price: in fact, given the goods supply, the profit rate will be higher the higher the demand for consumer goods, and thus the lower the propensity to save and the higher the level of employment in the investment goods sector, which acts, in a sense, as an exogenous addition to the demand for consumer goods stemming from that market itself (in fact, if the propensity to save were zero, the condition for a positive profit rate would reduce to N I / N C > i , making it clear that only a high demand for consumer goods coming from workers employed in the investment goods sector would make the price of consumer goods, and thus the profit rate, sufficiently high

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to cover at least the interest rate to be paid to the bankers who anticipate the capital corresponding to money wages). The whole scheme is unsatisfactory because it pretends to derive a condition for profit equalization from the combination of a single-period partial equilibrium competitive price and an accounting definition rather than to the unique system of relative prices that guarantees the reproduction of the productive process in a monetary economy. In more general terms the two conditions of profit equalization and given supplies are mutually inconsistent and one must be relaxed in order to provide an appropriate description of the working of the economic system and avoid logical and analytical faults. In a short-run perspective, when supplies are given, the condition of profit equalization must be dropped. In fact, this is the track followed by classical political economists, for whom single-period prices, i.e. market prices, are determined by supply and demand, but rates of profit are generally different. Profit equalization requires, even in the presence of given demands, free mobility of capital and output between sectors. In this perspective supplies cannot be given and prices will be determined by costs; as Sraffa notes: There is a unique set of exchange-values which if adopted by the market restores the original distribution of the products and makes it possible for the process to be repeated; such values spring directly from the methods of production (Sraffa, 1960, p. 3).

In a reproduction perspective, then, the solution to the dilemma of incoherent basic assumptions is found in dropping the condition of given supplies; in this theoretical framework, since profits are determined by costs, they can never be negative.

10.5

The Monetary Circuit Scheme as a Reproduction Scheme: Industrial Profits and Bankers’ Rent

If one of the necessary conditions for the reproduction of the system is the uniformity of profit rates between sectors, then by simply equalizing equations (10.7) and (10.8), correctly interpreted as costs conditions, we have: pC π I = p I πC

(10.12)

If the sectoral rates of profits are to be uniform, then, relative prices of manufactured goods will depend on the techniques of production only. This condition also holds true in a single-period monetary scheme, even though it is not explicitly stated, but now the definition of relative prices correctly stems from a proper interpretation of classical competition, whereby capitalists seek for the highest profit rate, given the available techniques of production. It is worthwhile noticing that in determining these relative prices the rate of interest is not involved: therefore the bankers’ interest is equivalent to the Ricardian rent. However, while

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in Ricardo’s theory the relative prices of manufactured goods do not depend on rent because these goods are produced with labor only, interest does not affect relative prices because it is a given share of gross profits (and production requires only labor under constant returns). If from the uniformity condition of the profit rates we get the price of one of the two goods, for example that of the capital good, and we rewrite the equation of the general gross profit rate, we will see that this is equal to the ratio between unpaid and paid labor, i.e., to the surplus rate σ : r +i = σ =

πC pC − w πC = −1 w x

(10.13)

where x = w / pC is the real wage rate. The net profit rate will be: r = σ−i =

πC − (1 + i) x

(10.14)

This point was already clear to Marx: Since interest is merely a part of profit paid by the industrial capitalist to the moneycapitalist, the maximum limit of interest is the profit itself, in which case the portion pocketed by the productive capitalist would = 0. Aside from exceptional cases, in which interest might actually be larger than profit, but then could not be paid out of the profit, one might consider as the maximum limit of interest the total profit minus the portion [...] which resolves itself into wages of superintendence (Marx, 1998, p. 356).

Here Marx also quotes The Economist: ‘The rate of interest depends 1) on the rate of profit; 2) on the proportion in which the entire profit is divided between the lender and borrower’ (The Economist, January 22, 1853, p. 89). The profit rate, net of interest, therefore depends on the technical conditions of production, on the real wage rate and on the rate of interest. In the monetary circuit scheme, which is of the Money-Money type, the determinants of the profit rate are therefore the same outlined by Ricardo in his corn economy, with interest playing the same role rent does in the Ricardian model. Indeed this is obvious since in both cases capital takes the form of an advance (in one case as commodity-capital, and in the other as money-capital). The only difference is that in a Ricardian world the non-wage incomes are profits and rent, while in our world they are profits and interests. Rent and interests, though, have a different origin, since the former comes from the Ricardian avarice of nature while the latter originates from the Keynesian cumulative oppressive power of the capitalist to exploit the scarcityvalue of capital. However, in the production process, in the distribution of income and in the accumulation of capital, and therefore in the conflict between classes, bankers essentially play the same role as landlords do in Ricardian theory. The practical problem, which no theoretical scheme can solve, is how industrial capitalists and bankers, post factum, actually divide up the surplus between them;

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157

this is really the problem of transforming unpaid labor into profit and financial rent. Once more Marx says, à ce propos: How the two parties who have claim to it divide the profit is in itself just as purely empirical a matter belonging to the realm of accident as the distribution of percentage shares of a common profit in a business partnership. Two entirely different elements, labour-power and capital, act as determinants in the division between surplus-value and wages, which division essentially determines the rate of profit; these are functions of two independent variables, which limit one another; and it is their qualitative difference that is the source of the quantitative division of the produced value (Marx, 1998, p. 362).

Even though they have different determinants, the time dynamics of the rate of profit and of the rate of interest are intertwined (but, as Sraffa remarks, the rate of interest is a matter of observation). The question regarding the relative behavior of the rate of profit and of the rate of interest was already clear to Smith and Ricardo, who in Chapter XXI of his Principles (on the Effects of Accumulation on Profits and Interest) writes: Adam Smith has justly observed, that it is extremely difficult to determine the rate of the profits of stock. ‘Profit is so fluctuating, that even in a particular trade, and much more in trades in general, it would be difficult to state the average rate of it. To judge of what it may have been formerly, or in remote periods of time, with any degree of precision must be altogether impossible’. Yet since it is evident that much will be given for the use of money, when much can be made by it, he suggests that ‘the market rate of interest will lead us to form some notion of the rate of profits, and the history of the progress of interest afford us that of the progress of profits’. Undoubtedly if the market rate of interest could be accurately known for any considerable period, we should have a tolerably correct criterion, by which to estimate the progress of profits (Ricardo, 1970, p. 296).

10.6

Alternative Closures of the Monetary Circuit Scheme: Some Simple Exercises

If we consider the previous definitions of the sectoral profit rates (equations (10.7) and (10.8)), we can see that they are analogous to those implicit in the Sylos Labini-Bain mark up model (but also analogous to the schemes of perfect competition where constant returns are assumed, and σ is the normal profit rate). By reordering (10.14) we get the following equation for the price of consumer goods: pC =

w w (1 + rC + i ) = (1 + σC ) πC πC

(10.15)

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Money Credit and the Role of the State

where σC is the traditional mark up of oligopoly schemes (in our case σC = rC + i). An analogous price equation holds for the sector producing investment goods, so that we have: pI =

w w (1 + rI + i) = (1 + σ I ) πI πI

(10.16)

For ease of notation let lC = 1/ πC and lI = 1/ π I stand for the labor inputs per unit of output in the two sectors (the opposite of labor productivity). As we have already seen, if we assume the surplus rates to be equal in the two sectors (so that σC = σ I = σ ), then the ratio between the prices of the two produced goods ( p = pC / pI ) will be equal, in a truly Ricardian tradition, to the ratio between the amounts of labor embodied ( l = lC / lI ). This ratio is therefore given and is completely independent of any other variable, since it is uniquely determined by the techniques of production. It is not clear whether in the monetary circuit scheme an explicit assumption concerning the nature of returns is advanced. We might assume that, as in Production of commodities, the monetary circuit scheme is just a picture of the economic system at a particular moment of time, and this does not require any explicit hypothesis about returns. However the purpose of the scheme is actually the analysis of the reproduction conditions of the economic system, so that an explicit hypothesis about returns seems inevitable. We can also see that the assumption of a uniform profit rate sets a definite link between the prices of consumer and investment goods ( pC = lpI ). This allows us to eliminate one price from the scheme and go back to a model with just one product (we will discuss the consequences of this assumption further on in this chapter). Finally, we can see that in the system with the two price equations, if the money wage is given, there are three unknowns: there is therefore a degree of freedom that allows alternative closures of the model. Summarizing our previous results, then, we can see that if the monetary circuit scheme is to be correctly interpreted as a reproduction scheme, this requires dropping the hypothesis of fixed supplies. The condition of profit equalization unambiguously determines the value of relative prices, but leaves absolute prices and income distribution undetermined. A comprehensive representation of the economic system then requires a closing equation from the distribution standpoint.

10.7

Ricardo: the Real Wage and the Quantity Theory of Money

In the pure Ricardian model the exogenous variable is the real wage x. With a given real wage the money wage will be w = xpC. Since in the monetary circuit scheme the money wage is also given, it could be argued that further imposing the real wage to be given is untenable: since prices must be determined endogenously, x and w cannot both be considered exogenous. This objection can be overcome by

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assuming that in each period w is determined either on the basis of the expected price for the same period or of the actual price of the previous period, in order to achieve the target real wage. In this way it may be possible to maintain the hypothesis of a given money wage and of a desired real wage simultaneously. The Ricardian solution would thus emerge as an equilibrium solution when actual and expected prices are equal or when prices are constant. Therefore, assuming that x is given, substituting for w = xpC in equation (10.15) and reordering we get: 1+ σ =

π 1 = C lC x x

(10.17)

The gross profit rate is therefore unequivocally determined by the technical conditions of production of consumer goods (the wage goods) and in particular by the ratio between labor productivity and the real wage. The gross profit margin is equal to the sum of the net profit rate and of the interest rate. The Ricardian theory is open with regards to their relative dimension, even though their sum is constrained. It might be assumed, as we can infer from the quotes above, that this size depends on those factors of risk and entrepreneurship outlined by Smith, without which the two rates would be equal (as in Ricardo). In any case the two rates move in time in the same direction, but it is the profit rate that determines the interest rate. Ricardo’s theory however leaves absolute prices undetermined (in fact, as a consequence of the hypothesis of an exogenously given real wage, pC does not appear in equation (10.17)). This fact should not by itself be surprising, since a given real wage is compatible with infinite combinations of money wages and prices. Ricardo solves this indeterminacy problem by recurring to the quantity theory of money, according to which, in our context, we have: MV = pC C + pI I

(10.18)

We must remember that in the monetary circuit scheme, C and I are given. Since pI = πpC (where π = 1/l), we get: MV = pC C + πpC I = pC (C + πI )

(10.19)

This allows us to determine the absolute price of consumer goods: pC =

MV C + πI

(10.20)

and therefore also that of investment goods. In this way the Ricardian ‘closing solution’ is coherent: there is a dichotomy between output and prices; the conditions of production determine relative prices; the real wage determines the surplus rate (which will be divided between profit and interest); money only determines absolute prices.

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Money Credit and the Role of the State

10.8

Sraffa: Production of Commodities by Means of Money

According to Sraffa the system can be closed, from the distribution side, if we assume, contrary to Ricardo, that the exogenous variable is σ. However, unlike Keynesian theory, Sraffa assumes σ to be a function in some way of the interest rate (so that the alleged causal link goes from i to σ ). In his theory the profit rate is not determined in the production sphere (and this as a consequence of disregarding the problem of the origin of surplus). In fact the profit rate is ‘susceptible of being determined from outside the system of production, in particular by the level of the money rates of interest’ (Sraffa, 1960, p. 33). This is so in § 44 of Production of Commodities, but in an unpublished note Sraffa wrote: It is possible to conceive of the rate of profits as being ‘given’ from outside the system of production, much as conforming to the pattern of money rates of interest determined independently by the banking system or Stock Exchange (Ranchetti, 2001, p. 327).

The obvious reference is to the (conventional) money interest rate Keynes dealt with in Chapter XVII of The General Theory, and to which he gave greatest practical importance in determining the volume of output and employment, with respect to the own rates of interest. The introduction of the Sraffian hypothesis whereby i is exogenous in the monetary circuit scheme (as determined, for simplicity, by an Overlord: the Central Bank), together with the relationship linking the price of investment goods to the net income expected from them, that is equation (10.2), produces some other important effects. In general we might suppose that i determines σ in some way and that, as in the basic monetary scheme, R is endogenous: in this case we would be back with the same logical problem, previously discussed, of requiring an endogenous revision of capitalists’ investment expectations by the exact amount required for equation (2) to hold. From a different standpoint, it might be claimed that only i is exogenous, with no a priori link with σ, while R is given: this couple of hypotheses would yield an equilibrium value of pI (and thus also of the price of consumer goods, as a consequence of profit equalization). Given this framework, we would get, then, the corresponding equilibrium value of the surplus rate, given by: 1+ σ =

R lI wi

(10.21)

This equation clearly shows that the distribution of income would be determined by the conditions of production of investment goods only and that there would be an inverse relationship between the interest rate and the profit rate. This would happen because if i went up, the price of investment goods, constrained by the accounting definition (10.2), would have to go down. Given the structure of costs, with an unchanged money wage this could happen only if σ

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161

decreased. The condition of a uniform rate of profit would then imply that the price of consumer goods should also decrease proportionally so that the real wage would rise. In fact from the price equation (10.15) and the equilibrium value of the surplus rate, given by (10.21), we get: x=

w lI wi = pC lC R

(10.22)

that highlights the direct relationship existing between i and x. The model however is implausible. It is not clear why, under constant returns, an increase in the interest rate should not lead to a necessary increase in σ and to a subsequent increase in prices rather than to their decrease. Of course, this implausibility is a consequence of the constraints imposed by equation (10.2) and of the hypothesis the R and i are the alleged exogenous variable. As we shall see later on, the most satisfactory way of solving the puzzle, and thus of looking at the causal link implicit in relation (10.2), is to assume that the unknown is R rather than pI, but from a different perspective than that adopted in the standard monetary circuit scheme: as Keynes said in 1937, in fact, investment is pushed to the point where the demand price of capital goods is the same as their supply price. This happens for a well-defined amount of investment: that for which, in The General Theory, the marginal efficiency of capital is equal to the interest rate. In other words relation (10.2), given the price equation (10.16) for investment goods, defines the desired level of investment that is instead assumed to be exogenous in the monetary circuit scheme. This is the proper solution of the puzzle if the monetary circuit scheme is to be interpreted in a reproduction perspective; it is also coherent with the fact that, as we have already noticed, in this perspective the assumption of fixed and unchangeable supplies must be relaxed.

10.9

Kalecki and the Post-Keynesians: the Mark up as Given

In Kalecki’s scheme, as in that of the Post-Keynesians, but also in that of the socalled ‘New Keynesians’, the mark up is exogenous. Given the money wage and the constraint on relative prices, absolute prices are uniquely determined. Under this assumption the real wage will be endogenous; in fact from the price equations we get: x=

π w = C pC 1 + σ

(10.23)

Once again, as for Ricardo, the relationship between the real wage and the gross profit rate is settled by the conditions of production of consumer goods. The only difference now is that it is the exogenous mark up that determines the real wage and not vice versa. In particular the real wage is what firms can afford to

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pay, given their technology and their desired gross profit margin. As regards the relationship between profit and interest, this is undetermined. We can claim that interests are a deduction from profits (i = σ – r), or that, given the interest rate imposed by banks (or monetary authorities), the mark up (σ = r + i) takes this into account and the net profit rate is therefore unconstrained by the interest rate. In this way a higher interest rate, given the rate of profit, implies a higher mark up and therefore a corresponding reduction in the real wage. In this case there would be a distribution conflict between bankers and workers as well as between industrialist capitalists and workers. With this type of closing solution money prices are determined by production costs. Under constant returns prices do not vary with output; this means that output can be determined in other ways (for example by the principle of effective demand, as we shall see further on). If we wished to introduce a quantity equation this could be used either to determine M endogenously or to determine V, assuming that the latter is a function of the rate of interest. This could also help to explain i in terms of a money market equilibrium, in a quite traditional way (rather than assuming i to be predetermined by bankers or by an Overlord). However, a problem of interpretation would remain: that is whether i should be interpreted as a deduction from σ (given the gross profit rate) or whether it ends up with reducing the real wage through an adaptation of σ to i. A lot depends on the theory used to determine σ. If for example σ was exogenously given by the constraint of international competition, then σ would be the maximum mark up level compatible with maintaining the status quo in world markets. In this case the real wage would depend on the assumed level of σ and the rate of interest would reduce the net profit: capitalists would be in conflict with bankers and the interest rate could be assimilated to a Ricardian rent.

10.10

An Extended Keynesian Approach

In the standard Keynesian approach where prices are determined by costs, under constant returns there is a dichotomy between output and prices. The latter depend on costs and the supply of goods is horizontal, while aggregate demand depends negatively on prices. The intersection between supply and demand determines the level of output that firms can sell. According to the multiplier mechanism aggregate demand ultimately depends on investment decisions. The scheme we are considering, properly extended to let quantities vary, is more complicated than the basic Keynesian one: there are two goods and therefore two prices; aggregate demand also depends upon the distribution of income (through consumption expenditure); if the profit rate is not exogenously given, as it is in the PostKeynesian tradition, it must be endogenously determined. If σ is exogenous, we go back to the previous case: prices are univocally determined and so is the relationship between the gross profit rate and the real wage. From the consumption function pC C = cwN , where c = 1 – s, we get:

The Monetary Circuit and Income Distribution: Bankers as Landlords?

C=

cwN = cxN pC

163

(10.24)

and from this, recalling that N = N C + N I = lC C + lI I , we can get the following equation linking C to I: C=

cxlI I cI = 1 − cxlC l (1 + σ − c)

(10.25)

This shows on the one hand that, as in Keynes, investment is the fundamental variable which determines aggregate demand and on the other hand that in this model consumption also depends on the distribution of income: in particular C grows if x rises (and vice versa with respect to σ). The value of nominal income will be equal to: Y = pC C + pI I = pI I

1+ σ 1+ σ − c

(10.26)

showing that there exists a sort of a multiplier in a two-sector model. All this holds if σ is exogenously given. If income distribution is to be endogenously determined it is necessary to resort to a supplementary equation whereby, for example, the surplus rate desired by firms is an increasing function of employment, such as: σ = f (N ) ; f ′ > 0

(10.27)

This relationship, together with that linking employment to investment decisions: N = lC C + lI I =

lI I l I (1 + σ) = I 1 − lC cx 1 + σ − c

(10.28)

would yield a system for simultaneously determining distribution and employment (or income), once firms decide the desired level of investment. The model could however be extended, as in standard textbooks, by assuming that investment depends on the interest rate and that an equilibrium in the money market has to be assured, thus introducing an IS-LM system into the analysis (even though this perspective, whereby the interest rate is not a priori given, would be at variance with the monetary scheme logic). If this extension is accepted, however, then as we shall see in more detail later on with reference to the simpler case of a single-good model, we would have a complete system of interdependent equations to determine prices (actually to determine just one absolute price since the other one is constrained), output and income distribution. In this model an increase in investment, triggered by improved entrepreneurial expectations, would raise

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aggregate demand but also employment, which in turn would increase the surplus rate. For the same reason money prices would go up and the real wage down. Therefore prices, production and distribution would be simultaneously determined, and the relationship between the interest rate and net rate of profits might be conflicting or not according to which exogenous variable changes the IS–LM equilibrium.

10.11

Distribution, Prices and Output in Single-Good Scheme

In order to better understand the implications of alternative assumptions regarding the closing equation of the system, from the standpoint of income distribution, it is enough to consider the fact that a two-goods system, where the profit rate is uniform, is fundamentally analogous to a system where only one good is produced. Since pC / pI = l = 1/ π , and nominal income is Y = pC C + pI I , real income will be: y=

Y = C + πI pC

(10.29)

where relative prices are given by the quantities of labor embodied and there is a dichotomy between output and absolute prices; as in classical political economy, ‘effectual’ demands are given while supply, in a full equilibrium state, just adapts itself to demand. In the scheme under consideration, to better understand the existing links between distribution, absolute prices and output, it is convenient to refer to a system where only one good is produced, so that we have the following equations. Prices are defined by: P = lw(1 + σ) =

w (1 + σ) π

(10.30)

income and the multiplier by: y = C + I = cxN + I = cxly + I =

1 I 1 − cxl

(10.31)

and the demand price for investment goods is: pk =

R . i

(10.32)

Equation (10.31) can be rewritten in terms of employment, to show its equivalence with the case of a two-sector model. In this case we have:

The Monetary Circuit and Income Distribution: Bankers as Landlords?

N = NC + N I = l (C + I ) = l (cxN + I ) =

lI 1 − cxl

165

(10.33)

The meaning and implications of equation (10.32) can be better understood if we consider the use that Keynes makes of it in his 1937 QJE article. For each investment project R is given and therefore so is pk. There is however a multiplicity of investment plans and all possible projects are then ranked according to their present value starting off from the most profitable ones. The value of each investment project is compared to the supply price, which in the case of a single product is just P. All projects for which pk is greater than P are undertaken. Since P is given, equality between P and pk determines the optimal amount of investment, given costs conditions and entrepreneurial expectations. By imposing this equality in equation (10.32) we get: P=

R i

(10.34)

If P and i are given, the only unknown in (10.34) must be R. In fact pk depends on R and just as pk varies considering different investment projects, the same thing happens to R, which is then a function of I. Therefore equation (10.34) is equivalent to: R ( I ) = Pi

(10.35)

I = R −1 ( Pi )

(10.36)

from which we get:

which defines the volume of investment desired by firms. The procedure is the same as that used by Keynes in The General Theory, whereby he compares the marginal efficiency of the capital (mec, the unknown in equation (10.36) when R and P are given) to the interest rate. Here too there are different investment projects which have different marginal efficiencies; the desired level of I is again that one for which mec = i. The system of equations (10.30)-(10.31) has three unknowns (P, y and x or σ) and therefore requires a further closing equation which must be sought in the distribution sphere. The Ricardian solution imposes an exogenously given real wage (x). In this case from (10.30) we get: 1+ σ =

π x

(10.37)

This solution is represented in Figure 10.1. Once x has been fixed, equation (10.30), that is (10.37), determines σ (as the graph on the left shows) while equation (10.31) determines y (graph on the right). The two equations are

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independent of each other, i.e. the system is decomposable. If we re-elaborate equation (10.31) we get: x=

π I  1 −  c y

(10.38)

which describes the curve in the right-hand graph, intersecting the horizontal axis at point I and tending asymptotically to the value π/c. Furthermore, when σ =0, x = π; and since c < 1, then π /c > π. If σ has to be positive, the equilibrium position along the aggregate demand curve (as a function of income distribution) occurs below the dotted line. The absolute price level is undetermined. By substituting w = xP in equation (10.30) we get in fact: P = lxP(1 + σ)

(10.39)

showing that P disappears from both sides of the equation. We then need a further equation to determine the price level, as for example a quantity equation (supposing we know y). It should be noticed that results more or less similar to the previous ones can be achieved, if we suppose, as the so-called ‘New Keynesian economics’ does, that the real wage is an increasing function of employment or rather of the level of income. In this case we have: x=

w = f ( y ) ; f′ > 0 P

(10.40)

Figure 10.1 would be modified in its right hand-side graph, where, together with the aggregate demand curve, there would be a new upward-sloping line expressing relationship (10.40) (just as shown in Figure 10.3 below). In this case,

x

π c

π

π 1+σ

Figure 10.1 The Ricardian solution

I

y

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167

if a solution exists, x and y would be determined together in the right hand graph. Once y and x are known, the latter would determine σ in the left hand graph. If workers are ‘too demanding’ (i.e., they ask for a real wage which is ‘too high’ in relationship to y) there may be no solution. The situation of a unique solution (when the real wage line is tangent to the effective demand curve) is a fluke; usually there are two solutions, even if only one of these is likely to be acceptable. In any case, if we overlook the simultaneous solution for y and x, the model is substantially the same as Ricardo’s: distribution and output are determined while money prices are not. If x is exogenous, supply does not matter; only demand influences y and N (with a very significant difference with respect to the textbooks AS-AD models). We can also see that if we specify the demand side through an IS-LM model (a model whose logic is actually the opposite to the one implied by the monetary circuit scheme), for example: M = L( y, i ) P

(10.41)

and y = cxly + I (i ) = cxly + R −1 ( Pi ) =

I (i ) R −1 ( Pi ) = 1 − cxl 1 − cxl

(10.42)

we would have two equations and three unknowns (y, i and P) so that the system would remain underdetermined and we would not be able to know the equilibrium level of income. The difference between this framework and the quantity equation is that in the latter context we assume to know y (for example because I is exogenous). If however I is endogenous we are faced with the same problem once again. To determine the optimal level of investment with i given it is necessary to know P, which is however undetermined. If I is not given neither is y: therefore the IS-LM model and the quantity equation are on the same (shaky) ground. In a pure Ricardian context the problem is solved because investment is exogenously given and so we have the possibility of using a quantity equation. It is interesting to notice that introducing the hypothesis whereby i is given, following a recent suggestion in American literature meant to capture the actual behavior of Central banks, would make the system determined once again. When i is given, the IS-LM equations could be solved for y and P. The consequences of this assumption would be interesting. In the pure Ricardian case where x is given, income distribution (i.e. the values of x and σ) would be known beforehand while the interest rate would only determine prices and output (and also the conflicting distribution between r and i). In the case where x is a function of y, instead, we would have three equations to determine together distribution with output and prices. In this way the fixing of the interest rate by an Overlord would end up influencing income distribution through the channel of aggregate demand. In

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particular, a reduction in the rate of interest would increase investment and thus income, which would in turn lead to an increase in real wages and then a reduction in the rate of surplus. This decrease could be caused by a fall in the price level, needed to allow the required increases in both x and the real supply of money, necessary to balance the increased liquidity preference. The Keynesian solution (Post and New) to the problem of closing the system from the distribution of income standpoint is to assume that the exogenous variable is σ rather than x. In this case we would get: x=

π 1+ σ

(10.43)

With a given price level (eq. (10.30)), the volume of investment (eq. (10.36)) and consequently of income (eq. (10.31)) would be determined. As Figure 10.2 shows, the situation would be similar to the Ricardian one, even though the causal links on the distribution side would be different. Unlike the Ricardian system, furthermore, since P is determined by costs, the quantity equation could only be used to identify the endogenous quantity of money needed to carry out the amount of transactions corresponding to the given values of P and y. If we introduced an IS-LM system into the scheme we are analyzing, the predetermination of P would allow us to univocally identify the simultaneous equilibrium solution for y and i. In fact, this framework would be exactly identical to the standard Keynesian scheme of textbooks, with the only difference being that there is an added consumption function depending on income distribution. In fact, the assumption of σ and w as being exogenously given is equivalent to the hypothesis of fixed prices. If the surplus rate σ is assumed to be exogenously given and at the same time we introduced the further assumption that the real wage is an increasing function of income, as in equation (10.40), we would get the standard theoretical

x

π c

π

π 1+σ

I

Figure 10.2 The basic Keynesian solution

y

The Monetary Circuit and Income Distribution: Bankers as Landlords?

169

framework used in the textbooks representation of Keynesian analysis. This combination of hypotheses, however, would raise serious problems according to the previous examination: with σ given, x would be determined; and there would be just one value of y compatible with it. From a graphical point of view this situation may be described by Figure 10.3. In the case we are considering the equilibrium level of income would be determined by the supply conditions alone, i.e. by the system of equations (10.43) and (10.40). This level would correspond to the so-called natural or potential income level of textbooks (i.e., the income level associated to the so-called NAIRU): that one for which the aggregate supply function is vertical. Since in this case income is supply-determined, aggregate demand would not be able to settle anything and, in a full-equilibrium situation, should adapt itself to supply. As we can see from the graph this does not necessarily happen in the K equilibrium point in the short run. The shift from the short run to the long run, as we know from textbooks, comes about by allowing w (and therefore P, when σ and then x is given) to adapt to the required level until demand and supply are equal. Solving the IS-LM system for i and P, with y given at its potential level, there is only one value for these variables and thus for investment I, which makes the rightward shifting aggregate demand curve go through the equilibrium point E determined by supply conditions only in Figure 10.3. This is exactly the long run equilibrium solution depicted in textbooks: starting from this position, an increase in the money supply would reduce the interest rate and increase investment and aggregate demand, but income would then rise beyond the potential level; the desired real wage would increase and so would the money wage with it; with σ given, prices would rise and everything would go back to the previous equilibrium situation. Introducing the assumption of an interest rate imposed by an Overlord into this hypothetical scheme would lead to a different conclusion. Since σ and y are given, there is only one value for M/P, according to the LM equation, which is

x

π c

π K

E

π 1+σ

I

Figure 10.3 The extended Keynesian solution

y

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Money Credit and the Role of the State

compatible with liquidity preference (if the demand for money is exogenous, then supply must be endogenous). In the short run, with given money wages and prices, the money supply must adapt to the interest rate imposed by the Overlord. On the other hand, if M is given, then it will be prices and wages to adapt to the value required by equilibrium, through an adjustment of aggregate demand to the natural value of output. If starting from an equilibrium point the Overlord decides to reduce the interest rate, investment will rise and with it aggregate demand. However, desired real wages will be higher and therefore money wages would increase; this would cause prices to rise, so that everything would go back to what it was like before: money is neutral. If the Overlord insists on keeping the interest rate too low, the situation repeats itself and a Wicksellian process of inflation is set off which will lead to the Overlord increasing the interest rate. Therefore there is only one interest rate that is compatible with the stability of prices and with the level of income determined by supply forces.

10.12

A Summary

The monetary circuit scheme can be interpreted in two alternative ways that it is best to keep separate: it can be seen as a single-period bookkeeping scheme or as a scheme of reproduction. The difference is in the price theory which is adopted: whether prices stem from a combination of a short-run competitive equilibrium in the consumer goods market and an accounting definition of the investment goods market, or whether they are natural or long–run prices, determined by technical conditions of production. In both cases the rates of profit in different sectors can be set uniform, but while the former interpretation has logical and analytical faults, the second one correctly emphasizes the cost conditions that appear as a prerequisite for the reproduction of the system. This is the track we have chosen in this chapter. The monetary circuit scheme remains an open scheme, in the sense that the number of equations it is made up of is less than the number of unknowns. This is a positive aspect of the scheme, rather than a drawback. We could say that open schemes are open to history; they allow us to decide, according to the relevant circumstances, rather than mechanically, which variables can be taken as given and which other are to be determined endogenously. Here are some results of our approach: •

In the standard monetary circuit schemes supplies are given while at the same time the rates of profit are assumed to be uniform between sectors; in this framework prices do not depend only on the techniques of production and on the money wage but also on the propensity to consume and the output mix. The surplus rate, on the other hand, does not depend at all on the real wage but only on the propensity to consume, the techniques of production and – in a quite peculiar way – the output mix; nothing in the scheme can assure that the equilibrium profit rate is positive.

The Monetary Circuit and Income Distribution: Bankers as Landlords? •

•

•

•

•

171

The two conditions of given supplies and profit equalization are mutually inconsistent; their coexistence produces a hybrid model with insurmountable analytical problems. In a short-run perspective, the dilemma can be solved by dropping the hypothesis of profit uniformity, but in this case prices would appear as ephemeral phenomena incapable of surviving the effects of market forces led by the quest for the highest profit. In a reproduction perspective, then, the dilemma has to be solved by dropping the hypothesis of given supplies, letting them to adapt to the level of effective demand. Profit equalization will however unambiguously fix the value of relative prices only, leaving absolute prices and income distribution undetermined. Thus a comprehensive description of the economic system requires a closing equation from the distribution sphere. Given the technical conditions of production, there is an inverse relationship between the surplus rate (σ = r + i) and the real wage rate. With regard to the distribution of the social product there is a conflict between industrial capitalists and bankers on the one hand and capitalists and workers on the other. The result is the same depicted by Ricardo in his Essay on Profits. Interests appropriated by bankers to themselves are determined differently but they play the same role rent does in the Ricardian scheme, since interests are not involved in the determination of reproduction relative prices of manufactured goods and they substantially behave like a bounty on profits. The Ricardian assumption of a given real wage is just one of the possible ways of closing the system, which has the drawback of leaving the level of absolute prices undetermined. Since a given real wage is compatible with infinite combinations of money wages and prices, a Ricardian solution to the indeterminacy problem can be found in the quantity theory of money. An alternative closure of the system can be obtained by following the suggestions in § 44 of Sraffa’s Production of Commodities, whereby the level of the (conventional) nominal interest rate is assumed to be given. If this hypothesis implies that the value of the surplus rate is also given, as a consequence of a direct causal link to be specified, then the same consequences characterizing Keynesian theory, and specified below, will be reached. If instead the surplus rate is allowed to be determined endogenously, the basic assumptions of the monetary circuit scheme in a reproduction perspective will make income distribution ultimately depend upon the conditions of production of investment goods; and an inverse relationship between the interest rate and the profit rate will emerge. If one adopts a Kaleckian or Postkeynesian viewpoint and assumes the mark up to be exogenously given, then money wages, absolute prices, and therefore the real wage, will be determined, while the division of surplus between profits and interests will remain undetermined. Under appropriate hypotheses about the mark up determination, however, one can also say that there is a conflict in the field of income distribution not only between capitalists and workers but also between bankers and workers. If it is further assumed that there is an upper

172

•

•

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limit to the mark up level, for example as a consequence of price competition on world markets, then there would also be a distribution conflict between industrial capitalists and bankers: in this case, again, interest would play the same role rent does in Ricardian analysis. If the surplus rate σ is assumed to be given and at the same time the real wage is an increasing function of the level of activity, as in standard textbook analysis, then absolute prices will be determined, but output will be supply determined and demand irrelevant. If income distribution is to be endogenously determined and aggregate demand has to play a role in determining the level of activity, then the surplus rate desired by firms has to be an increasing function of output and employment. In this case we would get a complete system for simultaneously determining prices, output and income distribution.

References Graziani, A. (1984), ‘Moneta senza crisi’, Studi Economici, 24, pp. 3–37. Keynes, J.M. (1936), The General Theory of Employment, Interest and Money, London: Macmillan. Keynes, J.M. (1937), ‘The General Theory of employment’, The Quarterly Journal of Economics, 51, pp. 209–23. Marx, K. (1998), ‘Capital. A critique of political economy’, in Karl Marx. Frederick Engels. Collected Works, vol. 37, London: Lawrence & Wishart. Ranchetti, F. (2001), ‘On the relationship between Sraffa and Keynes’, in T. Cozzi and R. Marchionatti (eds), Piero Sraffa’s Political Economy. A Centenary Estimate, London and New York: Routledge, pp. 311–32. Ricardo, D. (1970), ‘On the principles of political economy and taxation’, in The Works and Correspondence of David Ricardo, vol. 1, Cambridge: Cambridge University Press. Smith, A. (1976), An Inquiry into the Nature and Causes of the Wealth of Nations, Oxford: Oxford University Press. Sraffa, P. (1960), Production of Commodities by Means of Commodities. Prelude to a Critique of Economic Theory, Cambridge: Cambridge University Press.

Chapter 11

Credit and Money in Schumpeter’s Theory

*

Marcello Messori

11.1

Introduction

Together with Wicksell (1898) and other German speaking authors (for example, A. Hahn 1920), Schumpeter re-defined the foundations of monetary theory replacing the traditional view of money as a ‘veil’, which facilitates exchanges, with the concept of money as capital, which acts as an essential premise for the starting of new production processes.1 This means that, analogously to Keynes (1930 and 1936), Schumpeter criticized the quantity theory of money but, unlike Keynes (1936), he based his criticism on the function of money as a means of payment rather than as a store of value. Thus, paraphrasing a famous statement made by Robertson, 1940, p. 12), whilst Keynes (1936) underlined the willingness of the individual agents to hold money as a stock, Schumpeter insisted on their wish to take possession of money in order to use it as a flow. Moreover, Schumpeter proved that the flows of money matter for the ‘real’ variables, especially if obtained before the sale of produced goods and services (see also: Robertson 1926). However, these results were not enough to give credit to Schumpeter as a monetary theorist. According to many historians of the economic analysis, the Schumpeterian framework of cyclical development is centered on the process of innovation and on the role of the entrepreneur rather than on the availability of means of payment and on the role of banks. On the other hand, the writings in which Schumpeter dealt predominantly with monetary issues are few compared to his whole work.2 The narrow number and the scanty renown of Schumpeter’s contributions on money can be attributed to the main characteristics of his monetary theory. By stating that money as capital acts as an essential premise for the starting of new production processes at the basis of the cyclical development, Schumpeter aims to reach a close integration between the monetary and the ‘real’ aspects of the economic system. Such aim is already clear in Schumpeter (1908), where the analysis of the economic development has not yet been elaborated.3 By inferring the existence and the role of money from the theories of exchange and price, Schumpeter shows that the theory of money ‘constitutes an integral part of the

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system of pure economics, in the sense that it cannot be separated from the remaining parts of this system’ (1908, p. 279; see also Reclam, 1984, p. 9). This statement is confirmed in various passages of Schumpeter’s later works which focus on cyclical development. For example, Schumpeter states (1939, p. 548): economic action cannot, at least in capitalist society, be explained without taking account of money, and practically all economic propositions are relative to the modus operandi of a given monetary system;

but, immediately after, he adds: that economic analysis cannot [...] abstract from money is a truth which is useful only if supplemented by the other truth that monetary processes never carry their explanation in themselves and cannot be analized in monetary terms alone.4

The passages just quoted clarify why Schumpeter’s most important writings do not isolate the analysis of the monetary aspects with respect to that of the ‘real’ aspects. To a certain extent, this also applies to Schumpeter’s Theory on Money and Banking5 and to his few articles which specifically deal with monetary matters (e.g. Schumpeter 1917–18). In such works the monetary part assumes a predominant weight and it is dedicated to the investigation of those concepts which, even if playing an important role for the integration between the monetary and the ‘real’ aspects of the cyclical development, do not find a suitable analytical treatment in Schumpeter’s contributions of a more general content. Therefore, Schumpeter’s main monetary writings do not examine the traditional monetary problems but deal with the difficult task of giving analytical capacity to those money functions which are an essential part of the cyclical evolution of the economic system. In order to accomplish such a task, one needs to elaborate a monetary theory which fits with the analysis of the cyclical development. It is often stated that Schumpeter does not go further than outlining such a ‘dynamic’ theory of money and that, therefore, he is not able to specify the relations between money and credit in the various phases of the economic cycle. The aim of the present chapter is to challenge such a negative judgement, and to prove that: (i) Schumpeter’s analysis of credit and money functions, within the cyclical development, leads to an elaborated monetary theory; (ii) even if such theory leaves various problems unsolved, one of its basic features consists in specifying the links between the functions carried out – respectively – by money and by credit. In what follows both the meaning of ‘dynamic’ theory of money and the links between money and credit will be defined more precisely by recurring to a distinction made by Schumpeter himself (in particular, 1954), between the ‘credit theory of money’ and the ‘monetary theory of credit’ (section 11.2). Besides presupposing a criticism of the traditional monetary framework, Schumpeter’s formulation of a credit theory of money points out that the bank credit lent to

Credit and Money in Schumpeter’s Theory

175

entrepreneurs during the economic development acts as (money-)capital (section 11.3). Schumpeter’s examination of the role of money capital highlights the macro and microeconomic sequence characterizing the cyclical evolution (sections 11.4 and 11.5). This examination, however, cannot deal with all the problems raised by Schumpeter’s monetary theory. In the Conclusions the main unsolved problems will be underlined, and their possible developments will be touched upon.

11.2

The Credit Theory of Money

The research program followed by Schumpeter is well summarized in his ‘Preface’ to the Japanese edition of the Theorie der wirtschaftlichen Entwicklung through his highly regarded although critical reference to the Walrasian general equilibrium model (Schumpeter, 1937, pp. 159–60; also 1954, pp. 242 and 998–1026). According to Schumpeter, Walras’ apparatus represents a milestone of economic theory but it is ‘static in character’, that is, it is restricted to determining the conditions for the existence and stability of the equilibrium, and apply only to a stationary process without discontinuous endogenous changes.6 Instead, analogously to Marx, Schumpeter maintains that there is a ‘source of energy within the economic system’ able to disrupt ‘any equilibrium that may be attained’. From it, Schumpeter (1937, p. 160) derives that: there must be a purely economic theory of economic change which does not merely rely on external factors propelling the economic system from an equilibrium to another. It is such a theory that I have tried to build [...].

This means that the stationary state must be treated as a specific case, or, better saying, as the starting point and as the (temporary) point of arrival of the process of cyclical development.7 Schumpeter raises analogous remarks concerning Walras’ monetary theory. After having affirmed that this theory integrates with the ‘real’ aspects of the general equilibrium system and thus marks an important progress, he adds that this same theory leads to a static conception of money since it applies to a stationary state and cannot be extended to the economic development (Schumpeter,1954, p. 1082; see also 1917–18, p. 33; engl. trans., p. 150). Moreover, Schumpeter (1954, pp. 1020–26) maintains that this limit is due to analytical reasons. Walras (1900 4) manages to integrate monetary and ‘real’ aspects through the assimilation of money to one of the funds (or stores of goods) which offer a service as stock and which are exchanged in the ‘circulating capital’ market.8 The price of money as store is determined by the demand of its service (‘encaisses désirées’), and by the amount of its stock. The influence exerted by this price directly on the prices of capital goods and other stores, and indirectly on the remaining prices and on all the quantities, implies however the dependence of the encaisse désirée themselves on the price of money service. Hence the encaisse désirée too should be an

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endogenous variable determined simultaneously to other quantities. However, apart from making the proof of the existence and stability of the economic equilibrium more complicated,9 this would prevent Walras’ model from determining those additional variables which are necessary for the analysis of money as a flow. Walras (1898) singles out some mechanisms of banks creation of means of payments, but he considers these mechanisms as being a source of instability and abuse and he expunges them from his theoretical apparatus (Walras 19004). At this stage it is not possible to enter upon Schumpeter’s interpretation, according to which Walras’ definition of encaisse désirée brings the demand for money back to ‘the wish to hold stocks of money’ and, therefore, anticipates the essential aspects of Hicks’ (1935) and Keynes’ (1936, chs. 15 and 17) portfolio theories. What is certain is that Schumpeter has a critical attitude towards such conception of money: ‘all explanations which start with the famous adage: ‘if people choose to hold...’, are ipso facto condemned’ (Schumpeter, 1939, p. 548; see also 1970, p. 301). This clarifies Schumpeter’s attempt to build a ‘dynamic’ theory of money as a flow:10 outside the stationary states, the demand to hold money is due not to individual and voluntary (equilibrium) decisions but to unexpected (disequilibrium) outcomes of individual plans or to time lags between individual receipts and disbursements. It is worth noting that Hicks too (see 1967, pp. 14–16) maintains that the store of money held for transactions is not the result of a ‘voluntary demand’, based on ‘individual decisions’ or on the aggregation of individual choices, but the temporary result of the actual streams of payments or the effect of unexpected transactions. However, Hicks’ criticism does not go as far as involving the store of money held for precautionary or for speculative motives (see Hicks 1967, lecture III). Conversely, as the above passage points out, Schumpeter’s criticism to the demand to hold money covers the concept of stock of money as such.11 However, in order to go over Walras’ definition of money, Schumpeter has to criticize not only the demand for money as a stock, but also the traditional view of money as a ‘veil’ which does not affect the ‘real’ working of the economic system. This implies that Schumpeter has to prove the influence of money on the ‘real’ variables by only referring to the monetary flows. The essential role played by the monetary flows in Schumpeter’s cyclical changes is based on the creation of new means of payments by banks. This ‘creation’ leads to the so called ‘credit theory of money’. As will be shortly pointed out, Schumpeter’s credit theory of money has the merit of showing how the importance of bank credit lies in its function of money capital (e.g.: Schumpeter, 1970, p. 82). However, such a theory pushes too far the idea that money – in the strict sense of the word – can be assimilated to credit, and consequently that the availability of credit flows empties the (precautionary) function traditionally performed by money stocks. 12 The formulation of a credit theory of money is present in Schumpeter’s work as far back as 1912. However, it finds completion in the History of economic analysis

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177

thanks to a comparison with the ‘monetary theory of credit’. This latter doctrine offers a definition of ‘means of payment’ which is so extensive as to include the bank deposits and the bills of exchange besides the various types of money and currency. However only money, in the strict sense of the word, is the ‘good’ acting as unit of account, means of payment and store of value. The credit means of payment can temporarily (and partially) replace money; nevertheless, money stricto sensu remains at the analytical foundations of credit since the settlement of each payment and of each loan has to occur in money. The creation of means of payment by banks is thus mechanically constrained by their amount of reserves in money stricto sensu. According to Schumpeter, it follows that the monetary theory of credit is a form of that traditional theory which affirms that the only function of the means of payment and of money is to ‘facilitate’ the exchanges between goods and services without affecting their quantity and relative prices. Schumpeter maintains that, in order to escape from such a result, it is necessary to take into account three monetary aspects of the economic development: (i) the realization of new productions which break off the stationary equilibrium and begin the development process, requires the introduction of additional means of payment into the system (see Schumpeter, 1912, p. 108; engl. trans., pp. 72-3; 1939, pp. 110–11; 1970, p. 297); (ii) such additional means of payment are made available by the bank supply of credit and, therefore, represent newly created ‘claims’ on money which carry out its same functions;13 (iii) unlike money circulating in the stationary state, the availability of ‘claims’ on money does not vouch for a previous personal or material contribution to the economic activities but instead allows the participation to the ‘national dividend’ before having brought any service or good (see Schumpeter, 1912, pp. 109–110; engl. trans., pp. 73–4; 1917–18, p. 38; engl. trans., p. 154; 1939, p. 123; 1970, pp. 297–8; see also Graziani 1978, p. 463). Points (i)-(iii) found Schumpeter’s credit theory of money. Point (i) clarifies that the additional ‘claims’ on money are required by the entrepreneurs. Points (ii) and (iii) highlight that banks usually create new means of payments, and both money and the ‘claims’ on money can act as capital since they constitute a ‘voucher’ on the productive services and not only on the final goods. Schumpeter does not confine himself to state that all the means used for paying can be assimilated to the current form of money stricto sensu, that is legal tender. His main point is that legal tender represents the ending rather than the initial ring in the chain of creation of purchasing power. As emerges from the actual working of ‘capitalist finance’, monetary flows are governed by a ‘clearing system that cancels claims and debts and carries forward the differences – so that “money” payments come in only as a special case without any particularly fundamental importance’ (Schumpeter, 1954, p. 717; see also: ibid, pp. 321 and 719–20). This ‘book-keeping’ conception of the monetary system which is dealt with at a greater depth in the published (see Schumpeter, 1970, pp. 126–8, 150, 209–11, 213–14) and the additional (see Schumpeter 1996) chapters of the Theory of money and banking and which anticipates fundamental aspects of the current organization of the payment system, highlights bank creation of means of

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payments and the essential role of credit in the cyclical development (Schumpeter, 1970, ch. VI and VII; and 1996, ch. XIV; see also: Schumpeter 1996, Part I Appendix; Messori 2000). Such a conception is not a radical new representation of the monetary system, but elaborates on J.S. Mill’s intuitions and Wicksell’s analytic work, and parallels various aspects of Robertson’s (1926) and Keynes’ (1930) approaches. Schumpeter however improves the analytical framework of this monetary system. In particular, he does not lock his analysis of bank behaviour in a ‘pure credit’ model, but admits that the amount of legal tender acts as a restriction to bank creation of means of payment by regulating the reciprocal links amongst the individual competing banks and between each bank and the central bank. Hence, Schumpeter’s neglect of money as a stock and his related assimilation of money to credit have a more fundamental theoretical meaning than in Wicksell’s monetary theory.14 Before examining the ways in which banks create means of payment, it is appropriate to analyze Schumpeter’s definition of money (see 1917–18, pp. 57–65; engl. trans., pp. 168–74). Money broadly speaking should include all those circulating elements which are accepted in exchange for goods and services, and should exclude all those liquid means which are not actually in circulation. On the basis of this definition, neither the liquidity held as reserve by agents against future payments, nor the means of payment held as stock in order to cover other transactions or utilized for transfers of property rights, nor the means of payment ready to enter into circulation but temporarily hoarded can be calculated in the quantity of money (see ibid, pp. 67–8; engl. trans., pp. 175–6; see also: Bousquet, 1929, p. 1030). This makes the concept of ‘quantity’ of money unsteady and difficult to predict. It is enough to consider that the amount of ‘claims’ on money, which are added during the cyclical evolution to the money in circulation in the stationary state, depends on the decisions and behavior of various economic agents; moreover, such an amount is prone to frequent variations also because of the wide spectrum of means of payment which may flow from circulation into non circulation, and viceversa (see Schumpeter, 1970, pp. 232–36; and Shah-Yeager, 1994, p. 454). This last aspect is important in order to clarify the links between Schumpeter’s monetary theory and the quantity theory of money. Schumpeter’s definition of money implies that the quantity of money is by and large equal to the purchasing power used in each period by producers for taking possession of the services of the original factors (labor and land), or to the monetary income spent in the same period by the holders of such factors in the market of consumption goods. Given the sequence of exchanges in the markets of services and consumption goods (see below, section 11.3), the velocity of circulation of money is stable. Hence, if the sum of its components were exogenously determined, the quantity of money lato sensu would determine the absolute level of prices of the productive services and consumer goods without affecting their quantities and their relative prices. This would restore the traditional formulation of the quantity theory and, as a consequence, would imply the failure of Schumpeter’s attempt to integrate money

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as capital into the process of economic development. However, in the different phases of the cyclical development, a Schumpeter’s component of money lato sensu is endogenously determined (see below, section 11.4). Therefore, Schumpeter’s monetary theory becomes incompatible with two of the cornerstones of the quantity theory of money: the exogenous determination of money supply and the consequent causal relation between this quantity and the general level of prices.15 The previous considerations are sufficient for pointing out a few clear-cut aspects. Although it does not give a solution to all problems raised by the link between credit and money stricto sensu, Schumpeter’s credit theory of money allows three crucial aspects of a ‘dynamic’ monetary theory to emerge: (i) monetary flows have ‘real’ effects since they act as capital, (ii) this presupposes a (partial) endogenization of the money supply, and (iii) this implies a criticism of the traditional formulations of the quantity theory of money.

11.3

Money Capital and Economic Development

In order to better appreciate Schumpeter’s monetary analysis, it is useful to start with the following three assumptions: (1) the economic system is in a stationary state, (2) the quantity of money is determined exogenously, and (3) the money endowment of the managers of the productive units satisfies the reproduction constraints of the stationary equilibrium.16 Given these assumptions, the economic agents can only utilize existing money as a unit of account and as a medium of exchange; in that case, money does not affect transactions but it represents the ‘cloak of economic things’.17 This does not mean, however, that monetary flows are unimportant for the sequence of exchanges of goods and productive services. Schumpeter’s stationary state is not based on ‘simultaneous exchanges’ but on a circulation of goods and services as well as of ‘money’ which takes place in a sequence, even if it reproduces itself on an unchanged pace from period to period (see Schumpeter, 1912, pp. 54–7; engl. trans., pp. 41–6; 1970, pp. 109–11; see also Graziani 1978, pp. 459–60; Oakley 1990, pp. 240–1). Each period (t) is opened by the monetary demand for the services of the original factors (land and labor) made by the managers of the m productive units, who hold a quantity of ‘money’ equal to the unchanging monetary proceeds realized in the previous period.18 In the labor market the demand curve has a constant and unitary price elasticity, and the money wage rate ensures the full employment equilibrium. We have: Rss = M = wss N

(11.1)

with: Rss = ∑ j =1 R jt −1 ; M = ∑ j =1 M jt −1 ; N = ∑ j =1 N jt ; wss = wt = wt −1 ; and where Rjt–1 denotes the monetary proceeds realized by the productive unit j at the beginning of the previous period (t − 1) and stored until the beginning of period (t), Rss the m

m

m

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unchanging aggregate proceeds realized by the m productive units in each period of the stationary state, Mjt–1 the quantity of ‘money’ that the productive unit j carried over from (t − 1), M the unchanging amount of ‘money’ circulating in the economic system, wt the equilibrium money wage rate in t which is unchanging over each period of the stationary state (wss), Njt the amount of labor services hired by the productive unit j in t, and N the level of full employment. As (11.1) shows, the advance of money income to labor (and land) services transfers the existing quantity of ‘money’ to workers (and landowners) who utilize it for carrying out their unchanging purchase of final goods (unitary propensity to consume). The supply of these goods is given by the output produced at the end of the previous period and held in stock by the m productive units: wss N = ∑ j =1 p jss Q jss = Rss = M m

(11.2)

with: Qjss = Qjt–1; pjss= pjt ∀ j = 1,2,...,m; and where Qjt–1 denotes the amount of the final good which is produced in (t − 1) and offered in t by the unit j and which is unchanging over each period of the stationary state (Qjss), pjt denotes the equilibrium market prices of this same good in periods t which are also unchanging over each period of the stationary state (pjss). As (11.2) shows, the m productive units instantly take again possession of their initial quantity of ‘money’ which will be used to finance their unchanging monetary demand for productive services at the opening of the next period. Moreover, during the current period, the m productive units obtain that amount of factors which is necessary to carry out their production processes on an unchanged scale. The representation of the working of the economy in the stationary state stresses that it is a ‘synchronized’ process; hence, the sequence of exchanges and production does not imply important changes with respect to a framework based on simultaneous transactions (see Schumpeter, 1970, pp. 113–16). This sequence is, however, sufficient to point out that, in the aggregate, money represents the irreplaceable ‘claim ticket’ to the world of productive services and goods. In the stationary process, the set of productive units must hold (unintentionally) the quantity of ‘money’ from each period to the following one; and, at the beginning of any given period, the ‘money’ held is essential for financing the purchase of the productive services and for carrying out the current production. As a consequence, ‘money’ can act as a medium of exchange only because it acts as a monetary advance which allows for production processes to take place. Such role of advance, although not being strictly equivalent to the function of money capital, constitutes a partial approximation of it. Schumpeter defines capital as a ‘fund of purchasing power’ placed at disposal of entrepreneurs to allow the realization of their decided innovations (see 1912, pp. 165–74; engl. trans., pp. 115–23; see also: 1939, p. 129). In principle, this fund could be constituted by both ‘money’ and ‘claims’ on money. In fact, being added to the quantity of ‘money’

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circulating in the stationary state, the typical form of this new fund is that of bank credit. Schumpeter infers from this that capital is a concept which is typical of economic development: ‘in an economic system without development there is [...] no ‘capital’; or, otherwise expressed, capital does not fulfil its characteristic function’ (1912, p. 172; engl. trans., p. 121; see also: 1970, p. 116). This suggests that, according to Schumpeter, money capital accomplishes the dual role of financing the purchasing of productive services and of re-allocating these services between the preexisting productive units of the stationary state and the innovative firms founded by the entrepreneurs. It is clear that the monetary advances in the stationary state only fulfil the first role. According to Schumpeter’s previous passage, I can thus conclude that such advances act as ‘potential’ capital even without playing its full functions (see also Schumpeter, 1970, pp. 283–8). These conclusions can be translated into current economic parlance by maintaining that Schumpeter’s stationary state does not allow for a microfoundation of money as capital. For example, it is clear that, given the logical priority of the monetary purchase of productive services with respect to any other transaction, it becomes arbitrary to assume that there is a given quantity of ‘money’ exogenously determined and endowed to the managers of the productive units. On the other hand, the possible reference to means of payment, endogenously created by bank lending, gives rise to new problems (see also above, n. 17). The banks would grant loans which would be risk free, and which would be paid back instantly by borrowers. Furthermore the latter, obtaining monetary proceeds equal to monetary costs from their unchanging productive activities, would have neither incentives nor the possibility to pay a positive interest on loans (see Schumpeter, 1970, p. 299). This eliminates the typical features of debt contracts which can be brought back to the three following: (i) a time lag between the financing and its refunding, (ii) the consequent positive risk that (some of) the borrowers will default and (iii) the connected determination of a specific interest rate by the lender. I think that Schumpeter excluded the concepts of credit and capital from the stationary state also in order to avoid these problems.19 The fundamental reason of the author’s choice is, however, attributable to his wish for emphazising not only the links but mainly the analytical differences occurring between stationary state and cyclical development (see Schumpeter, 1912, p. 151; engl. trans., p. 105). Assuming that in the stationary state there is an exogenous quantity of ‘money’, Schumpeter can justify the lack of a capital market where debt contracts are designed and drawn up and where different interest rates are determined. On the other hand, by describing the stationary state as a period process, Schumpeter lays the bases for his criticism of the traditional definitions of capital. The result is that a complete analysis of money as capital requires a well organized capital market and, therefore, goes hand in hand with cyclical development. Such analysis, however, must start from the role of ‘advance’ played by money in the stationary process.

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Money Credit and the Role of the State

The process of cyclical development takes place in a sequence of exchanges similar to the period process of the stationary state.20 As stated earlier (see also equations (11.1) and (11.2)), at the end of each period of the stationary state, the only ‘money’ holders are the managers of the productive units, who plan to use the entire amount of this ‘money’ to purchase the services of the original factors (here labor services) at the opening of the following period. In this framework, the introduction of an innovative activity does not alter the plans of the incumbent productive units. Even if the entrepreneurs were to identify with a subset of the old managers, the latter would anyway consider it convenient to associate the innovative production with their previous productive activity for they would expect the routine behaviours to be economically efficient until the innovative output will be supplied in the market of final goods.21 It follows that the entrepreneurs, besides being devoid of services of the original factors and of investment goods, do not have any purchasing power and cannot obtain transfer of cash from the managers of the incumbent productive units. This implies that: (1) the accomplishment of the decided innovations and the consequent beginning of the development process presuppose the creation of means of payment in favour of the entrepreneurs; (2) such monetary means add to the ‘money’ circulating in the stationary state; (3) the bank system is the institution typically set up for the financing of entrepreneurial activities through the creation of new ‘claims’ on money.22 An investigation on points (1)-(3) would raise a number of questions. That of point (3), in particular, would require an analytical and historical explanation of why Schumpeter ascribes a role of ‘venture’ capitalist to banks. Here I confine myself to recalling that Schumpeter’s analysis of bank behaviour is strongly affected by the German financial set-up at the beginning of the twenties century, and that this analysis does not imply that the credit supply is infinitely elastic (see Schumpeter, 1912, pp. 161–4; engl.trans., pp. 112–15). A more careful investigation would not change, anyhow, the fact that the entrepreneurs utilize their money capital in order to take possession of the amount of the services of labor which are necessary for carrying out their innovative activity.23 This implies that there is an additional demand for labor services compared to the level set in the stationary state which, in its turn, coincides with full employment. As a consequence, bank’s creation of means of payment in favour of the entrepreneurs implies not only changes in the produced amount of investment and final goods but, primarily, changes in the absolute and relative prices and a re-allocation of productive services.

11.4

The Sequence in the Cyclical Development

It is possible to formally sketch the sequence of exchanges, which characterizes the process of cyclical development (see Schumpeter, 1970, pp. 292–93), by starting from the framework of the stationary state, synthesized by equations (11.1) and (11.2) above. At the beginning of period (t + 1) in which n-m (n > m)

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entrepreneurs come on and obtain new purchasing power through bank financing, the managers of the incumbent productive units have, as a budget constraint, the unchanging monetary proceeds realized in the previous stationary state. It follows that, at the beginning of (t + 1), the monetary demand for labor services made by the set of productive units is still R = M; however, unlike in the previous periods of the stationary state, the aggregate monetary demand for labor services is increased n by that of the entrepreneurs which is equal to ∑ k =m+1 Lkt +1 – where Lkt+1 denotes the credit flow granted by a given bank to entrepreneur k. The adjustment between the increased monetary demand and the unchanged supply of labor services in the labor market implies an increase in money wages,24 that is: M + Lt +1 = wt +1 N

wt +1 > wss

(11.3)

with: Lt+1 = ∑ k =m+1 Lkt +1 ; and where wt+1 denotes the equilibrium money wage rate in (t+1). This increase in the money wage rate allows the new firms to start their innovative processes through the withdrawal of a part of the labor services from the incumbent productive units, that is: n

M = wt +1 N o , Lt +1 = wt +1 N n

No < N , Nn > 0

(11.4)

with: No ≡ ∑ j =1 N jt +1 ; Nn = N − No; and where No and Nn denote the amount of labor services hired, respectively, by the set of the old productive units and by the set of entrepreneurs at the beginning of (t + 1). The related increase in the total amount of money wages implies furthermore that, in the market of final goods, there is an equivalent increase in the aggregate monetary demand. Given that the supply of final goods is equal to the unchanged output produced by the incumbent units in the previous stationary state (period t), an increase in the price of those goods will follow. Confining the analysis to the aggregate level, 25 we have: m

pt +1 = wt +1

N wt +1 = Qss πss

pt +1 > pss

(11.5)

where pt+1 and pss denote the aggregate level of prices, respectively, in (t + 1) and in the stationary state, Qss the aggregate level of output in the stationary state, and πss the average productivity of labor services in the stationary state. At the aggregate level, this price increase is proportional to that of the money wages; hence, the real wage rate remains unchanged (wt+1 /pt+1 = wss/pss). However, these changes in the absolute prices and in the allocation of the productive services are not free of consequences for the income distribution (see also: Schumpeter, 1996, ch. XV). The incumbent productive units, being the only suppliers in the market of final goods, get monetary proceeds higher than the unchanged production costs so that they reach unexpected profits (ρot+1). Given (11.4) and (11.5), we have:

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ρot +1 = pt +1Qss − wt +1 N o = wt +1 N n

(11.6)

(11.4)–(11.6), however, do not point out all the macroeconomic and microeconomic changes of the first phase of the cyclical development to which Schumpeter refers by the term prosperity (or expansion). At least two other elements enter into the previous picture: the lengthening of the new production processes, and the appearance of ‘swarms’ of entrepreneurs and imitators. Innovations imply a lengthening of the new production processes (Schumpeter, 1939, p. 93; see also: Clemence and Doody, 1950, p. 9). Analogously to the productive units of the stationary state, the innovative firms utilize not only the labor services but also investment goods. In the vertically integrated production process which is typical of the ‘Austrian school’ and of Schumpeter, investment goods are ‘potential’ consumption goods (that is, intermediate goods). The investment goods are ‘specific’ to the innovative production processes and, unlike the homogeneous labor units (see n. 23), they cannot therefore be withdrawn from the incumbent productive units of the stationary state through an increased monetary demand. Hence, before producing the final goods, each innovative firm has to produce the intermediate goods necessary for producing its final good (see also: Amendola and Gaffard, 1988). Let me assume, for sake of simplicity, that the production of the new intermediate goods requires only one standard production period, and that an additional standard period is sufficient to produce the final goods by combining these new intermediate goods with the labor services. Hence innovative firms are able to end their innovative productions in two periods, and therefore they supply their final goods on the market at the opening of the third period (here, period (t + 3)). The lengthening of the innovative productions changes the above described picture of the prosperity phase.26 It implies that, at the beginning of the second period of the innovative process (that is, at the beginning of (t + 2)), entrepreneurs ask successfully for a new bank financing. Let me assume, for sake of simplicity, that (a) the old productive units decide not to utilize the unexpected profits, ρot+1, held in stock from the beginning of (t + 1), to increase its monetary demand for labor services, that (b) such a decision is ‘common knowledge’, and that (c) the amount of labor units, required by the production of the new intermediate goods in (t + 1), is equal to that required by the combination which produces, in (t + 2), the new final goods. Assumptions (a)–(c) imply that, in (t + 2), the amount of the entrerpreneurs’ demand for financing is equal to that of the previous period, that is Lt+2 = Lt+1. Hence, the equilibrium in the labor market does not change, that is: M + Lt +2 = wt +1 N M = wt +1 N o , Lt +2 = wt +1 N n

(11.3 bis) No < N , Nn > 0 (11.4 bis)

Equations (11.3 bis) and (11.4 bis) and the lengthening of the innovative productions imply that workers undergo a ‘forced savings’.27 It is sufficient to note that, given the unchanged total amount of money wages and hence the unchanged

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monetary demand by workers (see points (a)–(c) above), in (t + 2) the availability of final goods is decreased compared to the previous period. The old productive units continue to be the only suppliers of final goods, but their output has decreased at the end of (t + 1) due to bank financing of the innovative processes and the related withdrawal of labor services by the entrepreneurs. As a consequence, remaining at the aggregate level and assuming full employment (see n. 24), at the beginning of (t + 2) the price of the final goods marks a new increase so that the unchanged amount of money wages leads to a fall in real wages. We have (see also equation 11.5): pt +2 = wt +1

Nn   1 N = wt +1  +  Qt +1 π π ss N o   ss

(11.7)

with: Qt+1 < Qss; and pt+2 > pt+1; and where Qt+1 denotes the aggregate level of output produced at the end of (t + 1) and sold at the beginning of (t + 2), and pt+2 denotes the aggregate level of prices in (t + 2). Conversely, continuing to be the only supplier, the set of the old productive units gets the same amount of profits obtained in the previous period, that is ρot +2 = pt +2 Qt +1 − wt +1 N o = wt +1 N n

ρot+2 = ρot+1 (11.6 bis)

The analysis made so far implies that the prosperity phase should have to finish at the beginning of period (t + 3), when the innovative output is offered in the market of final goods. Given that the entrepreneurs realize their expectations,28 their amount of final goods would more than compensate the negative difference between the current and the stationary state output realized by the old productive units. Therefore, at the aggregate level, the price of the final goods would decrease, the set of the old productive units would suffer losses, the entrepreneurs would attain their expected profits (gross of the financial charges), and the unchanged amount of money wages would imply a real wage rate even higher than that in force in the stationary state and in (t + 1). We would have: pt +3 = wt +1

wt +1 N N = Qt +2 πss N o + πn N n

(11.8)

with: Qt+2 > Qss > Qt+1; pt+3 < pt+2; and wt+1 /pt+3 > wt+1 /pt+1 = wss /pss > wt+1 /pt+2; and where πn (>πo) denotes the average productivity of labor services in the innovative productions; ρot +3 = pt +3Qot +2 − wt +1 N o =

wt +1 N o N n (π ss − πn ) πss N o + πn N n (11.9)

ρnt +3

w N N (π − π ss ) = pt +3Qnt +2 − wt +1 N n = t +1 o n n πss N o + πn N n

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Money Credit and the Role of the State

with: ρot+3 < 0 and ρnt+3 > 0 since πss < πn; Qot+2 + Qnt+2 = Qt+2; and where Qot+2 (≡ πss No) and Qnt+2 (≡ πn Nn) denote the total level of output produced at the end of (t + 2), respectively, by the m incumbent productive units and by the (n – m) innovative firms, and ρot+3 and ρnt+3 denote the monetary profits realized in (t + 3), respectively, by these same two sets of producers. It must be noted, however, that equations (11.8) and (11.9) does not consider that the innovative activities are not restricted to those realized by the first entrepreneur(s) but take place in ‘swarms’ (see e.g.: Schumpeter, 1912, pp. 334– 42; engl. trans., pp. 223–31). Taking into account this aspect is crucial since it marks the shift from the aggregate to the microeconomic analysis. The problem is that this shift runs the risk of making Schumpeter’s model so ‘open’ as to become analytically intractable. Therefore, it is worth introducing some simplifications and, then, describing informally a plausible working of the economic system.

11.5

The ‘Swarm’ of Innovations: Some Microeconomic Implications

In order to analyze the ‘swarm’ of innovations, I assume that: (i) the first and limited group of entrepreneurs, which starts innovative processes at the beginning of period (t + 1), operates in specific sectors of the economic system; (ii) this group opens the way to a second and broader group of entrepreneurs that, in (t + 2), undertakes a modified version of (part of) the innovative processes under way in order to adapt them to the economic sectors which are close to the innovative ones;29 (iii) the expected profitability of innovations pushes, in (t + 3), a first group of imitators, which operates in the numerous sectors by now touched by the initial or by the induced innovations, to replace their old activities of the stationary state with the new processes; (iv) in (t + 3) the old productive units, which continue to operate routinely in sectors – directly or indirectly – touched by the innovations and by the first imitations, suffer actual losses so that a second group of imitators is pushed to undertake imitative processes at the beginning of (t + 4). The reference to the behaviors of the four groups of producers sub (i)–(iv) explains why the prosperity phase does not finish in (t + 3).30 Assumption (i) implies that, at the beginning of period (t + 1), there is not a generalized increase in money wages but an increase in the money wage rates of the labour units hired in the innovative sectors (see instead equation 11.3 above). Given the variance in households’ consumption, this leads to increases in the prices of some final goods but not of others (see instead equation 11.5 above). It follows that there is a change in the relative prices of final goods and services and a redistribution of the monetary proceeds within the set of the old productive units. In particular, if they do not attain adequate increases in the monetary demand for their final goods, the old productive units operating in the innovative sectors or in those contiguous to the innovative sectors may suffer losses; and the workers, employed in productions ‘remote’ from the innovative sectors and hence with unchanged money wages,

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may suffer a fall in their real wages (see instead equation 11.6 above). The undertaking of induced innovations implies that, in (t + 2), the number of innovative sectors as well as the labor units with increasing money wage rates broaden. This accentuates the changes in the relative prices of goods and services as well as the income redistribution within the set of workers and the set of the old productive units. Finally, the progressive spread of the imitative processes may imply that, in (t + 3), in (t + 4), and in (t + 5) the new supplies of final goods produced – respectively – by the first innovators (see above, point i), by the second group of entrepreneurs (see above, point ii), and by the first group of imitators (see above, point iii), do not lead to an increase in the aggregate output (no matter how measured) and/or to a fall in the prices of these goods. As regards to (t + 3), it must be recalled that the second group of entrepreneurs has started his/her two-period innovative processes in (t + 2) and will offer his/her final goods only at the beginning of (t + 4); moreover, at the beginning of (t + 3), the amount of money wages undergoes an increase because a first group of imitators resorts to bank lending and starts the new productions in the innovative sectors. Hence, at the beginning of (t + 3), the amount of new final goods supplied by the first innovators can be more than countervailed by the lack of supply by the second and larger group of entrepreneurs, and by the increased monetary demand for final goods which follows from the increase in money wages. As regards to (t + 4), it must be recalled that the first group of imitators just mentioned is now achieving his lengthened production processes, and will offer the new output of final goods only at the beginning of period (t + 5); moreover, at the beginning of (t + 4), there is a new increase in the amount of money wages because a second group of imitators resorts to bank lending and starts the new production processes. If the first and the second groups of imitators are sufficiently large in number, their withdrawal of labor services at the beginning of (t + 3) and (t + 4) with the consequent lack of supply and increase in money wages at the beginning of (t + 4) can more than countervail the supply of final goods by the two groups of entrepreneurs. And a similar reasoning could apply to (t + 5). If these possible results come true, there is a common feature in the periods of the cyclical development analyzed so far: in all these periods, the undertaking and implementation of innovative or imitative processes dominate the lagged outcome of previous innovative or imitative processes so that the aggregate output of final goods either decreases or increases less than the increase in the amount of money wages, and prices raise. Hence the bank financing, required to realize these new processes, introduces in the economic system an amount of purchasing power that, at the prices of the stationary state, exceeds the supply of final goods. Schumpeter (1912, p. 147; engl. trans., p. 101) maintains that ‘the credit structure projects [...] beyond the existing commodity basis’. As I have already noted, this determines an increase in prices (of the majority) of the final goods. This increase is labelled ‘credit inflation’. It is worth stressing that we are dealing with a temporary inflation because it is only due to the lengthening of the innovative and imitative

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processes and to the related time lag between the starting of these processes and their output of final goods. The output of the new processes will more than compensate for the previous surplus of purchasing power (see also Schumpeter, 1996, ch. XIV). This temporary inflation emphasizes that, by falling into debt with banks, the entrepreneurs and their imitators become indebted with the whole society so that, from the economic point of view, the settlement of their debts does not end in the repayment to lenders, but it also requires the refund of the final goods withdrawn from the circular flow through the withdrawal of labor services. Therefore, by anticipating the money capital, the banking system plays a role of ‘social accountant’: it issues a ‘claim ticket’ which enables entrepreneurs – differently from any other economic agent – to buy before selling. This means that the banking system issues, on behalf of the economic system, that ‘claim’ which is necessary to realize the decided innovations and imitations (see Schumpeter, 1912, pp. 158–9 and 110; engl. trans., pp. 110–11 and 73–4; see also: 1913, pp. 57 and 61–3; 1917–18, p. 109; engl. trans., pp. 205–6; 1970, pp. 125–6 and 149–54). It is important to stress the economic functions of the temporary credit inflation. This inflation cannot be interpreted as a distortion in the working of the economic system which could be avoided or corrected by means of a restrictive monetary policy (see Schumpeter 1925b), but it has to be considered as a necessary consequence of the redistributive mechanisms which are at the basis of economic development and which gradually spread to consumers as a whole (see below). Therefore, in contrast with Keynes (1923), Schumpeter (e.g. 1925a and 1927a) maintains that any attempt to stabilize the general level of prices, in order to avoid the credit inflation in a two-phase cycle, would have the undesired effect of binding the economic system to the stationary state or to exogenous growth. 31 Schumpeter adds that price swings are distorsionary, and hence must be corrected, only when they cease to be a normal consequence of the innovative processes and become the result of speculative behaviors which are typical of the four-phase cycle. These last statements will become more evident if the turning point, which divides the prosperity from the recession phase of Schumpeter’s two-phase cycle, is specified. Due to the lengthening of the new production processes, Schumpeter’s prosperity phase is characterized by a decrease in the available amount of final goods and/or by an increase in the aggregate level of prices.32 Hence, there is the turning point in Schumpeter’s two-phase cycle when the amount of final goods produced through the innovative or imitative processes more than compensates for the increase of money wages and for the lack of supply of final goods due to the implementation of other imitative processes by old productive units. Then the aggregate supply of final goods begins to increase continuatively and their prices to decrease continuatively.33 According to Schumpeter, this implies that credit inflation lasts and prosperity gives way to the the second cyclical phase, called recession. The turning point in the two-phase cycle is helped by the self-deflation process which is induced by the progressive settlement of the debts to the banks by

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the innovators and by (a part of) the imitators (see Schumpeter, 1912, pp. 158–9 and 345; engl. trans., pp. 110–11 and 233–4; 1939, pp. 133–7; 1970, pp. 293–7). The recession phase tends to flow into a neighborhood of equilibrium in which the ‘claims’ on money, introduced in the economy in order to finance innovations and imitations, are no longer in circulation because they have been returned to banks which, therefore, first created them and now ‘destroy’ them (see Schumpeter, 1970, pp. 188 and 194). If exogenous increases of the ‘money’ supply are excluded, in the economic system there will remain the quantity of ‘money’ already circulating in the initial stationary state (ibid., p. 296). However, at this stage such ‘money’ is differently allocated amongst the economic agents. The old productive units, which were not able to imitate any innovation and were turned out of the market during the process of recessive adaptation, suffered losses and gave up ‘money’ flows to innovators and to the first groups of imitators, who monetized, in this way, their profits gross of financial charges. These profits are nevertheless temporary, and the new income produced is gradually spread over the economic system. Here I do not investigate Schumpeter’s analysis of the recession phase and of the related process of recessive adaptation. Given the previous assumptions, I limit myself to underline few implications. As in the case of the temporary increase in prices due to ‘credit inflation’ during prosperity (see above), Schumpeter does not give any negative connotation to recession: his latter phase fulfils the function of spreading the results of innovations to the economic system, by making the prices to fall and by transferring the increased income to the households. According to Schumpeter (e.g. 1912, pp. 348–9; engl. trans., pp. 236–7; 1939, pp. 142–3), recessions thus represents a physiological element of economic development. Let me assimilate, for sake of simplicity, the reached neighborhood of equilibrium to a new stationary state. We have (see also equations 11.1, 11.2, and 11.5): Rss = M = wss N

(11.10)

wss N = ps ' s 'Qs ' s '

(11.11)

with: Qs’s’ > Qss; ps’s’ < pss so that wss/ps’s’ > wss/pss; where Qs’s’ and ps’s’ denote, respectively, the aggregate level of output and the aggregate level of prices in the final stationary state. Before concluding the analysis of Schumpeter’s model of cyclical development, it is worth stressing that its two-phase cycle can hardly be assimilated to the standard representation of a cycle fluctuating around a trend (see Schumpeter, 1939, pp. 207 and 223). Moreover, Schumpeter makes use of quite idiosyncratic labels. The phase, which is called prosperity (or even expansion) and which is normally identified with the upward cyclical phase, is characterized by interperiod decreases in the aggregate output of final goods and/or by interperiod increases in their prices whereas the phase, which is called recession and which is normally identified with the downward cyclical phase, is characterized by interperiod increases in the aggregate output of final goods and/or by interperiod

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Money Credit and the Role of the State

decreases in their prices until the attainment of a new stationary state. By roughly illustrating these changes – respectively – in the aggregate output of final goods and in their prices, Figure 11.1 point immediately out the ‘oddity’ of Schumpeter’s two cyclical phases.

Qt+i

Pt +i i = 0, 1, 2, 3 , ... SS = stationary state P = prosperity R = recession

SS

P

R

P

R

(a)

R

P

SS P

R

SS

R

SS SS

t+ i

t+4

R P

SS

SS

SS

P

t+i

t+ 5

(b)

Figure 11.1 Schumpeter’s two-phase cycle: a) the aggregate output; b) the aggregate prices

11.6

Conclusions

Schumpeter’s analysis of the two-phase cyclical development leaves other more analytical problems still unsolved. For example, Kuznets (1940, pp. 262–4) has underlined that the temporal swinging between ‘swarm’ of entrepreneurs and lack of innovations is justifiable only by means of ad hoc hypothesis. Other commentators have shown that, by modifying a few assumptions, the innovative processes generate cyclical movements which are very different from Schumpeter’s two-phase or four-phase cycle (see Brouwer, 1991). Others have maintained that the unilateral reference to innovations does not explain the periodic swinging of cyclical phases (e.g.: Tobin, 1991, p. xi). Others have pointed out Schumpeter’s too sketchy analysis of the turning point from the prosperity to the recession phases (e.g.: Oakley, 1990, pp. 182–3). Although the close examination of each of these problems is preminent in order to reach an adequate reconstruction of the Schumpeterian framework, in this chapter it is not possible to deal with such a task.34 The overlooking of the limits which characterize the Schumpeterian model of the two-phase cyclical development, does not represent, however, the main

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weakness of the present chapter. Even if it is dedicated to Schumpeter’s credit theory of money, this chapter does not specify the form of the debt contract between banks and entrepreneurs (or imitators) during the prosperity phase. The fact is that the determination of the debt contract design cannot be achieved through a simple summing up of the few pages which Schumpeter dedicates to the subject. As I show in a paper centered on this particular but crucial aspect of Schumpeter’s credit theory of money (see Messori, 2000), Schumpeter’s analysis leaves various problems such as the objective-function of the individual banks, the determination of interest rates, and the role played by the credit demand and supply curves, unsolved. These limits do not cancel the fact that Schumpeter (1912, 1939, 1970, and 1996) elaborates a more complete and stimulating theory of bank behavior than Wicksell’s (1898), Robertson’s (1926), and Keynes’ (1930) path-breaking analyses.

Notes *

1

2

3

4

5

This chapter addresses one of the main issues analyzed by Augusto Graziani in his original research project centered on the ‘circuit of money’ and on the reconstruction of a strand in the history of economic analysis from Marx and Wicksell to Keynes and post Keynesians. An important feature of this project has been the analysis of the introduction of means of payments into the economic system and its consequences for the realization of market exchanges and for productiuon processes. It follows that the content of this chapter is largely influenced by Augusto’s ideas. Needless to say, my intellectual debt towards Augusto Graziani cannot be reduced to this. I had the privilege of working with him for more than ten years, and you cannot imagine how much I learnt in that period from the analytical as well as from the human point of view. It should be noted that, at least according to Klausinger (1990), Schumpeter (1908 and 1912) himself can claim the autorship for the expression ‘veil of money’. The differences between Schumpeter’s and Wicksell’s monetary theories will be dealt with later on. Taking also into consideration the chapters included in volumes, Schumpeter’s monetary writings number slightly over a dozen. Moreover, in grouping the 1916 works on Schumpeter into eight categories, Augello (1990, pp. 21–4) highlights that the works dedicated to ‘money’ are largely lesser in number than those concerning ‘development’ and ‘politics’. However, the ‘money’ category includes over 170 references; and its rate of growth is faster than the average in the last decades. Graziani (1977, 1978, and 1982) mainly contributed to this growing interest in Schumpeter’s monetary theory. Schumpeter (1908) points out the limits of a framework confined to the stationary state or to the ‘growth’, and introduces some of the crucial concepts for the analysis of the cyclical development. The first framework which includes the cyclical development, is however offered by Schumpeter (1910). Similar thoughts can be found in Schumpeter (1948; and 1954, p. 292 n.). Furthermore, Schumpeter notes that ‘stationary capitalism is a contradiction in terms’ (1943, p. 174; see also 1936, p. 155; 1946a, p. 193) and has to include, amongst its fundamental features, ‘the creation of means of payments [...] by private banks’ (1943, p. 170; see also 1928, p. 48). For reasons clarified in Messori (1997), from now on such title will indicate the twelve chapters of Schumpeter’s treatise on money published posthumous as Das Wesen des

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Geldes (see Schumpeter 1970), and the three additional chapters of this treatise published for the first time in an Italian edition (see Schumpeter, 1996, Part I). 6 Although warning not to confuse the ‘static conditions’ and the ‘stationary conditions’ (see also Schumpeter 1927b; Marget, 1938, p. 41; Marget, 1942, pp. 112–3 and 361), Schumpeter (1937) turns the latter into a particular case of the former which are, in turn, assimilated to the situations of equilibrium. The result is, as showed in the two German editions of the Theorie (see Schumpeter, 1912, pp. 76–80), that Schumpeter ends up by contrasting the ‘static-stationary-equilibrium’ concepts to the ‘dynamic-developmentdisequilibrium’ ones. However, when presenting the English edition of the Theorie (see Schumpeter, 1934, p. xi; see also the added footnote at p. 64), Schumpeter acknowledges the ambiguity of this use of the terms ‘statics’ and ‘dynamics’. With the exception of the convenient expression of ‘”dynamic” theory of money’, in this chapter I will avoid assimilating statics to the circular flow or to the stationary state (see also below, n. 7) and dynamics to development. 7 In this chapter, I am not concerned with the problem of whether Schumpeter’s stationary state represents either an ‘ideal’ reference point or a part of the economic process. It is sufficient to remember that such a stationary state: (i) can easily be extended to the circular flow with growth or exogenous changes (see Schumpeter, 1912, ch. I); (ii) it must act as a premise of the economic development both for avoiding misinterpretation between what explains and what needs to be explained (see Schumpeter, 1910, p. 277; 1912, p. 89; engl. trans., p. 58), and for founding analytically the entrepreneurial choices (see Schumpeter, 1912, p. 347; engl. trans., pp. 235–6; 1939, pp. 135–6); (iii) it characterizes the new equilibrium, into whose ‘neighborhoods’ the phase of recessive adaptation tends to flow in the two-phase cycle (see Schumpeter, 1939, pp. 70–71); (iv) it favours but does not guarantee the re-starting of the economic development since the mechanical conception ‘according to which there would be booms because there are depressions, and depressions because there are booms’ is refused (see Schumpeter, 1927b, p. 29; see also: 1912, p. 336; engl. trans., p. 225; Stolper, 1982, pp. 30 and 42). 8 In order to distinguish the stores of money from the stores of goods, Walras affirms that the exchanges of money services are realized in a specific market called ‘marché du capital’. In Walras’ terminology, the ‘marché des capitaux’ refers, instead, to the market in which capital goods are exchanged. 9 According to Schumpeter (1954, pp. 1024–5), Walras chose to neglect the effects that the value of the overall transactions exert on the encaisse désirée in order to avoid such complications. However, Schumpeter states that this simplification cannot be accepted because, as Walras himself (19004) recognizes, it leads to the separation between the money equation and the system of equations of the ‘real’ part of the economic system with the consequent relapse into the conception of the money as a ‘veil’. 10 By criticizing Walras’ theory of money and its ‘new lease of life’ (see, for the last expression, Schumpeter, 1939, p. 547), Schumpeter is also intent on criticizing Keynes’ definition (1936) (see also Schumpeter 1936 and 1946b). 11 In various passages (e.g. 1970, pp. 301–302) Schumpeter recognizes that the stores of money held by the individual agents (firms, households) can be the result of intentional actions. However, in such passages, Schumpeter also stresses that these aspects are irrelevant for the theoretical representation of the economic working. Furthermore, he tends to exclude money stocks from his definition of money. 12 Hicks’ most recent monetary analysis (1982, part IV; 1989, part II) has sketched a way for integrating bank credit and the demand to hold liquidity for precautionary motives. A first attempt to develop Hicks’ suggestions is offered in Messori and Tamborini (1995). Shortly, it will be clear to what extent this differs from Schumpeter’s analysis.

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13 See Schumpeter, 1912, pp. 140 and 142; engl. trans., pp. 95 and 97; 1917–18, pp. 56–7; engl. trans., pp. 167–8; 1927a, p. 85 n.; 1970, p. 233. See also the first part of the unpublished chapter XIV of Theory of money and banking, available in Italian (see Schumpeter 1996). It should be noted that Schumpeter (1939, pp. 578–81) lists eleven possible sources of financing, and some of these sources do not increase the amount of means of payment (see also Earley, 1983, pp. 9–15). However, as Schumpeter himself underlines (1939, p. 578), this list does not refer to ‘the origin of the cyclical process’ but goes ‘away from it’. Following Schumpeter’s two-phase cycle, I, therefore, restrict the analysis to bank credit (see also Schumpeter, 1970, pp. 149 and 230). 14 This relates Schumpeter’s monetary analysis to that stream of the ‘new Keynesian economics’ centered on information asymmetries and on the connected imperfections in the capital market. The monetary theory of this new Keynesian stream is, in fact, limited to the credit flows (see Blinder-Stiglitz 1983; Greenwald-Stiglitz 1991 and 1993). 15 Analogously to Wicksell (1898, ch.5) Schumpeter (see e.g.: 1948; 1970, pp. 48–53) stresses that the ‘fundamental equation’, which is another cornerstone of the quantity theory of money and does not imply any causal link between its two sides, can still be valid without becoming a ‘tautology’ (see Schumpeter, 1917–18, p. 78; engl. trans., p. 183; 1970, pp. 282–3; see also Marget, 1938, pp. 19–22 and 91–2). Schumpeter’s conclusion is that the ‘fundamental equation’ remains an important descriptive tool of monetary theory even if it asks for a sensible re-definition, compared to Fisher’s traditional formulation, in order to be embodied in his framework 16 As touched upon above, the terms ‘entrepreneur’ and ‘firm’ are attributed – respectively – to innovators and to innovative activities. Hence, the economic agents who manage the production processes in the stationary state are labelled ‘managers’ or ‘administrators’ of productive units which realize routine activities. 17 See Schumpeter, 1912, pp. 60–6; engl. trans., pp. 46–52. Schumpeter adds that, in principle, the money functions as unit of account and medium of exchanges are separated (see also 1908, p. 289; 1970, pp. 33–4). As a consequence, in the stationary state money could take the form of a credit means of payment, and money stricto sensu could confine itself to act as a ‘debt-discharging unit of account’ (see De Vecchi 1995, p. 66). Following Schumpeter, I assume that the money circulating in the stationary state is money stricto sensu (from now on ‘money’) and not a ‘claim’ on money. Together with (1) and (3), this assumption also facilitates the determination of the quantity of money (see Schumpeter, 1939, p. 546; 1954, pp. 704–705; 1970, p. 232–3). 18 From now on I will exclusively refer to the services of labor since the analysis of the services of land would require further qualifications. Moreover, the level of aggregation of equation (11.1) below conceals that the productive units must replace the investment goods consumed in the current productions. It is worth noting, in this respect, that Schumpeter follows the Austrian representation of vertically integrated production processes; hence, Schumpeter cannot assimilate this replacement to the demand for the services of the original factors (e.g.: 1912, pp. 19–21 and 57-9; engl. trans., pp. 16–7 and 45–6). However, the Austrian representation of the production processes does not affect the analysis of the stationary state. Conversely, as it will be specified later, this representation plays an important role in the cyclical development. 19 What has just been said does not contrast with Schumpeter’s repeated statements that credit and interest penetrate into the stationary state and become permanent and important phenomena of the capitalist economic system (e.g.: 1912, p. 150; engl. trans., p. 104; 1970, p. 300). As it clearly emerges from such statements, this is the result of previous development processes and of (speculative) excesses induced by innovations. In order not to fall into the vicious circle which explains the development phenomenon by presupposing it (see also n. 7, point ii), my analysis of the stationary state is not based on a previous development process. Furthermore, I am referring to Schumpeter’s

194

20

21

22

23 24

25

26 27

Money Credit and the Role of the State two-phase cycle (or ‘first approximation’) and not to the four-phase cycle (or ‘second approximation’). Without neglecting any essential aspect, in this way I exclude any speculative phenomenon which would lead to depression (see Schumpeter, 1939, ch. 4). As will result clearer below (see section 11.4), the crucial differences between the time sequences of the cyclical development and of the stationary state lay in the fact that the former cannot be reduced to an instantaneous process through the synchronization of exchanges and productions. Schumpeter (e.g.: 1912, pp. 100–101; engl. trans., pp. 65–6) insists on the fact that the entrepreneur is a new figure, not characterized by her/his link with an old productive unit but by her/his capability to produce ‘other things’ or ‘the same things by a different method’. Schumpeter does not offer, however, an analytical justification on why the innovation should be embodied in a new firm. The explanation just suggested, which is also compatible with other passages by the author (see Schumpeter, 1912, p. 216; engl. trans., pp. 136–7; 1939, pp. 94–6), aims to fill this gap. Schumpeter stresses points (1)–(3) in several passages. E.g.: 1912, pp. 104–109 and 141–4; engl. trans., pp. 69–71 and 96–8; 1913, pp. 57–62; 1917–18, pp. 104–105; engl. trans., pp. 202–203; 1939, pp. 110–11; 1970, pp. 291–2. A large part of these quotations refer furthermore to my following analysis. I will also offer some information concerning the allocation and spread of innovations through the reference to the ‘swarm’ of entrepreneurs and to to the ‘imitation’ processes (see section 11.4). In any case, I assume that the entrepreneurial activity always reaches a dimension sufficient to affect market prices Let me recall that I am exclusively referring to the services of labor (see above, n.18). Moreover, I assume at first that the labor units are homogenous. Although Schumpeter refers to the traditional supply curve of the labor unit, which – at least in its first part – increases with the real wages (e.g.: 1912, pp. 27–8; engl. trans., pp. 22–3), Schumpeter’s analysis requires that the labor supply becomes infinitely rigid to the predetermined full employment level. For a brief examination of the ad hoc arguments which may make Schumpeter’s position coherent, see Messori (1987), p. 147, nn. 12 and 13. Anyway I assume here that, in the two-phase cycle, this full employment condition is always realized. Schumpeter refuses the method of aggregates (see 1935, p. 136; 1936, pp. 154–5; 1939, pp. 43–4; 1946c, p. 210; 1970, p. 269). My simplification therefore contrasts with Schumpeter’s analysis of the macroeconomic consequences of innovations (e.g. Schumpeter, 1939, p. 144). I have resorted to this simplification because I have not yet specified the hypotheses concerning the time lags in the realization of innovations and their sectorial allocation. I have confined myself to assuming that the innovative activities have, since the beginning, a sensible macroeconomic impact (see n. 22). This is why I stated earlier (see n. 18) that the Austrian analysis of the production process plays an important role in Schumpeter’s cyclical development. An opposite thesis is maintained by various critics (e.g.: Stolper, 1982, p. 37). An accurate definition of ‘forced savings’ is given by Machlup (1943, pp. 27–8). Schumpeter seems to swing between two extreme positions: at times he attributes great importance to this phenomenon (e.g. 1912, pp. 155–6; engl. trans., pp. 108–9; 1917–18, pp. 92–3; engl. trans., pp. 193–4), at others he considers the reference to it misleading (see 1939, p. 112n). In fact, Schumpeter does not modify his position over time. In his development process, the ‘forced savings’ may indicate the fall in the purchasing power of the receivers of fixed incomes as well as of a subset of managers of the old productive units (and, in a subordinate position, a fall in the real wages of a subset of workers). However, Schumpeter’s ‘forced savings’ never indicate the fall in the total amount of real wages (see also Schumpeter 1996, ch. XV). The limit of this position, which is softened only in Schumpeter (1954, pp. 1115–6), is due to the underestimation

Credit and Money in Schumpeter’s Theory

28 29 30 31

32

33

34

195

of the temporary effects that the lengthening of the innovative productions has on the income distribution. This condition is always fulfilled in Schumpeter’s model of ‘first approximation’. This strenghtens Schumpeter’s criticism to those authors that, like Keynes (1936), reserve a role of deus ex machina to the expectations (Schumpeter, 1936, p. 154n; 1939, p. 55). It is possible to denominate these later innovations as induced innovations. In this chapter I do not enter into Schumpeter’s intuitable explanation of why the induced innovations can involve a broader group of entrepreneurs than the initial ones. The analysis of these behaviors requires the elimination of the previous simplification concerning the perfect omogeneity of the labor units. For what follows, see also: Schumpeter (1996), chs. XIV and XV. This also helps to pointing out an important difference which divides the cyclical models elaborated, respectively, by Schumpeter and by Hayek (e.g., 1931). The analytical structure of the these two models is similar in many respects. However, according to Hayek, the bank financing of the lengthening of production processes does not only prime a disequilibrium cycle but it also causes a distorsion in the optimal working of the economic system. The decrease in the amount of final goods and the increase in the level of their prices do not perfectly coincide. The aggregate level of prices can continue to increase even if the amount of final goods produced and supplied increases; it is sufficient that this last increase is more than compensated by the increase in the amount of money wages. I neglect this analytical problem, which is completely overlooked by Schumpeter too. This is one of the differences between Schumpeter’s and Wicksell’s (and A. Hahn’s) analysis (see also Bellofiore, 1992). In Wicksell’s disequilibrium framework, bank creation of means of payment does not induce productive innovations and leads to repeated increases in the general level of prices, so giving rise to a cumulative inflation process (see also Schumpeter 1917–18, pp. 93–5; engl. trans., pp. 194–5; 1939, pp. 604– 5; 1954, p. 1118). Schumpeter himself acknowledges the importance of the listed problems. For example, Schumpeter (1912, p. 347; engl. trans., p. 235) ponders for a long time on the reasons for ‘why other entrepreneurs seeking credit do not always step into the place of those liquidating their indebtedness’; and even if he stresses the importance to explain the occurrence of the ‘alternating phases’ of prosperity and the recession, Schumpeter recognizes that ‘there is nothing in the working of our model to point to periodicity in the cyclical process economic evolution’ (see 1939, p. 143). Furthermore, it is undeniable that Schumpeter’s analysis of the working of the economic system in the cyclical development is so rich as to result often inaccurate.

References Amendola, M. and J.L. Gaffard (1988), The Innovative Choice, Oxford: Blackwell. Augello, M.M. (1990), Joseph Alois Schumpeter. A Reference Guide, Berlin: SpringerVerlag. Bellofiore, R. (1992), ‘Monetary macroeconomics before the ‘General Theory’. The circuit theory of money in Wicksell, Schumpeter and Keynes’, Social Concept, 2. Blinder, A. and J.E. Stiglitz (1983), ‘Money, credit constraints and economic activity’, American Economic Review, 73, May, pp. 297–302. Bousquet, G.-H. (1929), ‘L’oeuvre scientifique de quelques économistes étrangers: Joseph Schumpeter’, Revue d’Economie Politique, 43, pp. 1017–49.

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Brouwer, M. (1991), The Schumpeterian Puzzle. Technological Competition and Economic Evolution, New York: Harvester Wheatsheaf. Clemence, C.V. and F.S. Doody (1950), The Schumpeterian System, Cambridge Mass.: Addison-Wesley. De Vecchi, N. (1993), Entrepreneurs, Institutions and Economic Change. The Economic Thought of J.A. Schumpeter (1905–1925), Aldershot: Edward Elgar. Earley, J.S. (1983), ‘Schumpeter’s theory of money, credit, and cycles: a second approximation’, Working Paper Series, no. 71, Riverside: University of California. Graziani, A. (1977), ‘Il processo capitalistico di J.A. Schumpeter’, in J.A. Schumpeter, Il processo capitalistico. Cicli economici (Italian edition of the abridged version of Business cycles, 1964), Torino: Boringhieri. Graziani, A. (1978), ‘Il Trattato sulla moneta di J.A. Schumpeter’, in Scritti in onore di Giuseppe De Meo, vol. I, Roma: Facoltà di Scienze Statistiche. Graziani, A. (1982), ‘L’analisi marxista e la struttura del capitalismo moderno’, in Storia del marxismo, vol. 4, Torino: Einaudi. Greenwald, B. J.E. and Stiglitz (1991), ‘Towards a reformulation of monetary theory: competitive banking ‘, The Economic and Social Review, 23. Greenwald, B. and J.E. Stiglitz (1993), ‘New and old Keynesians’, Journal of Economic Perspectives, 7, pp. 23–44. Hahn, A. (1920), Volkswirtschaftliche Theorie des Bankkredits, Tübingen: J.C.B. Mohr. Hayek, F.A. (1931), Prices and Productions, 2nd ed., London: Routledge & Kegan, 1935. Hicks, J.R. (1935), ‘A suggestion for simplifying the theory of money’, Economica. Reprinted in J.R. Hicks, Critical Essays in Monetary Theory, Oxford: Claredon Press, 1967. Hicks, J.R. (1967), ‘The two triads’, in J.R. Hicks, Critical Essays in Monetary Theory, Oxford: Claredon Press, 1967. Hicks, J.R. (1982), ‘The foundations of monetary theory’, in J.R. Hicks, Money, Interest and Wages, Cambridge Mass.: Harvard University Press. Hicks, J.R. (1989), A Market Theory of Money, Oxford: Claredon Press. Keynes, J.M. (1923), A Tract on Monetary Reform, London: MacMillan. Keynes, J.M. (1930), A Treatise on Money, 2 vols, London: MacMillan. Keynes, J.M. (1936), The General Theory of Employment, Interest, and Money, London: Macmillan. Klausinger, H. (1990), ‘The early use of the term ‘veil of money’ in Schumpeter’s monetary writings - A comment on Patinkin and Steiger’, Scandinavian Journal of Economics, 92, pp. 617–21. Kuznets, S. (1943), ‘Schumpeter’s business cycles’, American Economic Review, 30, pp. 257–71. Machlup, F. (1943), ‘Forced or induced savings: an exploration into its synonyms and homonyms’, Review of Economic Statistics, 25, pp. 26–39. Marget, A.W. (1938), The Theory of Prices, vol. I, New York, Prentice Hall. Marget, A.W. (1942), The Theory of Prices, vol. II, New York, Prentice Hall.

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Marget, A.W. (1951), ‘The monetary aspects of the Schumpeterian system’, Review of Economics and Statistics. Reprinted in S.E. Harris (ed.), Schumpeter, Social Scientist, Cambridge Mass.: Harvard University Press. Messori, M. (1987), ‘L’offre et la demande de crédit chez Schumpeter’, Cahiers d’Economie Politique, 13, pp. 131–52. Messori, M. (1997), ‘The trials and misadventures of Schumpeter’s treatise on money’, History of Political Economy, 29, pp. 639–73. Messori, M. (2000), ‘Schumpeter’s analysis of the credit market’, mimeo Messori, M. and R. Tamborini (1995), ‘Fallibility, precautionary behaviour, and the new Keynesian monetary theory’, Scottish Journal of Political Economy, 42, pp. 443–64. Oakley, A. (1990), Schumpeter’s Theory of Capitalist Motion. A Critical Exposition and Reassessment, Aldershot: Edward Elgar. Reclam, M. (1984), J.A. Schumpeter’s ‘Credit’ Theory of Money, Riverside: University of California. Robertson, D.H. (1926), Banking Policy and the Price Level, London: King & Son. Robertson, D.H. (1940), ‘Mr Keynes and the rate of interest’, in D.H. Robertson, Essays in Monetary Theory, New York: Staples Press. Schumpeter, J.A. (1908), Das Wesen und der Hauptinhalt der theoretischen Nationalökonomie, Leipzig: Duncker & Humblot. Schumpeter, J.A. (1910), ‘Über das Wesen der Wirtschaftskrisen’, Zeitschrift fürVolkswirtschaft, Sozialpolitik und Verwaltung, 19, pp. 271–325. Schumpeter, J.A. (1912), Theorie der wirtschaftlichen Entwicklung, 2nd ed., München und Leipzig: Duncker & Humblot, 1926. Engl. ed. The Theory of Economic Development, New York: Oxford University Press, 1934. Schumpeter, J.A. (1913), ‘Zinsfuss und Gelverfassung’, Jahrbuch der Gesellschaft Österreichischer Volkswirte. Reprinted in Schumpeter (1952). Schumpeter, J.A. (1917–18), ‘Das Sozialprodukt und die Rechenpfennige: Glossen und Beiträge zur Geldtheorie von heute’, Archiv für Sozialwissenschaft und Sozialpolitik. Reprinted in Schumpeter (1952). Engl.trans. in International Economic Papers, 1956, pp. 148–211. Schumpeter, J.A. (1925a), ‘Kreditkontrolle’, Archiv für Sozialwissenschaft und Sozialpolitik. Reprinted in Schumpeter (1952). Schumpeter, J.A. (1925b), ‘Oude en nieuwe bankpolitiek’, Economisch-Statistische Berichten, 10, 552–4, 574–7, 600–601. Engl. trans. in Schumpeter’s in the History of Ideas, edited by Y. Shionoya e M. Perlman, Ann Arbor: University of Michigan Press, 1994. Schumpeter, J.A. (1927a), ‘Die goldene Bremse an der Kreditmaschine. Die Goldwaehrung und der Bankkredit’, Koelner Vortraege, vol.I Die Kreditwirtschaft. Reprinted in Schumpeter (1952). Schumpeter, J.A. (1927b), ‘The explanation of the business cycles’, Economica. Reprinted in Schumpeter (1951b). Schumpeter, J.A. (1928), ‘The instability of capitalism’, Economic Journal. Reprinted in Schumpeter (1951b).

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Schumpeter, J.A. (1935), ‘The analysis of economic change’, Review of Economic Statistics. Reprinted in Schumpeter (1951b). Schumpeter, J.A. (1936), ‘J.M. Keynes General Theory of Employment, Interest and Money’, Journal of the American Statistical Association. Reprinted in Schumpeter (1951b). Schumpeter, J.A. (1937), ‘Preface’, in Japanese trans. of Schumpeter (1912). Reprinted in Schumpeter (1951b). Schumpeter, J.A. (1939), Business Cycles: A Theoretical, Historical and Statistical Analysis of the Capitalist Process, 2 vols, New York: McGraw-Hill. Schumpeter, J.A. (1943); ‘Capitalism in the postwar world’, in S.E. Harris, Postwar Economic Problems, New York. Reprinted in Schumpeter (1951b). Schumpeter, J.A. (1946a), ‘Capitalism’, in Encyclopaedia Britannica. Reprinted in Schumpeter (1951b). Schumpeter, J.A. (1946b), ‘John Maynard Keynes: 1883–1946’, American Economic Review. Reprinted in Schumpeter (1951a). Schumpeter, J.A. (1946c), ‘The decade of the Twenties’, American Economic Review. Reprinted in Schumpeter (1951b). Schumpeter, J.A. (1948), ‘Irving Fisher’s econometrics’, Econometrica. Reprinted in Schumpeter (1951a). Schumpeter, J.A. (1951a), Ten Great Economists, from Marx to Keynes, New York: Oxford University Press. Schumpeter, J.A. (1951b), Essays of J.A. Schumpeter, edited by R.V. Clemence, Cambridge Mass.: Addison-Wesley. Schumpeter, J.A. (1952), Aufsätze zur Ökonomischen Theorie, edited by E. Schneider e A. Spiethoff, Tübingen: J.C.B. Mohr. Schumpeter, J.A. (1954), History of Economic Analysis, edited by E. Boody Schumpeter, New York: Oxford University Press. Schumpeter, J.A. (1970), Das Wesen des Geldes, Göttingen: Vandenhoeck & Ruprecht. Schumpeter, J.A. (1996), Il trattato sulla moneta: capitoli inediti, edited by L. Berti and M. Messori, Napoli: ESI. Shah, P.J. and L.B. Yeager (1994), ‘Schumpeter on monetary determinacy’, History of Political Economy, 26, pp. 443–64. Stolper, W.F. (1943), ‘Monetary equilibrium and business cycle theory’, Review of Economic Statistics, 25, pp. 88–92. Stolper, W.F. (1982), ‘Aspects of Schumpeter’s theory of evolution’, in H. Frisch (ed.), Schumpeterian Economics, New York: Praeger. Tobin, J. (1991), ‘Foreword’, in E. März, Joseph Schumpeter. Scholar, Teacher and Politician, New Haven: Yale University Press (ed.or. ted.: 1983). Walras, L. (1898), Etudes d’économie politique appliquée. Théorie de la production de la richesse sociale, Lausanne: Corbaz, 1936. Walras, L. (19004), Eléments d’économie politique pure, ou théorie de la richesse sociale, Paris: Guillaumin, 1926; engl. trans. by W. Jaffé, London: Allen & Unwin, 1954. Wicksell, K. (1898), Geldzins und Güterpreise, Jena. G. Fischer; engl. trans. by R. Kahn, London: Macmillan, 1936.

PART III KEYNES, KEYNESIAN ECONOMICS, AND BEYOND

Chapter 12

Budgetary Constraints, Stocks and Flows in a Monetary Economy: Keynes’s Economics Once More Jean Cartelier

12.1

Introduction

Stocks and flows are simultaneously present in most standard macroeconomic models, ISLM being the most famous. A basic methodological problem has to be solved.1 For any discrete period with two extremities a choice has to be made concerning the point of time at which stocks are dealt with: should they be considered at the beginning or at the end of the period? It will be argued that although the two alternatives give identical results in standard models, namely the absence of any involuntary unemployment equilibrium, they do not have the same formal structures. Models are interdependent in the traditional end-of-period approach while they are recursive when, following Tsiang (1966), the beginningof-period point of view is adopted. This property may account for Keynes’s contention about the monetary character of the rate of interest. More generally, the beginning-of-period approach is well-suited to the study of monetary economies, taking due account of the fact that transactions are carried out with money. Graziani (1988 and 1994) followed this line of reasoning when he emphasized the role of money as a means of payment (finance motive). Discussions about stocks and flows also concern budgetary constraints. Clower’s cash-in-advance constraint (Clower, 1967) or Tsiang’s finance constraint is at home in beginning-of-period models where money is mostly a means of payment. Graziani’s general approach belongs to this class of model with special emphasis laid on the role of banks. Beginning-of-period models are well-suited to recast some of the controversial views Keynes expressed about the finance motive or about the determination of the rate of interest. But involuntary unemployment equilibrium does not come directly from cash or finance constraints which account only for low employment equilibria. The labour market always clears in these models even if it is at a low level of employment. The main assertion of General Theory is socially stronger than that: the labour market may be in excess supply (involuntary unemployment) even if all other markets are in equilibrium. As we shall see, this conjecture rests on another assumption, namely that of the refusal of the ‘second classical

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postulate’ to use Keynes’s own terms. This refusal has something to do with budgetary constraints. Wage-earners cannot get means of payment but through the payment of wages. Wage-earners do not control their own budgetary constraint2 while entrepreneurs do. While credit rationing, if any, is but an additional constraint, asymmetry between entrepreneurs and wage-earners is a permanent and intrinsic feature of our economies. Whereas the fact that every agent may be credit rationed leads to low employment equilibria, asymmetry between entrepreneurs and wage-earners is a necessary (but not sufficient) condition for the existence of involuntary unemployment equilibria. On the whole, investigating stocks and flow relations may help to reformulate some basic points in Keynes’s economics, namely the existence of involuntary unemployment equilibria, the nature of the rate of interest and properties of a monetary economy. Moreover, the emphasis laid on the role of money as a means of payment directly leads to explore effective out-of-equilibrium positions by contrast with the so-called ‘law of supply and demand’ which deals only with virtual situations. A determination of monetary prices in disequilibrium is possible, following an ancient tradition which can be traced back to Cantillon. The concept of market mechanism, crucial here, is easily integrated into a model adopting the beginningof-period point of view, allowing a monetary dynamics to be sketched. It turns out that Keynes adopted in the Treatise this very market mechanism. The gap between the Treatise and the General Theory, due essentially to the dynamic character of the former as opposed to the static nature of the latter, is less severe than often alleged. It must not prevent us from aiming at a synthetic reformulation of Keynes’s economics. Section 12.2 presents the two views on the relations between stocks and flows in standard macroeconomic models. The reasons to prefer the beginning-of-period approach are given in section 12.3 whereas existence of involuntary unemployment equilibria is shown in section 12.4. A brief analysis of out-ofequilibrium situations is contained in section 12.5.

12.2

Stocks and Flows in a Standard Model: Two Views

Let us suppose a standard macroeconomic model of a four market-economy with labour, corn, bonds and money. A bond is a right to one unit of money for each period over infinity. Quantities of bonds and money are defined at one instant of time (stocks) whereas labour and production of corn are defined over one period (flows). Relations between flows and stocks being the main topic of this section, it is necessary to make explicit the treatment of time with the help of the schema below t

period τ

t+θ

period τ + 1

t + 2θ

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Although time is continuous agents consider their stocks only at discrete moments t, t + θ, t + 2θ, etc. Instants t and t + θ delimit period τ and instants t + θ and t + 2θ delimit period τ + 1. Transactions in period τ take place at any moment of time t + λθ (with 0 ≤ λ ≤ 1) but are decided at the beginning of the period. A single commodity, say corn, is produced thanks to a given quantity of corn K saved the period before and a certain quantity of labour N according to a wellbehaved production function: Qτ = F ( N τ , K τ )

(12.1)

Production is conceived of as a flow defined over period τ as are the quantities of labour and corn (circulating capital) used for production. In order to t +θ take into account that transactions may take place at any time, one should write ∫t Q(t )dt t +θ for Qτ and ∫ N (t )dt for N τ and likewise for pτ the money price of corn and t wτ the money wage. For the sake of simplicity, Q(t), N(t), p(t) and w(t) are assumed to be constant in the interval between t and t + θ so that flows are strictly proportional to the length of the period considered. Two groups of private agents exist in the economy: entrepreneurs demand labour and corn for next period production; they supply corn and bonds; wageearners demand corn for present consumption, bonds and money; they supply labour. The government buys corn by issuing money. Two different descriptions of such an economy in period τ are possible according to the way agents view their stocks in period τ. They could be concerned by the value of their stocks at t, the beginning, or at t + θ, the end of period τ.3 Let see first the usual description where stocks at the beginning of the period are exogenous whereas agents are motivated by their position at the end of the period which is also the end of the market for labour and corn. Budgetary constraints are the following: •

for wage-earners: pτ Cτ +

1 d ( Bt +θ − Bt ) + M td+θ − M t = wτ N τs + Bτ iτ     d Bτd

(12.2)

Mτ

where C is corn consumption, B d the demand for bonds, M d the demand for money, N s the supply of labour, Bt the initial amount of bonds, Bτd the dividends received and i the rate of interest; •

for entrepreneurs: wτ N τd + pτ I τ + Bτ = pτ Qτ +

1 s ( Bt +θ − Bt ) iτ  

(12.3)

Bτs

d

where N is the demand for labour, I, the investment in corn consumption, Q the supply of corn and B s the supply of bonds;

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for government: d t +θ − M t pτ Gτ = M  

(12.4)

M τs

where G is the government’s demand for corn and B s the money supply. Summing (12.2), (12.3) and (12.4) gives Walras law: pτ (Gτ + I τ + Cτ − Qτ ) + wτ ( N τd − N τs )

(

) (

)

1 Bd − Bs + M td+θ − M ts+θ ≡ 0 t +θ iτ t +θ

(12.5)

An equilibrium exists from the point of view of the end of period τ if the following system has a solution:   1 1 N d  wτ , pτ ,  = N s  wτ , pτ ,  iτ  iτ       1 1 1 C d  wτ , pτ ,  + I d  wτ , pτ ,  + Gτ = Q  wτ , pτ ,  iτ  iτ  iτ       B  wτ , pτ , 1  = Bts+θ i τ   d t +θ

 1  wτ , pτ , i  τ  

 1 M td+θ  wτ , pτ ,  = M ts+θ i τ  

(12.6)

 1  wτ , pτ , i  τ  

Due to Walras law, only three equilibrium conditions are independent, a necessary condition for determining the three unknowns wτ , pτ and 1/ iτ . Assume that excess demand functions are continuous such that at least one equilibrium exists. The description above needs no detailed comment. A special point is however worth noticing. The market for money equation is very general. The reader is left free to understand it as a standard expression for quantitative theory, Patinkin’s real balances or liquidity preference. System (12.6) is subject to Hicks’s argument about the indifference between ‘loanable funds’ and ‘liquidity preference’ theories of interest, depending on whether the bond market or money market equation is left aside as a consequence of Walras law. In a simultaneous general equilibrium it makes little sense to claim that a particular price is determined by a particular equilibrium condition: as a matter of fact all prices are simultaneously determined in all markets. There is no clear meaning in trying to derive from (12.6) a special theory of the rate of interest. Moreover, if the quantitative theory of money holds, money is neutral. Rate of interest and real wage are determined on the same footing and at the same time. Now agents are supposed to be concerned with their stocks at t and no longer at t + θ.

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Budgetary constraints must be modified. Two points are worth mentioning. The first is that at time t net wealth cannot change due to transactions in bonds and money markets. Only its distribution may be affected. The following constraint applies: Mt +

(

) (

)

1 1 1 B t = W t = M td + Btd ⇔ M td − M t + Btd − B t ≡ 0 iτ iτ iτ

(12.7)

where W t is the net wealth at time t. The second point is that transactions in flow markets (corn and labour) are responsible for changes in wealth at the end of the period. But nothing can be said about its composition. As a consequence, Walras law still applies but as follows:

(

)

pτ (Gτ + I τ + Cτ − Qτ ) + wτ ( N τd − N τs ) + Wt +θ − W t ≡ 0

(12.8)

Taking account of this change in point of view requires new equilibrium conditions in stock markets but not in flow markets (recall that transactions in labour and corn are decided at t in any case and take place at any point of τ). In money and bond markets at t, the arguments of excess demand functions are now expected price p τe and wage wτe for τ, and no longer wτ and pτ , whereas 1/ iτ is still the variable to be determined. Let us assume that wτe = ψ( wτ−1 ) and pτe = ψ( pτ−1 ) where ψ(.) are continuous expectations functions. The fact that 1/ iτ is determined at t and not at t + θ obviously accounts for a modification of excess demand functions. Equilibrium equations are now:   1 1 Btd  wτ−1 , pτ−1 ,  = Bts  wτ−1 , pτ−1 ,  i i τ  τ      1 1 M td  wτ−1 , pτ−1 ,  + M ts  wτ−1 , pτ−1 ,  i i τ  τ      1 1 N  wτ , pτ ,  = N s  wτ , pτ ,  iτ  iτ   

(12.9)

d

   1 1 1 C d  wτ , pτ ,  + I d  wτ , pτ ,  + Gτ = Q  wτ , pτ ,  iτ  iτ  iτ     Describing an economy from a beginning-of-period point of view introduces an interesting change as compared to a traditional end-of-period point of view. From equations (12.9) and constraint (12.7) it appears that system (12.9) is recursive. The rate of interest is clearly determined by financial markets only and not by all markets. Moreover there is no sense in opposing liquidity preference and loanable fund theories since, as (12.7) makes it clear, equilibrium in the money market implies equilibrium in the bond market as well (Tsiang, 1966). Clearly this is

206

Money Credit and the Role of the State

reminiscent of Keynes’s position in the Treatise on Money4 and of Hicks’s socalled ‘special Keynes model’.5 But, despite this, at full equilibrium (when pτ = pτ−1 ) the two descriptions are almost equivalent. Therefore the question is: is there a reason to adopt one rather than the other view? The weight of tradition is in favour of the end-of-period view: agents enter the market with more or less arbitrary initial endowments and leave the market with equilibrium allocations. In this view, only situations at t + θ are theoretically interesting. Opting for the beginning-of-period view, as will be the case in this chapter, requires a little justification.

12.3

Stocks and Flows in a Monetary Economy: Transaction Constraints

Both versions of the model above contain a money market. However, taking for granted the existence of money is inappropriate. It seems well established that not only is there ‘no room left for money in general equilibrium theory’, as Franck Hahn put it many years ago, but also that the basic problems raised by money are far from being solved in modern standard theory.6 Macroeconomic theoreticians too often ‘forget’ to address this issue. Keynesians (in a broad sense) resort to a radical uncertainty hypothesis in order to justify that money be held as a store of value, emphasizing the store of value function as do authors resorting to overlapping generations monetary models. This is not the proper place to discuss this point. It is enough to note that such a view, whatever its foundation may be, is in accordance with the end-of-period point of view. Following another tradition, exemplified by Cantillon, Steuart and Wicksell, to name but a few, leads to justifying money’s existence by its role as an exclusive intermediary in exchange. Being a general means of payment is a specific feature of money. Any durable commodity may be a good store of value and a possible numéraire.7 A monetary economy is characterized by the fact that transactions are carried out with money only (purchases and sales instead of barter). Adopting this view obliges us to seriously consider the influence of the way transactions are processed, contrary to standard theory in which this point is never addressed. A minimum requirement is to model agents’ behaviour accordingly and to derive excess demand functions, making explicit the transactions constraint on planned purchases. In a monetary economy, as Clower (1967) and Tsiang (1966) frequently recall, agents are concerned with their money holdings before visiting commodities and labour markets.8 Cash-in-advance or finance constraints are often used to formally introduce this fundamental aspect of monetary economies. Each agent or group of agents is then supposed to maximize utility or profit under two different constraints: a budgetary one which imposes that received and given (planned) values must be equal and a transaction constraint which imposes that the value of planned purchases does not exceed the amount of means of payments available to the agent.9

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207

Emphasizing the medium of exchange function of money naturally leads to adopt a beginning-of-period view in describing financial stock markets. According to the constraint (12.7), which leaves only one degree of freedom, one of the two markets for assets is redundant. Let us skip the market for bonds and adopt a very simple Keynesian argument stressing the importance of the rate of interest with that of expectations. The demand for money, which concerns wage-earners only, will be given by:  1 M td = M  wτ−1 , pτ−1 ,  iτ  

(12.10)

whereas the supply of (outside) money at t is exogenous and results from what happened in the past. Equilibrium condition in the money market at the beginning of the period determines the equilibrium rate of interest iτ (or 1/ iτ the equilibrium price of bonds):  1 M td = M  wτ−1 , pτ−1 ,  = M t iτ  

(12.11)

At t, equilibrium values of Bt , M t and M t are known. On this basis it is possible to examine what is going on in the markets for corn and labour. Assume that wage-earners cannot borrow from the banks and that liquidity of bonds is such that it is not possible to sell on the second-hand market more than a fraction a of their value. Only ( a / iτ ) Bt is relevant for the transaction constraint (distinct from the budgetary constraint which holds on period τ). Wage-earners transactions constraint is thus: pτ Cτ ≤

a Bτ + M τ iτ

(12.12)

and their budgetary constraint is:

pτ Cτ + S ≤ wτ N τs + Bτ

(12.13)

with S = (1/ iτ ) ( Btd+θ − Bt ) + ( M td+θ − M t ) and Bτ interests received. Composition of S at the end of τ does not matter. At the beginning of period τ + 1 agents will trade in the assets market in order to get their desired portfolio. Assume a well-behaved utility function U(C, S, N). Maximisation of U(C, S, N) under transaction and budgetary constraints gives:     w    a Cτ = min C  Bτ + M τ  , C   N τs + Bτ     p τ     iτ

(12.14)

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Money Credit and the Role of the State

  a     w  S τ = min  S  Bτ + M τ  , S   N τs + Bτ     p  τ   iτ  

(12.15)

 w N τs =    p τ

(12.16)

and:

Everything being constant, the higher w the less likely (12.12) is binding (inversely for p). By contrast with wage-earners, entrepreneurs are able to borrow from the banks. Banks are able to modify the tightness of a beginning-of-period transaction constraint in allowing entrepreneurs to finance their planned expenditures during the period. Let us introduce this finance motive in the model above through shortterm bank loans with maturity of one period. Entrepreneurs transactions constraint at t is then: wτ N τd + pτ I τ + Bτ ≤ Ldt

(12.17)

where Ldt is the amount of bank loan demanded. Their budgetary constraint is still (12.3). Assume that planned investment depends positively on animal spirits and negatively on the rate of interest according to Keynes’s view:  1 I τ = H  A,   iτ 

(12.18)

Demand for labour is determined by maximizing pτ F ( N τ , K τ ) − wτ N td − Bτ such that wτ N td + pτ H ( Aτ ,1/ iτ ) + Bτ ≥ Ldt . Demand for labour is a decreasing function of ( w / p) τ : N τd = F t −1 ( w / p ) τ when (12.17) is not binding. If entrepreneurs do not wish to be constrained by the means of payment they have to demand bank loans according to:  1 Ldt = wτ N τd + pτ H  A,  + Bt  iτ 

(12.19)

Let 0 ≤ λ ≤ 1 be the degree of bank accommodation. If λ = 1, (12.17) is not binding. It is binding otherwise. For the sake of simplicity assume that investment and labour expenses are reduced by the same proportion. Thus, if effective loans are λLtd demand for labour is  w N td = ηF t −1    p t

(12.20)

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209

where η = (λLdt − Bτ ) ( Ldt − Bτ ) and investment is:  1 I τ = ηH  A,   iτ 

(12.21)

Corn supply is Qτ = F ( N td , K τ ) . Equilibrium conditions on the markets for labour and corn determine respectively the equilibrium real wage and the money price of corn:  w    w N td = ηF t −1   = N s    p  t  p  t   1 Qts = F ( N τd , K τ ) = Cτ + ηH  A,  + Gτ  iτ 

(12.22)

System (12.22) is recursive. Labour market clearing determines equilibrium real wage. Then, corn market clearing determines corn money price. Credit rationing affects both real and nominal prices as well as the level of activity. Effective bond supply at the end of period Bts+θ and money supply M ts+θ are nothing but the consequence of budgetary constraints (12.3), (12.2) and (12.4) and reflect simply Walras law (12.5). So far three propositions may be derived from what precedes: 1.

2.

3.

In a monetary economy, where all transactions are purchases or sales against money, it is natural to adopt a beginning-of-period view when dealing with stocks and flows. Such a view appears to be in accordance with Keynes’s approach in the Treatise on Money as well as some developments of the General Theory, namely the determination of the rate of interest independently of corn and labour markets. Taking into account transaction constraints modifies individual derivations of excess demand functions. Availability of means of payment may now enter as an argument in demand functions. But, contrary to what Clower and Tsiang claimed, this does not prevent Walras law holding in a monetary economy. When transaction constraints are not binding, a competitive monetary economy has the same properties as a Walrasian one despite the fact that the model of the former is recursive by contrast with the model of the latter which is interdependent. When transaction constraints are binding, the level of activity is lower and real wage is higher than in a Walrasian economy. However there exists no involuntary unemployment at equilibrium.

At this point two further developments are possible. The first is to inquire into the modification which could make the model above exhibit a Keynesian equilibrium, that is involuntary unemployment in a world of perfect competition with flexible prices. The second is to explore out-of-equilibrium positions taking the opportunity to introduce a market mechanism specific to monetary economies.

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Money Credit and the Role of the State

12.4

Competitive Involuntary Unemployment Equilibrium

A brief examination of the model above is sufficient to reveal where the problem lies. In order to determine an equilibrium level of involuntary unemployment U τ = N τs − N τd , besides 1/ iτ , w / p and pτ , we need one additional equation but there is no additional good or market to justify it. Moreover, Walras law makes impossible to have an equilibrium in every markets but one, that of labour. This is reminiscent of Clower’s point: ‘either Walras’ law is incompatible with Keynesian economics, or Keynes had nothing fundamentally new to add to orthodox economic theory’ (Clower, 1965, p. 41). Walras law is nothing but the consequence of exchange equivalence. Budgetary constraints impose Walras law and there seems to be no way to escape from its clear implication: involuntary unemployment equilibrium is a contradictio in adjecto. Keynes however gives us the clue when he refuses the so-called ‘second classical postulate’ which is simply the first order condition of the usual utility maximisation program, namely equality between real wage marginal utility and marginal utility of leisure. Two arguments are invoked against this ‘postulate’: the first is that wage-earners and entrepreneurs do not bargain over real wage but on money wage; the second, ‘a more fundamental objection’, is that wage-earners, in some cases, cannot behave according to the first order condition of utility maximisation. In Keynes’s words: For there may be no method available to labour as a whole whereby it can bring the wage-goods equivalent of the general level of money-wages into conformity with the marginal disutility of the current volume of employment (Keynes, 1936b, p. 13).

In other words, wage-earners may be off their labour supply curve. Basically, Keynes’s last argument is tantamount to a rejection of wage-earners Walrasian budgetary constraint (12.2) pτ Cτ + (1/ iτ ) Bτd + M τd = wτ N τs + Bτ . If wageearners were able to control both their labour supply and their demands, they would never be off their Walrasian supply and demand curves. This lack of control for certain values of real wage is due to their specific budgetary constraint. Keynes’s point clearly makes good sense if (12.2) is replaced by: pτ Cτ +

1 d B + M τd = wτ N τd + Bτ iτ τ

(12.23)

The Keynesian constraint for wage-earners (12.23) differs from standard constraint (12.2) only in that wτ N τd , the value of total wages paid by entrepreneurs, replaces wτ N τs , the value of total wages desired by wage-earners. This change is more radical than it may appear. The new budgetary constraint means that wage-earners are no longer treated on the same footing as entrepreneurs or as any standard economic agent. Wage-earners do not control the two legs of

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211

their constraint but only one. They are free to maximise utility in allocating their resources between corn, bonds and money but they have no power over the resources if real wage is above its market clearing value, i.e. when N τs ≥ N τd . Adopting the constraint (12.23) means accepting (and modelling) heterogeneity among economic agents. Entrepreneurs and wage-earners do not have the same prerogatives or powers. The former have command over one side of the budgetary constraint of the latter and the reverse is never true. Now, if (12.23) is assumed, Walras law is modified. The sum of budgetary constraints gives now what may be called a Restricted Walras law: pτ (Gτ + I τ + Cτ − Qτ ) +

1 d ( B − Bts+θ ) + ( M td+θ − M ts+θ ) ≡ 0 iτ t +θ

(12.24)

The market for labour is no longer contained in (12.24) as a straightforward consequence of wage-earners budgetary constraint. A Keynesian equilibrium, that is an equilibrium in every market except for an excess supply in the market for labour, is no longer excluded. We are however not yet out of the woods. If a restricted Walras law is a necessary condition for the existence of an involuntary unemployment equilibrium it is not a sufficient condition. Moreover, as noted above, we have only three independent equations to determine four variables. This is where Keynes’s first argument comes in: the labour market determines only the money wage and not the real wage. We need to be more precise. If the labour supply curve is not effective for ( w / p) ≥ (W / p)* where (W / p)* is the market clearing value, there is no sense using it to analyse the market for labour. Only the demand for labour makes sense (recall that Keynes accepts what he calls the ‘first classical postulate’, that is the first order condition of profit maximisation, namely the equality between marginal productivity of labour and real wage). In order to determine the money wage wτ we need a new equation describing a bargaining process over the money wage. To make this process explicit is not an easy task. Let us assume however that such a negotiation exists which depends on every variable known at t (and on expectations for τ):  1  Θ  wτ−1 , pτ−1 ,  = wτ iτ−1  

(12.25)

(12.25) gives the level of money wage prevailing in period τ.10 As its determinants belong to past periods it is not unnatural to take it as a parameter. Assuming it to be constant does not mean that it is rigid but only that it is quite possible to argue for w given, postponing the study of the consequences of variations in w. Indeed, Keynes assumes a constant money wage during the eighteen first chapters of General Theory and deals with a variable money wage in the 19th chapter. A Keynesian model would be:

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 1 M td = M  wτ−1 , pτ−1 ,  = M t i τ    1  Θ  wτ−1 , pτ−1 , = wτ iτ−1    1 w  Q = F ( N , K τ ) = Cτ  N τd  + ηH  A,  + Gτ p   iτ  s τ

(12.26)

d τ

 w    w N s    − ηF t −1   = U p  p τ   τ  Equation (12.25) determines wτ while the market money clearing condition gives the rate of interest. Market clearing for commodity (corn) gives the price and thus the real wage.11 Demand for labour fixes the level of employment N (if ( w / p) ≥ (W / p)* ) and the equilibrium involuntary unemployment is given by the difference between labour supply and demand at the prevailing real wage. 12 Figure 12.1 sums up the argument. Standard competitive equilibrium is described by star-variables and Keynesian equilibrium by variables indexed with k. Arrows show the order of resolution of the Keynesian recursive model (the interest rate is given by the market for assets at the beginning of the period and money wage by the negotiation process). Keynesian static general competitive equilibrium has a steady-state growth equilibrium equivalent that can be compared to Solow’s model. Money wage and rate of interest being determined (assume they are constant to keep the story simple), there remain two market equilibrium conditions (corn and labour). w/p

U*

(w/p)k

(w/p)*

p*

pk

Nk

p

qk

q*

qs

q

Figure 12.1 Competitive Keynesian equilibria

N*

N

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213

According to Solow, if the labour supply grows at the exogenous rate n, equilibrium in the labour market requires that demand for labour grows at the same rate and k = K/N being constant at steady-state, the rate of growth of capital I/K = γ must be equal to n. Equilibrium condition in the commodity market is, neglecting G: I τ + Cτ = Qτ

(12.27) α

1−α

and if s is wageIf the production function is Cobb-Douglas Qτ = K t N τ earners’ propensity to saving, (12.27) may be rewritten, combined with γ = n = n : γ=

α + s (1 − α) =n=n k 1−α

(12.28)

Equilibrium value of k is [α + s (1 − α ) n ] . Asymmetry between wage-earners and entrepreneurs radically modifies Solow’s result. Restricted Walras law holds and the market for labour may be in excess supply even if the market for commodities clears. Accordingly, it is the rate of growth of capital which rules the roost. This rate depends on the long-term state of expectations and on the rate of interest. Let assume that animal spirits are such that this rate is equal to γ ≤ n . Equilibrium condition is now: γ=

α + s (1 − α) =n≤n k 1−α

(12.29)

For each γ ≤ n there exists an equilibrium value for k determined by: k =

α + s (1 − α) γ

(12.30)

There is a continuum of involuntary unemployment steady growth defined by: u = n −n = n − γ

(12.31)

where u is the rate of growth of equilibrium unemployment. Condition (12.31) can be considered as an equilibrium condition in the ordinary sense: although wageearners are not on their Walrasian curves, they are on the curves that maximization of utility subject to (12.23) allows them to reach. It is only when N d > N s that Walrasian reasoning applies. The familiar diagram below (Fig. 12.2) shows how equilibrium condition in the commodity market is related with the labour market. Commodity market equilibrium condition is ∆K τ = (α + s(1 − α))Qτ . In steadystate, k = K/N must be constant. As ∆k/k = γ – n = 0 ⇒ ∆k = γk – nk = 0. But γk = ∆kK / K = kN [a + s (1 − α ) ]Qτ . Finally, equilibrium condition in the commodity market is:

[α + s(1 − α)] k α = nk

(12.32)

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Money Credit and the Role of the State Q/N

nk*

n^ k

[α + s (1 − α) ] k

0

k*

^k

α

k

Figure 12.2 Solow’s and Keynes’s steady states If we impose, as in neoclassical models,

n = n , (12.32) becomes

[α + s(1 − α)] k α = nk . This special case is illustrated in Figure 12.2. In a monetary

economy with asymmetry between entrepreneurs and wage-earners, we generally have equilibria with different properties, as that shown in bold which exhibits a positive growth of involuntary unemployment ( n < n ). The story told by this monetary model is quite different from the neoclassical one. The exogenous rate of growth of the labour force no longer determines the steady-state rate of growth (the equilibrium condition n = n is not relevant here due to wage-earners’ monetary constraint) but only its maximum value. The steady-state rate of growth γ is fixed instead by the rate of accumulation of capital (which depends on entrepreneurs’ animal spirits among other variables). If this rate of accumulation is less than n involuntary unemployment grows at a steady-state rate u = n − γ . This result is by no means due to a special assumption about technique (namely fixed input coefficients) as it is too commonly maintained in textbooks. It comes only from the causality implicit in the model: the rate of growth of capital is an independent variable which rules the roost. Steady-state rates of growth of employment and output must be adjusted to γ and not to n so that k appears to be constant (and v = K/Q as well). Capital output ratio and capital per capita are however flexible: to each level of steady-state rate of growth of involuntary unemployment corresponds a particular v or k. An obvious question is whether nominal wage flexibility would or would not alter the results above, either in static or dynamic analysis. The traditional argument is well-known and rests upon the law of supply and demand. Excess supply in the labour market is supposed to generate a decrease in money wage, which ceteris paribus brings about full employment equilibrium. Note that Walras

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law guarantees an adjustment to full employment equilibrium even if the nominal wage is constant. Adjustment is performed by an increase in p because excess supply in the labour market necessarily corresponds to excess demand in the market for a commodity, such that w/p, the real wage, tends toward its equilibrium value given by condition n = n . This argument does not hold in the model presented here because Walras law does not hold either. The level of w/p is determined instead by the level of accumulation. The only effect a change in nominal wage w may have concerns the rate of accumulation. It is through an adjustment in the market for commodity and not in the market for labour that any change in w affects equilibrium. In chapter 19 of General Theory Keynes reminds us that: if the reduction of money-wages is expected to be a reduction relatively to money-wages in the future, the change will be favourable to investment, because, as we have seen above, it will increase the marginal efficiency of capital; (...). If, on the other hand, the reduction leads to the expectation, or even to the serious possibility, of a further wagereduction in prospect, it will have precisely the opposite effect. For it will diminish the marginal efficiency of capital and will lead to the postponement both of investment and of consumption (Keynes, 1936b, p.262, Keynes emphasis).

A decrease in w could increase unemployment instead of remedy it. The opposite case is equally possible. But, even in this case, the reason why flexibility of w may improve the situation has nothing to do with the law of supply and demand in the market for labour.

12.5

Dynamics in a Monetary Keynesian Economy

The preceding section is reminiscent of General Theory and its analysis of equilibrium properties. This section is inspired rather by the Treatise on Money and relates to disequilibrium dynamics. A prerequisite for any market dynamics is to account for effective out-of-equilibrium positions. This entails getting rid of the so-called ‘law of supply and demand’ and of the virtual dynamics attached to it. A market mechanism has to be substituted for the ‘law of supply and demand’. It is indeed a venerable rule which can be traced back to Smith and Cantillon. A basic analysis of Keynesian dynamics will be derived from it. Assume, as in the preceding section, that wτ and (1/ iτ ) are determined at t. Dynamics is introduced by taking seriously the fact that transactions are against money which means that they are irreversible. Once payments have been made it is not possible to go back in order to adjust decisions to what appears to be the state of the market. Adjustment are necessarily postponed to the next period. The story runs as follows. Entrepreneurs decide first. They chose an amount of investment I τ and a level of employment N τ (entrepreneurs do not manipulate the prices). N τ may be determined as a reaction to unexpected profits or losses. As a consequence of that decision and of past investment, entrepreneurs bring to the

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market a quantity Qτ of corn. The expenses for corn depend on wτ N τ and on pτe I τ + pτe Gτ , where pτe is the expected market price for period τ. Plans of entrepreneurs and wage-earners will be generally non-compatible. At the money price of corn which would justify the quantity supplied, wage-earners do not buy all that quantity. At the money price of corn which ensures the clearing of the market, entrepreneurs do not realise their expected receipts and profits. Disequilibrium is experienced by agents and not by an imaginary auctioneer. Disequilibrium is effective and not simply virtual. This means that an effective disequilibrium price and allocations must be determined. Which price will prevail? What quantity will be sold? Here comes a crucial point. Economists are used to resorting to the famous ‘law of supply and demand’: if supply exceeds demand in the market for corn nothing will happen except for a decrease in price. The decrease in price ceases when supply and demand have been made equal. Then transactions can be realized. But such a view raises more questions than it solves. We know that tâtonnement is not globally stable in general and that it is not an acceptable metaphor for describing a market economy. In a monetary economy, transactions are taking place even if the market is out of equilibrium. The question now is: when decentralised actions are not mutually compatible what is to be effectively observed in the market? Answering this question means assuming a determinate market mechanism. A market mechanism is an algorithm which calculates effective market allocations and prices given decentralized individual actions, be they mutually compatible or not. Among many conceivable market mechanisms one is salient. It can be traced back as early as 18th century in the writings of Smith and Cantillon. It is also part of some models of strategic market games in modern theory. Let us therefore call it the Shapley-Shabik rule (calling it Cantillon’s rule would be correct as well). The Shapley-Shubik rule states that the market price is given by the ratio of the quantity of money brought to the market in order to pay for the commodity traded to the quantity of commodity brought in order to be sold. 13 The Shapley-Shubik rule guarantees that the corn market clears in the sense that all the quantity brought to the market is sold but at a non-expected price in general. Symmetrically, all the money spent by buyers is accepted by sellers but buyers do not generally get the quantity of corn they expected. Smith assumed such a rule in chapter 7 of the Wealth of Nations. Disequilibrium is perceived by individual agents, by contrast with Walrasian theory where individuals are always in equilibrium and where the auctioneer alone is aware of a possible disequilibrium in the market. Here, thanks to the market mechanism adopted, prices and allocations are effective in disequilibrium and not only virtual. An interesting consequence is that not only is disequilibrium dynamics meaningful but reactions to disequilibrium no longer emanate from an imaginary auctioneer but from individual agents themselves. Let us be more explicit. Starting from economic actions taken by entrepreneurs and then by wage-earners (recall that the budgetary constraint of the latter is determined by decisions of the former), the market price of corn pτ is:

Budgetary Constraints, Stocks and Flows in a Monetary Economy

pτ =

pτe Cτ + pτe I τ + pτe Gτ Qτ

217

(12.33)

At price pτ ≠ pτe , neither wage-earners nor entrepreneurs get their desired quantities of corn but only a fraction pτe / pτ of them. The reader familiar with the Treatise easily recognises in (12.33) a special case of Keynes’s fundamental equations. For instance E – S is the money expenditure in the market for consumption goods and R is the quantity of consumption goods brought to market. The price P is thus: P = [( E − S ) / R ] = ( E / O ) + [( I ′ − S ) / R ] . Similarly, with I as the money expenditure on investment and C the quantity of investment goods brought to market, we have: P′ = I / C . At these prices windfall profits (or losses) may occur which are the mainspring of dynamics as Keynes reminds us: profits (or losses) are an effect of the rest of the situation rather than a cause of it. (...) profits (or losses) having once come into existence become (...) a cause of what subsequently ensues; indeed, the mainspring of change in the existing economic system. This is the essential reason why it is useful to segregate them in our fundamental equation (Keynes, 1936a, p. 126)

Reactions to disequilibrium are the less robust point in any dynamic model. Aware of disequilibrium, agents are deprived of references and benchmarks in order to decide what they have to do. Clearly, at this point, any assumption is possible even if Keynes’s basic point – positive windfall profits prompt an increase in activity and, consequently in prices – seems reasonably robust. Let us try to sketch such Keynesian dynamics. For simplicity’s sake, very straightforward assumptions will be made, namely that of inertia in expectations. Entrepreneurs and wage-earners are supposed to expect that the future market price by which they maximize profit or utility, is the market price they have experienced in the preceding period. Formally: (12.34) pτe = pτ−1 so that price dynamics is given by: pτ =

pτ−1 (Cτ + I τ + Gτ ) Qτ

(12.35)

Realised profit is πτ = pτ−1 (Cτ + I τ + Gτ ) − wτ N τ − Bτ . Expected profits are πeτ = αpτ−1Qτ − Bτ if the production function is Cobb-Douglas with α as capital elasticity of production. Windfall or unexpected profits are then, recalling that [( wτ N τ ) pτ−1 ] = (1 − α) and that Cτ = (1 − s) [( wτ N τ ) pτ−1 ] neglecting Bτ: πτ − πeτ = ( I τ + Gτ ) − [α + s (1 − α)Qτ ]

(12.36)

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For the sake of simplicity assume that Gτ = 0 ∀τ. Dividing by K t the two sides of 12.36 gives: rτ − rτe = γ τ−1 −

α + s (1 − α) 1−α kτ− 1

(12.37)

where rτ and rτe are respectively the effective and expected rate of profit, γ the rate of growth of capital and k 1−α the capital output ratio with k = K / N . Note that rτ − rτe is equivalent to pτ − pτ−1 : from (12.35) it is easy to check that pτ − pτ−1 = γk 1−α − [α + s (1 − α) ] . Not surprisingly, entrepreneurs’ equilibrium condition rτ = rτe is that found above (12.12.29). The difference between the effective and expected rate of profit rτ − rτe is what Keynes refers to as ‘the mainspring of change’. But, as we shall see, such a force may bring about very different effects according to the variable applied. The basic result is as follows: when the level of employment (or its rate of growth) is influenced by rτ − rτe , the economy is globally stable whenever animal spirits do not vary; but global instability occurs as soon as animal spirits are allowed to vary under the influence of rτ-rτe. Assume that entrepreneurs modify the rate of growth of employment and of accumulation of capital according to the sign of unexpected profits or equivalent to that of pτ − pτ−1 , but with different coefficients of reaction:  α + s (1 − α)  ∆nτ = a (rτ − rτe ) = a  γ τ−1 −  1−α kτ− 1  

(12.38)

 α + s (1 − α)  ∆γ τ = b(rτ − rτe ) = b  γ τ−1 −  1−α kτ− 1  

(12.39)

Evolution of k over time depends on the value of n and γ. For a constant γ the economy is globally stable since any n > γ means a decrease in k and an increase in α + s (1 − α) / k 1−α  that leads to a further decrease in n. A similar reasoning holds for n < γ. The diagram below illustrates the point:  ∆k α + s(1 − α)  = (b − a) =  γ τ−1 −  1−α k kτ− 1  

(12.40)

Formally, the evolution of the economy over time is given by the following system: ∆γ = bγ − bσk α−1

∆k = (b − a) γk − (b − a )σk α

(12.41)

As (12.41) reveals, there is no determinate equilibrium in this economy. The two equations of (12.41) are not independent since they both describe the same

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219

kind of reaction to r − r e . There is instead a continuum of equilibria given by equilibrium condition γ =  α + s (1 − α) / k 1−α  which is nothing but (12.29) modified to allow for changes in γ. Any value of γ between 0 and n is acceptable as soon as k is adjusted to it. For a predetermined γ with b = 0 employment dynamics is stable. The second equation of (12.41) becomes:

∆k = −a( γk − aσk α )

(12.42)

Positive unexpected profits cause an increase in n which tends to be greater than γ and the ratio k decreases until windfall profits disappear and r − r e = 0. Flexibility of price, profit and employment drives these variables to their equilibrium level (be they involuntary unemployment or full employment ones). This may justify Keynes’s position in chapter 5 of General Theory not to deal with short-term adjustments. Taking into account banks and financial markets may modify the dynamics. It may happen for low levels of employment that credit rationing prevents entrepreneurs hiring wage-earners at desired levels. But such mechanisms although not implausible are not sufficiently robust to reverse the basically stable influences. Allowing the long-term state of expectations to vary under the influence of unexpected profits radically changes the story. This is the fundamental point made by Harrod. To cast it in Kalecki’s terms, as investment explains realised profits a high level of investment tends to raise the difference between realised and expected profits, reinforcing the inducement to invest. The rate of accumulation is the primum movens in this model. Entrepreneurs are able, thanks to the monetary system, to decide and realize investments independently of financing conditions. Of course, in equilibrium, profit generated by investment is just sufficient to finance it jointly with wage-earners’ savings. But a market economy is not normally in equilibrium and we have to inquire into the dynamics of disequilibrium characterizing this monetary economy. What happens when planned and realized profit differ? The answer was long ago given by Harrod (1948): in equilibrium such an economy evolves on a razor’s edge which means that it is highly unstable. Consider now a predetermined k and allow γ to vary according to windfall profits. The first equation of (12.41) is then: ∆γ = bγ − bσk α−1 = bγ − bg

(12.43)

where g is the equilibrium rate of growth σk α−1 = σ / v . Trajectories generated by (12.43) are unstable. If at any period an exogenous shock were to change entrepreneurs’ animal spirits, the economy would never return to an equilibrium position and would grow exponentially without economic limits if the shock were positive and would decrease to zero if the shock were negative. Equation (12.43) expresses a very fundamental property of a monetary economy with entrepreneurs and wage-earners which contrasts with the relative

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stability of a simple market economy. The reason for the contrast is very straightforward. Having the ability to decide their income expenses (namely investment) entrepreneurs as a whole indirectly decide their receipts since investment is at the same time an expense and a receipt. Investment is a receipt but not a cost. If wage-earners were to spend all their income, investment would equal (and would determine) entrepreneurs’ profits. When wN d is not entirely spent, entrepreneurs’ profits are equal to their expenses minus wage-earners’ savings. Keynes and Kalecki were among the first to emphasize this consequence of the asymmetry between entrepreneurs and wage-earners. Kalecki found a felicitous expression for it ‘entrepreneurs earn what they spend whereas wage-earners spend what they earn’. Figure 12.3 sums up the reasoning above.

Instability of γ n

γ

Stability of k

[α + s (1 − α) ] k

0

1− α

k k*

k

Figure 12.3 Dynamic properties of Keynes’s steady-state

Notes 1

Hicks recognized in a discussion with Klamer: I did a sort of revision of IS/LM not many years ago (...). These two curves do not belong together. One is a flow equilibrium, the other a stock. They have no business being on the same diagram (Klamer, 1989, p. 175).

2 3

As a matter of fact this is true only when there is a positive excess supply in the market for labour (see below). Instant t + θ is also the beginning of period τ + 1 and instant t the end of period τ – 1. But this can be neglected here since period τ only is considered.G

4 The decision as to the volume of saving, and also the decision relating to the volume of new investment, relate wholly to current activities. But the decision as to holding bank deposits or securities relates, not only to the current increment to the wealth of individuals, but also to the whole block of their existing capital. Indeed, since the current increment is but a trifling

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221

proportion of the block of existing wealth, it is but a minor element in the matter (Keynes, 1936a, p. 127)

5

Even if Keynes was clearly not thinking of a beginning-of-period point of view, the opinion according to which current flows do not play a significant role in portfolio decisions may well be rationalised following Tsiang. Moreover, this offers an explanation of the two-stage decision process criticised by Patinkin and neoclassical economists who could not conceive of a portfolio decision which would not encompass everything on the same footing. Special Keynes model is recursive according to Hicks. It may be written as follows, using standard notation: M = L(i)

S(i, Y) = I(i)

Hicks contrasts this special model with his own general model: M = L(i, Y)

S(i, Y) = I(i)

which corresponds to the end-of-period view. 6

As Martin Hellwig put it: We understand all about the mechanics of stocks and flows within the formalism of Walrasian sequence economies. However, I am not convinced that we understand the interrelation of stocks and flows in a monetary economy in reality (Hellwig, 1993, p. 223).

7 Wicksell, after he reminds the reader of the three functions, measure of value, store of value and medium of exchange, goes on to say: Of the three main functions, only the last is in a true sense characteristic of money; as a measure of value any commodity might serve. Indeed compared with the two others, this is not a function at all, for it has no relation to the thing itself or to any of its external physical properties (...) Similarly, the function of acting as a store of value is not essentially characteristic of money. One might even go so far as to say that, from the social point of view, money never has this function, but only from the individual or private point of view (Wicksell, 1935, vol 2, pp. 7–8).

8

9 10 11 12

13

It is often held that imposing such cash-in-advance constraints is not very satisficing because we should be able to endogenously account for the existence of money. A search-theoretic approach to money addresses this issue. Some important results are available but it is not very easy to combine these results with standard macroeconomic models. Contrary to what Tsiang and Clower claim, introducing transaction constraints does not affect Walras law which still rules the economy as a whole (see Cartelier, 2001). A candidate for (12.25) obviously is the Phillips curve. To keep the story simple, one may assume that wage-earners are never liquidity constrained so that their demand for corn, when ( w / p ) ≥ ( w / p ) * is Cτ = [α /(α + β) ]  ( w / p ) τ N τd + Bτ  . A complete demonstration of the existence of a Keynesian equilibrium in an ArrowDebreu framework exists (Glustoff, 1968). It is due to Errol Glustoff. It seems that no Keynesian has ever been aware of it. I did not know Glustoff’s article when I wrote in 1996. A more detailed account of the Shapley-Shubik rule is given in Benetti and Cartelier (2001).

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References Benetti, C. and J. Cartelier (2001), ‘Money and price theory’, International Journal of Applied Economics and Econometrics, 9, April-June, pp. 203–23. Cartelier, J. (1996), ‘Chômage involontaire d’équilibre et asymétrie entre salariés et nonsalariés: la loi de Walras restreinte’, Revue économique, 1996. Cartelier, J. (2001), ‘Stocks, flux et contraintes budgétaires dans une économie monétaire’, mimeo. Clower, R.W, (1965), ‘The Keynesian counter-revolution: a theoretical appraisal’, reprint in D.A. Walker (ed.), Money and Markets, Cambridge: Cambridge University Press, 1984, pp. 34–58. Clower, R.W. (1967), ‘A Reconsideration of the microfoundations of monetary theory’, Western Economic Journal, reprint in D.A. Walker (ed.), Money and Markets, Cambridge: Cambridge University Press, 1984, pp. 81–9. Glustoff, E. (1968), ‘On the existence of a Keynesian equilibrium’, Review of Economic Studies, pp. 327–34. Graziani, A. (1988), ‘Le financement de l’économie dans la pensée de J.M. Keynes’, Cahiers d’Economie Politique, 14–15, pp. 151–66. Graziani, A. (1994) La teoria monetaria della produzione, Banca Popolare dell’Etruria e del Lazio/Studi e Ricerche. Harrod, R. (1948), Towards a Dynamic Economics, London: MacMillan. Hellwig, M. (1993), ‘The challenge of monetary theory’, European Economic Review, 37, pp. 215–42. Hicks, J. (1939), Value and Capital, Oxford: Clarendon Press. Keynes, J.M. (1936a), The Treatise on Money, The Collected Writings, volumes V and VI, London: MacMillan, 1973. Keynes, J.M. (1936b), The General Theory of Employment, Interest and Money, The Collected Writings, volume VII, London: MacMillan, 1973. Klamer, A. (1989), ‘An accountant among economists: conversations with Sir John R. Hicks’, Journal of Economic Perspectives, 3, pp. 167–80. Patinkin, D. (1958), ‘Liquidity preference and loanable funds: stock and flow analysis’, Economica, (XXV), pp. 300–318. Patinkin, D. (1987), ‘Walras’s Law’, in General Equilibrium, New Palgrave, London: MacMillan. Rhodes, J. (1984), ‘Walras’ Law and Clower’s Inequality’, Australian Economic Papers, 23(42), pp. 112–22. Tsiang, S.C. (1966), ‘Walras’ Law, Say’s Law, and liquidity preference in general equilibrium analysis”, International Economic Review, 7, pp. 329–45, reprint in M. Kohn (ed.), Finance Constraints and the Theory of Money, pp. 133–51. Wicksell, K. (1935), Lectures on Political Economy, 2 vols., London: George Routledge.

Chapter 13

Krugman on the Liquidity Trap: Why Inflation Will not Bring Recovery in Japan *

Jan A. Kregel

13.1

Introduction

The failure of the Japanese economy to respond to aggressive monetary easing in the form of a zero bid rate on the Bank of Japan's overnight financing facility has reminded some economists of Hicks's rendition of Keynes's 'liquidity trap'. Those who use Hicks's IS-LM diagram to evaluate monetary policy will recall that the horizontal portion of the LM curve emanating from the vertical axis indicates the minimum below which the interest rate cannot fall. It is meant to represent the lack of influence of monetary policy on the rate of interest. The conclusion is that in the horizontal range has no influence on the equilibrium level of output since a rightward shift of LM does not change its intersection with IS. If monetary policy has no impact on output, debt financed government expenditure is remains the only policy capable of influencing output. The explanation usually given of the failure of monetary policy is that interest rates are so low that they cannot be reduced further. Since Japanese policy rates are zero and cannot be reduced it is considered to be the first clear example of an economy facing a liquidity trap.1 Those who have studied Keynes's analylsis of changes in the quantity of money on the level of output will recall that there 'may be several slips between the cup and the lip' (JMK:VII, p. 173) and that his theory of liquidity preference, the foundation for the liquidity trap, challenged the mechanical relationship between money creation, the price level and the nominal level of output in the traditional quantity theory. It is paradoxical that the theoretical explanation of the recession in the Japanese economy should be founded on quantity theory models in which the rate of expansion of the quantity of money directly determines the rate of change in the price level. Indeed, in canonical quantity theory models money is neutral and has no impact on the long-run equilibrium of real output, irrespective of any reference to a liquidity trap, since money only affects nominal variables. The failure of a positive rate of change in the quantity of money to reverse the decline in the price level in these traditional quantity theory models is considered to be

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equivalent to the failure of expansionary money policy to reduce the rate of interest in Keynes's explanation of the liquidity trap. This apparent contradiction is resolved once it is recognised that the liquidity trap in these neo-quantity theory models represents the failure of changes in the quantity of money to influence the 'real' rate of return. Thus, with the nominal rate of interest bounded at zero, the real rate of interest can only be reduced if prices are rising. If prices are falling, then the real rate is rising, and if the Central Bank nonetheless increases the money supply and prices are not responding, then the real rate is not falling and the economy is said to be in a liquidity trap since monetary policy has no influence on the real rate. The reason for the liquidity trap is then the failure of money growth to raise prices as postulated by the traditional quantity theory. This// failure is not explained by any shortcoming in the theory, but failure of the Central Bank to make credible its intention to produce inflation. After decades of urging Central Banks to adopt independent policies and to create credibility in their pledge to keep prices stable by tying their hands and other sorts of sadistic practices, it is now argued that in Japan it is precisely this credibility that makes the attempt to create inflation incredible. Paradoxically, the current policy prescription for the Bank of Japan is to make its commitment to price stability incredible in order to convince market participants that it will produce a rate of inflation that is sufficient to reduce the real rate of interest to the level that causes domestic savings to fall to the near zero level of real domestic investment expenditures. This modern explanation of liquidity preference is in fact based on Irving Fisher's version of the theory in which the nominal rate of interest is determined by the real rate of return adjusted for the rate of change in the price level. If instead of rising, the price level is falling then nominal rates will have to be below real rates of return and equilibrium may require negative nominal interest rates if the real rate is less than the deflation rate. But, if nominal rates are bounded at zero, then nominal interest rates cannot be adjusted downwards and the only way to restore savings-investment equilibrium is a policy of inflation. This is precisely the policy that Fisher urged on Franklin Roosevelt during the Great Depression in the United States. It was also the basis of the decision to devalue the dollar by raising the price of gold and the various measures to create US government agencies designed to put floors under domestic prices. The inflation policy that Paul Krugman is recommending for Japan is based on exactly the same principles as Irving Fisher's recommendations during the Great Depression.

13.2

Hicks’s Horizontal LM curve as Liquidity Trap

Hicks not only claimed to be ‘a convinced liquidity preference man’ (JMK:XIV, p. 83), he also claimed that ‘Keynes accepted the IS-LM diagram as a fair statement of his position’ (Hicks, 1977, p. 146) However, Keynes was not an uncritical reader of Hicks’s exposition of his theory in the Economic Journal review of the

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225

General Theory and the subsequent derivation of the now famous IS-LL (as it was originally called) diagram. In particular, Keynes notes that Hicks inserted two illicit assumptions concerning the elasticity of supply of consumption goods and the income elasticity of the rate of interest in his discussion. Both were important to the derivation of the horizontal portion of the LM curve that represents the liquidity trap for most economists, but both were extraneous to Keynes’s theory. In his review Hicks notes that even if one accepts Keynes’s multiplier proposition that an increase in investment will cause a rise in demand for consumption goods and thus a multiplied increase in aggregate income, the empirical magnitude of the increase in real output will be small if the elasticity of supply of consumption goods is low. Hicks thus concludes that Keynes must be implicitly assuming ‘a high elasticity of supply in the consumption goods industries...; and if things do work out this way, it is perfectly intelligible that the increased demand for loans from the investment industries should encounter an increased supply, so that there is no reason for the rate of interest to rise’ (Hicks, CEII, pp. 89–91) when investment and output increase. The idea is that the increased output of consumption goods will produce the increased savings necessary to fund the loans for the new investment expenditures. Hicks also argues that if the supply of consumption goods is inelastic during the expansive phase of the cycle: Mr. Keynes’s analysis of this case would evidently lead to the conclusion that there would be an indefinite rise in the prices of consumption goods... but he would admit, on second thoughts, that this would lead to a more or less corresponding rise in the demand for money; and therefore that, unless the supply of money was indefinitely expanded, the rate of interest must rise... I do not think that this differs essentially from what has been said by earlier writers [Hicks refers in a footnote to Hayek’s Prices and Production]; they would, however, begin by assuming the supply of money not indefinitely expansible, and so proceed straight to the rise in the rate of interest. But they would admit, on their second thoughts, that if the supply of money were to be indefinitely expanded, the rate of interest could be kept down, and the inflation proceed without limit (Hicks: CEII, pp. 93–4).

Thus, Hicks concludes that Keynes is assuming either a highly elastic supply of consumption goods or an infinitely elastic supply of money and that it is one or the other of these assumptions that allows Keynes’s theory to differ from the traditional explanation of the response of the rate of interest to an increase in the level of activity. Thus, Hicks’s explanation of the stability of the rate of interest in the face of an increase in investment and output, which becomes the horizontal range of the LM curve, is based on the assumption of either a high elasticity of supply of consumption goods (implicitly loanable funds) or of money. Keynes, however, rejects any dependence of his theory on the elasticity of supply:

226

Money Credit and the Role of the State you argue... that my argument depends on the assumption of a ‘high elasticity of supply of consumption goods’, but why high... Towards the end you speak of the imperfect elasticity of supply of consumption goods in a trade cycle leading to a ‘consequent hardening of interest rates’. I do not follow why the one is consequent on the other (JMK:XIV, p. 71, 72).

In answer to this criticism Hicks agrees that the elasticity of supply need only be greater then zero and then goes on Surely it is quite in accordance with your own theory to speak of the imperfect elasticity of supply of consumption goods in the trade cycle leading to a consequent hardening of interest rates. As investment increases, the prices of consumption goods rise; this raises the transaction demand for money, and if the supply of money is not perfectly elastic, interest rates must rise too. The same thing may indeed happen to some extent merely by increasing employment, even if the supply of consumption goods is perfectly elastic, but imperfect elasticity of supply intensifies it. Is not this orthodox?’ (JMK:XIV, p. 73 italics added).

Keynes agrees that this is orthodox, but not his own theory, replying ‘I quite misunderstood what you meant... I quite agree with what you say’ (ibid., p. 75).2 The reader will note that this discussion confuses two separate points. Hicks’s initial statement concerned the low probability of a rise in the rate of interest increasing saving out of a given income in order to balance the failure of the consumption goods industries to expand in step with increased investment, the same effect being produced by an elastic supply of consumption goods keeping prices constant and allowing the required increase in the supply of saving. What Hicks had in mind was presumably the availability of stocks to allow the operation of the temporal multiplier process without raising prices. The second argument, on the other hand, refers to the impact of higher consumption goods prices in increasing the demand for money and thus raising interest rates, even when the multiplier is able to proceed without encountering supply shortages. Thus it is the assumption of the infinitely elastic supply of money that is crucial to the presumed constant rate of interest. But this proposition Keynes clearly accepted as being consistent with classical theory, and as such was not a distinguishing feature of this own theory or of any relation to the liquidity trap as defined above. Having agreed that in his theory, as in any other, an increase in investment would in general cause an increase in output and probably prices and, via an increase in transactions demands for money an increase in the rate of interest, irrespective of the value of the elasticity of supply above zero, Keynes must have been perplexed by Hicks’s statement in the article that set out the IS-LL analysis, ‘Mr Keynes and the Classics’, that Keynes’s theory leads to the ‘startling conclusion, that an increase in the inducement to invest, or in the propensity to consume, will not tend to raise the rate of interest, but only to increase

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employment’ (Hicks: CEII, p. l07, italics supplied) and that ‘the most important thing in Mr Keynes’s book’ is that ‘It is not only possible to show that a given supply of money determines a certain relation between Income and interest (which we have expressed here by the curve LL) it is also possible to say something about the shape of the curve. It will probably tend to be nearly horizontal on the left, and nearly vertical on the right’ (ibid., p. 109, italics supplied), implying that the rate of interest would not rise as investment and output expanded until full employment was reached. But, given the above discussion the horizontal behaviour of the LL curve ‘on the left’ could only take place even in the presence of a perfectly elastic supply of money, while its behaviour ‘on the right’ could only result from a less than perfectly elastic supply of money. Keynes was quick to note his disagreement with Hicks’s clearly ad hoc representation of the behaviour of the rate of interest as the ‘most important thing’ in Keynes’s theory: From my point of view it is important to insist that my remark is to the effect that an increase in the inducement to invest need not raise the rate of interest. I should agree that, unless the monetary policy is appropriate, it is quite likely to. In this respect I consider that the difference between myself and the classicals lies in the fact that they regard the rate of interest as a non-monetary phenomenon, so that an increase in the inducement to invest would raise the rate of interest irrespective of monetary policy (JMK:XIV, p. 80, italics added).

Thus Keynes rejects the argument that the difference between his theory and the Classics lies in the restrictions placed on the money supply function, in particular the existence of a horizontal portion usually known as the ‘liquidity trap’ or in any restriction on the elasticity of supply. Keynes clearly stated that liquidity trap conditions, while possible, had not yet been experienced; they thus could not serve as an explanation for the Great Depression.3 Nonetheless, Hicks’s formulation of liquidity preference led to a presentation of Keynes’s theory which implicitly required either 1) the operation of the liquidity trap due to the elasticity of supply of money, or 2) the assumption of unchanging prices of consumption goods, for a horizontal LM curve represented stable prices in conditions of perfectly elastic supply of consumption goods. However, the IS-LM framework makes no reference to any supply conditions for money or consumption goods output, only the supply of savings. Even though this representation was never accepted by Keynes – Hicks’s suggestions to the contrary – it has become the standard representation. Tobin, for example comments ‘In terms of the Hicksian language ... I thought (and I still think) ... the main issue ... is the shape of the LM locus’ (Tobin, 1972, p. 853). Indeed, both Friedman and Tobin accept a positive slope for the LM curve, rejecting a vertical or horizontal curve. But, as Hicks’s article pointed out, here there is no difference between Keynes’s and the ‘ordinary method of economic theory’. Clearly, Hicks’s explanation of the liquidity trap as the horizontal portion of the LM curve is consistent with traditional theory, as Keynes agreed. But it

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cannot be considered as an analytical foundation for the failure of the rate of interest to respond to policy changes in the amount of base money created by the central bank for it deals with the behaviour of rates when output is increasing with perfectly elastic money supply, not the behaviour of rates when the quantity of money is increasing with perfectly elastic supply of output.

13.3

The Modern Theory of the Liquidity Trap

Although Krugman considers Hicks’s model as a ‘very useful heuristic’ (Krugman, p. 7) he notes that it is considered too ad hoc and thus not the best vehicle for presenting the traditional version of the liquidity trap. In his view A liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal rates are at or near zero – so that injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes.

He notes that an alternative ‘way of stating the liquidity trap problem is to say that it occurs when the equilibrium real interest rate, the rate at which savings and investment would be equal at potential output, is negative’ (ibid., p. 16). As noted above, in traditional theory, if the nominal interest rate is determined by adjusting the real rate of return for depreciation in the monetary standard a rise in the inflation rate, given the nominal rate should cause the real rate to decline. If a rise in the growth of base money causes a rise in the rate of inflation, then it should be possible for monetary policy to achieve the required equilibrium real rate. This raises the question of, how is the liquidity trap possible? The answer lies in a little-noticed escape clause in the standard argument for monetary neutrality:... there is no... argument that says that a rise in the money supply that is not expected to be sustained will raise prices equiproportionally – or indeed at all. In short, to approach the question from this level of abstraction already suggests that a liquidity trap involves a kind of credibility problem... if monetary expansion does not work, if there is a liquidity trap, it must be because the public does not expect it to be sustained (ibid. p. 7).

Although a one-shot increase in base money will lead to a once over increase in the price level, this should have no impact on the rate of inflation and leave the nominal rate of interest unchanged if the real rate of interest is unchanged. The liquidity trap thus occurs because the central bank cannot make individuals with rational expectations believe that it will keep money growing in perpetuum at the new higher rate so as to ensure a higher rate of inflation in perpetuum. This looks just the opposite of Hicks’s theory, which is based on stable prices of consumer goods and belief in the perfect elasticity of the money supply.

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Krugman argues that investors do not believe that the money supply will be perfectly elastic, indeed the increases that occur in the present period will be reversed in future. Thus, monetary policy cannot influence the real rate of interest to make it adjust to the level that will lower private sector savings to equality with the voluntary investment decisions of the private sector. ‘The easiest way to think about this is to say that there is an equilibrium real interest rate which the economy will deliver whatever the behaviour of nominal prices’ (ibid., p. 10). Thus, the liquidity trap occurs because the real rate cannot be influenced by monetary policy. As already noted, this is a perfectly standard result within Fisher’s version of the quantity theory and formed the basis for Keynes’s belief that Hicks had not captured his essential difference from classical theory: Put shortly, the orthodox theory maintains that the forces which determine the common value of the marginal efficiency of various assets are independent of money, which has, so to speak, no autonomous influence; and that prices move until the marginal efficiency of money, i.e. the rate of interest, falls into line with the common value of the marginal efficiency of other assets as determined by other forces. My theory, on the other hand, maintains that this is a special case and that over a wide range of possible cases almost the opposite is true, namely, that the marginal efficiency of money is determined by forces partly appropriate to itself, and that prices move until the marginal efficiency of other assets fall into line with the rate of interest (JMK:XIV, p. 101).

13.4

Liquidity Preference and the Liquidity Trap

Krugman notes that unlike Hicks’s ad hoc version his explanation of the liquidity trap depends on the modern theory of intertemporal choice. But, it is precisely in the exposition of this intertemporal relation that Keynes differed from Fisher. Fisher’s explanation – which is the one used by Krugman – of the determination of nominal interest rates is based on expectations of future goods prices relative to present goods prices as expressed in the expected rate of inflation or deflation of goods prices. The theory is based on a proposition presented in Irving Fisher’s The Theory of Interest (1930) that on Fisher’s own admission only applied to conditions in which ‘rational tendencies’, based on ‘rational and empirical laws... analogous to rational and empirical laws of physics and astronomy’ (Fisher, 1930, p. 321). However, Fisher notes that where actuarial risk cannot be applied and ‘uncertain’ conditions make the value of money unstable, ‘We must... give up as a bad job any attempt to formulate completely the influences which really determine the rate of interest’ (ibid.). These are precisely the conditions that Keynes believed to be normal and thus the basis for this theory. Both Fisher and Keynes specify the rate of interest as an intertemporal relationship represented by a spot-forward swap, or by the excess of the forward price over the par or spot price. However, In Fisher’s time preference approach the rate of interest is the discount of future over present income that makes their utility

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equal at the margin, while for Keynes liquidity preference represents the return that must be paid on illiquid assets to make investors indifferent to holding more liquid assets. Since time preference is a relation between real income today and in the future, it would be disturbed by changes in relative prices, thus Fisher argues that the money rate of interest that allows individuals to transfer income from the present to the future, r, must be corrected for the rate of inflation, p, in order to leave the time transformation of income undisturbed: thus the Fisher relation: (1+p)(1+r)=(1+i), or i = [ ( 1 + r ) ( 1 + p ) ] – 1 = r + p + r p , which is usually written i = r + p when rp is small and p is the rate of inflation, r the rate of increase in real income, and i the rate of interest on money. In the case of Japan, the problem is not inflation, but deflation, and p < 0. Then if i is constrained to be non-negative, r must be positive and it is impossible for the competitive market system to achieve an equilibrium which requires r to be negative. In simple terms this is Krugman’s version of the liquidity trap. In Krugman’s simple monetary view, p should be determined by the rate of growth of base money; but if money growth is indeed positive and p remains negative this can only be explained by the expectation that money growth will not remain positive and the expansionary monetary policy will be reversed in the medium run. Thus the system is stuck in a liquidity trap with a real rate of interest that is too high, or a nominal rate of interest that is too high, because the rate of inflation is too low when nominal interest rates are fixed at zero. The reason can only be the failure of the central bank to convince the public that p will be permanently higher. Overcoming the liquidity trap thus requires permanent and perfectly anticipated inflation in the form of a positive value of p sufficient to allow r to be negative when i is constrained to be non-negative. Keynes has a very simple objection to Fisher’s relation between the rate of interest and the rate of inflation. First, pace Krugman’s emphasis on the lack of central bank credibility, he objected because it relied on the assumption of perfect foresight over the path of future incomes and prices (see 1930, pp. 202–3 and JMK:VII pp. 142–3). Second, he objected because Fisher’s argument that the money rate of interest should automatically reflect a perfectly foreseen rise or fall in the price level overlooks the impact of a rise or fall in interest rates on the capital value of existing stocks of financial assets. While it is true that if a rise in the price level for the coming year of 2 per cent is perfectly foreseen, interest rates must be 2 per cent higher to keep real returns for investors in one-year bills constant, the same would not be true for an investor holding fixed-interest assets of longer maturity in order to sell after one year, since there would be a positive or negative change in its capital value if interest rates change. Since market arbitrage should ensure that the one- year holding period rate of return should be the same for any instrument (even 30-year bonds sold one year after purchase) held for one year, longer-dated instruments should have a larger adjustment in their interest

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rates to offset the fall in capital value due to the rise in interest rates. A change in the rate of inflation should then have a differential impact on the rate of interest along the maturity spectrum, rising with time to maturity.4 Keynes noted that a rise in the rate of interest from 10 per cent to 12.2 per cent will cause the price of a £100 par value British consol paying a £10 coupon to fall from £100 to £81.96, a decline of 1.8 per cent and a capital loss of over £18. While the ‘variations in the rate of interest earned during the year in question are too small to make much difference’ (e.g. the extra 2.2 per cent earned on the reinvestment of the £10 coupon) relative to the much more substantial capital loss since the benefit of being able to invest the future £10 interest coupon payments at the higher rate of 12.2 per cent will be swamped by the £18 decline in the capital value of the bond. The rise in the rate of interest equal to the rise in the rate of inflation could by no means be considered as sufficient to compensate for the loss in purchasing power. Thus, Keynes argues, Fisher’s relation goes in the wrong direction for existing bondholders, since the higher yields required to preserve real yields cause capital losses that will more than offset the increased interest earnings. What change in the rate of interest would be required to keep the capital position of the bond holder unchanged? Since the impact of the rate of interest will increase interest earned on reinvestment of coupon interest, while it changes capital values in the opposite direction, the breakeven condition for a perpetual bond will be P–C=0

(13.1)

where P is the annual cumulative change in price, and C its annual coupon payment. The price, or present value, of a perpetual bond is C/i, where i is its current yield to maturity. The change in price P of a perpetual bond is given by the product of its market price, the change in the rate of interest, i, and the modified duration of the bond. For a perpetual bond duration is given by D = (1 + i) /i, and modified duration, DM , by D/(1 + i), which simplifies to 1/i. Thus P = PiDM, which can be expressed as P=

C 1 C i =i 2 i i i

(13.2)

From (13.1) and (13.2) we obtain i = i2 as the condition under which P = C and is Keynes’s square rule.5 Thus, for increases in the rate of interest equal to the increase in the rate of inflation to leave capital values unchanged they must be equal to i2. Thus, the Fisher relation will hold only for an increase in the rate of inflation p = i2, but this only keeps capital values constant and does not provide any adjustment for inflation. For the Fisher relation to hold, interest rates must rise by more than this, but this means that capital value will fall further, etc., which illustrates Keynes’s point that in general it is impossible for a simple adjustment in the interest rate to keep purchasing power unchanged once the impact of the interest rate on the value of existing stocks of assets is taken into account. There is

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thus no reason to expect the Fisher relation to hold, as has indeed turned out to be the case empirically. But, Keynes’s calculation also served another purpose. It can also be represented as the ‘breakeven’ point for the two opposing forces working on the value of the bond, that is, the point at which the change in capital value is just offset by the opposite change in interest income from reinvesting coupon interest at the higher or lower interest rate over the remaining time to maturity of the bond. This point is called the ‘duration’ of the bond in the finance literature. The lower the rate of interest, the higher the bond’s ‘duration’, and the longer it takes to recover the fall in capital values from the increased reinvestment earnings due to higher reinvestment interest rates. At a 3 per cent nominal interest rate, duration is 34.33 years, at 2 per cent to 51 years. At 1 per cent it is 101 years. Keynes’s explanation of the liquidity trap is based on this relation. If an investor has to wait 101 years to recover the capital loss due to a rise in the rate of interest equal to 1 per cent squared, which is only an absolute increase in rates from 1 per cent to 1.01 per cent, it seems rational for the investor to decide that it would be better not to hold bonds, but to hold money instead since the loss in holding money is only the interest rate, while the loss from holding the bond is the much larger decline in capital value. Thus, on Keynes’s definition the liquidity trap will occur whenever investors expect interest rates to rise by more than the square of the current interest rate, for they will then prefer to hold money rather than bonds. Thus Keynes’s statement that the lower the rate of interest, the more likely that liquidity trap will be sprung, since the longer it takes to recoup the capital loss through higher interest earnings and thus the higher the probability there will be a reversal in interest rates. Since liquidity preference is a relative concept, it should be clear that the existence of a liquidity trap at high interest rates cannot be ruled out. At 8 per cent, duration is 13.5 years and modified duration, 12.5 years. A rise in the rate of interest to.0864 would produce a fall in the price of a par 8 per cent consol of 100*12.4*0.0064 = çZKLFKLVH[DFWO\WKHFRXSRQYDOXH$QH[SHFWDWLRQRIDULVH in interest rates of more than 8 per cent then should lead to a decision to sell bonds for money. If this expectation is generally held by investors then there will be no buyers of bonds other than the monetary authority and it will be impossible to change interest rates by buying bonds from the public since there is perfectly elastic supply at prevailing interest rates. The expected percentage rise in interest is however, twice as high as in the case of 4 per cent rates. However, these should be judged relative to recent changes in bond prices. If 8 per cent lies within two standard deviations from the mean of rate changes over the recent past, then it would be just as rational to remain liquid at 8 per cent as it was at 4 per cent in similar conditions of volatility. It is clear that the liquidity trap depends on expectations of future bond prices, and that expectations will be based on recent volatility of rates. In a volatile rate environment, it will become more difficult to use changes in interest rates to influence the demand for money since they will have to be larger in order to produce an impact.6

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It is also important to remember, as noted above, Keynes’s argument refers primarily to the impact on long rates, or more precisely on the range of rates of assets of different maturities as represented by the yield curve. Of course, the argument given above concerns the impact of changes in short rates on the prices of assets of all maturities. Thus, Keynes notes that ‘If the monetary authority deals only in short-term debts, we have to consider what influence the price, actual and prospective, of short-term debts exercises on debts of longer maturity’ (JMK:VII, p. 206). Thus, the existence of the Keynesian liquidity trap does not depend on the absolute level of the interest rate, but on the size of the value of the square of the interest rate relative to the historic volatility of the interest rate and the uniformity of expectations concerning increases in interest rates in excess of this rate. It is also clear that it does not depend on the lack of credibility of the central bank in producing inflation, for even if the central bank’s pledge to raise the inflation rate were credible and believed by the public, it would also have to induce the credible belief that there would be no upward shift in the entire yield curve as a result. As a result, Keynes recommends ‘Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement which can be made in the technique of monetary management’ (ibid.) capable of overcoming the liquidity trap. Although investors in Japanese securities may believe in the ability of the central bank to set the rate of growth of the money supply and/or its short-term policy rate, they certainly do not believe that the central bank can control the shape of the yield curve. This would be particularly improbable given the changes that have taken place in ten-year rates since the Japanese Central Bank adopted its zero rate policy. Thus, even if investors have perfect confidence in the Central Bank’s ability to increase the rate of inflation, the existence of a zero bid rate means that there is a zero probability of a further fall in rates short rates, making the expected value of the change in short rates positive. As long as there is a uniform market expectation that interest rates would rise by more than the square of themselves, the expectation is that long rates will rise by more than this and the failure of the economy to respond to monetary policy will remain (although the actual existence of a liquidity trap could only be confirmed if the Central Bank did attempt to influence long rates). From a Keynesian point of view, Krugman’s policy cannot work for a credible central bank policy for inflation would have to create perfect certainty not only that short term interest rates would not rise, but that the yield curve would remain stationary. In current Japanese conditions it is extremely unlikely that such conditions could be created. Government bond issuance has increased dramatically along with the rising government expenditure packages that have been introduced in response to the slump. The largest proportion (around 40 per cent of existing stocks) of these bonds have gone into the portfolios of government agencies such as the Trust Fund Bureau (TFB). The next largest proportion went into bank

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portfolios (around a quarter). This shift was facilitated by what is called the ‘dual flight to quality’ that has occurred in the post bubble period. in which the weakness of the banks caused households to shift from risky bank deposits to government guaranteed postal deposits (and the newly introduced ten year compound interest bearing savings accounts) which provided the funds for the TFB which invests in government securities. The weakness in the corporate sector caused a sharp fall in bank lending to the private sector, and banks increased their holdings of government securities in their reduced balance sheets. In the end of 1998 and early 1999 two important structural changes took place which are quite independent of the credibility of the Central bank’s inflation policy. First, as part of Japan’s financial liberalisation, banks will be required to mark their investment portfolios to market. The duration of a ten-year bond issued at a 1 per cent current yield is above 9.5 years. Any increase in long rates, such as the jump from around 1 per cent to 2.25 per cent that occurred during the last quarter of 1998 would produce a decline of around 12 per cent in the value of the 1 per cent par bonds in bank portfolios. For conditions prevailing in February 1999 it has been estimated that a 100 basis point rise in interest rates on long bonds would have produced a 15 trillion Yen capital loss for all financial holders of Japanese government bonds. It is thus likely that banks will be reducing their portfolio holdings of bonds, causing falling prices. Further, the TFB announcement that it would reduce its purchases of securities from the 25 trillion Yen in fiscal 1998 to less than half (in January of 1999 it was only 5 trillion on an annual basis) because of maturing postal term deposits and the elimination of the requirement that postal deposits and pension contribution be held by the Bureau, concentrated the market’s attention on the importance of public bond market management on supply conditions. It is quite clear that the continued financial liberalisation will reduce the holdings by government agencies, and that banks will reduce their portfolio holdings as the volatility of bond prices increases. Finally, banks will be given permission to raise funds through bond issues from the last half of fiscal 1999. All of these factors put a sustained upward pressure on term interest rates. This also means that banks will not only be unwilling to buy bonds, they will be hesitant to lend to finance private sector holdings of bonds or productive enterprise. In these conditions the market will suffer from continued fears of a steepening of the yield curve and the associated capital losses associated with holding long-term issues. Since there must be equivalence between short issues and long issues with short holding periods, this will mean continued upward pressure on short rates. Thus, the policy that the central bank would have to adopt in order to eliminate the risk of a rise in rates according to the square rule would be to peg long rates, much as was done in the US in the second world war (see IBJ Securities, 1999). This, however, does not seem likely for a Central bank that was just granted its independence in the context of big bang liberalisation.

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Clearly, in present conditions it is not the lack of a credible inflation policy, but a credible interest rate policy that is creating difficulty. As Keynes notes in relation to Fisher’s recommendations of inflating out of the Great Depression: The stimulating effect of the expectation of higher prices is due, not to its raising the rate of interest (that would be a paradoxical way of stimulating output – in so far as the rate of interest rises, the stimulating effect is to that extent offset), but to its raising the marginal efficiency of a given stock of capital’ (JMK:VII, p. 143)

that is, raising the expectation of returns on new investment relative to the rate of interest, and this requires a credible policy that interest rates will not rise along with the rate of inflation, which is to say that the Fisher relation and the quantity theory should not hold. But the failure of a higher rate of increase in the quantity of money to increase prices and the rate of interest is what Krugman calls the liquidity trap and he identifies as the cause of Japan’s recession. In Japan even if the Bank of Japan could mount a credible inflation policy, there would be no guarantee of the stability of the yield curve. What is required is a credible policy to ensure increased higher rates of return on investment, which may or may not be accompanied by rising prices. In general in Japan it has not. This requires credible increases in aggregate demand. Traditionally in Japan this has come from exports. Given recent Yen strength and other structural changes in global markets this is now unlikely. What Japan needs is a credible policy of increasing the return on producing for domestic demand. From a Keynesian point of view it might be more appropriate to say that Japan is in an underemployment equilibrium with deficient aggregate demand than in a liquidity trap. Notes * 1 2

3 4

I am grateful to Paul Davidson, Rogerio Studart, Mario Tonveronachi and Randy Wray for reactions to the argument presented here without implicating them in the final result. Although it is interesting to note that interbank deposit bid rates were in fact less than zero during 1998. See Joan Robinson’s comment on this aspect of Hicks’s Review (1937, p. 16): ‘There appears to be no warrant for Mr. Hicks’ view... that an indefinitely great rise of prices will develop in a state where capacity is limited but available labour unemployed. It is true, as Mr. Hicks says, that when effective demand increases and the supply of money is constant, the rate of interest will rise if the supply of consumption goods is less than perfectly elastic, so that prices rise. But it will rise even if supply is perfectly elastic and prices are constant’. ‘I know of no example of it hitherto’ (p. 207). Keynes always notes that his argument refers to ‘the objective of reducing the long-term rate of interest’ (p. 202) or ‘a determinate rate of interest or, more strictly, a determinate complex of rates of interest for debts of different maturities’ (p. 205). He lists one of the reasons (in addition to the liquidity trap) why central banks have difficulty influencing the rate of interest as ‘the monetary authority’s own practices in limiting it willingness to deal to debts of a particular type’ (p. 207), and that ‘owing to the unwillingness of most monetary authorities to deal boldly in debts of long term there has not been much

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5

6

Money Credit and the Role of the State opportunity for a test [of the liquidity trap]’ (ibid.). It is thus the influence on the longterm rate of interest that is crucial, but we would now talk in terms of affecting the slope of the yield curve. The duration of a par perpetual bond with a £4 coupon is 26 years. Modified duration, defined as D/(1 + I), which measures the volatility of bond prices, is 25 years. The change in the price of the 4 per cent par consol is thus calculated by multiplying modified duration by the current price and the change in the bond’s yield to maturity. In the case of a 16 basis point (4 basis points squared) rise in the yield from.04 to.0416, the value of the bond will fall over the year by 25*100*.0016 = £4, which is precisely the bond coupon. For any greater increase in interest rates, the fall in the bond’s value will exceed the current coupon of the bond, producing net losses for the holder. If an investor expects interest rates to rise by more than the square of the current rate Keynes says the investor should prefer to hold cash rather than bonds. In such conditions, attempts to lower the rate of interest by increasing the purchase of bonds will find ready sellers at the prevailing interest rate, and the attempts of the monetary authority to lower rates will be prevented by a ‘liquidity trap’. As rates rise, the square rule produces larger and larger absolute changes in the interest rate, and the use of modified duration to calculate the change in price becomes less and less accurate. The full calculation of the change in the bond price will require the calculation of convexity. It is interesting to note that Hicks (1939, p. 261, note 2) reproduces the square rule, and notes that it is very likely that returns will be negative, since the fall in capital values will be even greater if changes in risk are taken into account.

References Hicks, J. (1939) Value and Capital, Oxford: Clarendon Press. Hicks, J. (1965) Capital and Growth, Oxford: Clarendon Press. Hicks, J. (1977) Economic Perspectives, Oxford: Clarendon Press. Hicks, J. (CEII) Collected Essays on Economic Theory, Volume II: Money, Interest and Wages, Oxford: Blackwell, 1982. IBJ Securities (1999), ‘The dual managed system of the moratorium period,’ IBJS Research & Reports, April/May. Keynes, J.M. (1930) A Treatise on Money, Vol. II, London: Macmillan. Keynes, J.M. (JMK:VII) The General Theory of Employment, Interest and Money, London: Macmillan for the Royal Economic Society, 1973. Keynes, J.M. (JMK:XIV) The Collected Writings of J. M. Keynes: The General Theory and After - Part II, London: Macmillan for the Royal Economic Society, 1973. Krugman, P. (1998), ‘It’s baaack! Japan’s slump and the return of the liquidity trap’, at http://web.mit.edu/krugman/www/bpea_jp.pdf Robinson, J. (1937) Essays in the Theory of Employment, London: Macmillan. Tobin, J. (1972) ‘Friedman’s theoretical framework’, in R. Gordon (ed.), Milton Friedman’s Monetary Framework, Chicago: University of Chicago Press.

Chapter 14

Saving and Investment: Keynes Revisited Basil Moore

The outstanding faults of the economic society in which we live are its failure to provide for full employment, and its arbitrary and inequitable distribution of wealth (John Maynard Keynes, 1936, p. 372) The extent to which one sees one’s destination before one discovers the route is the most obscure problem of all in the psychology of original work… It is the destination which one sees first, [though] a good many of the destinations so seen turn out to be mirages (John Maynard Keynes, quoted in Moggridge, 1992, p. 552). The accounting identities equating aggregate expenditures to production and of both to incomes at market prices are inescapable, no matter which variety of Keynesian or classical economics you espouse. I tell students that respect for identities is the first piece of wisdom that distinguishes economists from others who expiate on economics. The second?… Identities say nothing about causation (James Tobin, 1997, p. 300)

14.1

Introduction

The dissatisfaction with Keynes neglect of the role played by banks in the financing of production in the General Theory led some economists to search openly for an alternative approach to monetary theory. The circuitists turned to Kalecki and Keynes’ Treatise and post-GT articles, and placed emphasis on the creation and destruction of money. Augusto Graziani is famous for his contributions to the Circuit literature. But there is another even more radical critique of Keynes’ analysis of the role of finance, saving and investment in the GT. Economists have long followed Keynes and viewed saving and investment as independent behavioral relationships, undertaken by different groups. Business firms, the administrators of the economy’s capital stock, are responsible for most investment spending. Households, the ultimate owners of the economy’s net worth, undertake most of the economy’s saving. Yet ex post saving and investment are identical as a national income identity. The question then becomes: What is the mechanism that brings

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these two largely independent magnitudes, undertaken by different economic groups, into equality? The dilemma has conventionally been resolved by distinguishing ex ante saving and investment, which are clearly not identical, from ex post saving and investment, which represent the definitional accounting identity. Broadly speaking, classical economists regarded the mechanism that equilibrates planned saving and investment as the market for loanable funds. The supply and demand for funds are brought into equilibrium by changes in a market rate of interest. Keynes disagreed, and insisted that saving and investment were a function of the level of income. Inequality between planned saving and planned investment would cause the level of AD to change. Keynes maintained that the level of income continues to adjust until planned saving is brought into equality with planned investment. The ‘neoclassical synthesis’ argued that both interest rates and income adjusted to equilibrate saving and investment. The mainstream view currently regards saving behavior as establishing the physical limit of resources available for investment. The Competitiveness Policy Council has expressed the conventional view clearly as follows: Economic theory teaches us that the allocation of a nation’s resources between consumption and investment is determined by saving. In practical terms, private individuals decide how much of their income to save rather than consume; private businesses decide how much of their earnings to retain rather than pay out as dividends; and governments decide how much to spend and tax, with surpluses augmenting and deficits diminishing the saving done in the private sector (Quoted by Baker, 1997, p. 36).

Many mainstream economists would concede that so long as there are unemployed physical resources, an expansionary Keynesian investment-led multiplieraccelerator process operates. As the economy approximates full employment, saving establishes the physical constraints on investment, so in the longer run the logic of a saving-led expansion prevails. But it is widely believed in the profession that low saving ratios have led to low rates of capital formation and low rates of growth for the economy. Summers well captures the mainstream academic view: It is widely recognized that low national saving is the most serious problem facing the US economy. Low saving accounted for the trade deficit and the slow growth in standards of living that continued through the 1980’s. Part of the reason for low national saving is the excessive federal deficit. But the low U.S. saving rate is increasingly the result of insufficient personal saving by U. S. households (Quoted by Pollin, 1997, 2-3).

In the U.S. a host of measures have been proposed and adopted in the name of increasing public and private saving. Critics of the mainstream position insist that saving is a passive variable at less than full employment. The difficult question then becomes how to determine when the economy comes to approximate full employment. The argument tends to deteriorate into technical questions of how

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‘saving’ should be defined, and what constitutes ‘full employment’ (see the discussion in Pollin, 1997). Tobin (1997, p. 300) has argued: Experience recommends an eclectic view, to which Keynes himself and even Pigou … subscribed. Sometimes economies are in one regime, sometimes in the other. That leaves plenty of room for debate about their relative frequencies and for diagnosing which is the effective constraint at any particular time.

To demonstrate the centrality of saving in mainstream theory, the saving ratio plays the critical role in all growth models determining the economy’s ‘equilibrium’ growth rate. In a much-cited 1980 study, Feldstein and Horioka (1980) found high correlations between domestic saving and domestic investment for all industrialized OECD countries. They reasoned that if international capital markets were perfect, when domestic saving was added to a world saving pool, and domestic investment competed for funds in that same saving pool, there should be no correlation between a nation’s saving rate and its rate of investment. They thus interpreted their findings as evidence of the existence of substantial international capital market imperfections.1 One core proposition that delineates heterodox Post Keynesian from mainstream views is a sharp disagreement concerning the direction of the causal process by which saving and investment are equated (Sawyer, 1996). Mainstream economists largely maintain the classical position. While they concede that short run movements in economic activity are dominated by movements in AD, ‘The trend movement is predominately driven by the supply side of the economy’ (Solow, 1997, p. 230). In the long run the direction of causality is from saving to investment.2 Saving must be undertaken in order to provide the resources for investment. Saving is therefore the chief constraining factor in economic growth. 3 Post Keynesians maintain Keynes’ position, that capitalist economies are typically demand constrained, and the direction of causation runs from investment to saving. Since the future is strictly unknowable, investment expenditures must be shaped by investors’ ‘animal spirits’. By increasing aggregate demand (AD), investment creates the saving necessary to finance itself (See e.g. Keynes, 1936; Davidson, 1990, 1994). Output is demand-led, and no unique long run ‘equilibrium’ natural growth path exists.4 Both schools agree that saving and investment are independent behavioral relationships ex ante. Both accept the National Income Accounting definition that saving is identical to investment ex post. Both agree on the desirability of more rapid economic growth. To this end mainstream economists put forward a set of supply-side policy recommendations designed to stimulate additional saving and investment, and so an expansion of aggregate supply (AS). Scarcity is viewed as the core economic constraint. Market economies are supply-constrained, and typically operate near their production possibility frontiers. In sharp contrast Post Keynesians espouse a set of demand-side policy recommendations designed to stimulate additional consumption and investment

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spending, and so an expansion of AD. Ignorance is the core economic constraint. Market economies are demand-constrained, and ordinarily operate well within their full employment production possibility potential (Keynes, 1936; Davidson, 1994). This chapter addresses the question of the causal relationship between saving and investment. Since saving is identical to investment ex post as anaccounting identity, it is not possible to sort out the direction of causality between the two by empirical analysis. A detailed explanation of the dynamic process how saving, investment and income are interrelated over time must be produced.5 It will be argued that the true nature of the relationship between saving and investment has not as yet been grasped. Aggregate saving, intuition to the contrary, is not for the economy an independent behavioral relationship. It is very easy to demonstrate in a simple one-sector model that aggregate saving is simply an accounting identity: the accounting record of investment. It will be shown that this identity is maintained in ever more complex multi-sector models, providing capital budgeting is carried out consistently. Since saving is the accounting record of investment, it is hardly a surprise that saving and investment are very closely correlated. If there were no measurement errors, the two would be identical. As the accounting record of investment, a change in saving cannot ‘cause’ a change in investment, no matter how high the correlation. The accounting identity that saving equals investment holds however close or far away the economy is from ‘full’ employment. The belief that aggregate saving is the sum of volitional decisions by individual economic units is yet another illustration of the fallacy of composition. In this case it is encouraged and in part explained by the strong volitional connotations of the verb ‘to save’. But as economists well know, what is true for the part is not necessarily also true for the whole. Total saving is equal to the sum of individual savers’ volitional decisions to save. But since it is the accounting record of investment, it is not ‘caused’ or ‘explained’ by the total demand of agents to save. There are many examples of the fallacy of composition in economics. When an individual farmer is blessed by the gods, and enjoys a bumper crop, his income increases. But when good weather enables all farmers to enjoy a bumper crop, total farm income falls. In this case due to perfect competition individual farmers face a perfectly elastic demand curve, but the demand curve for the industry is highly inelastic. Similarly if the number of job vacancies is given, increased job search may enable an individual unemployed worker to find employment. But this is a zero sum game, and does not itself increase the total numbers of jobs and employment available. Individual agents, by increased spending or lending, can on their own initiative reduce their own money balances to zero. But when one agent reduces her balances to zero, another agent acquires them. It is not possible for individuals by spending collectively to eliminate their aggregate holdings of money, unless they were to purchase all the financial assets in bank portfolios. Individuals do have a demand to hold money balances as a function of their income, wealth, and relative

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interest rates. The total quantity of money supplied is necessarily identical to the total quantity of money demanded by individual economic agents. If total quantity of money supplied were exogenously determined by the amount of reserves provided by the central bank, as the mainstream view maintains, the money supply is not determined by the total quantity of money demanded by individual depositors. Post Keynesians recognize that the supply of credit money in modern banking systems is endogenous credit-driven. The supply of money is not determined by the high-powered base, or by total deposits demanded by bank depositors, but by total bank credit demanded by credit-worthy borrowers.6 The belief that the total supply of deposits is determined by the total amount of deposits demanded by individual depositors represents the fallacy of composition.

14.2

Saving Is the Accounting Record of Investment

There are a number of ways of demonstrating that aggregate saving, when defined as ‘income not consumed’, is simply the accounting record of aggregate investment. We will analize three of them in turn. Consider first the familiar textbook demonstration that saving and investment are identical in a simple one-sector model. With no government or international trade, nominal income (Y) is defined as equal to the total value of currentlyproduced consumption (C) and investment (I) goods, valued at current market prices: Y≡C+I

(14.1)

Nominal saving (S) is defined as equal to all income not consumed: S≡Y–C

(14.2)

Keynes argued that a ‘fundamental psychological law’ linked consumption spending with income earned. This could be expressed as a behavioral relationship, the ‘consumption function’. Equation (14.2) looks superficially like a behavioral saving relationship, and is frequently graphically so portrayed in textbooks.7. But equation (14.2) may be very simply rearranged into a third identity: all income is either consumed or saved: Y≡C+S

(14.2a)

Equation (14.2a) has now become a definitional identity. It no more implies the existence of a behavioral relationship between saving and income, than equation (14.1) implies a behavioral relation between consumption and income. Equation (14.1) defines income (measured as the flow of output) as the sum of consumption and investment goods. Equation (14.2a) defines income (measured as

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the flow of income) as the sum of consumption and saving. Equating (14.1) and (14.2a), saving is seen to be identical to investment. S≡I

(14.3)

The above argument is presented in all the textbooks. But its implications have not as yet been fully absorbed. It is universally admitted that S ≡ I ex post. But in the internal paradigm of most economists, and as categorized in most textbooks, ex post is viewed as designating past events. It is never explicitly recognized that ex post comprises the present as well as the past.8 Equation (14.3) is a timeless accounting identity. Actual saving is always identical to actual investment, irrespective of the time unit or time period over which they are measured, or how investment is defined. If investment is highly volatile over time, so is saving. For the economy as a whole there is no behavioral ‘savings function’.9 Second, the two saving identities (14.2), saving as identical to income not consumed: (S ≡ Y – C), and (14.3), saving as identical to investment (S ≡ I), imply that whenever the definition of income, consumption, or investment changes, so does ‘saving’. This occurs without any deliberate volitional or even conscious behavior on the part of savers.10 On pragmatic grounds, due to the impossibility of precisely defining the relevant time period for services, NIPA conventions arbitrarily exclude all expenditures on services, training, and education as investment. The NIPA thus substantially underestimates the ‘true’ amount of investment activity undertaken (Eisner, 1989). Suppose, in the attempt to better explain productivity growth, investment expenditures were redefined more inclusively, to include expenditures on investment services and human capital.11 Recorded ‘investment’ would then increase substantially. Recorded ‘saving’ would increase by an identical amount, without any volitional decision by savers. Saving is identical to investment, however investment is defined. Suppose that the price of investment goods were to fall relative to consumption goods. Real investment would increase. Real saving would increase by the same amount, in the complete absence of any volitional behavior by ‘savers’12. Finally, suppose saving were defined as what it is, net wealth accumulation, rather than what it is not, income not consumed. If not spent on consumption goods, income must necessarily either be spent on, or held in the form of, nonconsumption goods and assets. When individuals ‘save’, their net ownership increases. Providing all asset prices remain constant, saving may be defined as the change in an economic unit’s net worth. If asset prices change, wealth owners will receive capital gains and losses, which must be included in income if saving is defined as net wealth accumulation. When saving is also defined as the change in net worth, it may immediately be seen to be the accounting record of investment. From the National Balance Sheet, the total wealth in an economy consists of total financial and tangible assets. Financial assets are IOU’s, the accounting record of claims of creditor units against debtor units. Under double-entry bookkeeping, for every financial asset

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outstanding there must be an identical financial liability. Apart from differences in valuation, for the economy as a whole total financial assets excluding equities equal total financial liabilities, and so cancel out.13 The accounting identity holds for first differences as well as for totals. The fact that saving is the accounting record of investment is now immediately obvious. Net financial assets, and the net change in financial assets, sum to zero. The change in tangible assets is the definition of net investment. The change in net worth is the definition of net saving. Saving then changes with changes in investment, and with how investment is defined. Since saving is the accounting record of investment, total saving of an economy is equal to total net investment, and so does not reflect the sum of the volitional behavior of savers.14

14.3

Widening the Model

Saving is the accounting record of investment. But if total measured saving were identical to total measured investment, this simple accounting identity could not have remained unrecognized in the profession for half a century. Economists are after all not so obtuse. There are a number of reasons for the present state of affairs. One reason why saving and investment have not been recognized as a simple accounting identity is the fact that, when the government sector and the rest-of-theworld sector are added to the model, the National Income Accounts have conventionally been incorrectly extended. Current and capital transactions in the government sector, and domestic and national transactions in imports, have not been consistently distinguished. Due to sloppy accounting procedures, in multisector models the identity between saving and investment does not appear to hold. Total, private, public, and foreign saving are conventionally presented in all textbooks as follows: C+I+G+X≡Y≡C+S+T+M From which one of the following is obtained: I+G+X≡S+T+M (I – S) + (G – T) + (X – M) ≡ 0 (S – I) ≡ (G – T) + (X – M)

(14.4)

where G = Government spending, T = Government tax receipts, X = Exports, and M = Imports. In multi-sector models from equation (14.4) saving and private investment thus appear to differ by the government deficit or surplus (G – T) and the current account deficit or surplus (X – M). Only when the government runs a balanced

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budget (G = T), and the current account is also balanced (M = X), is private saving equal to private investment. Since governments never exactly balance their budgets, and countries never exactly balance their current accounts, private saving is never identical with private investment in the conventional accounts. When the government runs a budget deficit, and the economy concurrently has a deficit on current account (the ‘twin deficit’ problem as it was recently termed in the US), the inequality between the two may be quite substantial. It is then easy to claim that government deficits ‘crowd out’ private saving. But capital budgeting must be applied consistently to the government sector, as the U.N. has long recommended, and also to the foreign sector, which appears to have been overlooked. Current and capital components of income, consumption, investment, saving, government expenditures, and imports must be consistently defined. In addition GNP must be replaced by GDP in the ROW accounts. Once these changes have been made, saving becomes the accounting record of investment in all multi-sector models, no matter how many sectors are included in their construction. Consider now the government sector in isolation. Under the conventional accounts saving appears to be different from investment by the size of the government’s deficit or surplus: I ≡ S + (T – G)

(14.5)

For proper capital budgeting, government and private consumption, saving and investment must all be carefully distinguished: 15 (I ≡ Ip + Ig), (S ≡ Sp + Sg), (C ≡ Cp + Cg), (G ≡ Ig + Cg) So long as capital budgeting is done properly, government saving (T – Cg) is seen to be the accounting record of government investment, irrespective of the size of the budget deficit, or how government investment is financed. Substituting and rewriting (14.5): Sp + Sg ≡ Sp + (T– Cg) ≡ S ≡ Ip + Ig ≡ I Suppose government tax receipts equal government consumption spending [(T – Cg) = 0], so the government budget is balanced on current account. All government investment is then financed externally by borrowing, government saving is zero, and all saving is undertaken by the private sector. Total saving is the accounting record of total investment: S ≡ Sp ≡ Ip + Ig ≡ I Suppose government tax receipts are equal to total government spending (T = Cg + Ig). The government’s budget is then balanced on capital account. All government investment is then financed internally by government saving.

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Government borrowing is zero, and private saving finances private investment. Total saving is again the accounting record of total investment. S ≡ S p + Sg ≡ Ip + Ig ≡ I 14.4

Words and Terms

There is another more insidious reason why the profession has failed to recognize that ‘saving’ is simply the accounting record of investment. This stems from the unfortunate choice of the common verb ‘to save’, with its robust colloquial transitive meanings, to designate what in economics is a simple accounting identity. The result may be the most damaging fallacy of composition ever to have occured in economics. Keynes was largely responsible for defining saving as ‘income not consumed’. But his definition was not unanimously accepted. Although now largely unread, a large economic literature of the 1930’s exists on the puzzling identity between saving and investment. This literature for the most part accepted the linguistic presumption that saving and investment are separate behavioral and volitional relationships. It was primarily concerned to establish how they were brought into equality (see e.g. Lerner, 1939). Economists have tended more or less unquestioningly to construe saving and investment in the colloquial sense, as independent ex ante behavioral relationships undertaken by different individual units. The colloquial meaning of the verb ‘to save’ denotes a host of meanings, all except one pertaining to transitive volitional individual behavior. The confusion has been caused by the use of the verb ‘to save’, with its strong transitive, volitional and behavioral overtones, for a quite different economic term which denotes an accounting identity. Webster’s Collegiate Dictionary lists 4 different broad meanings of the verb ‘to save’, and 12 distinct sub-connotations: 1.

TO SAVE: (a) to deliver from sin; (b) to rescue or deliver from danger or harm; (c) to preserve or guard from injury.

2.

TO AVOID: (a) to make unnecessary; b) to keep from being lost to an opponent; (c) to prevent an opponent from scoring or winning.

3.

TO ACCUMULATE: (a) to put aside a store or reserve; (b) to spend less by ~.

4.

TO PRESERVE: (a) to rescue or deliver someone; (b) to put aside money; (c) to avoid unnecessary waste or expense; (d) to spend less money.

All the above meanings refer to individual volitional actions. Each, with the sole exception of 3b), to spend less or economize, is deeply transitive. One saves, avoids, preserves, or accumulates, ‘something’. Used in its colloquial sense it appears absolutely self-evident that saving ‘governs’ investment. If investment demand is to be effective it must somehow be financed. In order to finance investment expenditure, economic units must first abstain from consumption. But

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since the term ‘save’ is used with two distinct meanings, the problem is falsely posed. The difficulty lies in the misleading and confusing attribution of the economic term ‘to save’, which in economics denotes an entirely non-volitional accounting relation, with the common verb ‘to save’, with the identical appellation, but a host of extremely strong volitional and colloquial associations. ‘Saving’ defined as ‘income not consumed’ appears to be loosely equivalent to the last two colloquial meanings of the verb ‘to save’: ‘to preserve’ and ‘to accumulate’.16 For individuals, these are both volitional and transitive actions. Superficially they appear synonymous. Both refer to either individual or to collective action. But on considered reflection, there is one subtle difference: ‘To accumulate’ and ‘To preserve’ is transitive. But ‘To spend less’ is intransitive. Saving is often regarded as ‘abstention from consumption’. The dictionary defines ‘to abstain’ as ‘to refrain deliberately with an effort of self-denial from an action or practice.’ Economists have unfortunately implicitly retained this deliberative meaning when thinking about saving. The colloquial use of the word ‘save’ implies volitional action. It is a very short logical step to associate the volitional meaning of ‘saving’, ‘to accumulate’, with the non-volitional accounting identity meaning of the saving identity, ‘to spend less than total income on consumption’. But it is a serious error in logic, and has very serious consequences. The common sense conclusion, that since individuals volitionally decide on the amount they wish to save, aggregate saving may be regarded as the sum of these independent individual volitional behavioral functions, represents a serious fallacy of composition. What is true for an individual is not necessarily true for the group17. ‘Saving’ as defined in macroeconomics is an accounting relationship, which need not represent volitional behavior. Since ‘saving’ is defined as the accounting record of investment, it cannot also be the ‘cause’ of investment.18 There is one very important exception to the above statement, which serves to further add to the confusion. Changes in household saving, when directed to the accumulation of previously-produced and non-producible financial or tangible assets, result in inverse changes in AD. Whenever such changes in AD are unanticipated by firms, which in a complex world is generally the case, they will ‘cause’ (be responsible for) unintended changes in inventory accumulation and decumulation. The latter are recorded as changes in net investment and saving in the National Accounts. As a result unanticipated changes in business inventories (investment) can legitimately be viewed as ‘caused’ by unanticipated changes in saving. In overdraft systems, most unintended increases in business inventories are automatically financed by additional bank credit. They are also offset by firms as soon as they are perceived, by volitional reductions in output. Only business volitional saving that represents planned internal finance is the accounting record of permanent volitional increases in capital formation.19 So long as investment and saving are viewed by economists as independent volitional behavioral relationships, this presents an insuperable difficulty for students and scholars alike to comprehend how and why saving is always identical

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to investment. In modern economies, ‘saving’ and ‘investment’ are highly specialized, and largely performed by different groups. Unless planned saving and planned investment somehow were exchanged as a market transaction, and prices and/or incomes changed instantaneously, how could such an equality be continuously maintained? The answer is, if saving and investment were indeed independent behavioral relationships, such an equality could not occur, with one important exception: when the planned saving and investment undertaken by each individual unit is identical. This condition is precisely satisfied when all investment is internally financed. In economies without financial assets, all economic units must run a balanced budget, and all investment expenditure must be internally financed. Only in this case are all the saving and investment undertaken by individual units, and the aggregate saving and investment in the economy, volitional and identical.20 14.5

Volitional and Nonvolitional Saving21

Economists have equated the colloquial meaning of saving, the volitional accumulation of wealth, with the economic definition of saving, not to consume all one’s income. On the surface, they appear to be much the same thing. But closer examination reveals critical behavioral differences. Investment designates an increase in the quantity of capital in an economy. Saving is the accounting record of such investment, so all increases in investment result in identical increases in saving. But the saving that is undertaken may be either volitional or non-volitional. In monetary economies, all investment spending must be financed with money balances. Money balances can be accumulated in two ways 1) internal finance (Type A, volitional saving) and 2) external finance (Type B, non-volitional saving). Whenever investment is internally financed (Type A, volitional saving), the money to finance the investment must somehow first be saved before any investment goods can be purchased.22 Changes in volitional saving to finance real investment are offset by opposite equal changes in consumption or investment spending. As a result changes in Type A saving leave the level of AD unaffected. A change in Type A saving to accumulate previously-produced and nonreproducible assets automatically results in an inverse change in AD.23 Non-volitional Type B saving occurs whenever investment expenditures are externally financed by bank credit. Type B saving is non-volitional, need not be consciously regarded as saving, and need not involve a decision to abstain from consumption.24 When investment expenditure is financed by bank credit, the newly-created deposits are willingly accepted in exchange. The money supply and the level of AD increase. Deficit finance and Type B saving do not occur in non-monetary economies. In such economies all saving is volitional and transitive (Type A), and all investment

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is internally financed. In this case it may be concluded that saving ‘causes’ investment. The classical mainstream view is correct. But only ‘Crusoe’ barter economies fit the mainstream paradigm. Mainstream economists tend to accept the classical dichotomy. They are predisposed to believe that economic analysis can ‘pierce the veil of money’ and focus on the underlying ‘real’ phenomena. As one consequence, mainstream economists have failed to recognize the radical consequences of evolutionary changes in financial institutions and practices for how money is supplied, and for the causal relation between real variables.25 In monetary economies saving includes the nonvolitional acquisition of money balances. In such economies all investment is no longer internally financed, and all saving is no longer volitional. Since saving is the accounting record of investment, saving can never be ‘in excess’ of investment. Investment can never be constrained by ‘too little’ saving. Investment can only be constrained by ‘too high’ an interest cost of borrowing, and by the inability to find finance for the amount of credit demanded.

14.6

Volitional Saving

We are taught that saving is a supreme virtue, the sole path to increased wealth and greater economic security. It is true that in order to accumulate wealth, economic units must refrain from consuming all their income. But in modern economies only about half of total saving is volitional, corresponding to the internal finance of investment spending, Even though such investment and saving is the result of deliberative volitional decisions it is not undertaken by shareholders, the ultimate owners of the economy’s capital stock. It is directly undertaken by business managers, the administrators of the economy’s total stock of wealth. The purchase of previously-existing financial assets by economic units, although it constitutes saving for individual economic units, is a portfolio allocation and not an income allocation decision from the point of view of the economy. Saving decisions determine the ownership of net worth among individual economic units. Ceteris paribus, the volitional decision to increase saving by surplus-spending units denotes a volitional decision to reduce spending on consumption. The attempt by surplus units to save an amount in excess of planned volitional deficit spending by deficit units leads to a net demand for previously-existing assets. When surplus-units acquire existing assets in excess of newly-issued assets by deficit-spending units, this is reflected in a reduction in expenditure on current output, AD, income and saving. This is Keynes’ wellknown ‘paradox of thrift’. Such expectations tend to be self-fulfilling. Since the future is unknowable, expectations are frequently formed adaptively. A fall in current AD generates negative expectations about future AD, profits, and output, which impact negatively on current AD. Conversely decisions to deficit-spend ceteris paribus raise the growth of AD, expectations of future AD, and the income, wealth and

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investment spending of other units. A rise in current AD by changing expectations of future AD results in unintended increases in income, saving and wealth accumulation. Classical economists believed that an increase in saving increases the supply of ‘loanable funds’, and so reduces the level of interest rates. The lowered cost of capital purportedly induces businesses to increase investment spending. Keynes was at pains to demonstrate why this Classical argument was incorrect, since the level of AD and income do not remain constant in the face of increases in planed saving, but fall pari passu. In the General Theory Keynes (1936, Ch. 13–18) maintained that the level of interest rates was determined by the supply and demand for liquidity, and not the supply and demand for loanable funds. For simplification he assumed that the money supply was determined by the monetary authorities (Moore, 1988, Ch. 8). Once it is recognized that the monetary authorities exogenously set the short-term rate of interest, rather than the money supply, as their chief policy instrument, this opens the door to how changes in saving behavior may indirectly affect the level of investment.26

14.7

Conclusions

Investment is the terrain, and saving is the accounting measure of this terrain. Saving is the accounting record of investment. The decision how much to invest is volitional. But the decision on how much to save may be volitional or nonvolitional. Investment spending depends on firms’ expectations of future quasirents and profits, and on their expectations of the present and future cost of finance and of its availability. Aggregate saving is the accounting record of investment spending, so that its quantity depends on how investment is defined. Since saving is the accounting record of investment spending, investment is never limited by an ‘insufficiency’ of saving. Investment is limited by an ‘excess’ of volitional saving, which depresses AD. The volitional decision to increase ‘saving’ is recorded in the market for current output as a reduction in consumption spending. An increase in volitional saving does not reduce the cost, and/or increase the supply of loanable funds. It reduces the level of consumption spending, current AD, expected future AD, and so current investment spending. Total saving is the sum of volitional (Type A) saving plus non-volitional (Type B) saving. Type A saving comprises the internal finance of investment spending by households, business units, and governments. For households an increase in Type A saving implies an equal reduction in consumption expenditures, so AD remains constant. Type B saving by households, businesses, and governments takes the form of the net accumulation of deposit balances (‘convenience lending’ of fiat money to the banking system). It occurs whenever spending is deficit-financed by borrowing money from banks, and provokes a process of portfolio adjustment into longer-term financial and non-financial assets.

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Mainstream macroeconomics has regarded saving and investment as if they were separate behavioral relationships, undertaken by different groups. The question becomes, ‘what is the mechanism by which saving and investment are equilibrated?’ The classical view was that the level of interest rates would adjust to some new ‘equilibrium’ level, at which planned saving was again equal to planned investment. The Keynesian view was that the level of income would adjust to some new ‘equilibrium’ level, where planed saving is equal to planned investment. The neoclassical synthesis concluded that both interest rates and income would continue to adjust, until all variables reached some new general equilibrium level. The recognition that saving is the accounting record of investment has critical consequences for mainstream macroeconomic modeling. There is no independent behavioral saving function, and so no tendency for income to approach any future ‘equilibrium’ level, where the amount saving units plan to save is equal to the amount investing units plan to invest. Changes in income are governed by changes in AD. There is no ‘equilibrium’ level of income. Income changes continuously, has a unit root, and broadly approximates a random walk over time. Volitional increases in saving do not provide additional resources to finance investment spending. Increased abstention from consumption out of income instead reduces the level of AD. If the reduction in AD leads to expectations of lower future AD growth, it is likely to result in lower current investment spending, and so lower current AD. In this case an increase in planned saving results in a fall in the actual amount of income saved, Keynes’ famous ‘Paradox of Thrift’. An increase in planned saving, providing it sufficiently lowers AD and the level of income, results in a reduction in actual saving. Keynes’ conclusion, that income tends to an ‘equilibrium’ level where planned saving is equal to planned investment, is fundamentally in error. Saving is identically equal to investment, at every level of income, over every period of time. There is no tendency for economies to approach any ‘equilibrium’ level, where income is in a position of ‘balance’, with no further tendency to change. Planned saving by households is in fact never identical to planned investment by firms. But income does not change to eliminate differences between planned saving and planned investment. Income responds to all changes in AD, and changes continuously over time. Deficit spending on consumption goods has a similar initial effect on AD as deficit spending on capital goods. One year after the General Theory was written, Keynes wrote: The banks hold the key position in the transition from a lower to a higher scale of activity. … The investment market can become congested through a shortage of cash. It can never become congested through a shortage of saving. This is the most fundamental of my conclusions within this field (Keynes, CW XIV, 222).

Keynes was correct in the ‘destination’ of his vision. But he was mistaken in his explication of how it came about.

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Notes 1

2

3

4 5 6

7

8 9 10 11 12 13

In a subsequent study Feldstein and Bacchetta (1991) concluded that more recent data supported their earlier conclusions that domestic investment responds to changes in domestic saving. They concluded that government budget deficits therefore ‘crowd out’ private investment.. Equilibrium analysis cannot be reconciled with causality. Mathematical theorists argue that, to the extent everything is related to everything else, the concept of causality is otiose. Such a position is unenlightening for understanding economic activity, and unhelpful for policy analysis. See e.g. Solow (1956). To the extent mainstream economists teach and embrace the Keynesian multiplier process, where AD drives income and saving in the short run, they exhibit in Solow’s terms, ‘the lack of real coupling between the short run picture and the long run picture’ (Solow, 1997, p. 232). As Abba Lerner (1957) frequently proclaimed, ‘In the long run we are always in the short run.’ The World Bank research project has identified eight factors that purportedly drive saving: income, growth, fiscal policy, pension reform, financial liberalization, external borrowing and foreign aid, demographics, and uncertainty. Consider the ‘hat check’ theory of money. Suppose tokens given out in the hat check room of a leading opera house came to circulate as the money supply. Individuals would then demand to hold money tokens as a function of their income, wealth, and relative interest rates. But the total quantity of tokens in existence in the economy is determined by the number of hats checked, not by the transactions demand for tokens. In the case of credit or bank money, bank loans correspond to hats. ‘Loans make deposits’ (see Moore, 1988). Since the savings-income ratio is the inverse of the consumption-income ratio, if there is a stable behavioral relationship between consumption and income, there must also be a stable behavioral relationship between saving and income, the ‘savings function’ (Keynes, 1936, Ch. 8–10). Even though the relation is frequently expressed as actual saving equals actual investment. This logically also implies there is no stable behavioral ‘consumption function’ for the economy. This alone is conclusive logical proof that ‘saving’ is not a volitional relationship. Such a partial revision was recently undertaken in the US. This similarly offers conclusive proof that saving is simply an accounting identity. Equities represent a serious complication to the above. Equities constitute ownership claims to business net worth. Their book value is equal to the accounting value of business net worth, total assets minus total liabilities. Standard accounting principles measure business tangible assets at historical cost minus estimated depreciation. This constitutes the book value of equities. But the market value of equities determined on stock exchanges represents the market’s weighted consensus of the discounted present value of expected future dividends and capital gains by all participants. The ratio of the market value of equities to their replacement value is what Kaldor termed the valuation ratio, and Tobin termed Q. When firms retain earnings rather than distributing them as dividends, and when wealth-holders expect the future growth of corporate earnings to increase, stock prices rise concurrently. Shareholders then receive income in the form of capital gains. But capital gain income is not included in the NIPA measure of income, which includes only income derived from current output. Measured consumption and saving ‘ratios’ are extremely sensitive to how income and saving are defined, in particular whether capital gains on existing assets are excluded or

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14

15

16

17

18

Money Credit and the Role of the State included in the definition of income. If capital gains are excluded, total saving is simply the accounting measure of total investment spending, measured at historical cost. But the book value of business capital provides a very distorted measure of the state of household finances, and the role of wealth in consumption and investment behavior. Due to their high marketability, equities are valued by their owners at their current market values. This is particularly relevant for the US at present (2000), when priceearning ratios and accompanying capital gains have risen to historically unprecedented levels. The market value of equities in the US is now about 200 percent of GDP. NIPA income data thus very substantially understate the flow of resources to the household sector, which has sustained the rapid growth of consumption expenditures and provided the foundation for the general prosperity of the 90’s. There is widespread concern about the rise in household debt and the fall in the personal saving rate. But in fact household debt has fallen as a ratio of household assets. When realized capital gains are included in income, the US personal saving rate, rather than falling below zero has remained constant at 10 percent. When unrealized capital gains are included, the personal saving rate has risen to above 40 percent. To adequately explain recent consumption behavior, income must be redefined along Hicksian lines, to include capital gains and losses. NIPA conventions must be fundamentally revised (see Peach and Steindal, 2000). Changes in asset prices result in capital gains and losses to asset-owners. If saving is defined as net wealth accumulation, as well as income not consumed, for consistency income must then be redefined to include holding gains and losses. The following chapter will argue the case for a Hicksian definition of income. As argued in Chapter 8, consumption goods, investment goods, and intermediate goods and services must at the limit be arbitrarily distinguished. If it were recognized that some public goods were intermediate e.g. police services, national defense, etc., measured GDP would fall (see Eisner, 1989). The required changes in the ROW accounts will be considered in Part V, Open Economy Considerations. It will be shown that under rudimentary financial conditions – a barter economy where all investment is internally financed – the two meanings are in fact identical. But in modern financial environments, where more than half of total investment spending is on average deficit-financed, the two concepts differ quite substantially. Consider the supply of credit money. Economic units demand to hold deposits as a function of their income, wealth, and relative interest rates. Each individual unit decides on the amount of deposits it wishes to hold. Since a deposit cannot exist without an owner, the total quantity of deposits outstanding is also identical to the sum of deposits held by all depositors. But the money supply is not determined by the total quantity of deposits demanded by individual economic units. The mainstream holds that 17total deposits are exogenously determined by the CB by controlling the high-powered base. Post Keynesians believe deposits are endogenously created by the act of bank lending, and in overdraft systems are determined by the demand for credit by bank borrowers. Total deposits outstanding represent the accounting record of bank loans and securities. Individuals decide on the amount of deposits they wish to hold. But the total amount of deposits outstanding is determined by the total amount of deposits created, and so the amount of loans granted and securities purchased. Total liabilities in bank balance sheets are the accounting record of the total volume of loans and securities in bank asset portfolios (see Moore, 1988, 2000). The analysis of investment behavior in world where financial assets are absent is quite illuminating. National Income Accounting, with the exception of rent on owneroccupied housing, makes no attempt to impute the value of the consumption or production services-in-kind received on durable assets. But the non-pecuniary services from many tangible assets can be ‘saved’ in the colloquial sense by volitional

Saving and Investment: Keynes Revisited

19 20

21 22 23

24

25 26

253

abstention. Such ‘saving’ results in an equal increase in internally-financed net investment, defined as the net accumulation of tangible assets. For wealth owners, the decision to ‘save’ (in the sense of ‘conserve’ rather than to consume) is entirely volitional. All such saving ‘causes’ investment. This serves powerfully to reinforce the robust colloquial volitional meaning of ‘saving’. The extent that corporate decisions to finance investment spending by retain earnings induce household decisions to abstain from consumption of wealth will not be addressed. Neither is totally volitional. Economies where financial assets do not exist, and borrowing and lending cannot occur, correspond to the case of services-in-kind on tangible assets in modern economies. Under such circumstances the colloquial and accounting meanings of ‘saving’ then coincide. ‘To accumulate’ denotes ‘to spend less’. All decisions to spend on investment goods are volitional, and are accompanied by identical volitional decisions to save. The pedagogical suggestion to distinguish type A and type B saving is due to Paul Davidson. Note that much Type A saving and investment goes unrecorded. All saving and investment which involves the conserving of the services-in-kind on tangible assets does not involve a market transaction, and is excluded from the National Income Accounts. Classical economists clearly recognized the antisocial consequences of saving to accumulate money balances. They denoted the accumulation of money balances as ‘hoarding’, and regarded the supply of the money commodity as exogenous (Moore, 1988). As Keynes emphasized saving directed to the accumulation of land has the same effect. Depending on their liquidity, all non-reproducible or previously-produced assets may be used as temporary stores of purchasing power. Their accumulation reduces AD for current output. When investment is deficit-financed by bank credit, it is technically correct to state that ‘investment creates the saving necessary to finance itself’. But since saving is the accounting record of investment, the statement is misleading to the extent it implies that saving is something that can be independently ‘created’. If consumption is financed by bank credit, this implies a simultaneous increase in Type B dissaving. Economic recessions are associated with sharp falls in AD. These may be viewed as a sudden increase in volitional saving. The ensuing reduction in AD results in a fall in output, reduction in capacity utilization, and increase in unemployment rates. (Keynes’ paradox of thrift was a description of the process when a rise in planned saving rates results in a sufficiently large reduction in income and output that the total quantity saved decreases.) Assuming that the CB actively attempts to reach its stabilization objectives, it will respond by lowering the level of short term interest rates, in an attempt to restore AD and income towards the economy’s full employment output capacity. If households and firms persistently maintained higher volitional saving rates, the CB would be forced permanently to maintain lower levels of interest rates to achieve its stabilization goals. Depending on the CB’s reaction function, a change in volitional saving may be seen to indirectly affect the volume of investment, by altering the rate of interest established by the CB.

References Baker, D. (1997), ‘Conceptual Accounting issues in the analysis of saving, investment and macroeconomic activity’, in R. Pollin, The Macroeconomics of Saving, Finance and Investment, Ann Arbor, Michigan: University of Michigan Press

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Davidson, P. (1990), Money and Employment: the Collected Writings of Paul Davidson 1, London: Macmillan. Davidson, P. (1994), Post Keynesian Macroeconomic Theory: A Foundation for Successful Economic Policies in the Twenty-First Century, Aldershot: Edward Elgar. Eisner, R. (1989), The Total Incomes System of Accounts, Chicago: University of Chicago Press. Feldstein, M. and P. Bacchetta (1991), ‘National Saving and International Investment", in B.D. Bernheim and J.B. Shoven (eds), National Saving and Economic Performance, Chicago: University of Chicago Press. Feldstein, M. and C. Horioka (1980), ‘Domestic saving and international capital flows", Economic Journal, 90, pp. 314–29. Keynes, J.M. (1973 ssq.), The Collected Writings of John Maynard Keynes, 32 vols, managing eds A. Robinson and D. Moggridge, London: Macmillan. In the text referred to as CW, volume number and page number. Keynes, J.M. (1936), The General Theory of Employment, Interest and Money, London: Macmillan. Lerner, A. (1939), ‘Saving and investment: definitions, assumptions and objectives’, Quarterly Journal of Economics, 52(4), pp. 611–19. Lerner, A. (1957), Class Notes, The John Hopkins University. Moggridge, D. (1992), Maynard Keynes, An Economist’s Biography, London: Routledge (Letter to O.T. Falk, 19 February, 1936). Moore, B.J. (1988), Horizontalists and Verticalists: The Macroeconomics of Credit Money, London: Cambridge University Press. Peach, R. and C. Steindel (2000), ‘A nation of spendthrifts? an analysis of trends in personal and gross saving’, Curent Issues in Economics and Finance, 6; 10, Federal Reserve Bank of New York. Polin, R. (1997) The Macroeconomics of Saving, Finance and Investment, Ann Arbor, Michigan: University of Michigan Press Sawyer, M. (1996) ‘Money, finance and interest rates: some post Keynesian reflections”, in P. Arestis (ed.), Keynes, Money and the Open Economy: Essays in Honour of Paul Davidson, Vol. 1, Cheltenham, UK: Edward Elgar. Solow, R. (1956), ‘A contribution to the theory of economic growth’, Quarterly Journal of Economics, 70, February, pp. 65–94. Solow, R. (1997), ‘Is there a core of usable macroeconomics we should all believe in?’ American Economic Review, 87(2), pp. 230–32. Tobin, J. (1997), ‘Comment’, in B.D. Bernheim and J.B. Shoven (eds), National Saving and Economic Performance, Chicago: University of Chicago Press.

Chapter 15

The Solution of the Paradox of Profits *

Alain Parguez

15.1

The Paradox of Profits

Money exists because it is the existence condition of production. Herein is the core axiom of the objective theory of money (the Essentiality axiom). This axiom explains why capitalism is the pure monetary economy relative to pure nonmonetary economies like the pure command and/or collectivist economies. From this axiom stems the first characteristic of the monetary circuit: Firms as industrial capitalists need and get money to exact their targeted accumulation of net wealth or capital out of the production process. Money is therefore created by banks loans generating firms required expenditures relative to their accumulation target. Money cannot have some intrinsic value; its value is only an extrinsic one since its source of value or purchasing power is the output generated by expenditures reflecting the creation of money. From the monetary law of value stems the second characteristic of the monetary circuit: Money must be destroyed as soon as firms as a whole get their effective increase in net wealth or capital out of the realized value of output which is generated by the sale of output to its final normal users for consumption or accumulation. The law of value is met by the counterpart of money in banks balance sheet which is debts that are payable when firms recoup money by their receipts from the sale of output. As soon as firms get their receipts or proceeds, their debts to banks are extinguished, which leads to an equivalent destruction of money. A logical corollary of the monetary theory of value is that money cannot be accumulated over time; it is bereft of any wealth-holding function. As it has been shown, hoarded or accumulated deposits are not money but liquid saving which is deprived of any positive value, having no more anchor into output (Parguez, 2002). For a long time there has been a debate over the nature of firms outlays which require a creation of money. According to a widespread postulate, firms or capitalists as a whole only need money to hire labor by paying the wage bill. Assuming a ‘pure capitalist theory’ bereft of State, foreign sector and banks loans to workers, an assumption very often made by those who rely on the postulate, money creation is identical to the wage bill. Assuming also a zero workers saving rate firms can only recoup the wage bill by the sale of their output. The wage

256

Money Credit and the Role of the State

postulate is tantamount to the proposition that sales and therefore the realized value of output are identical to workers consumption. Herein lies the paradox! What determines output is firms desire for a net increase in their wealth. It is reflected by the targeted excess of the realized value of output over the net cost of output for firms as a whole. What is this desired difference but the amount of profits firms as capitalists want to exact out of the production process. Since realized value is identical to receipts from sales, the existence condition of profits is that firms as a whole recoup more money than they had to spend as costs to carry on their production profit-motivated plans. From the essentiality axiom stem the three fundamental characteristics of profits: I II III

Profits must exist for firms as a whole and they must be accounted at the macro-economic level; Profits are generated in their money form as a share of receipts in money; In the pure capitalist money profits are instantaneously transformed into real wealth as firms in their role of capitalists spend that share of receipts to acquire in full property a share of the available output.

There is therefore not the least contradiction between the necessary existence of profits and the full destruction of money in the reflux stage of the monetary circuit as long as profits can be exacted in their money form. As soon as the labor postulate holds, characteristic II is violated since firms cannot catch receipts greater than their wage bill. Characteristic III is violated because there are no monetary profits to be transformed into capital, which means that the realized value of output is just equal to workers consumption. Characteristic I is ultimately violated. Since firms cannot accumulate capital, the existence condition of the capitalist mode of production is denied. There are two ways of getting rid of the paradox, either the labor postulate is denied, or there is some possibility of reconciling the postulate with the existence of profits. Let us assume for a while that the postulate must hold whatsoever the explanation. There could be only three solutions of the paradox.

15.2

The Classical-Marxian Solution: Profits Only Appear in Real Terms

This solution relies on the proposition that profits are not to be realized in money before being transformed into capital. Since they account for the increase in wealth generated by the production process for firms as a whole (Characteristic I), their amount is independent on their distribution between individual firms. As long as we want to explain profits, firms must therefore be dealt with as if they were a single or collective entity (class) using labor to extract wealth. As soon as wages are paid firms acting together determine both aggregate employment and its distribution between consumption goods and equipment goods.

The Solution of the Paradox of Profits

257

Firms desired accumulation in real terms or labor units is just the excess of aggregate output over the sole share of output on which workers have rights of acquisition, available consumption goods. It is tantamount to the well-known proposition that firms together impose both aggregate output and real wages or workers maximum consumption. The remaining share of output is therefore instantaneously transformed into capital without any monetary intermediate−it is both profits and desired accumulation. There would be therefore no paradox in the wage postulate. It should be true that firms only need true money (generated through banks credit) to pay the required amount of labor. What is deemed ‘investment expenditures’ by Post-Keynesians and NeoKaleckians alike should be nothing but pure intra-firms transactions distributing among individual firms the available new capital. They reflect the allocation amid them of the already determined total amount of profits. Being therefore perfectly neutral relative to the generation of value they cannot involve the creation of money proper or true money. They are mere accounting or book-keeping transactions which automatically cancel each other in an instantaneous way. The proof seems final. It explains why from the Classical-Marxian approach stems the proposition that: Investment defined as the acquisition by individual firms of new capital goods does not require a specific or supplementary creation of money. Ultimately it relies on a shrewd attempt by the Italian Circuit School (Graziani, 1994; Graziani, 1998; Bellofiore and Realfonzo, 1997) to integrate the Marxian theory of labor value into the theory of the monetary circuit by replacing the traditional Marxian value cycle I. M being the value in its form of capital, L in its labor form, Q in its commodities form, k the increase in value M t → Lt → Qt → M t′ → kt → M t +1 with

M − M ′ = k , M t +1 = M t + k by the Paradox-free value cycle M t → Lt → M t → k k ≡ Qt − Q2 ≡ a ( Lt − L2t )

Qt , Q2 , a, Lt , L2t being respectively aggregate output, output for workers, labor productivity, aggregate labor and labor invested into output for workers. In I real profit (the so-called surplus value) automatically generates an equal increase in the fund of money capital (profits in their money form) which is transformed into more labor in the next production process. Firms need new credit to hire more labor than the amount allowed by the capital fund. In II there is no capital fund because profits are never materialized in their money form. Firms

258

Money Credit and the Role of the State

need banks money to pay their whole wage bill even when employment is constant. Profits are generated in real terms as the share of output on which workers are bereft of acquisition rights by the very will of firms or capitalists. II is not truly paradox-free! According to the core axiom of the theory of the monetary circuit, an economy is a genuine monetary one if and only if value is always generated by an expenditure of money and therefore is always materialized in a money form. Value cycle II contradicts the axiom because output as a whole is endowed with a perfectly determined value−albeit only a share of it is realized or backed by expenditures. The economy is divided in two realms: one is a monetary economy, the productive sphere; the other, the accumulation sphere, which functions as a non-monetary, some pseudo-command economy where money plays no part at all as if were perfectly neutral. It is true that capital is expressed in monetary units but they passively reflect the real values in labor units. Acting together as they must since intra-firms transactions cannot generate wealth firms create by a mere act of will the wealth they want expressed in labor units. /HW /DQGZEHWKHVKDUHRIRXWSXWLQODERUXQLWVUHVHUYHGIRUDFFXPXODWLRQ the unit price of output available for workers consumption and the wage rate in monetary units  a L = k

(15.1)

w L = p* (1 – a L

(15.2)

p* =

w 1 a 1− γ *

(15.3)

where (15.1) explains total employment as fully determined by the desired real DFFXPXODWLRQ   DQG D GHSHQGLQJ LWVHOI RQ SDVW DFFXPXODWLRQ  SURYHVWKDW the price level is fully determined in the production sphere, its sole role is to adjust the purchasing power of wage bill to the given output of consumption goods while according to (15.3) p is also adjusting for any wage rate, the real wage to its predetermined level. To close the system one just needs to assume that firms together want to attain a given rate of their real profits to total employment m*, that can be deemed the desired rate of surplus value (or exploitation). m* =

k L

(15.4)

Here are now two exogenous real parameters under the full control of firms as DFODVV)URP VWHPVWKHUHIRUHWKHSODQQHGDOORFDWLRQRIODERU  γ* = and from (15.1):

m* a

The Solution of the Paradox of Profits

L=

259

1 k m*

7KHJUHDWHULVWKHGHVLUHGUDWHRIVXUSOXVYDOXHWKHJUHDWHULV*, and the lower aggregate employment for the given desired accumulation. The value cycle II describes an economy entirely ruled by real factors m* and k. A rise in the wage rate is merely reflected by the proportional increase in the price of wage goods without any change in total employment, its allocation and the real wage. Herein is the proof that as long as value cycle II holds the wage rate is perfectly neutral relative to the underlying real economy, which is tantamount to the proposition that: As a unit of account money does not matter as though it were the veil of the real forces of capitalism.

15.3

The Transfer Solution: Profits are Included into the Wage Bill

Before being transformed into capital profits must be realized in money as a share of firms aggregate proceeds. By virtues of the postulate proceeds are identical to wage-earners expenditures, assuming as always a zero propensity to save. Profits must therefore reflect the discrepancy between the aggregate wage bill and the share of the wage bill devoted to the production of consumption goods. They are identical to the share of the wage bill allocated to that share of output which is reserved for accumulation. Firms impose on wage earners the price of consumption goods adjusting their desired receipts from their sale to the aggregate wage bill, as in equation (2). Instead of extinguishing their debt to banks, as in value cycle II, they retain the share of their receipts equal to wage paid for accumulation and they spend that amount of money to acquire the remaining share of output. As shown by value cycle III money is not fully destroyed before firms realize their desired accumulation: 0 :Nt :Lt :Nt :Œ≡Œ :k : money creation money destruction ŒDQGŒ EHLQJHIIHFWLYHDQGGHVLUHGSURILWVZLWKŒ   W  wL. This cycle is tantamount to a transfer of income imposed by firms through the price mechanism. Assuming that the sole source and therefore measure of value is labor income, the value of output is identical to the wage bill, which seems a sensible explanation of the postulate. Because of firms power to fix the price, wage earners are obliged to give up their whole income in exchange of just a share of it: the income value of consumption goods. Firms acquire the remaining share and spend it. Investment as an expenditure is therefore substituted for wage-earners real consumption. The rate of exploitation can be defined as the ratio of profits in money terms to the wage bill accounting for the value of total output:

260

Money Credit and the Role of the State

m* =

π * γ * wL = = γ* W wL

It is again a pure exogenous parameter determining the allocation of labor and output. Since it is only defined for firms as a whole or class independently on firms individual plans, the neutrality of intra-firms transactions still holds. Value cycle III supports the well-known ‘Russian Dolls Theorem’ of profits spelled out by the French Dijon School (Rossi, 2002, p. 163): Profits are hidden within the wage bill and both their existence and magnitude depend on the desired rate of exploitation reflected in the transfer price or macro-economic price that must be p* (1 – L = wL or p* = w

1 1− γ *

A rise in the wage rate just raises proportionally the transfer price without any impact on the magnitude of the transfer which, for a given level of employment, only depends on the desired rate of exploitation. The neutrality of the wage rate relative to the value cycle still holds. Neither the rate of exploitation nor as a consequence the transfer price depends on labor productivity. The transfer provides firms with an increase in capital (real profits in labor units) equal to the share of labor allocated to accumulation. Herein lies the major difference between value cycles II and III relative to the magnitude of accumulation: II k = a LG k is not realized by an expenditure

III k  /G k is realized by an expenditure

III relies on a paradox: either labor productivity is irrelevant for capital accumulation, or the share of the available surplus generated by productivity sk  /a – 1) is directly transformed into capital without being realized by an expenditure reflected by a transfer. It should therefore be deprived of value and could not be accounted as capital according to the Russian Dolls Theorem. There is more to doubt value cycle III because what is deemed ‘investment expenditures’ is not a genuine value-generating expenditure. As soon as firms recoup wages, the transfer of value in III is operated and therefore a share of income has been transformed into capital. No second round of expenditure is needed to realize firms accumulation, the so-called ‘investment’ is nothing but a pure book-keeping

The Solution of the Paradox of Profits

261

operation which is perfectly neutral relative to the value cycle. Value cycle III is a generalization of value cycle II which does not truly fit the essentiality axiom

15.4

The Neo-Kaleckian Solution: The Multi-sectors Approach

This solution relies on the artificial division of the macro-economic production structure between two independent entities or ‘sectors’, one producing for consumption (sector 2), the other only producing for accumulation (sector 1). Assuming again no saving out of wages, sector 2 receipts are automatically equal to the wage bill paid by both sectors. Sector 2 raises profits equal to the wage bill paid by sector 1; it spends this profit to realize it desired accumulation or investment, which provides sector 1 with enough money to extinguish its own debt to banks. The circuit is now closed, as shown by the value cycle IV: W1 → L1 Q2 →Œ2 = W1 → k2 → M2 → 0

0 → M2 W2 → L2 money creation

money destruction

Being rooted into Kalecki (1954) it has been explicitly spelled out by the PostKeynesian theory of accumulation (Parguez and Seccareccia, 2002).1 A logical consequence is that sector 1 cannot raise profits in money terms−the whole amount of profits being generated by its wage bill. One has sometimes argued that an escape way lies in the division of 1 into two (or more) secondary sectors but whatever the number of sub-sectors, the sole source of profits remains the transfer imposed on wage earners through the price of consumption goods. As a whole sector 1 gets nothing as profits and therefore cannot benefit from a transfer of value. Herein lies a deep contradiction. Either the value cycle IV describes a genuine monetary economy where the value of output must be realized by an expenditure in money; accumulation is therefore equal to k2 and sector 1 cannot accumulate capital, or it directly raises capital in pure physical terms. In the first case: K1 = 0 , k = k2 Sector 1 does not exist and the division between sectors is irrelevant to explain profits. Value cycle III holds. In the second case value cycle II holds for sector 1 which contradicts the general law of value enshrined into the essentiality axiom. It implies that sector 1 output expressed in labor is split between the two sectors with: k2 = L1 =

W1 w

262

Money Credit and the Role of the State

k1 = Q1 – L1 = L1 (a – 1) Productivity is a source of capital for the sole sector 1 which is free to determine its own wage bill, which only depends on its accumulation target and its desired rate of exploitation: m1* =

k1 W1

Sector 1 controls sector 2 accumulation. There is only one genuine sector, the multi-sector approach is again sheer irrelevance, a dance with logic which proving nothing.

15.5

A General Solution: The Wage Postulate Must Be Rejected Because Profits Require a Specific Creation of Money

It has been proven that the wage postulate cannot hold in a genuine capitalist economy relying on money creation to realize desired accumulation. Money being the existence condition of capital, money creation is not bound by the sole wage bill. Let us still assume no saving out of wages and no interest on banks credit. It would be impossible to explain interest payments were the postulate accepted, at least net interest payment to banks reflecting their own profit. Indeed some early writers in the field of the monetary circuit theory (for instance: Leonard, 1997) bluntly declared that they do no exist at all−banks being some charity institution! According to the nature of the capitalist economy, accumulation of wealth in the form of commodities endowed with a money value as capital is the sole motive of production. Firms are producers because they are capitalists planning the growth of their capital. From their dual nature stems the right explanation of the existence of money: Money is essential because it is created and destroyed to provide firms with the profits they need to fulfill their accumulation plans endorsed by banks. Herein lies the solution of the profits enigma: Money creation must encompass profits-generating expenditures or investment. Let us assume that the outcome of individual capitalist plans is I* accounting for the desired monetary value of the growth of their capital. I* reflects aggregate desired profits for firms as a class. They must provide them with the rate of return r* on their labor-cost so that: r* =

π* I * = w W

Desired profits in money units are identical to planned accumulation by virtue of characteristic III of profits. Relative to the production process, I* and r* are exogenous parameters controlling the ongoing value cycle. Contrary to value

The Solution of the Paradox of Profits

263

cycles I to IV, accumulation plans are expressed in money units instead of pure real or physical units. r* reflects firms as a class ability or power to generate wealth out of hiring labor. Defining r* for firms as a class does not contradict the existence of individual capitalists and does not require any kind of ‘market mechanism’ coordinating plans. It is imposed by the very existence of banks and therefore of money. Banks are private firms targeting the accumulation of wealth in the form of firms liabilities. The money value of their wealth depends on the money value of firms capital, which explains why banks strive to control the validity of firms wagers on the future by imposing a minimum or standard level of r* on all borrowers. For a given amount of I* the higher is the unit price of output and the lower is real accumulation labor units. Assuming some unchanged I* overtime, a rise in p generates a decreasing real accumulation and therefore a fall in what is the ultimate anchor of the value of money in a pure capitalist economy, which is deemed ‘inflation’. Inflation reflects a decreasing efficiency of wagers on the future and leads to a fall in the value of firms capital. Banks are therefore also striving to repel the danger of inflation by forcing firms as producers to maintain a stable price level or at least to control the increase in price. It means that in the genuine monetary economy the unit price of output is exogenous relative to firms as a consequence of banks credit as the source of money. For the sake of simplicity let us assume a constant targeted price p* which is tantamount to the assumption that banks thrive on a constant ratio of I* relative to real accumulation. The ultimate outcome of accumulation plans is spelled out by the three intertwined relationships: W=

1 I* r*

(15.5)

p* Q = p* a L = w L (1 + r*)

(15.6)

p* (1 – a L = w L

(15.7)

Equation (15.5) proves that the wage bill, the effective value of labor, is imposed by firms and banks. Equation (15.6) proves that together they also determine the monetary wage rate, since its level, w=

a p* 1+ r

(15.8)

has to be adjusted to the required value of output. Equations (15.5) and (15.8) explain the level of employment (and therefore of output) while the distribution factor γ * has to meet constraint (15.7) adjusting the wage bill to the money value of output for consumption. It leads to: p* =

w 1 = a 1− γ *

264

Money Credit and the Role of the State

and since (15.6) holds: r* =

γ* 1− γ *

This distribution factor is fully controlled by the required rate of return. Let us assume that to endorse an unchanged level of I* banks impose a higher r* because of more pessimistic vision of the future. It simultaneously shrinks the wage bill and the wage rate but the fall in the wage rate (lower real wage) cannot compensate for the fall in the wage bill because * is raised while employment for accumulation is invariant. Because of this distribution effect, there is a fall in aggregate employment (and output),which compounds the total subordination of labor to accumulation plans. It explains the structure of the monetary circuit which relies on two interdependent value cycles reflecting the two ‘rounds’ of money creation. The first V1 is initiated by the payment of the wage bill; it generates an output in labor units on which workers have only a limited right equal to the predetermined output of consumption goods. Firms recoup the whole wage bill which instantaneously extinguishes their wage debt to banks. C being receipts from workers, V1 is therefore:

money creation

0 → M1 → W → C → M1 → 0 money destruction

No profits are earned in V1 which does not let any wage money to be spent again as in value cycle IV. Its outcome is to let firms as producers with a yet unsold output Q1 deprived of value. Now starts the second round of the monetary circuit as firms in their role of capitalists activate the credit lines they received from banks when they endorsed their plans. There is a creation of money by an amount of I which is spent at once to acquire the available output Q1 which is henceforth transformed into capital. The counterpart of this transformation is an equal destruction of money in banks balance-sheet. Value cycle V2 is therefore: 0 → M2 → I → C′ →Œ→ M1 → k [Q1] money creation money destruction M2 ≡ I* ≡ C′

(15.9)

C′ ≡Œ

(15.10)

k ≡ Q1 Spending M2 for investment capitalists create an equal amount of receipts for themselves as producers (15.9) accounting for their profits (15.10). As soon as

The Solution of the Paradox of Profits

265

they are generated monetary profits are destroyed to extinguish the debt M2 to banks and what remains in firms balance-sheet is their increased capital equal to the money value of Q1. Being henceforth free of the yoke of the wage postulate there is no more any ‘net interest paradox’. Banks accumulate firms liabilities as net wealth because they impose on them a debt which can only be paid by the sale of long-term debt titles. Its source is the rate of interest which is imposed on all firms debt contracts involved in V1 and V2. It reflects banks targeted increase in their wealth which is the existence condition of their loans. Let us assume again an exogenous amount of investment, B being the desired rise in banks net wealth while i* is the rate of interest and R firms interest bill B = i* I* = R ⇔ i =

B I*

Banks use the rate of interest to oblige firms to transfer to them a share of their wealth; it is therefore equal to the ratio of B to investment. Firms net wealth (profits) and the required rate of return are now π = I* – R = I* (1 – i*) r* =

(15.11)

I *(1 − i*) W

Being a compulsory outlay of firms as producers, the interest bill is included into M1. Banks provide firms with an equal amount of money which is instantaneously transformed into net wealth for banks. In value cycle V1 its counterpart is a net debt of firms to banks because firms do not recoup their interest bill in expenditures. To be discharged of their debt they are obliged to issue liabilities by an amount equal to R. Banks acquire them by spending their interest receipts, which leads to an equal destruction of money reflected in banks assets by the transformation of monetary wealth into long-term claims on firms. D being the increase in firms liabilities, value cycle V1 is henceforth: 0 → M1 → W → C → M1 → B R→D with D ≡ R ≡ B. Through the value cycle V2 firms accumulate a gross wealth of I*. Their profit is the excess of I* over liabilities generated to close M1, which proves the validity of their definition in (15.11): π = I* – D = I* – R

(15.12)

266

Money Credit and the Role of the State

This new ultimate outcome of accumulation plans is again spelled out by three intertwined relationships: W =

I *(1 − i*) r*

(15.13)

p* Q = p* a L = w L (1 + b) + r* w L = w L (1 + b + r*)

(15.14)

p* (1 – γ*) a L = w L

(15.15)

Equation (15.13) implies: R i = b = r* W 1− i According to (15.12) while the rate of interest has no impact on investment, it leads to a lower wage bill for a given r*. The new unique level of the wage rate meeting firms and banks accumulation is according to (15.14): w=

a p* 1+ b + r *

where the cost structure factor only depends on r* and i*. A rise in i* raises b and therefore for a given labor productivity leads to a fall in the wage rate. From (15.14) and (15.15) stems the new level of the distribution factor γ* γ* = b+r* 1− γ *

(15.16)

Banks accumulation reinforces the subordination of labor. Whatever the state of their wagers on the future, firms as capitalists are certain to meet banks constraints through adjustments imposed on labor. For instance, a rise in i leads to an automatic fall in the wage rate that cannot compensate for the fall in the wage bill. Employment for accumulation does not change but, according to (15.16), there is a rise in γ* reflected by the fall in employment for consumption and therefore by a fall in aggregate employment.2

15.6

Beyond the Solution of the Paradox: True and False Scarcity

Profits do exist in the pure capitalist economy and they are ‘endogenous’ relative to firms accumulation plans which create them. The solution does not mean that those ‘endogenous’ profits are enough to generate a sustainable system. Full employment cannot exist as long as both the wage income and the wage rate are the sole adjusting factors reconciling firms wagers on the future with banks desired

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accumulation. The very notion of a ‘labor market’ is inconsistent with the existence of money as the essential nature of the capitalist mode of production. Income is therefore to be scarce relative to the level that would grant all the potential labor force the real consumption it needs and desire. From the pure theory of profits stem three crucial propositions: I Involuntary unemployment is the natural state of the system; II It is self-increasing because it reflects a cumulative rise in the share of labor allocated to accumulation (rise in γ*) and therefore a growing scarcity of consumption to absorb the growth of output generated by accumulation. It must lead sooner or later to a change in the state of wagers on the future reflecting a drop in investment increasing again unemployment (Parguez, 1996; Parguez, 2003); III The labor force cannot find solace in a fall in the wage rate relative to productivity. Whatever its magnitude it can never convince firms to increase employment. One still uses to denounce the shortage of saving as the source of scarcity−saving being just thriftiness. Herein is the central dogma of orthodox ‘responsible’ economic policies which is more absolute in these early years of the twenty-first century than ever. By being thrifty, wage earners increase the real scarcity because they squeeze profits. Firms react by imposing a lower wage bill to maintain the rate of return while labor is more concentrated into production for accumulation. Wage earners thriftiness generates a rise in unemployment, which proves instead of a lack of thriftiness, there is always too strong a propensity to thriftiness! Proof that the ‘pure capitalist economy’ is not a very sensible framework for the general theory of the capitalist economy. The State must exist since the start as an independent source of money and expenditures generating ‘exogenous’ profits through the so-called ‘deficit’, which softens the constraints on labor.

Notes * 1 2

This chapter is the outcome of very rewarding discussions with Virginie Monvoisin, Warren Mosler, Pierre Piégay, Louis-Philippe Rochon, Mario Seccareccia and Bernard Vallageas. Chick (2000) is a remarkable exception. She strives to elaborate the synthesis of PostKeynesian theory and the monetary circuit while explicitly rejecting the wage postulate. It has therefore been proven that one does not need a Central Bank to explain the rate of interest as an exogenous factor relative to employment. In the pure capitalist economy there cannot be a Central Bank since there is no State. As shown in previous papers (Parguez, 2002; Parguez, 2003) Post-Keynesians pay too much attention to the Central Bank by confusing the theory of interest with the possibility of monetary policy.

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References Bellofiore, R. and R. Realfonzo (1997), ‘Finance and the labor theory of value’, Journal of Political Economy, 27, pp. 97–118. Chick, V. (2000), ‘Money and effective demand’ in J. Smithin (ed.), What is Money?, London: Routledge, pp. 124–38. Graziani, A. (1994), La Teoria Monetaria della Produzione, ‘Studie Ricerche’ series, Banco Populare dell’Etruria e del Lazio. Graziani, A. (1997), ‘The Marxist theory of money’, Journal of Political Economy 27, pp. 26–50. Kalecki, M. (1954), Theory of Economic Dynamics, London: Unwin University Books. Leonard, J. (1997), ‘Le paradoxe de l’intérêt et la crise de l’économie monétaire de production’, Économies et Sociétés, 9, pp. 149–68. Parguez, A. (1996), ‘Beyond scarcity: a reappraisal of the theory of the monetary circuit’ in E. Nell and G. Deleplace (eds), Money in Motion: The Post-Keynesian and Circulation Approaches, London: Macmillan, pp. 155–99. Parguez, A. (2002), ‘Victoria Chick and the theory of the monetary circuit’ in P. Arestis, M. Desai and S. Dow (eds), Money, Macroeconomics and Keynes: Essays in Honour of Victoria Chick, vol. 1, London: Routledge, pp. 45–55. Parguez, A. (2003), The Tragedy of Disciplinary Fiscal Policies in Contemporary Capitalism: A Long-run Perspective, paper presented at the Eastern Economic Association Annual Conference, New York, February 21-23. Parguez, A. and M. Seccareccia (2000), ‘The credit theory of money: the monetary circuit approach’ in J. Smithin (ed.), What is Money?, London: Routledge, pp. 101–23. Rossi, S. (2002), Money and Inflation, Aldershot: Edward Elgar.

Chapter 16

Some Notes on Post-Classical Macroeconomics *

Alessandro Roncaglia

16.1

Contending Paradigms in Economic Thinking

Since the origins of capitalism and of systematic enquiry into economic issues, (at least) two contending approaches may be identified in the literature. The first, and elder, ‘subjective’ approach centres on the idea that the economic value of goods and services depends on their utility and scarcity. We can find traces of it in classical antiquity and in the Medieval period, and it is clearly illustrated by authors such as Galiani and Turgot in the 18th century, well before being taken up by the so-called Marginalist Revolution of the 1870s and becoming the mainstream of the 20th century. The second, ‘objective’, approach locates the source of the value of commodities in their relative difficulties of production, and focuses attention on technology and the division of labour for explaining the wealth of nations. This approach takes off with Petty in the 17th century and culminates in the golden period of the classical school, from Smith to Ricardo, with an important related stream in Marx; it has been revived in the contemporary debate by Piero Sraffa (on this, see Roncaglia, 2001). We may also distinguish the two approaches by considering the different ways in which they represent the functioning of a market economy. On the one hand, the subjective approach characterises the market as a point in time and space in which supply and demand confront each other and, adapting to price signals, reach an equilibrium. More specifically, both supply and demand are considered as welldefined and independent functions of the price of the commodity under consideration (and possibly of other variables, in a fully-fledged general equilibrium approach), and equilibrium is reached when the market clears, that is, when supply equals demand. In other terms, equilibrium prices and quantities are the result of a comparison between endowments of resources (scarcity) and individual agents’ tastes and desires (utility).1 On the other hand, within the objective approach the market consists in the sufficiently regular, repetitive flows of means of production and consumption that allow for the repetition of productive activities. In a society based on the division of labour, such flows are required for ensuring that each productive unit, and each individual, reacquires the means of production and consumption necessary for the

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continuance of activity, by giving in exchange their own specific product or products; moreover, in a capitalistic market economy, such exchanges simultaneously determine the distribution of the surplus produce between classes, sectors, firms and individuals. Relative prices thus stem from the conditions that, in a competitive capitalistic economy, must be satisfied for the regular reproduction of activity: each sector must recover production costs, and in addition to this the firms within each sector must earn a rate of profit sufficient for inducing them into continuing their activity, hence we may assume a uniform rate of profits to prevail in all sectors of the economy under fully competitive conditions.2 As a consequence of the basic differences in the two approaches, we are confronted with two basically distinct ways of dealing with macroeconomic issues such as aggregate income, employment, money. In what follows, we will consider first (§ 16.2) the ‘subjective’ approach to macroeconomics, which constitutes today’s ‘mainstream’ both for teaching and as the background for economic policy debates. We will then try to prepare the ground for the discussion of an alternative, ‘objective’ approach to macroeconomics, by considering the implications of the two basic characteristics of a capitalistic market economy, division of labour (§ 16.3) and ‘fundamental’ uncertainty (§ 16.4). This will allow us to proceed (§ 16.5) to try to sketch the main lines along which macroeconomic theorising could develop (and has already developed) within an ‘objective’ approach.

16.2

Nature and Limits of the Equilibrium Approach to Macroeconomics

Traditional marginalist theory maintains that in a perfectly competitive economy labour demand is brought by market mechanisms into equality with labour supply – in other terms, the labour market clears in the same way as all other markets –, so that national income depends on available resources and the state of technological knowledge. Real wage, being the price for labour, brings into equality labour supply and demand; more precisely, substitution between productive factors connected to technological flexibility and to adjustment in the structure of consumption ensures the full utilisation of all available endowments of resources. While all this was considered to be true for long-run equilibrium, a long stream of marginalist theorists have indicated the possibility of short-run disturbances, making room for short-run unemployment equilibriums (see, for example, Hayek, 1931). Analogous results (that is, implying the possibility of unemployment) have been reached by bringing into play more or less credible obstacles to perfect competition, from the market power of trade unions to – more recently – insideroutsider asymmetries, menu costs, and the like. The basic analytical structure of the traditional marginalist theory of employment has been attacked by Keynes and Sraffa, from two different, but complementary, points of view. Keynes’s criticisms centre around a strong notion of uncertainty.3 As a consequence of it, the financial system assumes a crucial role, as a set of

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institutions and markets that mediate between the (separate, and surrounded by uncertainty) saving and investment decisions. In the presence of basic uncertainty, the financial system cannot be a perfect substitute for an automatic market equilibrating mechanism. Hence, among other things, the possibility of crises. Keynes’s representation of the capitalistic economy based on uncertainty has important theoretical implications. First, the demand for labour is determined not so much by the comparison between the wage rate and the marginal productivity of labour as by entrepreneurs’ (short run) production decisions based on their (short run) expectations about the amounts of product that the market can absorb at profitable prices (‘effectual demand’). Second, the rate of interest – seen as the price required to part with liquidity – is a monetary phenomenon, determined by ‘liquidity preference’ (that is, by the choices between more or less liquid assets as a form in which to store one’s wealth) rather than from the comparison between the demand for loans (investments) and the supply of loans (savings). 4 Third, investments and savings are brought into equilibrium by changes in the level of output (hence of employment); such an equilibrium may correspond to a less than full employment situation. The traditional market adjustment mechanism does not hold for the labour market: unemployment affects the money rather than the real wage rate; simultaneously, money prices may move so as to leave the real wage unchanged (or even so as to push it in the ‘wrong’ direction),5 so that no increase in employment stemming from adjustment in the capital-labour ratio takes place, while expectations may move in the wrong direction, worsening unemployment. Sraffa’s criticisms, in turn, concern the internal logical consistency of the traditional (long run) marginalist theory of employment and distribution, and specifically the notion of ‘capital’ as a factor of production, the price for the use of which – the rate of profits – ensures the equality between demand of and supply for it. This also implies a criticism of the idea that the wage – the price for the use of the factor of production ‘labour’ – brings labour demand into equality with labour supply. Sraffa’s point (or rather, the point we may draw from his 1960’s analysis) is that the choice of techniques stemming from changes in distributive variables (wage rate and rate of profits) does not necessarily go in the right direction for adjustment: the capital-labour ratio may increase rather than decrease when (and if) the real wage rate falls as a consequence of unemployment. These criticisms do not simply imply limits to the applicability of the traditional mainstream theory (in the long run, for instance, but not in the short run), but reject from different angles its basic structure. Keynes’s criticisms point to a different representation of the decision processes, where (fundamental) uncertainty leads us to subdividing into different specific fields the analysis of a capitalistic economy. Sraffa’s criticisms show that the results of analyses based on one-commodity models cannot be extended to a multi-commodity economy. In the next two sections we will focus attention on these two crucial characteristics of a capitalistic economy: uncertainty and the multi-commodity structure of production. Before going on to these aspects, let us recall that these criticisms have (or, better, should have had, if seriously considered) devastating effects on mainstream

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textbook macroeconomics. The so-called neoclassical synthesis (the IS-LM scheme), which tries to insert into the traditional demand and supply framework some of Keynes’s relations (the influence of money supply on the interest rate and of the latter on the level of investments), is compatible with unemployment equilibriums either (in Hicks’ 1937 version) by leaving aside the labour market, and thus ignoring the traditional marginalist adjustment process, or (in Modigliani’s 1944, 1963 versions) by introducing non-competitive features which hinder the adjustment process (see Roncaglia and Tonveronachi, 1978, 1985). These versions, in fact, fail to accommodate fundamental uncertainty and the multi-commodity nature of the real world: the traditional results of long-run competitive equilibrium marginalist theory are accepted by simply ignoring Keynes’s and Sraffa’s criticisms.6

16.3

Division of Labour and the Multi-Commodity Economy

Any theory implies a process of abstraction, whereby most aspects of the real world are left out of consideration as ‘complications’, some of which eventually to be considered in subsequent ‘approximations’ of the analysis, and attention is focused on a limited number of basic features, considered as crucial for the representation of the real world. The process of abstraction thus defines the relationship between theory and reality: if a theory ignores a crucial feature of the real world, its adequacy for the interpretation of reality is clearly hindered; if even subsequent approximations of the theory cannot take into account such a crucial feature of reality, the need arises to reconsider the underlying process of abstraction and hence the very foundations of the theoretical approach itself. No theory, not even with a myriad of subsequent approximations, can ever take into account all aspects of reality. But there is a wide distance between the two opposite poles, of on the one hand rejecting any attempt at theorising as implying a loss of some features of the real world, and on the other hand accepting on an equal footing any simplifying assumption, even the most absurd ones. Clear-cut and ‘objective’ criteria of distinction between which abstraction is admissible and which is not are not available; in fact, as it is impossible to give a complete representation of reality in all its details, it is equally impossible to produce a full list of all the features of the real world left out of consideration in working out any given theory. However, an attempt at establishing some common-sense boundaries may be (indeed, should be) recognised as an admissible (indeed, as a necessary) component of the scientific debate. In synthesis, the theory must embody in a stylised way (in some subsequent approximation if not in the first instance) the features of reality which are ‘crucial’ for the issue under consideration: that is, those aspects that constitute a dominant feature of reality – so much so that nobody could seriously deny their relevance – and the consideration of which makes a decisive difference for the results obtained by the theory.

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The division of labour clearly constitutes a dominant feature of reality, and it has been recognised as such, being, for centuries, at the centre of attention of economic thinking. At least in a market economy, it entails, among other things, both uncertainty and a multi-commodity economy. Let us consider this latter point in more detail. The division of the labour process into separate activities has been accompanied, as far back as economic history goes, by a process of continuous formation and development of separate individual productive units specialised in bringing out different products or groups of products. There are differences of detail even within product categories (as between a compact disk featuring Bach and one featuring Beethoven, or different works by the same composer, or different interpretations of the same work), but there are more basic differences between textiles and steel, between manufactured and agricultural products, between commodity production and services. Any representation of reality, in the collection of statistics and in applied economics alike, without entering into the finest details of the differences between specific individual products, chooses a certain level of aggregation, adequate for the issue at hand. In statistics collection, for instance, we may legitimately consider on the one hand the (fully aggregate) measure of national income and on the other hand the amount of production of the individual firm, or even of the individual product division within the firm. In theoretical analysis, we do not need to explicitly define some chosen level of aggregation; but the structure of the model must be such as to accommodate for the existence of different commodities, different productive activities and different productive units. For instance, any theory of income and employment for a market economy must recognise that decisions on production and employment levels are taken separately by individual firms. Failing this, the issue at hand changes nature (the co-ordination problem vanishes) and the results reached by our model cannot any longer be considered as directly applicable to the real world. For ease of exposition, the model may be illustrated in terms of a onefirm, one-commodity world; but care must be taken in checking that the results may be extended to a multi-firm, multi-commodity world. As a long tradition of mainstream macroeconomics shows, it may be too easy to forget the need to comply with such a basic requirement; hence, it may be better to start directly with an employment theory explicitly located in a multi-firm, multi-commodity context. In fact, it is precisely the existence of separate autonomous productive units that gives rise to the theoretical possibility of situations characterised by underemployment of labour and other productive resources, and more generally to the macroeconomic problem of finding out the determinants of national income and employment.7

16.4

Uncertainty

Let us now turn to uncertainty. This may be seen as the consequence of two features: the duration over time of economic processes, and the structural changes

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in the economy connected to technical progress. When fixed capital is concerned, any investment decision covers a span of time that embraces years (up to thirty years and beyond, for instance, for an electricity plant), so that entrepreneurs’ evaluations over the future are necessary in order to assess any investment project. The future is not a replica of the present, among other things because over time technical progress takes place. While the fact of technical progress is a constant feature of economic life, its specific characteristics are different from period to period and from one sector (from one activity) to another. By its very nature, technical progress cannot be foreseen – there may be empirical aggregate regularities in its pace or a sufficiently good fit for econometric relationships with some of its determinants, such as cumulated output (learning by doing) or investments, but nobody could have foreseen, twenty years ago, the contemporary features of many production processes, for instance of genomic medical remedies or of the e-book. Moreover, technical progress takes place at a different pace and with different characteristics from sector to sector: aggregate data hide the fact that there may be intervals of technological stagnation in some sectors, while in other sectors the pace of technological change may be very rapid indeed for a number of years in a row – think for instance of the computer industry over the recent four decades. This implies changes in the production structure of the economy, and hence in the inter-industry flows of trade; moreover, when technology changes at different speeds in different sectors, the relative prices of the products of these sectors change over time8 – and if the difference in the speed of technical progress in any two sectors cannot be foreseen, neither the change in the relative price of their products can be foreseen.9 All this concerns the ‘regular’ evolution of events; there are moreover single events, that in themselves cannot be foreseen but that have a profound impact on economic life: let us recall for instance the Chernobyl accident with its catastrophic impact on the prospects for atomic energy. In his Treatise on probability, Keynes (1921) confronts the notion of uncertainty and tries to construct a general theory of knowledge and rational behaviour that takes this fact of life into account. He distinguishes two opposite poles: absolute certainty and complete ignorance. The general case – partial knowledge – is intermediate between these two poles: the general theory is constructed focusing on the intermediate cases but – at the limit – also applies to the extreme ones. Thus, in the general case, there is room for a reasoned evaluation of the situation (we will not choose whether to build an hydro-electric rather than a thermo-electric plant by simply tossing a coin), though it should be clear that no certainty is possible, even no actuarial certainty. In evaluating the situation, we should use as best as we can all the available information, and it is also possible – though in general costly – to increase the amount of our information; this will reduce, but never fully eliminate, uncertainty. Different people may have different evaluations of the same situation; even if they have the same evaluation, they may have a different ‘degree of confidence’ in their evaluations; moreover, both their evaluation and their ‘confidence’ may change over time, as a consequence of new information or of additional reasoning on the already available information. It may

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well happen, too, that the probability we attribute to a certain event decreases while our ‘degree of confidence’ in our evaluation increases. Some implications of this approach to uncertainty are crucial for the construction of a non-neoclassical macroeconomics: first, a method of analysis based on ‘short chains’ of relations between variables; second, the role of money and financial institutions; third, the recognition of the different roles played by different groups of economic agents, such as banks, entrepreneurs, consumers. The traditional representation of the functioning of a market economy based on the notion of equilibrium implies a logical compulsion to take into account all interdependencies within the economy – thus the notion of general economic equilibrium, and the strong appeal of this stream of analysis. This method, however, favours the risk of increasing the distance between theory and reality: it seems that everything is taken into account, while in fact – since goods markets do not behave like Medieval fairs or old-style continental stock exchanges – many aspects are left aside. Thus Marshall (1890), while retaining the notion of equilibrium between supply and demand as the basic stone for his theoretical building, limited his analysis to ‘short chains of reasoning’ through recourse to partial equilibrium analysis, leaving in the background the general equilibrium model; unfortunately, this implied a crucial logical contradiction between the notion of competition and the required assumption of ‘ceteris paribus’.10 What Keynes instead propounded – and Sraffa pursued in his 1960 book – is an approach ‘by issues’, whereby each issue is rigorously defined while being treated, within its boundaries, in a fully general way; at the same time, the ‘chain of reasoning’ is kept as short as possible, being reduced to the crucial causal links on which attention is focused for the purposes of the specific issue under consideration. The traditional notion of equilibrium, interpreted as market clearing, is abandoned; in its place, there are logical constraints whose definition depends on the specific issue under consideration and the kind of abstraction better suited for dealing with it.11 As for the role of money, it ceases to be a mere means of exchange and measure of value, and loses its theoretical nature of a ‘veil’, irrelevant for the definition of long run equilibrium solutions for the ‘real’ variables (exchange ratios, including the relative prices of the ‘factors of production’ and hence distribution; employment and output levels). Attention is focused on a third characteristic of money (partly stemming from the two previous ones), that of being a reserve of value. Our market economies need such a reserve of value precisely because of the presence of uncertainty; hence the characteristic required for it, that of being the ‘most liquid’ of all assets. Liquidity, intended as the (expected) ease and cost of disposing of anything which is used as store of value (bank notes or sight deposits, but also bonds and shares, paintings or houses) in exchange for any other commodity or service, depends crucially on ‘social’ elements such as customs, habits and institutions. Money, or rather its liquidity characteristics in comparison to the lower degrees of liquidity of other stores of value, influence the choices of economic agents, and consequently crucial

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variables such as the levels of investment, production, employment. Furthermore, we cannot consider money as endowed with specific characteristics and invariant over time and among different social systems: its definitional relation with habits, customs and institutions causes each specific financial system to influence in a different way the above-mentioned macroeconomic variables. Third, in an uncertain environment asymmetries in information and knowledge become asymmetries in power and differences in economic roles. Thus, for instance, financial institutions do not play a purely passive role limited to reducing information and transaction costs for the economy as a whole and to bringing about macroeconomic market clearing between savings and investments; they play a crucial role – together with entrepreneurs – in determining the economy’s evolution. Power asymmetries and different roles allow for some ordering in the ‘short chains of reasoning’, though with important feedbacks (which may themselves be the object of separate analyses). From a representation of the economy where the consumer is sovereign, implicit in the derivation of values from the confrontation between scarcity of resources and consumers’ preferences, we thus shift to a representation where financial oligopolists play a leading role and entrepreneurs have autonomous decision power. The Keynesian sequence of analytical blocks – financial markets and institutions, entrepreneurial decisions over (separately) investment and production levels, market validation of entrepreneurial expectations – is thus vindicated from the Hicksian transfiguration in terms of a set of markets (money, bonds, commodities) 12 simultaneously reaching market clearing equilibrium.

16.5

Macroeconomic Dynamics, an Evolutionary Approach With Social Accounting Constraints

On the basis of what has been said up to now, how can we model the macroeconomic issues of income and employment determination? An answer, even a tentative one, to this question requires much further research: constructing a fully-fledged approach alternative to the mainstream one is clearly beyond the scope of this chapter (though many of the building blocks required for this purpose are already available, in the writings of Keynes and the post-Keynesians). Here we will limit ourselves to a few hints. First, if we consider the notion of equilibrium between supply and demand (market clearing) as unfit for the analysis of a capitalistic market economy, such an approach should be discarded for the determination of macroeconomic variables as well. In other terms, we should not build our analysis of employment on the idea that changes in the wage rate (the price of labour) tend to bring about automatic market clearing in the labour market through movements along labour demand and supply schedules, respectively considered as increasing and decreasing functions of the wage. The very notion of an ‘equilibrium’ level of output and employment (where ‘equilibrium’ is of the market-clearing type) is better left aside. In fact,

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within the so-called ‘surplus approach’ classical economists in their theories of accumulation referred simply to employment levels, without recourse to notions such as full employment (that is, market clearing in the labour market) or even unemployment (defined as the distance from the full employment, market clearing level). This is also true for the classical literature concerning the debate on machinery and the so-called ‘compensation theories’, maintaining that the creation of new jobs compensates for the destruction of jobs provoked by the introduction of machinery, which did not refer to full employment, nor to unemployment for the economy as a whole. The notion of full employment appears later, in marginalist theories, as the logical outcome of applying the notion of market clearing to the labour market. In parallel, the notion of unemployment appeared, defined as the difference between full employment and the actual employment level. The difficulties to precisely and univocally define these magnitudes at the statistical level often lead applied economists into preferring to them such notions as those of active population, share of employment over total population (or over population of working age); in any case, the notion of unemployment should lose the meaning of measure of a theoretically well-specified gap.13 Second, the Keynesian notion of an equality between aggregate demand and aggregate supply involves a concept of equilibrium somewhat different from that based on the idea of market clearing. It is not equilibrium in the sense of a balance between the opposite forces of demand and supply, brought about for instance by increases or decreases of the general price level whenever aggregate demand turns out to be higher or lower than aggregate supply. It only implies that entrepreneurial decisions over production levels are validated by the market; or, in other terms, that such decisions are overall ‘compatible’ among themselves and with the decisions of other (groups of) agents in the economy. The Keynesian notion is, in a sense, a simplifying assumption introduced as a first approximation, in order to leave aside the issue of mistaken entrepreneurial expectations. There is no market clearing mechanism underlying this assumption: at least, it is not necessary to assume such a mechanism for introducing our ‘Keynesian’ assumption (though we may easily imagine adjustment processes – not instantaneous ones, but taking place over time – like the one based on the difference between current and desired inventories inducing increases or decreases in production levels). We may then develop the assumption of equality between aggregate demand and supply bringing into play a set of national accounting constraints, as specific as we like (thus the simplest one commonly used as a first approximation, focusing on a closed economy and with no distinction between the private and the public sector, implies the equality between savings and investments). We may also explicitly consider, as a theoretical problem in itself corresponding to the transition to a subsequent approximation, the (determinants and effects of the) systematic errors in the entrepreneurs’ short run expectations (that is, those cases in which the errors are not casual, and hence cannot be assumed to cancel out in the aggregate). Third, we should consider an economy with many firms (many independent decisional centres), but as a first approximation we may ignore the differences

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between production processes for different commodities. We may ignore, again as a first approximation, such complexities as the different risk propensities or informational situations or inferential capabilities of the individual entrepreneurs, or differences in the market structures in which they operate. The list of such simplifications may become quite long; the important point is that we focus attention on the crucial features determining the entrepreneurs’ decisions. Expectations by themselves do not constitute an explanatory variable; however, it is important to keep them in mind, since they indicate a specific way in which the crucial entrepreneurial decisions take place; but we must then look for some key economic variables to be inserted into our model, representing the main factors influencing expectations. Fourth, if we look at the way in which decisions on production levels are usually taken, we see that they assume the form of decisions on increases or decreases of the production level compared to that prevailing at the moment in which the decision is taken. In other words, as soon as we discard the traditional notion of equilibrium (as the point of intersection between demand and supply schedules) as the ‘core’ of our theory of income and employment, it appears natural to focus on the determinants of change, rather than on the determinants of the levels prevailing at any given moment in time. These latter levels will be the real-world results of previous decisions, and hence embody all the complexities from which by its nature the theory abstracts. Fifth, we may refer here to Keynes’s conceptual representation (in the General Theory) of entrepreneurs’ decisions on production levels through the notion of ‘effective demand’ – though in a modified form, for as already stated we are interested here in determinants of change rather than an ‘equilibrium’ level. Thus, rather than looking for the intersection between two curves representing entrepreneurs’ expectations about production costs and receipts for different output levels, we may consider entrepreneurs’ evaluation of the current costs-receiptsoutput situation and of short-run economic perspectives (while long-run perspectives are those relevant for investment decisions). In other words, first we consider the effects of different costs-receipts-output configurations (under an implicit assumption of static expectations), then we add into this picture the entrepreneurs’ reactions to expected changes in the current costs-receipts situation. Sixth, and last, we will find ourselves not building a single model for explaining employment, but a number of analytical blocks, in which different aspects of the picture will be considered. As an example, we may consider the influence played upon employment by one among different explanatory variables: the interest rate (or, more generally, the liquidity situation of the economy). Rejecting the idea of an equilibrium level for the interest rate as well, we may consider the influence of changes in the interest rate, compared to the situation prevailing at a given moment in time, on the entrepreneurial decisions over changes in output levels. We may assume that in the minds of the entrepreneurs a reduction in the interest rate is likely to imply, ceteris paribus, an increase in investments, and hence an increase in demand that from the sectors producing

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investment goods propagates throughout the economy. Hence changes in the interest rate may be introduced into our model, with a minus sign, as explanatory variables for the changes in output and employment levels. (Of course the ceteris paribus clause is most relevant here, since we are considering a single explanatory variable, and even not necessarily the most important one. For instance, if a decrease in the interest rate is due to a central bank decision to react to a serious economic crisis, the very decision to adopt the new policy stance may be taken as the indication that ‘those who know better’ – the central bank and the policy authorities – consider the economic situation to be bad, possibly worse than that implicit in the expectations of money market operators embodied in the current interest rate. Hence entrepreneurial expectations may worsen, and output and employment decisions may be revised downwards.) We may also consider the influence of a change in short-run interest rates on share prices in the stock exchange, and hence – through wealth effects – on consumers’ spending decisions. Our example thus shows that theoretical analysis may bring to light a number of different ‘short chains of reasoning’, and we may then combine them in different ways. Moreover, even when we put together a set of ‘analytical blocks’, its application to the real world constitutes a separate and most difficult issue, since it implies attributing greater or lesser force to the various aspects.

16.6

Conclusions

Let us briefly recall the main steps of our reasoning. First, we contrasted two different economic approaches: the traditional approach based on the comparison of scarce resources with economic agents’ desires, revolving around a notion of equilibrium as market clearing, and the alternative approach focusing on the division of labour. We then discussed the limits of the macroeconomic theories built within the traditional approach, and we illustrated two basic requirements for macro theorising, namely the need to take into account the multi-commodity nature of an economy based on the division of labour, and uncertainty. From these requirements we tried to gain some insights as to the characteristics of nonmainstream macroeconomic theorising. Such hints point in the direction of a multiplicity of ‘short chains of reasoning’ that could constitute a set of analytical blocks rather than a single unifying macroeconomic theory. Furthermore, the abandonment of the notion of market equilibrium may lead us to prefer the analysis of changes, thus an evolutionary perspective. In other words, what we hint at is a different way of looking at macroeconomic issues and a different method for analysing them, not a different ‘core macroeconomic model’. But as always the proof of the pudding is in the eating, and a fuller exploration of our tentative hints is necessary before the test is attempted.

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Notes *

1

2

3

4 5

6

Thanks, but no implication, are due to Marco Lippi, Cristina Marcuzzo, Claudio Sardoni and especially to Mario Tonveronachi for reading and commenting on a previous draft, and to the Miur for research funding. This chapter has been written in honour of Augusto Graziani: as for so many in my generation, my studies on macroeconomics began on his books (Graziani, 1965, 1967), and he has long been insisting on the existence of different approaches to macroeconomic issues, especially pointing to the crucial difference between attributing an active or a passive role to money and finance in economic development (Graziani, 1994). The Arrow-Debreu axiomatic general equilibrium approach may be considered as the analytical apex of this approach. In fact, it is based on a representation of the capitalist economy as an economy-wide set of market fairs, or as an economy-wide set of oldstyle Continental stock exchanges: that is, a set of markets interpreted as a point in time and space where demand and supply meet, and where instantaneous market clearing takes place, and this, moreover, simultaneously for all markets. These characteristics may be introduced within a general equilibrium model, as a particular version of it; but its analytical structure will remain focused on market clearing, which on the contrary does not represent a basic analytical requirement of the ‘objective’ theories (though it may be superimposed on them). The strong notion of uncertainty also implies rejection of the (later) Arrow-Debreu axiomatic paradigm which represents the market economy as a complete system of spot and forward markets. These latter may still exist in the presence of (subjective) probabilistic uncertainty, thanks to the introduction of ‘contingent markets’, in which the execution of the contract is conditional on the occurrence of a pre-specified state of the world. However, in his Treatise on probability (1921) Keynes maintains that a quantitative estimate for the probability of their coming true cannot be assigned to all possible states of the world; hence some forward markets at least cannot exist. In the absence of slavery, this holds true in particular for the labour market (see Nuti 1970). Let us notice here that decisions to save and decisions concerning the allocation of the stock of past savings should be kept separate. Whether real wages move counter-cyclically (as Keynes rather a-critically assumed on Marshall’s wake) or cyclically (as maintained by Dunlop, 1938, and Tarshis, 1939, in opposition to Keynes, who was anyhow ready to accept their point) is an important issue in applied economics; here the issue at stake is different, concerning the abstract theory of employment, more precisely the specification of a set of causal relationships such as to guarantee that the labour market automatically clears under competitive conditions. Traditional marginalist theory requires, of course, that real wage increases correspond to decreases in output, as a consequence of the assumption of decreasing marginal productivity. A critical survey of post-Hicksian developments in mainstream macroeconomics is outside the scope of this chapter. As a personal bet, I may surmise the hypothesis that no theory of employment and output illustrated in mainstream textbooks succeeds in keeping into account fundamental uncertainty and the multi-(basic)-commodity nature of the real world. This applies for instance to Kydland and Prescott’s 1982 seminal model of the ‘real trade cycle’ and the subsequent elaborations: first of all, it is a onecommodity model, where an inverse relation between real wage and employment holds; secondly (and consequently) it assumes away uncertainty. It may be added that this latter fact does not necessarily follow from the ‘rational expectations’ assumption, if interpreted simply as the idea that economic agents keep into account in their decisions all the information available to them; it is only when applied to traditional (onecommodity, no basic uncertainty) models that this assumption implies knowledge ex

Some Notes on Post-classical Macroeconomics

7

8 9 10

11

12 13

281

ante of the final equilibrium position – indeed, only for this kind of models is a (stable and unique) equilibrium position guaranteed. Let us also recall here that, despite the references to Walrasian analysis, a one-commodity model (with no uncertainty) also underlies Friedman’s (1970) ‘theoretical framework’; on the other side of the mainstream economic policy spectrum, the same may be said for Stiglitz’s long stream of ‘new Keynesian’ models that are only able to arrive at ‘Keynesian’ results by introducing ad hoc assumptions (mainly market imperfections) into the usual mainstream analysis based on the inverse relationship between real wage and employment. Heterogeneity of commodities is a necessary but not a sufficient condition for underemployment results for a fully competitive economy; Arrow-Debreu equilibria, for instance, are characterised by general market clearing (though the stability of such equilibria cannot be demonstrated without additional restrictive assumptions). In Sraffa’s 1932 terms, there may be as many ‘natural interest rates’ as there are commodities (own rates of interest in Keynes’s 1936, chapter 17, terminology). An analogous influence stems from changes in consumption patterns, whenever – as it is generally the case – we cannot assume constant returns to scale. Sraffa’s 1925 and 1926 critique to the Marshallian theory of the firm, centred on the contradiction between the ceteris paribus assumption and perfect competition, has often been interpreted as demonstrating the need to shift to a general equilibrium approach. In fact, Sraffa was already looking for something different, namely the revival of the classical approach. On this, as on the interpretation of Sraffa’s 1960 contribution as an approach ‘by issues’, see Roncaglia 2000, chapter 2. This point should be stressed: the term ‘equilibrium’ has been used in economic theory with different meanings, and the rejection of the traditional (market clearing) marginalist notion does not necessarily imply rejection of all such meanings. For instance, the notion of equilibrium as the systematic result of the action of basic economic forces considered in isolation may be said to underlie the classical (and Sraffian) notion of natural prices. Again, an idea of equilibrium as ‘balancing’ of opposite elements may be read into Harrod’s (1939) ‘warranted growth rate’, the rate of growth at which the expansion of aggregate demand (the total sum of the economy’s spending decisions) balances the expansion of productive capacity, namely accumulation; interpreted in this way Harrod’s rate (precisely alike Sraffa’s prices of production) summarises the conditions prevailing at a moment in time, and does not describe a long-run equilibrium path; this will only happen with Solow’s (1956) theory of growth, where the supply and demand (market clearing) framework is again adopted. Modigliani (1944) completes the picture by adding to these the labour market. Phenomena such as the responsiveness of activity levels to labour market conditions, treated as ‘hysteresis effects’ within mainstream theories, are in fact a demonstration of the unsafe foundations of the notion of full employment. Moreover, when the economic system is assumed to coincide with the nation state, migrations come to play a crucial role (explaining, for instance, how West Germany could grow in the 1950s beyond any pre-defined ‘full employment barrier’).

References Dunlop, J.T. (1938), ‘The movement of real and money wage rates’, Economic Journal, 48, pp. 413–34. Friedman, M. (1970), ‘A theoretical framework for monetary analysis’, Journal of Political Economy, 78, pp. 193–238. Graziani, A. (1965), Equilibrio generale ed equilibrio macroeconomico, Naples: ESI.

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Graziani, A. (1967), Teoria economica, Naples: ESI. Graziani, A. (1994), La teoria monetaria della produzione, Banca Popolare dell’Etruria e del Lazio, Arezzo. Harrod, R. (1939), ‘An essay in dynamic theory’, Economic Journal, 49, pp. 14–33. Hayek, F. von (1931), Prices and Production, London: Routledge. Hicks, J. (1937), ‘Mr. Keynes and the classics: a suggested interpretation’, Econometrica, 5, pp. 147–59. Keynes, J.M. (1921), A Treatise on Probability, London: Macmillan. Keynes, J.M. (1936), The General Theory of Employment, Interest and Money, London: Macmillan. Kydland, F.E. and E.C. Prescott (1982), ‘Time to build and aggregate fluctuations’, Economica, 50, pp. 1345–70. Marshall, A. (1890), Principles of economics, London: Macmillan. Modigliani, F. (1944), ‘Liquidity preference and the theory of interest and money’, Econometrica, 12, pp. 45–88. Modigliani, F. (1963), ‘The monetary mechanism and its interaction with real phenomena’, Review of Economics and Statistics, 45, Supplement, pp. 79–107. Nuti, D.M. (1970), ‘‘Vulgar economy’ in the theory of income distribution’, De Economist, 118, pp. 363–9; reprinted with a ‘Postscript’ in E.K. Hunt and J.G. Schwartz (eds), A critique of economic theory, Harmondsworth: Penguin, 1972, pp. 222–32. Roncaglia, A. (2000), Piero Sraffa. His life, thought, and cultural heritage, London: Routledge. Roncaglia, A. (2001), La ricchezza delle idée. Storia del pensiero economico, Roma-Bari: Laterza. Roncaglia, A. and M. Tonveronachi (1978), ‘Commenti a un recente studio di Modigliani e Padoa-Schioppa’, Moneta e Credito, 31, pp. 3–21. Roncaglia, A. and M. Tonveronachi (1985), ‘The pre-Keynesian roots of the neoclassical synthesis’, Cahiers d’économie politique, 10, pp. 51–65. Solow, R.M. (1956), ‘A contribution to the theory of economic growth’, Quarterly Journal of Economics, 79, pp. 65–94. Sraffa, P. (1925), ‘Sulle relazioni tra costo e quantità prodotta’, Annali di economia, 2, pp. 277–328. Sraffa, P. (1926), ‘The laws of returns under competitive conditions’, Economic Journal, 36, pp. 535–50. Sraffa, P. (1932), ‘Dr. Hayek on money and capital’ and ‘A rejoinder’, Economic Journal, 42, pp. 42–53 and 249–51. Sraffa, P. (1960), Production of Commodities by Means of Commodities, Cambridge: Cambridge University Press. Tarshis, L. (1939), ‘Changes in real and money wages’, Economic Journal, 49, pp. 150–4.

Chapter 17

Aspects of a New Conceptual Integration of Keynes’s Treatise on Money and the General Theory: Logical Time Units and Macroeconomic Price Formation Mario Seccareccia*

17.1

Introduction

As is well known, time and price formation are inextricably linked in research developed along Austrian lines. From Böhm-Bawerk to Hayek, the Austrians’ analysis of logical time units, especially in their theories of capital and interest, served as the basic building blocks for their micro and macroeconomic models of price determination that were developed during the half-century between the years 1890 and 1940. These developments were, perhaps, of greatest importance at the macroeconomic level since the work of such important Austrian writers, as Mises and Hayek, directly impacted on the then emerging literature on the business cycle. However, this latter connection with aggregate price formation and the business cycle was a development largely made possible owing to the innovative research first undertaken by Wicksell at the turn of the twentieth century. In his work, Wicksell had tried to explain the evolution of aggregate prices as a result of changes in the time structure of production originating from a state of disequilibrium in the capital market. Advancing on Wicksell’s earlier insights, during the first few decades of the twentieth century, a number of ‘overinvestment’ writers (as Haberler, 1937 was to describe them) extended the research to the new area of business-cycle theory. The notion of ‘time structure of production’ was a terribly elusive concept that ultimately did not withstand successfully the test of correspondence with real world phenomena. This failure was so despite the heroic attempts to salvage it by such well-known Austrian economists as Machlup (1935). Yet, these original developments by Wicksell were of heuristic importance and did serve to spawn a complete literature on aggregate price formation and the business cycle whose subsequent developments have, in part, been summarized in Seccareccia (1990, 1992). However, in addition to the Austrian and Swedish followers of Wicksell,

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this view also came to permeate the theoretical work of certain British writers, of whom the most distinguished was Keynes himself in his Treatise on Money. The object of this article is to describe the extent to which this Austro-Swedish view of the time profile of production became implanted in Keynes’s early thought, before the publication of his most celebrated work in economics, and to show what insights this knowledge may bring to an understanding of his theory of macroeconomic price formation in both the Treatise and the General Theory. In this regard, this chapter contributes directly to the broader ongoing debate between those scholars who argue that there was a fundamental continuity in Keynes’s thought between his Treatise on Money and the General Theory (see Amadeo, 1989, Marcuzzo, 1998, and Fontana, 2003) and those who emphasize that there was an underlying methodological break (see, inter alia, Ertürk, 1998). By studying closely Keynes’s macroeconomic analysis of investment and price formation within the temporal analytical framework specific to each of his two major works, it will become apparent that the General Theory’s break with previous writings, especially the Treatise, has been considerably overstated. Moreover, the profoundness of Keynes’s theory of macroeconomic price formation in the Treatise was such that it still permeates some current-day post-Keynesian writings, of which the work of Augusto Graziani (1981, 1987, 1990, 1994) represents perhaps the most developed version of Keynes’s Treatise analysis that is embedded in a comprehensive model of endogenous money and monetary circulation.

 17.2

Keynes’s Fundamental Equations of the Treatise: An Exposition

Keynes’s formulation of the fundamental equations in the Treatise on Money reflects a trend that became fashionable especially among continental writers, well versed in the work of Wicksell, who had become dissatisfied with traditional quantity theory analysis that focused on a single overall price level and imposed an aggregative treatment of monetary influences. As Wicksell himself and many of his nineteenth-century predecessors of the loanable funds theory had surmised, it was the relation between saving and investment that was the primary source of dynamic change in the price level. Keynes’s treatment of the fundamental equations of the Treatise was one among many early twentieth-century attempts undertaken by disparate continental writers, such as Lindahl and Hayek, of providing a more disaggregative approach in terms of consumption and investment-goods prices. All of these approaches, including that of Keynes in the Treatise, focused on the investment-saving relation in explaining the short-run oscillation of prices. Although one cannot exclude the implications that perhaps his contact with Hawtrey and Lavington, as well as his reading of such American institutionalists as W.C. Mitchell on the business cycle, may have had during his formative years, Keynes’s knowledge of this continental literature was partial and may have come

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primarily by way of Robertson. As can be demonstrated by the evidence provided by Moggridge (1973, p. 1), Keynes had been introduced to some of the ideas of the continental over-investment theorists, such as Spiethoff, Labordère and Aftalion, most likely by his reading of Robertson’s fellowship dissertation which was submitted to Trinity College, Cambridge, in 1913 and which was later published as A Study of Industrial Fluctuation in 1915.1 Indeed, in a paper read to the Political Economy Club in London on December 3, 1913, Keynes presented his first important ideas on industrial fluctuations. Like the other over-investment writers of the period, he began his paper by criticizing Fisher’s quantity theory explanation. Any movement in cash reserves (and, thus, in the money stock) is, according to Keynes, ‘a symptom but it is not at all a fundamental cause’ (Keynes, 1973, Vol. 13, p. 9). The mainspring of cyclical fluctuations is, instead, investment spending as it affects activity ‘in those industries which are chiefly concerned in the production of capital goods’ (Keynes, 1973, Vol. 13, p. 11). Or, more precisely, it is the level of investment spending either set in relation to the community’s savings or financed through bank credit, which governs the process of expansion and contraction in economic activity. Keynes (1913) writes: Of the resources of the community earned or available within a given year, a certain part is saved, a certain part is spent, and a certain part is held, so far as the individual is concerned, in suspense – it is kept as free resources to be spent or saved according as future circumstances may determine.... Hence, in any year the value of material goods actually utilised for capital works may run ahead of or fall behind the value deliberately saved, according as the advances of bankers are made, to a greater or less extent, for the purpose of capital expenditure. I should say that there is a tendency to over-investment... when the proportion of the funds in the hands of the bankers which is fixed in permanent capital works is increasing (Keynes, 1973, Vol. 13, pp. 4–5).



Although the terms ‘saving’ and ‘investment’ were very loosely defined in this early paper, and may not necessarily let presage the Robertsonian conceptions of saving or ‘lacking’ (including what was later to become Robertson’s 1926 concept of ‘abortive lacking’ or hoarding), from the above quotation one may legitimately argue that an embryo of the Robertsonian analytics was already in place in Keynes’s pre-W.W.I writings. Moreover, as did Spiethoff (1923), Robertson (1915) and most over-investment theorists of the period, Keynes also placed great emphasis on the role of inventions and the opening up of new markets in explaining the periodic spurts in investment spending. Except for this very early paper relating to business-cycle questions, Keynes did not return to this matter until after the publication of his Tract on Monetary Reform (1923), the latter book being an attempt to understand the early post bellum monetary phenomena within the Marshallian framework of the quantity theory. In conformity with what has also been emphasized by numerous historians of economic thought, such as Eshag (1963) and Patinkin (1976), Keynes’s research in

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monetary theory was very deeply rooted in the work of other well-known Cambridge economists of the period and advocates of the cash balance version of the quantity theory, notably Marshall and Pigou. As of 1924, influenced by some of Robertson’s dynamic analysis, he quickly returned to his pre-war interest on business cycle theory. As in his 1913 paper, Keynes (1924, 1928) argued that, broadly speaking, inflation is a symptom of over-investment, that is, a result of the recurrent imbalance between the overall structure of demand and output. In Keynes’s own terms, general over-investment takes place whenever the flow of income or ‘buying power’ (that firms transfer to households during a given period) exceeds the stream of available ‘liquid’ consumption goods. 2 This state of general over-investment, which should be distinguished from any specific form of ‘misdirected’ investment, can occur only because of the existence of credit.3 In effect, an elastic monetary system allows the value of investment to exceed the money value of these ‘liquid’ goods that the community has abstained from consuming.4 Keynes’ formulation of what he was to describe later as a ‘monetary theory of production’ depicted productive activity as taking place within two main branches – the sector producing ‘liquid’ or ‘available’ output of consumption goods and the one supplying the ‘non-available’ output of investment goods. The liquid or available output was composed of both the physical commodities flowing from the final stages of production during a given period and the flow of services of any consumer durable good, while the non-available output was made up of the net increment in fixed and working capital (i.e., the net increase in the production of machinery and equipment, in inventories, and of goods in process at the earlier stages of production). The critical concept in Keynes’s Treatise which offers a direct link with Robertson’s ideas and which was widely debated before, during and after the publication of his book is his definition of saving. Because of his concern with the inequality of investment and saving in determining the price level, Robertson had originally proposed an operational concept of saving defined in relation to his notion of an expenditure lag, the latter time-unit being defined in terms of ‘finite but indivisible atoms of time to be called ‘days’ ’ (Robertson, 1926, p. 59) From this, Robertson had postulated a definition of saving that took into account his hypothesized expenditure lag: St = Yt −1 − Ct

(17.1)

where Yt–1 is the flow of income of the preceding period, while Ct is the current period’s consumption expenditures. In the Treatise, Keynes deviated slightly from the Robertsonian definition of saving. In accordance with the Marshallian concept of normal equilibrium (see De Vroey, 2000), he defined it instead as the difference between the flow of income (which can be considered to be ‘normal’ by the factors of production) and the current period’s consumption expenditures:5 St = Y * − Ct

(17.2)

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287

where, according to Keynes (1930), Y* is ‘normal’ income (it being the sum of factor earnings, including the entrepreneurs’ ‘normal’ remuneration) as against current income, Y (which is the ex post receipts accruing to all the factors of production).6 Following the Marshallian tradition, the difference between the actual remuneration, Y, and the ‘normal’ remuneration, Y*, is termed pure ‘profit’, Π, or quasi-rent (see Opie, 1931). This value can be either positive or negative. Indeed, since by definition the sum of receipts must be equal to the gross expenditures in the system (Yt=Ct+It) and since, from equation (17.2) above, St = Y* – Ct, then according to Keynes (1930), we get that ‘the value of the increment of the wealth of the community is measured by Savings plus Profits’ [Emphasis in original] (Keynes, 1971, Vol. 5, p. 126); i.e., I t = St + Π t

(17.3)

In Robertsonian terms, St is the ‘spontaneous lacking’ and Π t is the ‘imposed’ or ‘automatic lacking’.7 Given Keynes’s definition, it follows that the value of investment could differ from saving, unless expected ‘normal’ incomes are realized by entrepreneurs during the period. From Keynes’s concept of saving, one can easily arrive at the First Fundamental Equation of the Treatise. As has been shown elsewhere (Seccareccia, 1983, 1984), his first fundamental relationship can be derived without relying upon any such ambiguous aggregative measures of output and prices ‘in general’. Unfortunately, Keynes’s Treatise was very much plagued by such controversial concepts as ‘output in general’, the ‘price level of output as a whole’, Wicksell’s ‘natural rate of interest’, and the aggregate ‘coefficient of efficiency’. Despite Keynes’s own acute criticism of Robertson for using similar aggregative concepts, 8 he was unable to break away completely from the quantity theory framework which permeated both Robertson’s 1926 book and Keynes’s own previous analysis in the Tract. In the Treatise, Keynes’s questionable aggregative analysis became most apparent when deriving his First and Second Fundamental Equations by postulating additivity of heterogeneous outputs. He had assumed namely: QT = QC + QI

(17.4)

where QT is output ‘in general’ and, in this two-sector world, QC and QI are outputs of the consumption and investment-goods sectors respectively. With the exception of the trivial one-commodity case, numerous economists during the early thirties pointed to the obvious conceptual problem of aggregating output in a two-sector model of the type described in Keynes’s Treatise. Among these we find Hayek (1931, p. 287) and Hansen (1932, p. 462), who argued that Keynes had ‘an entirely irrelevant criterion’ for measuring output. Hart (1933, p. 634) emphasized the conceptual impossibility of specifying ‘a bill of goods for which (an index) so developed would be a price relative, owing to the lack of a simple common denominator in the expressions...’. It is only in the General Theory that Keynes

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was to tackle the problem of aggregation seriously and to propose what he felt to be a more promising method of measuring ‘output in general’ in terms of labour units (for further discussion, see Seccareccia, 1982, pp. 134–7). The problem of measurement notwithstanding, Keynes arrived at his particular formulation of the First Fundamental Equation by means of his definition of saving. Indeed, since S = Y* – PC QC and QT = QC + QI, then we get that:  Y* PC QC =   QT

  (QC + QI ) − S 

(17.5)

Assuming, as Keynes did implicitly in the Treatise, that the share of ‘normal’ income, Y*, accruing to the investment-goods sector is equivalent to the share of investment out of total output (QI /QT), and defining the multiplicative expression of these values Y*(QI /QT) as the cost of production of investment goods, I, then equation (17.5) above becomes  Y*  PC QC =   (QC ) + ( I '− S )  QT 

(17.6)

or, on a per unit basis,  Y* PC =   QT

 ( I '− S ) + Q C 

(17.7)

which is Keynes’s First Fundamental Equation. As presented by Keynes in the Treatise, this equation is but an identity that merely classifies in a specific fashion an actual economic phenomenon retrospectively. Indeed, it is a snapshot or ex post portrayal of an entire process that has already taken place during a certain lapse of time. Given the system’s history, the first term of the fundamental equation incorporates for Keynes all the relevant information that would have gone into formulating the expectations of economic agents at the beginning of a unit-period if all parameters of the system remained unchanged,9 while the second term reports what actually took place during the period. Whenever the flow of income in the investment-goods sector (I), financed by credit creation, exceeds the quantity of that amount of purchasing power which the community has withheld from spending on consumption during the period, then the price of consumption goods, PC, must exceed its ‘normal’ value given to us by the first term of the fundamental equation. A windfall profit, ΠC, will thus have arisen in the consumption-goods industry.10 In fact, since ΠC is, by definition, the difference between total sales proceeds and costs of production in the consumption-goods industry, we have  from which we then get

Q  Π C = PC QC − Y *  T   QC 

(17.8)

Keynes’s Treatise on Money and the General Theory



Π C = (Y * − S ) − (Y * − I ') = I '− S

289

(17.9)

which is, of course, the second term of the First Fundamental Equation. In much the same way, Keynes also derives his Second Fundamental Equation of the Treatise. If one would be prepared to abstract from Keynes’s conundrum of aggregating output (as in the one-commodity case), we can just as easily obtain his equation for the price level of output ‘in general’:  Y *  (I − S ) PT =  + Q T  QT 

(17.10)

where I = PI QI, the money flow of investment.11 Just like the First Fundamental Equation, this latter relation describes the basic underlying statement of the Treatise: total proceeds going to entrepreneurs in the system must be made up of two components, the expected proceeds (contained in Y*) and the unexpected proceeds or windfall profits (defined by I – S).12 These two equations are ‘instantaneous pictures’, to use Keynes’s expression (1936: vii), taken at a given moment in time. In themselves, they are no more dynamic in character than the ‘static’ quantity-theory equations of which Keynes was to become so critical. Indeed, as was emphasized in the Treatise: ... all these equations are purely formal; they are mere identities; truisms which tell us nothing in themselves.... Their only point is to analyze and arrange out material in what will turn out to be a useful way for tracing cause and effect,.... (Keynes, 1930, Vol. I, p. 138).



To go from mere tautologies to behavioural relations, Keynes makes a crucial assumption concerning his narrowly-defined term – ‘profit’. For a system to be at rest, he concludes that this term should have a zero value in equilibrium. That is,  ΠC = Π I = Π = 0 (17.11)  where Π I and Π are profits in the investment-goods sector and total profits respectively.13 Keynes (1930) was thus able to establish, by means of this strict Marshallian assumption for long-period equilibrium, the connecting link between the first and the second terms of the fundamental equations. This is a link which, as Shackle (1968, pp. iv–xviii) argued, forms the basis of Keynes’s sequence analysis – a technique that he had borrowed from both the Swedish writers and from Robertson (1926) (for a brief description of the Swedish sequence analysis, see Seccareccia, 1990, pp. 137–54). Any discrepancy between the volume of saving and the value of investment sets a process in motion. However, contrary to the Marshallian and, indeed, the classical tradition, as will be shown below, the time path that the system was presumed to follow was not a stable one. As soon as a discrepancy arises between I and S, this would trigger, for a time, a (constrained)

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cumulative process of the Wicksellian variety. This time path is carefully described in Keynes’s analysis of the ‘Credit Cycle’ in the Treatise of which we shall now seek to provide an outline.

17.3

Keynes’s Theory of the Inflationary Process and the Credit Cycle

Keynes’s fundamental equations of the Treatise allowed him to provide a particular typology of the possible sources of inflationary pressures. These sources pertain to either the first or second terms of the fundamental equations. To understand Keynes’s analysis, let us begin with some more definitions found in the Treatise:

and,

W* = the rate of (normal) earnings per unit of human effort, a = the coefficient of efficiency, w* = the rate of efficiency earnings,

such that w* = W*/a, whereby w* can be considered as the normal costs per unit of output. In W*, there would be included not only wages, salaries and supplementary labour income, but also dividends, interest payments by firms on their longer-term debts, and other elements of ‘normal’ return. At the same time, one would exclude windfall gains, some of which would emerge ex post as business retained earnings. Now, since for analytical purposes one can treat a = QT /LT, we then have that: w* =

* W * W LT = QT QT LT

(17.12)

From this, we can then modify appropriately the fundamental equations of the Treatise. For instance, the Second Fundamental Equation becomes: PT =

W * (I − S ) + a QT

(17.13)

with the condition for long-period equilibrium being that: PT = w*

(17.14)

As Keynes states it, ‘the long-period or equilibrium norm of the Purchasing Power of Money is given by the money rate of efficiency earnings of the Factors of Production; whilst the actual Purchasing Power oscillates below or above this equilibrium level according as the cost of current investment is running ahead of, or falling behind, saving’ (Keynes, 1930, Vol. I, pp. 152–3). Keynes’s discussion of the long-period norm is pure Marshallian comparative statics. Indeed, he does not attempt to offer any explanation of how the transition

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291

between equilibrium states takes place. For any ‘coup de main on the part of Trade Unions’, a ‘spontaneous’ rise in W* brings about a proportional shift in the longperiod norm (Keynes, 1930, Vol, I, p. 157). Similarly, a change in the coefficient of efficiency, a, due to technical change, would result in an inverse causal change in PC or PT. In general, therefore, the trend value or long-period norm of the price level is modified as a result of a ‘spontaneous’ or ‘induced’ change ‘either in the method of fixing wages or in the coefficient of efficiency’ (Keynes, 1930, Vol. I, p. 157). Keynes dubs this type of inflation (or deflation), which affects the first term of the fundamental equation, ‘Income inflation’. The form of its movement can be described as a non-oscillatory once-and-for-all disturbance in prices. Imposed diagrammatically on a presumed sinusoidal movement in prices, this disturbance can be portrayed as shown in Figure 17.1. In the figure below, prices are assumed to oscillate around a trend value, w*, unless some exogenous disturbance in money wages shifts the long-term value from w* to w*. Yet, Keynes (1930) provides very little analysis of the transition phase. Presumably, an increase in W* would affect not only the first term of the fundamental equations but also the second via its impact on the cost of producing investment goods, I. Given this type of obvious interdependence, how then can the system reach a new long-period position? No answer can be found within this comparative static framework that Keynes, unfortunately, was also to adopt in the General Theory. What we are told is merely that a new long-period norm ought to be the outcome of the process.14

PT (Index)

I>S

I<S

I >S

I<S

I>S

w* 100

w* time

Figure 17.1 Effect of income inflation on the oscillatory movement of prices

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While Keynes discussed in some details the possibility of an exogenous rise in remunerations, at one point in Vol. II of the Treatise he argues that the money rates of efficiency earnings are a ‘sticky’ factor in the fundamental equations, and thus considers such disturbances to be of relatively minor theoretical and practical importance (Keynes, 1930, Vol. II, p. 205). It is primarily the oscillatory movement around this trend path that is of critical significance. In other words, Keynes’s prime concern in the Treatise is the dynamic Wicksellian process analyzed within a business-cycle perspective that had become fashionable during the inter-war period. In agreement with the work of the over-investment theorists, behind this cyclical movement in prices and output is the critical role played by investment. Keynes was to label this accompanying seesaw movement in prices and output as the regular ‘Credit Cycle’. As will be shown, contrary to conventional wisdom, therefore, Keynes’s Treatise presents a fairly sophisticated model of the business cycle borrowed mainly from the Austro-Swedish writers of the period and from Robertson. Hence, even a superficial reading of the Treatise can never substantiate the view put forward by a number of orthodox writers that: ... the Treatise leads to a very strained reading of what seems to be a fairly straightforward example of pre-Depression thinking on business cycles. The main objective of the book is to try to understand fluctuations in economic activity about a secular trend in which real magnitudes are determined by the real considerations of neoclassical value theory and in which nominal prices are governed by the quantity theory of money (Lucas, 1980, p. 699; on the issue of neutrality, also Meltzer, 1988, pp. 63–4)

Nothing can be further from the truth than this textbook interpretation that depicts Keynes’s Treatise within the confines of some Patinkinesque dichotomy between the monetary and real sector. Despite its many shortcomings, as a number of writers have pointed out (see Bellofiore, 1992, and Realfonzo, 1998) Keynes’s work held a fully-integrated view of money and production which even Hawtrey (1932, p. 359) at the time had quite facetiously described as a ‘non-monetary theory of money’. This integration is best revealed in Keynes’s analysis of the ‘investment factors’ underlying his theory of the Credit Cycle. In much the same way, the traditional portrait of the Treatise in which supposedly is assumed, as Moggridge (1992, p. 484) presents it, ‘a “full employment” level of output with the adjustment to monetary influences occurring through changes in prices’ is also fundamentally problematic. As we shall see, a closer scrutiny of Keynes’s formal model of the ‘Credit Cycle’ in the Treatise would suggest that the mechanism of employment and output adjustments was very much there, although not emphasized to the extent found in the General Theory. In order to dispel any doubt about the inaccuracy of the above-mentioned interpretations of the Treatise, it becomes essential to provide a more precise description of his analysis of the Credit Cycle.

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For Keynes, as for the over-investment writers of the period, the initiating cause of the Credit Cycle could be any one of a number of exogenous nonmonetary disturbances that might modify entrepreneurs’ expectations of what is the ‘natural rate of interest’ (to use Wicksellian terminology) or, simply, the rate of profit. For instance, a technical innovation, a war, or even a shift in expectations about the future course of prices, may lead to anticipation of a higher rate of profit. A change in any of these parameters would drive the system out of its long-period equilibrium norm, of PC = PT = w*, and would result in a divergence between investment and saving. In all likelihood, this increased I or Iwould be financed by means of credit-money created endogenously within the banking system. Alternatively, and anticipating somewhat his monetary analysis in the General Theory, this increased investment may also be financed, Keynes (1930, Vol. I, p. 302) argues, ‘almost unnoticed, out of the general slack of the system, or may be supplied by a falling off in the requirements of the Financial Circulation without any change in the total volume of money’. In either case, Keynes assumes a fairly elastic monetary system. In the Treatise, Keynes classifies Credit Cycles into three Lindahlian categories that were in vogue during the late 1920s. The first and simplest model (to be named Model I), which may have misled writers to believe that Keynes had a fullemployment model, is that in which investment is exclusively in fixed capital and total output remains constant, so that what essentially occurs is a redistribution of resources in favour of investment-goods production. Given these restrictive assumptions, the effects of a disturbance can then be easily traced out. Let us assume that the exogenous shock affecting the relationship between the ‘money rate’ and the Wicksellian ‘natural rate’ occurs in period t0 and that, during the period, firms are able to obtain the necessary credit advances needed to finance investment in excess of ‘available’ saving. For convenience, we shall define our time-unit, t, as the period of time required by entrepreneurs to acquire the relevant information originating in the capital markets, obtain the necessary bank financing, and take the decision regarding investment. For analytical purposes, this unit period t would be considered similar to the Robertsonian ‘day’ or the Hicksian ‘week’, and would serve as our reference unit. If such an exogenous increase in the ‘natural rate’ were to occur, in period t1 factor resources previously employed in the consumption-goods sector are now suddenly withdrawn from the latter and shifted to the production of investment goods. Concurrently, as firms attempt to attract resources from the consumption-goods sector, the prices of investment goods will also be bid up in some proportion to the endogenous flow of creditmoney. We know, however, that the production of both consumption and investment goods can neither decline nor increase instantly. For a time, goods in process will continue to flow out of the consumption-goods sector. If we further assume, for simplicity of exposition, that firms do not hold any inventories of the various goods at period t0, then output will not decline in the consumption-goods sector before one full period of production of the consumption goods has elapsed. As a result, unless wages rise in either sector, consumer prices will start to increase

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only after one full period of production of the consumption goods that we shall assume to be equal to, say, two of our unit-periods (for a precise definition of Keynes’s concept of the ‘production period’, see Keynes, 1930, Vol. I, p. 280, and Vol. II, pp. 104–105). The analytics of this is depicted in Figure 17.2. Panel A shows that prices will change in relation to movements in the composition of output, as represented by changes in the structure of employment in Panel B. Indeed, from the beginning of the second period of production in the consumptiongoods sector (at t3) until the end of the period of production of the fixed capital (at, say, t6, in which case we are arbitrarily supposing the latter good’s period of production to be five unit periods), consumer prices will rise ultimately by the amount by which I, the cost of production of the new investment, exceeds the flow of saving, S. In other words, what Keynes was saying was that, given the assumption of constant output, and given money rates of earnings, any exogenous shift of resources from the production of consumption goods must necessarily bring about a reduction in real consumption by the same amount as the increase in investment. This can come about through voluntary saving at the end of the period of production of the consumption goods (t2), or through ‘forced saving’ (i.e., inflation) for the remaining period. This constant-output case was perfectly compatible with much of the analysis of the neo-Wicksellian writers of the period (see Seccareccia, 1990). In the diagram above, ‘t1–t3’ is the length of time for completing production of consumption goods, ‘t1–t6’ is the length of the period of production of the new investment goods, and ‘t1–t6’ is the period of inflation. However, as shown by the dotted lines in Figure 17.2, the rise in prices of consumption goods during the period ‘t3–t6’ is further influenced by whether or not the coefficients of efficiency differ between the two sectors. Indeed, to the extent that the investment-goods sector is more capital intensive than the consumptiongoods sector and, therefore, aI > aC, the rate of inflation in PC will be higher and the level of total employment, LT, would be lower than if aI = aC. As depicted in the Figure 17.2, the opposite would be the case when aI < aC. Moreover, Keynes also notes that, in this expansionary phase of the cycle, factor remunerations may also rise through competitive bidding by entrepreneurs. Although ‘Income Inflation’ may also appear during this process of expansion, these rising costs merely shift upwards w* to w*', and thus compound the effects of the underlying ‘Commodity Inflation’ which is reflected in changes in the second term of the fundamental equations. From period t6 , the process can pursue the following possible time path. If no additional exogenous disturbances come to dislodge the system from its original trajectory described above, then, from the end of the fixed capital’s production period, prices will continue to rise even if resources were somehow to move back immediately to producing consumption goods again. As shown in Figure 17.3, this inflation will persist until another full period of production in the consumptiongoods sector has expired. Indeed, by period t8, PC reaches a peak and begins to decline until, by period t10, consumer prices would have fallen back to their long-

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period norm. Unfortunately, Keynes does not explore these different avenues in his original analysis. Essentially, he leaves us at t6 and merely implies that prices should fall subsequently.15 Panel A: Prices PI

Pi

PCŽ Pc PC

t1

t2

t3

t4

t5

t6

time

Panel B: Employment LT ( a 1 < a c )

Li

LT

(a1=ac)

LTŽ ( a 1 > a c )

LC LC LCŽ LI

t1

t2

t3

t4

t5

t6

Figure 17.2 Initial time path of prices and employment

time

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Panel A: Trajectory of PC

PC

t1

t2

t3

t4

t5

t6

t7

t8

t9

t10

time

Panel B: Structure of Employment [if a1 = ac] Li LT LC

LI

t1

t2

t3

t4

t5

t6

t7

t8

t9

t10

time

Figure 17.3 Evolution of consumer prices and the composition of employment Implicit in Keynes’s original formulation are the usual assumptions of competitive markets with a high degree of mobility of factor resources. Otherwise, PC would not necessarily behave in the manner depicted above. Moreover, Keynes’s arguments retain a certain level of simplicity only on the assumption that there are two sectors and that within the two industries each competitive firm produces a homogeneous output with a given technology so as to guarantee that the production process within each sector is uniform in length. Between the two

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sectors, however, it becomes crucial that these lengths differ. Specifically, the length of the period of production in the investment-goods sector ought to exceed that in the consumption-goods sector. If this were not so, then the extent of the ‘Commodity Inflation’ would be less clear. While Keynes’s first model of the credit cycle (that we have just sketched) may tend to corroborate the view that the Treatise still stood very much in the Wicksellian constant output (or full-employment) world, the analytical framework of his second model clearly sets out the distinguishing characteristic of Keynesian thought. Indeed, while he begins with the same investment decision as the initiating cause in both Models I and II (i.e., investment in fixed capital), total output and employment is assumed to vary in the latter case. He believes this to be a much more reasonable supposition since workers cannot be shifted from sector to sector ‘at short notice’ as was assumed in Model I. In order to introduce more realism into his model of the Credit Cycle, Keynes (1930) thus makes the assumption of a fairly widespread ‘involuntary unemployment’ of factors at the initial phase of the cycle.16 He writes: This assumes, of course, that the factors of production are not fully employed at the moment when the Cycle begins its upward course; but then that generally is the case, whether as the result of the slump which had ensued on the previous cycle or for some other cause (Keynes, 1930, Vol. I, pp. 284–5).

In this primary phase of the credit cycle, any growth of employment ought to be reflected in a proportional increase of firms’ working capital by an amount equal to a multiple of the money wage. Except for the existence of a minor Robertsonian expenditure lag, as the overall wage bill rises, prices of consumption goods will begin to increase almost immediately in some proportion to the growth of employment, since I > S. Keynes describes this process as the primary phase of the cycle and it has emerged because of the increased investment arising from generally enhanced expectations of profits by entrepreneurs. The secondary phase of the economic expansion results from a separate set of conditions that are vital to the logic of his variable output model. The buoyant conditions now existing in the consumption-goods sector generate accelerator effects and spill over as further increases in demand for investment goods. This expansion in employment in the investment-goods sector then triggers a still further rise in the demand for consumption goods. The whole process thus takes the form of a cumulative expansion in both prices and employment in all sectors along the lines of the accelerator models put forth by such well-known overinvestment theorists as Aftalion (1913). It is during this phase of overall expansion that, according to Keynes, ‘Income Inflation’ is most likely to occur since the economy would be approaching full capacity utilization such that ‘in certain cases specialized factors of production will be fully employed,...’ (Keynes, 1930, Vol. I, p. 288). However, as long as prices are expected to rise further, firms will go increasingly into debt and ‘Commodity

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Inflation’ will persist or even heighten with the possible speculative hoarding of goods engendered by these swollen expectations. The tertiary phase, or what Keynes denotes as the ‘collapse’, is inevitable and ensues directly from this speculative build-up. In effect, as soon as commodities from the newly produced fixed capital start to gush out at ever increasing rates, the speculative bubble bursts and entrepreneurs begin to face windfall losses. Keynes provides two reasons as to why this should be so. Firstly, in the product market, the downward pressure on prices coupled with higher money earnings secured in the previous upswing will induce entrepreneurs to reduce production and to disinvest in both working and fixed capital. Secondly, as Keynes (1930, Vol. I, p. 304) points out, ‘the evaporation of the attractions of new investments’ consequent on the speculative outburst contributes to unhealthy developments in the money and financial markets. Presaging somewhat the analysis in the General Theory, the rise in the bearish sentiments in the financial markets will bring about a reduction in the volume of money destined for ‘Financial Circulation’ and thus a decline in total velocity. Inevitably, these developments would have further negative consequences on employment and investment. In much the same way as in the previous upswing, Keynes concludes that the downswing will also feed on itself, and that ‘the interval between the beginning of a downward swing on the other side of the equilibrium position and the beginning of the reaction may be connected with the length of [the productive] life of important capital-goods and, more generally, with the duration of the existing contracts between entrepreneurs and the factors of production,...’ (Keynes, 1930, Vol. I, p. 278). 17 Diagrammatically, the movement in Pc can be depicted in the following manner. Simplifying the exposition to the case where there is only ‘Commodity Inflation’ and deflation (i.e., excluding ‘Income Inflation’ and the spillover effects on wages arising during the secondary phase of the cycle), the movement in prices and output should follow some simple pattern as shown in the diagram below. In Figure 17.4, we again have that ‘t1–t3’ = ‘t6–t8’ = ‘t8–t10’ = the composite period of production of consumption goods, ‘t1–t6’ = the period of production of the fixed capital, and ‘t8–t12’ = the length of life of the fixed capital equipment and/or the duration of labour contracts. In his algebraic presentation of this model, Keynes shows how, by including the various spillover effects, the fluctuations are smoothed out and come to form a more regular sinusoidal pattern. Finally, his Model III of the Credit Cycle represents to all intents and purposes only a trivial departure from his critical Model II. Indeed, in this third model, factor resources previously unemployed are now committed to the production of consumption goods (i.e., investment in inventories) instead of fixed capital. However, on the logical assumption that the composite average period of production in the consumption-goods sector is somewhat shorter than in the investment-goods sector, the ensuing Credit Cycle will be of a shorter duration and amplitude. Much like Wicksell before him (see Wicksell, 1953, pp. 58–78 on inventory adjustment over the cycle), Keynes considered this third model to be quite characteristic of the Credit Cycle, although not in its purest form, but most

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commonly as a slight mixture of the latter two. From this elaborate analysis, Keynes (1930) concluded that it is the duty of the central banking authorities to mitigate the violent fluctuations in prices and output, typical of the Credit Cycle, via a Wicksellian interest rate policy.





PC

t1 t2 t3 t4 t5 t6 t7 t8 t9 t10 t11 t12 t13 t14 t15 t16 t17 t18 t19 t20 t21

time

Figure 17.4 Cyclical movement of PC over a complete credit cycle 17.4

The Link Between the Treatise and the General Theory: Another Possible Interpretation?

Despite some of the above-mentioned difficulties with his fundamental equations, Keynes’s Treatise seeks to explain the dynamic properties of the fundamental variable of his system – investment. Investment is both a creator of profit, in the narrow sense defined by Keynes, and, at the same time, determined by it. Indeed, by means of a rudimentary period analysis, he demonstrates how an initial investment decision normally gives rise to a set of expectations that may trigger further changes in the investment variable over a range of unit periods. These time paths can be sketched out on the basis of Keynes’s various assumptions as to the nature of the Credit Cycle. Aggregate price formation is intimately linked with investment activity. It is primarily by means of the price variable that, for instance, unanticipated changes in profit may take place. In the competitive environment about which Keynes was theorizing in the Treatise, prices can be shown to follow a sequential pattern of the neo-Wicksellian type. Because of the resulting changes in the composition of output, prices of consumption goods would usually chase, with a certain time lag,

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any variation in investment-good prices. Movements in investment activity, fuelled by sequential adjustments in expectations, are thus the causa causans behind all cyclical variations within Keynes’s monetary system of production in the Treatise. This dynamics of the Treatise rather forcibly coalesces into the comparative statics of the General Theory. While in the former work Keynes attempts to understand how changes in expectations affect movements in investment activity, in the latter book he simply parameterizes this state of expectations and thus takes as given the level of the capital stock. The bulk of the General Theory is basically concerned with Marshallian short-period comparative static analysis in the context of exogenous long-term developments. While in the General Theory we are brutally left to wonder what determines this state of long-term expectations, in the Treatise expectations are themselves endogenous to this wavelike pattern of behaviour inherent to the logic of the Credit Cycle. Yet, there are obvious connections between these two works. This is especially noteworthy in his discussion of financial markets where the arguments are almost identical. As Marcuzzo (1998) points out, the Keynes of the General Theory frequently tries to impress this view on us. For instance, in his Chapter 22 on the Trade Cycle, he makes it reasonably clear that the details of his argument ought to be found in Book IV of the Treatise (see Keynes, 1936, p. 319). As much as the General Theory was a struggle to escape from received wisdom, it was by no means a significant break from the Treatise. Quite generally, Keynes attempts to solve in his General Theory any conceptual conundrums that were evident in the Treatise without ever rejecting the essence of his former work. Indeed, in addition to proposing a less ambiguous method of aggregation whereby he defines all his ‘real’ variables in terms of labour units, among many other things, Keynes also substitutes the term ‘wage-unit’ for his rather vague ‘rate of earnings per unit of human effort’, and for Wicksell’s dubious ‘natural rate of interest’ he substitutes a purely subjective-psychological variable – ‘the marginal efficiency of capital’.18 In carefully examining the two works, one acquires the obvious impression that, with some inevitable modifications, the General Theory could be incorporated into the Treatise, perhaps, as an additional volume on the workings of a particular phase of the Credit Cycle. As the diagram below tries to highlight, one essential difference between these two works pertains to the time framework of their analysis. In the presentation of the theory of the Credit Cycle, the Treatise takes us through a logical process covering a complete cycle (represented by the full length ‘T’ in Figure 17.5). Conversely, in the General Theory, he limits himself to the notional space ‘-i’ representing an interval of logical time within which the level of investment, the capital stock and the state of long-term expectations are all given. In this respect, one may conceive the time-space of Keynes’s Credit Cycle in the Treatise as merely a long sequence of such Marshallian short periods of the General Theory.19 The investment process, propelled forward by revisions of expectations, supplied the connecting link and allowed time to unfold and proceed unidirectionally as a temporal sequence of such notional states adopted by Keynes in his 1936 work.

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Stock of Capital Marshallian Short Period τi [with ∆K = 0

Trend Line

τ1 τ2 τ3 τ4 τ5 τ6 τ7 τ8 τ9 τ10 τ11 τ12 τ13 τ14 τ15 τ16 τ17 τ18 τ19 τ20 τ21 Τ time

Figure 17.5 Logical time constructs and cyclical movement in capital stock To first present a static short-period analytical framework where longer-term parameter values are given to us for the major portion of the General Theory, then to fall into a discussion of some of the determinants of these long-term values in his ‘Notes on the Trade Cycle’, and, finally, to refer back to the Treatise for some of the details regarding the cycle, all of this seems to be rather clear with regard to the object that Keynes had in mind. His pondering over the Treatise at the most discrete moments, so as to ensure that some of the logical errors of the Treatise appear to be fully resolved, would imply that Keynes perhaps hoped to erect a more complete behavioural model of the economy applicable to varying conditions and, in particular, to different analytical time frameworks. It is thus in this sense that one can explain Keynes’s insistence on constructing a ‘complete theory of a Monetary Economy’ (Keynes, 1936, p. 293). Contrary to the Treatise, however, why did Keynes of the General Theory emphasize primarily output rather than price adjustments? Was the General Theory ‘Depression Economics’ with Hicksian fix-price assumptions? While there may inevitably be an element of truth in the statement that Keynes became less interested in price movements at a time when output adjustments were of such significant magnitude in the 1930s, there may also be another important reason why Keynes of the General Theory placed less emphasis on price adjustments unless, of course, they arose out of changes in the wage-unit. As various commentators have argued (see, among others, Lavoie, 1985), inflation in the General Theory pertains primarily to the behaviour of wage costs per unit of output. At less than full employment, an increase in effective demand would ‘spend itself partly in increasing the cost-unit and partly in increasing

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output’ (Keynes, 1936, p. 303). However, at full employment, he continues: ‘When a further increase in the quantity of effective demand produces no further increase in output and entirely spends itself in an increase in the cost-unit fully proportionate to an increase in effective demand, we have reached a condition which might be appropriately designated as one of true inflation’ (Keynes, 1936, p. 303).20 Hence, it is a matter of the degree of elasticity of wage changes to labour demand which would ultimately determine whether or not an economy enters a state of ‘true inflation’. Whether it be the traditional post-W.W.II Keynesians and advocates of what became the Phillips Curve approach or whether it be some of the more fundamentalist Post-Keynesians who pointed, instead, to the largely ‘autonomous’ nature of the wage-unit, such as Weintraub (1978), the focus of the analysis of inflation was dramatically narrowed and restricted to what in the Treatise was a mere feature of ‘Income Inflation’. This shift of emphasis in favour of ‘Income Inflation’ and/or output adjustment (accompanied by the almost complete exclusion of inflation arising because of ‘investment factors’) may have much to do with the peculiar analytical framework of the General Theory. The Marshallian ‘short period’ was a logical time construct that, although being a powerful tool, highly restricted Keynes’s field of research in the General Theory. Within the Marshallian short period, increases in effective demand could only correctly be analyzed if they lead to a change in output of the consumption-goods sector. This is because, at the macroeconomic scale, changes in output of the investment-goods sector would analytically have taken Keynes outside of the theoretical confines of Marshall’s short period within which the capital stock is presumed fixed. Given the constraint of his logical time framework, only variations of output in the consumption-goods sector could be legitimately analyzed in which the period of production was supposed shorter than that of the investment-goods sector. If the temporal toile de fond of the Treatise were to be applied to the General Theory, one would be forced to infer that the Marshallian short period adopted by Keynes would have to be a very precise time dimension. For the macroeconomic application of this Marshallian time concept, its length ought logically to be shorter than the period of production in the investment-goods sector (so that the aggregate capital stock would remain unchanged during the period) but longer than the period of production in the consumption-goods sector (so as to permit overall adjustments in output).21 Given the methodological straitjacket within which he had placed himself in the General Theory, one could perhaps easily surmise why, except for changes in the wage-unit, Keynes did not address what had been the principal concern of the Treatise – the link between inflation and investment. This latter connection was one of the important casualties not only of this restrictive Marshallian methodology that he had adopted but also of the early post-war success of the General Theory. With the exception of the monetarist revival of the quantity theory, the broad Keynesian literature on inflation during the fifties and sixties became almost exclusively focused on the role of the wage-unit as it is affected by conditions in the labour market within the framework of the Phillips

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Curve. The original Treatise relation between investment and macroeconomic price formation virtually vanished from the literature.22 As partly summarized in Seccareccia (1984), only during the last few decades has this important link been revived by Post-Keynesian writers such as Graziani (1981, 1987, 1990, 1994), as well as in the writings of Eichner and Harcourt who during the 1970s formally established a connection between oligopolistic pricing behaviour and investment, in this case, via firms’ targeting of internal finance. However, the richness of some of the original Treatise interpretation, that emphasized the relation between macroeconomic price formation and changes in the temporal dimension of production, has completely disappeared, ironically even among more contemporary Austrian writers (see van Zijp and Visser, 1995).

Notes *

1

2

3 4

5 6

Mario Seccareccia is a Full Professor in the Department of Economics at the University of Ottawa, Canada, as well as lecturer at the Labour College of Canada. His areas of teaching and research include the history of economic thought, monetary economics, labour economics, and Canadian economic history. Without implicating them, the author wishes to acknowledge the helpful comments provided by Robert Dimand, Frédéric Hanin, Marc Lavoie, and Alain Parguez. Robertson’s fellowship dissertation had been primarily under the supervision of Keynes and Walter Layton (see Laidler, 1995, p. 153). As to Wicksell’s work, it was probably known to Keynes because of Wicksell’s article published in the Economic Journal in 1907. It had, however, not achieved the popularity found on the European continent. Indeed, it was, perhaps, not before the late 1920s that Keynes had been seriously exposed to it because of its growing popularity in continental Europe. He writes: ‘Subject to a certain time lag, over-investment must raise commodity prices because it increases the stream of buying faster than the stream of liquid goods available to be bought – this is the meaning of over-investment. Subject to time lag, therefore, the course of prices proves whether or not there is over-investment (I am assuming that there is no observable tendency for costs of production to rise)’ (Keynes, ‘Is there inflation in the United States?’, 1928, Collected Writings (CW), 1973, Vol. 13, p. 54). In a letter to C. Snyder on October 2, 1928, Keynes makes this distinction: ‘Overinvestment in particular directions is quite a different thing from the general overinvestment which is associated with inflation’ (Keynes, CW, 1973, Vol. 13, p. 64). In a strictly Robertsonian manner, Keynes argues that ‘Price instability must result whenever the rates of saving and of investment part company. But it is only the existence of a currency and banking system (i.e., of money) which makes it possible that they should part company? (Keynes. ‘A variorum of drafts of Chapter 23 of the Treatise,’ CW, 1973, Vol. 13, p. 93). Keynes (1933, p. 701) wrote: ‘If so, it may be that my definition of saving is equivalent to that as defined by Mr. Robertson, aggregated from a base period when business profits may be considered to have been in some sense normal’. Keynes (1930) embraced the Marshallian concept of ‘normal’ costs and, therefore, defined normal income as ‘that rate of remuneration which, if they were open to make new bargains with all the factors of production at the currently prevailing rates of earnings, would leave them under no motive either to increase or to decrease their scale of operations’ (Keynes, 1930, p. 125).

304 7

8

9 10

11

12

13 14

15

Money Credit and the Role of the State An excellent summary statement of this relationship is given by R.F. Kahn (1929) who, perhaps, more than anyone else, may have debated Wicksell’s ideas with Keynes during the long gestation period of the Treatise. In a letter to Keynes, he wrote: ‘Profits are, in the first place, an effect rather than a cause. It would be absurd to add them to savings, because if this were done, it would be impossible to fall off (assuming that no portion of profits is spent...). They are indeed, “automatic lacking”,... and as such cannot be regrouped with savings’ (Kahn, ‘Letter to Keynes, December 17, 1929, CW, 1973, Vol. 13, p. 121). A more extensive presentation of the link between Keynes’ concept of saving and that of Robertson is given by Keynes in his ‘Notes on the definition of saving’ (1932, CW, 1973, Vol. 13, pp. 275–89). For instance, Keynes (1931, p. 419) argues: ‘I do not, by the way, understand the relevance of the quantity equation with which Mr. Robertson concludes his #5. We are discussing the relation between prices of consumption goods and of investment goods... But neither of these price levels occur in his equations, which are concerned with the price level of output as a whole and the price level of transactions’. As was restated by Hansen and Tout (1933, p. 125), ‘the first term... represents the normal long-run tendency of the price level and it is not liable to sudden changes’. Since the fundamental equation is an ex post concept, this prompted Hawtrey (1932) to argue that one cannot breathe any causality into the relation. For instance, he wrote: ‘... a difference between savings and investment cannot be regarded as the cause of a windfall loss or gain, for it is the windfall loss or gain’ (Hawtrey, 1932, p. 349). As we shall see, this is no more equivocal than giving a causal role to the money stock in the quantity equation for determining prices. It is all a matter of the appropriateness of the underlying theoretical framework in which the relation is embedded. Equation (17.10) is obtained as follows. Since PTQT = PCQC + PIQI or, on a per unit basis, that PT = (PCQC /QT) + (PIQI /QT), then substituting for PCQC, one obtains PT = (Y* – S)/QT + PIQI/QT, which with some minor re-organization becomes equation (17.10) above. Admittedly, the concepts of expected and unexpected (or windfall) are questionable concepts in Keynes’s Treatise since ‘expected’ pertains to the Marshallian notion of ‘normality’ and are therefore of relevance in a ‘static’ framework of analysis. Surely, entrepreneurs could ‘expect’ above normal profits during a particular period! In this case, Keynes’s ‘windfalls’ in the Treatise would actually include both expected (in the sense of above normal profits) and the purely unexpected. Several writers, such as Hayek (1931, Part I, pp. 282–4), and Marget (1938, Vol. I, pp. 38–40), had criticized Keynes for the static nature of his equations. One is abstracting from some very important issues in the determination of profits in the Treatise raised by Vallageas (1986, 1996). The only discussion about the possible transition phase from w1* to w1*′ can be found with respect to the reactions of the monetary authorities. Keynes argues that the monetary authorities can do one of two things in a situation of Income Inflation. Firstly, they can accommodate the demand for credit-money arising from firms’ needs for financing their working-capital requirements. The effect of this policy would be to allow prices to rise proportionally with wages without any significant impact on the net income receipts of entrepreneurs. Or secondly, within a quantity theory setting, the monetary authorities could try to limit monetary expansion. In this case, the second term of the fundamental equations would also be affected and both the income velocity of money and unemployment may change in the process. See, for instance, Keynes (1930, Vol. I, p. 285). In addition, Keynes does not define the form of his fixed capital investment. For example, if his fixed capital happened to have been a commercial building, then chances are that consumer prices could theoretically fall back to their initial level at t10. If,

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18

19 20

21

22

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instead, the fixed capital good produced was a more efficient machinery to be used in the consumption-goods sector, then PC may be forced to take a much steeper dive since ac would also be affected by the investment process, along later Kaldorian lines. For instance, in his criticism of D.H. Robertson over the economic losses due to deflation, Keynes (1930) describes the accompanying loss in output as derived from ‘involuntary unemployment’ (see Keynes, 1930, Vol. I, p. 295). It is interesting to notice in the above quotation that there are still a few examples in the Treatise (as in his latter statement in the above quotation) where Keynes gives some role to the neoclassical mechanism for regulating unemployment. However, just one year after the publication of the Treatise, Keynes rejected outright the neoclassical mechanism of wage adjustment in clearing the labour market. See Keynes, ‘An Economic Analysis of Unemployment’ (1931, CW, Vol. 13, 1973, p. 369). Keynes’s recantation in his ‘Preface’ to the General Theory that, in the Treatise, he had ‘failed to deal thoroughly with the effects of changes in the level output’ (1936, p. vii), should in no way lead the reader to think that he had necessarily rejected his analysis of output adjustment in the Treatise. One would thus agree with Marcuzzo (1998) and Dimand (1988, p. 44) when the latter concludes that ‘Keynes’ development from the Treatise to the General Theory can thus be seen as a continuing struggle to remedy deficiencies in the earlier work and to round out its analysis’. There does not appear to be any major break between the two works. This is the sense, for instance, in which one can interpret Asimakopulos’s insistence on linking a series of such short periods. See, for instance, Asimakopulos (1978, pp. S3S10 and 1991, p. 9). This view of inflation prompted Hicks to remark that Keynes’s theory seems ‘to give the impression that there are just two ‘states’ of the economy: a ‘state of unemployment’ in which money wages are constant, and a ‘state of full employment’ in which pressure of demand causes wages to rise’ (Hicks, 1974, p. 60) A close reading of Keynes would suggest that such is not true. For a defense of Keynes, see, for instance, Kahn (1978, p. 555). There are other serious problems with the macroeconomic application of Marshallian partial equilibrium analysis that numerous writers have addressed, especially in reference to Keynes’s aggregate demand/supply analytics. For an interesting defense of Keynes’s approach when pitted against conventional general equilibrium theory, see Chick (1985, pp. 196-7). Another important exception to the ones to be discussed below is the work by Parguez (1994) who develops a variant of the Treatise model of inflation. He asserts, for instance, that ‘The existence of a state of full employment is not a pre-condition for inflation, the latter of which merely depends upon the relative importance of the rate of investment’ (Parguez, 1994, p. 14).

References Aftalion, A. (1913), Les Crises Périodiques de Surproduction, Paris: Marcel Rivière et Cie. Amadeo, E.J. (1989), Keynes’s Principle of Effective Demand, Aldershot, U.K.: Edward Elgar Publishing. Asimakopulos, A. (1978), ‘Keynesian economics, equilibrium, and time’, Canadian Journal of Economics, 11(4), Supplement (November). Asimakopulos, A. (1991), Keynes's General Theory and Accumulation, Cambridge: Cambridge University Press.

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Bellofiore, R. (1992), ‘Monetary macroeconomics before the General Theory: the circuit theory of money in Wicksell, Schumpeter and Keynes’, Social Concept, 6(2). Chick, V. (1985), ‘Time and the wage-unit in the method of the General Theory: history and equilibrium’, in T. Lawson and H. Pesaran (eds), Keynes' Economics, Methodological Issues, Armonk, N.Y.: M.E. Sharpe Inc. De Vroey, M. (2000), ‘Marshall on equilibrium and time: a reconstruction’, European Journal of the History of Economic Thought, 7(2). Dimand, R.W. (1988), The Origins of the Keynesian Revolution, The Development of Keynes' Theory of Employment and Output, Stanford, Cal.: Stanford University Press. Ertürk, K.A. (1998), ‘From the Treatise to the General Theory: the transformation of Keynes's theory of investment in working capital’, Cambridge Journal of Economics, 22(2). Eshag, E. (1963), From Marshall to Keynes, An Essay on the Monetary Theory of the Cambridge School, Oxford: Basil Blackwell. Fontana, G. (2003), ‘Keynes’s Treatise on Money’, in J.E. King (ed.), Elgar Companion to Post Keynesian Economics, Cheltenham, U.K.: Edward Elgar Publishing. Graziani, A. (1981), ‘Keynes e il Trattato sulla moneta’, in A. Graziani et alii (eds), Studi di economia keynesiana, Napoli: Liguori. Graziani, A. (1987), ‘Keynes' finance motive’, Économies et sociétés, 21(9). Graziani, A. (1990), ‘The theory of the monetary circuit’, Économies et sociétés, 24(6). Graziani, A. (1994), La teoria monetaria della produzione, Arezzo: Banca Popolare dell'Etruria e del Lazio. Haberler, G. (1937), Prosperity and Depression, A Theoretical Analysis of Cyclical Movements, Geneva: League of Nations. Hansen, A.H. (1932), ‘A fundamental error in Keynes's 'Treatise on Money’, American Economic Review, 22(3). Hansen, A.H. and H. Tout (1933), ‘Annual survey of business cycle theory: investment and saving in business cycle theory’, Econometrica, 1. Hart, A.G. (1933), ‘An examination of Mr. Keynes's price-level concepts’, Journal of Political Economy, 41(5). Hawtrey, R.G. (1932). The Art of Central Banking, London: Longmans, Green & Co. Hayek, F.A. (1931), ‘Reflections on the pure theory of money of Mr. J.M. Keynes’, Part I. Economica, 2(33). Hayek, F.A. (1941), The Pure Theory of Capital, London: Macmillan. Hicks, J.R. (1967), ‘A note on the Treatise’, in Critical Essays in Monetary Theory, Oxford: Blackwell. Hicks, J. (1974), The Crisis in Keynesian Economics, Oxford: Basil Blackwell. Kahn, R.F. (1978), ‘Some aspects of the development of Keynes's thought’, Journal of Economic Literature, 16(2). Kahn, R.F. (1984), The Making of Keynes's General Theory, Cambridge: Cambridge University Press. Keynes, J.M. (1913), ‘How far are bankers responsible for the alterations of crisis and depression?’, in D.E. Moggridge (ed.), The Collected Writings of John Maynard Keynes, vol. 13, London: Macmillan, 1973.

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Keynes, J.M. (1923), A Tract on Monetary Reform, London, Macmillan; also in D.E. Moggridge (ed.), The Collected Writings of John Maynard Keynes, vol. 4, London: Macmillan, 1971. Keynes, J.M. (1924), ‘Draft of chapter I of the Treatise, November 1924’, in D.E. Moggridge (ed.), The Collected Writings of John Maynard Keynes, vol. 13, London: Macmillan, 1973. Keynes, J.M. (1928), ‘Is there inflation in the United States?’, in D.E. Moggridge (ed.), The Collected Writings of John Maynard Keynes, vol. 13, London: Macmillan, 1973. Keynes, J.M. (1930), A Treatise on Money, vols I-II, New York: Harcourt, Brace and Co.; also in D.E. Moggridge (ed.), The Collected Writings of John Maynard Keynes, vols. 56, London: Macmillan, 1971. Keynes, J.M. (1932), ‘Notes on the definition of saving’, in D.E. Moggridge (ed.), The Collected Writings of John Maynard Keynes, vol. 13, London: Macmillan, 1973. Keynes, J.M. (1933), ‘Mr. Robertson on 'saving and hoarding’, in D.E. Moggridge (ed.), The Collected Writings of John Maynard Keynes, vol. 13, London: Macmillan, 1973. Keynes, J.M. (1936), The General Theory of Employment, Interest and Money, London: Macmillan and Co.; also in D.E. Moggridge (ed.), The Collected Writings of John Maynard Keynes, vol. 7, London: Macmillan, 1973. Laidler, D. (1995), ‘Robertson in the 1920s’, European Journal of the History of Economic Thought, 2(1). Lavoie, M. (1985), ‘Inflation, chômage et planification des récessions: La 'Théorie générale' de Keynes et après’, L'Actualité économique, 61(2). Lindahl, E. (1939), Studies in the Theory of Money and Capital, New York: Rinehart & Co. Lucas, R.E. (1980), ‘Methods and problems in business cycle theory’, Journal of Money, Credit and Banking, 12(4), Part 2. Machlup, F. (1935), ‘Professor Knight and the “period of production”’, Journal of Political Economy, 43(5). Marcuzzo, M.C. (1998), ‘From the “fundamental equations” to “effective demand”: continuity or change?’, paper presented at the History of Economics Society Conference, at the University of Quebec, Montreal (June). Marget, A.W. (1938), The Theory of Prices, vol. I, New York: Prentice-Hall. Meltzer, A.H. (1988), Keynes's Monetary Theory, A Different Interpretation, Cambridge: Cambridge University Press. Moggridge, D.E. (1973), ‘Chapter I: prologue’, in The Collected Writings of John Maynard Keynes, vol. 13, London, Macmillan Press. Moggridge, D.E. (1992), Maynard Keynes, An Economist's Biography, London/New York: Routledge. Opie, R. (1931), ‘Marshall's time analysis’, Economic Journal, 41(162). Parguez, A. (1994), ‘Full employment and inflation’, Working Paper No. 9424E, Department of Economics, University of Ottawa. Patinkin, D. (1976), Keynes' Monetary Thought: A Study of Its Development, Durham, N.C.: Duke University Press. Realfonzo, R. (1998), Money and Banking: Theory and Debate (1900–1940), Chelteham, U.K.: Edward Elgar Publishing.

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Robertson, D.H. (1914), ‘Some material for a study of trade fluctuations’, Journal of the Royal Statistical Society, January. Robertson, D.H. (1915), A Study of Industrial Fluctuation, London: P.S. King & Son Ltd. Robertson, D.H. (1926), Banking Policy and the Price Level, London: P.S. King & Son Ltd. Seccareccia, M. (1982), ‘Keynes, Sraffa et l'économie classique: le problème de la mesure de la valeur’, L'Actualité économique, 58(1-2). Seccareccia, M. (1983), ‘A reconsideration of the underlying structuralist explanation of price movements in Keynes’ “Treatise on Money”’, Eastern Economic Journal, 9(3). Seccareccia, M. (1984), ‘The fundamental macroeconomic link between investment activity, the structure of employment, and price changes: a theoretical and empirical analysis’, Économies et sociétés, 18(4). Seccareccia, M. (1990), ‘The two faces of neo-Wicksellianism during the 1930s: the Austrians and the Swedes’, in D. Moggridge (ed.), Perspectives in the History of Economic Thought, vol. 4, Aldershot, U.K.: Edward Elgar Publishing Ltd. Seccareccia, M. (1992), ‘Wicksellianism, Myrdal and the monetary explanation of cyclical crises’, in G. Dostaler et alii (eds), Gunnar Myrdal and His Works, Montreal: Harvest House. Shackle, G.L.S. (1967), The Years of High Theory, Cambridge: Cambridge University Press. Shackle, G.L.S. (1968), Expectations, Investment, and Income (Second Edition), Oxford: Oxford University Press. Spiethoff, A. (1923), ‘Business cycles’, International Economic Papers, 3(1953). Vallageas, B. (1986), ‘Le problème de la nature du profit et de son aggrégation dans le Traité sur la monnaie et la Théorie générale’, Économies et sociétés, 20(8-9). Vallageas, B. (1996), ‘L'apport de l'analyse financière des flux à la théorie post-keynésienne des circuits et à la mesure des profits’, Économies et sociétés, 28(2-3). van Zijp, R., and H. Visser (1995), ‘On the non-neutrality of mathematical formalization: Austrian vs. new classical business cycle theories’, in G. Meijer (ed.), New Perspectives on Austrian Economics, London: Routledge. Weintraub, S. (1978), Capitalism's Inflation and Unemployment Crisis, Reading, Mass.: Addison Wesley Wicksell, K. (1907), ‘The enigma of business cycles’, International Economic Papers, 3(1953).

PART IV PRODUCTION AND INCOME DISTRIBUTION

Chapter 18

The Democratic Firm as a Public Good

*

Bruno Jossa

18.1

Introduction

Analysing economic trends in Italy and the fundamentals of the country’s economy in a paper dated 1975, Augusto Graziani categorises that period as ‘one of persisting depression’ and emphasised that ‘business profits were constantly dwindling as a result of the wage pressure’ caused by a ‘mounting conflict between employers and the working class’. At the end of his analysis he posed the overriding question of the future evolution of, and possible solutions to, social conflict in Italy at the time. From the employers’ perspective, he argued, ‘business profits are the main source of investment financing’, and this means that wage pressure and the resulting decline in bottomline results will inevitably slow down accumulation and thereby cause economic stagnation. In Marxian theory, conversely, ‘every time workers strive to curb employer profits, they will automatically dispossess the class of capitalists of part of their means of production’, which entails that the ultimate aim of workers’ demands for higher wages is to do away with capitalism. In point of fact, Graziani also discussed a third, intermediate view, in which the working class is assigned a constructive, as opposed to a disruptive, role. The rationale behind this approach is that working class struggles are actually aimed to ‘force through a reorganisation of the economic system along lines that will both meet the ends of employers … and reflect the needs of the working class’. And the latter’s goals, he clarified, are not only higher wages and better standards of living, but also a much more broadly democratic political context and ‘far more effective participation in the decisionmaking processes of firms’ (see Graziani, 1975, pp. 5–8). Of the three above-mentioned approaches, Graziani shared and continues to endorse both the second and mainly – albeit with scant prospects of hope – the third, to which he has so far devoted the best of his scholarly endeavours. As we set out to celebrate Augusto Graziani’s academic work and professional and civic commitment, it seems appropriate to devote this chapter to the subject of democracy within the firm, bearing in mind that whenever this goal is consistently pursued, it becomes a political objective targeted towards achieving both ‘more effective worker participation in the decision-making processes of firms’ and a new form of social organisation entailing the abolition of capitalism.

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Economic Democracy and Spontaneous Growth

In recent economic debate, the efficiency of democratic (or labour-managed) firms has been called into question time and again, though none of the objections so far raised have proved decisive. Accordingly, it seems possible to argue that the scant concern of economic theorists with democratic firms to this day stems from their assumption that the slow pace at which the cooperative movement has been making headway (despite its origin back in time) is due to inadequate efficiency levels of labour-managed firms as such or to obstacles inhibiting their spontaneous growth. This explanation of the scant concern with democratic firms in today’s mainstream literature is confirmed by the assumption of economists that what benefits society will inevitably assert itself sooner or later, whereas what does not assert itself spontaneously cannot be advantageous for the community as a whole. While it is true that this is the typical approach of economic liberalists and supporters of ‘social Darwinism’ (see, for example, Nozick, 1974, pp. 314–17 and Williamson, 1985, pp. 265–8), a less radical version of this view is broadly endorsed even by academics who do not think of themselves as liberalists. Putterman, for instance, who dealt with labour-managed firms in several essays, holds that, given the absence of legal barriers to prevent workers from founding firms entirely run by themselves, this kind of firm will make its appearance in market economies as soon as its advantages exceed the costs involved, as perceived by workers (see Putterman, 1990, p. 161). 1 Nonetheless there are strong reasons for arguing that the social benefits associated with democracy within the firm are such that its advancement should be furthered even in situations where it is slow to emerge spontaneously. Indeed, greater worker participation in the firm’s decisions, which is tantamount to more economic democracy, can be rated as a benefit that workers may well be expected to pursue at the price of lesser efficiency or a concession that firms can be assumed to make to their workers in order to boost efficiency. Be that as it may, as there is little doubt that worker management – like justice or education – is a ‘merit good’ working to the advantage of private individuals and the general public alike, it may be convenient to appraise the pros and cons of economic democracy by weighing its private costs and benefits against the corresponding costs and benefits for the community as a whole.

18.3

Democracy as a Private Good

The contention that economic democracy is a good in itself, irrespective of its results, is often termed a self-evident truth which needs not be supported by detailed argumentation (see, for example, Dahl, 1985, p. 153 and Bowles and Gintis, 1986, pp. 3–4). There is no denying that the power position inherent in decision-making, i.e. in the exercise of sovereignty over a group, is a highly

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rewarding one because the decision-maker feels free from any constraints stemming from other people’s decisions. Hayek is one of the authors who most forcefully identified freedom with absence of subjection to other people’s decisions (see, for example, Hayek, 1960, chapter I). From this, it obviously follows that the importance of economic democracy lies in its ability to meet such a fundamental need as man’s desire for freedom and self-determination.2 One of the advantages of democracy within the firm is, quite naturally, its broader scope for meeting worker requirements. One argument in support of this assumption runs as follows: while it is generally in the best interests of capitalistic firms to satisfy the preferences and requirements of their workers, we know that they consider the needs of marginal – not average – workers. A telling example is a resolution concerning the introduction of a given safety device. If marginal workers (i.e. those indifferent to the option whether or not to accept the job) are young people wishing to earn an income as soon as possible and thus willing to take risks for the sake of obtaining just any job, the firm concerned will not think it worthwhile to install the safety device (to which these workers can be assumed to attach little, if any, importance). On the contrary, if the firm were run by the workers themselves, the resolution would be put to the vote and the opinion of the majority would prevail (Hansmann, 1996, pp. 30–31). In this connection, it is worth noting that while democratically made choices reflect the preferences of the group’s median member, the most efficient solution would be the one endorsed by the average member (provided always such a one can be defined); and the preferences of the median member may widely diverge from those of the average member (see Hansmann, 1996, p. 40). The exercise of discretionary power on the part of workers is both an invaluable good and one obtainable at low direct costs (for example premises to hold meetings in). As mentioned above, from this it follows that the actual efficiency level of a democratic firm will never be correctly appraised if the ‘freedom’ associated with it is not given proper consideration. Moreover, and this is the crux of the matter, as economic democracy is in many respects a ‘merit’ or ‘public’ good (see below), the labour-managed firm will generate both greater satisfaction for its direct workforce and, simultaneously, appreciable external economies, advantages for those not directly involved in the firm’s production processes. Confuting the idea that economic democracy can be obtained at no (or little) direct cost, there are some who argue that vesting decision-making power entirely and exclusively in workers does have a price, in that it deprives investors of this power. In Hansmann’s view, for instance, shareholder-managed firms are no less democratic and the right approach to the problem would rather be to contend that capitalistic and democratic firms respectively confer power on one of the two main actors of production activity, workers and investors. As a result, there would be ample scope for contending that the ‘fairer’ – or, in any case, better – solution is to vest decision-making power in all those who are directly related to the firm, i.e. in ‘stakeholders’ or, in Hansmann’s words, ‘patrons’ (see Hansmann, 1996, pp. 43–

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44). However, as the theory of production cooperatives (see Vanek 1971a and 1971b) suggests that cooperatives should fund their investments with borrowed capital í DQG OHQGHUV IXQGLQJ D ILUP DUH ZHOO DZDUH WKDW WKH\ ZLOO QRW WKHUHE\ acquire any decision power í WKLV RSLnion is not correct. Labour-managed firms adopt the truly democratic guiding principle ‘one person, one vote’, whereas those advocating investor power uphold the (plutocratic) criterion ‘one share, one vote’, and there is no way to reconcile such antithetical principles.

18.4

Alchian and Demsetz’s Theory of the Firm and Economic Democracy

Before we move on to the problem of economic democracy as a public or merit good, it may be convenient to discuss both the arguments of those holding that economic democracy is by no means a private good and those of theorists that focus on the costs it entails. In Alchian and Demsetz (1972, p. 777) we read: ‘It is common to see the firm characterized by the power to settle issues by fiat, by authority, or by disciplinary action superior to that available in the conventional market. This is a delusion’. Indeed, in the opinion of these authors a firm draws its origin from contracts and its authority and disciplinary powers are strictly determined by the clauses of agreements freely negotiated between parties in the marketplace. An entrepreneur telling his employees what to do is comparable to the individual consumer ordering the commodities he needs from a grocer’s and ceasing to buy his provisions from that supplier if his orders are not satisfactorily performed. To look at the manager as continually engaged in organising, directing or assigning workers to individual tasks within the firm is misleading, for the entrepreneur’s real task is to negotiate contracts on terms that will prove acceptable to both parties (see Alchian and Demsetz, 1972, p. 777; see, also, Nozick, 1974, p. 160 ff.). If this is true, where does the difference between the employer/employee relationship and the corresponding customer/grocer relation lie? In the fact – is Alchian and Demsetz’s answer – that a firm is (a) a team which carries on production activities and (b) an organisation in which a central agent enters into contracts with all of the remaining team members.3 Alchian and Demsetz’s idea that the entrepreneur/employee relationship vests in the former just as much power as is wielded by a party entering into contracts in the marketplace has been called into question by most of the theorists who look upon the firm as a hierarchical structure where specific investments are allimportant. According to these authors, Alchian and Demsetz’s view that – at least from the perspective that interests us here – firing an employee is, to a manager, tantamount to switching over to a different supplier is not correct, since the costs involved in finding a new job are far higher than those necessary to obtain fresh orders (see, for all, Williamson, 1986, pp. 67–70; Dahl, 1985, pp. 114–16 and Gould, 1985, pp. 206–208).4

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As argued by Coase (1960), Alchian and Demsetz’s approach would be correct if no transaction costs were entailed; but in the absence of transaction costs there would be no firms at all and all business operations would be directly transacted in the marketplace. This suggests a very general argument that can be expressed in the following manner. As mentioned before, if transaction costs were nil, there would be no firms; but this amounts to saying that ‘in the absence of transaction costs’ there would no longer be any need for firms at all and that ‘any enterprise will operate efficiently regardless of how rights to participate in its management decisions may be assigned’ (McCain, 1992, p. 206). One additional criticism of the idea that the employer exercises no power over workers is found in a number of analyses which have shown that certain forms of monitoring associated with the division of labour and other forms of organizational structure are not chosen just for reasons of efficiency, but also in order to maintain and strengthen the employer’s authority (Marglin, 1974, Braverman, 1974, Edwards, 1979, Putterman, 1982 and Bowles, 1985). ‘Wage-labour relationships – Howard and King argue (2001, p. 796) – are one area in which Marx discusses the role of coercion as a coordinating device within fully developed capitalist systems. His argument hinges on the fact that employment contracts cannot be specified for all contingencies, so that the terms of exchange of labour services for wages are contestable, and conflict is endemic’.

18.5

The Costs of Democracy in Business Firms

Although democracy is doubtless a valuable good, there are grounds for maintaining that it is not advantageous as a matter of course. Numerous academics and general practitioners (i.e. non-specialists) rather endorse the view that the main benefit of self-management, namely a more democratic environment, is actually its main shortcoming (see, for example, Webb and Webb, 1921 and 1923, p. 133; Hodgson, 1982–3 and 1987, pp. 137–8; Benham and Keefer, 1991 and Klein, 1991, pp. 219–20). However, in this chapter we will discuss the disadvantages of democracy as such, rather than the much broader issue of inefficiencies that may arise in democratic firms. The first cost of democracy we have to address is the difficulty with which joint resolutions are made. Right from the start, problems are encountered in the start-up phase of a democratic firm. To set up a new firm, a group of individuals with equal decision-making powers must adopt a consensus-based resolution. As all participants are expected to concur on all the main aspects of a project, agreement will be anything but easy to reach. The same does not apply to the capitalistic firm: here the founder has to negotiate bilateral agreements with individual stakeholders and may consequently try to persuade each of them to enter into a contract by conducting negotiations from which all the others are excluded. In other words, whereas by definition the democratic firm originates from a multilateral contract entered into by unanimous agreement amongst a

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number of parties, the capitalistic firm is based on a set of bilateral contracts in which one party – always the same – invariably has access to a greater amount of information and is thus in a position to dictate the required stipulations. It is selfevident that a multilateral contract is more difficult to negotiate than a bilateral one (McCain, 1992, pp. 214–15), and this is doubtless a convincing explanation of why cooperative firms are set up so seldom. One additional cost of democracy is the danger that majority and minority groups may line up against each other. In a capitalistic firm workers do lack decision-making power, but they can ‘vote with their feet’; unable to make or influence decisions, they have no option but to accept the role assigned to each of them and ‘get accustomed’ to the fact that their needs are seldom, if ever, heeded. On the contrary, in a democratic firm workers do have a say and whenever they are in the minority they may resent the scant respect given to their needs. At this point, a minority group may oppose majority resolutions and accuse those who refused to listen to their opinion to abuse their power position. The resulting conflict between the members of the cooperative may induce the minority group to stop cooperating or attempt to reverse the resolutions adopted. The costs highlighted above may even be magnified if the final solution reflects, not the stance of a numerical majority, but that of a particularly energetic or resourceful minority which, as often happens, manages to impose its will on the majority taking advantage of the indifference of many or a better knowledge of circumstances. As a result, the members of a democratic firm may even prove less cooperative than those of a capitalistic firm. A very similar argument can be developed from the perspective of an economic liberalist such as Hayek. As is well known, this author prioritises market choices over policy decisions because the latter, being passed by a majority vote, may entail an abuse of power on the part of the majority. In Hayek’s words, economic freedom is ‘the state in which a man is not subject to coercion by the arbitrary will of another or others’ and ‘describes one thing and one thing only, a state which is desirable for reasons different from those which make us desire other things also called ‘freedom’’ (Hayek, 1960, pp. 11 and 12). Faced with this argument, those who endorse Alchian and Demsetz’s approach may contend that democracy in the firm is anything but an advancement. Indeed, while a worker entering into a contract with a capitalistic firm can be assumed to freely accept its clauses and not to feel subject to other people’s will when performing his tasks within the organisation, in a democratic firm, where resolutions are adopted by a majority vote, minority members may experience the decisions made by other members as a constraint and resent such state of things.5 These arguments make clear that economic democracy have costs, but they obviously don’t deny that it is a good.6 A very general argument that throws light on the nature of the costs illustrated above is that joint decisions take much time and effort to make. If the decisionmaker sets out to reconcile the preferences of all the participants in the initiative,

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he/she must call a number of meetings to provide an opportunity for exchanges of opinion and the taking of polls. As each participant can be assumed to have his/her distinct preferences, there will hardly be such a thing as a single option and polling operations may prove all the more cyclic the more such preferences are found to diverge. In addition to this, the cyclical nature of joint resolution processes may result in attempts at manipulating the voting procedures themselves. One way to reduce the impact of these drawbacks is to delegate voting powers, i.e. to vest them in committees empowered to devise options or pass resolutions in lieu of the meeting, although the practice of delegating powers is associated with well-known principal-agent conflicts (see Weingast and Marshall, 1988, p. 32). This is the rationale behind the contention that ‘the more firms are owned and managed by individuals, the more efficiently will firms be run’ (see Putterman, Roemer and Silvestre, 1998, p. 884). As it is known, many cooperative firms, including smaller ones, are actually run, not by a majority of their members, but by a small group of senior members or a sole manager, who is often a salaried employee of the firm. While this is not a cost of economic democracy proper, it is certainly an aspect that detracts from its value. Consequently, when appraising the real benefits of labour management it is probably worth stressing that within a hierarchical organisation such as a firm democracy must necessarily act itself out by delegation and that meetings may be confined to just a few, for example those needed to elect the members of the managing body.7 This last point deserves particular emphasis. According to Hansmann, 1996, the main cause that prevents labour-managed firms from making headway is the high costs of democracy.8 Given the hierarchical structure of the firm and the difficulties attending the adoption of joint resolutions, those who advocate a greater role for democratic firms in society – because they look upon them as merit or even public goods (see below) – have no option but to endorse the passing of legislation that will vest full autonomy in managers and confine the powers of meetings to the casting of votes at elections for the managing board and the adoption of just a few, particularly important resolutions.9 But there is more to this. Provided it is true that joint decisions are costly and inefficient, there are reasons to believe that the members of a democratic firm – who (in line with today’s mainstream theory) must be assumed to behave rationally – will freely resolve to do without joint decisions every time this is feasible. On closer analysis, therefore, as the members themselves, acting in their personal interests, will tend to reduce the powers vested in meetings, there would be no need for specific legislation to this effect.10

18.6. Economic Democracy as a Merit Good Let us move on to discuss the advantages of economic democracy for the community as a whole.

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In Dahl’s opinion (1989, p. 311), the democratic process is superior to any other form of government for at least three reasons. Firstly, democracy tends to expand and thereby promote ever more freedom in terms of greater individual as well as collective self-determination and the continual extension of particular forms of freedom. Secondly, by promoting human growth it makes for the realisation of diverse human abilities. Thirdly, it vouchsafes protecting the property and interests of individuals. Moreover, as equality is in many respects a necessary prerequisite of democracy, ‘the close association between democracy and certain kinds of equality leads to a powerful moral conclusion: if freedom, self-development, and the advancement of shared interests are good ends, and if persons are intrinsically equal in their moral worth, then opportunities for attaining these goods should be distributed equally to all persons. Considered from this perspective, the democratic process becomes nothing less than a requirement of distributive justice. The democratic process is justified not only by its end-values, but also as a necessary means to distributive justice’ (Dahl, 1989, pp. 311–12). And greater distributive justice can be assumed to magnify economic growth (see Alesina and Rodrik, 1994; but also Tavares and Wacziarg, 2001). Focusing on economic democracy in particular, Dahl extols one of its major advantages, namely its function as a medium for political democracy (see Dahl, 1985, pp. 94–8 e Schweickart, 2002, pp.151–2, but also Rothschild and Witt, 1986, p. 13).11 In this chapter, this subject will receive particular attention because we endorse the view that economic democracy is not merely a ‘medium’ for, but an essential component of, political democracy.12 The unique role that economic democracy plays in the making of political democracy is associated with ts ability to deprive capital of all its power. This is particularly true of democratic firms, provided they are organised as LMFs in accordance with Vanek’s suggestion (1971a e 1971b) and consequently fund their investments solely with borrowed, or external, capital. As is well known, one central idea propounded in Marxian theory, by militant Marxists and in other theories critical of the way capitalistic society is organised is that political democracy is just a façade and that all power is actually in the hands of capitalists; in short, that the power of capital holds everything under its sway. A quotation from The German Ideology runs as follows: In the history up to the present it is certainly an empirical fact that separate individuals have, with the broadening of their activity into world-historical activity, become more and more enslaved under a power alien to them…, a power which has become more and more enormous and, in the last instance, turns out to be the world-market (Marx and Engels, 1845-46, p. 27).

As is well known, in Capital Marx dwells on similar concepts time and again (see, for example, Marx, 1867, pp. 799, 1027–8, 1054, 1058 and Marx, 1894, pp. 298– 9, 319, 343–4, 373).

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This explains why, on the subject of the cooperative movement íZKLFKLVOLNH saying a system of democratic firms í0DU[ZURWH G But there was in store a still greater victory of the political economy of labour over the political economy of property. We speak of the cooperative movement, especially the cooperative factories raised by the unassisted efforts of a few bold ‘hands’. The value of these great social experiments cannot be overrated. By deed, instead of by argument, they have shown that production on a large scale, and in accord with the behest of modern science, may be carried on without the existence of a class of masters employing a class of hands; that to bear fruit, the means of labour need not to be monopolised as a means of domination over, and of extortion against the labouring man himself; and that, like slave labour, like serf labour, hired labour is but a transitory and inferior form, destined to disappear before associated labour plying its toil with a willing hand, a ready mind, and a joyous heart (Marx, 1864, p.11).

In this excerpt and elsewhere, Marx is emphasising one major advantage of cooperative firms, namely their ability to dispossess capitalists of all their power. From a Marxian perspective, it thus seems right to contend that the democratic firm reverses the capital–labour relationship and thereby dethrones capital from its dominant position. Yet this view is confuted by more than one Marxist. Sweezy, for instance, holds that control on these firms from within, the selective action of the market and the use of material incentives are three factors which, taken altogether, generate a strong tendency towards the emergence of an economic order that will increasingly reproduce capitalistic working modes irrespective of the name we give it. In other words, Sweezy’s argument is that when such firms are run by small groups bent on maximising their incomes by producing commodities for the market, the resulting system will generate the basic production and class relationships of a capitalistic system (see Sweezy, 1968–1969; see also Ticktin, 1998 and Ollman, 1998). On this same subject, Adorno wrote: ‘Sway over men continues to be exercised through the economic process, faced with which not only the masses, but also those who own capital are reduced to mere objects’ (see Adorno, 1969, p. 25). In this connection, we may object that that Sweezy and Adorno not only ignored Ward and Vanek’s theory of production cooperatives, but even failed to focus on the different part that competition plays in capitalism as opposed to a system of self-managed firms. As is well known, competition is the very ‘heart of capitalism’ and acts itself out mainly through the threat of bankruptcy proceedings. In very general terms, a firm will go bankrupt when its capital and labour costs exceed labour productivity. If this is true, the absence of labour costs in labourmanaged firms removes the danger of bankruptcy proceedings and makes competition much less oppressive than it is in a capitalistic system. More precisely, competition does survive in a system of labour-managed firms, but it is no longer an ‘external power’ obliging individuals and firms to rush as hard as they can.

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Coming to the heart of the matter, in firms run in accordance with the principle ‘one person, one vote’ the power of capitalists is nil by definition. While there is no denying that such firms are required to abide by the law of markets and while there is even ample scope for arguing that they are subject to the laws of capital, what can be ruled out is that power will be swayed by capitalists. Hence our reply to Sweezy and Adorno: although the rules of the market continue to apply in a system of labour-managed firms, it is no less true that in such a system capitalists are prevented from acquiring power as a result of their superior financial standing. In a system of labour-managed firms all the media, including the press and television, would consequently secure greater levels of freedom and the influence of economic lobbies on policy-making would lose much of its present grip. Without pushing our argument too far, it is hardly to be doubted that even in a system of democratic firms managers of large-size firms will gain external power of some sort, but what can certainly be ruled out is the danger that a firm may exercise control over others by acquiring majority holdings in them. Agreements between firms, though not altogether impossible, would become more difficult to contrive and could be kept under more effective check by a competition authority.

18.7. A Critique of ‘Industrial Democracy’ In the light of the above reflections, we must necessarily agree with those who argue that í E\ UHPRYLQJ WKH SULPDU\ FDXVHV DQG VRFLDO URRWV RI DXWKRULWDULDQ modes of governance í VHOI-management automatically averts any forms of topdown command from governments intending to regulate society and the living conditions of the working class. And this quite naturally entails that any changes in production relations in the direction of labour management are bound to pave the way for more democratic patterns of social life. As a rule, the prevailing approach of political theorists to industrial democracy is not a positive one. In the opinion of the most renowned Italian political theorist, Norberto Bobbio, political representation within a capitalistic society has serious shortcomings because the people’s sovereign power is severely curtailed by weighty economic decisions made, not by constitutional organs proper, but in forums where few citizens have a say (Bobbio, 1975, p. 63). However, despite this unequivocal statement, the author fails to suggest that the introduction of ‘industrial democracy’ might help overcome the current limitations of political representation. He writes that ‘leftist criticisms of representative democracy are actually levelled at lack of direct democracy’ and adds that ‘direct democracy is the crucial, and perhaps the only founding principle behind the socialist theory of the state’ (Bobbio, 1975, p. 58), but just a few pages further onward, discussing the subject of self-governing producers and certain writings by Marx and Korsch, he misses the opportunity to highlight links between direct democracy and ‘industrial democracy’ and, above all, makes the same mistake he imputed to others: he merely raises the query whether industrial democracy is at all possible and omits the associated issue of its relations with indirect democracy.

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More precisely, he argues that ‘theoreticians of industrial democracy have continued to cling to the misleading assumption that political democracy will melt into economic democracy and self-governing citizens into self-governing producers’ (Bobbio, 1975, p. 64). Faced with this contention, theorists of a system of producer cooperatives organised in accordance with Ward and Vanek’s theories can be expected to object that, far from suggesting that political democracy melts into industrial democracy, they are simply proposing to supplement political democracy with economic democracy. Compared to Bobbio’s, the arguments of another well-known Italian political theorist, Giuseppe Vacca, sound far more convincing. He rightly contends that ‘as novel institutions in keeping with producer democracy are set up and gain ground, political liberties are sure to enjoy more effective protection and to assert themselves. The proliferation of viable institutions of this kind will result in the creation of effective barriers inhibiting new and old forms of authoritarianism into which late capitalistic societies tend to lapse as a result of their very structure’ (Vacca, 1976, p. 63). However, as Vacca’s idea of economic democracy does not fall in with ours, he takes it for granted that salaried labour will survive for a long time to come and dwells on ways to do away with market economy. For our part, we feel that opposing the power of capital is one thing, while opposing the power of the market – or market economy as such – is another. One reason why this idea is slow to assert itself within Marxist thought is that Marxian and non-Marxian political theorists still continue to ignore Ward and Vanek’s economic theory of cooperatives. In this connection, we are inclined to concur with Bobbio’s argument that the somewhat blurred relationship between socialist thought and democracy is mainly due to serious theoretical shortcomings inherent in Marxist tradition (see Bobbio, 1975, pp. 54–6).

18.8

The Main Advantages of Democratic Firms

The foregoing may help clarify our main point in this chapter. The view that democracy is a merit or public good suggests that those free to make their own decisions concerning their personal interests are better off that those obeying other people’s directions; but this is only one aspect of our problem, not our main point, because it is hardly to be doubted that in any business firm decision-making must be the task of a small group of people, i.e. managers.13 The main advantages of self-management lie elsewhere, not only in the satisfaction members draw from the democratic nature of their firm. And as it is barely practicable to address them individually within the scope of this article, here below we can only list the main ones, namely: a) an end to capitalistic power; b) enhanced political democracy;

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c) superior firm efficiency due to a greater involvement of the workforce in the production process (for in-depth analyses of this point, see Bonin, Jones and Putterman, 1993 and Craig and Pencavel, 1995);14 d) the disappearance of classical and Keynesian unemployment (see, Jossa, 2001); e) reduced risks of inflation through the elimination of wage pressure of any sort; f) an end to external control over business firms; g) more environment-friendly production processes (see, for example, Gorz, 1970, pp. 336-39, Putterman, 1990, p. 171 and Schweickart, 2002, pp. 15658); h) beneficial effects on workers’ characters. Among those listed above, the end of capitalistic power is both the greatest advantage and the one most directly associated with economic democracy. In this connection, we wish to emphasise once again that democracy is a valuable public good not only because workers wield power in the firm by actively participating in its day-to-day decision-making processes, but rather because it deprives capitalists of this power.15 The foregoing may help us decide whether, and in what ways, economic democracy is a ‘merit good’ (see Musgrave, 1958, 1959 and 1987) or even a public good. Economic democracy may come about in two manners: through the abolition of salaried labour by act of parliament or, as is both more convenient and more likely, thanks to piecemeal increases in the number of labour-managed firms. In the former case, those holding that the advantages of democratic firms outnumber their disadvantages will speak of the creation of a public good; in the latter case, each new democratic firm will rather be categorised as a merit (or public) good. In Musgrave’s opinion, ‘the setting in which the concept of merit or demerit goods is most clearly appropriate’ is the situation where one good, besides benefiting its direct users, produces advantages in line with the community’s main values (1987, p. 453). This means that whenever a newly-founded firm, besides generating benefits for its direct workforce, also reduces capitalist power through the introduction of the principle ‘one person, one vote’, slows down risks of inflation or improves the characters of workers, it can be categorised as a merit good (although those prioritising the advantages under a), b), d), e), g) and h) will tend to class it also, and primarily, as a public good). The last-mentioned advantage, which Mill and Marshall highly valued, has received little attention in contemporary economic literature and will be analysed in depth in the following two paragraphs.

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The Advantages of Cooperation from Mill’s Perspective

The best-known authors who unreservedly extolled the cooperative firm by emphasising the solidarity it creates and its beneficial effects on human character are probably John Stuart Mill and Alfred Marshall. Mill looked upon cooperation as the organisational form that best meets the interests of the working classes. ‘I cannot think – he wrote – that they will be permanently contented with the condition of labouring for wages as their ultimate state. They may be willing to pass through the class of servants in their way to that of employers; but not to remain in it all their lives’ (Mill, 1871, p. 760–61). This means he shared the socialist view that workers’ emancipation would come about through association, i.e. through the creation of cooperatives abolishing salaried labour, granting workers the status of members and allowing them a say in their management. Besides this basic reflection, the main idea Mill had in mind when praising the cooperative firm was associated with competition and the way it impacts human nature and happiness. In Mill’s opinion, increased productivity levels were not the main advantage of a system of cooperative firms. Underscoring the impetus to production that stems from cooperative modes of work, he rated this advantage ‘nothing compared with the moral revolution in society that would accompany’ cooperation, namely ‘the transformation of human life, from a conflict of classes struggling for opposite interests, to a friendly rivalry in the pursuit of a common good to all; the elevation of the dignity of labour; a new sense of security and independence in the labouring class; and the conversion of each human being’s daily occupation into a school of the social sympathies and the practical intelligence’ (Mill, 1871, p. 789–90).16 Mill approved of competition as a means of discouraging indolence, inducing individuals to improve and reinforce their inborn abilities and providing both a selection criterion and rules to govern rates of pay. That is why, at least in his younger years, Mill severely criticised those socialists who were inimical to the idea of the market as a major inducement to work and the governing criterion for income distribution17 and that is why he argued against Owen’s self-contained communities for eliminating incentives to production. 18 But competition in a labour-managed firm is not like competition in capitalism. The positive effect of cooperative production on human character is even more prominent in passages where Mill comments on the cooperative movement in his day, in particular on a famous cooperative firm (the Rochdale Society) which had been founded in 1844 and was then still experiencing rapid growth. These cooperatives, he wrote, are clear evidence that shared interests have prompted a feeling of solidarity amongst the members and thereby helped improve their characters. Mill went so far as to contend that cooperatives were ‘a course of education in those moral and active qualities by which success alone can either be deserved or attained’ (Mill, 1871, p. 791). In another passage, he also discussed the distinction (re-proposed by Marshall in later years) between base motivations

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behind economic activity (which was to be put to good use for want of anything better) and motivations based on lofty feelings (which he typically ascribed to cooperative firms). From Mill’s perspective, both political economy and political science overall were to be grounded in a thorough knowledge of the laws that determine and govern human character. Even more so, the main idea he had in mind when planning to write a treatise on ethology (a project he later abandoned) was that a thorough knowledge of the evolution of human character was a prerequisite for the construction of a social science proper and that this, in turn, required elaborating a science of character (see Mill, 1871, pp. xvi-xvii; see, also, Becattini, 1989, pp. 135–6).

18.10 Marshall’s Idea of the Cooperative Firm as an Agent That Moulds Character Another major author who addressed the impact of economic organisation on character was Alfred Marshall. Defining the essence of economic science in the opening pages of Principles of Economics, he stressed its two main goals with the following words: ‘It is on the one side the study of wealth, and on the other, and more important side, a part of the study of man. For man’s character has been moulded by his every-day work, and the material resources which he thereby procures, more than by any other influence unless it be that of his religious ideals; and the two great forming agencies of the world’s history have been the religious and the economic’ (Marshall, 1890, p. 1). An even more significant excerpt, dated 1897, reads as follows (pp. 299–300): Social science or the reasoned history of man, for the two things are the same, is working its way towards a fundamental unity; just as is being done by physical science, or, which is the same thing, by the reasoned history of natural phenomena. Physical science is seeking her hidden unity in the forces that govern molecular movement: social science is seeking her unity in the forces of human character.19

The idea that human character is not given from the outset, but is thoroughly shaped by the environment and its economic structure, is already found in Marshall’s early writings. In one of them, for example, we are told that ‘we scarcely realise how subtle, all pervading and powerful may be the effect of the work of man’s body in dwarfing the growth of man’ (Marshall, 1873, pp. 105– 106). In Principles, on the subject of the relative importance of the main two factors in world history, Marshall states that, compared to religious factors, whose influence is more intense, economic factors act themselves out by the day and hour, throughout the greater part of a man’s life; for a man’s mind is absorbed by matters associated with his business even when he stops working and, as often is the case, sets out to plan future actions (Marshall, 1890, p. 2).

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The decisive part played by work in shaping man’s character led Marshall to contend that the main task of a social thinker was to suggest institutional reforms that would enhance the best qualities in man, namely the ‘high’ motivations he equated with ethics. In Marshall’s view, the shaping principles of capitalism were the profit motive and individualism, the main springs of ‘base motivations’. The foregoing may explain why Marshall exalted the ethical motives behind the cooperative movement (Marshall, 1890, p. 306) and its main goal, namely ‘the production of fine human beings’ (Marshall, 1889, p. 228). In his opinion, cooperation was grounded in high aspirations and the wish to enhance what is best in man, educate him to collective action and to work jointly with others for the achievement of shared ends. Its direct aim was ‘to improve the quality of man itself’ (Marshall, 1889, p. 228). This idea returns in a passage from The Economics of Industry, where Marshall and his wife praise the personality of Owen, his ‘boundless faith in the ultimate goodness of human nature and the possibility to mould noble characters, his deeply-felt desire to bring to the fore the best qualities of men by trusting in them and appealing to their reason’ (Marshall and Marshall, 1881, pp. 271–2). In the start-up phase, the cooperative movement is sure to come up against major difficulties, but it holds within itself the seeds of growth, since education helps workers see to their interests and teaches them the moral strength needed for the joint pursuit and attainment of their political goals (Marshall, 1925, p. 228). 20

18.11 Conclusion The fact that the democratic firm is a public good may explain why it can hardly be expected to assert itself in its own right, through the working of the market mechanism. In a ‘free competitive contest’ with the capitalistic firm, it is likely to be the loser weither due to its lesser inherent efficiency or because those planning to create or reorganise business enterprises are barely encouraged to set up or turn existing capitalistic companies into democratic firms. From this it follows that advocates of industrial democracy viewed as a public good should never take it for granted that a system of democratic firms will come about through private initiative. Criticising mainstream economic theory for its all too narrow limits and stressing that ‘efficiency considerations are but one of the bases for decisionmaking, and are often among the less important of these’, Rawls argued that all too often we embrace the moral and political climate behind the status quo without thinking hard about the matter, thereby accepting decisions which haphazardly arise from conflicts between economic and social forces. In his opinion, political economy was bringing this problem into the right focus (see Rawls, 1971, p. 222).21 This begs the question: as the democratic firm is a public good, why does it not assert itself by democratic means?

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Very often markets and democratic governments are prevented from promoting the welfare of all citizens because in an effort to alleviate the miserable conditions of people they meet the demands of the general public although individuals are seldom able to decide, albeit within the narrow limits of their private lines, exactly what it is that may increase, if not maximise, their happiness. According to Lane (2000, p. 283), the basic assumption behind any democratic theory is the idea that every one is the best judge of his/her own interests, though he adds that he mistrusts the optimism behind this statement both because there are people who are unaware of the origin and nature of their feelings and, above all, because social institutions responsible for promoting the best interests of the general public often fail to make the right choices. Setting out from the fact than men ignore the causes of their feelings, Lane speaks of a ‘hedonistic fallacy’, i.e. a mistaken persuasion that to be aware of one’s feelings means to know their origin as well. In point of fact, numerous research results have suggested that people are ignorant of the causes of their happiness or unhappiness. In part, this is due to the fact that unhappiness is much more widespread in today’s society than in the past both because of worsening interpersonal relationships and because many people look to money and property as a compensation for friendship and love, which they miss (ch. XVI). On closer analysis, irrespective of the correctness of Lane’s arguments, there are other reasons why a system of self-managed firms fails to make headway democratically, through the enactment of parliamentary legislation. A well-known subject which needs not be further addressed here is the role of vested interests. For our part, we wish to point out that in consequence of uncertainties regarding the way a system of self-managed firm works and theoretical objections against such a system, few people, including economists, are prepared to confirm the superiority of a system of labour-managed firms over a capitalistic system; and this may explain why a proposal in this direction is not part of the agenda of any political party. The scant favour with which economists and politicians alike look at democracy within the firm stems in part from the sheer unorthodoxy of such a proposal. Throughout most of the past century political debate was the scene of endless confrontation between advocates of capitalism and soviet socialism and few, if any, thought of a democratic approach to socialism that would depart from the intermediate solution of Social Democracy. The heterodox essence of economic democracy is also apparent in mainstream economic theory, where criticising capitalism is tantamount to combating the market and any critique of capitalism must be set forth from a Marxian or neo-Ricardian perspective, instead of being conducted with the typical instruments of neo-classical economic analysis. The truth of this is borne out by the cultural experience of Oskar Lange. Although this author found fault with capitalism and socialism alike and shaped an original approach to market socialism of high theoretical value, his model has never been seriously taken into consideration, not even when the collapse of the

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Berlin wall would have provided a clear opportunity for its practical implementation (see Jossa, 1993). From the perspective of those endorsing the superiority of a system of selfmanaged firms over capitalism, the only solution is to wait until times are ripe for a transition to this new system, bearing in mind that, as such a turn will hardly come about in its own right, it must be encouraged through the enactment of effective legislation not only founded on the notion of the democratic firm as a public good, but also framed in a way that will promote its establishment.

Notes * 1

2 3

4 5

6

Paragraphs 18.9 and 18.10 re-propose ideas and excerpts from a previous work, JossaCuomo, 1997. I wish to thank Domenicantonio Fausto and Rosario Patalano for their valuable collaboration. Evolutionary theory is often described as an appeal to the sacred altar of tradition and, at the same time, as a set of arguments endorsing the view that what is must necessarily be (see Hodgson, 1995, p. 204). However, as pointed out by many authors, Darwinian approaches to economic theory are generally inspired by the faith in laissez faire policies, rather than by an attentive scrutiny of facts. Many jurists and business operators within the cooperative movement also endorse the view that the most prominent social aspect of cooperation is economic democracy (see, for example, Galgano, 1982, p. 81). The fact that neither employers nor workers are obliged to extend their contractual relationship indefinitely in time induced Alchian and Demsetz to contend that long-term employment contracts are not the essence of the organisation we call a firm (see Alchian and Demsetz, 1972, p. 777); as mentioned by Williamson, however, Alchian ceased endorsing this view some time later (see Williamson, 1985, p. 53, note 11, and Williamson, 1986, pp. 241–2). The right approach would be to contend that those who have no option but to do what is essential in view of their subsistence or the attainment of other fundamental aspects of their well-being cannot be categorised as free. Despite a different political background, Bobbio’s line of reasoning on the important distinction between public and private action closely recalls both Alchian and Demsetz’s and Hayek’s: ‘following the emergence of political economy and the resulting clear-cut distinction between economic and political relations – the former involving entities formally viewed as equals in the marketplace, but actually unequal in consequence of the division of labour – he argues – the public-private dichotomy reappeared in the form of a distinction between the political community (made up of equals) and the economic community (made up of non-equals)’ (see Bobbio, 1985, pp. 6–7). On this point, however, it is probably convenient to mention that Bobbio has constantly emphasised both the distinction between formal and substantive democracy and the primacy of public over private action in all this theoretical work (see Bobbio, 1985, pp. 149–50 and 10–15). Opinions close to Bobbio’s are widely shared in political theory. An antithetical opinion to Hayek’s is owed to Gobetti, according to whom ‘irrespective of whether liberalism is viewed as an economic, ethical or constitutional movement, its method entails the acknowledgement that political strife is crucial to the survival of modern society’ (Gobetti, 1923, p. 514). And it is against this background that we have

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11 12 13

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to view his contention that ‘both in the past and today, the real contrast is not between dictatorship and freedom, but between freedom and unanimity’ (Gobetti, 1948, p. 25). A general argument to this regard is that ‘evolution has given our species an inherent preference for hierarchically structured social and political systems’ (cfr. Somit and Peterson, 1995, p. 27, cit. by Lane 2000, p. 49). Lane writes also that recognition of authority in historical evolution seems to be the prescription. But it is also true that the value of economic democracy is not necessarily curtailed by the firm’s hierarchical structure, since the supervisor-bluecollar relationship (in which the latter obeys the instructions of the former) will not strike us as an instance of repression provided the parties involved are social equals (Heller, 1980, pp. 37–8). According to Stuart Mill (1871, pp. 790–91), for example, the advantages of singleowner management over joint management in a firm are many. A single unit of command affords taking actions that would hardly prove feasible if they were made to depend on improbable consensus-carried decisions from board members diverging in their views or on sudden policy changes. An able private capitalist free from the control of a managing body is far better able to take balanced risks or adopt costly improvements than a group of people. It is, therefore, correct to say that selfmanagement does not, and simply cannot be equated with collective management proper, since any commission-type management is incompatible with the proper conduct of the business of any firm. No assembly will ever be in a position to meet such crucial requirements for the proper running of a firm as superior professional expertise, efficiency and prompt decision-making (Galgano, 1982, p. 81). For a different opinion, see, among others, Blumberg, 1973. The main reason why most Marxists ceased endorsing the cooperative movement from 1870 onwards was its inability to do away with the costs of democracy (see Bernstein, 1899, pp.109–21). Based on the Italian civil code, cooperatives and public limited companies are governed by the same provisions, i.e. the principle whereby corporate powers are apportioned between the General Meeting and the Board of Directors and the Meeting is not allowed to pass resolutions affecting the way the firm’s business is to be run. The more you live and breathe democracy, the more you value it. There is evidence that in some democratic environments workers began to show interest in decision makingprocesses only after they had been working in a cooperative for some time. In the opinion of other authors who have addressed this subject, economic and political democracy have the same founding principle (namely greater social justice) (see Gould, 1985, pp. 208–210). On the subject of political democracy, there are those who maintain that parliaments pass government decisions without hearing the opinion of the electorate. With respect to this particular aspect of process whereby policies are implemented there is hardly any difference between a ‘democratic’ government and a dictatorship. In a cooperative firm – Mill argued, for example – workers become their own masters, and this results in substantial labour productivity gains made possible by the encouragement to production activity stemming from the right to appropriate the surplus earned by the firm (Mill, 1871, p. 792). Here is the opinion of Heller (1980, p. 129) on this point: ‘Consequently I think of social change as an end to the confrontation between a minority owning most of the extant resources and a propertyless majority, as the very first step towards the acquisition of ‘property’ (because everyone is given the opportunity to acquire property) and the beginning of self-determination and self-government’. According to Bataille: ‘Any factory has a clear idea of categories of people that have a bearing on its business (proletarians, intermediaries, accountants, technicians), but ignores individuals as far as it can. No such thing as the warmth of close interpersonal

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18

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relations will bind together those who are caught up in its internal cogs: a firm is spurred on by glacial greed, employs heartless labour – and has as its only god its own growth’ (1976, p. 64). In a cooperative firm, each worker is aware that the greater earnings that will result from his greater or better dedication to work will benefit not only himself, but also the other members of the firm; and this is in itself enough to weaken the grip of competition. In our globalised age, in which the dismantling of barriers to international trade is resulting in ever stronger competition, it is barely possible to discard Mill’s argument only because, having clearly identified the benefits of competition, he failed to see that one of the advantages of a system of cooperatives (which by its very nature makes for competition amongst groups rather than between individuals) is to slow down competition and remedy its defects. To disprove well-known arguments against communist societies (for instance the assumption that by doing away with the division of labour they were causing declines in productivity), he used to remark that ‘these difficulties, though real, are not necessarily insuperable’ (Mill, 1871, p. 207). Elsewhere (1871, p. xiv) he stated that criticisms of competition, though usually overstated, were not necessarily erroneous. See, also, Pesciarelli, 1981, pp. 98–100. While it is true that personality is the result of social relationships (Heller, 1980, p. 51), it seems fairly obvious that social science must mainly focus on the agents that shape human personality. On the cooperative movement in Mill’s and Marshall’s works, see Jossa and Cuomo, 1997, pp. 297-302, and Raffaelli, 2000. A statement by Keynes on this point may be of interest here: ‘If irreligious capitalism is ultimately to defeat religious communism, it is not enough that it should be economically more efficient – it must be many times as efficient’ (Keynes, 1925, pp. 267–68).

References Adorno, T.W. (1969), ‘È superato Marx?’, in M. Spinella (ed.), Marx vivo, Milan: Mondadori, pp. 19–35. Alesina, A. and D. Rodrik (1994), ‘Distributive politics and economic growth’, Quarterly Journal of Economics, 109(2), pp. 465–90. Alchian, A.A. and H. Demsetz (1972), ‘Production, information costs and economic organization’, American Economic Review, 62(December), pp. 777–95. Becattini, G. (1989), ‘Mercato e comunismo nel pensiero di A. Marshall’, in B. Jossa (ed.), Teoria dei sistemi economici, Turin: Utet, pp. 131–56. Benham, L. and P. Keefer (1991), ‘Voting in firms: the role of agenda control, size and voter homogeneity’, in Economic Inquiry, 29(4), pp. 706–19. Bernstein, E (1889), Evolutionary Socialism, Engl. transl., New York: Schocken Books, 1961. Bataille, G. (1976), La limite de l’utile (fragments), Paris: Ed. Gallimard. Blumberg, P. (1973), ‘On the relevance and future of workers’ management’, in G. Hunnius, G.D. Garson and J. Case, Workers’ Control, New York: Vintage Books. Bobbio, N. (1975), ‘Quali alternative alla democrazia rappresentativa?’, re-printed in N. Bobbio, Quale socialismo?, Turin: Einaudi.

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Bobbio, N. (1985), Stato, governo, società; frammenti di un dizionario politico, 2nd edn, Turin: Einaudi, 1995. Bonin, J.P., D.C. Jones and L. Putterman (1993), ‘Theoretical and empirical studies of producer cooperatives: will the twain ever meet?’, Clinton N.Y.: Department of Economics, Hamilton College, Working paper no 91/4. Bowles, S. (1985), ‘The production process in a competitive economy: walrasian, neoHobbesian and Marxian models’, American Economic Review, 75(1), pp. 16–36. Braverman, H. (1974), Labor and Monopoly Capital: the Degradation of Work in the Twentieth Century, New York: Monthly Review Press. Coase, R. (1960), ‘The problem of social cost’, Journal of Law and Economics, 3(1), pp.1– 44. Craig, B. and J. Pencavel (1995), ‘Participation and productivity: a comparison of workers cooperatives and conventional firms in the Plywood industry’, Brookings Papers in Economic Activity: Microeconomics, pp. 121–74. Dahl, R. (1985), A Preface to Economic Democracy, Cambridge: Polity Press. Dahl, R. (1989), Democracy and its Critics, Yale: Yale University Press. Edwards, R.C. (1977), Contested Terrain, New York: Basic Books. Galgano, P. (1982), ‘L’autogestione cooperativa e il sistema organizzato di imprese’, in Lega Nazionale Cooperative e Mutue, L’impresa cooperativa negli anni 80, Bari: De Donato, pp. 78–88. Giolitti, A. (1977), ‘L’autogestione’, in G. La Ganga (ed.), 1977, Socialismo e democrazia economica, Milan: F. Angeli, pp. 29–38. Gobetti, P. (1923), ‘Revisione liberale’, re-printed in Gobetti, P., Scritti politici, Turin: Einaudi, 1969. Gobetti, P. (1948), La rivoluzione liberale, Turin: Einaudi. Gould, C.C. (1985), ‘Economic justice, self management, and the principle of reciprocity’, in K.Kipnis and D.T.Meyers (eds), Economic Justice; Private Rights and Public Responsibilities, Totowa: Rowman & Allanheld, pp. 202–16. Gorz, A. (1970), ‘Workers’ control is more than just that’, re-printed in K. Kipnis and D.T.Meyers, Economic Justice; Private Rights and Public Responsibilities, Totowa: Rowman & Allanheld, 1985, pp. 325–43. Graziani, A. (1975), ‘Aspetti strutturali dell’economia italiana nell’ultimo decennio’, in A. Graziani, Crisi e ristrutturazione nell’economia italiana, Turin: Einaudi, pp. 5–73. Hansmann, H. (1996), The Ownership of Enterprise, Cambridge Mass.: Harvard University Press. Hayek, F.A. (1960), The Constitution of Liberty, London: Routledge. Heller, A. (1980), Per cambiare la vita; intervista di Ferdinando Adornato, Rome: Editori Riuniti. Hodgson, G.M.. (1982-83), ‘Worker participation and macroeconomic efficiency’, Journal of PostKeynesian Economics, 5(2), pp. 266–75. Hodgson, G.M. (1987), ‘Economic pluralism and self-management’, in D.C.Jones and J. Svejnar, Advances in the Economic Analysis of Participatory and Labor Managed Firms, vol. II, Greenwich, CT: JAI Press, pp.129–42. Hodgson, G.M. (1995), ‘The political economy of utopia’, Review of Social Economy, 53(2), pp. 195–213.

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Howard, M.C. and J.E. King (2001), ‘Where Marx was right: towards a more secure foundation for heterodox economics’, Cambridge Journal of Economics, 25(6). Jossa, B. (1993), ‘Is there an option to the denationalization of Eastern European enterprises?’, in M. Baldassarri, L. Paganetto and E.S. Phelps (eds), Privatization Processes in Eastern Europe, London: Macmillan, pp. 205–22. Jossa, B. and G. Cuomo (1997), The Economic Theory of Socialism and the Labour Managed Firm, Cheltenham: Edward Elgar. Jossa, B. (2001), ‘L’impresa gestita dai lavoratori e la disoccupazione classica e keynesiana’, Rivista italiana degli economisti, 1, pp. 121–35. Keynes, J.M. (1925), ‘A short view of Russia’, re-printed in J.M. Keynes, The Collected Writings of John Maynard Keynes, vol. IX, London: Macmillan, 1972, pp. 253–71. Klein, B. (1991), ‘Vertical integration as organizational ownership: the fisher body–general motors relationship revisited’, in O.E. Williamson and S. Winter, The Nature of the Firm: Origins, Evolution and Development, New York: Oxford University Press, pp. 213–26. Lane, R.E. (2000), The Loss of Happiness in Market Democracies, New Haven: Yale University Press. Marglin, S. (1974), ‘What do bosses do?’, Review of Radical Political Economics, 6(2), pp. 33–60. Marshall, A. (1873), ‘The future of the working classes’, in A. C. Pigou, Memorials of Alfred Marshall, London: Macmillan 1925, pp. 101–18. Marshall, A. (1889), ‘Co-operation’, in A.C. Pigou, Memorials of Alfred Marshall, London: Macmillan 1925, pp. 227–55. Marshall, A. (1890), Principles of Economics, London: Macmillan. Marshall, A. (1897), ‘The old generation of economists and the new’, in A. C. Pigou, Memorials of Alfred Marshall, London: Macmillan, 1925, pp. 295–311. Marshall, A. and M. Marshall (1881), The Economics of Industry, 2nd edn., London: Macmillan. Marx, K. and Engels, F. (1845–46), The German Ideology, Engl. transl., New York: International Publishers, Inc., 1939. Marx, K. (1864), ‘Inaugural address of the working men’s international association’, reprinted in K. Marx and F. Engels, Collected Works, vol. 20, London: Lawrence and Wishart. Marx, K. (1867), Capital, vol. I, Engl. transl., Harmondsworth, Middlesex: Penguin Books, 1976. Marx, K. (1984), Capital, vol. III, Engl. transl., Harmondsworth, Middlesex: Penguin Books, 1981. Mc Cain, R.A. (1992), ‘Transaction costs, labor management, and codetermination’, in D.C. Jones. and J. Svejnar, Advances in the Economic Analysis of Participatory and Labor Managed Firms, vol. IV, Greenwich, CT: JAI Press, pp. 205–22. Mill, J.S. (1871), Principles of Political Economy, edited by Ashley, Longmans, Green & Co., London, 1909. Musgrave, R.A. (1958), ‘On merit goods’, re-printed in R.A. Musgrave, Public Finance in a Democratic Society; Collected Papers of Richard A. Musgrave, vol. I, Brighton: Wheatsheaf Books, 1986, pp. 26–31.

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Musgrave, R.A. (1959), The Theory of Public Finance, New York, Mc Graw-Hill. Musgrave, R.A. (1987), ‘Merit goods’, in J. Eatwell, M. Milgate, and P. Newman., The New Palgrave. A Dictionary of Economics, vol. 3, London: Macmillan, pp. 452–53. Nozick, R. (1974), Anarchy, State and Utopia, Oxford: Basil Blackwell. Ollman, B. (1998), ‘Market mystification in capitalist and market socialist societies’, in. B. Ollman, Market Socialism; the Debate among Socialists, London: Routledge, pp. 81– 121. Pesciarelli, E. (1981), Un nuovo modo di produrre; la cooperazione nel pensiero degli economisti classici da Smith a Cairnes, Ancona: Editrice CLUEP. Putterman, L. (1990), Division of Labour and Welfare; an Introduction to Economic Systems, Oxford: Oxford University Press. Putterman, L., J.E. Roemer and J. Silvestre (1998), ‘Does egalitarianism have a future?’, Journal of Economic Literature, 36(June), pp. 861–902. Raffaelli, T. (2000), ‘Sul movimento cooperativo nel pensiero di John Stuart Mill e Alfred Marshall’, Il Ponte, 56(11-12), pp.54–66. Rawls, J. (1971), A Theory of Justice, Oxford: Oxford University Press. Rothshild, J. and J. Whitt (1986), The Cooperative Workplace, London: Routledge. Sweezy, P.M. (1968–69), ‘The Invasion Of Czechoslovakia: Czechoslovakia, Capitalism, And Socialism’, Monthly Review, 20, pp. 5–16. Tavares, J. and R. Wacziarg (2001), ‘How democracy affects growth’, European Economic Review, 45(8), pp. 1341–78. Ticktin, H. (1998), ‘The problem is market socialism’, in B. Ollman, Market Socialism; the Debate among Socialists, London: Routledge, pp. 55–80. Vacca, G. (1977), Quale democrazia?, Bari: De Donato. Vanek, J. (1971a), ‘Some fundamental considerations on financing and the form of ownership under labor management’, re-printed in J. Vanek, The Labor Managed Economy: Essays by Jaroslav Vanek, Ithaca: Cornell University Press, 1977, pp. 171– 85. Vanek, J. (1971b), ‘The basic theory of financing of participatory firms’, re-printed in J. Vanek, The Labor Managed Economy: Essays by Jaroslav Vanek, Ithaca: Cornell University Press, 1977, pp. 186–98. Webb, S. and B. Webb (1921), A Constitution for the Socialist Commonwealth of Great Britain, London: Longman. Webb, S. and B. Webb (1923), The Decay of Capitalistic Civilization, London: Allen & Unwin. Weingast, B.R. and W.J. Marshall (1988), ‘The industrial organization of congress; or, why legislatures, like firms, are not organized as markets’, Journal of Political Economy, 96(February), pp. 132–63. Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press. Williamson, O.E. (1986), Economic Organizations: Firms, Market and Policy Control, New York: Harvester Wheatsheaf. Williamson, O.E. and S. Winter (1991), The Nature of the Firm: Origins, Evolution and Development, New York: Oxford University Press.

Chapter 19

Rent, Technology, and the Environment Alberto Quadrio Curzio and Fausta Pellizzari*

19.1

Introduction

In this chapter we consider the problems of how environmental resources can be introduced in a linear multisectoral model of production and price distribution and what consequences such an introduction will have on ranking techniques. The original model within which this problem is considered has recently been developed in many ways by the authors (Quadrio Curzio and Pellizzari, 1996– 1999, 1998, Quadrio Curzio, 1997, Pellizzari, 2001). The novelty of this essay is to consider environmental resources and to show how the original model is flexible enough to take them into account, especially due to the choice of techniques.

19.2

Utilization and Reintegration of Environmental Resources

Let us assume that R represents the total quantity of an available environmental resource at time t and that the use of the environmental resource is proportional to the level of production. The symbol r ′ = [r1

r2

... rm ]

(19.1)

is a row vector, and the element ri is the coefficient of the environmental resource employed and destroyed to produce a unit of the i-th commodity. Total use of the environmental resource is therefore

mR = r ′q ≤ R

(19.2)

with q representing the vector of the produced quantities of the m commodities. Let us assume that the quantity of the available environmental resource at time t cannot be raised. After being used as a means of production in the productive processes, however, a partial reintegration of quantity R is possible. In other words the process of production of qR must be activated to recover part of the environmental resource used in the production processes, but the total consumed quantity mR cannot be recovered.

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Now we should assess the ways to connect the input coefficients of the environmental resource used to produce q and the coefficients of reintegration of R to the technical coefficients of the traditional matrix. There are different ways to connect these coefficients that we discussed in previous essays (Pellizzari, 2001). In this essay we choose to consider each sector employing the environmental resource broadly responsible for its reintegration according to the Polluter Pays Principle (PPP). The Polluter Pays concept is a wellestablished legal principle in international law. In stating its ‘Guiding Principles Concerning International Economic Aspects of Environmental Policies’ the Organization for Economic Development and Cooperation was the first organization to codify the Polluter Pays Principle, explaining the concept as ‘the principle to be used for allocating costs of pollution prevention and control measures to encourage rational use of scarce environmental resources and to avoid distortions in international trade and investment … This principle means that the polluter should bear the expenses of carrying out the above mentioned measures decided by public authorities to ensure that the environment is in an acceptable state. In other words, the cost of these measures should be reflected in the cost of goods and services which cause pollution in production and/or consumption’ (OECD, Recommendation of the Council of 26th May 1972 on Guiding Principles Concerning International Economic Aspects of Environmental Policies [C(72)128], 1972). The Polluter Pays Principle is a policy whereby governments seek to preserve a safe and healthy environment while making polluters pay for their pollution abatement costs. Applying the Polluter Pays Principle raises a myriad of subsidiary questions. The two basic questions are: who are the polluters? What should they pay for? In this essay we take into account the ‘liability of the polluters’, modifying both the traditional quantity system and the price-distribution system. This means that each sector of the economic system will bear the burden of partial reintegration of the environmental resource. As regards the first system we choose to raise the technical coefficients of the traditional matrix A by introducing the coefficients of reintegration of the environmental resource, A being the typical non-negative, indecomposable, and viable matrix of technical coefficients. The changes in the traditional price-distribution system will be discussed in § 19.6. Let us define an input vector of technical coefficients devoted to reintegrating the environmental resource

a′R = [a1R

a2 R ... amR ]

(19.3)

The element aiR is the quantity of the i-th commodity required to reintegrate the use of one unit of environmental resource at the maximum possible level. So each ai process of production becomes:

Rent, Technology, and the Environment

aˆ ′i = [a1i + a1R ri

a2i + a2 R ri

... ami + amR ri ]

335

(19.4)

In general, the partial reintegration matrix of the environmental resource, R, takes the form:  a1R r1 a1R r2 ... a1R rm   a r a r ... a r  2R 2 2R m  R = aRr′ =  2R 1 (19.5)  a3 R r1 a3 R r2 ... a3 R rm   a r a r ... a r  mR 2 mR m   mR 1 Post-multiplying the matrix R by the vector q, we obtain a vector q R , whose generic i-th element gives the quantity of the i-th commodity devoted to the partial reintegration of the environmental resource used in producing the vector q. Of course a necessary condition to carry out the reintegration is q R ≤ q , that is the maximum eigenvalue of matrix R must be no higher than one. For the reproduction of the environmental resource, let us assume that its production function depends on the quantity of commodities devoted to partial reintegration, the level of its stock, the quantity of labour employed to carry out the reintegration, as well as the quantity of environmental resource used as a means of production. We have then qR = F (q R , R, LR , mR )

(19.6)

with LR representing the labour employed in the reintegration process. The form of this production function allows only one output qR ≤ mR , whatever is the quantity of means of production and labour employed in its production (Pellizzari, 2001).

19.3

The Problem of the Choice of Techniques

If we consider the reintegration of the environmental resource, holding each sector responsible for the partial reintegration of the quantity of the resource it employs, the matrix of technical coefficients and the vector of labour coefficients become respectively [A + R ] and [l ′ + l ′R ] . The matrix [A + R ] includes m processes producing m commodities. When every commodity is produced from a single production process there is no problem of choice of techniques. When for the same commodity several production processes are available, its production can take place only after having made a selection according to some criteria. If we assume that for every j-th commodity hj production processes are available, then we can build h1... h2... hj... hm = h matrices of technical coefficients by combining in all possible ways the production processes and by choosing one

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for each commodity. We can associate to every  A ( h ) + R ( h ) matrix thus obtained the corresponding vector of labour coefficients l ( h ) '+ l ( h ) ' R ( h ) . Now we face the problem of selecting the technique to activate among the h available matrices. Our past analysis of the choice of techniques was based fundamentally on two criteria: one considers physical efficiency; the other the level of rentability; terminology which we originally used to analyze the problem of rent (Quadrio Curzio and Pellizzari, 1996). The first criterion ranks techniques according to their ability to generate net product: the techniques are ranked according to their uniform rate of net product and the most efficient technique is the one with the highest magnitude of this rate. In the case of total accumulation of net product, the choice of this technique also allows maximum growth for the economic system. The second criterion ranks techniques according to their costs of production. This is not exclusively a technological criterion. Minimisation of production costs depends not only on the technology of the system but also on the distribution of income. From another point of view, this criterion ranks techniques according to the level of the rate of profit (wage) for a given level of wage (rate of profit), the most efficient being the technique with the highest rate of profit (wage), for a given level of the other distributive variable. Changing the value of the latter may affect the ranking among techniques.

19.4

The Criterion of Physical Efficiency

Now we aim to inquire if the previous ranking criteria of techniques are still valid when environmental resources are employed in production and must be reintegrated at the maximum possible level. With the first criterion, the ranking among the production techniques depends on the rate of net product. The matrices of technical coefficients A ( h ) , without considering (or using) the environmental resource, can be ranked according to the magnitude of the uniform rate of net product s ( h ) which is determined by solving, for each h, the following system 1 + s ( h )  A ( h ) − I  q ( h ) = 0

(19.7)

where q ( h ) is the vector of production at a uniform rate of net product, which is also the uniform and maximum rate of growth. Following the magnitudes of s ( h ) to rank techniques is correct only if the production processes do not consume the environmental resource. If this resource is indeed used in production, then the physical efficiency of techniques cannot be established on the magnitudes of s ( h ) . In this case the s ( h ) magnitudes are unable to discriminate among techniques: in the presence of the environmental

Rent, Technology, and the Environment

337

resource, the rate of net product loses its property of being a suitable index. The environmental resource, consumed and destroyed in the production process, can be only partially reintegrated, yet the values of s ( h ) are left unaffected. However, in evaluating efficiency among techniques we must take into account the conditions of conservation of the environmental resource. Previously we presented a way to take account of the environmental resource, namely to raise the technical coefficients by adding the coefficients of reintegration. With the introduction of this kind of reintegration, the matrix of technical coefficients becomes  A ( h ) + R ( h ) and we can compute for this matrix the magnitude of the uniform rate of net product of s A+ R ( h) in order to determine the physical efficiency of that technique. The magnitude of s A+ R ( h) is determined by solving the following system 1 + s A+R ( h )  A ( h ) + R ( h ) − I  q A+R ( h ) = 0

(19.8)

where q A+ R ( h ) is the vector of production at a uniform rate of growth. Comparison between (19.8) and (19.7) shows that, with the reintegration of the environmental resource, the technical coefficients of the various production processes are increased and this increase causes a reduction in the uniform rate of net product. Therefore, system (19.8) is better than system (19.7) in assessing the physical efficiency of a technique when there is consumption of the environmental resource. However, if we use s A+ R (h) to rank the techniques, the result would be correct in the particular case of perfect reintegration of the environmental resource; that is, only in this case would the succession of the magnitudes of s A+ R ( h) show the order of physical efficiency among techniques. Importantly, ranking based on s (h) and that based on s A+ R (h) could be different. The increase in the technical coefficients, required by the reintegration of the environmental resource, could not be uniform in the various production processes. This has the effect of changing the order based on s( h), but one may argue that the relevant order is based on s A+ R ( h) . Yet we believe that in the general case of incomplete reintegration of the environmental resource, s A+ R (h) , although lower than s (h), does not fully represent the physical efficiency of a technique. The reintegration of the environmental resource is considered, but it is not complete. The existence of a negative net product of the environmental resource is not mirrored in s A+ R ( h) . There are serious doubts, therefore, in using this method to rank techniques. One observes that the greater the technological possibility of reconstituting the environmental resource, the greater the coefficients of the matrix  A ( h ) + R ( h ) and thus the lower s A+ R (h) . Paradoxically, the techniques with lower environmental reintegration possibilities would appear the most efficient, if estimated according to s A+ R (h) . If the environmental resource is only partially reconstituted, s A+ R (h) is insufficient to assess the physical efficiency of the techniques. In other words, if a technique, with s A+ R (h) lower than that of another technique, has a greater integration of R, the comparison between the two techniques becomes impossible on the basis of the rate of net product.

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Money Credit and the Role of the State

A proper method of selection among techniques must take account of the impact of each technique on the preservation of the environmental resource. One could think, for instance, of calculating for each technique the rate of exploitation of the environmental resource or even the length of the period in which the environmental resource will be available, at the current technological level, before being exhausted. One must face, finally, the problem of how to assemble the information embodied in the different indexes: the complexity of the operation is evident. The presence of the environmental resource prevents the formulation of ranking based on a single index, such as the uniform rate of net product. If we choose this rate, the most efficient technique in terms of s A+ R ( h) could not be the most efficient in terms of preserving the environmental resource. It is particularly difficult to find a happy medium between the importance of economic growth and the importance of maintaining a healthy environment. Yet, this assessment would be necessary to rank the techniques properly. The theoretical positions as well as the practical ones taken by public institutions are rather different, being affected by subjective considerations about the present and the future. There are several factors that weigh in favour of the present – the confidence that technical progress can relax the scarcity constraints of the environment in the coming years, the urgent need for the poorest countries to achieve rapid growth to improve living conditions and satisfy basic needs, and the influence on environmental policy exerted by lobbies with vested interests that perceive as a threat any decision entailing environmental protection. However, our improved knowledge of the weak equilibrium of many ecosystems, the existence of global environmental problems, the irreversibility of many environmental phenomena, the uncertainty about the consequences of such phenomena, ethical concerns on a fair inter-generational distribution of resources and the emergence of less anthropocentric and more ecocentric pressure movements, all this increasingly shifts the balance towards greater consideration for the future. Moreover, and although there is no full agreement on the policies that best implement sustainable development, increasing emphasis has been placed on this concept.

19.5

The Criterion of Rentability

To estimate the capability of techniques of minimising production costs, we begin by considering the following price-distribution system, summing up a wellestablished model: 1 + π ( h ) p ( h ) ' A ( h ) + w ( h ) l ( h ) ' = p ( h ) '

(19.9)

Rent, Technology, and the Environment

339

where π ( h ) represents the rate of profit, w ( h ) the wage of a unit of labour and p ( h ) the vector of prices. It is a well-known system of m equations in m + 2 unknowns, i.e. m prices plus π ( h ) and w ( h ) . The system is undervalued. Even with the choice of a commodity as a numeraire, we are left with a degree of freedom: one of the two distributive variables must be exogenously given to close the system and determine the prices and the other distributive variable. Once the level of wage has been fixed, the criterion of rentability ranks techniques according to the values of π ( h ) determined by the following system: 1 + π ( h ) p ( h ) ' A ( h ) + w l ( h ) ' = p ( h ) '

(19.10)

alternatively, in the case of an exogenously given rate of profit, the ranking of techniques is made on the values of w(h) determined by the following system

[1 + π] p ( h ) ' A ( h ) + w ( h ) l ( h ) ' = p ( h ) '

(19.11)

From (19.10) and (19.11), and with the i-th commodity as the numeraire, we have respectively w=

{

1

}

l ( h ) ' I − 1 + π ( h ) A ( h )

w(h) =

−1

1

(19.12) ei

l ( h ) '{I − [1 + π] A ( h )} ei −1

(19.13)

Ranking techniques according to the values π ( h ) obtained from (19.12) or according to the values w ( h ) obtained from (19.13), we obtain the order of rentability according to the magnitude π ( h ) or w ( h ) . This order is correct only if there is no consumption of the environmental resource. If this is not the case, the capability of the techniques of minimising the production costs cannot be established according to the values π ( h ) or w ( h ) , because equation (19.9) does not include the cost of reproduction of this resource. There are different ways to introduce this cost and each will change the pricedistribution system.

19.6

Rentability and Reintegration

First we consider the case in which the price of the environmental resource pˆ R ( h ) covers the cost of reintegration, with its profit margin, and the labour cost employed in reproducing it, that is

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pˆ R ( h ) = 1 + πˆ ( h ) pˆ ( h ) ' a R ( h ) + wˆ ( h ) l ( h ) ' a R ( h )

(19.14)

pˆ R ( h ) is a sort of shadow price, depending on the cost of partial reintegration, and can be interpreted as the minimum price of the environmental resource, because if this price were below the level of (19.14), it could not even cover this cost. In order to determine pˆ R ( h ) , and the order of rentability among techniques, we must modify the traditional price-distribution system that, in this case, becomes

1 + πˆ ( h ) pˆ ( h ) ' A ( h ) + wˆ ( h ) l ( h ) '+ pˆ R ( h ) r ( h ) ' = pˆ ( h ) '

(19.15)

System (19.15) shows the relation between distribution, commodity prices and the price of the environmental resource. This system is undervalued, as it is a system of m equations in m + 3 unknowns, i.e. the prices of the m commodities, the price of the environmental resource, plus πˆ ( h ) and wˆ ( h ) . We suppose that the price of the environmental resource is determined according to its reintegration cost. Given (19.14), system (19.15) becomes 1 + πˆ ( h ) pˆ ( h ) ' A ( h ) + wˆ ( h ) l ( h ) '+

{

}

+ 1 + πˆ ( h ) pˆ ( h ) ' a R ( h ) + wˆ ( h ) l ( h ) ' a R ( h ) r ( h ) ' = pˆ ( h ) '

(19.16)

that is 1 + πˆ ( h ) pˆ ( h ) '  A ( h ) + R ( h ) + wˆ ( h ) l ( h ) '+ l ( h ) ' R ( h ) = pˆ ( h ) ' (19.17) Also system (19.17), as was system (19.15), is undervalued; but we can close the system by choosing a commodity as a numeraire and fixing the level of one of the two distributive variables. Thus we can determine the prices of the m commodities, the price of the environmental resource and the other distributive variable. Once the level of wage is given exogenously, setting ˆl ( h ) ' = l ( h ) '+ l ( h ) ' R ( h ) and with the i-th commodity chosen as the numeraire, the criterion of rentability ranks techniques according to the values of πˆ ( h ) determined by the following equations: w=

{

1

}

ˆl ( h ) ' I − 1 + πˆ ( h )  A ( h ) + R ( h )    

−1

(19.18) ei

Alternatively, in the case of an exogenously given rate of profit, the ranking of techniques is made on the values of wˆ ( h ) determined by the following equations:

Rent, Technology, and the Environment

wˆ ( h ) =

1

{

341

}

ˆl ( h ) ' I − [1 + π]  A ( h ) + R ( h )  

−1

(19.19) ei

By comparing (19.18) with (19.12) and (19.19) with (19.13), it may be noted that the increase in the technical coefficients brings about a lower rate of profit (wage) for any given level of wage (rate of profit), due to the partial reintegration of the environmental resource. It is important to note that the ranking of techniques according to πˆ ( h ) (or wˆ ( h ) ) could differ from that established according to π ( h ) (or w ( h ) ), the former being a function of the coefficients of reintegration. The level of rentability of techniques according to the values of πˆ ( h ) obtained from (19.18), or to the values of wˆ ( h ) obtained from (19.19), is correct if the cost of using the environmental resource is properly accounted for. For instance 1 + πˆ ( h ) pˆ ( h ) ' R ( h ) + wˆ ( h ) l ( h ) ' R ( h ) ei is an accurate evaluation of the cost of the environmental resource per unit of production in each i-th sector only if the environmental resource could be completely reintegrated. In this particular case, the sequence of πˆ ( h ) (or alternatively of wˆ ( h ) ) gives the correct order of rentability among techniques. But we have assumed that, by its very nature, the environmental resource cannot be completely reintegrated and the order of rentability cannot be established on those values. When the rentability of the various techniques is determined according to the costs of partial reintegration, including the labour cost and the profit margin, the global costs involved by the activation of each technique, which might also include the degradation of the environmental resource, are missing in the computation.

{

19.7

}

Rentability, Scarcity and Incomplete Reproducibility

The price of the environmental resource determined according to (19.14) does not consider its scarcity nor the reduction in its stock; such a relation gives the correct price only when the reintegration of the environmental resource is perfect. With the assumption of non-complete reintegration, the price to be applied should be greater than that given by (19.14) in order to allow for the loss of the resource, which cannot be reproduced. The order of rentability, that is the order that minimises the production costs, can be correctly determined by considering all the production costs. The price of the environmental resource must include both its costs of reintegration both the other additional costs derived from its consumption; only referring to this price it would be possible to determine a correct order of rentability among techniques. Let us assume, for instance, that p R ( h ) = 1 + π ( h ) p ( h ) ' a R ( h ) + w ( h ) l ( h ) ' a R ( h ) + ρ ( h )

(19.20)

342

Money Credit and the Role of the State

Equation (19.20) takes account of the scarcity and incomplete reproducibility of the environmental resource: the price of the environmental resource is made of two components – one that reflects the cost of partial reintegration, including the labour cost and the profit margin, and the second that reflects the environmental rent ρ ( h ) , that is a true rent, being the difference between the price of the environmental resource and its cost of partial reproduction. If this latter component is determined taking into account the incomplete reproducibility and scarcity of the resource, then a correct order of rentability among techniques is achievable. To establish this order of rentability we must refer to the following price-distribution system:  ( h ) l ( h ) '+  p ( h ) r ( h ) ' = p ( h ) ' 1 + π ( h ) p ( h ) ' A ( h ) + w R

(19.21)

System (19.21) results undervalued, as it is a system of m equations in m + 3 unknowns, i.e. the prices of the m commodities, the price of the environmental resource, plus π ( h ) and w ( h ) . We supposed that the price of environmental resource covers its reintegration cost and includes a pure environmental rent. Given (19.20), system (19.21) becomes  ( h ) l ( h ) '+ 1 + π ( h ) p ( h ) ' A ( h ) + w

{ 1 + Œ (K ) p (K ) ' a

( K ) + Z ( K ) l ( K ) ' a R ( K ) + ρ ( K )} r ( K ) ' = p (K ) '

(19.22)

 ( h ) ˆl ( h ) '+ ρ ( h ) r ( h ) ' = p ( h ) ' 1 + π ( h ) p ( h ) '  A ( h ) + R ( h ) + w

(19.23)

R

that is

System (19.23) is undervalued; as it is a system of m equations in m + 3 unknowns, i.e. the prices of the m commodities, the pure environmental rent, plus π ( h ) and w ( h ) . Even if we choose a commodity as a numeraire and consider the value of one of the two distributive variables exogenously given, we cannot close the system; we need to know the value of ρ ( h ) . Environmental resources are non-market goods; however we need to assign them a monetary value in order to determine a proper order of rentability among techniques. There are different kinds of techniques available for environmental valuation: the various approaches may be summarized as conventional market, implicit market and constructed market. In order to assign values on non-traded goods and services the first approach considers the traded goods markets and seeks to establish a link between market values and environmental values. The production function method, the dose–

Rent, Technology, and the Environment

343

response method, preventive and defensive expenditures and the opportunity cost method belong to this approach. Under the production function method, the environment is considered a factor of production. Changes in environmental quality lead to changes in outputs and prices; the value of these changes is used to determine the value of the environmental change. Under the dose–response method, a relationship between pollution and illness is established; then the cost of the increase in morbidity and mortality is estimated and used to infer the value of the environmental change. Under the defensive expenditure valuation method, the value of the environmental change is inferred from the defensive expenditures that individuals and the community choose to incur in order to prevent or mitigate environmental damage. The implicit market approach infers the valuations of features of the environment by observing the behaviour of individuals who reveal their implicit valuations of those features. The main techniques belonging to this approach are hedonic pricing and the travel cost method. Hedonic pricing is based on the valuation of the contribution of environmental quality to total economic value. For example it is possible to infer the valuation of different levels of environmental quality by observing the differences in rents and prices for properties with different environmental amenities that individuals are willing to pay or observing the differences in wages that individuals are willing to accept for work in different locations. Under the travel cost method the valuation of a particular environment, for example a recreational site, is inferred from the expenditure that individuals are willing to incur in order to reach that site. The last approach consists in constructing a hypothetical market and the valuation of an environmental asset is determined by directly questioning individuals. The main technique belonging to this approach is the contingent valuation method. Under this method individuals are asked to state their willingness to pay for an environmental benefit or their willingness to accept compensation for a loss of environmental quality. All these approaches are useful in order to derive a monetary value for goods without a market value and to permit proper environmental management decisions. However, the above methods involve different valuations of environmental resources and environmental qualities. Depending on which approach we choose to infer the value of the environmental rent, we obtain different values of ρ ( h ) and therefore different rankings among techniques. In fact, once we have established the value of ρ ( h ) , the order of rentability among techniques is made on the values of π ( h ) determined by the following equations

344

Money Credit and the Role of the State

{

}

−1

1 − ρ ( h ) r ( h ) ' I − 1 + π ( h )  A ( h ) + R ( h ) w= ˆl ( h ) ' I − 1 + π ( h )  A ( h ) + R ( h ) −1 e i    

{

}

ei

(19.24)

when the wage is exogenously given and the i-th commodity is chosen as the numeraire. When the rate of profit is exogenously given, the ranking of techniques is made on values of w ( h ) determined by the following equations

{

}

1 − ρ ( h ) r ( h ) ' I − [1 + π]  A ( h ) + R ( h ) w ( h ) = ˆl ( h ) ' I − [1 + π]  A ( h ) + R ( h ) −1 e i  

{

19.8

}

−1

ei

(19.25)

Concluding Remarks

The analysis raises several problems when the order of techniques involves environmental resources that cannot be completely restored. First, we observed the impossibility of having a single index to evaluate physical efficiency – an impossibility that disappears when the environmental resource is not consumed or is fully replaced. The equilibrium point between the information embodied in the index s A+ R (h) and the information derived from a broader consideration of the full environmental impact of the technique  A ( h ) + R ( h ) – equilibrium that is necessary to determine physical efficiency – is left ultimately to subjective evaluation. The analysis of the choice of techniques without considering the environmental resource highlights a relationship between the order of physical efficiency and the order of rentability. Namely, it shows their coincidence when the former order is calculated according to the maximum rate of profit of each technique. This consideration suggests the superiority of the order of physical efficiency, since it is unaffected by income distribution. Yet our analysis, by considering the environmental resource, shows the impossibility of defining unequivocally the order of physical efficiency. At first sight, this observation would confer superiority on the criterion of rentability in ranking the techniques. When we consider the order of rentability, the discretionary assessment, which hampers the formulation of an unequivocal order of physical efficiency, also prevents an order among techniques being defined. This is because also in this case the order depends on the subjective evaluation attached to the environmental resource. Indeed, analysis of the order of rentability has led to ranking the techniques in various orders according to the method adopted in determining the price of the environmental resource.

Rent, Technology, and the Environment

345

The order based on (19.12) or (19.13) is the order followed by entrepreneurs if they are not charged for the use of the environmental resource. We already observed that this order of rentability – i.e. the one that minimises the production costs of the economic system – is correct only if the environmental resource is not employed. The order based on (19.18) or (19.19) is the order followed by entrepreneurs if each economic sector is charged for the reintegration of the environmental resource. This order minimises the production costs of the economic system only if the environmental resource can be completely reintegrated. The order based on (19.24) or (19.25) is the order followed by entrepreneurs if each economic sector is charged for the reintegration of the environmental resource plus an additional amount given by ρ that allows for the scarcity and partial reproducibility of the environmental resource. This order minimises the costs of production also of the entire economic system. An order determined in this way may change every time ρ changes. Any value imputed to the latter variable, therefore, has far-reaching consequences for the choice of technique and the degree of conservation of the environmental resource.

Note *

†† 19.1, 19.2, 19.4 were written by Alberto Quadrio Curzio; §§ 19.5, 19.6, 19.7 were written by Fausta Pellizzari; §§19.3, 19.8 were written by both authors. Financial support from D.1. 2001 Catholic University of Milan research program is gratefully acknowledged.

References Barde, J. and D.W. Pearce (eds), (1991), Valuing the Environment, London: Earthscan Publications Limited. Fisher, A.C. (1981), Resource and Environmental Economics, Cambridge: Cambridge University Press. Leontief, W. et alii (1977), The Future of the World Economy, Oxford: Oxford University Press. Meadows, D. et alii (1972), The Limits to Growth, New York: Universe Book. Meadows, D. et alii (1992), Beyond the Limits, Post Mills: Chelsea Green Publishing Company. Musu, I. and D. Siniscalco (eds), (1993), Ambiente e Contabilità Nazionale, Bologna: Il Mulino. OECD (1972), Recommendation of the Council of 26th May 1972 on Guiding Principles Concerning International Economic Aspects of Environmental Policies C(72)128. Pasinetti, L. (1975), Lezioni di Teoria della Produzione, Bologna: Il Mulino, English trans. (1977), Lectures on the Theory of Production, London: Macmillan.

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Pearce, D.W. and R.K. Turner (1990), Economics of Natural Resources and the Environment, New York: Harvester Wheatsheaf. Pellizzari, F. (2001), ‘Environmental resources, prices and distribution’, Economia politica, 3. Quadrio Curzio, A. (1997), ‘Rendita’, in Enciclopedia delle Scienze Sociali, Roma: Istituto della Enciclopedia Italiana Treccani, Volume VII. Quadrio Curzio, A. (1998), ‘Rent’, in H.D. Kurz and N. Salvadori (eds), Elgar Companion to Classical Economics, Cheltenham: Edward Elgar. Quadrio Curzio, A. and F. Pellizzari (1996), Risorse, Tecnologie, Rendita, Bologna: Il Mulino, English trans. (1999), Rent, Resources and Technologies, Berlin: SpringerVerlag. Quadrio Curzio, A.and F. Pellizzari (1998), ‘Extensive and intensive rent’, in H.D. Kurz and N. Salvadori (eds), Elgar Companion to Classical Economics, Cheltenham: Edward Elgar. Turner, R.K., D.W. Pearce and I. Bateman (1994), Environmental Economics. An Elementary Introduction, New York: Harvester Wheatsheaf. World Commission on Environment and Development (1987), Our Common Future, Oxford: Oxford University Press.

Chapter 20

Is Ricardian Extensive Rent a Nash Equilibrium? *

Neri Salvadori

20.1

Introduction

The Ricardian extensive theory of rent is well known and does not require an introduction. The chapter ‘On Rent’ in Ricardo's Principles is certainly the locus classicus of the Ricardian theory of rent. More recently the issue has been investigated by Samuelson (1959), Sraffa (1960, pp. 74–8) and Quadrio Curzio (1967, 1980); see also Kurz and Salvadori (1995, pp. 277–320) and the literature referred to there. Following Ricardo and the other Classical authors, none of the modern contributors give a role to the distribution of land ownership among landlords. In this chapter, on the contrary, I will argue that if the demand for agricultural commodities and the distribution of marginal land ownership is such that demand can be satisfied only if the owner of the largest plot of that land rents out at least part of his or her land, then a positive rent on marginal land is possible (if landlords behave in a strategic way). This chapter is not devoted to a complete analysis of the case under consideration. In this respect I will fully explore only two cases: that in which each owner has the same amount of marginal land and that in which there are just two owners. The other sections are as follows. Section 20.2 provides a summary account of a simple model of Ricardian extensive rent in order to introduce the language used in the following sections. Section 20.3 shows with a simple example in which the marginal land is equally distributed among a finite number of landlords that there are cases in which the equilibrium predicted by the Ricardian extensive theory of rent is not a Nash equilibrium, that no Nash equilibrium in pure strategies exists whereas there is one in mixed strategies. Section 20.4 shows exactly the same thing when marginal land is not equally distributed and there are only two owners of marginal land. Sections 20.5 raises some doubts on the relevance of the results presented when interpreted as a criticism of Ricardo; it suggests that a deeper analysis of Ricardo's ideas on the attitudes of landlords would be needed. Section 20.6 provides some concluding remarks.

348

20.2

Money Credit and the Role of the State

Ricardian Extensive Rent Theory

In this section I will give a presentation of extensive rent in the simplest case, that is when a commodity is produced by labour and land. The aim is just to introduce the language that will be used in the rest of the chapter. Thus the reader familiar with the literature on rent referred to by Kurz and Salvadori (1995, pp. 305–311) can skip this section. Many of the assumptions used in this section are totally dispensable for the argument developed in the following sections. Consider an economy which produces only ‘corn’. At the beginning of the production period labourers cultivate the land and at its end they harvest the crop. There is no commodity input in the production, i.e. there are no produced means of production. Corn is the only means of subsistence to support the population. Cultivation of the land does not alter the quality of the land. Labour is of uniform quality. There is no use of land other than employing it in corn production. As a consequence, the reservation price of the use of land is zero.1 By contrast, the reservation price of labour in terms of corn is positive, even if it is not specified. Production is taken to be a time-consuming process. The length of the production period is assumed to be uniform across all available processes of production; that period is here called a ‘year’. Wages and rents will be paid to workers and landlords respectively at the end of the year. The production technology can be represented, in abstract terms, as a set of processes. Returns to scale with regard to each process are assumed to be constant. There are n different qualities of land, named 1, 2, ... , n , and for each quality of land there is exactly one process producing corn. Each process can be described as follows: t acres of land i ⊕ li hours of labour → 1 bushel of corn or, for short, ti ⊕ li → 1 Table 20.1 provides the list of the existing processes. Obviously the existing qualities of land (and corresponding processes) can be numbered in such a way that l1 ≤ l2 ≤ ... ≤ ln . Let us first assume that l1 < l2 < ... < ln . The case in which li = li +1 , some i, will be considered later. Let G be the amount of corn produced and let Ti be the existing amount of land of quality i. If land i is cultivated, the following equation must be satisfied: ti qi + wli = 1

where qi is the rent per acre (or rate of rent) of land of quality i and w is the (post factum) wage rate.2 Obviously w > 0 and q j ≥ 0 . Moreover, it is assumed that no process can yield a surplus. Otherwise all farmer-capitalists would prefer to operate the surplus yielding process. Therefore it is assumed that: t j q j +wl j ≥ 1

(j = 1, 2,..., n)

Is Ricardian Extensive Rent a Nash Equilibrium?

Table 20.1

349

The processes of production land inputs

processes

1

2

(1)

t1

—

(2)

—

... (n)

...

n

labour

corn

...

—

l1

→

1

t2

...

—

l2

→

1

...

...

...

...

...

→

...

—

—

...

tn

ln

→

1

If none of the qualities of land is scarce, competition amongst landlords drives the rent for each quality of land down to zero. As Ricardo wrote: On the first settling of a country, in which there is an abundance of rich and fertile land, a very small proportion of which is required to be cultivated for the support of the actual population, or indeed can be cultivated with the capital which the population can command, there will be no rent; for no one would pay for the use of land, when there was an abundant quantity not yet appropriated,3 and, therefore, at the disposal of whosoever might choose to cultivate it (Works I, p. 69, emphasis added).

Also in the subsequent paragraph Ricardo insists that in these circumstances the rent must be nought. On the common principles of supply and demand, no rent could be paid for such land, for the reason stated why nothing is given for the use of air and water, or for any other of the gifts of nature which exist in boundless quantity. With a given quantity of materials, and with the assistance of the pressure of the atmosphere, and the elasticity of steam, engines may perform work, and abridge human labour to a very great extent; but no charge is made for the use of these natural aids, because they are inexhaustible, and at every man's disposal. In the same manner the brewer, the distiller, the dyer, make incessant use of the air and water for the production of their commodities; but as the supply is boundless, they bear no price (ibid.).

In such a situation with land of quality i being cultivated the wage rate w must satisfy the equation: wli = 1 As a consequence w = 1 li . If i ≠ 1 , then a surplus can be generated by operating process (1) since by assumption l1 < li . Hence, if landlords get nothing from renting their land, then only land 1 can be cultivated since all farmers would

350

Money Credit and the Role of the State

want to employ land 1. Since in this circumstance land 1 is not scarce, G must be lower than T1 /t1 , which is the maximum amount of corn producible on land of quality 1. As we have established, in this case all rent rates must equal zero and w = w1 :=

1 l1

A positive rent on land 1 needs to be paid when land 2 is taken into cultivation. When in the progress of society, land of the second degree of fertility is taken into cultivation, rent immediately commences on that of the first quality, and the amount of that rent will depend on the difference in the quality of these two portions of land (ibid.).

This is the case in which T1 /t1
t2 q2 + wl2 = 1

Since G < T1 / t1 + T2 / t2 at least part of the land of quality 1 or of quality 2 remains uncultivated. Land 1 is fully used, and q2 = 0 . In fact, if land 1 were not fully used, then competition amongst landlords would push q1 down. Of necessity only lands 1 and 2 are cultivated. In fact if land i ≠ 1, 2 is cultivated, then the tenant will get a lower amount of corn than that he or she can get on land 2. This is enough to determine the wage rate and the rates of rent: w = w2 :=

1 , l2

q1 = q12 :=

l2 − l1 , t1l2

qk = 0

(k = 2, 3, ... , n)

In the present case land of quality 2 is what is called marginal land, that is, the quality of land which is cultivated, but not fully used. (Conversely, those qualities of land which are fully used are called intra-marginal.) In the formula above q12 is the rent rate paid to the owners of land 1 on the assumption that land 2 is marginal. i −1 i In general, if ∑ h =1 Th th < G < ∑ h =1 Th th , the same argument proves that lands 1, 2,..., i – 1 are fully used; land i is used, but only partially, and the wage rate and rates of rent are determined as follows: w = wi :=

l −l 1 , qh = qhi := i h li th li qk = 0

(h = 1, 2, ... , i ) (k = i, i + 1, ... , n)

Is Ricardian Extensive Rent a Nash Equilibrium?

351

There remain two special cases to be analysed. The first refers to a constellation where several processes employ the same amount of labour per unit of product, that is the case in which two or more lands may be marginal at the same time. In order to simplify the exposition, let us assume that i −1 i +1 l1
1 − wli ≤ qi ,i +1 ti

1 − wlh ≤ qh ,i +1 th

qk = 0

(h = 1, 2, ... , i − 1) (k = i + 1, ... , n)

Hence we can conclude by asserting that if the quantity of produced corn is no n greater than ∑ h −1 Th th , then there is a positive wage rate and there are nonnegative rates of rent such that the economy can produce that quantity of corn. Further, ‘[i]t is only [...] because land of an inferior quality [...] is called into cultivation, that rent is ever paid for the use of [land]’ (ibid.).

20.3

The Distribution of Marginal Land Ownership: The Case of Equal Distribution of Marginal Land

In the exposition of the previous section no attention was paid to the distribution of land ownership. A simple example can raise some doubt as to the validity of the argument. Assume that the amount of land 1, T1 , is owned by s landlords and each of them owns T1 s units of it. Further, assume that ( s − 1)T1 st1 < G < T1 t1 . The Ricardian extensive rent theory predicts that the rent rate q1 equals 0. But this cannot be a Nash equilibrium. If all landlords but one charge a zero rent and one landlord charges a rent equal to q12 this ingenious landlord will be able to get a

352

Money Credit and the Role of the State

positive rent and he or she will be able to rent out the positive amount Gt1 − ( s − 1)T1 s of his or her land. No Nash equilibrium exists in pure strategies. Indeed, if not all landlords rent out their land at the same rate, all landlords who rent out their land at a rate lower than the maximum would get more if they were to rent out their land at a higher rate, provided it is still lower than the highest. If all landlords rent out their land at the same rate which is lower than q12 [ sGt1 − ( s − 1)T1 ] Gt1 , at least one of them would get more by renting out his or her land at the rate q12 . Finally, if all landlords were to rent out their land at the same rate greater than q12 [ sGt1 − ( s − 1)T1 ] T1 , at least one would get more by renting out his or her land at a slightly lower rate in order to rent out the whole amount of owned land instead of only part of it. A Nash equilibrium in mixed strategies can easily be found. It is clear that no landlord can charge a rate higher than qM := q12 , otherwise the tenants would prefer to rent land of quality 2. On the other hand no landlord is willing to charge a rate lower than qm :=

sGt1 − ( s − 1)T1 qM T1

otherwise it would be convenient to rent out the amount Gt1 − ( s − 1)T1 s of land at rate qM . Let Fj ( q ) ( j = 1, 2, ... , s) be the probability that all landlords but landlord j charge a rate lower than q; landlord j is indifferent among the rates in the range [qm , qM ] at which to rent out his or her land if Fj ( q ) is such that qm

T1 = qM s

T1  T1  T1   Gt1 − ( s − 1) s  = q Gt1 − ( s − 1) s  Fj ( q ) + q s 1 − Fj ( q )    

that is Fj ( q ) = F ( q ) :=

T1 ( q − qm )

(T1 − Gt1 ) sq

It is immediately recognised that F ( qm ) = 0 , F ( qM ) = 1

Finally if f j ( q ) ( j = 1, 2, ... , s) is the probability that landlord j charges a rate lower than q , then Fj ( q ) = Π f h ( q ) h≠ j

and, as a consequence of the perfect symmetry among the landlords, then f j ( q ) = f ( q ) := s −1 F ( q )

Is Ricardian Extensive Rent a Nash Equilibrium?

353

It is also possible to calculate the average rate of rent q1a . Since each landlord gets a payoff of qM [sGt1 − ( s − 1)T1 ] s , the s landlords get altogether qM [sGt1 − ( s − 1)T1 ] for the use of the amount Gt1 of land 1. Then q1a = qM

sGt1 − ( s − 1)T1 T = qm 1 Gt1 Gt1

Hence w=

1 − t1q1a l1

When q1a = 0 (that is G = ( s − 1)T1 st1 ), w = 1/ l1 , whereas when q1a = qM = q12 (that is G = T1 t1 ), w = 1/ l2 . Assume now that the amount of land i, Ti, is owned by s landlords and each of them owns Ti s amount of land. Further, assume that i Th ( s − 1)Ti Th G + < < ∑ ∑ sti h =1 t h h =1 t h i −1

Following the previously stated argument it is possible to show that the solution predicted by the Ricardian theory of extensive rent is not a Nash equilibrium, that no Nash equilibrium in pure strategies exists and that a Nash equilibrium in mixed strategies exists and the average rent on land i is q1a = qi ,i +1

sG * ti − ( s − 1)Ti G * ti

where i −1

Th h =1 t h

G* = G − ∑

Then the wage rate and the rent rates of all lands are determined: w=

1 − ti qia 1 − wlh , qh = li th qk = 0

20.4

(h = 1, 2, ... , i − 1) (k = i + 1, ... , n)

Marginal Land Ownership Distribution: The Case of Two Landlords

In the previous section it was assumed that the marginal land was equally distributed among s landlords. In this section I wish to consider the case in which

354

Money Credit and the Role of the State

marginal land is not equally distributed, but where there are only two owners of marginal land. Assume that the amount of land i, Ti , is owned by two landlords, landlord j owns the amount Tij ( j = 1, 2 ) of land i, and Ti1 > Ti 2 . Further, assume that: i −1

Th

h =1

h

∑t

+

i Ti 2 T
Following the previously stated argument it is possible to show that the solution predicted by the Ricardian theory of extensive rent is not a Nash equilibrium and that no Nash equilibrium in pure strategies exists. Let us define  T  Th , G ** := min  G*, i1  ti  h =1 th  i −1

G* := G − ∑

It is clear that no landlord can charge a rent rate higher than qM := qi ,i +1 , otherwise the tenants would prefer to rent land of quality i + 1 . On the other hand landlord 1 is not willing to charge a rent rate lower than qm :=

G * ti − Ti 2 qM G **ti

otherwise it would be convenient to rent out the amount G * ti − Ti 2 of land at rate qM. Hence, landlord 2 is also not interested in renting out his or her land at a rate lower than qm, provided that the probability of landlord 1 renting out his or her land at rate qm is nought. Let f j ( q ) ( j = 1, 2 ) be the probability that landlord j charges a rate lower than q; then landlord 1 is indifferent among the rates in the range ( qm , qM ) at which to rent out his or her land if f 2 ( q ) is such that qm G **ti = qM (G * ti − Ti 2 ) = q (G * ti − Ti 2 ) f 2 ( q ) + qG **ti 1 − f 2 ( q ) that is f2 (q ) =

G **ti ( q − qm )

(G **ti + Ti 2 − G * ti ) q

It is immediately recognised that f 2 ( qm ) = 0 ,

f 2 ( qM ) = 1

Similarly, landlord 2 is indifferent among the rates in the range ( qm , qM ) at which to rent out his or her land if f1 ( q ) is such that H = q (G* − G**) ti f1 ( q ) + qTi 2 1 − f1 ( q )

Is Ricardian Extensive Rent a Nash Equilibrium?

355

that is f1 ( q ) =

Ti 2 q − H

(G **ti + Ti 2 − G * ti ) q

where H is the expected payoff of landlord 2. Obviously 0 ≤ f1 ( q ) ≤ 1 for each q in [qm , qM ] if and only if4

(G* − G**) ti qM

≤ H ≤ Ti 2 qm

If H < Ti 2 qm , then landlord 2 could get a larger payoff by charging a rent equal to q :=

H + Ti 2 qm < qm 2Ti 2

Then H = Ti 2 qm and f1 ( q ) =

Ti 2 ( q − qm ) (G **ti + Ti 2 − G * ti ) q

It is immediately recognised that f1 ( qm ) = 0 , f1 ( qM ) =

Ti 2 <1 G **ti

This means that landlord 1 rents out his or her land at rate qM with probability 1 − Ti 2 G **ti , which is positive. As a consequence the support of the set of the strategies of landlord 2 is the range open on the right [qm , qM ) . On the contrary, the support of the set of the strategies of landlord 1 is the closed range [qm , qM ] . The average rate of rent q1a is determined by the ratio of the sum of the two expected payoffs to the cultivated land: q1a = qm

G **ti + Ti 2  T  T = 1 + i 2  1 − i 2 G * ti G ** t G * ti  i 

  qM 

Then the wage rate and the other rent rates are determined as at the end of the previous section.

20.5

Reasons to Ignore the Fact that Distribution of Properties May Affect Rent Rates

It could be interesting to investigate whether there are good reasons to ignore the fact that the distribution of landed property may affect rent rates. At the moment I can see only two circumstances which would work in this direction.

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First, if each landlord had just a small amount of land, then the strategic behaviour of landlords would explain such a small part of the formation of rent that it could be ignored. This reason is not very close to the idea of society that Ricardo had in mind. The landlords were mainly aristocrats, the monarchy, and the clergy. The idea of a world of small landowners was certainly not in Ricardo’s thoughts. Second, we can assume that landlords – precisely because they are mainly aristocrats, the monarchy, and the clergy – do not behave strategically since rentseeking or profit-seeking was not part of the behavioural code of these social classes. Both extensive and intensive rent can be explained on the assumption that the tenants are profit-seeking and the landlords just get what is offered to them (in the long run only the tenants offering the highest rent rate would survive). However, this contrast with the attitude of Ricardo towards the Wealth of Nations and the fact that WN, III abounds with arguments concerning the rent-seeking attitude of landlords; see for instance: Farms were enlarged, and the occupiers of land, notwithstanding the complaints of depopulation, reduced to the number necessary for cultivating it, according to the imperfect state of cultivation and improvement in those times. By the removal of the unnecessary mouths, and by exacting from the farmer the full value of the farm, a greater surplus, or what is the same thing, the price of a greater surplus, was obtained for the proprietor, ... . ... [the proprietor] was desirous to raise his rents above what his lands, in the actual state of their improvement, could afford. His tenants could agree to this upon one condition only, that they should be secured in their possession, for such a term of years as might give them time to recover with profit whatever they should lay out in the further improvement of the land. ... and hence the origin of long leases (WN, III.iv.13).

20.6

Concluding Remarks

The analysis of classical themes on the basis of game theory has a well-established tradition. I recall the analysis of competition à la Bertrand. Modern literature has shown that the result obtained by Bertrand requires that each duopolist has enough productive capacity to satisfy the whole demand. When this condition is not met, there are different outcomes. In this chapter I showed that a similar story can be told with respect to the Ricardian theory of extensive rent. The determination of rents yielded by intramarginal lands is analogous to the case in which two firms compete à la Bertrand, but the capacity available to each firm is severely constrained: each capacity is lower than or equal to the quantity which is the best reaction in the assumption that the other firm produces a quantity equal to its capacity. The determination of rents yielded by the marginal lands when the owner of the largest plot of marginal land does not need to rent out at least part of his or her land is

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analogous to the case in which two firms compete à la Bertrand and their capacities are higher than the quantity demanded when price equals zero and so the typical Bertrand outcome is obtained. These two results are also those predicted by the Ricardian theory of extensive rent. But if the owner of the largest plot of marginal land needs to rent out at least part of his or her land, then the Ricardian theory of extensive rent predicts exactly the same outcome. This chapter showed that such a prediction is not a Nash equilibrium and investigated two special cases: that in which marginal land is equally distributed among a finite number of landlords and that in which this is not so, but where there are only two landlords owning the marginal land. In both special cases a Nash equilibrium in mixed strategies was found. This is analogous to the case in which two firms compete à la Bertrand, but their capacities are between the two cases mentioned above.5 One of the main differences between the Ricardian theory of extensive rent and the argument proposed here is that the Ricardian theory predicts that if the output increases continuously, prices (including the wage and rent rates) change spasmodically, whereas if distribution of land property is taken into consideration, then if output increases continuously, prices are either constant or change continuously but not necessarily smoothly.

Notes *

1 2

3 4 5

Section 20.2 of this chapter draws freely on still unpublished fruits of a most pleasant collaboration with Heinz Kurz. I should like to thank Antonio D'Agata, Massimo De Francesco, Giuseppe Freni, Heinz Kurz, and Pier Mario Pacini for useful conversations on previous drafts of the other sections. An alternative use of the land – for example, a landowner retaining a part of his/her land for country walks or hunting – would run counter to the assumption that there is only a single commodity produced in the economy. The use of a post factum wage rate in a framework in which there are no material inputs apart for the use of land avoids the concepts of ‘capital’ and ‘profit’. Alternatively, also in order to be close to the spirit of the Ricardian presentation, we can assume that there is a given real ante factum wage rate w ≤ 1/ ln and that the rate of profit r is determined by the equation w = w(1 + r ) once the post factum wage rate is determined. In this way a fall in the post factum wage rate turns out to be a fall in the rate of profit. The reference to uncultivated land as ‘non-appropriated land’ could be considered a sign of a doubt of Ricardo about the issues developed in this chapter. However this doubt is not investigated at all by him. It is easily verified that (G * −G **)ti qM < Ti 2 qm since G **ti − Ti 2 > 0 and G **ti + Ti 2 > G * ti . These results concerning firms have been known since Kreps and Scheinkman (1983). In their paper they present a two-stage oligopoly game where in the first stage there is simultaneous setting of production capacities and, in the second, after capacity levels have been made public, there is production and price competition à la Bertrand. The unique outcome equilibrium is the Cournot equilibrium. Unlike capacity, the amounts of land cannot be modified by man: ‘Rent is that portion of the produce of the earth, which is paid to the landlord for the use of the original and indestructible powers of the soil’ (Works I, p. 67). Nevertheless, a two-stage model can be built. In the first stage the

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Money Credit and the Role of the State distribution of property rights on land among landlords can be established. I do not exclude that the Ricardo theory of extensive rent could be totally vindicated by proving that the outcome of the first stage cannot be that in which the owner of the largest plot of marginal land needs to rent out at least part of his or her land.

References Kreps, D., and J. Scheinkman (1983), ‘Quantity precommitment and Bertrand competition yield Cournot outcomes’, Bell Journal of Economics, 44, pp. 326–37. Kurz, H.D. and N. Salvadori (1995), Theory of Production. A Long-period Analysis, Cambridge, Melbourne and New York: Cambridge University Press. Quadrio Curzio, A. (1967), Rendita e distribuzione in un modello economico plurisettoriale, Milano: Giuffrè. Quadrio Curzio, A. (1980), ‘Rent, income distribution, and orders of efficiency and rentability’, in L. Pasinetti (ed.), Essays on the Theory of Joint Production, London: Macmillan, pp. 218–40. Ricardo, D. (1951 ssq.). The Works and Correspondence of David Ricardo, 11 volumes, edited by P. Sraffa in collaboration with M.H. Dobb, Cambridge: Cambridge University Press. In the text referred to as Works, volume number and page number. Samuelson, P.A. (1959), ‘A Modern treatment of the Ricardian economy: I. The pricing of goods and of labor and land services; II. Capital and interest aspects of the pricing process’, Quarterly Journal of Economics, 73, pp. 1–35; 79, pp. 217–31. Schumpeter, J.A. (1954), History of Economic Analysis, New York: Oxford University Press. Smith, A. (1976), An Inquiry into the Nature and Causes of the Wealth of Nations, 1st edn 1776, Vol. II of The Glasgow Edition of the Works and Correspondence of Adam Smith, edited by R.H. Campbell, A.S. Skinner and W.B. Todd, Oxford: Oxford University Press. In the text quoted as WN, book number, chapter number, section number, paragraph number. Sraffa, P. (1960), Production of Commodities by Means of Commodities. Prelude to a Critique of Economic Theory, Cambridge: Cambridge University Press

Chapter 21

Vertical Integration in the Changing Economy Ian Steedman

21.1

Introduction

Augusto Graziani has himself written (1992), in relation to his book General Equilibrium and Macroeconomic Equilibrium (1965), that he ‘puts forward the suggestion that an overall equilibrium position is in itself inconsistent with the typical features of a capitalist economy. In a changing economy, in which by definition the rates of growth of single sectors differ, rates of profit must also differ, in order to draw resources out of declining sectors and into expanding ones’. The same emphasis is to be found in works by Graziani’s compatriots Paolo Leon (1967) and Luigi Pasinetti (1981, for example) who stress that overall growth takes the form of non-proportional growth in outputs, so that growth rates and profit rates will indeed differ amongst industries. Such economic growth is complex and hard to grasp in analytical schemes, of course, so that any way of thinking about such matters which will help to render them manageable and transparent will always be greatly welcome. Now for the purpose of analysing a non-changing economy the concept of a ‘sub-system’ (Sraffa, 1960, Appendix A), or of a ‘vertically integrated sector’ (Pasinetti, 1973) has proved to be a brilliant device; consider, for example, how it enabled Pasinetti to show that the prices of commodities can indeed be resolved, without residue, into wages and profits as Adam Smith had claimed (and then been criticized by Marx for his pains).1 It is thus natural to ask whether – and to hope that – vertically integrated sectors might be equally fertile in simplifying the analysis of a changing economy. First appearances, it is true, are not encouraging. Such sectors are hypothetical constructions, built by the theorist, whilst actual investment decisions relate to investment in actual, individual industries and even in specific production processes. (And this remains true even if simultaneous ‘up-stream’ and ‘downstream’ investments are contemplated). Similarly, technical change actually occurs at the level of quite particular production activities and, while the theorist can calculate the consequent changes at the vertically integrated level, the result is just that – a calculated, accounting magnitude. There is no such real thing as a way of acting to reduce some vertically integrated production coefficient. Any such

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reduction is only an ex-post statistical artefact. First appearances can be deceptive, however, and it thus merits explicit consideration whether, for example, simple and manageable forms of technical change at the (hypothetical) verticallyintegrated level can emerge as the result of (actual) process level change. This matter of technical change will be our central focus of attention but we first consider, quite briefly, rates of profit at the industry and vertically-integrated levels.

21.2

Process and Sector Rates of Profit

Consider a square price/wage/profit system involving heterogeneous labour (paid ex-post) and differential rates of profit, rj, on the process level values of capital. If L is the matrix of labour inputs and w the row vector of wage rates then, in an otherwise obvious notation, pB = wL + pA(I + rˆ )

(21.1)

p = wV + p A rˆ (B − A) −1

(21.2)

From (21.1),

where V ≡ L (B − A) −1 is the matrix of vertically-integrated labour uses. Since H ≡ A(B − A) −1 is the matrix of vertically-integrated capital good uses, the rates of profit at the vertically-integrated level, ρ j , will have to satisfy p = w V + p H !ˆ

(21.3)

p A (B − A)−1 !ˆ = S $ Uˆ (% − $)−1

(21.4)

From (21.2) and (21.3),

Since pA is not zero, it follows from (21.4) that the ρj and rj always satisfy (B − A) −1 !ˆ − Uˆ (% − $) −1 = 0 More directly, however, we see that p A rˆ (B − A ) j

−1

ρj =

p A (B − A ) j

−1

If (B − A ) −1 is strictly positive, each ρ j is a positively weighted average of all the ri. If (B − A ) −1 is semi-positive, with a block of zero elements in the ‘southwest’ corner, then the ρ j relating to Sraffa-basics will be positively weighted averages only of the similarly related ri, while the remaining ρ j will depend on all

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361

the ‘basics’ ri and some (or all) of the other rk. Finally, if (B − A ) −1 contains any negative element(s) then we fall into the familiar complications of joint-production systems, which it would not be appropriate to pursue here but which the reader will no doubt hasten to consider in great detail. It also follows from (21.4), of course, that rj =

pA(B − A) −1 !ˆ (% − $) j pA j

(21.5)

and in any (non-diagonal) system (B − A) j and (B − A ) −1 cannot both be semipositive, so that rj is not ‘nicely defined’ in terms of the ρ j . Is this point correct but completely insignificant given that, as was emphasized above, the elements of !ˆ are purely hypothetical constructs, only the elements of rˆ being actual economic magnitudes? Not quite. It will certainly be an insignificant fact for any analysis firmly centred on actual economic processes. By contrast, it is a significant point for anyone tempted to regard the vertically-integrated sector level as fundamental. Anyone working in that way, and supposing some given !ˆ for example, does have a duty to show that the given !ˆ is compatible with an economically meaningful rˆ ; and (21.5) shows that the duty in question is not a purely nominal one.

21.3

Process and Sector Rates of Technical Change

In order to keep our discussion reasonably simple we shall from now on consider only single-product, circulating capital systems. In terms of the previous section’s notation, that is, we shall set B = I throughout. (The reader is naturally welcome to generalize what follows, beginning perhaps with the case in which B ≠ I but B is constant over time). Constant returns will be supposed. We shall ask how various ‘forms’ of technical change at one level of analysis are related to those at the other level. Parallel to the final paragraph of the previous section, not the least significant question to be pursued will be whether certain familiar forms of change in the vertically-integrated coefficients of production are consistent with economically meaningful (or plausible) changes at the actual, process level of productive activities. Since we consider here only single-production, the relations H (I – A) = (I – A) H = A

(21.6)

V (I − A ) = L

(21.7)

and

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will be fundamental to what follows. We may begin by noting that the ‘form’ of technical change certainly can be the same at both the direct and the integrated levels. It is easily shown from (21.6) and (21.7) that if A t = eαˆ t A o e −αˆ t , Lt = eλt L o e −αˆ t

(21.8)

H t = eαˆ t H o e −αˆ t , Vt = eλt Vo e−αˆ t

(21.9)

ˆ

then ˆ

Moreover, (21.9) implies (21.8). With respect to Lt and Vt the ‘form’ of technical change will be recognized as an example of the so-called RAS method of adjusting input-output tables. With respect to At and Ht, however, the ‘form’ is more special since ‘R’ and ‘S’ are here reciprocal. Whilst (21.8) and (21.9) may be elegant they are not convincing, at least in relation to A and H. In the first place, all the main diagonal elements are completely constant over time, which hardly provides a general picture of technical change. Secondly (and more generally), for both A and H some offdiagonal elements are rising and some falling (with αi ≠ αj) and, more specifically, the (ij)th and (ji)th elements have a constant product over time. (The constancy of the (ii)th elements is of course a special case of this). No one is likely to view this, presumably, as a plausible general description of technical change. We now allow the ‘form’ of technical change to be different at the two levels and ask what a familiar ‘form’ at one level implies for the other. In particular, we concentrate on ‘Hicksian’ technical change.

21.3.1. Hicksian Change Suppose first that  = − Ahˆ A

and L = −Lhˆ

Then from (21.6) and (21.7),  = −Hhˆ I + H < −Hhˆ H ( ) and

 = − Vhˆ I + H < −Vhˆ V ( )

Unsurprisingly, technical change is not ‘Hicksian’ in form at the vertically integrated level and is at faster rates than shown by hˆ .

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363

More important perhaps is the question what a ‘Hicksian’ form of progress at the integrated level implies for change at the actual level, since it might be useful to be able to assume the former. Thus suppose now that  = − Htˆ , H

V = − Vtˆ

From (6) and (7)  = − Atˆ I − A > − Atˆ A ( )

(21.10)

L = −Ltˆ ( I − A ) > −Ltˆ

(21.11)

Again unsurprisingly, the implied changes in A and L are not of the Hicksian form and are, now, at slower rates than those given by tˆ . There is, however, more to be said here. To begin with a very simple case, consider the familiar ‘corn-tractor’ model for which a α  A=  0 0  The top row of (21.10) becomes:

[a , α ] = −  a (1 − a ) t1 , α (t2 − at1 )

(21.10*)

and, as is obvious from (21.10*), (α / α ) could be negative, zero, or even positive. Hicksian progress at the vertically-integrated level might imply technical regress at the actual, process level of ‘corn’ production. It is true, however, that since ‘a’ is always falling α will eventually do so as well, even if (at1) > t2 at first. A little (not much!) more generally, (21.10) becomes  a 11  a 21

 a11 (1 − a11 ) t1 − a12 a21t2 a12  a22  = −   a21 (1 − a11 ) t1 − a22 t2 

a12 (1 − a22 ) t2 − a11t1    a22 (1 − a22 ) t2 − a12 a21t1 

(21.10**)

 < 0 is certainly possible, it is very far from certain. In In (21.10**), while A particular, note that (aii = 0) implies ( a ii > 0 ) whenever a12 a21 ≠ 0; Hicksian progress at the integrated level now requires technical regress in the direct ‘ownuse’ coefficients. If direct ‘own-use’ is always to be zero, then Hicksian change is impossible at the integrated level. Note that, with t1t2 ≠ 0, det A = (a11 a22 – a12 a21) = 0 in (21.10**) implies that A is subject to Hicksian progress, at rates [(1 – a11) t1 – a22 t2] in industry 1 and [(1 – a22) t2 – a11 t1] in industry 2. Conversely, Hicksian progress in (21.10**)  = − Asˆ , implies that det A = 0 and this point may generalized from (21.10). If A say, in (21.10) then

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ˆ Asˆ = Atˆ − AtA

(21.12)

But if A–1 exists it follows at once that ˆ ˆ −1 ) A = (I − st

Thus (21.12) can only hold for non-diagonal A if det A = 0. We have noted that a continued ‘zero-own-use’ at the actual level can rule out Hicksian change at the integrated level. But it is not only zero diagonal entries in A that can be a ‘problem’. Suppose, for example, that A is of the imprimitive form 0 A= 0 a  31

0 a23  0 

a12 0 0

so that (21.10) becomes  0 A =  a a t  23 31 3  −a31t1

−a12 t2 0 a31a12 t1

a12 a23t2  −a23t3   0 

(21.10***)

Here the null diagonal elements can and do remain zero; but now there are three off-diagonal elements that must increase from zero. Does (21.10***) describe technical progress or technical regress? Thus if A is to remain an imprimitive matrix, so that the qualitative pattern of input use is unchanged, then Hicksian change is impossible at the integrated level. We now consider (21.11). In the ‘corn-tractor’ case it becomes

(b , β ) = − (1 − a ) bt , βt 1

2

− αbt1 

(21.11*)

and β can be negative, zero, or even positive. And on comparing (21.10*) and  (21.11*) we see that ( a / a ) = b / b always holds but that (α / α ) = β / β if and only if (αb – aβ)t1 = 0. Hicksian progress in the ‘corn’ industry is a fluke. Moreover (α/β) is rising or falling according as (α/β) is below or above (a/b); hence (α/β) always moves towards (a/b). Just a little more generally, with a single type of labour (11) becomes

( )

(l ,l ) = − [(1 − a 1

(

2

11

)

(

) l1t1 − a21l2 t2 , (1 − a22 ) l2 t2 − a12 l1t1 ]

)

(

)

(21.11**)

  In (21.11**) l1 / l1 and l2 / l2 can both be negative but they can also be of opposite sign. (They cannot both be positive). It can be shown that if not only is det A = 0 but – a stronger condition – (a11, a21, l1) is proportional to (a12, a22, l2) then direct, process level change is of the Hicksian form, at the rates mentioned above. But this is clearly not a case of any great importance; the two real productive processes are almost indistinguishable.

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21.3.2. Non Hicksian Change The Hicksian ‘form’ of technical change is not, of course, the only one familiar to the economic theorist. We therefore now consider, very briefly and without any discussion of whether Harrod or Solow would acknowledge paternity, ‘labour augmenting’ and ‘capital augmenting’ technical change. In each case we ask what such change at the vertically-integrated level requires of the actual, process level. Suppose first, then, that  = −V2ˆ  = 0, V H  = 0 and hence Clearly A −1 L = −L (I − A ) 2ˆ (, − $ )

(21.11***)

The presence of the (I – A) term here signals at once that L < 0 may not be ensured and we may illustrate the point by reverting to the simple ‘corn-tractor’ model with homogeneous labour. Equation (21.11***) now reduces to  b   b  = − 21       .E   2 2 − 21     = −2 2 −     1 − a       and it is clear that if τ1 > τ2 there is the possibility that β has to increase over time. Even in the special case (αb = aβ) we find that   

(1 − a )    = (a21 − 2 2 )  

so that ‘Harrodian’ change at the integrated level may require technical regress in the corn industry. (Note that, with τ1 ≠ τ2, the condition (αb = aβ) cannot persist over time). Now suppose, secondly, that  = − H1ˆ , H

 =0 V

The condition with respect to H and A is no different from the ‘Hicksian’ case  = 0 implies that and thus requires no further comment. But V  L = −VA  ≤ 0 does happen to obtain, L ≥ 0 ! ‘Solow’ change at the integrated so that, if A level would then require that, at the real level of productive activity, every labour input coefficient must increase over time (or at best remain constant). More

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 ≤ 0 is not ensured. It will perhaps generally, of course, we already know that A suffice to illustrate the required condition −1 L = L (I − A ) A1ˆ ( , − $ )

by a final reference to the ‘corn-tractor’ model. It can be shown that     b   b  = a11 , (1 − a)    = . (1 2 − D11 )     so that, with respect to labour use, there must be technical regress in the tractor industry and there may or may not be technical regress in the corn industry. If these results are compared with those in (21.10*) – after replacing tj by σj in the latter – it is found that (a/b) falls at the percentage rate of σ1 but that (α/β) will rise or fall according as (aσ1) is or is not greater than σ2. Since ‘a’ is falling over time, (α/β) will eventually be falling, even if it first increases. 21.3.3. More Radical Change While we have now considered a number of different ‘forms’ of technical change, they have all had a restrictive common feature, namely that change has consisted merely of quantitative change in the required amounts of unchanged kinds of commodity and types of labour. Such change no doubt occurs and is important but no less important is the fact that new methods of production can involve the introduction of qualitatively new produced inputs and new labour skills. Does this perhaps counteract the somewhat discouraging nature of our findings thus far? Begin by pretending that the set of final consumer goods is unchanged over time, with change affecting only methods of production and the set of produced and primary inputs employed by these methods. We note first that a significant element of the overall picture will still consist of the merely quantitative changes considered above, so that it will still be perfectly possible that particular ‘forms’ of integrated level progress require elements of regress in actual production processes. As for the qualitative changes that we are now moving on to consider, note that – by definition – the complete replacement of old methods and skills by new methods and skills will ensure that, while some vertically-integrated labour uses will decrease (perhaps to zero) some others will increase (quite possibly from zero). Did the vertically-integrated use of computer programming labour time per passenger mile, in the holiday air travel sector, decrease or increase between 1950 and 2000? (Similarly for diskettes per passenger mile). Technical progress in the vertically integrated production of a given consumer good or service can perfectly well involve increasing use of many specific producer goods and labour skills; one cannot reasonably identify ‘progress’ with universal decrease in input use. In this respect, then, the conclusion is not in fact much altered by allowing for qualitative change in production methods.

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367

One cannot, of course, keep up for long the pretence that the set of final consumer goods and services is unchanging. That is just empirically false, in terms of any definition of goods and services that is sufficiently narrow to make it sensible to speak of their conditions of production. (There is no such thing as ‘the method of production for food’, for example). And as soon as adequate recognition is given to this brute fact of modern capitalist life, the economic theorist is obliged to acknowledge that the set of vertically integrated sectors, even for consumer goods and services alone, is constantly changing. (Expanding on the whole, no doubt, but with some sectors disappearing over time. The vertically integrated sedan-chair sector is reported to be quite small now.) Even if the number of vertically integrated (consumption) sectors is significantly smaller than the number of actual productive processes, it is both large and ever changing. This fact, together with the constant need to be very careful about what (hypothetical) technical change at the integrated level implies for real change at the actual level, forces one to the reluctant conclusion that the concept of a vertically integrated sector does not really offer a manageable simplification of the complexities of modern economic growth. Could one perhaps avoid at least the ‘problem’ of the ever-changing (increasing?) number of vertically-integrated (consumption) sectors by supposing, à la Kelvin Lancaster, that the set of characteristics of consumer goods and services is far more stable over time than the set of goods and services themselves? If so, one could at least think in terms of a fixed (and relatively small?) number of vertically-integrated sectors, each of which ‘produces’ a single characteristic. This would do nothing, of course, towards resolving the ‘problem’ that sectoral progress would often involve increases in actual production coefficients but at least there would be a fixed set of sectors. How convincing though is the supposition of a stable (let alone a small) set of characteristics? We leave the matter in the form of a question, pointing out only that the claim involved is not self-evidently acceptable and would need to be argued for.

21.4

Concluding Remarks

The concept of a sub-system or a vertically-integrated sector is such an impressive one for the purpose of analysing an unchanging economy2 that it would be pleasing indeed to find it equally valuable in the analysis of a changing economy. But we have found, alas, that when considered in some detail it proves to generate difficulties as much as to resolve them. Even in a changing economy it may well be useful sometimes to think in a broad and intuitive way about the direct and indirect requirements for the final production of one shirt or one surgical operation. As soon as one enters into the details of pricing, production and technical change, however, there is probably no adequate substitute for facing head on the full complexity of actual, process by process description of the economy.

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Notes 1 2

We leave open the question whether Smith understood the matter as clearly as did Pasinetti! It is probably the one economic concept I would most like to have invented and did not!

References Graziani, A. (1965), Equilibrio generale ed equilibrio macroeconomico, Naples: ESI. Graziani, A. (1992), “Autobiographical entry”, in P. Arestis and M. Sawyer (eds), A Biographical Dictionary of Dissenting Economists, Aldershot: Edward Elgar. Leon, P. (1967), Structural Change and Growth in Capitalism, Baltimore, Md: John Hopkins University Press. Pasinetti, L.L. (1973), ‘The notion of vertical integration in economic analysis.’ Metroeconomica, 25, pp. 1–29. Pasinetti, L.L. (1981), Structural Change and Economic Growth: A Theoretical Essay on the Dynamics of the Wealth of Nations, Cambridge: Cambridge University Press. Sraffa, P. (1960), Production of Commodities by Means of Commodities, Cambridge: Cambridge University Press.

PART V THE ROLE OF THE STATE

Chapter 22

Financial Sector Reforms in Developing Countries with Special Reference to Egypt *

Philip Arestis

22.1

Introduction

One of Augusto Graziani’s most important aspects of his theoretical work is in the field of money and finance. His central theme is that in a monetary economy the power of producers is located in their ability to have access to bank credit and financial markets. A postulate that leads squarely to a great concern with monetary and financial issues. This concern along with his early writings on Development Economics, makes it imperative to examine the question of money and finance in the context of growth and development. This is particularly fitting in view of recent contributions in the area, especially in the case of the developing world under the banner of ‘financial sector reforms’. Financial reforms, and financial liberalization in particular, have been at the root of many recent cases of financial and banking crises, as a number of studies have demonstrated (Arestis and Demetriades, 1997; Chang, 1998; Demirgüç-Kunt and Detragiache, 1998a, 1999; Kaminsky and Reinhart, 1999). The examination of the central issues surrounding these contributions is, therefore, crucial and vital. This is the intention of this chapter, and the exercise is undertaken with Augusto Graziani’s relevant theoretical positions very much in mind. The case of Egypt is of some relevance to the debate, and this is precisely the reason that we utilize the relevant experience of this country as an example of the theoretical position taken in this chapter and elsewhere (see, for example, Arestis and Demetriades, 1999). This chapter draws on this experience, in addition to that of Egypt, in an attempt to show that the main reason behind these crises is the application of a theoretical framework that is predicated on a number of assumptions that are problematic, and are based on weak empirical foundations. Consequently, it should not be surprising that the reforms have led to many instances of unsuccessful implementation of financial reforms and to many cases of severe financial crises. We will also argue that the case of Egypt is particularly interesting in this regard since although financial reforms have taken place, the experience has been rather

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different. There has been no financial crisis during this period, although it should also be pointed out that the period of reforms has not been quite completed yet. We begin this chapter with an examination of the experience of a number of countries that implemented financial reforms and were faced subsequently with severe financial crises. This is followed by a discussion of the theoretical problems of the model that underpins the reforms as we see them. This is essentially the model based on the work of McKinnon (1973) and Shaw (1973), and summarized in Hussein (2000). It will be argued that it is the problematic nature of the model underpinning the reforms that is the fundamental cause of the crises. This leads us conveniently to the issue of financial reforms in Egypt and whether the argument of the chapter sits comfortably with the evidence afforded by the experience with financial reforms in this country. A final section summarizes and concludes.

22.2

Recent Banking and Financial Crises

We draw on two periods and report the experience of a number of countries to make the point. The first covers the long period 1977 to 1996 and comments on the experience of 23 countries as in World Bank (1997). The second refers to the more recent period, 1997 to 1998, which is known as the South East Asian crisis. There are, in fact, common features of these crises summarised in UNCTAD (1998, p. VII). 22.2.1

The 1977–1996 Period

Table 22.1 reports a number of countries that faced banking and financial crises, and the costs of resolving them. The latter is the authorities’ estimates of the costs incurred in restructuring their financial sectors.1 They are the direct fiscal and quasi-fiscal costs of bailouts, as a percentage of GDP. In the same table, in brackets, non-performing loans as a percentage of total loans (estimated at the peak) are reported. We restrict the analysis in this sub-section to the period prior to 1996. The countries in this category also implemented financial reforms prior to the crises. This table reveals the enormity of the costs of bank crises. The direct cost of resolving the crises as a percentage of GDP ranges from 10 per cent in the cases of Hungary, Tanzania and Brazil to a staggering over 50 per cent for Argentina. Their experience was catastrophic. Interest rates exceeded 20 per cent, a number of ‘bad’ debts and waves of bank failures and other bankruptcies ensued, along with extreme asset volatility. The whole financial system reached a near collapse stage. As a result the real sectors of the affected economies entered severe and prolonged recessions. On the whole, financial reforms in these countries had a severe destabilising effect on the economy. What typically happened in these economies was that financial reforms unleashed a massive demand for credit by households and firms that was not offset by a comparable increase in the saving rate. Loan rates rose as households demanded more credit to finance purchases of

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consumer durables, and firms plunged into speculative investment in the expectation that government bailouts would prevent bank failures. In terms of bank behaviour, banks increased deposit and lending rates to compensate for losses attributable to loan defaults. High real interest rates failed to increase savings or boost investment – they actually fell as a proportion of GNP over the period. The only type of savings that did increase was foreign savings, i.e. external debt (Grabel, 1995). This, however, made these economies more vulnerable to oscillations in the international economy, increasing the foreign debt to reserves ratio. This, combined with deteriorating service obligations, increased the likelihood of currency crises as explained above. Financial reforms thus replaced domestic with international markets. Long-term productive investment did not materialize to a large extent either. Instead, short-term speculative activities flourished whereby firms adopted risky financial strategies, thereby causing financial and banking crises and economic collapse. Returning to Table 22.1, we note that the countries reported there comprise a sample of them that experienced the more serious banking crises identified in a survey-study by the IMF (1996) and elsewhere (see, for example, Lindgren et alii, 1999). In all the cases summarized in the two publications just cited, the direct losses sustained by governments in these crises exceeded 3 per cent of GDP. Table 22.1 summarizes those countries which had to devote more than 10 per cent of GDP to the resolution of banking sector crises; there were, in fact, fifteen cases falling into this category for the period 1977 to 1996. This experience suggests that in the case of developing countries both relative to the experience of developed countries and in comparison to their experience in the preceding three decades, the degree of severity of these crises was particularly pronounced (World Bank, 1997). The magnitude of these crises is also significant. In addition to the figures just quoted, the IMF (1998) survey reports that at least two thirds of its member countries experienced significant problems in their banking sectors over the period late 1977 to 1996, and that of these one-third warrant the designation ‘crisis’. Equally serious is the finding that in Africa and Asia as well as in the transition economies of central and eastern Europe, over 90 percent of the respondents had at least one serious banking crisis over the same period. The resolution costs of financial sector crises cannot be taken as an accurate guide to losses in economic welfare. They could be larger than the economic welfare losses if the real assets financed by failed banks remained and continued to yield returns in the future. They could be smaller in view of the cumulative misallocation of financial resources represented by bad loans. The more inefficient and feeble financial intermediaries are, the higher the cumulative misallocation is expected to be. There may also be indirect adverse consequences for longer-run growth where participants have asymmetric information. Moral hazard and adverse selection, two important implications of asymmetric information, reduce exchange below the levels allowed by better information (Arestis and Demetriades, 1998).

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Table 22.1 Costs of resolving banking sector crises amounting to more than 10 per cent of GDP (Non-performing loans as a per cent of GDP in brackets) Direct Cost of Banking Crisis (percentage of GDP)

Country and Time Period of Crisis LATIN AMERICA

AFRICA

SOUTH EAST ASIA

MIDDLE EAST TRANSITION ECONOMIES

EUROPEAN UNION

Argentina Chile

1980-82 1981-83

55 41

Uruguay

1981-84

31

Venezuela

1994-95

18

Mexico

1995

15

Brazil

1994-96

10

Cote d’Ivoire Benin

1988-91 1988-90

25 17

Senegal

1988-91

17

Mauritania

1984-93

15

Tanzania

1987-95

10

Indonesia Malaysia

1997-99 1997-99

45(55) 12(na)

Philippines

1997-99

17(na)

South Korea

1997-99

15(16)

Thailand

1997-99

25(52)

Israel

1977-83

30

Bulgaria Hungary

1995-96 1991-93

14 10

Spain

1977-85

17

Source: World Bank (1997); IMF World Economic Outlook (October, 1999); Hoggarth et alii (2000); Lindgen et alii (1999).

The experience of banking and financial crises we have discussed in this section, points to four striking findings (see, for example, IMF, 1996; World Bank, 1997). The first is that the banking crises over the period examined were both frequent and severe. The second is that the costs of these crises to the local economies were substantial and caused or exacerbated downturns in economic activity. The third finding is that these serious episodes of banking crises have no parallels in monetary history, and cannot be construed as simply a return to the type of crises of earlier periods. The IMF (1996) report conducts comparisons of potentially similar episodes across time periods and can find no historical precedent for the dismal track record of banking crises reported in Table 22.1. The fourth finding is that given the relative severity of the problem, along with the increasing weight and integration of these developing countries in international

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financial markets, potential spillover effects to industrialized countries become a real possibility.2 22.2.2

The South East Asian Experience (1997–1999)

Prior to 1997, the South East Asian countries (for our purposes we restrict ourselves to the five most-affected: South Korea, Indonesia, Thailand, the Philippines, Malaysia) had had ‘a miraculous three decades: incomes had soared, health had improved, poverty had fallen dramatically … Some had not suffered a single year of recession in 30 years’ (Stiglitz, 2000, p. 1). On 2 July, 1997, however, these countries experienced severe banking and financial crises. Table 22.1, under South East Asia and for the period 1997–99, reports the cost of resolving that crisis. Two types of costs are cited. The fiscal and quasi-fiscal costs as a percentage of GDP and in parenthesis the non-performing loans as a percentage of total loans. Here again these costs are very high, well in excess of 10 per cent. Table 22.2a, which contrasts real GDP growth in the five most affected countries with that in the ‘emerging markets’ group of countries as a whole, indicates the size of the real sector effects of the credit boom years of 1995 and 1996 as well as of the consequent crisis. This table may appear to suggest that the South East Asian countries have now been able to overcome most of the crisis. There are, however, still severe problems. Stiglitz (2000) concludes on the current situation by suggesting that ‘Close to 40 percent of Thailand’s loans are still not performing; Indonesia remains deeply mired in recession. Unemployment rates remain far higher than they were before the crisis, even in East Asia’s best performing country, Korea … Thailand, which followed the IMF’s prescriptions the most closely, has performed worse than Malaysia and South Korea, which followed more independent courses’ (p. 6). Table 22.2b delves further into the costs of the crisis. It reports the overall cost to the economy of a banking crisis. These are welfare costs and are proxied by losses in GDP as described and reported in Hoggarth et alii (2000).3 GAP(G) and GAP(L) are the cumulative differences between trend and actual output growth, and trend and actual level of output respectively. Trend is the average arithmetic growth in the three-year prior to the crisis in the case of GAP(G), and the trend in GAP(L) is based on the Hodrik-Prescott filter ten years prior to the crisis. The end of the crisis is defined when output growth returns to trend in the case of GAP(G), and GAP(L) uses a ‘consensus’ crisis endpoint from a range of case studies. The losses reported are very high. Even higher are the 1999 estimates of the IMF also cited in Table 22.2b. During the 1990s these countries undertook extensive financial deregulation (examples of relevant studies include, Chang, 1998; Jomo, 1998; Wade, 1998; and Arestis and Glickman, 2002).4 They removed or loosened controls on companies’ foreign borrowing, abandoned co-ordination of borrowing and investments, and failed to strengthen bank supervision. Firms were thus able to borrow abroad without government control or co-ordination. They actually discovered that they could borrow abroad half as cheaply as they could domestically. As a result, large

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capital flows took place, which promoted extension of bank lending; a credit boom ensued. Investors who transferred vast amounts of capital to South East Asia also helped the credit boom. The better returns in these countries when markets elsewhere offered less profitable opportunities, especially in the industrialized countries owing to slow economic growth there, was a significant contributory factor. Low interest rates in the industrialized world, led investors to search for higher returns, and these South East Asian countries offered fertile ground. The high growth rates and high interest rates of these countries, and the economic problems in Latin America, produced large interest rate differentials, which international investors exploited. The 10-year experience of currency pegs, which implied fluctuations relative to dollar of less than 10 per cent, was another significant contributory factor (UNCTAD, 1998). Table 22.2a Emerging and South East Asian economies: real GDP growth (percentage change on previous year)

Average Real GDP Growth *

South East Asian Economies

1995

1996

1997

1998

1999e

2000f

4.5

5.1

5.0

1.2

2.9

4.7

8.3

7.1

4.1

-7.6

6.2

6.1

Source: IIF (2000, Table 7, p. 10) e = estimate, f = forecast * Indonesia, Malaysia, Philippines, South Korea, Thailand.

Table 22.2b South East Asian economies: overall costs of financial crisis (output gaps) Country Indonesia Malaysia Philippines South Korea Thailand Source: *

GAP(L)**

IMF*** (1999-2002)

Date of Crisis

GAP(G)*

1997 – 1985–88 1997 – 1981–87 1997 – 1997 –

24.4 14.5 na 38.2 na 16.7

15.5 31.5 na 111.9 na 14.3

82 na na na na 27

1997 –

24.0

27.7

57

Hoggarth et alii (2000); IMF World Economic Outlook (October, 1999).

Cumulative difference between trend and actual output growth during the period of crisis (as in IMF World Economic Outlook, May, 1998). ** Cumulative difference between trend and actual output level during the period of crisis. *** These are forecasts of the output gap as the cumulative difference between the level of actual output and the assumed trend level (on the basis of a 4 per cent annual trend growth in output) – as in IMF World Economic Outlook, October, 1999.

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Large net private capital inflows took place, escalating foreign debt with most of it being private and short-term (maturing in twelve months or less). Indeed, three of the countries discussed here were among the world’s top six recipients of private foreign capital inflows. In 1996 Indonesia received the world’s third largest share of private foreign capital flows ($17.96 billion), Malaysia the fourth largest share (16 billion), and Thailand the sixth largest share ($13 billion). World Bank (1997) reports that net inflows of long-term debt, foreign direct investment, and equity purchases, were only $25 billion in 1990 and exploded to more than $110 billion in 1996. These enormous amounts of foreign funds were often at interest rates, which reflected only a very modest risk premium relative to safe returns on investment in the lender country. The low risk premiums may have reflected a belief that even without explicit depositor’s insurance, the governments of these countries would not allow bank failures, so that effectively lenders had a government guarantee. Given lenders’ low risk premiums, even a slight increase in their perception of risk was likely to lead to substantial capital outflow. Prior to 1996 those developments did not appear to have caused any obvious problems, simply because the inflows were utilized essentially for investment purposes. In 1996 and 1997, however, most of the inflow was directed at speculative activities, essentially on real estate and equities (between 1996 and 1997 the inflow was of the order of $109 billion, 11 per cent of before-crisis aggregate GDP).5 When the bubble burst, property prices fell substantially and the share of nonperforming bank loans rose dramatically. Vulnerability was heightened as banks and their corporate customers, in an effort to lower borrowing costs, undertook most of their foreign borrowing at short maturities and foreign currency. A serious unfolding contagion of financial disturbance across countries ensued. The contagion was helped by the fact that the region’s currencies were on the whole pegged to the US dollar (an important mechanism in their attempts to develop their economies in a globalized world) which prevented the currencies from moving in response to domestic fundamentals. A currency crisis in Thailand in the summer of 1997 (when the baht was devalued) was spread almost overnight to Malaysia, Indonesia and the Philippines. In November 1997 South Korea’s currency was under heavy pressure from speculators who believed it to be overvalued. The won was devalued but the IMF had to be called in to help finance its short-term debts. Several major firms were declared insolvent and by mid-December smaller firms were failing at the rate of 50 per day. Short-term interest rates soared to just over 30 per cent. The most commonly held view is that the South East Asian crisis was the result of intrusive governments which were practising over-regulation of the economy throughout the region along with deeply rooted corruption, and forcing banks to lend to unprofitable firms. The solution should thus be to create a ‘genuine’ free market economy through an even more extensive liberalization of finance, international trade and labour market. More privatization and more extension of free markets is what is paramount in this view. One response would be to point out

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that the IMF-inspired $110 billion package for South East Asia is quite obviously a major intervention in the workings of the free market in any case. Another is to ask the question of why corruption became catastrophic so suddenly in 1997 after a long period of high growth, and, indeed, after investors had already committed vast amounts of funds to these economies and for a long time. A more promising response is to look closely at the origins of the crises, which would reveal a different story. It would suggest that the fundamental reason for the crisis is insufficient regulation rather than under-regulation (see, also, Chang, 1998).6 There was too little government control over the financial liberalization process, which these countries had implemented before the crisis. In all the South East Asian countries measures were introduced to liberalize their financial and banking systems; there was both internal and external financial liberalization. Internal financial liberalization allowed domestic banks to become heavily involved in foreign operations and allowed them to get involved in riskier domestic lending activities. The promotion of stock markets alongside external financial liberalization contributed to the creation of an attractive investment climate for international portfolio investors. Speculative booms ensued which promoted higher rates of leveraging by the private sector. Exceptionally high leverage, of course, often is a symptom of excessive risk taking and leaves financial systems and economies vulnerable to loss of confidence. Financial liberalization does not lead necessarily to an orderly system of market supervision and management. Indeed, such attempts lead to structural inadequacies in the regulation and supervision of financial institutions and make financial systems vulnerable to shifts in international speculator sentiment. A very good example is Thailand which liberalized its financial system (with Thai banks lending to property developers to support vastly over-priced office blocks, and lacking in expertise in terms of collateral evaluation), only to discover that foreign capital brought its economy to near collapse and sparked the whole South East Asian crisis (see, for example, Jomo, 1998). Another good example is South Korea where during the five-year period prior to the crisis the government relaxed its control over the financial system significantly and in 1993 the process was accelerated. In addition, relaxation of state control over large-scale firms took place. In fact, the Economic Planning Board, the main body for making economic strategy since the early 1960s, was merged with the Ministry of Finance to form the Ministry of Finance and Economy, thus emphasising the demise of indicative planning. Capital account liberalization implied inadequate monitoring of foreign borrowing activities, especially by the inexperienced merchant banks. For example, on the eve of the South Korean crisis there was a huge mismatch in the maturity between their borrowings (64 per cent of their foreign borrowings were short-term) and lendings (85 per cent of them were long-term). A rapid accumulation of debts ensued which reached a total of $116 billion (November 1997) with roughly 70 per cent of them being less than a year’s maturity. This is explained by the more extensive liberalization of short-term than long-term foreign borrowings (Chang, 1998).

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379

The lesson to take away from the South East Asian crisis is that high growth rates and low unemployment were built on a weak financial infrastructure. In any case, these South East Asian economies are different from other economies. They have high levels of saving re-cycled as loans to corporations and companies are closely linked with governments. This difference would imply that financial liberalization would have higher costs and smaller benefits in Asia than elsewhere (Arestis and Glickman, 2002). It is no wonder that Malaysia reimposed wideranging capital controls on the 1st of September 1998 (and financial markets there soon recovered and allowed interest rates to fall). UNCTAD (1998) summarizes the argument for capital controls by suggesting that ‘In the absence of global mechanisms for stabilising capital flows, controls will remain an indispensable part of developing countries’ armoury of measures for the purpose of protection against international financial instability’ (p. XI).

22.3

The Problematic Nature of the Theoretical Model

In two papers Arestis and Demetriades (1998, 1999) work out the key assumptions of the theoretical model underpinning financial reforms, which are found to be highly unlikely to be met in the real world. The more important ones are those of perfect information, profit-maximising competitive behaviour by commercial banks and the assumption of institution-free analysis (including the scant attention paid to the role of stock markets). We may also add a further reason which is attributed to lack of due consideration of the microeconomic aspects of the theoretical model underpinning financial reforms. Stiglitz and Weiss (1981) demonstrated that asymmetric information leads to two serious problems: adverse selection and moral hazard. The implication of the presence of these problems is that the informational asymmetries of higher interest rates, which actually follow financial reforms and financial liberalization policies in particular, exacerbate risk-taking throughout the economy, thereby threatening the stability of the banking system, which can easily lead to frequent financial crises. Profit-maximising competitive behaviour by commercial banks is particularly unrealistic in the case of developing countries. The banking sectors in these countries are oligopolistic, in which case financial reforms may well lead to increased spreads between lending and deposit rates without increased financial deepening. It would not be unreasonable to argue that threatened banks attempt to recoup losses by increasing lending rates and/or reducing deposit rates to savers. This is particularly possible in the oligopolistic environment of the developing country banking sectors. A relevant further consideration is the undue attention paid to microeconomic aspects of financial reforms. One such microeconomic phenomenon is bankruptcy and the fear of default, both of which are rarely, if at all, incorporated in the analysis of financial reforms. Wholesale financial reforms based on models that do not pay due attention to these details could cause serious problems. The experience of South East Asia is a very telling case (Stiglitz, 2000,

380

Money Credit and the Role of the State

p. 6). The institutional framework surrounding the banking sector is paramount and assuming an institution-free approach to financial reforms could lead to expensive policy mistakes. For example, ignoring the role of banking supervision by central banks proved very costly in the period 1977–1996 especially in Latin America. It is now widely accepted that financial reforms need to be preceded by improved quality of regulation (World Bank, 1989). The more recent South East Asian crisis has demonstrated weaknesses in the legal framework, including the non-existence or deficiency of bankruptcy laws and procedures as well as deficiencies in banking regulation. A further example is that financial reforms have paid little attention to stock market development despite the enormous growth of stock markets over the last twenty years (Arestis and Demetriades, 1997, 1999; Arestis, Demetriades and Luintel, 2000). Despite these problems, financial reforms had a relatively early impact on development policy through the work of the IMF and the World Bank. Perhaps in their traditional role as promoters of free market conditions, they were keen to encourage financial reforms, especially financial liberalization policies, in developing countries as part of more general reforms or stabilization programmes. Events following the implementation of financial reforms did not justify the theoretical premises. A number of factors were blamed for these events, including differential speeds of adjustment, competition of instruments, macroeconomic instability and inadequate bank supervision. There occurred a revision of the main tenets of the thesis. More precisely, these revisions followed the experience with financial reforms over the period 1977–1996 as analysed above. Caprio et alii (1994) reviewed financial reforms in a number of primarily developing countries, which fall well within our 1977–1996 period, with the experience of six countries studied at some depth and length. They conclude that managing the reform process rather than adopting a laissez-faire stance is important, and that sequencing along with the initial conditions in finance and macroeconomic stability are critical elements in implementing successfully financial reforms. It is thus recommended now that gradual financial liberalization – if not very little – is to be preferred. In this gradual process a ‘sequencing of financial liberalization’ (for example, Edwards, 1989; McKinnon, 1993) is recommended, emphasising the achievement of stability in the broader macroeconomic environment and adequate bank supervision within which financial reforms were to be undertaken (McKinnon, 1988). Employing credibility arguments, Calvo (1988) and Rodrik (1987) suggest a narrow focus of reforms with financial liberalization left as last. These post hoc theoretical revisions were thought of as sufficient to defend the original thesis despite its disappointing empirical record. Further revisions were suggested following the South East Asian crisis. Moral hazard arguments leading to the so-called ‘overborrowing syndrome’ have been employed (McKinnon and Pill, 1997). These arguments are associated with ‘private’ monetary intermediaries, both national and international, because their deposits are insured by governments, and international institutions in their turn

Financial Sector Reforms in Developing Countries with Reference to Egypt

381

would resort to helping governments in financial difficulties if necessary. Consequently, the modern version of the liberalization thesis represents an attempt to account for the implications of imperfect information and, to some extent, institutions. Assuming that sequencing is capable of producing a stable macroeconomic environment and that strengthening banking supervision is sufficient to address the moral hazard and adverse selection problems in bank lending, it is in principle possible to design a programme of reforms that does not result in financial crises. The experience so far with financial liberalization, however, may suggest otherwise. Even where the ‘correct’ sequencing took place (i.e. Chile), where trade liberalization had taken place before financial liberalization, not much success can be reported. The opposite is also true, namely that in those cases, like Uruguay, where the ‘reverse’ sequencing took place, financial liberalization before trade liberalization, the experience was very much the same as in Chile (Grabel, 1995). The experience with financial reforms in developing countries in the 1980s and 1990s suggests a marked increase in the frequency and severity of financial crises (Demirgüç-Kunt and Detragiache, 1998b). Indeed Demirgüç-Kunt and Detragiache (1998a, 1999) demonstrate that in the case of 53 countries covering the period 1980–1995, banking and financial crises are more likely to occur in liberalized financial systems with weak institutions The stronger the institutional environment is, the lower the probability that financial liberalization would affect the banking sector adversely. Relevant institutional characteristics include: respect for the rule of law, a low level of corruption, good contract enforcement and effective prudential regulation and supervision. These results support the view that financial liberalization should be approached cautiously, especially where institutions are not fully developed. The most recent crises in the South East Asian countries, in which the initial macroeconomic conditions were very favourable, have shown that even in the best of circumstances, financial liberalization remains a treacherous policy exercise. It is actually surprising that analyses of the Asian crisis have revealed weaknesses in banking supervision and have blamed the moral hazard in ‘implicit’ deposit insurance as the main culprits. This is so since it is not so long ago when the dominant view on Korea, Thailand and Malaysia was that these countries benefited from strong institutions, including the civil service and government (World Bank, 1993). This analysis suggests that advocating adequate banking supervision, macroeconomic stability, appropriate sequencing of reforms, and ‘transparency’, although useful and necessary, are clearly not sufficient to prevent financial crises. Recent experience suggests that the list should be a great deal longer, and even then there is no guarantee that it would be exhaustive. Strong and uncorrupt institutions, including the civil service and the central bank, a well functioning legal system that effectively enforces contracts and property rights, effective bankruptcy laws and procedures, are amongst some of the items to be added. Ensuring that the items on the list are adequately addressed well before reforms take place, is probably the best strategy to avoid crises in the future under these circumstances. Also of equal importance is that the assumptions underlying the

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theoretical framework of the reforms should be scrutinized closely in an attempt to ameliorate the serious problems identified in this and the other studies referred to above. 22.4 22.4.1

The Egyptian Experience with Financial Reforms Institutional Arrangements

The Egyptian experience with financial reforms is very interesting. As Hussein (2000) reiterates, the more recent financial reforms have been going on in Egypt since 1981, but more intensely since 1991, and are expected to be completed by 2001. The period 1981–1991 was characterized by an attempt to create more financial intermediation. Even so, during this period the state-owned banks, which carried out some 80 per cent of the financial activities, dominated the financial sector in Egypt (see, also, El-Refaie, 1998). Financial reforms must have been very slow, or perhaps cautious, in that during that period Egypt was financially repressed still rather heavily (see, also, Hussein and Mohieldin, 1997). In 1991, however, Egypt embarked on an extensive financial, and in more general terms, economic reforms as well as structural adjustment programmes. The reforms were to some extent in accordance with the IMF and the World Bank prescriptions, themselves based on the McKinnon/Shaw model. One may identify two stages in this process. The first stage of the reforms (1991–1996), and the most important, comprised almost all of what has come to be known as the orthodox IMF/World Bank macroeconomic stabilization programmes and the inevitable restructuring of the banking and financial sectors as well as capital markets. More precisely, they included substantial reductions of the fiscal deficit and monetary restraints, financial liberalization measures and major restructuring of the capital and foreign exchange markets. A de facto unified foreign exchange market was established in February 1991, in which banks were allowed to set buying and selling rates free from administrative controls. In addition, exchange rate controls were abolished and convertibility of the Egyptian pound on both the current account and the capital account was achieved; at the same time an exchange rate anchor was introduced.7 The convertibility of the currency enabled Egypt to enjoy exchange rate stability since 1991, along with positive real interest rates, both of which encouraged significant capital flows. But although portfolio investment jumped from a very low level in 1994/5 to nearly $1.5 billion in 1996–97, it fell again the following year rather substantially (Smith, 1999, p. 9). The reforms of the period 1991–96 also included financial liberalization measures. In 1992 interest rate ceilings were abolished for both the private and the public sector; lending limits to the private and public sectors were also eliminated in 1992 and 1993 respectively. Treasury bill issues were introduced on a weekly-auction basis in an attempt to create a market for these financial assets where interest rates would be determined by the forces of demand and supply.

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The second stage of the reforms (1996–2001) continued with the liberalization of prices, but also embraced foreign trade liberalization along with the beginnings of privatization and deregulation. It was early during this period that the Social Development Fund was inaugurated to alleviate specifically the side effects of the reforms. The fund spent $800m in grants and soft loans between 1997 and 2000. It claims to have provided 300,000 permanent and 150,000 temporary jobs (Smith, 1999, p. 10). Further encouragement towards private sector participation in economic activity is now being implemented so that by the year 2001 the private sector would control around 80 per cent of the economy. Banks, insurance companies and big state-owned companies have been earmarked for privatization. 22.4.2

Performance of Financial Reforms

This short review of the Egyptian experience with financial reforms points towards a striking feature. This is the avoidance of serious problems in the financial system. Egypt over the period under scrutiny suffered no major banking or currency crises, and yet financial reforms have taken place. Indeed one might suggest that although the financial reforms as such were no different from similar experiments in many of the developing countries reported in Table 22.1, the Egyptian experience has been successful. We refer to two Tables to make the point. The first is Table 22.3, which reports the spread between lending and deposit rates in Egypt and in other countries for comparison. The second is Table 22.4 (as in Subramanian, 1997), where a number of financial system indicators are presented which refer to the period of financial liberalization. Taken together, Tables 22.3 and 22.4 suggest that four indicators are of particular significance: (1) the spread between lending and borrowing rates which widens at the beginning of the period under scrutiny to reach a peak of 8.30 percent in 1992, but subsequently narrows to reach a low 3.40 percent in 1999. This low percentage is noteworthy in that it contrasts favourably with spreads in other countries as shown in Table 22.3. Not only are spreads in Egypt lower than in the developing countries cited in this table (the comparison with Jordan is particularly pertinent8), but also of developed countries, with the exception of Spain; (2) the size of overall provisioning9 by the banking system as a whole (Table 22.4) increased initially as a percentage of loans and then declined, reflecting improved loan quality. This is consistent with the rising share of credit accounted for by the private sector, indicating a reduction in the share of nonperforming loans; (3) the profitability of the four public banks between them representing 60 percent of the Egyptian banking system, increased steadily, save for 1991–92 which is an exceptional early increase in the period (due to recapitalization, see Subramanian, 1997, p. 33); (4) the indirect bank-specific assistance in the form of Treasury bills, the bulk of which has been held by commercial banks.10 Table 22.4 shows that in 1990/91 roughly 78 percent was held in the banking system, increasing to nearly 89 percent by 1995/96, with income from these holdings increasing from 0.4 billion to 2.6 billion respectively ( with the

384

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Table 22.3

Spreads between lending* and deposit** rates in selected countries

Country

1990

1991

1992

1993

1994

1995

1996

1997

1998 1999

Jordan+

4.80

5.70

5.50

5.50

5.46

5.25

5.44

5.58

6.38

5.87

Poland

-----

7.70

7.20

7.30

6.60

6.70

6.10

6.50

5.90

5.80

Czech Republic

-----

-----

-----

7.67

6.05

5.12

5.75

5.63

4.07

4.22

Slovak Republic

-----

-----

-----

6.39

5.24

7.84

4.62

5.15

6.17

5.56

Hungary

4.10

4.70

8.70

9.70

7.00

6.50

-----

3.30

-----

-----

Albania

-----

-----

2.10

2.30

3.90

4.40

7.80

4.10

-----

12.20

Estonia

-----

-----

-----

-----

11.6

7.30

7.60

13.60

8.60

7.66

Italy

7.29

7.26

8.65

6.08

5.01

6.03

5.57

4.92

4.72

3.80

Spain

5.36

3.91

4.35

3.15

2.25

2.37

2.38

2.12

2.09

1.76

Denmark

6.02

4.02

4.30

4.00

4.00

6.80

6.40

5.00

4.80

4.70

Sweden

6.76

8.54

7.40

5.30

5.73

4.95

4.91

4.51

4.30

3.93

Egypt

7.00

7.00

8.30

6.30

4.70

4.80

5.60

5.10

4.00

3.40

Source: International Financial Statistics (December, 1999). *

Upper margin on commercial bank loans to the general public, except for Jordan where it is the average interest rate on loans. ** Upper margin offered on fixed term deposits for less than one year, except for Jordan where it is the average interest rate on deposits. + The Jordanian ‘spread’ does not include the commission rate, which is fixed at 1 per cent. If it were to be included, the ‘spread’ should be higher by 1 percentage point.

Table 22.4

Selected banking system indicators (in billions of Egyptian pounds, unless otherwise indicated) 1990/91 1991/92 1992/93 1993/94 1994/95 1995/96

Share of total credit to private sector (in percent)

28.8

27.3

27.9

31.7

38.4

42.8

Overall Provisioning (as percent of loans)

11.3

15

16.7

16.4

14.8

13.9

Stock of government securities

3.1

12.6

23.5

28.9

25.1

26.8

Percent of total

77.7

73.8

76.9

82.1

84.1

88.6

Income from government securities

0.4

1.3

3.5

3.6

2.8

2.6

As percent of GDP

0.4

0.9

2.2

2.1

1.4

1.2

Increase in provisions

1.2

1.8

2.6

2.0

2.7

2.1

As percent of income from government securities

300

138

74

56

96

81

Pre-tax profits of 4 public banks

1.4

2.8*

1.7

1.9

2.2

2.7

Source: Subramanian (1997) *

Exceptional increase owing to the 6 billion Egyptian pounds recapitalisatio

Financial Sector Reforms in Developing Countries with Reference to Egypt

385

equivalent percentages to GDP being 0.4 and 1.2). The entry ‘Increase in provisions’ for the government securities in the same table, clearly implies that banks did not seem to ‘provision themselves’ against bad debts and yet the spreads were not high by comparison with other countries (Subramanian, 1997, p. 35). As Begg (1996) shows, the prevalence of wide spreads in a number of transition economies reflected the need to cover against bad debts and strengthen capital adequacy. The issue of Treasury bills enabled the banks to avoid ‘high provisions’ and the need for wide spreads between lending and deposit interest rates. 22.4.3

Explaining the Performance of the Financial Reforms

The interesting question is, of course, the possible explanation for the apparent success of the Egyptian financial reforms, especially so in view of the observation that in other countries similar reforms resulted in the severe problems alluded to above and evidenced by Table 22.1. It may not be surprising actually that the financial reforms have avoided severe problems in view of the ‘cautious’ way they have been implemented. It was suggested above that caution is of paramount importance in the implementation of financial reforms. Indeed, Egypt may very well be a good example of what is precisely meant in this context. It is readily accepted in Egypt that a full dose of financial reforms should not be undertaken in view of the inevitable fierce competition from the international financial markets. So, for example, financial liberalization has only been given a cautious approval and implementation (Hussein, 2000, is a good example). As a result the financial reforms have been implemented without any great sense of urgency. ‘Gradualism’ and ‘caution’ have been the key words. In this process Egyptian banks have had to deal with issues such as mergers and acquisitions, improving the quality of services provided along with cost reductions, enhancing their capital adequacy ratios and addressing the problem of non-performing loans. These are important ingredients of successful implementation of financial reforms. It would thus appear that reforms have been slow or cautiously implemented. In fact, Roe (1998, p. 95) lists a number of financial reforms still to be undertaken. Smith (1999) suggests that ‘The legal and regulatory systems still remain enmeshed in their ancient cobwebs... The government still employs, in one way or another, nearly one-third of the work force of 22m; another third work on the land’ (p. 4). The institutional framework of the country, however, appears to be strong enough to withstand shocks to the economy. We may mention the recent experience of the country to make the point. There have been three episodes that hit harshly the economy over the 1990s. Firstly, revenues from tourism went down dramatically following the murder of 58 tourists at Luxor in November 1997; secondly, the price of oil (half of Egypt’s exports) continued to tumble for a long time before the recent upsurge; and thirdly, the Asian crisis produced a drop in both portfolio investment and Suez Canal dues. It would appear, though, that these shocks have been absorbed easily in view of the country’s institutional strength (Smith, 1999).

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Money Credit and the Role of the State

In terms of the theoretical problems identified earlier, the problems with perfect information and profit-maximising competitive behaviour are potentially there, although it should be recognized that the Egyptian authorities through their intervention and cautionary manner in doing so, may have recognized the limitations of these two assumptions. The building up of strength in the institutional framework of the country sits very comfortably with the arguments advanced in this chapter. A further consideration may be pertinent. This is the recognition that bankruptsy and the fear of default can cause serious problems. The Egyptian authorities, unlike the South East Asian authorities, with their cautious approach to financial reforms may have mitigated the severity of this problem. Ultimately, though, the success of financial reforms depends on the level of interest rates achieved following their introduction and implementation. On this score we entirely agree with Hussein and Mohieldin (1997) who, in their empirical work on the Egyptian experience with financial repression, show that ‘a ceteris paribus increase of the real interest rate may be as deleterious as setting it too low’ (p. 19). Indeed, such an increase ‘would lead, inter alia, to discouragement of investment and further deepening of the problem of excess liquidity of the banking system, which, in turn, would encourage banks to apply imprudent activities’ (ibid., p. 20). The setting of the appropriate rate of interest is an issue not amenable to generalizations. It depends crucially on the specific historical and institutional characteristics, as well as on the macroeconomic and financial conditions of the country concerned. For example, in the case of Egypt, Hussein and Mohieldin (1997) are right to suggest that ‘further comprehensive institutional and policy changes, that go beyond the mere liberalization of some financial variables, are required’ (p. 20). One such institutional and policy change may very well be some degree of financial repression along the lines suggested by Stiglitz (1998), when he argued that ‘there are a host of regulations, including restrictions on interest rates or lending to certain sectors (such as speculative real estate), that may enhance the stability of the financial system and thereby increase the efficiency of the economy. Although there may be a trade off between short-run efficiency and this stability, the costs of instability are so great that long-run gains to the economy more than offset any short-term losses’ (p. 33). Another is the further development of the financial sector. In this sense the emphasis in the 1980s and 1990s on strengthening the banking sector, probably at the expense of the stock exchange, can be construed as a major policy innovation. It has contributed substantially to the strengthening of the institutional framework of the economy, and at the same time enabled the country to avoid the potential speculative excesses that could have been induced by the operation of a stock market at a grand scale.

22.5

Summary and Conclusions

We have drawn on the experience of a number of countries that implemented financial reforms over the last twenty years or so. That experience was marred by

Financial Sector Reforms in Developing Countries with Reference to Egypt

387

serious banking and financial crises, and a number of reasons have been put forward to explain it. The Egyptian experiment with financial reforms is rather different. No serious banking or financial crises took place, and this calls for some explanation. We suggest that the ‘cautious’ approach pursued by the Egyptian authorities, along with the enhancing of the institutional strength of the economy, could explain this experience. Further development of the financial sector and comprehensive financial liberalization measures, however, cannot be viewed as panacea. A strong regulatory framework is also paramount. Demirgüç-Kuntand Detragiache (1998a, 1999) in their study of 53 countries, for the period 1985 to 1995, show that, although financial liberalization increases the probability that banking crises will occur, their severity can be substantially lower in countries where the regulatory environment is strong. They suggest that ‘Such institutions include effective prudential regulation and supervision of financial intermediaries and of organized security exchanges, and a well-functioning mechanism to enforce contracts and regulations’ (p. 2). Inadequately supervised, newly privatized and inexperienced banks operating in a regime of financial reforms, induce excessively high real interest rates. A degree of control over lending and deposit rates may very well be necessary under these circumstances. The aim of interest rate controls would be to prevent interest rates from reaching excessively high levels. This study has argued that the Egyptian authorities are well disposed to accepting the policy implications of these arguments and findings.

Notes *

1

2

3 4

I would like to thank Abed Shibli of the Central Bank of Jordan for generously providing me with the Jordanian ‘spread’ data (Table 22.3), and Alaa Mohamed for helping me with the rest of the data collection. I am grateful to Guglielmo Caporale, Bassam Fattouh, Khaled Hussein and to the participants of the International Conference (entitled Financial Development and Competition in Egypt) held in Cairo, May 30-31, 2000, for helpful comments. Hoggarth et alii (2000) define these as ‘various types of costs involved with rehabilitating the financial system, including both bank recapitalisation and losses incurred through protecting deposits either implicitly or through explicit government deposit insurance schemes’ (p. 6). IMF (1996) reports that developing countries actually receive about 40 percent of global inflows of foreign direct investment and of almost $260 billion of net portfolio flows over the period 1990–95. They have outstanding liabilities to banks (which report to the IMF) of over $717 billion, which is about $46 billion more than their claims on those banks. In addition, they account for the majority of IMF drawing rights since the late 1970s, and purchase about 25 percent of the exports of industrial countries. There are a few issues and a number of problems in the construction of the measures of welfare costs of a banking crisis reported in the text. They are discussed in Hoggarth et alii (2000). There were no apparent reasons to liberalise the financial and capital markets, other than international pressures (Stiglitz, 2000). In fact, the South East Asian countries had

388

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already been running surpluses, with relatively low and falling inflation rates, and saving rates running at record levels of 30 percent or more (Stiglitz, 2000, pp. 1–2). 5 One exception to this was South Korea where foreign borrowings financed investments in tradeable sectors rather than real estate developments (as in the rest of the South East Asia) or imports of consumer goods (as in Mexico and other Latin America countries) (see, for example, Chang, 1998, p. 1555). 6 Even Soros (1997) recognises the validity of this proposition when he calls for the formation of an ‘International Credit Insurance Corporation’ to regulate and supervise international capital flows. This recognition by someone like George Soros, demonstrates the importance of curbing financial systems. Also of interest is the recent experience of Chile, where a transaction tax and a requirement that investors deposit 30 per cent of their funds with the central bank for one year have been introduced. This imposition came about after a similar crisis in Chile, and so far this country has avoided the South East Asian type of financial crises. 7 There is the intriguing question of why an exchange rate anchor in preference to either a price/wage or a money-based stabilisation programme. An interesting explanation is provided by Subramanian (1997) who suggests that a most compelling argument is ‘perhaps the Egyptian context, and the history of exchange shortages and crises, which made the exchange rate an important symbol of stability in itself; exchange rate stability was a consummation devoutly to be pursued and not just a means to achieving broader price stability. Moreover, contemporaneous movements in the nominal rate in the late 1980s and inflation meant that the pass-through effect to domestic prices was perceived as important and an exchange rate anchor was seen as having merit in containing this source of inflationary pressure’ (p. 23). 8 Jordan went through a similar experience to that of Egypt’s in terms if financial reforms. In September 1988 the authorities in Jordan liberalised the deposit rate of interest, and in September 1993 abandoned direct controls and credit ceilings. 9 Loan loss provisioning should be the relevant variable in the context of the argument in the text. However, since data for this variable do not exist, the data in Table 22.4 refer to overall provisioning. Subramanian (1997) suggests that in fact ‘changes in overall provisioning during this period should broadly correspond to changes in loan loss provisioning, which is likely to have been the main impetus for greater provisioning’ (p. 32, fn. 18). 10 The point should be made that a high percentage of the banking sector’s asset holdings is in treasury bills. It increased from 8.3 percent (of total security holdings) in 1991 to 53.9 percent in 1996. At the same time banking holdings of government securities and shares declined from 74.2 in 1990 to 17 percent in 1996 (government securities) and from 22.6 percent in 1990 to 12.9 percent in 1996 (shares) – see El-Refaie, 1998, Table 3.2). It follows that Egyptian banks opted for safe holdings in short-term government assets over the period.

References Arestis, P. and O.P. Demetriades (1997), ‘Financial development and economic growth: assessing the evidence’, Economic Journal, 107(442), pp. 783–99. Arestis, P. and O.P. Demetriades (1998), ‘Financial liberalisation: myth or reality?’, in P. Arestis (ed.), Method, Theory and Policy in Keynes: Essays in Honour of Paul Davidson, Vol. III, Cheltenham: Edward Elgar Publishing Limited.

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Arestis, P. and O.P. Demetriades (1999), ‘Financial liberalisation: the experience of developing countries’, Eastern Economic Journal, 25(4), pp. 441–58. Arestis, P, O.P. Demetriades and K. Luintel (2000), ‘Financial development and economic growth: the role of stock markets’, Journal of Money, Credit and Banking, 33(1), pp. 16–41. Arestis, P. and M. Glickman (2002), ‘‘Financial crisis in South East Asia: dispelling illusion the minskyan way’, Cambridge Journal of Economics, 26(2), pp. 237–60. Begg, D. (1996), ‘Monetary policy in central and Eastern Europe: lessons after half a decade of transition’, International Monetary Fund Working Paper, WP/96/108, Washington DC: International Monetary Fund. Calvo, G. (1988), ‘Servicing the public debt: the role of expectations’, American Economic Review, 78(4), pp. 647–61. Caprio, G. jr., I. Atiyas and J.A. Hanson (eds), (1994), Financial Reform: Theory and Experience, Cambridge: Cambridge University Press. Chang, H-J. (1998), ‘Korea: the misunderstood crisis’, World Development, 26(8), pp. 1555–61. Demirgüç-Kunt, A. and E. Detragiache (1998a), ‘Financial liberalisation and financial fragility’, International Monetary Fund Working Paper, WP/98/83, Washington DC: International Monetary Fund. Demirgüç-Kunt, A. and E. Detragiache (1998b), ‘The determinants of banking crises in developing and developed countries’, IMF Staff Papers, 45, pp. 81–109. Demirgüç-Kunt, A. and E. Detragiache (1999), ‘Financial liberalisation and financial fragility’, in B. Pleskovic and J.E. Stiglitz (eds), Annual World Bank Conference on Development Economics 1998, Washington DC: The World Bank, pp. 303–31. Edwards, S. (1989), ‘On the sequencing of structural reforms’, OECD Working Paper, No. 70, OECD Department of Economics and Statistics. El-Refaie, F. (1998), ‘Financial intermediation: the efficiency of the Egyptian banking system’, chapter 3 in M. El-Erian and M. Mohieldin (eds), Financial Development in Emerging Markets: The Egyptian Experience, The Egyptian Centre for Economic Studies, Cairo, Egypt and The International Centre for Economic Growth, San Franscisco, California, USA. Grabel, I. (1995), ‘Speculation-led economic development: a post-Keynesian interpretation of financial liberalization programs’, International Review of Applied Economics, 9(2), pp. 127–49. Greenspan, A. (1998), Testimony Before the Committee on Banking and Financial Services, 30 January, Washington D.C.: House of Representatives. Hoggarth, G., R. Reis and V. Saporta, V. (2000), ‘Costa of banking instability: some empirical evidence’, Bank of England Discussion Paper, Regulatory Policy Division. Hussein, K.A. (2000), ‘Finance and Growth in Egypt’, presented to the conference Financial Development and Competition in Egypt, held in Cairo, May 30-31, 2000. Hussein, K.A. and M. Mohieldin (1997), ‘Interest rates, investment and growth under financial repression: the Egyptian experience’, Arab Economic Journal, 9, pp. 3–26. International Monetary Fund (IMF) (1996), Bank Soundness and Macroeconomic Policy, (with two supplements), February, Washington, D.C.: International Monetary Fund.

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International Monetary Fund (IMF) (1998), World Economic Outlook, May, Washington, D.C.: International Monetary Fund. Jomo, S. K. (1998), Tigers in Trouble, London: Zed Press. Kaminsky, G.L. and C.M. Reinhart (1999), ‘The twin crises: the causes of banking and balance-of-payments problems’, American Economic Review, 89(3), 473–500. McKinnon, R.I. (1973), Money and Capital in Economic Development, Washington, DC: Brookings Institution. McKinnon, R.I. (1988), ‘Financial liberalisation and economic development: a reassessment of interest-rate policies in Asia and Latin America’, Occasional Papers, No. 6, International Centre for Economic Growth. McKinnon, R.I. (1993), The Order of Economic Liberalisation: Financial Control in the Transition to a Market Economy, Second Edition (First Edition, 1991), Baltimore: John Hopkins University Press. McKinnon, R.I. and H. Pill (1997), ‘Credible economic liberalisation’s and overborrowing’, American Economic Review, Papers and Proceedings, 87(2), pp. 189–203. Rodrik, D. (1987), ‘Trade and capital account liberalisation in a Keynesian economy’, Journal of International Economics, 23(1-2), pp. 113–29. Roe, A.R. (1998), ‘The Egyptian banking system: liberalisation, competition and privatization’, chapter 4 in M. El-Erian and M. Mohieldin (eds), Financial Development in Emerging Markets: The Egyptian Experience, Cairo, Egypt: The Egyptian Centre for Economic Studies, and San Francisco, California, USA: The International Centre for Economic Growth. Shaw, E.S. (1973), Financial Deepening in Economic Development, New York: Oxford University Press. Smith, B. (1999), ‘Egypt survey’, The Economist, 20 March, pp. 3–18. Soros, G. (1997), ‘Avoiding a breakdown’, Financial Times, December 31. Stiglitz, J.E. (1998), Knowledge for Development: Economic Science, Economic Policy and Economic Advise, Address to the World Bank’s 10th Annual Conference on Development Economics. Stiglitz, J.E. (2000), ‘What I learned at the world economic crisis. The insider’, The New Republic Online, 17 April (www.tnr.com/041700/stiglitz041700.html). Stiglitz, J.E. and A. Weiss (1981), Credit rationing in markets with imperfect information, American Economic Review, 71(3), pp. 393–410. Subramanian, A. (1997), ‘The Egyptian stabilisation experience: an analytical retrospective’, International Monetary Fund Working Paper, WP/97/105, Washington DC: International Monetary Fund. United Nations Conference on Trade and Development (UNCTAD) (1998), Trade and Development Report, 1998, New York and Geneva: United Nations. Wade, R. (1998), ‘From “miracle” to “cronyism” in the Asian crisis’, Cambridge Journal of Economics, 22(6), pp. 693–706. World Bank (1989), World Development Report, Oxford: Oxford University Press. World Bank (1993), The East Asian Miracle: Economic Growth and Public Policy, Oxford: Oxford University Press.

Chapter 23

The European UMTS Licences Allocation: Why Economic Theory Has not Worked Alfredo Del Monte

23.1

Introduction

Governments’ ‘main objectives’ to be met in allocating licences to the spectrum are: 1. 2. 3. 4.

Making the licences available to whoever will make the best use of them Making the price of licences for the spectrum represent ‘fundamental values’ Promoting a competitive industry Raising some revenue for the government in a non-distorting fashion.

The question is what method of allocation best meets these objectives. In Europe beauty contests and auctions have been used to allocate spectrum for the third generation cellular networks (UMTS). Many European governments chose auctions because they were considered quicker and more economical than beauty contests (administrative allocation). Economic theory says that the main advantage of the auction is that it allocates licences efficiently. ‘Efficiency lies in assigning each licence to the bidder who values it most, because that bidder will have the most effective business plan for the licence’, and ‘auction transfers the judgement on who should get a licence to real expert the contestant themselves’ (Binmore, 2000). When the bidders know their own value of the licence with certainty and the uncertainty about common value is low, auction of the spectrum leads to an efficient allocation. But when there is high uncertainty about the common value inefficiency could be expected (Goree and Offerman, 2002). On the other hand there are no theoretical reasons why always prices set by market mechanisms, namely auctions, reflect better than administrative mechanisms, namely beauty contests, fundamental factors. When a bubble exists excessive prices ‘will arise’, that are not justified by ‘fundamental factors’. Prices are high today only because investors believe that the selling price will be high tomorrow. If auction of the spectrum led to excessive prices it would raise the prices that telephone service customers ultimately pay. If operators spend large

392

Money Credit and the Role of the State

sums obtaining a licence they will invest less in infrastructure and this will increase costs and decrease the quality of the service and will prevent the creation of a competitive industry. In general when there are excessive prices investment resources will not be efficiently allocated. A qualified administrative body, on the other hand, will be less affected by the bubble and will look at fundamental factors to determine the right price of the licence. The answer to this objection is that the auction is paid before any service is provided. It is therefore a fixed cost and does not affect the marginal cost of supplying the service; in a profit-maximizing firm price depends only on the marginal cost and hence the price of the mobile service will not be affected. This will hold only if markets are perfect. If the capital market is imperfect, the more firms borrow, the higher is the interest rate they have to pay. Then the extra debt added by the auction price could result in the firm investing less and having a higher marginal cost. Yet according to MacMillan (1995), an authority on auction, ‘It is unlikely, however, that this is large effect’. As regard the fourth objective auctions have been seen as a better method to cream skim oligopoly rents expected from exclusive access to scarce spectrum. Theoretical arguments in favour of auctions are undoubtedly quite strong with regard to the first objective but not with regard to the second or third. The purpose of our chapter is to test whether empirical evidence from the European UMTS allocation supports the above arguments in favour of auctions or beauty contests. The first part of the chapter will examine how a licence is evaluated in a context of perfect information. Then we will analyse how a licence could be rationally evaluated in the UMTS market. UMTS experience shows that when the method of allocation was auction, the licence prices per head of population or GSM users were very different across countries. We find that the value of the licences determined in European auctions is negatively correlated to the degree of the concentration of the European GSM markets. Indeed, there is a very strong negative correlation between the value per head of licences paid in each country, in 2000 auctions, and the Herfhindal index of concentration of the GSM markets. Rent obtained by the larger incumbents was much higher when the concentration in GSM market was high than when it was low and therefore the forecasted position of the new entrant was much weaker. A similar correlation is not found when the allocation method was the beauty contest. This result is not a proof of efficiency of auctions in the sense that the licences were given to the participants that had the highest valuation and that there was no losing entrant that had a value for a licence that exceeded that of the marginal winner, but the above correlation could support such a hypothesis. On the other hand there is evidence that auctions lead to excessive prices during the bubble period. In the European UMTS auction bidding firms knew quite well the cost of the infrastrucure to build,1 and probably the market share that they could get in the UMTS market (private value elements) but there was an high uncertainty about the technology of the new UMTS network and the new terminals, and overoptimism about market demand of UMTS services (a common

The European UMTS Licences Allocation

393

value part). In the 2000–2001 there were expectations of double-digit growth in the telecommunications markets. Such expectations were the main causes of the excessively high prices of many mergers and acquisitions in Europe and the United States. Due to such excessive prices the take-over companies have significantly written down in 2002 and in 2003 the value of acquired firms. By the same token, overoptimistic expectations resulted in an excessive value of licences for the participants at the UMTS auction. However, share-holders of the telecommunications companies involved in the auction process believed that they could sell their shares at a higher price after the acquisition of the UMTS licence, and hence did not appear to care much about the ‘true’ value of the licence.2 The beauty contest approach makes licence fees much lower than licences fees determined in auctions. Analysis of the UMTS experience shows that auctions fees of the licences were highly affected by the speculative bubble ending in 2000, but this did not hold for beauty contests. Indeed the price of licences was much higher for auctions than in the case of beauty contests in 2000 but not in 2001. Our chapter shows that average differences between 2000 and 2001 were quite high in the auction, but there were no significant differences when the method of allocation was the beauty contest. The last part of the chapter shows that there is evidence for negative effects of the excessive prices of auctions on the development of a competitive sector of UMTS services. The debt ratings of Telecom operators have worsened more for the firms that spent most on licences and there is a negative correlation between change in market capitalization in the period 1999-2001 and the normalized amount of money spent for the licences. As the amount spent on the auctions is much larger than in the case of beauty contests, empirical evidence supports the argument that UMTS auctions increased the cost of debts and delayed the introduction of 3G commercial services. The conclusion of the chapter is that it is probably correct to say that the licence fees determined in the auction process in 2000 were too high and were determined by the bubble that affected the new economy, and that the large amount of money spent on licences delayed the commercialisation of 3G services.

23.2

The Value of a UMTS Licence with Perfect Information

The UMTS auctions adopted by most European countries were simultaneous ascending auction (English auction). Multiple licences were sold in the same bid, and each bidder could obtain only one licence. Bidding occurs over rounds, with the result of each round announced to the bidders before the start of the next. The bidding remains open as long as in a round the number of bidders is higher than the number of licences. Let us assume that there are seven competitors bidding for four licences of equal number of MHz. Let Fi be the value of the licence for the bidder i. As depicted in Figure 23.1 the bidders have different valuations. Each bidder knows

394

Money Credit and the Role of the State

its value (or at least the probability distribution from which to draw its valuation; this distribution is the same for all players), given the number of licences the seller has decided to sell simultaneously. We assume, initially, that knowing all other bids in advance would not change a player’s valuation (private value auction). If the licences are awarded via a simultaneous English auction the optimal strategy for player i is to choose to remain an active bidder when bid B is lower than Fi..When bid B exceeds Fi, player i will drop out of the bid. Price,Value of licence

P* F5 P°

0 1 2 3 4 5 Number of licences

Figure 23.1 UMTS bidding using a simultaneous English auction Once the value of B rises to P* only four bidders will be active and the price of the licence will be P*. In Figure 23.1, P* is equal to the value of the licence of the fourth player, but this is not necessary. If the price rise in each round is small the final value of price P* will be a little higher than F5, the value of the fifth player. If the number of licences sold in a bid is n as long as there is sufficient competition (number of competitors greater than n) and each player knows its value with certainty biddings, in a simultaneous English auction. The bidding ends when the price reaches the valuation of the player with the (n + 1) highest valuation (the fifth valuation in Figure 23.1). We now present a simple model that calculates the effect of the amount paid for the licences on prices and investments in the UMTS market. Consider n firms competing for s licences with S ≤ n . Firm i knows that the structure of the post–auction market will be an s oligopoly. The demand curve of firm i is given by X i = X ι (V1 ,..., Vi ,..., Vs ,..., p1 ,..., pi ,..., ps )

(23.1)

The European UMTS Licences Allocation

395

where p1, pi, ps are the prices of firm 1, i, s, and V1, Vi, Vs are the amount of investments made by firm 1, i, s to build their network. Our hypothesis is that the higher the investment of firm i, the higher is the coverage and quality of the network and the higher the quantity Xi demanded The cost function of firm i is given by Ci = Fi + c t X i + c d V i

(23.2)

where c t is the variable cost of producing one unit of service X and cd is the variable cost per unit of investment; F is the fixed cost of the licence. We assume that c t and cd are constant and are the same for all firms. The profits of firm i is πi = ( pi − cit ) X i − cid Vi − Fi

(23.3)

The number of licences awarded by the government affects the market structure of the UMTS industry (the number of firms) and the oligopoly equilibrium values. The equilibrium values of price, output produced and investments of firm i are pi*, Xi*, Vi*. If we put π*i = 0 we get the maximum value Fi that a firm i would pay, in equilibrium, for the licence. This value is Fi * = ( pi* − cit ) X i* − cid Vi *

(23.4)

The maximum value that such a firm would pay for the licence is a function of the variable costs and of the oligopoly equilibrium values. Oligopoly equilibrium values are also a function of the kind of competition that firms expect will characterize the market (Cournot competition, Bertrand competition, collusive behaviour, etc.). If there are N firms that participate in the bid, each of these will be characterized by a value of Fi. We could rank the firms by their value of Fi. In the English auction the licences will be given to the s firms that have the highest values of Fi and the price of the licence will be equal to that of firms ranking s-th as value of Fi, Fs > Fs+1. We call Fs the ex ante value of the licence of the marginal firm. The value of the licence fee in an English auction will be F*, where Fs ≥ F * > Fs+1 . The rent that each winning firm will expect to gain will be: R1 = F1 – F*; R2 = F2 – F*; … Rs = Fs – F* Equation (23.4) determines the maximum value that a firm that looks to fundamentals would pay for the licence and Ri is the difference between the value of the licence and price paid F*.In a market that looks only to fundamentals the value of the shares of firms i will increase by Ri. The question is why a firm would pay a price F** higher than F*. A possible answer is that there is a bubble in the market and the purchase of licences may well affect beliefs about future share prices. If we call St the capitalization value of the shares before the purchase of the

396

Money Credit and the Role of the State

licence and E(St+1) the expected value of the shares after the purchase of the licence, the market value of the licence will be: E(St+1) – St = F** This value could be higher than F* and therefore it is possible that that an excessive price will be paid. Evidence of excessive prices is given by the relatively large number of Telecom companies (Telefonica, Sonera, KPN, O2, etc.) that wrote down the value of 3G licences bought in the UK and German auctions.In May 2003 O2 announced a £ 10.2 billion pre-tax loss, and almost £ 6 billion went in writing down the value of 3G licences in Britain and Germany. What would happen if excessive licence fees F** were actually paid? Economic theory would suggest that decisions by firms, ceteris paribus (same technology, same size of the market, same tastes, etc.), would not change. The oligopoly equilibrium value of prices, outputs, and investments of firms s will not change. The profit of the marginal firm before fixed costs (the value of the licence fee) is positive and the firm has no incentive to exit from the market. ( ps* * −ct ) X s* − c d Vs* > 0 Now let us answer arguments against auctioning which repeatedly arise. One argument is that auctioning increases the price that telephone services customers ultimately pay and decreases the amount of investment made by the winners to build their network. Economists would argue that a firm that takes cares of profits bases its price on its marginal cost. The auction price is paid before any price is provided – it is a fixed cost – so it is not part of the marginal cost of supplying the service and does not affect the price incurred by customers. It is easy to show that the value of licence F does not affect equilibrium values of p*i , Vi * and X i* . Once a firm i has paid the fixed price for licence Fi, this price will not affect the equilibrium values. The above argument is correct if we could assume that the capital market is perfect, so there is no difference financing investments with own capital or with debt. But if the more the firm borrows the higher the interest rate it must pay, then the extra debt added by the auction price could result in the firm’s investing less and having a higher marginal cost. Variable costs, in this case, will be a function of F and hence also equilibrium values will be a function of F. Another argument is that an excessive price for the licence could change the kind of competition expected in the UMTS services market and therefore equilibrium values could change. This argument has been raised by Gruber (2002). Gruber considers an industry with n identical firms. Each firm in equilibrium will get the same profit. If excessive entry costs (licence fees) were paid firms would be threatened with bankruptcy. Suppose for example that two licences are offered. In a non-collusive equilibrium profits are less, for the two winners, than the licence fee paid. In this case there are two options for the firm: exit or collusion. With the exit of one firm the remaining firm could obtain monopoly profit and thus break even. If on the other hand the government could credibly precommit to a duopoly

The European UMTS Licences Allocation

397

structure then firms need to collude to get the monopoly profits to repay the licence fee. High licence fees could therefore lead to higher prices than would be the case without licence fees. As such licence fees could be viewed as an inducement for collusive behaviour and do not necessarily represent an allocation of scarce resources to the socially best use. 23.3

Evaluation of the Efficiency of UMTS Auctions

As MacMillan (1996) points out, only time could tell whether the licences were given to the right firms but it is possible to give theoretical and practical reasons that could determine an inefficient outcome of the auction. One of these is the problem of the winner’s curse (Klemperer, 2002, pp. 169–89). This problem could arise when there are interactions among different bidders’ valuations. In this situation a phenomenon called the ‘winner’s curse’ could arise. If bi is the price paid by the winner i, and E(Vi) the bidder’s expectation about the item’s value after he knows that he has won and E (Vi ) ≥ bi

(23.5)

there is a problem of the winner’s curse. The mere knowledge that bidder i has won will cause a downward revision of this estimate (Milgron, 1981). This problem could arise when there is a correlation among bidders’ valuations, the common value model being a special case.3 Another argument against UMTS auctions could be the following: UMTS auctions could favour an incumbent over a more efficient new entrant. We consider, as in the previous section, that two licences are awarded in an English auction. The competitors for the two licences are the monopolist in the GSM market and two new entrants. The three firms share the same technology and are equally efficient. If the incumbent loses the auction, in the UMTS market there will be two new operators that will share the market. Both will get a profit ΠE [(1/2) Ü XUMTS], where XUMTS is the quantity of services sold in equilibrium. If the incumbent obtains the licence, its profit in the UMTS market will be ΠM (αÜXUMTS,) where α is the share of the incumbent in the UMTS market. We assume that it will continue to get a profit ΠM(XGSM) in the GSM market. If the incumbent loses it will get only ΠM(XGSM).4 Thus the incumbent’s incentive to buy the licence will be ΠM (αÜXUMTS). In the GSM market there was only one firm and its share was equal to one. Hence it is reasonable to assume that its share α of the UMTS market will be higher than 1/2 due to switching costs and so on. As α > 1/2 the incumbent’s incentive to buy the licence will be higher than the new entrant’s incentive. ΠM (αÜXUMTS) > ΠE (1/2)ÜXUMTS

(23.6)

We assume now that the new entrants are more efficient and therefore have lower costs than the incumbent. We also assume that, due to switching costs, the

398

Money Credit and the Role of the State

incumbent is still able to obtain, if it is a winner, a share α* of UMTS subscribers greater than 1/2, albeit lower than in the case where all firms share the same technology. If the incumbent loses the auction the two entrants will share the market and the services produced will be X*UMTS and profits of each firm will be: 1 *  Π E  X UMTS  2  If the incumbent is awarded the licence because its costs are higher prices will ** lower than services supplied when there be higher and services supplied X UMTS are the two entrants in the UMTS market. Therefore when there are two entrants total profits in the UMTS market are greater than profits when there is only the incumbent and one entrant 1 *  ** ** 2Π E  X UMTS  > Π M (αX UMTS ) + Π E ((1 − α ) X UMTS ) 2 

(23.7)

Equation (23.7) does not guarantee that the incentive to buy the licence will be higher for the incumbent than for the new entrants. The higher the value of α and * ** − X UMTS lower the difference ( X UMTS ) , the higher will be the possibility of the incumbent being awarded the licence even if it is less efficient than the new entrant. 1 * ≥ ** Π E  X UMTS  < Π M (αX UMTS ) 2 

(23.8)

In this particuar case of asymmetric bidders the highest-valuation bidder is not the efficient one, even if there is a simultaneous English auction. Many economists think that the above theoretical case has not characterized UMTS auctions in Europe. The auctions in UK and Germany were considered a success of economic theory by many academics (Binmore, 2000; Klemperer, 2002) because, as in the case of UK and Germany, there was quite a large number of companies that participated in the auction and the sums paid were quite large. To criticism that the 22.47 billion raised in the UK at the auction was a huge sum and a large tax on the mobile telecom industry and would prevent operators creating a competitive and efficient industry, Binmore responded as follows: Those tempted to weep for the shareholders should dry their tears, because they didn’t enter the auction with their eyes shut. They are hard-headed businessmen who figure that the odds are high that they will make a healthy return on their capital even after the Chancellor has their £ 22.47 billion in his pocket. They know perfectly well that they are taking a risk, but it is because entrepreneurs risk their capital that they are entitled to their profit when thing go well (Binmore, 2000).

The European UMTS Licences Allocation

399

This opinion is based on the assumption that markets by themselves lead to efficient allocations and direct governments interventions will make people worse off. Evidence of inefficiency could be found in the secondary market. A large number of licences being resold would suggest that the auction had produced an inefficient allocation, but the secondary market is too tiny to provide decisive evidence of efficiency.5 A large number of licence hand-backs could also be seen an index of inefficiency. This is what happened in the case of UMTS. Several firms that received a licence decided to hand it back, forgoing the licence paid. In most cases such firms were new entrants. Broadband Mobile in Norway (beauty contest), Ipse in Italy (auction), 3G in Germany (auction), but probably also Mobilkom, that is close to bankruptcy, in Germany.6 Other firms have requested the postponement of the building of the network infrastructure. Orange, a new entrant in the Swedish market, asked the Swedish authorities to relax the terms of its 3G licence and to give it three extra years to build a network capable of providing national coverage. But not only are new entrants delaying the launch of 3G commercial services. Vodafone announced a delay to 2003 of 3G in Germany and has asked for an extension of the generation licence fee deadline in Ireland to decide whether or not to make the payment. In Portugal the four 3G licence holders, that were obliged to launch services at the start of 2003, said that they would welcome a delay in the scheduled launch of next generation services due to lack of 3G equipment. There are also technical problems that are delaying the offer of 3G commercial services. We could summarize the situation in the UMTS European market. Weaker new entrants will hand back the licence to the regulator and larger incumbents would delay the launch of 3G services. It seems that only the new entrant Hutchinson has the interest and the resources to launch the new service as soon as possible. Unlike the incumbents Hutchinson does not get any income in the GSM market, and its interest is to start to earn revenue as soon as possible from the sale of 3G services. Conclusive evidence on the efficiency of the different methods to allocate spectrum will come only after the firms have their UMTS services operating and this will take several years. But the empirical evidence (excessive licence fees and the large number of handbacks) does not support so far the hypothesis that UMTS auctions allocate licences efficiently.

23.4

Licensing Costs for UMTS Licences and Market Concentration

The model analysed in section 23.2 shows the main determinants, in the English auction, of the value of the licences: a) Number of licences issued; b) The expected size of the UMTS market; c) the expected market share of the marginal winner; d) the expected competitive environment. There are big differences in the amount of money paid for the UMTS licences in various countries whatever measure of size is used. In Table 23.1 we report total

400

Money Credit and the Role of the State

Table 23.1

Status of 3G mobile licensing Auctions

Country

Beauty contest

Amount (ECU 000’s)

Award date

Amount per head of population (ECU)

Country

Europe

Amount (ECU 000’s)

Amount per head of population

Europe

UK

27/04/00

38836932

Netherland

24/07/00

2685470

Germany Italy Austria Switzerlan d

18/08/00 23/10/00 3/11/00

50806153 12163575 832000

6/12/00

Belgium Greece Denmark Czech Republic Australia

Award date

Year 2000 652.61 Finland

18/3/1999

0

0

13/3/00

500000

12.5

613.62 Norway 211.05 Poland 102.32 Sweden

4/12/00 6/12/00 16/12/ /00

164840 1950000 0

36.79 50.46 0

133785

18.816 Portugal

19/12//00

399040

39.71

2/3/01 13/07/01 20/9/01

450000 455000 511000

Year 2001 and after 43.94 France 42.92 Ireland 95.76 Slovakia

31 /05//01 25//06//02 1/7/02

9900000 284000 102000

166.86 74.79 18.95

7/12/01

251342

Asia Pacific and Americas 22/2/2001 660642

Canada

1/2/2001

1073593

Taiwan

6/2/2002

1494841

168.98 Spain

24.44 34.44 Japan South 35.432 Korea 68.164 Singapore

Asia Pacific and Americas 22/6/00 0

0

15/12/ 00

3221649

67.867

11/4/01

173913

55.035

Source: Our calculation on UMTS Forum data

amounts paid to goverments on 3G mobile licensing, in Western Europe and some Asian Pacific and American countries, either when the method of allocation was beauty contest either auction. We computed total amounts using the prices of licences that were originally determined during the auction or fixed by the governments in the licensing process via beauty contest. After the award of the licences, in some countries governments changed the conditions of the licences in a more favourable direction to the carriers and in some cases lowered their fees.7 We believe that if we wish to compare the two methods of allocation it is more correct to consider the original amount to be paid and not the revised one. The amount in national money was converted in ECU at the exchange rate existing at the time of the award of the licences. Population data are those of 1999. Table 23.1 shows that the licence fees paid for the use of electromagnetic spectrum for mobile telecommunications in Europe were higher when the auction method was used than when the allocation method was the ‘beauty contest’ and much more money collected by governments with auctions. This was true until the end of 2000 when there was a favourable business climate and the stock market experienced

The European UMTS Licences Allocation

Table 23.2

Country

401

Cost of UMTS licences and index of concentration in GSM markets in European countries that used, in 2000, auction as a method to allocate spectrum Cost of the Cost of the Number H/H index Cost of the Cost of the marginal Number marginal of firms marginal marginal of the of licence per licence for taking licence per licence for GSM inhabitant GSM users by licences part in the inhabitant GSM users market issued 1 MHz by 1 MHz contest (euro) (euro) Year 2000 (euro) (euro)

UK

0.2661

117.18

288.81

3.67

9.04

5

The Netherlands

0.3778

24.99

47.37

1.00

1.89

5

13 6

Germany

0.3592

102.57

434.18

4.10

17.37

6

11

Italy

0.4315

42.02

64.80

1.62

2.49

5

6

Austria

0.3606

13.96

18.83

0.69

0.93

6

6

Switzerland

0.5765

5

5

4.55

8.78

0.13

0.25

µ

50.88

143.80

1.87

5.33

σ

47.60

175.91

1.64

6.69

σ /µ

0.93

1.22

0.88

1.25

Source: Our calculation on UMTS Forum data

the bubble of the new economy. After the change in business climate, in 2001, there was not much difference between the two methods, in the amount spent per head on 3G licences. But it is not just auction that can produce high licence fees. The French government used the beauty contest method but, guided by the results in the UK and Germany, set a high minimum fee.8 Another important consideration is that when the allocation method was beauty contest, there is not much difference, on average, in the amount per head of population before and after 2001 (Table 23.1). In the case of auction the difference was huge and the values much higher before 2001. This shows that values of licences in the auction process were highly affected by the business climate, but this was not true when the allocation method was beauty contest. In Table 23.2 we report the cost of the licence of the marginal operator on a per capita basis for the six countries that auctioned licences in 2000. We considered only auctions held in 2000 as the effect of the declining business climate in the telecom sector after 2000 could make comparisons not significant. We considered two different indicators: the cost of the licence for GSM users, and the cost of the licence per inhabitant. We have adjusted the two above indicators by the number of MHz allocated with each licence. Table 23.3 shows the cost of UMTS licences in countries where beauty contest was used as a method to allocate spectrum. With the exception of France all licences were issued in 2000s. In France the issue date was May 2001 but two licences of the four licences issued were not assigned as there were only two participants. Table 23.2 and Table 23.3 indicate that a) the cost of licence per head,

402

Table 23.3

Money Credit and the Role of the State

Cost of UMTS licences and index of concentration in GSM markets in European countries that used beauty contest as a method to allocate spectrum

H/H index Cost of the marginal of the licence per GSM Country inhabitant market (euro) Year 2000

Cost of the marginal licence per GSM user (euro)

Number of Cost of the Cost of the Number firms marginal marginal of taking part licence per licence per licences in the inhabitant by GSM user by issued contest 1 MHz(euro) 1 MHz(euro)

Finland

0.498

0.00

0.00

0.00

0.00

4

Norway

0.595

9.28

14.31

0.27

0.41

4

15 7

Sweden

0.387

0.00

0.00

0.00

0.00

4

10

Portugal

0.365

10.06

17.29

0.29

0.49

4

7

Poland

0.348

16.84

0.00

0.67

0.00

3

3

France

0.379

83.93

158.15

2.49

4.52

4

2

Spain

0.387

12.50

21.36

0.09

0.11

4

4

µ

20.55

46.67

0.59

1.33

σ

31.60

63.10

0.90

1.80

σ /µ

1.54

1.35

1.54

1.35

Source: Our calculation on UMTS Forum data

with the exception of France, was much lower when the allocation method was beauty contest; b) the licence costs per head of population or GSM users are very different between the countries. Why was the price of licence when the auction method was used was higher than in the case of beauty contest?9 Government demanded a low price of the licence in the case of beauty contest because they expected that the money saved by avoiding an auction process would help the winners to better position themselves in the market, avoid huge debt and provide their countries with a better terrestrial coverage. In the auction mechanism the firm’s choice was seen between quitting the business and bear the price of not bidding for a licence or buy the licence and massively increase its debt. Therefore if we denote the profit when the company wins the bid as Πi (B), and Πi (0), if it does not, the maximum value for the bid could be seen as Fi = Πi (B) – Πi (0). In the very optimistic business climate of 2000 the expressed value of the licence fees discounted very rapid market growth. The overestimation of the value of Πi (B) was also affected by the belief that buying the licence would have positively affected the share price of the firm, and a capital gain could result. The expected value of Πi (B) was overestimated and Πi (0) was underestimated by telecom executives and by shareholders. Hence the estimated value of the licence was highly overestimated. The second fact that we must explain is why the licence prices per head of population or GSM users vary greatly between countries. We could understand that governments with different objectives fix different prices for licence fees in beauty contests but why do we find this difference in the case of auctions? The

The European UMTS Licences Allocation

403

reason is that there is a very high correlation between the firm share of the GSM market and the expected share of the firm in the UMTS market. We must consider that incumbents have a mass of subscribers in the GSM market that, because there are switching costs, incumbents will also continue to provide UMTS services, unless quality and prices are much worse than those of competitors. The cost of converting existing customers to 3G customers is likely to be much lower than acquiring a new customer. With most products and services it is much cheaper to sell a new service to an existing consumer than a new service to a new customer. Furthermore, incumbents could have better expertise at running a network compared with marginal operators in the GSM market or new entrants. Therefore it is clear that marginal operators in the GSM market or new entrants will be, at least in the medium term, the marginal operators in the UMTS market. Their valuation of the licence will determine the final results of the auction and we might expect that higher the degree of concentration in the GSM market, the lower will be the expected market share in the UMTS market of the GSM marginal operator or of the new entrants. The higher the concentration in the GSM market, the lower, ceteris paribus, will be the final price in the UMTS auction. We calculated for six European countries (the UK, Germany, Italy, the Netherlands, Austria and Switzerland) where the spectrum is allocated through auction, the Herfhindhal index of concentration in the GSM market in the year 2000, and we correlated this index with the licence paid by the marginal operator. We considered the cost of the licence of the marginal operators presented in Table 23.2. Figures 23.2 and 23.3 show that there is a very strong negative correlation between the lower values of the licence paid in each country (the cost of the licence of the marginal operator) and the Herfindal index of concentration of the GSM markets i.e. in each country. When the allocation method was beauty contest, it is not possible to find such a negative relationship.Our interpretation of Figure 23.2 is that the higher the concentration index, the lower the value of the licence of the marginal operator. A different interpretation, according to Klemperer (2002), is that the higher the concentration index the higher the probability that incumbent firms collude and therefore the lower will be the auction price. ‘Finally, because an ascending auction often effectively blocks the entry of the weaker bidders, it encourages ‘stronger’ bidders to bid jointly or to collude; after all, they know that no one else can enter the auction to steal the collusive rents they create. In the ‘disastrous’ November 2000 Swiss sale of the four third generation mobile phonelicences, there was considerable initial interest from potential bidders. But weaker bidders were put off by the auction form’ Klemperer (2002). Table 23.2 shows that an ascending auction could block the entry of the weaker bidders. The correlation between the concentration index and the ratio between the number of firms participating in the bid and the number of licences is negative and R2 is 0.51. But this is not proof that the low price of the licence in Switzerland was

Money Credit and the Role of the State

cost of the licence per head of population

404

125

UK DE

100 75 50

IT

25

NH AT CH

0 -25 0,0

0,3

0,5

0,8

1,0

H/H index

Cost of the licence for GSM users and 1 MHz per abitante

Figure 23.2 The relations between the Herfindhal index and the cost of licences per head of population

5

DE

4

UK

3

2

IT

NH

1

AT CH

0 0,0

0,1

0,2

0,3

0,4

0,5

0,6

0,7

H/H index

Figure 23.3 The relations between the Herfindhal index and the cost of 1MHz per GSM user caused by collusion. Our interpretation is that the very high concentration index in the GSM Swiss market led to quite a low value of the licence of the marginal operator (see Figures 23.2 and 23.3). Therefore the price was not caused by collusive agreements between stronger bidders but was the correct price of the

The European UMTS Licences Allocation

405

marginal operators. We could repeat the same argument for two other third generation spectrum auctions that Klemperer (2002) considered a total (Netherlands) or a partial (Italy) fiasco.10 Only in the Austrian auction was the price much lower than the value estimated on the basis of the interpolation curve (black line in Figure 23.2. Therefore we do not share the Klemperer (2002) hypothesis that in Italy, the Netherlands, Switzerland and Austria some kind of abuse of dominant position resulted in excessive low prices of licences. In section 23.3 we showed that auctions could favour the incumbent over new entrants11 as the value of the licence is much higher for the incumbent than for the new entrant. Table 23.3 shows, on the other hand, that the beauty contest does not discourage participation when the GSM market concentration is high. The correlation between the concentration index and the ratio between the number of firms participating and the number of licences is positive (and not negative as in the auction method), and R2 is 0.18. However, there is not much evidence to suggest that auctions favour incumbents over new entrants (Table 23.4). The beauty contest shows a higher percentage of licences given to new entrants but there are no substantial differences in the share of the new entrants in the two cases. The reason was that in both cases the number of licences awarded was greater than the number of incumbents. In four cases one incumbent did not participate in the bid. Blue in Italy (auction), Meteor in Ireland (beauty contest), Sonafon in Denmark (auction), Table 23.4 Distribution of UMTS licences between incumbents and new entrants Auctions Country

Award date

Beauty contest Incumbent

New entrant

Country

Award date

Incumbent

New entrant

Year 2000 UK

27/04/00

4

1

Finland

18/3/1999

3

Netherlands

24/07/00

4

1

Spain

13/3/00

3

2 1

Germany

18/08/00

4

2

Norway

4/12/00

2

2

Italy

23/10/00

3

2

Poland

6/12/00

3

Austria

3/11/00

4

2

Sweden

16/12/00

2

2

Switzerland

6/12/00

3

1

Portugal

19/12/00

3

1

France

31/05/01

2

Ireland

25/06/02

2

Year 2001 Belgium

2/03/01

Greece

13/07/01

Denmark

20/09/01

Australia

22/2/2001

Total Total %

3 3 4

2

32

12

0.73

0.27

Source: Our calculation on UMTS Forum data

1

1 Total Total %

20

9

0.69

0.31

406

Money Credit and the Role of the State

Bouyghes in France (beauty contest). In all these case these operators, except in the Danish case, were marginal operators with a very tiny share of the GSM market. However, the only country where the dominant operator did not win the licence was Sweden, where the method of allocation was the beauty contest.12

23.5

Auction and the Effects on Investments

One of the arguments against UMTS auctions was that auctions would reduce investments and would slow down the process of the introduction of 3G services. Empirical evidence seems to support this argument. One of the effects of UMTS auctions was a large increase in the Telecom operators' debt. Since 2000 the seven largest European phone companies have accrued more than $170 million in debt. Last year individual companies’ ‘interest burdens ‘doubled, on average. Most carriers have seen their credit rating downgraded, a few others are also likely to be downgraded. The burden of huge interest payments will reduce the cash flow. As a result dividends, acquisitions and much needed investments in technology and infrastructure are all expected to decrease. Best positioned are Telefonica and Telecom Italia that have not spent huge sums on their UMTS licence (see Table 23.5). The cover ratio of British Telecom, Deutsche Telekom, France Telecom, KPN, Sonera deteriorated till the end of 2002. Most of the debt is short term, meaning they must raise money on the market soon and they are expected to pay more because of the recent downgradings. We computed the amount of money spent by each of the largest carriers in Europe to buy UMTS licences in Europe and the ratio between the amount spent buying licences and the value of the assets in 1999 (before the start of the sale of the spectrum rights).13 This ratio allows normalization of the amount spent by the size of the telecom operators. We have also computed the rate of change of the value of market capitalization of the operators in the period 1999-2001. These values are shown in Table 23.5. If the telecom operators had bought the licences at the right price we would have expected the money spent not to affect the change in market capitalization and the cost of debt. On the other hand if the prices of the licences were excessive operators that spent the most on UMTS licences, would have seen their market capitalization decreased further. A low market capitalization debt ratio makes it difficult to raise money to finance investments in the network. Table 23.5 shows that the debt rating has worsened more for the firms that spent most. Figure 23.4 shows that there is a negative correlation between changes in market capitalization in the period 1999-2001 and the normalized amount of money spent on licences. As the amount spent on auctions is much larger than in the case of beauty contests our empirical evidence supports the argument that UMTS auctions increased the cost of debts and delayed the introduction of 3G commercial services.

The European UMTS Licences Allocation

Table 23.5

407

Debt*, market capitalization and ratings in European telecommunications companies

Telecom Operators

Number of countries where they have licences (Europe)

Lon Term rating 1999

(Total cost of licences) /assets1999

% Change in market capitalizazion in the period 1999-2001

2000

2001

2002

A3

A3

A3

A3

0.155

-0.2758

Hutchinson

6

Vodafone

13

A2

A2

A2

A2

0.088

-0.6296

British Telecom

5

Aa1

A2

Baa1

Baa1

0.356

-0.6205

Deutsche Telekom

6

Aa2

A2

A3

Baa1

0.204

-07519

France Telecom

10

Aa2

A1

Baa1

Baa3

0.217

-08495

KPN

3

Aa1

Baa1

Baa2

Baa3

0.744

-0.7444

Telecom Italia

2

A3

Baa2

Baa1

Baa1

0.055

-0.3757

Telefonica

5

A2

A2

A2

A2

0.133

-0.2272

Sonera

5

A2

A2

Baa2

Baa2

1.129

-0.8888

T.Danemark

3

Aa3

Aa3

A2

A3

0.038

-0.6296

Source: Total cost of licences - Our calculation on UMTS Forum data; ratings *Moody; value of asset and capitalization Business Week ‘The global 1000’, issues 2000, 2001, 2002

% capitalization

0 -0,2

0

0,2

0,4

0,6

0,8

1

1,2

-0,4 -0,6 -0,8 -1

L/A

Figure 23.4 The relation between the percentage change in carriers’ market capitalization and L/A (the ratio between the money spent on licences and the value of assets)

408

23.6

Money Credit and the Role of the State

Conclusions

Analysis of the UMTS market shows that, in all likelihood, licence fees determined in the auctioning process in the year 2000 were too high and were caused by the bubble that affected the new economy, and that the large amount of money spent on licences delayed the commercialisation of 3G services. In July 2002 the situation of UMTS markets in Europe was the following: a) Telecom operators as Deutsche Telekom, France Telekom, KPN and Vodafone that spent more acquiring licences in different European countries, had huge debt and very high negative profits. Vodafone, unlike Telefonica and Telecom, has not yet begun to amortize the licence fees because it does not want to worsen its already poor profit performance. b) The project to create a continental network in Europe on a 3G standard is developing at a slower rate than anticipated. The high level of debt has slowed telecom capital spending in UMTS technology (building a high speed network, developing the software and handsets for 3G services). The commercialization of 3G services will be delayed until well into 2003 for technical and economic reasons.14 c) The demand for new services offered by 3G handsets is an example of the chicken-and-egg problem. Huge debt has slowed investments in UMTS technology. Due to the low investment in UMTS technology the demand for new services offered by 3G handsets did not emerge and expected profitable returns were shifted later in time. European telecom operators have slowly upgraded for faster data services known as GPRS, but promotion of such services has been scant. Telecom mobile operators are focusing on dependable revenue generators such as voice call and short–text messages (STM). d) It is possible to forecast that the number of bankruptcies will continue and the number of network operators per country will decrease significantly, perhaps also relative to the GSM market structure. This will make an escalation of regulatory intervention necessary. It is not correct to say that all these problems were caused by auctions. These problems were caused by the overoptimistic climate that drove Telecom operators to invest heavily both in physical and financial assets. The consequences are an excess in transmission capacity, huge debt and price wars. Auctions in Europe have contributed to this situation. When the market is bullish about the growth rate of services supplied, auctions result in overbidding. Managers seriously misjudged licence values as they were driven by a bullish stock market15 and they were sure of getting all the resources required. In this situation licence fees in beauty contests are not affected so heavily, as we have seen, by the overoptimistic climate. Auctions could be be better methods than beauty contests if the situation is such that operators are well aware of the value of the object up for auction. Otherwise the method could lead to a poor allocation of resources.

The European UMTS Licences Allocation

409

Notes 1

In countries like Italy and the UK the expected costs of building the new infrastructure network is 5000 million euro. 2 Immediately after the auctions prices of telecommunications companies were not negatively affected. The loss of the licence would had such negative effect “If we dropped out our market cap would fall by more than the price of the licence” said an executive at Spain Telefonica at that time, Business Week ‘Tale of a bubble’, June 3, 2002. Some entrepreneurs such as Bouygues thought that ‘shelling out billions just for a licence in an unproven technology was a tulipmania that would bankrupt the entire European Telecom industry’ Business Week, June 3, 2002. The operator Hutchinson Whimpas halfway through the German auctions left his partners NTT and Royal KPN and refused to enter in the bid. But for most telecom operators a loss in the auction was seen as a death sentence. 3 Milgron and Weber (1982) have shown that bids in the English auction have the effect of partially making public each bidder’s private information about the item’s true value, this lessening the effect of the winner’s curse. The English auction yields a higher expected value than the first–price sealed–bid auction, the second-price sealed-bid auction or the Dutch (Milgron and Weber, 1982). 4 We assume that when the incumbent is present only in the GSM market it will not try to be more competitive with firms that are in the UMTS market. Therefore XUMTS and ΠM(XGSM) will be the same whether or not the incumbent is awarded a licence in the UMTS market. A more realistic hypothesis could be that if the incumbent is only in the GSM market it will try to be more competitive with firms in the UMTS market and its profit in the GSM market will be higher than ΠM(XGSM) and the quantity produced in the UMTS market by the winning firms will be lower than XUMTS. 5 In 1997 in FCC an auction of the spectrum was held. In 1999 winners defaulted on their payments. The rerun pulled in only 10per cent of the $54bn bid the first time round. 6 Only in UK has none of the winning firms decided to hand back the UMTS licence. This is probably due to the fact that in England in the GSM market the share of the four firms is about the same (Orange 24 per cent, T-Mobil 24 per cent, Vodaphone 28 per cent, O2 24 per cent). Therefore each operator and the new entrant (Hutchinson) have equal probability of obtaining a good share (about 20 per cent) of the UMTS services market. 7 The most striking case was that of France where the fees have been cut dramaticallyfrom E 4.9bn to E619 million plus a one per cent charge on revenues generated by UMTS and the licence has been extended to 20 years from 15 years. In light of these new conditions a third operator, Bouygues, has submitted a bid on a 3G licence. 8 But such fees have not been paid. The failure of the beauty contest (there were only two competitors and four licences available) pushed the French government, after having awarded the two licences, to reduce substantially licence fees to allow the entrance of a new competitor. 9 Government used the ‘beauty contest’ method of allocation – instead of the auction style of distribution - in order to secure investment and quality coverage. Governments expected that the money saved by avoiding the auction process would help the winners to better position themselves in the market, avoid huge debt and provide the country with full terrestrial coverage in the shortest number of years. 10 Many specialized newspaper use the word fiasco to describe the situation of the 3G European markets. Speaking about the UK auction Business Week wrote ‘It produced a windfall for British coffers and a disaster for the industry’ Business Week ‘Tale of a bubble:how the 3g fiasco came close to wrecking Europe’, June 3 2002.

410

Money Credit and the Role of the State

11 The UMTS Forum (19 October 2001) shows another effect of auctions. If one divides licences into three categories (Global players, regional players and local players) it is apparent that the share of licences obtained by local players (that are generally also new entrants) when auction was the method to allocate the spectrum is much lower than in the case of beauty contest. 12 Telia, the dominant operator, lost a UMTS licence on its home market. Telia’s setback was due to shortcomings in the commitments to building infrastructure. 13 We computed the effective amount spent on licences. When a telecom operator is not the full owner of the company that won the licences we computed the cost of the licence in proportion to its share of ownership in the consortium. 14 Hutchinson Whampoo, which is most determined to introduce 3G services as it is a new entrants and it has no alternative on the European mobile market, had been experiencing technical problems with its 3G trials which led to a delay in the marketing of 3G services. 15 On the other hand investors were all too willing to bid up the stock of the bidding companies and punish the company drawing for the bid.

References Binmore, K. (2000), ‘Economic theory sometimes works’ ELSE, May 7, pp. 1–3. Brown, G. (2000), ‘Dial a fortune’, The Guardian, April 13. Gruber, H. (2002), ‘Endogenous sunk costs in the market for mobile telecommunications: The Role of Licence Fees’, The Economic and Social Review, 33(1), Spring, pp. 55–64. Klemperer, P. (2002), ‘What really matters in auction design’, Journal of Economics Perspectives, 16(1), pp. 169–89. Goeree, J.K and T. Offerman (2002), ‘Efficiency in auctions with private and common values: an experimental study’, American Economic Review, 2(3), pp. 625–43. McAfee, R.P. and J. MacMillan (1996), ‘Analyzing the airwaves auction’, Journal of Economics Perspectives, 10(1), Winter, pp. 159–75. McMillan, J. (1994), ‘Selling spectrum rights’, Journal of Economics Perspectives, 8(3), Summer, pp. 145–62. ‘Too Many debts, too few calls’ 2002, The Economist, July 20th, p. 57 Milgron, P. (1981), ‘Rational expectations, information acquisition, and competitive bidding’, Econometrica, 49(4), pp. 921. Milgrom, P. and R. Weber (1982), ‘A theory of auctions and competitive bidding’, Econometrica, 50(5), pp. 1089–221 UMTS FORUM, ‘Licensing costs for 3G Licences’, 19 October 2001, www.umts-forum.org UMTS FORUM, ‘Owners of the 3G Networks’, uptated May 2002, www.umtsworld.com /industry/owners.htm UMTS FORUM, ‘UMTS/3G Licences, uptated May 2002, www.umtsworld.com/industry /licences.htm

Chapter 24

From Corporative ‘Programmed Economy’ to Post-war Planning. Notes on the Debate Among Italian Economists (circa 1910–1953) Riccardo Faucci

24.1

The Origins of the Debate (1910–1925)

Augusto Graziani devotes the fifth chapter of his well-known anthology on postwar Italian economic growth (Graziani, 1979; see also Graziani, 1998) to ‘Economic planning and social reforms’. Graziani starts from the 1950s, and shows that economic planning was intended as necessary to overcome the underdevelopment of the South and to carry out a number of institutional and economic reforms. These reforms were designed to ensure a fairer distribution of income as well as the absorption of unemployment, and maintenance of the rate of growth of the economy. Yet, if we take a look also at the previous decades, we see that even before World War II planning was a debated subject in Italy, as it was connected with the ideas of strengthening the power of the State and/or controlling manpower – ideas which were most familiar to Fascism. As is well known, corporatism was one of the main pillars of Fascism. 1 This policy consisted in transforming the professional associations of workers and employers into public organs, in order to substitute professional representation under the rule of the totalitarian State for their political ‘Demo-Liberal’ representation through Parliament. It is not the goal of this paper to follow the history of the reforms carried out by Fascism, but rather to give a sketch of the intellectual history of the economists’ debate on corporatism and planning. From a purely intellectual point of view, we can date these positions as far back as the 1910s.2 At that time, a lively debate arose about the role of the workers’ unions in a new economic order no longer dominated by capitalism. Two streams of thought, the ‘Sindacalisti rivoluzionari’ and the Nationalists, agreed in assigning the Unions a crucial function in reorganising the economy. Let us neglect the ‘Sindacalisti rivoluzionari’ – these were followers of Georges Sorel who advocated a general revolutionary strike and the use of violence to overthrow capitalism –

412

Money Credit and the Role of the State

and turn to the Nationalists. The latter stressed that ‘the State … should intervene in the life of the Trade Unions with a special jurisdiction, in so far as the modern State, the juridical expression of the Nation, is the supreme expression of the economic organisation’ (Carli, 1916, pp. 316–17).3 This short sentence suffices to reveal a corporative leaning. The Nationalists were not revolutionary at all (although many of them came from Socialism), but they praised the German economic organisation. Many of them had indeed been uncertain whether to side with the Central Empires or with France and Britain in 1914. However, the Nationalist economists were a small minority in the economists’ profession, which rejected their overvaluation of the functions of the State and their latent protectionism.4 Regarding in particular the Trade Unions, the majority of the Italian economists were inclined to consider them as private associations, not deserving a special discipline enforced by the law. Most economists were rather unenthusiastic about their impact on the entire economic system: there was a widespread belief that the Unions represented a case of monopoly over a production factor, the labour force, whose productivity was by no means uniform. Collective bargaining on wages, it was argued, had the effect of levelling any difference in productivity among workers, and this was harmful to economic efficiency. According to the ‘prince of the Italian economists’ – Sraffa’s definition (Sraffa, 1924, pp. 648–53) – Maffeo Pantaleoni, the operation of the Unions could be compared to that of a trust or a cartel ‘of the older type’, since the ‘new’ vertically integrated American industrial cartels had much more flexibility than the old European version. The Trade Unions’ main objective, that of obtaining higher wages for their members, ran the risk of leading to the opposite outcome, because the economic variables were beyond the Unions’ control. Nevertheless, new and more satisfactory functions could be assigned to the Unions in the interest of the workers: for example, they could run some public services, such as transporting emigrants to the countries of destination.5 In this sense, there could be some agreement between cartels and trusts, on the one hand, and the Trade Unions on the other. ‘Economic complexes’ of producers of goods and services could be established, in which workers would be included (Pantaleoni, 1909b, p. 345). The latter words seemed to open the door to a corporative organisation of the economy, although Pantaleoni was by no means a corporatist, at least from the political point of view, since he considered corporatism no different from Bolshevism. 6 A distinct question was that of planning, i.e. of introducing a general scheme of the economy in which the public authority was called upon to decide the allocation of resources and their employment. Here professional economists were divided into two groups. There were those who admitted that some ‘collectivist’ economic planning could in principle be carried out, provided that the conditions, and therefore the equations, of general equilibrium be maintained. Pareto in his 1906 Manuale and above all Barone, in his famous 1908 article on the Minister of production, were the main representatives of this line, whose theoretical basis was provided by the second theorem of welfare economics (see Petretto, 1982).

From Corporative ‘Planned Economy’ to Post-war Planning

413

Nevertheless, the majority of Italian economists were sceptical about the effectiveness of a planned economy, mainly because the State was identified with the government, whom they viewed, following Bentham, as a mere spokesman of ‘sinister’ interests. The State could gain no real autonomy from interest groups. According to Pantaleoni, who clarified this argument as early as 1892, there were three different welfare optima: the individual, the collective (the sum of individual optima) and the ‘special’ (di specie). The latter were exemplified by class or group optima, which were difficult to reconcile with both individual and collective optima. Therefore the socialists, no matter whether revolutionary or reformoriented, inasmuch as they defended class interests, were inevitably the enemies of general (intended as the sum of individual) interests: all they aimed at was to achieve special optima of a ‘corporatist’ kind. Trade Unions were therefore accused of re-introducing those special privileges which had been abolished since the French Revolution (!) (see Pantaleoni and Bertolini, 1892, p. 43). The means through which the Socialists intended to achieve their special optima was ‘collectivism’, i.e. a centralised economy. At that time, Pantaleoni did not use the term ‘planning’, but the concept was clearly implied by his argument. Pantaleoni discussed the case against a planned economy in 1910. He compared the price determined in a fully competitive market economy with that established in a planned economy. The former was an ‘economic price’, and manifested itself ‘when the same commodity is bought and sold at the same average price, whoever the buyer or the seller is’. The latter was a ‘political price’; it appeared when ‘the same commodity is bought and sold at different prices, wherever the buyer or the seller have or have not certain political, or social, or ethical or religious or national or physiological requisites, and so on’ (Pantaleoni, 1911, p. 2). There followed that only economic prices could conform to the ‘price indifference law’, i.e. the rule warranting the existence of just one price for the same commodity in the same market. On the contrary, as far as political prices were concerned, a certain degree of coercion would be necessary, as they were differentiated according to the nature of buyers and sellers. In Pantaleoni’s view, the existence of political and economic prices could not last, since the former would eventually prevail over the latter – pace the supporters of a mixed economy – so that the whole economy, entirely socialised, would eventually fall under the weight of its inefficiency. It is interesting to note that Pantaleoni defined the political price system – the system of planned or socialised economy – as a ‘corporative system’, and underlined the existence of ‘thousands of obstacles, necessary to sustain the privileges given by this system’ (Pantaleoni, 1911, p. 7). In Italy and elsewhere, the First World War marked an impressive effort in economic organisation through a number of State agencies, especially for food supply and transport. The flow of public expenditure inevitably produced massive phenomena of corruption, and socialist co-operatives and Trade Unions were suspected of having taken part in such phenomena. After the war, the Liberal economists criticised these agencies and institutions as seriously inefficient.

414

Money Credit and the Role of the State

Pantaleoni complained against the attempts to redistribute personal income via the State-controlled prices (‘calmieri’). In his view, any redistribution would have negative effects on saving and consumption and thus distort the system’s economic equilibrium (see Pantaleoni, 1920, pp. 38–41).7 Luigi Einaudi, as a journalist in the Corriere della sera and as Senator from 1919, claimed that all the State agencies for food supply and house rents should be dismantled; he used the ironic term of ‘padreterno’ (Almighty God) as an appellation for the economist Vincenzo Giuffrida, a civil servant involved in running the economy of war.8 Einaudi’s Turin colleague Giuseppe Prato devoted considerable effort to uncovering from the economic history of Piedmont several instances of the failure of any kind of State control over prices and quantities (see Prato, 1919). Umberto Ricci, Pantaleoni’s first disciple, went even further: he maintained not only that State agencies and public controls were inefficient and harmful to the economy in peacetime (see Ricci, 1919, 1920a, 1920b), but that they were also a scourge during the war (see especially Ricci, 1921). Pantaleoni, Einaudi, Prato and Ricci unanimously supported a rapid return to pre-war conditions. It must be remembered that early Fascism was strongly in favour of the re-establishment of complete laissez-faire. In 1922, shortly before rising to power, Mussolini urged a return to the minimal ‘State as night-watchman’ and promised to abolish the ‘State as postman and railwayman’ (Mussolini, 1934, p. 320). This propaganda had the effect of capturing the sympathies of the middle classes and their intellectual representatives, the Liberal economists, who were staunch critics of the excessive burden of étatisme. Between 1922 and 1923 Mussolini and his Finance minister De’ Stefani carried out a programme of privatisation and supported the private sector by reducing taxes on higher incomes and, above all, by cutting public expenditure. The latter policy had the effect of firing many ‘subversive’ postmen and railwaymen.9 In the Corriere della sera, Einaudi manifested unambiguous pro-Fascist attitudes.10 The scene changed after 1925: Fascism abandoned economic liberalism and began to advocate a strong economic role for the State through corporatism. This volte-face still remains an unsolved historical puzzle. A political explanation of the change in economic policy may reside in the fact that the Fascist ruling class wished to gain increasing autonomy, in a financial perspective as well, from the capitalist forces that favoured its advent.11 Yet, it was not the Fascist inclination towards State intervention, but rather its proclaimed favour for public control over industrial relations that triggered the Liberal economists’ reaction. Einaudi remarked that the appointment of the Trade Unions as State organs was a bad remedy to the anarchy in industrial relations that had prevailed in 1919–20. Only by leaving workers free to organise themselves and, of course, to decide whether to strike or not could preserve a truly competitive society. In 1924, Einaudi collected his pre-war articles on labour problems in a book, Le lotte del lavoro (Einaudi, 1924). In the opening chapter, ‘La bellezza della lotta’, Einaudi maintained that the equilibrium in the labour market was unstable, because the contracting parties were continuously revising their original

From Corporative ‘Planned Economy’ to Post-war Planning

415

position, modifying their requests. Quite correctly, a British reviewer of the book, the economist and Labour statesman Hugh Dalton, commented that ‘Professor Einaudi is no industrial pacifist… He is opposed to ‘industrial parliaments’, such as are advocated from time to time by hazy thinkers desirous of ‘bringing capital and labour together’ and relieving political parliaments of their responsibilities for industrial legislation’ (Dalton, 1925, pp. 617–18). As is well known, the law of April, 3, 1926 stated that only the officially appointed (read: Fascist) workers’ associations could sign valid collective agreements. This was exactly what Einaudi feared. According to the right-wing Liberal economist Umberto Ricci, the Fascist decision to endow officially authorised Trade Unions with the power of signing collective agreements was inconsistent with the Fascist idea of the State. For on the one hand Fascism aimed at building up an over-powerful government; while on the other, the regime gave up a part of its authority in favour of the Unions (see Ricci, 1925). However, the inconsistency was only apparent, because the Unions were under the regime’s tight control. In 1928 Ricci published an article in a Fascist journal in which he equated corporatism with the restoration of medieval institutions (Ricci, 1928, pp. 220–5). This was no more than an application of Pantaleoni’s 1892 ideas; nevertheless, the regime reacted by forcing Ricci to resign from his chair at the University of Rome and to move to the University of Cairo (see Busino, 2001, pp. 355–8). Similarly, the left-wing Liberal economist Antonio de Viti de Marco observed that while Fascism should be acknowledged the merit of successfully contrasting the ‘corporative’ assaults on the State, after 1922 the regime had identified the State with the Party (de Viti de Marco, 1930, p. xlvii): this implied that the private interests supported by the Party could easily be satisfied at the expense of nonprotected interests. This intuition was to be developed by Einaudi, who argued that corporatism protected the vested interests which were already established, without taking care of the interests to come (Faucci, 1986, pp. 269–77). One could say that the Liberal economists threw the baby out with the bathwater, as they viewed the Trade Unions exclusively as private associations. They failed to realise that Corporatism was an answer – albeit an authoritarian one – to the crucial problem of industrial relations, whose discipline could no longer be considered as dependent on individual initiative. The latter view was stressed by the Social-Democrat economist Carlo Rosselli, a disciple of Einaudi, according to whom the Trade Unions should not limit themselves to contracting wages, but ought to ‘control enterprises, production, prices, profits’ (Rosselli, 1925b; see also Rosselli, 1924a; 1924b; 1925a). Rosselli, who pondered over Beatrice and Sydney Webb’s Industrial Democracy and Pigou’s Methods of Industrial Peace, tried to sketch the outlines of what he called ‘socialismo liberale’:12 a State-managed economy in which organised workers and producers could share the determination of the key issues of economic policy.

416

24.2

Money Credit and the Role of the State

The 1930s and Early 1940s

In spite of many evident political constraints, at least until 1935 the debate on the foundations of the corporative economy was quite lively (Mancini et alii, 1982). Three different streams of corporative thought can be traced. First, there was a ‘philosophical’ version of corporatism, according to which its function was that of merging the individual in the State, dialectically overcoming the Liberal individualist position. Ugo Spirito, a member of the editorial staff of Enciclopedia Treccani, and a disciple of Giovanni Gentile, followed the latter in maintaining that Fascism achieved the ideal of an identity between the individual and the State. Integral corporatism should therefore substitute the corporation for the State itself (see Spirito, 1935). Consequently, Fascism should abandon its previous TradeUnionism (see Punzo, 1990, p. 376). In a ‘planned corporative economy’ the professional groups, belonging to Corporations, should themselves fulfil the aims of economic planning. In so doing, they should eschew the evils of bureaucracy, typical of old-fashioned State socialism.13 Spirito proposed that private property be transformed into what he called ‘corporazione proprietaria’ (public-owned corporation). This should be achieved through an indirect socialisation of firms, i.e. through the introduction of a number of civil servants on their executive boards. In spite of the modesty of this proposal, it was labelled as ‘bolshevik’ and rejected at the 1932 Ferrara Conference on corporative studies (see Spirito, 1970, and his autobiography, 1976, in which he claims that his heterodox ideas on corporatism led to Fascist persecution against him). Not distant from Spirito, although less radical in conceiving corporatism as a ‘new’ economics, there was a group of economists who equated it with planning tout court. They were protected by the brilliant Minister of Corporations Giuseppe Bottai and belonged to the Pisa University High School of Corporative Sciences, founded in 1928 (Cassese, 1974, p. 175).14 The School published an interesting journal, the Archivio di studi corporativi, and the above-mentioned collection of books. A prominent economist of this group was Celestino Arena, who together with Bottai edited the collection ‘Nuova collana di economisti stranieri e italiani’ (12 volumes from 1932 to 1937) and planned to translate Keynes’s General Theory as early as 1938 (Bini, 1984, p. 115).15 This stream of thought considered the Great Slump of 1929 as the final crisis of laissez-faire capitalism and the advent of the mixed economy phase which assigned a leading role to the State. For these reasons, they were sympathetic to the French positions on ‘économie dirigée’.16 Another stream of thought, of Liberal origin, elaborated a model of the corporative economy as a market economy subject to special constraints, like administered prices, limited competition, and so on. This group was mainly concerned with the risk that Fascism would eventually transform economics into politics. Following Einaudi (1933, 1934; see also Faucci, 1986, pp. 273–7), only a ‘Corporazione aperta’ (open corporation) would not be at variance with the teachings of orthodox economics. But a ‘Corporazione aperta’ would have been a

From Corporative ‘Planned Economy’ to Post-war Planning

417

contradictio in adjecto, and Einaudi was well aware of this. In fact, he intended to oppose those corporatist thinkers who presumed to build a new science. On the contrary, Einaudi observed, corporatism resolved itself into an economy dominated by public and private monopolies. Einaudi’s critiques indiscriminately involved all the international experiments of regulated economy – including not only Stalin’s Five Year plan, but also Roosevelt’s New Deal.17 Einaudi considered the latter as capable of diverting the American economy from the right path of the free market in the direction of an impersonal rule system. Einaudi’s attitude towards planning was therefore very similar to that shared by the Austrian School scholars, like Mises and Hayek, and by the German Ordo-Liberal economist Wilhelm Roepke. Before the war, Luigi Einaudi in his Rivista di storia economica hosted a lengthy article by his friend, the Genoa economist Attilio Cabiati, who in his youth had been a Socialist, but subsequently became a staunch advocate of economic liberalism. After discussing the theses put forward by several economists, such as Hall, Dickinson, Taylor, Mises, Hayek, Lerner, Lange, and others, Cabiati formulated rather sceptical conclusions about the possibility of market socialism (Cabiati, 1940, p. 110). His article was at least an effort to acquaint Italian scholars with the planners’ theses. Yet, in an equally lengthy addendum to Cabiati’s paper, Einaudi objected even to the opportunity and usefulness of such a debate, since it was devoid of ‘realism’. The only historical collectivist economy mankind had experienced (apart from Russia) was the Jesuits’ rule in Seventeenth century Paraguay, and nobody was willing to resuscitate such experiments in modern world (Einaudi, 1940, p. 198). In 1942, the University of Pisa organised a conference on Europe’s reconstruction after the war (i.e., after the ‘inevitable’ Axis victory). The majority of the participants spoke in favour of a planned and partially autarkic economy. The most convincing case for planning was made by Cesare Dami, a young Bocconi economist who showed a deep knowledge of the debate on planning in English-speaking countries (Dami, 1942).18 But Giovanni Demaria, who delivered the opening lecture of the conference, presented a very unfavourable report on autarky and argued in favour of the return to international free trade. Inevitably, international freedom of trade and absence of planning turned out to be synonymous. The Demaria report gave rise to a heated discussion among the participants in the conference, and was not published until 1951 (Demaria, 1942). Another influential economist, Costantino Bresciani Turroni (1942), defended libertarian positions from a double point of view: a critique of Keynesian concepts, especially the multiplier, and a severe rebuttal of the theories of economic control experienced in Nazi Germany (Bresciani Turroni, 1942).19 Although he did not deal with contemporary ideas on a regulated economy in the UK and USA, he manifested opposition to every form of planning. After the war, in 1946, he edited the translation of Hayek’s Collectivist Economic Planning (Hayek et alii, 1935). It is noteworthy that in this edition Bresciani omitted Barone’s essay on ‘The minister of production’, present in the original version. This probably arose from

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his intention to exclude Barone’s name from the supporters of ‘collectivism’ (see Hayek, 1946).

24.3

Capitalism, Planning and Economic Reforms, 1942–50

In the same years Einaudi, Bresciani Turroni and Demaria (especially the first two) were fighting their battle against corporatists and ‘planners’, some intellectuals who were held in prison or in ‘confino’ (internal exile), devoted their thoughts to the best way of reconstructing the Italian economy on new bases. Of some interest are the ideas put forward by Ernesto Rossi and Altiero Spinelli, two anti-Fascists who in 1942 wrote the Ventotene Manifesto of European federalism, one of the incunabula of the post-war unification of Europe. Rossi, a disciple of Salvemini and Einaudi who contributed to the Riforma sociale before being imprisoned in 1930, was working at an ambitious Critique of the economic constitutions (part of this magnum opus was eventually published after the war). Rossi’s work was extensively permeated by Bentham and Pigou. It touched on several crucial points: the conflict between economics and ethics, the principal-agent problem, the difficulty of conceiving the factors of production as indefinitely divisible, and the danger that monopolies could cause high prices and artificial scarcity of some commodities, with the consequent rise of unearned rents. Possibly influenced by the American institutionalists, Rossi called for a reform in property law. Spinelli’s hand-written commentary on Rossi has been preserved. According to Spinelli, Rossi’s proposals were by no means sufficient to provide a foundation for a radical critique of capitalism, as was Rossi’s intention. The conflicts that capitalism provoked should, Spinelli believed, be settled by some sort of superior authority, such as a world democratic government or a federal super-State. His point was that a ‘pure economist’s’ perspective could not lead to a true reform of the economy: in order to investigate the premises of the capitalist order, it was necessary to have recourse to some general ‘philosophy (see Spinelli, 1940). Spinelli was very clear-cut in maintaining that socialism and corporatism were mutually exclusive. In a letter to an unspecified ‘Eugenio’ – probably the Socialist intellectual Eugenio Colorni – he expressed his discontent ‘over the hypothesis of using the Fascist corporations to build up Socialism without perceiving that in so doing we end up as prisoners of the autarkic economy’.20 As early as July 1943, a group of Catholic intellectuals drew up the so-called ‘Codice di Camaldoli’. This important document seemed to abandon the Church’s traditional corporatist leanings that were manifested, for example, in the encyclicals Rerum novarum (1891) and Quadragesimo anno (1931), turning instead to more modern schemes for governing the economy. These intellectuals were later to enter the Democrazia Cristiana, and several elements of the Codice would eventually become a part of the 1948 Italian Republican Constitution, especially as regards entrepreneurship and the social function of private property (articles 41 and 42). Pasquale Saraceno, one of the leaders of the group, showed

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in-depth knowledge of the phenomenon of the separation between ownership and management depicted by Berle and Means in their 1933 volume. According to Catholic economists, workers could not collaborate in the management of the firm for technical reasons, but they could benefit from the sharing of profits (Saraceno, 1968). Unlike the other anti-Fascist parties, the Communists considered Fascist corporatism not only as a reactionary policy, but also as a complex bourgeois strategy to offset class struggle and to integrate the workers’ movement in the State. In his Moscow Lectures on Fascism (1935), the Communist leader Palmiro Togliatti acknowledged that the regime had created some institutions for the workers (Dopolavoro for workers’ leisure, Opera nazionale Balilla for young people, and so on), suggesting, however, that such institutions could facilitate antiFascist propaganda through infiltrated Communist members (see Togliatti, 1973). A pure politician, Togliatti – himself a former graduate of Einaudi – had no confidence in economic reforms per se. On the one hand, he believed that a debate on reforms before the electoral victory of the Left – which he considered probable – was simply a waste of time. On the other hand, the necessities of material reconstruction of the country required a certain degree of consensus, while deep involvement in reforms could annihilate the precarious tripartito alliance made by the Christian-Democrats, the Communists and the Socialists. For these reasons, the years 1945–47, during which the three parties were in power, did not bring about any effective economic reform. The Left failed to obtain the cambio della moneta (change of currency) which was designed to be connected with a special levy on capital. The currency change, it was argued, could reduce the liquidity held by households and put a halt to inflation. The opponents – among whom the Bank of Italy Governor Einaudi and the Treasury minister Epicarmo Corbino – objected that the change was too complicated for the weak and inefficient Italian bureaucracy that had emerged from the war, so that the measure was eventually abandoned. There was a timid effort to introduce the consigli di gestione (workers’ management councils), sponsored by the highly competent Industry minister, the Left-wing-Socialist Rodolfo Morandi. These councils were intended to guarantee a sort of workers’ control over the management of large firms, but they could not survive a changed political context.21 For the above reasons, the only ‘plans’ that were admitted were those necessary to face the shortage of raw materials and to serve to the immediate needs of production. The debate on the specific features of a general plan for the economy as a whole was not encouraged. Economists were rare in the Left. The most prominent of them was Antonio Pesenti, a disciple of the Pavia professor of public finance and reform-oriented Socialist Benvenuto Griziotti. Condemned in 1935 to 24 years for anti-Fascism, Pesenti converted to communism while he was in prison. Freed in 1943, he became deputy-minister and later on minister of Finance in the post-Fascist governments chaired by Badoglio and Bonomi. Pesenti had the merit of founding the Centri economici per la ricostruzione (CER), a network of professionals, white collars and workers independent of any party affiliation, who shared a concern for

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reforms. The proceedings of the first (and last) national conference of the CER, held in Rome, 21-30 May, 1947, are particularly interesting. Among the reporters, there were distinguished economists, such as V. Angiolini, M. Bandini, A. Breglia, G.Fuà, G. Pietranera, M. Rossi Doria and S. Steve, and the jurist M. S. Giannini. In spite of the inevitable heterogeneity of their positions, some common features emerged. Many participants were in fact in favour of a clear separation between the public and the private sector of the economy. Moreover, they rejected the practice of the ‘azionariato di stato’ (State full or partial ownership of private firms) as in the IRI experience,22 and stressed the need for a number of sectorial plans, instead of a ssingle general plan for the whole economy. Finally, they opposed any kind of neo-corporatism in the form of the establishment of a certain degree of control over the economy by the professional associations. Some believed that even the consigli di gestione should not become examples of Mitbestimmung (co-partnership) of the firms, but rather should represent a sort of workers’ ‘Parliament’, exercising control over the firms’ ‘governance’, i.e. the management (Giannini, 1947, vol. I, p. 160). To a certain extent the CER conference led toward the guidelines already traced by the Report of the Economic committee of the Minister for the Constituent Assembly, active during 1946 and 1947. About 50 experts were distributed among the five sub-committees (agriculture, industry, credit and insurance, monetary and foreign trade problems, finance). Some of these eminent figures were appointed by the Minister for the Costituente, the Socialist leader Pietro Nenni: among them were some of the leading post-war economists, such as G. Demaria, F. Caffè, G. Di Nardi, G. Parravicini, P. Saraceno, S. Steve. Others (P. Baffi, M. Rossi Doria, E. Vanoni, P. Grifone, G. Medici, G.U. Papi, V. Marrama and C. Ruini) were appointed to the committee by anti-Fascist parties. The huge amount of work undertaken by the committee, whose chairman was Giovanni Demaria, resulted in a series of reports and hearings. Yet its conclusions stopped short of a clear-cut statement about laissez faire or State intervention. Nevertheless, many of the economic experts who answered the questions put to them by the committee’s members showed a certain leaning towards a planned economy. A different position was adopted by the majority of the entrepreneurs, who had profited from the autarky of the regime but who had rapidly converted to laissez-faire, although they still maintained a cautious attitude to any immediate and complete liberalisation of foreign trade (Ministero per la Costituente, 1946-47, partially reprinted by Villari, 1972). Only Adriano Olivetti, the chairman of the famous firm and social reformer, favoured territorial planning, based on selfgovernment and assisted by local bodies (Berta, 1980, especially ch. III). Another of Pesenti’s merits was the foundation of a journal of comments on current economic matters, Critica economica, issued every two months as the CER organ. In his foreword to the first issue, in 1946, Pesenti declared that the journal intended to resume the tradition of the early Riforma sociale (Pesenti, 1946, p. 5). Pesenti’s journal went through two phases. The first covered the years when the journal was published by Giulio Einaudi (until August 1947), during which the

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Communist party was in the cabinet: in that period the journal showed an admirable pluralism of positions. In its best days, it revealed a clear attitude to proposals for reforms, especially concerning taxation, foreign exchange and banking, and hosted several contributions by Carli, Fuà, Sylos Labini, and others. After 1947, the journal began to retrench within a narrower, exclusively Marxist ideological line and on the whole it was subordinate to the People’s Front. Therefore, its standard inevitably declined, until it ceased publication in 1956 (see Garzolino, 1988). To sum up, the reconstruction of post-war economic debates gives no support to recent interpretations according to which the cultural climate was imbued with excitation in favour of collectivism and against capitalism (see Padoa Schioppa, 1997, pp. 37–47; Carli, 1993, pp. 12–14; Quadrio Curzio, 2000, pp. 69–81; for a more balanced view, see Barucci, 1978, especially ch. II). Even the more radical economic experts of the Left were aware that Italy belonged to the Western world. For this reason, a general plan in the Soviet sense was simply unfeasible: economic reforms would necessarily have to take into account the serious constraints of the backwardness of the country and the urgent need to increase production. Togliatti himself rejected solutions such as ‘distributing free bread’ (Barca et alii, 1975, p. 69) and advocated a policy that privileged production over distribution. Nevertheless, he was cautious in speaking about ‘plans’ because he feared this might cause speculations against Communists. Only after 1947, when the Socialists and Communists were expelled from Government, did a greater (and clearly instrumental) interest in planning arise, but the results were far from satisfactory, because of the party’s dogmatism. The latter manifested itself against Cesare Dami, an heterodox Communist who had authored two challenging volumes, Economia collettivista ed economia individualista (Dami, 1947) and Esperienze di economia pianificata (Dami, 1950). Pesenti, although personally tolerant and broad-minded, criticised Dami according to Marxist-Leninist orthodoxy: the former book was considered ‘illuministic’ and not genuinely dialectical, while the latter was charged with failing to present planning in the West, outside the Soviet world, as a possible model for the Italian Left (but see Macchioro, 1951). The discussion shifted towards ideological grounds and was rapidly brought to an end. Under the leadership of Giuseppe Di Vittorio the Socialist-Communist Trade Unions (CGIL) were not so ideologically biased. In 1949–50 they launched a conference on the Piano del Lavoro (CGIL, 1950; see also Vianello, 1978). This issue may be considered as crucial, because it demonstrated that the Unions by no means intended to limit their action to wage bargaining, but were rather intending to contribute to the country’s macroeconomic policy in its broad lines. The Piano’s approach was Keynesian lato sensu. Its objective was to re-absorb 700.000 unemployed workers over a period of three to four years, through a structural intervention in the Italian economy that was to be carried out by three State agencies: a national company for electricity, an Ente (agency) for council housing, and an Ente for the South and agriculture. The workers themselves could provide

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part of the funds. A conference was convened in Rome to illustrate the Piano. Many economists took part, including V. Angiolini, M. Bandini, G. Fuà, S. Steve, D. Tabet and others. Alberto Breglia, a Liberal-Catholic economist who in 1946 had openly cast his vote for the Communists, drew up the general report. Breglia depicted a classical representation of the economy as a circular flow, where production and consumption are reciprocally connected and where, given an initial flow of financing, the consequent increase in production would open the way to a self-sustaining process (see Breglia, 1950). Other participants debated this issue. Giorgio Fuà, then a young professor of statistics in Pisa, was particularly brilliant in demonstrating that there were no dangers of inflation in such a scheme, provided that some controls over the flows of foreign trade and some rationing of primary consumption goods could be implemented (CGIL, 1950, pp. 132–3).23 The government paid little attention to the Piano del lavoro and considered it as mere Communist propaganda. De Gasperi repeated in Parliament that ‘there was no money’ for it (Barucci, 1978, pp. 246–9). Nevertheless, it is striking that as late as 1953 the Accademia Nazionale dei Lincei organised a conference on ‘planning in a democratic regime’, where none of the participants mentioned the Piano del Lavoro. The main reporter, Giuseppe Ugo Papi, was a former corporatist who had became a fierce libertarian after the war. He did not refrain from reaffirming that ‘the premises are lacking … which are indispensable for the preparation of an economic plan’ (Papi et alii, 1953, p. 20):24 this was due to the impossibility of reliable knowledge and forecasting of economic variables. It was the classical objection to planning made by Pantaleoni, refreshed with a bit of Mises and Hayek. The most Papi conceded was the possibility of a ‘master program’, purely indicative and devoid of the tools for actual intervention in the economy. In the debate following Papi’s report, the Finance minister Ezio Vanoni observed that the problems of liberty and democracy, which were moral problems, should not be confused with the problem of economic freedom, which was a political problem, dealing with opportunity and expediency. This, as is well-known, was also the teaching of Benedetto Croce in his discussion with Luigi Einaudi on the essence of Liberalism (see Croce and Einaudi, 1957). It is also well-known that Vanoni, professor of public finance at Venice university, gave his name to the first real attempt at planning in Italy: the so-called Vanoni scheme (1955). It would be beyond the scope of this paper to take this review further. In the following years an intricate set of political and economic features did succeed in promoting the notion of planning in Italy. A powerful engine for this process was the spread of Keynes’s views, with their macroeconomic approach that was so hard to swallow for most economists born before 1900. But this is quite another story, probably better known than the one we have told here.

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Notes 1

We do not intend to discuss here Charles Maier’s ideas on the phenomenon of corporatism in Western Europe after World War I. According to this author, corporatism was not at all limited to Fascism, since all Western countries, even the Liberal ones, underwent a deprivation of the State’s sovereignty in favour of semipublic organs, representative of private interest (Maier, 1975). To distinguish our analysis from Maier’s we could have preserved the term ‘corporativismo’ in Italian, but we have preferred to use corporatism, provided that it is understood as referring to the policy of Italian Fascism and to the intellectual debate before and during the Fascist regime. 2 In contrast, we do not agree with the interpretation according to which ‘corporatism’ arose as early as the 1880s as a by-product of the introduction in Italy of the ideas of the German ‘Chair socialists’ (see Piretti, n.d.). We rather consider it largely a product of Catholic social thought, as becomes clear from a review of the huge socio-economic literature along these lines published between 1900 and 1940. A study in this direction is beyond the scope of a short article. For a detailed review see Cavalieri (1994). Cavalieri problematically insists on the variety of intellectual sources of corporatism, but his polemical attitude against those who provide a comprehensive interpretation of the phenomenon is often exaggerated, if not sterile. 3 Another Nationalist, the jurist Alfredo Rocco, four years later wrote: ‘The State must return to its old tradition interrupted by the triumph of Liberal ideology, and must behave towards the modern Trade Unions exactly in the same manner as it behaved towards the Medieval corporations … The Unions of both workers and employers must be unified, industry by industry, into a single mixed syndicate (sindacato misto)’ (Rocco, 1920, reprinted as appendix to Cassese and Dente, 1971, p. 966). 4 See Prato (1916, pp. 513–41), deriding Carli; Porri (1916, pp. 33–55), article written in Italian, deriding the Nationalists Lorenzo Allievi and Alfredo Rocco; Prato (1917), against Carli again. 5 For this purpose, they would benefit from special tariffs, since the emigrants could be considered as if they were ‘foodstuffs’ (Pantaleoni, 1909b, p. 344). 6 He was finance ‘rector’ (Minister) in the D’Annunzio government of Fiume, but accused a former revolutionary unionist, Alceste de Ambris, of persuading D’Annunzio to add a reference to corporatism in the Fiume constitution. This reference, according to Pantaleoni, deserved to be termed ‘Bolshevik’: see the note added in the 1925 version of Pantaleoni (1909a, p. 95). On D’Annunzio’s corporatism, see Finer (1935, p. 495). 7 This was contrary to Pareto’s and Barone’s statements. 8 See the articles collected in Einaudi (1961) and (1963); and his parliamentary speeches and reports, in Einaudi (1980). 9 For a different evaluation of the same facts, see Gangemi (1924), and Rossi (1966). 10 Nevertheless, he was worried about the fact that even the Fascists had created their own Unions that proclaimed strikes together with the Socialist and Catholic unions. See Faucci (1986, pp. 194–98). 11 Of course, there were other specific reasons for the Fascists’ conversion to a more active role of the State. For example, among the most successful points of the Fascist program was that of carrying out the ‘bonifica integrale’ (land reclamation): this required substantial public expenditure. It is beyond the scope of this paper to illustrate all the features of Fascist economic policy. 12 This is the title of a book Rosselli published in France in 1930, which constitutes only a part of Rosselli (1973). Unfortunately, the 1930 book does not deal specifically with economics.

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13 The contrast between corporatism and the historical experience of State socialism is sketched by Spirito (1933). 14 This valuable article covers Bottai’s whole career, and correctly presents him as a ‘mediator’ between the corporatist die-hards and the quasi-Liberal Fascists. In spite of his ability, Bottai did not succeed in building up the corporative system, because the bulk of Fascist economic achievements was decided outside the Corporazioni. See also Faucci (1975). 15 It is most significant that Keynes’s book was to be hosted in a second series of Nuova collana, devoted to applied studies (!), and specifically in a volume on the ‘Organizzazione finanziaria’ (financial organisation), together with works by Hawtrey and others. Furthermore, there should have been a volume on ‘Economia regolata e corporativa’ (regulated and corporative economy) including writings by Hobson, Wootton, Landauer, Cole, Barone, Mises, and others. See Zanni (1985). 16 It is beyond the scope of this paper to reconstruct the international political debate on planning. Suffice it to note that some socialist intellectuals in Europe looked at the Fascist experiments with a degree of benevolence, since these experiments tended to offset the Great Crisis more effectively that the liberal governments’ traditional laissezfaire policies. This is particularly the case of Henri De Man (1886–1953), a Belgian socialist whose books had been translated by Laterza in 1929 and 1930. In 1934 De Man launched the idea of a ‘plan for labour’ that was discussed at a conference in Pontigny. On De Man’s influence on the Anti-Fascists, see Rapone (1979). On the French attitude to corporatism see Mornati (1997). It would also be interesting to follow the circulation in Italy of French economic ideas on planning. See, for example, the translation of an important article by Pirou (1932). 17 Einaudi suggested that his son, the publisher Giulio, should translate The Economics of the Recovery Program, containing a critique of Roosevelt (Schumpeter, Chamberlin, Mason, Brown, Harris, Leontieff, Taylor, 1935). It is interesting to compare Einaudi’s attitude toward the Roosevelt experiment with that displayed by an at that time Fascist economist, Eraldo Fossati (1902–62), who praised the New Deal exactly for the same reason for which Einaudi criticised it (see Fossati, 1937). 18 Contrary to Einaudi, Dami concluded that the debate on planning had enriched the economists’ profession. 19 Note that the second edition was issued in 1944, during the Nazi occupation of Northern Italy. 20 This is from a letter of August 11, 1943, kept in the Archives de la communauté européenne, Florence, Altiero Spinelli Papers (my translation). It is noteworthy that under the heading of ‘modern’ economics, he did not include the name of Keynes. On the contrary, Pigou and Robbins – though the latter often in a polemical tone – were recurrent in Spinelli’s writings. 21 The press accused Morandi, who had been imprisoned for Anti-Fascism, of dreaming of a revival of corporatism! See Morandi (1975, pp. 101–103). 22 It may be of interest that a different position can be detected here between Pesenti (in favour) and the Socialist Giannini (against). 23 Another supporter of the rationing of primary goods was Federico Caffè, who at that time contributed articles both to Critica economica and to the Left-Catholic Cronache sociali, in which he favourably commented the experience of planning in the UK, as well as Beveridge’s Full employment in free society. See Faucci (2003). 24 Papi had put forward the same arguments in several articles and books between 1939 and 1942. See Barucci (1978, pp. 254–57).

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Pantaleoni, M. (1911), ‘Considerazioni sulle proprietà di un sistema di prezzi politici’, reprinted in Pantaleoni, La fine provvisoria di un’epopea, Laterza, Bari 1919. English translation in ‘Economists’ Archives’, suppl. to Storia del pensiero economico, 1991, n. 22. Pantaleoni, M. (1920), ‘Una causa della crisi italiana’, in M. Pantaleoni, Bolcevismo italiano, Laterza, Bari, 1921. Pantaleoni M. (1925), Erotemi di economia, 2 vols., Bari: Laterza. Pantaleoni M. and A. Bertolini (1892), ‘Cenni sul concetto di massimi edonistici individuali e collettivi’, in Pantaleoni (1925), vol. I. Papi G.U. et alii (1953), Pianificazione economica in regime democratico, Accademia dei Lincei, Problemi attuali di scienza e di cultura, Quaderno 30, Rome. Pesenti, A. (1946), Foreword to Critica economica, n. 1. Petretto, A., (1982), ‘Enrico Barone e i fondamenti della moderna teoria dell’allocazione delle risorse’, in R. Faucci (ed.), Gli Italiani e Bentham, Milan: Franco Angeli, vol. II. Piretti, S. (ed.), (n. d.), Ideologie corporative e modelli corporatisti, Bologna: Pitagora. Pirou, G. (1932), ‘La crisi del capitalismo secondo gli economisti francesi’, in G. Pirou et alii, La crisi del capitalismo, Florence: Sansoni. Porri, V. (1916), ‘Die oekonomische Theorie der Herrschaft durch die ungebunden menschlichen Geist ueber die Naturproduktivkraefte’, Riforma sociale, 1. Prato, G. (1916), ‘Nazionalismo economico e rincaro del capitale’, Giornale degli economisti e rivista di statistica, 6. Prato, G. (1917), ‘Nel regno della gaia scienza’, in In onore di T. Martello. Scritti vari, Bari: Laterza. Prato, G. (1919), Riflessi storici dell’economia di guerra, Bari: Laterza. Punzo, L. (1990), ‘L’esperienza di “Nuovi studi di diritto, economia e politica”‘, in Il pensiero di Ugo Spirito, Rome: Istituto dell’Enciclopedia Italiana, vol. I. Quadrio Curzio, A. (2000), ‘Tre costituzioni economiche: italiana, europea, bicamerale’, in L. Ornaghi (ed.), La nuova età delle costituzioni, Bologna: Il Mulino. Rapone, L. (1979), ‘Il planismo nei dibattiti dell’antifascismo italiano’, Storia contemporanea, 3. Ricci, U. (1919), Politica ed economia, Rome: La Voce. Ricci, U. (1920a), La politica economica del ministero Nitti. Gli effetti dell’intervento economico dello Stato, Rome: La Voce. Ricci, U. (1920 b), Protezionisti e liberisti italiani, Bari: Laterza. Ricci, U. (1921), Il fallimento della politica annonaria, Rome: La Voce; reprinted as La politica annonaria dell’Italia durante la grande guerra, Bari: Laterza, 1939. Ricci, U. (1925), Dal protezionismo al sindacalismo, Bari: Laterza. Ricci, U. (1928), ‘La scienza e la vita’, Nuovi studi di politica, economia e diritto, 3; reprinted in Bocciarelli e Ciocca (1994). Rocco, A. (1920), ‘Crisi dello Stato e sindacati’, Politica, December. Reprinted as appendix to S. Cassese and B. Dente, ‘Una discussione del primo ventennio del secolo: lo Stato sindacale’, Quaderni storici, 1971. Rosselli, C. (1924a), ‘Scienza economica e leghe operaie’, Riforma sociale, May-June. Reprinted in Rosselli (1973).

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Rosselli, C. (1924b), ‘Monopolio e unità sindacale’, Riforma sociale, September-October. Reprinted in Rosselli (1973). Rosselli, C. (1925a), ‘Miti liberistici o miti sindacali?’, Riforma sociale, SeptemberOctober. Reprinted in Rosselli (1973). Rosselli, C. (1925b), ‘L’azione sindacale ed i suoi limiti’, Riforma sociale, NovemberDecember. Repr. in Rosselli (1973). Rosselli, C. (1973), Socialismo liberale, ed. by J. Rosselli, preface by A. Garosci, Turin: Einaudi. Rossi, E. (1966), Padroni del vapore e fascismo, Bari: Laterza. Saraceno, P. (1968), Ricostruzione e pianificazione, 1943-1948, edited and introduced by P. Barucci, Bari: Laterza. Schumpeter, J.A. et alii, (1935), Il piano Roosevelt, Turin: Einaudi. Spinelli, A. (1940), ‘Alcune osservazioni intorno alla Critica delle costituzioni economiche’, Archives de la communauté européenne, Florence, Altiero Spinelli Papers, AS 1, manuscript. Spirito, U. (1933), L’economia programmatica corporativa, in L. Brocard et alii, L’economia programmatica, Florence: Sansoni. Spirito, U. (1935), Capitalismo, e corporativismo, in E. von Beckerath et alii, Nuove esperienze economiche, Florence: Sansoni. Spirito, U. (1970), Il corporativismo, Florence: Sansoni. Spirito, U. (1976), Memorie di un incosciente, Milan: Rusconi. Sraffa, P. (1924), ‘M. Pantaleoni. Obituary’, Economic Journal, pp. 648–53. Togliatti, P. (1973), Lezioni sul fascismo, Rome: Editori Riuniti. Vianello, F. (ed.), (1978), Il piano del lavoro della CGIL 1949-1950, Milan: Feltrinelli. Villari, L. (ed.), (1972), Il capitalismo italiano del Novecento, Bari: Laterza. Zanni, A. (1985), ‘Sulla mancata apparizione della ‘Teoria generale’ di Keynes in una seconda serie della ‘Nuova collana di economisti’ (con corrispondenze inedite)’, Quaderni di storia dell’economia politica, n. 3.

Chapter 25

The Economic Role of the State as a Factor of Production Domenicantonio Fausto

25.1

Introduction

State (i.e., government)1 participation in the economy takes many forms. Indeed, the economy and the market could not exist without the State, which establishes and enforces the basic rules that permit the competitive market to perform its regulatory function. The State’s modern functions mainly consist in pursuing the common best against the particular interests of society. For this purpose, the State is endowed with a monopoly of coercive power over society. The most important use of coercion in the economic context is raising revenue to finance the provision of public services and the production of public policies. Therefore, the State is not only an institution that drains off community resources, but it is also a productive institution that is quite fundamental for the development of the economic system. The rules of private economic governance specify a pattern of rights or entitlements to shares of output for participants in production, according to functions performed or resources owned. By the same token, the State is also entitled to a share of the output available, given its participation in the organization and control of the economic system. In this chapter, an attempt is made to analyse some important aspects of the economic system that entitle the State to a share of the output available, draining off resources through taxation. Section 25.2 presents a survey of the approaches of the Italian economists – Maffeo Pantaleoni, Antonio De Viti De Marco, Mauro Fasiani, Luigi Einaudi – who advanced the theory which sees the State as a factor of production. Section 25.3 examines the themes that pervade this theory in the light of the classical appropriate role of the State in a market economy. Section 25.4 outlines the functions of public factors in the light of the post-Keynesian approach to macroeconomic policy and the conventional market failure paradigm. Section 25.5 draws the conclusions.

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Money Credit and the Role of the State

Approaches to the Theory of the State as a Factor of Production

The factors of production – as is well known – are the elements that increase production capacity and that, combined in given proportions, produce the goods and services required by the economic system. There is no a priori method whereby the number of the factors of production can be determined. To the classical distinction of the factors of production in land, labour and capital, Alfred Marshall added management, which may be considered not specifically a factor of production but a particular form of labour, different from manual work. Besides, other economists have postulated that also the State – seen as institution maker of the juridical, political and cultural framework in which the economic system works – can be considered as a factor of production. The first economist that clearly put forth the notion of the State as a factor of production was Pantaleoni, who argued that public finance and private market economy are strictly linked. In an essay published in 1883, Pantaleoni stated that, in the last analysis, it is Parliament which decides the distribution of the expenditure side of State budget. He points out: ‘the expenditure side of the budget, which represents a certain total sum of satisfactions, or fulfilment of needs, is set against the total sacrifice entailed by the tax bill. Total satisfaction must be worth at least total sacrifice in the mind of the legislator or, in other words, in the opinion of the average intelligence of Parliament’ (Pantaleoni, 1883, p. 17). According to Pantaleoni (ibid., p. 21), ‘it is impossible for Parliament to decide whether a particular expenditure is admissible or not admissible otherwise than on the basis of an opinion which is the resultant of a complex of different elements: the arrangement, in decreasing order, of the marginal utilities deriving from the various expenditures and the comparison between the marginal utilities inherent in every combination of possible expenditures with the degree of sacrifice entailed by the total taxation which each of these combinations would entail’. This relationship of reciprocal influence between total revenue and total expenditure ought to be considered in the light of Pantaleoni’s view that the State is a factor of production to be added to the classical trilogy of land, labour and capital. The cooperation of the State in the production activity, in the same way as any other factor of production, implies a cost that has to be offset by awarding part of the output in proportion to marginal productivity of the factor of production employed. Therefore, the State as a factor of production obtains part of the output of the economic system, and this part is represented by taxation. For public services provided by the State, the standard criterion holds, i.e., that marginal utility is equal to marginal cost, in spite of the coercive nature of the acquisition of public services by taxpayers. Pantaleoni also stresses that the criterion considering the State as a factor of production allows a limit to public expenditure to be established by comparing the marginal utilities of public expenditure and private expenditure (see Pantaleoni, 1906, p. 474).2 The link between the production of public services and private economic activity is analysed in greater depth by De Viti De Marco.3 The State, through the

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production of public services, is a factor necessary for any other productive activity and, like any other factor of production, is entitled to remuneration. De Viti De Marco (1936, p. 111) points out: ‘the tax is a share of the income of citizens which the State appropriates in order to procure for itself the means necessary for the production of general public services’. And then he adds: If we consider the State as a collective use-economy, the transformation of private goods into public goods is an exchange of whose economic advantage the State itself is the judge. (…) there can be no doubt that, if it is recognized that an exchangerelationship exists between the consumer and the State producing the special public service, an exchange-relationship also exists between the State as the producer of general public services and the community of tax-payers. (…) To sum up: the tax is the price which each citizen pays the State to cover his share of the cost of the general public services which he will consume (ibid., pp. 112–13).

For De Viti De Marco (ibid., p. 223): Another principle deriving from the theory is that each part of income produced, no matter how small, contains its proportionate share of the cost that the State has incurred in providing its productive services; and since the tax corresponds to this cost in the same way that wages correspond to the labour provided by labourers, it follows that each part of income, no matter how small, comes into existence bearing the corresponding tax-debt’.

With regard to this analysis, it has been pointed out that the main difference between the State as a factor of production and all other factors seems to rest on the matter that the State is a factor of production necessary to all other factors (Fubini, 1934, pp. 17–18). De Viti De Marco’s theory of the State as a factor of production was much criticised by Fasiani (1941, pp. 299–301) for the following reasons: it is the old thesis of productivity or reproductivity power of tax; the majority of public services cannot be considered a factor of production, unless one seeks to give the concept of factor of production such a broad meaning as to make it useless; public services are the premise of every economic activity, but they are not factors of production; the concept of the State as a factor of production has the indeterminateness and elusiveness of the Marshallian concept of external economies and, besides, it should be considered that we do not know the marginal productivity of the State as a factor of production; in the concept of the State as a factor of production there is only the vague idea that what is useful to us all increases general welfare, and neither the State can be considered a real factor of production, nor may taxation be considered – as rent, wages, interest and profit – the remuneration of a factor of production; it is impossible to use the concept of the State as a factor of production to identify a criterion of distribution of tax burden.

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Einaudi (1942a) commented broadly on Fasiani’s criticism of De Viti De Marco’s approach to the theory of the State as a factor of production, arguing in favour of the theory, which he had already defended in the past (Einaudi, 1919; 1930, pp. 306–7). With regard to the connection established by Fasiani between the theory of the State as a factor of production and the reproductivity of taxation, Einaudi (1942a, pp. 302–5) observes that the theory of reproduction of taxation is in substance an aspect of the contract theory approach, which is restricted to a link between two facts: there is a logical relationship between taxation and public services, i.e., taxation is the share of total social output given to the State in exchange for public services. Fasiani (1942, pp. 494–8) – making reference to von Stein’s version of the principle of the reproductivity of taxation – replies to Einaudi that he does not think that this principle can be restricted to the very simple concept of necessary link between government expenditure and revenue. Actually, De Viti De Marco greatly improved the principle, proposing it not as a general explanation of public finance activity, but as an explanation restricted to the case of the co-operative State. In our opinion, Fasiani’s criticism of the theory of the State as a factor of production, considered as the old principle of the reproductivity of taxation, is inappropriate. According to von Stein (1885, pp. 33–4), ‘the principle of public economy, as applied to taxation, leads us far beyond the tax itself to the dynamic link between the individual tax payment and taxation as a living institution. We shall call this principle briefly the principle of the reproductivity of taxation’. Then, von Stein (ibid., p. 35) adds: as a principle of public economy taxation must ultimately be so designed that public administration [which includes all functions of government] causes each tax payment to revert to the taxpayer by enhancing his ability to form capital. (…) In terms of the rigorous concepts of economics, we can say that the true purpose of every tax is to be reproductive and to create at least as much as its own magnitude. This reproductive power of the tax is and remains the absolute condition for the life of the State.

In fact, the principle of the reproductivity of taxation is only a vague and partial anticipation of the theory of the State as a factor of production. As De Viti De Marco pointed out, already in 1888, in his essay Il carattere teorico dell’economia finanziaria, the principle of the reproductivity of taxation seems imperfect, because the State does not produce only public services, but services directly utilizable and consumable by the individual too (De Viti De Marco, 1888, pp. 127– 8). Einaudi’s other remarks vis-à-vis the criticism levelled by Fasiani at De Viti De Marco’s approach concern the concept of factor of production. For Einaudi (1942a, pp. 305–25), public services definitely have a direct impact on the flow of wealth, so the difficulty in measuring the contribution of the State as a factor of

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production to the total output of a given firm or industry and economy as a whole, does not seem a valid reason to exclude that the State be a factor of production. In Einaudi’s opinion, the State is a factor sui generis, which works as a political entity (soldier, magistrate, educator, defender of public interest) and is rewarded in a different way from the other factors of production. According to Einaudi, from the theory of the State as a factor of production no rule can be deduced regarding the distribution of tax burden to finance the cost of public services. Einaudi’s refusal to accept De Viti De Marco’s proposition that ‘each part of income, no matter how small, comes into existence bearing the corresponding taxdebt’, is the logical corollary of his statement that from the theory of the State as a factor of production no reasons can be adduced in favour of or against the opposed theses that tax should affect all the produced income or only the share of income that is consumed (ibid., p. 326). Fasiani’s reply on this point is that, in his opinion, De Viti De Marco and Einaudi make use of the concept of factor of production in different ways. De Viti De Marco considers the concept similar to the fundamental factors of production (land, labour and capital) which, combining in different ways, produce different goods. Einaudi, instead, considers the concept as all the circumstances that affect production (Fasiani, 1942, pp. 499–511). Einaudi (1942b), in his rejoinder to Fasiani, stresses that any factor of production, and not only the State, is a factor sui generis, because it contributes to the production of goods according to its own nature.

25.3

Government Activities and the Theory of Public Finance in the AngloSaxon and Italian Traditions

In our opinion, the theory of the State as a factor of production arises solely from Italian economists4 for reasons that can lie in the Italian tradition in public finance. To clarify this point, it seems important to summarise the ways in which the theory of the economic role of the State has been differently drawn up in the Anglo-Saxon and Italian traditions.5 The relationship between the State and the economic system was not ignored even before economics established itself as a distinct and relatively independent subject. Adam Smith, the founder of modern economics, reacted against mercantilist ideas that saw a major role of the State in making use of political power to achieve economic ends. He was concerned about the allocations of too many resources to government activities, but he laid stress on the positive functions of the State, in protecting society from violence and injustice, undertaking public works, providing free compulsory education and abolishing positions of privilege and monopoly. As a whole, Smith’s approach to the role of government was restrictive, but not rigid, unlike that of his followers in the English classical tradition.

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For Smith and the other English classical economists, exponents of laissezfaire, writing during the century following the publication of Smith’s Wealth of Nations (1776), the good society and the market itself are an artifact. They are in favour of a free market economy provided that it be a competitive economy. They do not believe in an original contract. As Robbins (1952, pp. 56–7) stresses: They do believe that without a firm framework of law and order, harmonious relations between individuals are unlikely to come into being; the pursuit of self-interest, unrestrained by suitable institutions, carries no guarantee of anything except chaos. (…) The invisible hand which guides men to promote ends which were no part of their intention, is not the hand of some god or some natural agency independent of human effort; it is the hand of the lawgiver, the hand which withdraws from the sphere of the pursuit of self-interest those possibilities which do not harmonize with the public good. There is absolutely no suggestion that the market can furnish everything; on the contrary, it can only begin to furnish anything when a whole host of other things have been furnished another way.

The classical economists focussed on the allocative functions of the State, but argued in favour of a minimum State, because the proper role of government had to be non-interventionist. They – excepting Marx – failed to develop an explicit theory of the State as, in their opinion, the proper role of government was to provide the framework within which the laws of economics – immutable and universally applicable – could operate. In England, toward the end of the nineteenth century, with the transition from classical political economy to neo-classical economics, the theory and problems of the public sector became less and less important. The first edition of Marshall’s Principles of Economics (1890) includes no chapter on public finance, unlike the previous treatises by Smith, Ricardo and J.S. Mill. Marshall concedes an expanding role to public interest in the control of monopoly and examines the effects of shifting and incidence of taxation, but does not consider the potential role of public expenditure in the economy. Stigler (1965, pp. 7–8) emphasizes that, after a century of laissez-faire, the main school of economic individualism had not produced even a respectable modicum of evidence that the state was incompetent to deal with detailed economic problems of any or all sorts. There was precious little evidence, indeed, that the state was unwise in its economic activities, unless one was prepared to accept as evidence selected corollaries of a general theory.

During the early decades of the twentieth century, for the economists of the AngloSaxon tradition, the main problem of the theory of public finance is the distribution of tax burden through the minimization of the sacrifice that taxation imposes on individuals. The economic activity of the State is unproductive, public expenditure has no repercussions on citizens’ welfare, and therefore the State ought to limit its

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activity to reducing to a minimum public services, whose existence it is dictated by necessity. The continental Europe tradition in public finance during the nineteenth century was completely different. A precise formulation of the core problem of the theory of public finance emerged in the 1880s and 1890s. Austrians (Sax and Wieser) and Italians (Pantaleoni, De Viti De Marco, Mazzola and Barone), using the new marginal utility theory of value, made important contributions to a casual explanation of public finance.6 According to the Italian fiscal doctrine, benefit taxation is the efficient solution to the provision of public goods, whose main character is indivisibility. Taxes are the prices of public goods as paid by the taxpayer’s demand. The relationship between the taxpayer and the State is one of quid pro quo. The efficient provision of both public and private goods is subject to the rule of the equalization of the price payable by consumers with their marginal utility. Since paying taxes to finance public goods involves the withdrawal of resources from private use, the tax and expenditure side of the budget should be considered jointly, as part of a general equilibrium system. Therefore, the expenditure side of the budget cannot be neglected as in the Anglo-Saxon tradition. As in Italy, likewise in Germany, in the last decades of nineteenth century, in the writings concerning public economy, government is given a greater role than that suggested by the classical ‘minimum State’ model. Adolph Wagner (1883, p. 8), for example, resting on the idea of the necessary complementarity of the public and private activities throughout the process of economic development, indicated a law of increasing expansion of public sector. Interestingly, in the same period in Italy and in Germany, public finance evolved into an autonomous discipline, studying the public economy with a systematic analysis of both sides of public budget. It is no coincidence that the notion of the State as a factor of production is linked to the work of Pantaleoni and De Viti De Marco in the 1880s, when the Italian theory of public finance achieved independent status. Buchanan (1960, pp. 38–9) points out: From the outset and with a few notable exceptions, Italian fiscal theory has been developed in general-equilibrium terms. For the Italian, fiscal theory is concerned with the activity of the state, and not primarily with that of the individual as he is affected by the fisc. This is true equally for the ‘economic’ and ‘non-economic’ approaches. (…) The Italian model includes the state, and the more important feature has been the tyingtogether of the two sides of the state fiscal account, taxation and expenditure, and the general recognition of the limited usefulness of any one-sided analysis. It is natural that this feature should stem from the so-called ‘economic’ approach (De Viti De Marco, Einaudi). But somewhat surprisingly it is also accepted by those who specifically reject the economic aspects of fiscal choices.7

Buchanan (ibid., pp. 41–2) then stresses:

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Money Credit and the Role of the State Many of the more specific contributions which Italian fiscal theory contains are derivative from the general methodological approach. One of these is the recognition of the general productivity of public expenditure, a contribution which has been developed by those who adopt the ‘economic’ conception of fiscal activity, notably by De Viti De Marco and Einaudi. (…) The De Viti vision of public services goes beyond the mere acknowledgment of the usefulness of such services in a general and unspecified sort of way. Many students accept this view, but still conceive public services as consumption services, (…) De Viti looked at public services differently; to him these were productive services, that is, inputs in the whole productive operation of the economic mechanism. Public services are instrumental to the production of final goods and are on an equal basis with labor and capital. Therefore, it becomes conceptually possible to impute to such services an appropriate distributive share.

Buchanan’s interpretation of the Italian tradition in public finance is right: one of the main features is that some public services are productive factors. Buchanan (ibid., p. 33) suggests that the assumption of the Italian fiscal theorists that expenditure cannot be neglected, as in the Anglo-Saxon tradition, is mainly due to the fact the Italian fiscal theorists are explicit as regards their political presuppositions and devote greater attention to the form of the State. Buchanan also suggests that in the Anglo-Saxon tradition it was implicitly assumed that there is democratic participation in the processes of social or collective choices. In our opinion, Buchanan’s point of view is certainly acceptable for the Italian case,8 but it is not very explicative for the Anglo-Saxon case. Indeed, the Italian tradition in public finance enjoys theoretical superiority over its Anglo-Saxon counterpart. Importantly, as Olson (1965, p. 102) stresses, the most notable tradition in nineteenth-century economics – the British laissez-faire tradition – largely ignored the theory of public goods. Admittedly, many of the bestknown British economists enumerated the functions they thought the state should perform. (…) Except for a few imprecise comments by John Stuart Mill and Henry Sidgwick, it appears that the leading British economists largely ignored the problem of collective goods. Even in this century [twentieth century] Pigou, in his classical treatise on public finance, gave collective goods for the most part only implicit treatment.

25.4

Public Factors in post-Keynesian Economics

The post-world war II period saw a vast expansion of government spending. The reasons that contributed to this development derived both from welfare economics based on microeconomic theory and from the Keynesian approach to macroeconomic policy, putting public finance at the centre of economic policy for stabilizing the demand in the economy as a whole. In welfare economics – a term first associated with the work Economics of Welfare (1920) by A.C. Pigou – government intervention is defined in terms of

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market failure with regard to the efficient allocation of resources generated by a perfect competitive market. In the 1950s welfare economics put forward the theoretical articulation of the Smith’s invisible hand theorem by means of models of general equilibrium, which demonstrate the merits of market mechanism in achieving efficiency. In this context, market failure means that resources are not used efficiently, because a ‘Pareto optimum’ has not been reached. In the traditional Pigovian welfare economics, and also with newer welfare economics, market failure was a marginal problem. It is only with the contributions of Samuelson and Musgrave to the new public expenditure theory of the 1950s that stress was laid on the concept of public good and the Pigovian concept of externalities generalized. Following these developments, the coordination of the stabilization function with government’s more traditional functions (allocation and distribution) called for a multibranch approach to the theory of public finance, which was formalized by Musgrave (1959) as a normative or optimal theory. Scepticism about the role of government intervention arose in the late 1960s and increased in the 1970s. There was a questioning of government spending and a greater reliance on the allocative role of the market. On the side of welfare economics, it is pointed out that if there is ‘market failure’ there can also be ‘government failure’.9 But, since at least the 1970s, there has been analytical discussion to identify circumstances in which the basic conditions of the fundamental theorems of welfare economics are not satisfied. Early discussions of market failure focused on externalities, public goods and perfect competition markets to provide efficient resource allocation. Now, the market failures are centred on the assumptions hidden in the fundamental theorems of welfare economics.10 The standard competitive model of the Arrow-Debreu framework assumes given technology, perfect information and a complete set of markets. Indeed, especially for the transformation of an economy, what is necessary is innovation resulting from basic and applied research, a field in which there are positive externalities leading to underinvestment, where there is no government support. Information has many of the properties of a public good, and imperfect information raises problems of moral hazard and adverse selection. Risk market and capital markets are imperfect. The last propositions are essentially based on the Greenwald-Stiglitz theorem, which establishes that whenever information is imperfect and or markets are incomplete it is not possible to attain Pareto-efficient allocation, i.e. markets are almost always inefficient (Greenwald and Stiglitz, 1986). Stiglitz (1989, pp. 45–6) is wary about the pervasiveness of market failures through policy intervention, because there are government or political failures just as there are market failures. ‘But – as Dixit (1996, pp. 9–10) stresses – the relative emphasis given to market failures and political failures in his writings makes it abundantly clear where he judges the balance to be – in favor of government and against the market’. On the side of the Keynesian approach to macroeconomics, the effectiveness of fiscal and monetary policies to reduce the level of unemployment is debated. Numerous essays are published in which it is argued that fiscal and monetary

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policies are ineffective in reducing unemployment, which will always be at the natural rate. In these essays it is assumed that the real world is approximated by a Walrasian system of perfectly competitive markets and that individuals form rational expectations. But, in a Walrasian economy, markets are complete, information is perfect and there are no public goods, externalities, increasing returns, or transaction costs. Given these assumptions, there is first-best allocation of resources, and no place for any form of government intervention. However ‘real economies are not Walrasian: prices do not adjust with infinite acceleration; transaction costs, legally binding contracts, and uncertainties cause prices to adjust slowly; decisions are made sequentially in real time, not simultaneously; markets are often highly imperfect’ (Jackson, 1989, p. 111). The last fifty years have clearly shown the limitations and benefits of State action, both from the theoretical point of view and in the positive promotion of economic and social development. As regards development, the State is central, not as a direct provider of growth, but as a partner and facilitator (World Development Report, 1997, p. 1).11 Stiglitz (1997a, p. 13) points out: In a sense much of the role of government can be viewed as establishing infrastructure in its broadest sense – the educational, technological, financial, physical, environmental, and social infrastructure of the economy. Since markets cannot operate in a vacuum, this infrastructure is necessary if markets are to fulfill their central role in increasing wealth and living standards. Because constructing the broad infrastructure is beyond the capacity or interest of any single firm, it must be primarily the responsibility of government.

The contemporary State, constructing the broad infrastructure, creates what we call ‘public factors’, which enter the production of private goods and increase the marginal productivity of private factors.12 Public factors, as factors of production bringing about externalities, by assumption are provided by government. In contemporary economies, the fact that the economic activity of the State produces public factors, which are an internal and immanent part of the economic system, provides a clear indication that the State is a separate factor of production, – in the broad sense already put forward by Einaudi. As Graziani (1957, p. 475) says: all the elements that contribute to increase the total output are factors of production. The total output can be raised either by increasing the quantity of existing resources or increasing the use of available resources. Therefore, all the elements that somehow contribute to increase the total output should be considered factors of production. But, if such is the situation, the State ought to be recognized as a real factor of production.

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439

Conclusions

Smith and his followers up to Pigou minimize the economic role of the State, acknowledging that government should intervene, in some cases, in allocation and distribution of resources for reasons of efficiency and equity. In this framework, the theory of public expenditure is largely neglected. The new public expenditure theory of the 1950s, and mainly Musgrave’s contribution, brought a new favourable view of the beneficial functions of the public sector, along allocative, distributional and stabilization lines. With regard to the analytical scheme, which led classical economists to minimize the role of government, Myrdal (1930, p. 180) points out: The classics spoke of public activity as ‘consumption’ and this itself served as an argument for restricting it as a necessary evil as much as possible. The best tax, for them, was therefore the lowest tax. Against this laissez-faire theory List and many authors after him argued that public activity is ‘production’ and, moreover, a production of ‘productive forces’. This classificatory change helped to recruit sympathy for more extensive state activity.

As we have seen above, since the last two decades of nineteenth century the major Italian economists have regarded public finance activity as a production activity. Following in Ferrara’s footsteps, they apply the marginal utility approach to the theory of public finance in the framework of a general equilibrium analysis. The Italian tradition in public finance has also given little consideration to the welfare economics argument that the approach to the role of the State in the economy should adopt the principle of ‘neutrality’: the State should refrain from disturbing the pattern of resource allocation determined by private market relationships, except in cases where there are clear criteria that imply market failure. The Anglo-Saxon tradition is different: it is unaware that the public activity is also ‘production’, and therefore that the State is a factor of production. AngloSaxon ideology emphasizes the interests of the individual, whereas society is only a contractual arrangement among individuals and has no independent interests. The maximizing of wealth as the primarily goal of human life, and man as a rational being, reinforce the exclusion of government from the system (Ginzberg, 1974, pp. 281–2). In recent times too, the majority of Anglo-Saxon and western economists continue not to recognize the activism and importance of government.13 They support the idea that perfect competition and Pareto optimality deliver the efficient resource allocation, which maximizes society’s welfare. But perfect competition and Pareto optimality at best are empty categories, and in truth they do not maximize societal efficiency anyway. Societal efficiency is something quite different from market efficiency. There is no particular reason for believing that society wants to allocate resources so that each

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As a matter of fact, a dual system of resource allocation exists, and there is room for a governmental allocation of resources in which value is not determined by price. In brief, the economic role of the State greatly shifted in the twentieth century: Keynes stressed the great responsibilities open to government in stabilizing the economy; in addition, the policy of redistributing income involved a great increase in public expenditure and taxation. In recent years, there has been greater reliance on the allocative role of the market, but State intervention still has an important agenda to fulfil, because the overall achievements of the market are deeply contingent on appropriate public policies (Sen, 1999, p. 42). The State collective output is crucial for the performance of the economy, as there is a complementary relationship with the private market output. In our opinion, when the State makes good use of public resources, the ‘real’ invisible hand is the invisible hand of the State as a factor of production, acting in the role of providing a common benefit and working for the general welfare.

Notes 1

2 3

4

In the western world, the term ‘State’ generally consists of two distinct elements: a changeable one, the ‘government’, i.e., the executive branch, and a stable administration, comprising distinct, hierarchical structures. Therefore, it might be more appropriate to use the term ‘State’ instead of ‘government’, when considering the functioning of the economic system as a whole. In this chapter, the term ‘State’ and the term ‘government’ are used interchangeably. On this point, also see: Cosciani (1936, p. 51). Cosciani points out that Pantaleoni’s statement also appears in other editions of Pantaleoni’s lectures. De Viti De Marco worked out his own theoretical system concerning public finance, which finds the first reference in the essay, Il carattere teorico dell’economia finanziaria (1888). In this essay there is a short account of the theory of the State as a factor of production, then better specified in the various lithographic editions of De Viti De Marco’s lectures of public finance (whose first draft goes back to the academic year 1886-87, when he taught public finance at the University of Pavia). In the first printed edition of the lectures (De Viti De Marco, 1923, pp. 54–6 and 135), the theory of the State as a factor of production is explained in a complete way. The theory is also reported in De Viti De Marco (1928, pp. 97–9 and 214–5) and in De Viti De Marco, 1934, pp. 84–6 and 196). The latter edition was translated in English: De Viti De Marco (1936). The economic ability of the State to act as a separate factor of production is also recognised in the recent work of a non-Italian scholar (Papava, 1993, pp. 57–8; 2000, p. 49), who follows his own approach that gives indirect taxes the status of factor income

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5 6 7 8

9

10 11 12 13

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as State profit (by analogy with entrepreneurial profit). The increase in price brought about by such taxes is considered income in exchange for public services. On the economic role of the State in a historical perspective, see Baumol (1965, pp. 183–96); Helm (1990); Musgrave (1996); Tanzi (1999). The most influential essays on the subject are published in Musgrave and Peacock (1967). For an outline of the ‘non-economic’ approach in the Italian tradition in public finance, see Fausto (1998). The ‘non-economic’ explanation – given by Burkhead and Miner – of the reasons for which Italy, during the first part of nineteenth century, produced a remarkable body of fiscal theory seems, instead, rather questionable. According to Burkhead and Miner (1971, pp. 18–9), ‘in Italy, unlike Britain, there was no well-established central government budget system; the political processes of decision-making were hardly to be trusted. In this period, Italy was emerging as a natural state from the previously autonomous provinces. Standards of public administration were lax; public revenues were uncertain. It was perhaps easier in those circumstances for the Italian economists to look at both revenue and expenditure; certainly it was necessary to do this in order to devise some rules for the guidance of government authorities’. The major contributors, who have exposed problems of government failure, are: Buchanan and Tullock (1962), theorists of the public choice; the Chicago school of regulation, led by Stigler (1971), who has argued that regulation in general is linked to special interests; Coase (1960), Demsetz (1967) and others, who have put the analysis of externalities in the framework of property rights. On the extension of the market failure paradigm, see Stiglitz (1997b, pp. 64–75; 1998, pp. 24–9). For a balanced view of the role of the State in economic development, see Rodrik (1997). On the derivation of optimality conditions for public factors, see Sandmo (1972),. Boadway (1973). Samuels (2002, p. 11) stresses: ‘The dominant individualist ideology of western civilization emphasizes the individual and denigrates the social/ political. Individuals exist and have interests and values, whereas societies are mere aggregations of individuals and have no independent existence or interests. In one language domain, the concept of “private” is elevated over that of “public”; and in another domain, methodological and normative individualism are elevated over methodological and normative collectivism. And the chief formal agency of the latter category in each instance, government, is deemed to be inept, inefficient, immoral, ineffective and so on. There is no manifest function for public purpose’.

References Baumol, W.J. (1965), Welfare Economics and the Theory of the State, 2nd ed., The London School of Economics and Political Science, London: G. Bell and Sons Ltd. Boadway, R. (1973), ‘Similarities and differences between public goods and public factors’, Public Finance, 28, pp. 245–58. Buchanan, J.M. (1960), ‘ “La Scienza delle Finanze”: the Italian tradition in fiscal theory’, in J.M. Buchanan, Fiscal Theory and Political Economy. Selected Essays, Chapel Hill: The University of North Caroline Press, pp. 24–74.

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Buchanan, J.M. and G. Tullock (1962), The Calculus of Consent, Ann Arbor: University of Michigan Press. Burkhead, J. and J. Miner (1971), Public Expenditure, New York: Aldine Publishing Company. Coase, R.H. (1960), ‘The Problem of Social Cost’, Journal of Law and Economics, 3, pp. 1–44. Cosciani, C. (1936), ‘Il problema dello Stato e della soddisfazione massima nelle opere di M. Pantaleoni’, Rivista Internazionale di Scienze Sociali, 44, pp. 25–52. Demsetz, H. (1967), ‘Toward a theory of property rights’, American Economic Review, 57, Papers and Proceedings, pp. 347–59. De Viti De Marco, A. (1888), Il carattere teorico dell’economia finanziaria, Rome: Loreto Pasqualucci Editore. De Viti De Marco, A. (1923), Scienza delle finanze, Rome: Società Tipografica A. Manuzio. De Viti De Marco, A. (1928), I primi principii dell’economia finanziaria, Rome: Attilio Sampaolesi Editore. De Viti De Marco, A. (1934), Principii di economia finanziaria, Turin: Giulio Einaudi Editore. De Viti De Marco, A. (1936), The First Principles of Public Finance, London: Jonathan Cape. Dixit, A.K. (1996), The Making of Economic Policy: a Transaction-Cost Politics Perspective, Cambridge, Mass.: The MIT Press. Einaudi, L. (1919), ‘Osservazioni critiche intorno alla teoria dell’ammortamento dell’imposta e teoria delle variazioni nei redditi e nei valori capitali susseguenti all’imposta’, Atti della R. Accademia delle Scienze di Torino, 54, pp. 1055–131 (repr. in L. Einaudi, Saggi sul risparmio e l’imposta, 2nd ed., Turin: Giulio Einaudi Editore, 1965, pp. 161–240). Einaudi, L. (1930), ‘Se esiste, storicamente, la pretesa repugnanza degli economisti verso il concetto dello Stato produttore’, Nuovi Studi di Diritto, Economia e Politica, 3, pp. 302–14. Einaudi, L. (1942a), ‘Del concetto dello Stato fattore di produzione, e delle sue relazioni col teorema della esclusione del risparmio dall’imposta’, Giornale degli Economisti e Annali di Economia, 4(N.S.), pp. 301–31. Einaudi, L. (1942b), ‘Postilla critica’, Giornale degli Economisti e Annali di Economia, 4(N.S.), pp. 512–17. Fasiani, M. (1941), Principii di scienza delle finanze, vol. II, Turin: Giappichelli. Fasiani, M. (1942), ‘Della teoria della produttività dell’imposta, del concetto di «Stato fattore della produzione» e del teorema della doppia tassazione del risparmio’, Giornale degli Economisti e Annali di Economia, 4(N.S.), pp. 491–511. Fausto, D. (1998), ‘The role of the coercive element in fiscal choice in the Italian tradition in public finance’, Rivista Italiana degli Economisti, 3, pp. 3–25. Fubini, R. (1934), Lezioni di scienza delle finanze, Padua. Cedam. Ginzberg, E. (1974), ‘Government: the fourth factor’, in P.A. David and M.W. Reder (eds), Nations and Households in Economic Growth. Essays in Honor of Moses Abramovitz, New York and London: Academic Press, pp. 279–89. Graziani, A. (1957), ‘Lo Stato fattore di produzione’, Rassegna Economica, 21, pp. 469–77.

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Greenwald, B. and J.E. Stiglitz (1986) ‘Externalities in economies with imperfect information and incomplete markets’, Quarterly Journal of Economics, 101, pp. 229– 64. Helm, D. (1990), ‘The economic borders of the State’, in D. Helm (ed.), The Economic Borders of the State, Oxford: Oxford University Press, pp. 9–45. Jackson, P.M. (1989), ‘The boundaries of the public domain’, in W.J. Samuels (ed.), Fundamentals of the Economic Role of Government, Greenwood Press, New York, pp. 105–16. Musgrave, R.A. (1959), The Theory of Public Finance, McGraw-Hill, New York. Musgrave, R.A. (1996),‘The role of the State in fiscal theory’, International Tax and Public Policy, 3, pp. 247–58 (repr. in P.B. Sorensen (ed.), Public Finance in a Changing World, London: Macmillan, 1998, pp. 35–50). Musgrave, R.A. and A.T. Peacock (eds), (1967), Classics in the Theory of Public Finance, London: Macmillan. Myrdal, G. (1930), Vetenskap och politik i nationalekonomien (English translation quoted: The Political Element in the Development of Economic Theory, New Brunswick: Transaction Publishers, 1990). Olson, M. jr. (1965), The Logic of Collective Action. Public Goods and the Theory of Groups, Cambridge, Mass.: Harvard University Press. Pantaleoni, M. (1883) ‘Contributo alla teoria del riparto delle spese pubbliche’, Rassegna Italiana, 15 October 1883; repr. in M. Pantaleoni, Scritti varii di economia, vol. 1, Milan, Palermo, Naples: Remo Sandron Editore, 1904, pp. 49–110 (English translation quoted: ‘Contribution to the theory of the distribution of public expenditure’, in R.A. Musgrave and A.T. Peacock (eds), Classics in the Theory of Public Finance, London: Macmillan, 1967, pp. 16–27). Pantaleoni, M. (1906), Economia politica, Biamonti and Grispigni (eds), Rome: Stabilimento Tipolitografico F.lli Ferri. Papava, V. (1993), ‘A new view of the economic ability of the government, egalitarian goods and GNP’, International Journal of Social Economics, 20, pp. 56–62. Papava, V. (2000) ‘State, public sector and theoretical prerequisites to a model of an “economy without taxes” ’, International Journal of Social Economics, 27, pp. 45–61. Robbins, L. (1952), The Theory of Economic Policy in the English Classical Political Economy, London: Macmillan. Rodrik, D. (1997), ‘The “paradoxes” of the successful state’, European Economic Review, 41, pp. 411–42. Samuels, W.J. (2002), ‘An essay on government and governance’, in W.J. Samuels, Economics, Governance and Law. Essays in Theory and Policy, Cheltenham: Edward Elgar, pp. 1–37. Sandmo, A. (1972) ‘Optimality rules for the provision of collective factors of production’, Journal of Public Economics, 1(1), pp. 149–57. Schubert, W. (1979), ‘On the proper role of government in the dual economy’, Journal of Post Keynesian Economics, 1, pp. 127–30. Sen, A. (1999), Development as Freedom, Oxford: Oxford University Press. Stigler, G.J. (1965), ‘The economist and the State’, American Economic Review, 55, pp. 1– 18. Stigler, G.J. (1971), ‘The theory of economic regulation’, Bell Journal of Economics and Management Science, 2, pp. 1–10. Stiglitz, J.E. et alii (1989), The Economic Role of the State, Heertie, A. (ed.), Oxford: Basil Blackwell.

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Stiglitz, J.E. (1997a), ‘The role of government in economic development’, Annual World Bank Conference on Development Economics 1996, The World Bank, Washington, pp. 11–23. Stiglitz, J.E. (1997b), ‘The role of government in the economies of developing countries’, in E. Malinvaud et alii (eds), Development Strategy and Management of the Market Economy, vol. I, Oxford: Clarendon Press, pp. 61–109. Stiglitz, J.E. (1998), ‘The role of government in the contemporary world’, in V. Tanzi and Ke-Yong Chu (eds), Income Distribution in a High Quality Growth, Cambridge, Mass: The MIT Press, pp. 21–67. von Stein, L. (1885), Lehrbuch der Finanzwissenschaft, fifth, revised edition, Leipzig, part II, pp. 346–61 (English translation quoted: ‘On taxation’, in R.A. Musgrave and A.T. Peacock (eds), Classics in the Theory of Public Finance, London: Macmillan, 1967, pp. 28–36). Tanzi, V. (1999), ‘The changing role of the State in the economy: a historical perspective’, in L.R. De Mello jr. and K. Fukusaku (eds), Fiscal Decentralization in Emerging Economies: Governance Issues, OECD, Paris, pp. 17–36 (repr. in V. Tanzi, Policies, Institutions and the Dark Side of Economics, Cheltenham: Edward Elgar, 2000, pp. 12– 32). Wagner, A (1883), Finanzwissenschaft, third edition, Leipzig, 1883, part. I, pp. 4–16, 69–76 (English translation quoted: ‘Three extracts on public finance’, in R.A. Musgrave and A.T. Peacock (eds), Classics in the Theory of Public Finance, London: Macmillan, 1967, pp. 1–15). World Development Report (1997), The State in a Changing World, The World Bank – Oxford: Oxford University Press.

Chapter 26

Central Bank Independence and Democracy: A Historical Perspective Carlo Panico and Maria Olivella Rizza

26.1

Introduction

Augusto Graziani has made important contributions to the literature on the role of money and the conduct of monetary policy. Within the literature on the ‘monetary circuit’, his work occupies an outstanding place, and his recent reflections on central bank independence are equally worthy of note (see Graziani, 1998). Our chapter deals with the relation between central bank independence and democracy, examining the literature from the rise to dominance of the Keynesian school to the present day. Following a general trend in economics, there have been major changes in the analysis of this subject since the mid 1970s. Some of these changes have given cause for concern: one conclusion of the new dominant position, which has affected most central bank reforms during the last decade and the conduct of monetary policy, is that to increase the effectiveness of monetary interventions it is necessary to violate some rules of democracy (see Bowls and White, 1994; Samuelson, 1994; Tobin, 1994; Briault, Aldane and King, 1996; Blinder, 1997 and 1998; de Haan, 1997; Eijffinger and Hoeberichts, 2000).1 Here we aim to provide an overview of the literature in order to clarify the origin and content of the theoretical positions that have influenced recent central bank reforms and the state of the debate on the contradiction that is nowadays manifest in the dominant literature between central bank independence and democracy. It is pointed out that the approach that has become dominant since the 1970s is based on assumptions on the working of the economic system, which eliminate from the beginning the problems of effective demand that had been the main preoccupation of theory and policy up to then. Moreover we argue that up to the 1970s the economic literature accepted that the analysis of central bank independence was mainly the subject of those disciplines, which examine the organisation of the State and the relations among its institutions. Economic theory then cooperated with those disciplines to find the most convenient solution to this problem, a solution depending on the historical and political situation of each society. Since the 1980s, instead, the economic literature has narrowed the interaction with other disciplines, trying to solve the problems of the organisation of State institutions within its own domain. It has centred on the relations between the

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State and society in order to design their optimal configuration, but has adopted a representation of these relations, which is considered by other social disciplines over-simplified and unable to satisfactorily comprehend the phenomena it seeks to organise. As a consequence, this literature faces a theoretical problem. Through its simplistic representation of State-society relations it shows the existence of a contradiction between central bank independence and democracy. Other works, using different representations of State-society relations, show instead that this contradiction does not exist in the actual organisation of monetary policy and that central bank independence is legitimate in a democratic society. The starting-point of this paper is that the dominant positions in the economic literature do not only depend on the degree of analytical elaboration of the theories, but also on the consensus achieved by certain views over a specific historical period. Thus, the 1929 Great Depression enhanced Keynesian ideas, making them dominant for some decades. Some events of the 1970s shifted the consensus towards economic liberalism. Our chapter is organised as follows. Section 26.2 clarifies some different meanings that can be given to central bank independence. Section 26.3 examines the literature between the Great Depression and the 1970s oil shocks. Section 26.4 deals with some events of the 1970s that may have contributed to the adoption of economic liberalism in the organisation and conduct of monetary policy. Section 26.5 describes the literature that has introduced new positions on central bank independence. Section 6 recalls some criticisms raised against this literature, focussing on its belief that the economic system is permanently in a position equivalent to full employment and on its conclusion that to improve the efficacy of monetary interventions it is necessary to violate some rules of democracy. Section 26.7 describes the recent contributions, which use different representations of State-society relations and show that there is no contradiction between central bank independence and democracy in the actual organisation of monetary policy. Section 26.8 presents some conclusions.

26.2

Different Meanings of the Term Independence

The term central bank independence is used in different ways. It has several qualifications, whose meanings change from author to author (see de Haan, 1997; de Haan and Kooi, 1997). To avoid ambiguity let’s introduce we devote this section to clarify how we use it. Goal independence is the power of central banks to define the level of the objective-variables of economic policy. This kind of independence is seldom given to central banks and most recent reforms have entrusted this power to elected bodies, which can learn, through the electoral mechanism, society’s preferences and identify accordingly the results to be achieved by economic policy.2 Priority independence is the power of central banks to define the order of priority over the different policy goals. This power too can be attributed to democratically elected bodies, from the standpoint that they must take the most

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important decisions for the life of a society. The recent literature, however, has placed this kind of independence at the centre of the debate, considering it convenient for society to hand over this power to central banks. Instrument independence is the power of central banks to decide discretionarily the different aspects of the operation of monetary policy, once the goals and the priorities have been defined. They can decide the tools to use and the intensity of their intervention. This kind of independence is granted to central banks to guarantee the professional autonomy of institutions having great competence. Money issue independence regards a particular aspect of monetary policy. It refers to the ability of central banks to control the amount of money in circulation. Since the 1970s there has been a tendency in most countries to increase the power of central banks to control the domestic channels of base money issue, in particular that used to finance the government sector. The external channel, by contrast, has eluded the control of central banks on account of the liberalisation of international capital movements. The existence of these two opposite tendencies is the result of the dominance of positions favouring economic liberalism and the consequent tendency to reduce the role of the State in the economy. On the one hand, it is believed that reducing the influence of democratically elected bodies on monetary decisions can increase the effectiveness of monetary policy. On the other, it is believed that it is possible to rely on the spontaneous working of market forces, including the speculative movements on international financial markets, to increase the rate of growth of the economy and social welfare. Finally, personnel independence is the capacity of the monetary authorities to resist the pressures of other agents with political and economic interests. It depends on the procedures regarding the appointment and dismissal of the monetary authorities, the earnings of central bank staff, their career development after their term of service. Different laws can be introduced to increase or reduce this capacity of the monetary authorities. These laws have been the focus of great attention by the applied literature that has recently tried to define quantitative measures of central bank independence (see Grilli, Masciandaro and Tabellini, 1991; Cuckierman, Webb and Neyapti, 1992).

26.3

From the Great Depression to the Oil Shocks

The uncertain growth of economies in the 1920s led many economists to doubt the validity of the prevailing laissez-faire policies. These doubts were strengthened by the 1929 Great Depression, giving rise, in the following years, to widespread acknowledgement of the need of an active role for government intervention. Harrod wrote in 1933 that the Great Depression had posed a new problem for politicians and economists. Its severity had endangered political stability and shaken confidence in the belief that the economy was able to return to full employment. This situation had raised the problem of a new political approach and

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a new economic theory able to clarify whether market forces can lead the economy towards full employment or government intervention is required.3 The theories worked out by Keynes and Harrod concluded that the spontaneous operation of market forces does not necessarily bring about full employment and the exploitation of the growth potential of the economy. Without denying the benefits of competitive forces, they recognised the possibility of market failures and inefficient allocation of resources, thus admitting that government intervention can play a positive role in regulating and supporting the economy. The neoclassical theory before the Great Depression distinguished between a real and a monetary department of economics.4 The real department examines the long-run equilibrium level of real variables (the level of production, relative prices and distribution). The natural interest rate is determined in this part of the analysis, where monetary factors play no role. It depends on technology, consumer preferences, the availability of productive factors and their distribution among agents. The monetary department deals with the nominal price level and the fluctuations of the economy, and analyses the movements of the market interest rate, which depend on monetary factors, including the actions of monetary policy. When it is equal to the natural rate, the economy is at full employment and the rate of inflation is zero. When, instead, it differs from the natural rate, there are disequilibria in employment and inflation. As a consequence, the monetary authorities have to keep the market rate of interest at its natural level. This policy allows the economy to enjoy optimality conditions and prevents a political use of monetary policy, i.e. a use that favours, through inflation and deflation, some sectors of the economy at the expense of others. Thus, according to traditional neoclassical theories, the use of the natural rate of interest makes it possible to identify a technical, or neutral, or non-political, conduct of monetary policy. Before the Great Depression Keynes adopted this approach. After this event his position changed. At the beginning, in the parts of the Treatise on Money written after the Great Depression, he acknowledged the practical difficulty of the monetary authorities in recognising the level of the natural interest rate which they have to use as a guidance of policy (See Keynes, 1930, chapter 37, and in particular pp. 304–15 and 338–47). Subsequently, with the introduction of the notion of a monetary theory of production in 1932, he took a more radical position. He rejected the distinction between a real and a monetary department of economics and the related use of the natural interest rate as a guidance of monetary policy.5 According to Keynes, monetary events have a direct effect on the equilibrium level of economic variables, including the level of production and income distribution. As a consequence, the choices of the monetary authorities always have political implications. They favour some sectors of the economy at the expense of others. The influence of monetary events on the equilibrium level of real variables makes it impossible to separate the management of monetary and fiscal policy. This position was dominant during the twenty years following the Second World War. Both policies, it was thought, have to pursue the same final goals. They must be co-ordinated in order to achieve what Samuelson (1956) called national

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economic stability,6 which consists of the stability of the value of currency and financial institutions, the safeguard of international reserves, the stability of growth and employment, the reduction of divergences in regional growth and income distribution. At the time it was widely believed to be opportune to give priority to full employment over price stability, when such goals cannot be simultaneously achieved. Inflation, it was thought, is worrying when it overtakes levels that, after the stabilisation periods that immediately followed the Second World War, were not reached up to the 1973 oil shock.7 As to the conduct of monetary policy, it was thought necessary for monetary issues to maintain stable interest rates. A policy based instead on a rigid control of monetary issues, bringing about instability of the interest rates, would have several undesirable consequences: (i) the rates of interest would increase; (ii) the debt of the government and of the other sectors of the economy would grow and become unmanageable; (iii) financial speculation would be favoured and would dominate at the expense of channelling funds to the productive sectors of the economy; (iv) financial institutions would see their balance sheets weaken owing to the variability of the value of the securities used as second line reserves and to the increase in unrecoverable loans; (v) economic growth would slow down and unemployment increase. As to central bank independence, the economic literature of the time accepted that this was mainly the subject of those disciplines, which examine the organisation of the State and the relations among its institutions. It was widely agreed that the democratically elected bodies must take responsibility for the most important decisions, allowing the experts of central banks to decide the practical operation of policy, not its goals. The central bank was seen as ‘a highly skilled executant in the monetary field of the current economic policy of the central Government’ (Radcliffe Report, 767). It should be given instrument and personnel independence, but not goal and priority independence. As to money issue independence, under normal conditions this should not interfere with the need to co-ordinate the actions of all authorities to achieve national economic stability. The literature of the time acknowledged the technical character of the expertise of the monetary authorities. Yet it considered the latter political actors with an interest in strengthening their institutional role. The limits of the mandate of a central bank, and thus its independence, were seen to depend on the position it had historically acquired in society. Its decisions may be consequently influenced by the need to defend this position. By following these lines, Kaldor (1970) likened central banks to constitutional monarchs, who must avoid using the large powers that they formally have in order to preserve them. The Radcliffe Report, published in 1960, represents the moment of maximum consensus to these positions. Economic liberalism had limited prestige, even if Friedman and his colleagues in Chicago had already started to rehabilitate the quantity theory of money and conduct research that led to the birth of monetarism in the 1960s. Friedman, following the neoclassical tradition, believed that the operation of market forces was able to lead the economy to a full employment

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position, which was not influenced by monetary factors. He argued that the monetary authorities should not have the same goals as the fiscal authorities and should only be preoccupied with price stability. Moreover, he pointed out that economic analysis can only provide limited information on the time of reaction of the economic variables affected by monetary policy measures. For this reason, he concluded, the monetary authorities have to avoid intervening discretionarily, since the effects of their actions can manifest themselves when they are no longer necessary, thus aggravating the existing disequilibria, rather than correcting them. As to the issue of independence, monetarists were adverse to it. The recognition of the limited knowledge of the reaction time of economic variables to the impulses of monetary policy and the opposition to any form of concentration of power led them to fear the errors and abuses of independent authorities more than the damage of unemployment. According to authors fully confident of the operation of competitive forces, this damage can only be minor. Friedman (1962, pp. 50–51), presenting his main argument against central bank independence, said: ‘To paraphrase Clemenceau, money is too serious a matter to be left to the Central Bankers’. For him, monetary policy should be conducted by defining a rule of monetary issue that central banks have to follow in a rigid way. They should not be allowed any discretion, since this can bring about errors or abuses. Neither goal, nor priority, nor instrument independence should be attributed to these institutions, while the rules regarding the funding of the government sector should prevent it from financing its deficits with a monetary base. During the 1960s, the dominance of Keynesian over monetarist positions gradually waned. The reviews of the Radcliffe Report already show that it had not been received enthusiastically in central banking circles (see Musella and Panico, 1995, in particular the essay by Roosa reprinted there), preoccupied with the growth of the international liquidity produced by the policies pursued under the Bretton Woods agreements. These preoccupations were enhanced by the currency crisis of the following years, which broke down the Bretton Woods agreements in 1971, and by the stagflation that followed the 1973 oil shock. These events caused a gradual change in the conduct of monetary policy. The central banks of the German Federal Republic and Switzerland were the first, soon after the oil shock, to introduce policies that focussed more on inflation by adopting restrictive trends of monetary issues. United States, Canada, Great Britain, France and Australia made similar choices from 1976. Yet it was in October 1979, after the second oil shock, that the Federal Reserve announced the introduction of new operative procedures. As prescribed by monetarism, they introduced a rigid control over monetary issues, leaving aside the concern for the stability of the interest rates. In 1980 the Bank of England also adopted what was defined as a monetarist experiment. It went on up to 1982, when consequences similar to those forecasted by the Radcliffe Report forced the Federal Reserve to abandon the new procedures. The halt to the monetarist experiment was caused by the increase in interest rates, which in turn caused an explosion of foreign debt in several countries, balance-sheet problems for the US banks, which found it

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difficult to recover a large part of their loans, economic recession and unemployment. The literature has reached broad consensus on this interpretation of the events (see Musella and Panico, 1995). Even authors who had previously favoured the development of monetarism accepted it.8 Since then, the conduct of monetary policy has followed a pragmatic approach. On the one hand, it has rejected the use of a rigid rule for monetary issue; on the other, it has taken a more restrictive stance than in the year preceding the oil shocks, giving priority to price stability over full employment, but avoiding focusing only on the former goal. The idea of separating the goals and the functions of monetary and fiscal policy was considered by Cobham (1992, p. 266), who had previously developed monetarist positions, an aberration of the early 1980s. Those in favour of economic liberalism abandoned monetarism, replacing it with a new approach, which will be considered in the next section.

26.4

The 1970s and the Great Changes in Economies and Societies

Affecting economies and societies as severely as the Great Depression, the events of the 1970s set the conditions for gradual, yet profound changes in the world economy and in policy. These major events were as follows: (i) the breakdown of the Bretton Woods agreements; (ii) the oil shocks of 1973 and 1979; (iii) the emergence of a literature worried by the abuses of government intervention; (iv) the birth of a new approach to economics, differing from monetarism, but even more confident of the spontaneous working of market forces. The breakdown of the Bretton Woods agreements was sanctioned by President Nixon’s decision in August 1971 to abolish the convertibility of dollar into gold at the official parity. The agreements were also based on adjustable fixed exchange rates and on the use of administrative controls on capital movements to limit financial speculation and allow the use of monetary policy for domestic goals. The abandonment of the fixed exchange rate regime induced the European countries to adopt other agreements: the monetary snake in 1972, the European Monetary System in 1979, the European Monetary Union in 1999 and the introduction of the Euro in 2002. Another consequence of the disruption of the fixed exchange regime was the growth of international financial transactions, which was further strengthened by the subsequent tendency to eliminate the administrative controls on capital movements. The United States, Switzerland and the United Kingdom were the first in 1979 to allow the free circulation of capital. The countries of the European Union followed them in the second half of the 1980s. The boom in international financial transactions during this period is a significant indicator of the profound changes occurring in the world economy from the 1970s onwards. The amount of such transactions increased 89 times from 1977 to 1998, much more than the increase in international transactions in goods and services, which rose 3.5 times during the same period.9 As a consequence, the weight of financial sectors in the

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economy and in society has increased, particularly in the United Kingdom and United States, where the most important financial centres are located.10 The economic literature considers the financial sector a major opponent of inflation, owing to the re-distributive effects that it causes between lenders and borrowers, and a major supporter of market liberalisation. Hence the growth of the financial sector during the last few decades may be considered one of the factors that have enhanced the adoption of economic policies based on market liberalisation and giving priority to price stability over full employment. The oil shocks of 1973 and 1979 caused other changes in the world economy. That of 1973 caused stagflation. The world recession, attended by high inflation and international trade disequilibria, increased international competition and stimulated innovation at the corporate level. The rate of inflation overtook the twodigit threshold and touched levels previously reached during wartime. After the Second World War, as happened in Italy in 1947, stabilisation policies rapidly restored the confidence of those investing in the medium and long-term bond markets. By contrast, after the 1973 oil shock, there was no investment in these markets for a long time. The postponement of this kind of investment can be seen as a sign that investors (not only financial institutions, but also individuals belonging to the household sector) were preoccupied with the instability of the rate of inflation. This uncertainty may have contributed to orient electoral preferences towards policies giving priority to price stability. Another major event of the 1970s was the development of a critical literature on the problems that government intervention poses for representative democracy. Buchanan (1975) and Nordhaus (1975) made two outstanding contributions to this literature. They start from the assumption that political parties and elected representatives act in their own interests, which do not necessarily coincide with those of society. Buchanan (1975) underlines that the parties in power can have an interest in strengthening government intervention to favour their re-election. According to Buchanan, government intervention tends to be characterised by inefficiency and low morality. Nordhaus (1975) describes the existence of a political production cycle due to the fact that the parties in power, to be re-elected, tend to stimulate production through government expenditure before the election date. According to Nordhaus, the increase in government expenditure has a shortterm positive effect on production and employment, while the effects on inflation tend to manifest themselves later. The parties in power can thus take advantage of the difference in the reaction time of these variables. They can take in the voters, benefiting from their positive evaluation of the increase in the level of production and leaving to the new government the task of dealing with inflation. The attention given by this literature to the inefficiency of government intervention and to electoral tricks testifies to the lack of confidence of different sectors of society in the political world. This lack of confidence can be seen as another cause of the change occurring in electoral preferences, which have appeared more favourable than in the past to the reduction of government intervention in the economy.

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Finally, let us focus on a new approach, the New Classical Economics (NCE), which has replaced monetarism as a reference theory for laisser faire positions. This approach, which consists of complex arguments and advanced formal elaborations, has strongly influenced the recent literature on the role of the State and central bank independence. It considers that the economy is permanently in a full employment position, thereby meaning lack of involuntary unemployment. The problems of effective demand, which were the main governments’ concern from the Great Depression to the 1970s, are thus eliminated from the beginning. The presence of this element is evident in the formulation of the most widely used tools of this school, the Lucas aggregate supply curve, which assumes that the economy is always at full employment and tends to a position related to the natural rate of unemployment that depends on the imperfections in the circulation of information in the labour market. This position of the economy; like that of full employment equilibrium of the traditional neoclassical theory, is determined by non-monetary factors. The income produced when unemployment is at its natural level allows the full use of the potential of the economy, given the lack of perfect circulation of information in the labour market. If this kind of imperfection could be reduced, the natural rate of unemployment would decrease. The Lucas curve also assumes that the income actually produced may diverge from the level corresponding to natural unemployment. This divergence is caused by mistakes in the forecast of the price level, which are not due to problems of the theory, but to the operation of stochastic forces. This conclusion comes from the belief that the theory proposed by the NCE takes into account all elements producing a systematic influence on the economy. As a consequence, the forecasts made on the basis of this theory are on average correct. The occurrence of events, which are not systematic, is thus the only cause of the divergence between the actual and the expected price level, which, in turn, causes that between the income actually produced and that corresponding to the natural rate of unemployment. 11 One implication of this approach is that economic policies are unable to reduce unemployment. Since agents foresee the effects of government interventions, these can be effective if they take the operators by surprise, i.e. if they contradict what had been previously announced by introducing unexpected measures that raise inflation and reduce unemployment. The surprise effect is however short-lived: as soon as agents realise the changes which have occurred, unemployment goes back to its natural rate, leaving the price level at a higher level. The picture outlined above differs from that proposed by monetarism, according to which monetary policy affects real variables, but can have undesired consequences owing to the fact that the limited information provided by the theory does not allow one to make good forecasts. The possibility of mistakes is thus the main argument recalled by monetarists against the use of government intervention. By contrast, the NCE considers that economic policies are ineffective because economic theory allows agents on average to make good forecasts. Policies are effective if they are the result of dynamically inconsistent behaviour of the authorities. The arguments proposed by these economists thus underline the

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demagogy of the governments and the tendency of society to avoid the sacrifices related to the complex working of the economic system, like those coming from the imperfect circulation of information in the labour market. The differences with monetarism and the peculiarity of some assumptions have not prevented the NCE and the Lucas curve from becoming the main theoretical reference of laissez faire positions and having great influence on the literature on the role of the State and on central bank independence.

26.5

The Recent Literature on Central Bank Independence

The literature that has recently had the most influence on monetary policy and on the reforms of central banks tends to present a homogeneous approach based on the Lucas supply curve. The origin of this literature can be found in the 1977 essay by Kydland and Prescott, whose analyses show that the attempts of the authorities to maximise social welfare lead to interventions that are dynamically inconsistent, that is to interventions contradicting those previously announced. The results of Kydland and Prescott stimulated a large set of contributions that have examined the implications of dynamic inconsistency for different fields of economics. Barro and Gordon (1983) dealt with monetary policy. Following the NCE, they assumed that the monetary authorities control the rate of inflation and that the agents sign their contracts in money terms by taking into account their rational expectations on the rate of inflation. The underwriting of the contracts generates the dynamic inconsistency problem in the monetary authorities’ decisions. Taking the agents by surprise, they can attempt to increase social welfare by pursuing a policy to bring about a higher rate of inflation than that expected by the agents, but also, as foreseen by the Lucas curve, a rate of unemployment temporarily lower than the natural one. The opportunity taken by the authorities, however, is short-lived. Rational agents will anticipate the surprise effects exploited by authorities endowed with discretionary powers. They will thus stipulate contracts that incorporate a higher rate of inflation. The conclusion is that the dynamic inconsistency of the monetary authorities represents a problem for society, since it leads to a lower level of social welfare. As a consequence, the introduction of rules that deprive the authorities of discretionary powers leads to a positive result for society. It affects the rate of inflation expected by the agents, leading them to stipulate contracts which bring about a lower rate of inflation. The preference attributed by such analyses to rules over discretion does not imply similarity between their positions and those of monetarism. The term rule has for the recent literature a different meaning from that attributed by monetarism. It does not mean a fixed prescription on the rate of growth of some monetary aggregate, independent of conditions of the economy, but a behavioural norm that prevents dynamic inconsistency (see Kydland, 1992, p. 379). The introduction of laws setting irrevocable constraints to the behaviour of the authorities, however, is not considered feasible in a reality where it is always

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possible to modify previous rules. This difficulty has stimulated the search for different solutions, able to reduce, within the analytical models used, the loss of social welfare due to the presence of discretion. Barro and Gordon (1983) introduced a line of research based on the notion of reputation. They argued that a central bank interested in acquiring an antiinflationary reputation12 can act in such a way as to reduce the loss of welfare due to discretion, even if it is unable to lead to the same level of welfare as that of an irrevocable rule. The attempts of the central bank to improve its reputation have positive effects on the agents’ expectations as to the rate of inflation. Rogoff (1985) started a second line of research, which introduced the issue of central bank independence. Again within the framework of NCE, he proposed delegating the conduct of monetary policy to a conservative central banker, i.e. to a banker more adverse to inflation than government and society. A conservative central banker gives the struggle against inflation a higher priority than does society. Consequently, the attribution of priority independence to the central bank leads to a rate of inflation lower than that occurring in the case of discretion but higher than that of an irrevocable rule. The line of research initiated by Rogoff (1985) is called institutional design. Unlike the previous economic literature, which considered that the issue of central bank independence mainly belonged to other social disciplines, it tries to solve the problem of the organisation of State institutions by using the methods of economic analysis. The aim is to define the optimal configuration of these institutions and to identify a system of constraints and incentives that can lead private and public utility maximising agents to act in such a way as to allow society to enjoy the best combination of low inflation and reactivity of monetary policy to the shocks undergone by the economy. After Rogoff (1985) the institutional design literature produced a large body of contributions. Major contributions include Lohmann (1992) who introduced in Rogoff’s analysis an escape clause, which allows the government to dismiss the conservative central banker, in the presence of shocks that bring about a rate of unemployment considered too costly by the community. The introduction of this clause, according to Lohmann, induces the central banker to act in such a way as to avoid excessive gaps between actual and potential output of the economy. Another key contributor (Walsh, 1985) reformulated Rogoff’s analysis in terms of contract theory. It shows that the trade-off between independence and responsiveness to output shocks, which is present in Rogoff’s work, stems from the system of incentives implicitly adopted by this author and considers the possibility of improving on Rogoff’s results by offering the central banker a contract with incentives and fees related to the achievement of the announced objectives. At present, most literature on policy organisation follows Walsh’s attempt to identify the most convenient set of incentives. Within this literature, the approach called inflation targeting, in its complex articulation, underlines the role of transparency in monetary policy. According to this approach, the monetary authorities can enjoy full discretion in the choice of the analytical model to be used

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to define monetary interventions. Yet this discretion must be constrained by transparency: the authorities must clarify to the elected bodies the reasons for their choice. According to these authors, the laws on this subject must specify in detail, as done by the recent reform of the Bank of England, what information is to be published and the forms and dating of such publications.13 This kind of transparency allows the elected bodies to exert a democratic control on the conduct of monetary policy, which can be based, according to them, only on the simulations provided by the model chosen.

26.6

Critique of the Recent Literature on Central Bank Independence

In spite of the consensus achieved, several criticisms have been levelled against the recent literature on central bank independence. Here we deal with four of them, which refer to: (i) the claim that the economy is always in a full employment position and that unemployment depends on the imperfections in the circulation of information in the labour market and not on the lack of demand of goods and services; (ii) the simplistic characterisation of the relations between State and society; (iii) the empirical evaluation of the causal link between independence and inflation; (iv) the contradiction between independence and democracy, known as the problem of the accountability of the monetary authorities. The idea that the spontaneous operation of market forces leads to full employment is no more scientifically founded than the opposite idea that the operation of market forces can fail in generating an efficient allocation of all available resources.14 As to the claim that unemployment depends on the imperfect circulation of information in the labour market and not on the lack of demand for goods and services, although it comes from the theoretical positions on the tendency to full employment, it has been evaluated by the literature on an empirical basis. This evaluation has tried to estimate a natural rate of unemployment, which can play the role of reference point for the conduct of policy. This rate is calculated on the basis of those actually occurring and thus depends on them. In the case of the American economy in the 1990s the actual rates of unemployment progressively decreased, thus reducing the value of the natural one. This phenomenon has induced Solow to doubt that the natural rate can be used as a reference point for the conduct of policy. This role requires that the natural rate must be clearly identified by the model and must undergo slow and occasional changes. In the contrary case, Solow concludes (2000, p. 157), the story of a natural rate of unemployment as a reference point for policy loses its meaning. The approach used by the literature on institutional design, like that followed by Kydland and Prescott, Barro and Gordon and the subsequent literature on reputation, faces a problem with the characterisation of the relations between State and society. Recent works, which integrate the knowledge of economists and political scientists (see Cama and Pittaluga, 1999; 2000), have pointed out that this characterisation is simplistic. By using the categories of political science, they

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have defined as socio-centric the representation proposed by the recent literature on dynamic inconsistency. Socio-centric models are those assuming the existence of a one-way relation between State and society. They do not allow any dynamic interaction between these two entities. State institutions have no autonomous interests. They automatically express in a political form the preferences of society. The critique raised by these inter-disciplinary works thus underlines a weakness of the dynamic inconsistency literature. Although it centres on the relations between State and society in order to design their optimal configuration, this literature adopts a theory with no detailed description of the political process affecting these relations. By paying scarce attention to the analyses of other social disciplines, the approach has produced analyses which contain refined formal elaborations, but which show a superficial understanding of institutional phenomena. The empirical tests on the relationship between independence and inflation have lent support to the claim that central bank independence produces low inflation (see Berger, de Haan and Eijffinger, 2001). Yet in two contributions to this literature, Posen (1993; 1995) argues that the order of causality between inflation and independence should be reversed: rather than claiming that inflation is low when the content of laws favours central bank independence, one should say that societies with a real interest in pursuing monetary stability attribute independence to the central bank in order to achieve this result. By attributing a primary role to politics, Posen’s empirical tests show that central banks are more independent in the societies where the financial sector is stronger. According to Posen, the financial sector is a major opponent of inflation, since nominal net creditors are interested in avoiding the loss in the real value of financial activities. Thus, he argues, the independence of the central bank is the epiphenomenon of the economic interests of the financial sector in monetary stability. The question of the accountability of the monetary authorities has attracted the attention of some outstanding economists, sensitive to the implications of the theory of independence for the institutional equilibria. They have doubted the legitimacy of Rogoff’s solution, which allows a non-elected institution, like a central bank, to pursue objectives that differ from those expressed by society through its elected representatives. Tobin (1994) expressed some preoccupations for the safeguarding of democracy, which is founded on the respect of procedures and not on the mere achievement of results defined by economic theory as socially optimal. McCallum (1996) noticed the unrealism of the institutional design literature, since it is impossible that the government and the central bank can maintain different preferences for a long period of time. If the central bank systematically pursues different objectives from those of the government, it would be reasonable to expect a change in the laws regarding the powers of the monetary authorities. Greenspan’s views (1996) confirm this position. He claimed that central bank independence has to be limited by the fact that the American people and their representatives must consider adequate the policies implemented.

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26.7

The Contradiction Between Democracy and Independence: Real or Apparent

The contradiction between democracy and independence, as testified by the contributions recalled, has attracted the attention of academics and professionals. Some have denied its existence in the actual organisation of democratic societies. Blinder, a Princeton academic who was appointed Vice President of the Federal Reserve, has greatly contributed to this position. Without the background of a political scientist, but with the intelligence of a person able to appreciate the complexity of the political processes affecting the formation of American policy, he criticises the dynamic inconsistency approach for its limited comprehension of institutional phenomena and concludes that there is no contradiction between independence and democracy in the actual organisation of American monetary policy.15 According to Blinder, the monetary authorities have been attributed autonomy and responsibility over monetary policy by the elected representatives of the American people. These representatives attribute powers to the central bank in a moment of the political process that can be called constitutional, which is different from that of the ordinary political production. Blinder claims that a central bank endowed with a high degree of independence has to operate transparently, making clear to the public how the policy objectives have been achieved. Although he is not an advocate of inflation targeting, which considers it possible to conduct monetary policy only on the basis of the prescriptions from the simulations produced by the analytical model chosen by the authorities, Blinder approves the use of transparent information which, according to him, further contributes to the democratic legitimacy of the activity of the monetary authorities. Stiglitz, another academic who served as Chairman of the Council of Economic Advisers of the President of the United States and as Chief Economist and Senior Vice President of the World Bank, also recognises the legitimacy of some degree of central bank independence in a democratic society. Starting, like Blinder, from direct appreciation of the complexity of the political processes affecting the formation of American policy, he argues that the degree and forms of independence that a central bank should have depend on the situation and history of each country (see Stiglitz, 1998, p. 224). His analysis, which presents arguments similar to those proposed by Blinder, is less detailed than that of the latter (see Stiglitz, 1998, pp. 220–4). Yet it pays more attention to the extent to which the views of the monetary authorities represent the values of the whole society and reaches more cautious conclusions on the respect of democratic values. In his opinion, although the United States has struck a good balance in the institutional arrangements governing the Fed, there are some aspects of this problem in which questions may be raised (See Stiglitz, 1998, p. 223). The main point is that those who make the decisions are not representative of society as a whole, and in some countries, they are chosen in ways which is hard to reconcile with democratic values. In many countries, bankers are disproportionally represented …Few countries ensure that

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workers and their interests are represented, even though the actions of the central bank have a vital impact on them (Stiglitz, 1998, p. 217).

To reinforce his view, Stiglitz (1998, pp. 217–18) claims that ‘the separation of technical expertise from value judgements is not as clear as is sometimes depicted’ and ‘the bias values imparts to what is ostensibly technical analysis’. In the case of monetary policy this problem is particularly relevant, since ‘value judgements often assert themselves in what should be purely «positive» discussions of the trade-off between inflation and unemployment’. According to Stiglitz, the problem can be solved within the existing institutional arrangements governing the Fed and it should be solved in order to avoid that the central bank be seen ‘as a mechanism for the imposition of the values of a subset of the population on the whole’. Some recent interdisciplinary works, combining the knowledge of economists and political scientists, also recognise the legitimacy of central bank independence in a democratic society. These works (see Cama and Pittaluga, 1999; 2000) provide a richer analysis than those developed by Blinder and Stiglitz, which are based on brilliant intuition rather than a systematic interdisciplinary approach. They deny the existence of the contradiction between independence and democracy, which is manifest in the literature on institutional design, by adopting an articulated dynamic representation of State-society relations16 and clarifying the reasons that make monetary stability crucial for democratic life. According to Cama and Pittaluga, monetary instability has re-distributive effects for income and wealth among the sectors of the economy. These effects can be hindered or accommodated by monetary policy. Moreover, since it is possible to mask as technical, decisions that have political content, in the sense that they favour some groups of society at the expense of others, it is possible to mask the true reasons for such decisions, making nobody appear responsible for them. Yet the principle of political responsibility is fundamental for democracy. The responsibility for the decisions taken must always be transparent, so that the citizen can confirm or withdraw, through his or her vote, support for the policies implemented by the government. Thus, for Cama and Pittaluga, central bank independence guarantees the citizen that the monetary authorities have a neutral position in the distributional conflicts over income and wealth. Independence is thus seen as a prerogative reserved to those bodies that in a democratic system play the role of constitutional embankment, that is of preserving the rules of the games and protecting the citizen against surreptitious attempts to re-distribute benefits within society. The importance of this function can be further appreciated by considering that democracy does not simply require that decision-making reflect the preferences of the majority, an aspect of democratic life underlined by the Rousseauian tradition. It also requires, as underlined by the Madisonian tradition, the protection of the citizen against the abuses made by those in power, including the democratically elected representatives. Now, the attribution of the decisions regarding monetary stability to an independent authority can contribute to making transparent the political responsibility of crucial decisions over re-distribution of

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income and wealth. In this way, central bank independence, instead of leading to a deficit of democracy, preserves an essential condition of orderly democratic life. Cama and Pittaluga (1999, p. 260) also point out that the forms and the degree of independence attributed to the monetary authorities change in every society. They are the result of a political process that has balanced the demands of different groups of voters to safeguard democracy, on the one hand, from the excess of responsiveness to voters’ preferences, which can lead to demagogy or to favouring the most influential political groups and, on the other hand, from the excess of autonomy, which can lead the authorities to pursue their own interests instead of those of society.17 This equilibrium can be achieved in different ways, including the introduction of norms relative to personnel independence. Thus, Cama and Pittaluga, like Blinder, consider that the political appointment of some members of the Federal Reserve Open Market Committee, seeks to guarantee the need to make the monetary authorities respond to the preferences of the majority, while the technical appointment of other members guarantees the citizen against the risks of demagogy or of favouring the most influential political groups. To sum up, the literature that has recently had the most influence on the conduct of monetary policy and on the reforms of central banks has, on the one side, the merit of using refined formal instruments and of underlining the problems related to the search for electoral consensus; on the other, it has presented a simplistic characterisation of the economy and of the society. By assuming that unemployment is due to the imperfections in the circulation of information, it has excluded that expansive economic policies be used to solve this problem, even when the rate of unemployment is high. By proposing a simplistic representation of the dynamic relations between State and society, it leads to a limited comprehension of institutional phenomena. This simplistic representation leads to the conclusion that to increase the efficacy of monetary interventions it is necessary to violate some rules of democracy. This conclusion has raised several critical reactions, some of which have underlined that when more complex representations of the relations State-society, like those used by other disciplines, are employed to analyse the organisation of State institutions, the contradiction between central bank independence and democracy disappears. The organisation of the relations between monetary authorities, government and society can thus be seen as the solution of a political process which has to guarantee the citizen that the decisions regarding the re-distribution of income and wealth are taken transparently.

26.8

Conclusions

The analysis on the relation between central bank independence and democracy presented in the previous pages has focused on two aspects of the changes occurring in the literature after the mid 1970s. Firstly, it has pointed out that the theories developed during this period are based on assumptions that eliminate from

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the beginning the problems of effective demand, which had been the main preoccupation of government policies after the Great Depression. Secondly, it has shown that the economic literature up to the 1970s accepted that analysis of central bank independence was mainly the subject of those disciplines which examine the organisation of the State and the relations among its institutions. It cooperated with those disciplines to find the most convenient solution to this problem, a solution that depends on the historical and political situation of each country. Since the 1980s, instead, the economic literature has restricted the interaction with other disciplines, trying to solve the problems of the organisation of State institutions within its own domain. This attempt has the merit of using refined formal instruments and has contributed to underlining some specific aspects of the organisation of monetary policy, like the problems related to the search for electoral consensus. It has however adopted a representation of the relations Statesociety, considered over-simplified by other disciplines. As a consequence, it faces a theoretical problem, since it offers a limited understanding of the institutional phenomena it seeks to analyse and an unsatisfactory answer to the identification of the general guidelines according to which the activity of the monetary authorities should be organised. Its simplistic representation of State-society relations is the source of a contradiction between central bank independence and democracy which other works, using different representations of these relations, prove to be non-existent in the actual organisation of monetary policy. According to these works, central bank independence, instead of leading to a deficit of democracy, preserves an essential condition of orderly democratic life. These contributions also underline that the degree and forms of independence given to a central bank depend on the situation and history of each country, since they are the result of the political process which has taken place in that particular context. This conclusion recalls those reached by the economic literature up to the 1970s. Notes 1

2 3 4 5

Interest in these problems within central banking environments is testified by Greenspan (1996) and by the conferences of the Federal Reserve Bank of Boston on Goals, guidelines and constraints facing policy makers, held in 1994, and of the Bundesbank on Transparency in monetary policy held in 2000. The European Central Bank however decides the goal-variable rate of inflation. Harrod’s 1933 paper is a memorandum written for the Trade Unions. It is unpublished and belongs to the Harrod Papers, available at the Chiba University of Commerce in Ichikawa (Japan). The part recalled is quoted in Young (1989, p. 16). This distinction can be found in the writings of Walras, Marshall, Wicksell and other outstanding neoclassical figures. Keynes’s new approach entailed the abandonment of the concepts of natural interest rate and neutral monetary policy: ‘It cannot be maintained that there is a unique policy which, in the long run, the monetary authority is bound to pursue’ (Keynes, 1979, p. 55; Nov. 1932). He pointed out that the divergence between the traditional and his new position is ‘most marked and perhaps most important when we come to the discussion of the rate of interest’ (Keynes, 1973, p. 410; 1933). The centre of his investigation therefore moved along these lines: (a) to reject the notion of a natural interest rate; (b) to

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6

7

8 9

10

11 12

13

Money Credit and the Role of the State propose an alternative theory of the interest rate; (c) to try to criticise the consistency of the traditional theory of the rate of interest. For an analysis of this point, see Panico, 1988, pp. 102–41. Intervening in a debate between the Treasury and the Federal Reserve, Samuelson wrote: ‘I do not wish to go into the merits of the struggle between the Treasury and Federal Reserve. Let me simply state dogmatically that the Secretary of the Treasury should be just as concerned for the nation’s stability as the Central Banker. ... there is no legitimate clash between Treasury and Central Bank policy: they must be unified or coordinated on the basis of the over-all stabilisation needs of the economy, and it is unthinkable that these two great agencies could ever be divorced in functions or permitted to work at cross purposes. (In particular it is nonsense to believe, as many proponents of monetary policy used to argue, that fiscal policy has for its goal the stabilisation of employment and reduction of unemployment, while monetary policy has for its goal the stabilisation of prices. In comparison with fiscal policy, monetary policy has no differential effectiveness on prices rather than on output) … I have already asserted that the Treasury and Central Bank have to be co-ordinated in the interests of national stability, so I am little interested in the division of labour between them’ (1956, pp. 14–15). Stiglitz (1998, pp. 210-212) re-states the validity of this position against what he calls the current rhetoric of monetary policy. For him, the recent applied literature shows no evidence that inflation is costly when it is below a certain level. Quoting Akerlof, Dickens and Perry (1996) he claims that ‘low inflation is actually beneficial. Some inflation … helps maintain full employment by facilitating the downward adjustment of real wages’ (Stiglitz, 1998, p. 211). Friedman (1984) is among the exceptions. For him the experiment failed because the authorities did not apply the monetarist prescriptions with competence. Variations from 1977 to 1995 are calculated by Haq, Kaul and Grunberg (1996, p. 291) on data of the Bank for International Settlements, Central Bank Survey of Foreign Exchange Market Activity, of 1993 and 1996,. Variations from 1995 to 1998 are calculated on data of the same Survey, published in 1999. For further information on international transactions, see Eatwell (1997) and Panico (2000). Around one third of the international financial transactions takes place in London; another 25% in New York. By adding the transactions made in Tokyo, Singapore, Honk Kong, Zurich, Frankfurt and Paris, quoted in order of importance by volume of activity, one exceeds, according to 1996 data, 83% of total transactions. Lucas and Sargent (1979) discuss these issues from the NCE’s standpoint. In this literature the notion of central bank credibility, to which anti-inflationary reputation is related, differs from that used in ordinary language. For this literature, rational agents consider credible those central bank announcements which are consistent with the existent system of incentives and constraints. This definition of credibility is criticized by Blinder, who argues that the reputation of a central bank is built through the discipline of the persistent adhesion to the announced objectives. He challenges the view of dynamic inconsistency, based on the belief that the monetary authorities control inflation, that one deviation from the announced objectives is sufficient to persuade the agents to revise their inflation expectations. The Bundesbank, he claims, did not lose its reputation in 1992, when the rate of inflation was above the announced one. Blinder also argues, against the view of dynamic inconsistency, that central bankers are unaffected by inflation bias, since they value highly their reputation as monetary stability custodians. The recent reform of the Bank of England dictates the publication of a quarterly Inflation Report, containing information on the factors that have influenced the rate of inflation, on the analytical model used, on the forecasts obtained with it, on the quality

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15 16 17

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of these forecasts, on the problems of the existing models, on the values of the informative and instrumental variables. Moreover, the minutes of the meetings of the Directors of the Bank of England and of the meetings with the Chancellor of the Exchequer must be published within 15 days of their occurrence. According to the present state of knowledge, it is possible to solve the problem of the existence of solutions of a general equilibrium model of a perfectly competitive economy. The lack of realism of this model is generally recognised, as it is known that the attempts to mitigate its restrictive assumptions, for instance that relative to the symmetry in the distribution of information among agents, have failed to reach satisfactory results. As to the dynamic analyses of a perfectly competitive economy, which deal with the working of the economy and the tendency to full employment, the literature has concluded that, even under the unrealistic conditions just mentioned, nothing can be said on the stability of the existing equilibria. According to Blinder, the problems raised by the dynamic inconsistency approach give a false representation of the actual working of central banking. On these points, he says, this approach ‘is barking at the wrong tree’ (1998, p. 24). That adopted by Cama and Pittaluga (1999, pp. 247–51) is called the political exchange approach. This conclusion, like that of Posen, attributes a primary role to politics. A recent empirical analysis (see Rizza, 2001, chapter 4), which relates central bank independence to the degree in which decisions regarding income distribution are concerted, further supports this view. The interpretation of this result is that a society taking decisions over income distribution through a participatory process tends to watch over the interference of monetary policy.

References Akerlof, G., W. Dickens and G. Perry (1996), ‘The macroeconomics of low inflation?, Brooking Papers on Economic Activity, 1, pp. 1–76. Barro, R.J. and D. Gordon (1983), ‘Rules, discretion, and reputation in a model of monetary policy’, Journal of Monetary Economics, 12(1), pp. 101–21. Berger, H., J.E. de Haan and S.C. Eijffinger (2001), ‘Central bank independence: un update of theory and evidence’, Journal of Economic Surveys, 15(1), February, pp. 3–40. Blinder, A. S. (1997), ‘What central bank could learn from academics – and vice versa’, Journal of Economic Perspectives, 11(2), Spring, pp. 3–19. Blinder, A.S. (1998), Central Banking in Theory and Practise, Cambridge: MIT Press. Bowles, P. and G. White (1994), ‘Central bank independence: a political economy approach’, Journal of Development Studies, 31(2), pp. 235–64. Briault, C., A. Aldane and M. King (1996), ‘Independence and accountability’, Bank of England WPS, 40. Buchanan, J. (1975), The Limits of Liberty: between Anarchy and Leviathan, Chicago: The University of Chicago Press. Cama, G. and G.B. Pittaluga (1999), ‘Central banks and democracy’, Rivista Internazionale di Scienze Sociali, 107(3), pp. 235–77. Cama, G and G.B. Pittaluga (2000), ‘Origine ed evoluzione delle Banche Centrali: il ruolo delle lobbies sociali’, Working Papers of the Dipartimento di Scienze Economiche e Finanziarie dell’Università di Genova, no. 9/2000, Genova.

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Cobham, D. (1992), ‘Radcliffe Committee’, in J.L. Eatwell, M. Milgate and P. Newman (eds), The New Palgrave Dictionary of Money and Finance, vol. III, London: Macmillan, pp. 265–6. Cukierman, A., S.B. Web and B. Neyapti (1992), ‘Measuring the independence of central banks and its effect on policy outcomes’, World Bank Economic Review, 6(3), pp. 353– 98. de Haan, J. (1997), ‘The European Central Bank: independence, accountability and strategy: a review’, Public Choice, 93(3-4), pp. 395–426. de Haan, J and W. Kooi (1997), ‘What really matters? Conservativeness or independence?’, Banca Nazionale del Lavoro Quarterly Review, 50(200), pp. 23–38. Eatwell, J.L. (1997), ‘International financial liberalisation: the impact on world development’, The International Journal of Technical Cooperation, 3(2), pp. 157–62. Eijffinger, S.C.W. and M. Hoeberichts (2000), ‘Central banking accountability and transparency: Theory and some evidence’, Bundesbank/CFS Conference on Transparency in Monetary Policy. Friedman, M. (1962), Capitalism and Freedom, Chicago: The University of Chicago Press. Friedman, M. (1984), ‘Lessons from the 1979-82 monetary policy experiment’, American Economic Review, 74(2), pp. 397–400. Graziani, A., (1998), ‘Fra conflitti e autonomia: lo Stato e la sua Banca. Potere politico e Istituti Centrali’, Etruria Oggi. Economia e Finanza, 48. Greenspan, A. (1996), The Challenge of Central Banking in a Democratic Society, Remarks by Chairman Alan Greenspan at the Annual Dinner and Francis Boyer Lecture of the American Enterprise Institute for Public Policy Research, Washington, D.C., 5 December 1996, Federal Reserve Board, available at http/www.federalreserve.gov /boarddocs/speechs. Grilli, V., D. Masciandaro and G. Tabellini (1991), ‘Political and monetary institutions and public financial policies in the industrial countries’, Economic Policy, 6(2), pp. 341–92. Haq, M.U., I. Kaul and I. Grunberg (eds), (1996), The Tobin Tax: Coping with Financial Instability, New York: Oxford University Press. Kaldor, N. (1970), ‘The new monetarism’, Lloyds Bank Review, 97(July). Keynes, J.M. (1930), A Treatise on Money, London: Macmillan. Keynes, J.M. (1973), The General Theory and After; Part I: Preparation, in D.E. Moggridge (ed.), Collected Writings of J.M. Keynes, Vol. XIII, London: Macmillan. Keynes, J.M. (1979), The General Theory and After; A Supplement, in D.E. Moggridge (ed.), Collected Writings of J.M. Keynes, Vol. XXIX, London: Macmillan. Kydland, F.E. (1992), ‘Rules versus discretion’, in J.L. Eatwell, M. Milgate and P. Newman (eds), The New Palgrave Dictionary of Money and Finance, vol. III, London: Macmillan, pp. 379–81. Kydland, F.E. and E.C. Prescott (1977), ‘Rules rather than discretion: the inconsistency of optimal plans’, Journal of Political Economy, 85(3), pp. 473–91. Lohmann, S. (1992), ‘Optimal commitment in monetary policy: credibility versus flexibility’, American Economic Review, 82(1), pp. 273–86. Lucas, R.J. jr. and T.J. Sargent (1979), ‘After Keynesian macroeconomics’, Federal Reserve Bank of Minneapolis Quarterly Review, 3(2), reprinted in R.J. Lucas, jr. and

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T.D. Sargent (eds), Rational Expectations and Econometric Practice, London: George Allen and Unwin, 1981, pp. 295–319. McCallum, B. (1996), ‘Crucial issues concerning central bank independence’, NBER Working Paper 5597. Musella, M. and C. Panico (1995), The Money Supply in the Economic Process, Aldershot: Edward Elgar. Nordhaus, W. D. (1975), ‘The political business cycle’, Review of Economic Studies, 3. Panico, C. (1988), Interest and Profit in the Theories of Value and Distribution, London: Macmillan. Panico, C. (2000), ‘Unione Monetaria Europea e crescita economica’, Rivista di Diritto Pubblico e Scienze Politiche, 10(2), 177–201. Posen, A.S. (1993), ‘Why central bank independence does not cause low inflation: there is no institutional fix for politics’, in R. O’Brien (ed.), Finance and the International Economy, Vol. 7, The Amex Bank Review Prize Essays. In memory of Richard Marjolin, Chapter 3, Oxford: Oxford University Press, pp. 41–54. Reprinted in S.C.W. Eijffinger (ed.), Independent Central Banks and Economic Performance, Aldershot: Edward Elgar, 1997, pp. 505–29. Posen, A.S. (1995), ‘Central bank independence and disinflationary credibility: a missing link?’, Federal Reserve Bank of New York. Radcliffe Report (1960), Committee on the Working of the Monetary System: Report, Cmnd. 827, London: HMSO. Rizza, M.O. (2001), Regole, discrezionalità e indipendenza delle banche centrali: implicazioni per la democrazia, Tesi di dottorato, Università di Salerno. Rogoff, K. (1985), ‘The optimal degree of commitment to an intermediate monetary target’, Quarterly Journal of Economics, 100(4), pp. 1169–89. Samuelson, P.A. (1956), ‘Recent American monetary controversy’, Three Banks Review, 29(March), pp. 3–21. Samuelson, P.A. (1994), ‘Panel discussion: how can monetary policy be improved?’, in J.C. Fuhrer (ed.), Goals, guidelines, and constraints facing monetary policymakers, Proceedings of a conference held at North Falmouth, Mass., June, Federal Reserve Bank of Boston, Conference Series, N. 38, pp. 229–31. Stiglitz, J. (1998), ‘Central banking in a democratic society’, De Economist, 146(2), pp. 196–226. Solow, R. (2000), ‘Toward a macroeconomics of the medium run’, Journal of Economic Perspectives, 14(1), pp. 151–8. Tobin, J. (1994), ‘Panel discussion: how can monetary policy be improved?’, in J.C. Fuhrer (ed.), Goals, guidelines, and constraints facing monetary policymakers. Proceedings of a conference held at North Falmouth, Mass., June, Federal Reserve Bank of Boston, Conference Series, N. 38, pp. 232–36. Young, W. (1989), Harrod and his Trade Cycle Group, London: Macmillan. Walsh, C.E. (1995), ‘Optimal contracts for central bankers’, American Economic Review, 85(1), pp. 150–67.

Chapter 27

Updated Liberalism vs. Neo-liberalism: Policy Paradigms and the Structural Evolution of Western Industrial Economies after World War II *

Alessandro Vercelli

27.1

Introduction

This essay is rather unusual in scope, methodology, and contents. The scope is much broader than is considered sound within the research community, from the point of view of time, as it refers to more than half a century; space, as it refers to western industrialized countries in general;1 subject as it refers to the evolution of the structural features of these economies in a broad sense. Of course, the parable that we are going to tell in this paper does not fit exactly any of the countries of the reference group but aims to be representative of a few general features common in each period to most of them. The main motivation underlying this (perhaps too) daring approach is the conviction that to react to the loss of meaning determined by the increasing division of labour in economic research we have to work out higher-order cognitive structures based on the methods and results of the usual (first-order) economic research but overcoming some of its limitations.2 The higher-order cognitive structures have the role of coordinating the new pieces of knowledge continuously produced by the advancement of first-order science, both between them and within the corpus of received knowledge, in order to extract all their semantic and pragmatic implications. Higher-order science is not absent either in economics or in interdisciplinary research involving economics but in our opinion it is definitely underdeveloped. This is true in particular with the diachronic structures that coordinate the single pieces of information and knowledge according to a temporal order. Therefore this paper aims to suggest a few elementary diachronic structures that may help to interpret some crucial aspects of the recent history of economic facts and ideas. In this paper we will limit our analysis to a few simple, but controversial, historical patterns in industrialised countries after W.W. II concerning facts, policies and economic analysis, as well as their co-evolution. The scope of the paper is thus

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unusually broad although I am fully aware that more extension implies less detail and depth. To the best of my knowledge and capacity there is no way to avoid this trade-off altogether. The structure of this chapter is as follows. In the second section the main features of the process of growth of industrialised countries after W.W.II are briefly described. It is maintained that structural change was directed by two basic guidelines: welfarism in the rapidly growing public sector and Taylorism in the productive processes. Our attention then focuses on the 1970s, a period of long economic crisis that caused a sharp turn in the direction of structural change. The reactions against the critical features of the pre-existing period of growth gradually shaped a new period of growth characterised by two new guidelines: systematic privatisation at the cost of (or with a view to) dismantling the welfare state, and flexibility in the productive process and in the architecture of organisations, replacing Taylorism with less rigid technological and organisational guidelines. Section three describes how a steadier, though lower, rate of growth resumed in the 1980s and 1990s under the new guidelines. In particular it is argued that the new growth paradigm based on monetarism and market fundamentalism is unsustainable mainly because the underlying neo-liberal policy paradigm does not take account of market limits. Up to this point, attention is focused on the actual behaviour of private and public decision makers. In section four the change in the objective function of policy makers is rapidly described, as well as its co-evolution with the parallel change in economic thought. We distinguish between two basic policy paradigms that have influenced the evolution of western industrialised economies, as well as the world economy: updated liberalism that is fully aware of the limits to markets and therefore aims at their active regulation, and neoliberalism that is based on market fundamentalism and aims at privatisation, deregulation and budgetary austerity. The paper discusses how updated liberalism emerged after W.W.II, became hegemonic in the 1950s and 1960s and started to decline in the 1970s, while neo-liberalism gathered momentum in the 1970s and became hegemonic in the 1980s and 1990s. Concluding remarks follow in order to summarise the connections between the historical pattern observed in the history of events and the parallel evolution observed in the history of economic thought and policy paradigms. We claim in particular that neo-liberalism is inconsistent not only with the updated liberalism of Keynes and Pigou (and their followers) but also with the classical liberalism of Adam Smith and Stuart Mill, resembling rather the simplistic and over-optimistic laisser-faire of Say and Bastiat. It is also argued that neo-liberalism is unable to cope with crucial problems as it does not take account of the market failures which, together with the state failures, originated them. There is no alternative but further updating classical liberalism.

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The Rise and Fall of Keynesian Growth (1951-1971) and the Transition to a New Economic Paradigm (1971-1981)

Most industrialised countries grew very rapidly in the 1950s and 1960s. In some cases, as in Italy, the average rate of growth was considered miraculous because it happened to be so high and steady as to exceed the most sanguine expectations (Graziani, 2000). The economic paradigm3 underlying this extraordinary episode of growth was based on the technological side by the systematic adoption of Taylorist techniques of division of labour that greatly increased the productivity of labour and progressively reduced the price of many consumption goods. Therefore many of them (bicycle, car, radio, telephone, television, electric appliances, etc.) could enter in the basket of mass consumption. This technological approach gave the best results within large hierarchical firms that could fully reap the potential economies of scale involved. Not by chance in this period did the average size of firms increase in most industrial countries (Storey, 1994). The high rate of growth of aggregate supply was absorbed by a high, and relatively steady, rate of growth of aggregate demand sustained by the gradual consolidation of the welfare state that progressively increased the share of public aggregate demand from 10-15 percent of the aggregate demand (according to the country) in the 1920s, to about 40 percent in the late 1960s (see, e.g. Boltho-Toniolo, 1999, table 2). In addition the rate of growth was stabilised by countercyclical Keynesian policies while income policies assured that the technological progress translated into growing real wages. The increasing welfare of workers therefore boosted private aggregate demand, absorbing the high rate of growth of the items of mass consumption made possible by Taylorism. The stabilisation of aggregate demand obtained through Keynesian countercyclical policies reduced systemic uncertainty to a very low level and encouraged investment in plants and machineries. The gradual liberalisation of foreign trade promoted by frequent GATT (General Agreement on Tariffs and Trade) rounds increased at the same time the export of manufacturing goods from industrialised countries. As a consequence of growth rates exceeding the productivity rate, the unemployment rate diminished throughout the period so that by the early 1960s most industrialised countries reached the full employment barrier. As lucidly anticipated by Kalecky in the early 1950s, the economic paradigm based on Taylorism and welfarism proved to be unsustainable in conditions of persistent full employment within the existing institutional and political framework. He claimed that in these conditions the increasing power of labourers and trade unions would have induced an inflationary bias in the system, and that a reduction in flexibility would have implied a reduction in the rate of productivity growth. In the late 1960s Kalecky’s prophecy started to materialise. Most industrialised countries hit the barrier of full employment by the early 1960s. This increased the number of unionised workers in large hierarchical firms and decreased the deterrence of firing, unemployment being almost exclusively frictional. This encouraged wage increases and the concession of further contractual

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improvements that increased unit labour costs inducing bouts of cost-push inflation.4 The effects of the ensuing deflationary policies triggered countercyclical policies that added demand-pull inflationary tensions nurturing further rounds of wage increases, and so on. Such stop-and-go policies neither succeeded in maintaining monetary stability, nor in keeping full employment as inflationary expectations progressively increased. Since these tensions hit industrial countries differently in terms of extent and timing, the Bretton Woods System based on fixed exchange rates underwent increasing tensions. The situation rapidly became non-manageable such that the Bretton Woods System broke down. In 1971 the President Nixon declared the inconvertibility of the dollar. This decision put an end to the system of fixed exchange rates introduced in Bretton Woods. With fixed exchange rates the whole system of global governance of the world economy established in Bretton Woods was questioned. The philosophy underlying the Bretton Woods agreements was clearly inspired by the conviction, originating in the economic turmoil of the period encompassing the two world wars and strongly consolidated by the Great Crisis of the 1930s, that local and global markets must be regulated. This was not only the opinion of Keynes, the intellectual ‘godfather’ of these agreements, and of the British delegation led by him, but also of White, the powerful chief of the US delegation. The final architecture of the international economic system rested on two fundamental pillars playing quite different, complementary, roles. The IMF was supposed to play a role of active macroeconomic stabilisation of the member countries, while the World Bank had to intervene in structural matters (poverty, infrastructures, economic take-off, etc.) The third pillar of Bretton Woods global governance was the coordinated set of policies meant to progressively liberalize trade between countries. This role was entrusted to GATT. However the process of liberalization of international trade was supposed to comply with the constraints put forward by other international agreements promoted by the UN and its main offshoots (UNESCO, OIL, WHO, UNEP, UNPD, etc) in order to foster social, humanitarian, health, and environmental goals. The decision on dollar convertibility of 1971 jeopardised the stability of the whole Bretton Woods architecture. It took about a decade before the international economic order could settle on a new equilibrium. The 1970s were difficult years characterized by bouts of inflation, increasing unemployment, and all the other typical characteristics of cyclical crises (falls in the stock exchange, sharp reduction in investment and growth, increase in bankruptcies, increase in systemic uncertainty, etc.) The crisis, however, lasted much longer than usual: it encompassed several business cycles that were shorter but more marked than in the two preceding decades. The cause of this anomalous behaviour is often ascribed simply to the two oil shocks occurring in 1973 and 1979, interpreted as purely exogenous factors. No doubt they had a great impact on the industrialised economies but they were partly endogenous and interacted with other important endogenous factors. In particular, the inflationary tensions accumulating at the end of the preceding period had greatly reduced by the early 1970s the terms of trade between oil (and other primary resources exported by

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developing countries) and the industrial goods and services imported from the industrialised countries. The sudden quadruplication of the price of oil decided by OPEC in 1973 was not only a political move in reaction to the Kippur war but also an occasion to re-equilibrate the terms of exchange between industrialised countries and producers of commodities. In addition the suspension of the dollar convertibility in 1971 added the fear that the devaluation of the dollar could further worsen the terms of trade. The fall of the Bretton Woods regime in turn originated from the increasing inflationary tensions which had emerged in industrialised countries in the late 1960s. Since such tensions differed in timing and size in various countries, the tension on the system of fixed exchange rates became increasingly difficult to manage through official revisions of the exchange rates. We could therefore ante-date the beginning of the ‘long crisis’ (Vercelli, 1989) by a few years, more or less according to the specific country we have in mind. However the breakdown of the Bretton Woods system is a convenient conventional divide since it has the advantage of being a crucial event that affected all the industrialised economies, convincing most decision makers that the way out of the crisis had to be actively searched not within the framework of the preexisting policy paradigm as in the 1950s and 1960s but in a different direction. In particular this event, that amounted to a complete deregulation of the currency exchange market, also heralded a crucial characteristic of the new economic paradigm: the systematic deregulation of markets. Market deregulation started to be universally considered as a recipe to be applied to all sorts of problems. However only in 1979 with the government of Mrs.Thatcher did a systematic strategy of deregulation start at the domestic level. This example was soon imitated in the USA by President Reagan, appointed in 1980, and then spread progressively to the other industrialised countries. In the meantime, in the 1970s the industrial economies had reacted to the crisis by modifying their industrial structure. In the new environment with its intense industrial conflict, sudden unexpected fluctuations and strong systemic uncertainty, the Taylorist organisation of industry proved soon to be inadequate. This led to the demise of the traditional assembly line, to the decentralisation of production in smaller plants and\or the externalisation of many phases of the productive process in favour of small and medium enterprises (SMEs). As a result of such developments the share of employment in SMEs that had declined progressively in the 1950s and 1960s changed direction in the 1970s and continued to grow throughout the 1980s and 1990s (see e.g. Storey, 1994).

27.3

Monetarist Growth and the Rise of Market Fundamentalism (1980–2000)

Most industrialised countries reacted to the first oil shock in the traditional Keynesian way by lowering the interest rate and increasing public expenditure in order to sustain employment. However, in the new scenario with its supply-push

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inflation, this policy aggravated the problems, producing more inflation and increasing the public deficit towards unsustainable levels. The simplistic so-called Keynesian stance inspiring policy in those years failed to realise that the economic crisis hitting industrialised countries was completely different from that of the 1930s that originated Keynes’s own approach, as the macroeconomic disequilibria (monetary, budgetary, balance of payments, unemployment itself) were now brought about by excessive, rather than insufficient, aggregate demand. Therefore the most common initial reaction to the failures of the traditional Keynesian policies was explored in the direction of more ambitious versions of traditional policies (fine tuning, huge public expenditure programmes, etc.) that failed to redress the situation (see Boltho and Toniolo, 1999). In time, industrialised countries reacted to the second oil shock in a completely different way by adopting strict monetarist policies. This was a crucial turn around since from then on economic policy in most industrialised countries substantially adopted and maintained a, more or less rigorous, monetarist inspiration by prioritising strict control of monetary stability and the elimination of public deficit rather than the mitigation of structural unemployment. In addition most industrialised countries started to privatise public economic activities and public services systematically. After the election of Mrs. Thatcher (1979) Britain was the first country to frame this new policy within the radical project of a systematic dismantling of the welfare state. It was soon imitated by the Reagan administration (in charge since 1980) and then by most industrialised countries, albeit differing in timing and detail. These policies contributed to recover macroeconomic stability by curbing inflation and reducing the primary public deficit. However, as a result, in the 1980s the real rate of interest in industrialised countries became exceptionally high, increasing public debt in some of them (like Italy), while the average rate of growth remained rather moderate leading to creeping increases in unemployment. As a consequence of the new policy, technological and organisational decentralisation gradually consolidated and spread a new economic paradigm whose hallmarks were Deregulation and Flexibility (from now on the DF economic paradigm). The two basic tenets of the new paradigm were flags waived respectively against Welfarism and Taylorism, and – more in general – against the previously dominant Keynesism. However, sound Keynesism would be perfectly consistent with technological and organisational flexibility, although not with indiscriminate flexibility in labour markets. On the contrary, in the new policy approach, deregulation was taken to mean flexibility in all markets, including labour markets. Moreover flexibility in labour markets and industrial relations implied a shift of power from employees and their trade unions to the employers, while deregulation implied a shift of power from the electorate and their political representatives to managers and entrepreneurs. The transition towards the DF paradigm in national economies was accompanied and favoured by a parallel transition towards neo-liberal globalisation. The three pillars of global economic governance sharply changed direction in the early 1980s, abandoning the original Keynesian orientation in

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favour of monetarism and market fundamentalism. In particular the IMF stopped worrying about over-restrictive policies of member countries identifying in inflation the main evil to be tamed. In the early 1980s also the WB aligned on the neo-liberal line.5 The new active macroeconomic policies were reduced to deregulation and privatisation in the simplistic conviction, based on market fundamentalism, that once property rights are well defined and attributed to private subjects, unfettered markets are able to maximise welfare and eventually relaunch and sustain growth. This new global policy stance was christened the ‘Washington consensus’ (see, e.g., Chomsky, 1999; Stiglitz, 2002), i.e. policy approved by the Washington-based IMF, WB, and the US Treasury.6 The original complementarity between the IMF and the WB was progressively replaced by a sort of hierarchical subordination of the WB to the IMF that in turn typically acted in agreement with the American Treasury (Stiglitz, 2002). After 1981 the WB de facto accepted this asymmetrical link since it agreed to grant its structural adjustment loans subject to the approval of the IMF.7 The rationale for this dependence was apparently based on the recognition of the influence of structural policies (under the jurisdiction of the WB) on macroeconomic stabilisation policies (under the jurisdiction of the IMF). However in this way the feedback of macroeconomic policies on the structural features of the economy was completely disregarded. This led to the implementation of macroeconomic and structural policies in developing countries that involved negative, often dramatic, structural consequences such as sharp increases in persistent unemployment, poverty and inequality, and rapid deterioration in environmental and social conditions (ibid., 2002). The conditions imposed by the IMF on macroeconomic (and indirectly structural) adjustment loans to countries in a critical financial situation were deregulation of markets, privatisation, and budgetary austerity in the adamant conviction that these measures were necessary and sufficient conditions to stabilise the single economies and the world economy. However the rapid deregulation of markets in countries lacking the necessary institutions for regulating their activity (efficient legal system, effective antitrust authority, safety nets for the unemployed and the poor, etc.) brought about more unemployment, poverty and corruption without increasing the average wealth of the country. In particular, excessively rapid lifting of the trade barriers in developing countries produced the destruction of emerging local industry. In addition industrialised countries often pushed developing countries to eliminate trade barriers but did not dismantle their own barriers (e.g. in agriculture, farming and textiles). In addition the premature and too rapid liberalisation of capital markets greatly contributed to global instabilities triggered by the sudden vagaries of huge sums of “hot money” of investors and speculators exhibiting increasingly pronounced herd behaviour (Shiller, 2000; Vercelli, 2003). This was considered the single main cause of most recent financial crises including those of Far-Eastern countries in 1997–98 and Argentina in 2001 (see, e.g., Stiglitz, 2002). In order to avoid these catastrophic events it is not at all sufficient to develop the strength of markets through an indiscriminate process of privatisation. Many

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recent examples of rushed programs of privatisation strongly supported by the IMF without preparing the necessary conditions for their success (efficient legal system and regulation of markets) have led to economic and social disasters: ‘briberisation’, private monopolies, higher prices and lower quality of goods and services provided (Russia is a particularly impressive case in point: see Stiglitz, 2002). Finally, budgetary austerity was often imposed on countries already suffering from insufficient aggregate demand, further increasing unemployment and reducing growth. The beggar-thy-neighbour policies that greatly contributed to the birth and persistence of the Great Depression were replaced by ‘beggar-thyself’ policies that had similar catastrophic effects on the countries adopting them and on the world economy through spill-over effects. Summing up, the mistake made in the 1930s of reacting to economic depression caused by insufficient aggregate demand through deflationary measures was resumed under the aegis of the Washington Consensus after the brief interlude of Keynesian policies in the 1950s and 1960s. This produced new set-backs: financial crises (Mexico, the Far East, Brazil, Russia, Argentina), growing unemployment (in particular in Russia and Argentina), an increase in poverty in all the above cases and in most areas of the globe (with the only exception of far-east Asia; see Collier and Dollar, 2002; Vercelli, 2003). These acute crises were not greater only because the G7 countries, unlike in the 1930s, did not follow the same policy. In particular the USA throughout the period reacted to the first signs of recession with extreme energy by reducing the discount rate and engineering expansionary policies (in particular the FED governor Alan Greenspan was extremely successful in this game before September 11).8 However it is not clear, and not explained by neo-liberal supporters, why economic policy should adopt this double standard. From the early 1980s onwards, the humanitarian and economic transfers to developing countries fell sharply while the deregulation of international markets was pursued with increasing energy. In particular the GATT Rounds accelerated their action to establish free trade at the world level. This action was particularly successful with capital flows. This brought about an extraordinary increase in the size of international capital flows with a progressively growing share motivated by speculative goals: in 1971, 90 per cent of international financial transactions concerned the real economy (foreign direct investment) and only 10 per cent was speculative (short positions in foreign securities), while at the end of the 1990s more than 95 per cent was speculative. The internationalisation of economic and financial markets, interrupted and to some extent reversed in the period between the two world wars, was resumed after the second world war and continued from then on reaching and, in some cases, surpassing the level reached at the end of the 19th century. This process was favoured by a series of eight GATT Rounds that managed to reduce to some extent the tariff and non-tariff barriers to trade.

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The Uruguay round, starting in 1984, progressively introduced and enforced a new philosophy of deregulation of international markets fully consistent with the neo-liberalist tenets. This process culminated in 1995 with the establishment of the WTO, a new international organisation with the mission of deregulating not only the traditional markets for goods and capital, but also the new markets for services, intellectual property rights, etc. With respect to the previous situation, the new arrangement might even create benefits for developing countries. In particular, it had the authority, lacking within the GATT agreements, to apply sanctions to G7 countries including the USA for barriers to trade towards developing countries. Indeed in a few cases these countries were effectively sanctioned by the WTO. However on the whole the activity of the WTO was carried on in such a way as to sweep away many environmental, health and humanitarian constraints introduced by nation states, international organisations (such as UNEP, ILO, WHO, UNESCO, etc) and even by international agreements ratified by the countries that participate in the WTO itself. In fact the humanitarian, environmental, social and health constraints to trade were often interpreted as non-tariff barriers to trade that could not escape severe sanctions (see Wallach and Sforza, 1999; Esty, 2001). This new philosophy of management of international trade further consolidated free trade and increased the rate of growth of the participating countries. Yet at the same time it contributed to a further progressive worsening of global income inequality and the environmental health of the planet.9 This raises the question whether the neo-liberal view of development may be considered sustainable in the long run. The answer must be negative because it violates the two basic conditions of sustainable development: the environmental condition of a substantial preservation of the global environment and the social condition of sufficient equity in the distribution of income, wealth and use of resources (see Borghesi and Vercelli, 2003 and Vercelli, 2002). The way out may be found only by further updating the updated liberalism of Keynes and Pigou.

27.4

The Co-evolution of Economic Thought: Three Types of Liberalism

The structural evolution of industrial economies was accompanied by a parallel evolution in the cultural and scientific sphere. We are not going to discuss on this occasion to what extent one evolutionary path affected the other. However, casual observation suggests that the complex process of causation went both ways. In this essay we restrict our analysis to the evolution of liberalism in economic thought and its interaction with the evolution of events and policies. Traditional liberalism, as codified by the great classical economists (Smith and Ricardo) at the end of the 18th century and developed by their followers (in particular John Stuart Mill and Marshall) in the 19th century, underlined the virtues of free markets but never forgot their limits. The founding fathers of classical liberalism were fully aware of the crucial importance of a thorough analysis of the limits of markets in order to understand where they had to be

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supplemented by the intervention of the state.10 The legal system, education, defence and the health system are examples of services that the market was not believed to be able to provide efficiently and reliably and that had to be provided by the state. The liberal tradition dedicated much effort to careful definition of the limits of markets and of the best way to cope with them through public intervention. In the beginning the main focus was on the forms of competition. It was soon clarified that only ideal markets of perfect competition possess the virtues of optimal static allocation of resources and that in an unregulated market monopolistic and oligopolistic situations tend to emerge and consolidate spontaneously. This calls for some sort of market regulation able to prevent such degenerations from occurring. The model of general equilibrium elaborated since the early 1870s by Walras and Pareto further clarified another crucial limit of the markets. A perfectly competitive market is unable by definition to solve the distributional problems since the distribution of wealth and resources is given in each period described by the model. In the multiperiod version of the model the distribution of income is to some extent endogenised but its actual path depends on the initial distribution of resources and wealth and there is no tendency whatsoever to assure the convergence of this path to some sort of acceptable level. Typically unfettered markets increase inequality and only vigorous redistributive policies may improve the status quo (see, e.g. Vercelli, 2003). Economic policy therefore cannot avoid tackling distributive problems and intervening to assure acceptable distributive standards. Hence updated liberalism introduced income policies meant to preserve a fair distribution between profits and wages. Its practical implementations were much criticised but their foundations were, and still are, absolutely sound. In the 1920s and 1930s two crucial steps forward were made to understand the limits of competitive markets and the way to remedy them. Pigou, in his epoch-making book The Economics of Welfare (1920), elaborating on ideas sketched by Marshall, his academic mentor, clarified a fundamental reason for the existence of market failures: the existence of economic externalities, i.e. costs or benefits that cannot be registered by the market. He pointed out at the same time how to remedy them in principle (internalisation of externalities through subsidies or taxes). Pigou thus provided the microeconomic foundations for welfare economics and for the establishment of the welfare state previously supported with passion but weak foundations by political figures such as Lord Beveridge and political movements such as the Fabian Society. A few years later Keynes in the General Theory (1936) provided the macroeconomic foundations of a theory of market failures and of the macroeconomic policy required to mend them. These two fundamental contributions were in a sense complementary and were later on merged in a model of updated liberalist regulation (called in this essay updated liberalism) that spread after the second world war up to the 1970s.11 Its success was fostered by the soaring power of trade

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unions in the 1950s and 1960s as the growth of big firms increased the union base and diminishing unemployment increased their strength. Subsequent research clarified that there are further important reasons that distinguish real markets from ideal ones and require active regulation. In particular, a competitive market ensures the optimal allocation of resources among alternative uses only under very stringent assumptions underlying the abstract model of perfect competition, namely: completeness of markets, zero transaction costs, absence of serious uncertainty that is guaranteed only when the agents have perfect foresight or rational expectations, sufficient thickness and extension of markets that is assured in principle only when the number of traders tends to infinity, dynamic and structural stability of markets. The trouble is that real markets never comply with all these conditions. On the contrary very often they fail to comply with most of them. This is particularly true in developing countries. However, in principle, the process of globalisation could push the real markets closer to the abstract model of perfect competition; therefore it improves the economic and financial efficiency of markets by enhancing their extension and thickness (Vercelli, 2003). However the allocation of resources of unregulated global markets cannot be considered optimal for a host of reasons. First of all the uncertainty intrinsic in the working of the markets raises serious problems because it is often endogenous and\or inconsistent with the usual axioms of decision theory under uncertainty. It implies that the expectations of economic agents are in general neither correct nor rational (see, e.g., Shiller, 2000, Vercelli, 2002). Moreover, when information is imperfect or asymmetric, competitive equilibrium is not Pareto-efficient (Greenwald and Stiglitz, 1986). In addition markets are incomplete; in particular most future markets are missing and cannot be easily established. What is worse, it can be proved that in principle markets cannot be made complete, in particular as far as future markets are concerned; in any case, the optimal intertemporal allocation of resources cannot be realized by real markets even if they are relatively competitive because, since future markets are missing, the more expectations refer to the distant future the more they are liable to be systematically incorrect. Also transaction costs are often quite sizeable. In particular the costs necessary to match demand and supply may involve significant material costs, such as travel costs, or immaterial costs, such as those involved in the gathering and elaboration of information about the relevant characteristics of potential demand and supply. Their existence is sufficient to jeopardize the ability of a competitive market to achieve the optimal allocation of resources (see Arrow and Hahn, 1999, for a recent assessment of the problem). Externalities are particularly important in real markets because incomplete markets by definition cannot register all the costs and benefits of economic decisions, and because the property rights on goods and resources are not always well defined, as is typical with many environmental resources such as the global commons (water, air, biodiversity, etc.)

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There are in addition a few important markets that are fairly unstable from three different points of view. Competitive markets tend to be institutionally unstable in the sense that they tend to lose their competitive nature as a consequence of the exploitation of scale and scope economies, or of discretionary power in disequilibria, or of monopolist and oligopolist practices. In addition markets may be dynamically unstable in the sense that they do not recover their equilibrium position easily whenever they are displaced from it by a shock. Finally markets may be structurally unstable in the sense that a small shock may alter the qualitative characteristics of their dynamic behaviour.12 We must conclude from the above arguments that for sound reasons global markets cannot be left unregulated. Their active regulation is necessary for maintaining and perfecting competition, improving the intertemporal allocation of resources, reducing uncertainty and mitigating its effects, internalizing externalities. In addition, as argued above, the distribution of resources, income, and wealth cannot be left to unregulated global markets because even perfectly competitive markets cannot assure their fairness. Of course, if market failures require some amount of regulation, the failures of regulation are no less harmful. Both experience and the theoretical analysis of bureaucratic and political processes have shown that regulatory failures are systematic and may be even worse than market failures. In addition the failures of regulation are much more visible than market failures that they are supposed to mend. The disillusionment on the efficiency of regulation has been so strong that an irrational faith has spread, particularly since the 1970s, in the power of unregulated markets. The ensuing process of deregulation has been successful in dismantling many degenerated forms of regulation and must go on to this end, but in a few cases it has gone too far, also dismantling the necessary forms of regulation such as those that set environmental, health, humanitarian and ethical standards. In addition the relationship between regulators and regulated agents has proved to be a sort of evolutionary game: the regulated agents always try to elude the rules set by the regulators who must therefore continuously update them. Therefore a continuous process of re-regulation must accompany the process of deregulation meant to dismantle obsolete or inefficient rules in order to introduce the most efficient minimal necessary rules in the evolving context. However, the mistrust in regulation has gone so far as to cloud the need to regulate the markets. Of course market regulation must be kept to a minimum in order to avoid as far as possible the disruptive potential of regulation failures but cannot be altogether absent. Finally we wish to emphasize that the same reasons that cause the failures of state regulation lead to no less disruptive failures in deregulation (Russia is a case in point: see Stiglitz, 2002). The prophets of the neo-liberalist counter-revolution ignored the arguments on the limits of real markets accumulated not only by updated liberalism but also by classical liberalism that demonstrated the necessity of active regulation of markets in order to maximise their contribution to social welfare. In this essay I limit

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myself to briefly examining the crucial contributions of three of the most important founding-fathers of neo-liberalism. The microfoundations of the neo-liberalist stance was originally suggested by Coase (1960). He did not deny that real markets are subject to failures but in his opinion this happens whenever property rights are not well defined, as in the case of environmental commons. Therefore the remedy suggested was quite different from that of updated liberalism. This new explanation was not seen by the neoliberal followers of Coase as an additional explanation of market failures, that could well be considered consistent with those pointed out by updated liberalism, but as the ultimate cause of observed market failures that in principle substitutes all the other explanations analysed by both classical and updated liberalism. To the best of my knowledge, the reason why the other causes of market failures were ignored by this stream of thought has never been spelled out with thorough scientific arguments. This extremist interpretation13 of the Coase approach led to a very simplistic policy rule vis-à-vis the regulation of markets: ‘let’s define property rights on all the goods, including public goods (such as, e.g., environmental goods, global commons, etc). The unregulated markets will solve by itself all the other problems’. This was a very radical departure not only from updated liberalism but also from classical liberalism. All the areas reserved to the state by classical liberalism, including education, are now considered in principle as better manageable by unregulated markets. In addition, one particular aspect of the Coase theorem – it does not matter to whom property rights are attributed (rich or poor, polluter or polluted, etc.) - was interpreted as if distributional problems were immaterial for social wealth. Friedman suggested macroeconomic foundations against updated liberalism from the early 1950s onwards by arguing that countercyclical policies are harmful for the economy, at least in the long run, as they tend to increase the structural inflation rate and the natural rate of unemployment (see e.g. Friedman, 1969). His approach shares a few aspects of the dynamic methodology of Keynes and Pigou descending from the influence of Marshall,14 that focuses on the crucial role of disequilibrium dynamics, but this is turned against Keynes. The main argument is that the Keynesian attempts to stabilise the economy are bound to increase its instability by nurturing increasingly inflationary expectations. However the whole argument is based on severe undervaluation of the intrinsic instability of unfettered markets in a sophisticated monetary economy (see e.g. Vercelli, 2000, and the literature therein cited) A few years later Lucas provided different, and much more radical, macroeconomic foundations to the neo-liberal stance: the existence of a perfectly competitive equilibrium is just assumed. Provided that the model based on this assumption mimics reality sufficiently well, all the deviations from the perfectly competitive paradigm (disequilibrium, oligopoly, monopoly, etc.) are considered as irrelevant for economic analysis (see Vercelli, 1991). Under these assumptions Lucas proved that what is generally defined as Keynesian anticyclical economic policy is impossible, or at least fully unreliable, as it is disturbed in an

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unpredictable way by the structural instability of a monetary economy and is bound to increase structural uncertainty. Lucas argues that disequilibrium concepts, such as unemployment and out-of-equilibrium dynamics are meaningless so that he remains without any method for detecting market failures and remedying them. Friedman advocated a fixed monetary policy and systematic deregulation. Therefore in this view the only structural intervention considered sound was privatisation. Lucas does not rule out some scope for further structural policies that increase the efficiency of free markets, but both deny any scope for active regulation of competitive markets. Since the late 1970s the macroeconomic school of new classical economists inspired by Lucas has ousted both the Keynesian school and Friedman’s monetarism as the mainstream school in macroeconomics, fully consonant with the contemporaneous rise of neo-liberalism. As we have seen in the above brief analysis of the contributions of three of the most important prophets of neo-liberalism, departure not only from the updated liberalism of Keynes and Pigou, but also from the classical liberalism of Smith and Ricardo, was very radical. Active economic regulation was completely ruled out. In this view deregulation and privatisation must characterise a transition period towards the golden age of unfettered, perfectly competitive, free markets. The main role of the state remains that of defining and defending property rights. If we seek a precedent after the revolution of classical economists we have to refer not to their genuine followers but to Say, Bastiat15 and the other economists that Marx, impolitely but not without reason, called ‘vulgar economists’.

27.5

Concluding Remarks

The basic thesis argued in this essay is that the long crisis of the 1970s produced a crucial redirection in the path of structural change in industrial economies by replacing the pre-existing economic WT paradigm with a new DF paradigm and replacing at the same time the updated liberalist regulation of markets with neoliberal deregulation. This interpretation is by no means the usual one, as it has to compete with at least two alternative hypotheses that have many supporters. Many observers believe that it is artificial to detect general diachronic structures in historical evolution and see a fundamental homogeneity in the evolutionary process apart from exogenous shocks (see, e.g., Lucas, 1981). We have mentioned elsewhere a few good reasons for rejecting this point of view (Vercelli, 1991 and 2002). The other point of view that we have to mention here was, and is, very popular and greatly contributed to the rise of the neo-liberal approach and now contributes to its consolidation. In this view the Keynesism that spread after the second world war up to the 1970s is seen as a deviation from sound liberal principles as it led the policy authorities to impose growing constraints on the market, restricting its scope and therefore its ability to regulate the economy. Thus, in the neo-liberal view, the

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counterrevolution that has spread since the late 1970s is interpreted as the healthy restoration of traditional, supposedly sound, liberalist principles. However we have seen in the previous section that the market fundamentalism that characterizes neoliberal thought and policies has nothing to do with classical liberalism and that on the contrary the ‘Keynesian’ paradigm, based on seminal works such as The General Theory by Keynes and The Economics of Welfare by Pigou, was nothing but a further step in the evolution of liberalism. Of course the actual applications of both paradigms in industrialised countries are full of inconsistencies. Anticyclical policies were abused, particularly since the late 1960s, ignoring the constraints of basic monetary stability that Keynes never ignored. In general the intervention of the state in the economy went far beyond what Keynes and Pigou would have considered sound, both in size and method. A reaction to these degenerations became necessary in the 1970s, and to some extent monetarism, supply economics and systematic deregulation went for a while in a sensible direction, that even Keynes and Pigou could have approved of. Analogously the actual applications of neo-liberal regulation were not at all consistent. The abuse of anticyclical policies continued, although they were now openly orientated towards the interests of business rather than of workers. The corruption and conflicts of interests that accompanied the growing role of the state in the WT liberalism changed nature but did not diminish. Pensions in the WT liberalism were jeopardized by the growing debt of the state, while in the neoliberal era they were threatened by the unstable market value of Pension Funds recently shaken by the stock market crisis nurtured by bankruptcies and conflicts of interests. Of course the reconstruction of a diachronic structure requires a strong simplification of reality in order to discern a few essential patterns from the chaotic, and apparently contradictory, noise of raw empirical evidence. In particular we have to stress that classical liberalism, updated liberalism and neoliberalism coexisted in both periods. In what we have called WT growth, in the beginning the classical liberal approach was still dominant, while a sort of prodromic neo-liberal approach (traditional laissez-faire) was not at all absent but lacked sound foundations. However this period was characterized by a progressive strengthening of updated liberalism that officially took over economic policy, starting with the Labour government of Wilson in 1964 in the UK and the Democratic administrations of Kennedy (1960–63) and Johnson (1963–68) in the USA under the banner of ‘new economics’. The other industrialised countries followed their lead. For example, Italy officially adopted a Keynesian policy only with the centre-left government in 1962, although the preceding governments supported by coalitions led by the Christian Democratic party pursued a sociallyconstrained liberal policy under the influence of the social doctrine of the Catholic church rather than of Keynes and Pigou. By the same token, in the PF growth period updated liberalism retained much of its influence. A case in point is the emergence and development of environmental policies. They were inaugurated only in the 1970s and were mainly

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inspired by the Pigouvian approach. Only with the Bush administration was there outright rejection of the Pigouvian approach in favour of a Coasian approach more consistent with the neo-liberal drive. On the other hand left-wing governments tried on many occasions to resume in part the basic idea of updated liberalism (e.g. under the Carter and Clinton administrations in the USA, under the Prodi government in Italy, the Jospin government in France, and so on). However, notwithstanding these political fluctuations, since the early 1980s on the whole updated liberalism has declined while neo-liberalism has progressively increased its influence also with left-wing parties and governments. (A case in point is the policy of the Blair Government strongly influenced by neo-liberal ideas.) This change of direction is visible by comparing the actual policies realised before and after the long crisis of 1970s. By the early 1980s deregulation, privatisation, dismantling of the welfare state, and so on, were pursued with increasing determination by most governments in industrialised countries. It is not the purpose of this essay to discuss whether there could have been better ways out of the serious problems that affected the industrialised economies at the end of the Millennium. However it is by now quite clear that neo-liberalism was unable to provide the much needed remedies to market and state failures and is likely to aggravate them further because by definition it cannot tackle the causes of market failures as their existence is denied in principle. The neo-liberal approach seemed successful for a while because it reacted to the abuses of updated liberalism in a direction that to some extent was compulsory (stabilization of monetary and budgetary policy and check to the excessive interference of the state on the economy). But the way in which this was done and the further steps taken afterwards could have been different, for example tackling the causes rather than the symptoms of economic disease. This could be done by resuming the physiological evolution of liberalism as updated by Keynes and Pigou. Of course also their contribution should be updated in the light of the historical experience in the second part of the last century. Notes *

1

The author would like to thank Alessandro Roncaglia, the other participants in the conference on ‘Moneta, credito e ruolo dello stato. In occasione del settantesimo compleanno di Augusto Graziani’ (Napoli, 2–3 May 2003), and an anonymous referee for helpful comments and suggestions. The assertions and arguments of the paper refer to the G7 countries with the exclusion of Japan (i.e. the USA, the UK, Germany, France, Italy, and Canada). Japan, like other industrialised countries excluded from our reference group, is also affected by the tendencies underlined in this paper but these interact with peculiar cultural and institutional features. Of course also the other industrialised countries have peculiarities that we cannot mention in this paper; however we believe that a thorough analysis of their impact, fully absent in this paper, would add very important qualifications to the arguments developed herein without jeopardising their substantial soundness.

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What we call here first-order science (research) has in turn a hierarchical structure, but the prevailing criterion of division of labour is vertical, i.e. based on the specificity of subjects, rather than horizontal, i.e. referring to a hierarchical layer (a case in point is the classification adopted by the J.E.L.). Therefore, for the sake of simplicity, we ignore here the hierarchical structure of current science (research) calling it first-order science (research). Of course, we may find in it fragments of what we call higher-order science (research) that we implicitly hive off to the latter. On these methodological points see Vercelli (1999 and 2002). 3 As is well known the school of Freeman introduced the notion of technological paradigm (see Dosi, 1984) building upon the notion of scientific paradigm introduced by Kuhn (1970). We use the concept of economic paradigm in order to extend the concept beyond technological aspects, encompassing also the organisational and institutional aspects of the mode of production and distribution of goods and services (Vercelli, 1989). 4 The recognition of this causal nexus does not imply that the blame for rising inflation and the ensuing breakdown of the Bretton Woods system should be laid on workers or trade unions. The expansionist monetary policy that immediately followed a wage rise beyond productivity growth in order to save profits was another necessary link of the causal chain. In any case the problem could have been solved, and could be solved, through systematic adoption of a participatory method involving far-sighted agreement between the social parts. Unfortunately the income policies implemented in the late 1960s and 1970s did not succeed in obtaining these results. Their failure resulted in the unwarranted conclusion being drawn that the updated liberalism of the 1950s and 1960s was not viable and had to be substituted by a different economic paradigm. 5 We may identify a clear-cut conventional date for this turnaround. In 1981 Robert MacNamara, president of the WB since 1968 and the chief of economic research Hollis Chenery who had acted according to the updated liberal stance, were abruptly replaced respectively by William Clausen and Ann Krueger who began to act according to the neo-liberal doctrine. 6 This expression that became very popular with both experts and mass-media has two alternative meanings: either ‘international consensus coalesced in Washington’ or ‘consensus forced by Washington (i.e. the US Treasury)’. The second is strictly related to early worries expressed by Keynes himself when the decision was taken, against his opinion, of locating both the IMF and WB in Washington. He forcibly opposed the lastminute decision of the USA to transfer the head office of these institutions from New York to Washington. He observed in particular that the location in New York of these institutions would have the advantage of assuring a better link with the UN and the international financial community while shielding them from the excessive influence of the US government and Congress (see Harrod, 1951, chap. 15). 7 Recently there was a serious attempt by the WB, under the influence of Stiglitz appointed chief economist in 1997, to recover its original autonomy resuming an approach based on a further updated liberalism based on a full awareness of the limits to markets, but after only three years he was forced to resign (see Stiglitz, 2002). 8 However, it is now clear that he was definitely ‘too successful’ on the occasion of the long speculative bubble of the new economy that was inflated also by his permissive attitude. 9 In most OECD countries the indexes of inequality slightly diminished in the Bretton Woods era (1950s and 1960s) but have increased progressively since the early 1980s (see in particular Brandolini, 2002 and the comments in Vercelli, 2003). 10 In particular Adam Smith developed these themes in chapter 2 of book 4 of the Wealth of Nations (Smith, 1776), while Stuart Mill dedicated to them chapters 8–11 of his

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11

12 13 14

15

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Principles of Political Economy (1848), the most influential 19th century economic textbook in Britain. There can be no doubt that these fundamental contributions of Keynes and Pigou were fully consistent with the basic tenets of classical liberalism. Not by chance both elaborated ideas already present in germinal form in the works of their common master Marshall. The potential complementarity of these two contributions was not recognized by the two protagonists partly due to personal reasons (possibly a Freudian jealousy between the best pupils of the same master) and partly due to methodological reasons (acceptance by Pigou and rebuttal by Keynes of the General Equilibrium approach) although the latter difference was considered by some followers not insurmountable and was soon somehow mended by the founders of the neoclassical synthesis (Hicks, Samuelson, Modigliani, Patinkin).We do not discuss here to what extent this suggested synthesis was realized in a satisfactory way (the critical opinions of the author are expressed in Vercelli, 1991). See Vercelli (1991) for a discussion of the different concepts of instability. We have to stress that this interpretation is highly misleading as it ignores the full argument of Coase (1960) and its qualifications. See on this Pagano (2000). If we define Keynes and Pigou as ‘left-wing’ Marshallian, Friedman may be defined as ‘right-wing Marshallian’. Indeed, he accepts the partial equilibrium approach and the need to analyse disequilibrium positions and paths. However, he assumes an instrumentalist epistemological stance in contrast with the requirement of realism of the hypotheses underlined by Keynes. The latter aspect of Friedman’s vision prepares the ground for the rise of the new classical school. In particular Say believed that unfettered competitive markets are also able to realise the fair distribution of incomes, a thesis that was definitely swept away by the General Equilibrium theory. In addition he believed that we should not worry about unemployment because an excess supply of labour force would push wages below the subsistence level, thereby eliminating the problem. Also this cynicism is not altogether absent in the neo-liberal approach (see Stiglitz, 2002, for a host of examples).

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