The Misleading Issue of the Non-Neutrality of Money

The Misleading Issue of the Non-Neutrality of Money:

The Theory of Unemployment in the Monetary Economy

Alain Parguez

Professor of Economics

University of Besançon

France

A first version of this paper has been presented at the

Conference on Monetary Theory - Free University of Berlin 23-26 March 2001

I have to thank for their useful comments

Victoria Chick, Augusto Graziani and all the participants. The usual disclaims apply.

The False Non Neutrality of Money Theorem:

Money cannot be the cause of unemployment

According to the most recent review of the debate between Post-Keynesians and Circuitists (Fontana 2000) both agree on the non neutrality of money, but they disagree on the role of money underlying its non neutrality. Post-Keynesians following the Davidson’s tradition emphasize the reserve of wealth aspect on money which is rooted into the fundamental uncertainty. The ubiquitous threat of uncertainty leads economic agents to hold in money a share of their wealth which shrinks aggregate demand by squeezing spending. Herein, is the cause of the shortage of aggregate demand imposing a permanent constraint on employment. Circuitists would put the means of payment aspect of money because they ignore or just pay a lip service to fundamental uncertainty. If there were no hoarding and, therefore, a permanent circuit equilibrium the so-called perfect circuit closure, unemployment, would not exist albeit special assumptions could be integrated to the circuit model. When uncertainty is not ignored, liquidity preference rules and workers hoard a share of their savings in money which breaks the circuit. Being short of money in the reflux phase, firms are obliged to squeeze labour in the future. Circuitists could not escape from the alternatives: either they deny hoarding and fail to explain unemployment or they take care of the non neutrality of money and they restore the store of wealth function as the true nature of money. The fundamental theorem of the non neutrality of money could, therefore, be spelled out.

The sine qua non condition of the non neutrality of money is uncertainty which explains the store of wealth aspect of money as the true nature of money. Since a neutral money is nothing but the pseudo money of neo-classical economics, uncertainty is the existence condition of money.

Unemployment is the benchmark of a non neutral money economy; money is, therefore, the existence condition of unemployment. Davidson has explicitly spelled out this proposition which according to Fontana, ought to be the cornerstone of a synthesis encompassing Post-Keynesians and Circuitists. It is just a reestablishment of Keynes’ theory of money at least in the general theory. For Keynes, unemployment exists because of the indomitable liquidity preference of Capitalists animated by their fear of an uncertain future. They hold a share of their wealth or capital in money, which forces the adjustment of the required rate of profit to the money rate of interest which is itself endogenously determined. The rate of interest always adjusts the scarce stock of money to its desired level reflecting the degree of liquidity preference. Since there is an inverse relationship between the desired stock of capital and the targeted rate of profit, an inverse relationship connects the level of investment with the rate of interest. The multiplier principle being given, the Keynesian theory of unemployment is, therefore, embedded into the non neutrality of a money theorem.

Unemployment is imposed by too high a rate of interest that is the reflection of the lust for money. The very existence of money prevents the convergence of the rate of interest on its natural or full-employment level.

A corollary of the theorem is that unemployment does not exist in a moneyless economy. What is at stake is what can be deemed a non monetary economy. To fit the theorem it must be an economy in which money is not required because there is no uncertainty or because decisions takers are not aware or fully aware of uncertainty. In this economy, since money is not needed as a store of wealth, it is not even needed as a means of payment. Fontana is quite explicit on the non monetary nature of transactions in the economy bereft of a store of wealth money. Non monetary obligations between the non-banks agents, workers and firms, are substituted for monetary obligations of the same groups of agents that reflect the intermediation of banks. The non monetary economy is, therefore, a capitalist economy endowed with a Walrasian barter transactions structure. Herein, is the proof that the non neutrally theorem leads to a paradox:

Money is non neutral because it is perfectly neutral relative to the nature of the underlying economic system. It is not the sine qua non existence condition of the capitalist economy.

Since the capitalist economy is the Keynesian entrepreneur economy, Post-Keynesians of the Davidson’s pedigree are led to embrace a much narrower definition of money than Keynes himself -for whom the entrepreneur economy was the twin of the monetary economy.

The paradox contradicts the essentiality of money which is the cornerstone of the theory of the monetary circuit. Money is essential because it is the existence conditions of the capitalist economy. The non monetary obligations of firms and workers do not exist because in an economy bereft of money there are neither entrepreneurs nor workers having to hire their labour force to receive an income. The paradox encapsulates the obsessive reference to the impossible Walrasian barter economy that never existed as shown by all studies on the history of economic systems.

Money would be ultimately non neutral because it breaks the barter structure. Money being the by-product of uncertainty, unemployment would exist because uncertainty unravels the foundations of the barter system. Herein, lies the ultimate paradox:

History displays societies that were not monetary economies. Money did not exist because their economic structure did not need it [Parguez 2001 b]. Uncertainty always exists since it is embedded into the relationship between human nature and time. A society which is non monetary ought therefore to be monetary.

The reference to barter leads to a contradiction of which very few Post-Keynesians are aware, those at least of the Davidson school. Barter is both an impossible system and the logical system from which the nature of money is derived. The logical circle is completed. Starting from ideal barter, money is non neutral because it is the channel through which uncertainty generates unemployment. Rational agents use the device of money to neutralize uncertainty which should restore full-employment.1 The very non neutrality of money allows the convergence of the monetary economy on a quasi-barter system in which money is neutralized. Following this approach, Post-Keynesians are very close to those neo-classical economists, in the like of the Neo-Keynesians, who use money as some kind of super walrasian auctioneer monitoring the convergence on a quasi general equilibrium state.

Any reference to the impossible barter system must be suppressed, herein, is the cornerstone of a paradox-free theory of money. Money is non neutral because it is essential since it is the underlying existence condition of a specific economic system, the capitalist economy or the private property -led economy. Non neutrality of money must be assessed by comparing the capitalist economy to the non monetary economies that existed over time. An enlightening example of an economy bereft of money because it is not needed is the pure command economy of which the characteristics contradict those of the capitalist economy.

The Pure Command Economy / The Pure Capitalist Economy
1.The State owns all material resources / 1.Private property rules.
2.Free labour does not exist. / 2. Free labour exists.
3. Production is undertaken through direct orders of the State. Its purpose is the exaction of a real surplus from the working class. / 3. Production is undertaken by private firms and the State-Firms get access to labour and real resources they need through their expenditures financed by the creation of money by banks (Flux Phase). Their purpose is the realization of profit which is a part of their receipts out of which they payback banks (Reflux Phase). The State gets access to labour and real resources through its expenditures financed by the creation of its own money. Its purpose is the exaction of taxes in the reflux phase.
4. There is a State-decreed unit of account but no payments. / 4. Money is the set of liabilities that the State and banks issue on themselves. They are denominated in State-decreed units of account.
5. The surplus is divided into the consumption of the ruling class and the reproduction of the real capital fund. Savings bind investment. / 5. Savings do not bind investment.

The non neutrality theorem infers that money evolves only out of the choices of rational decision-takers searching for the best device to tame uncertainty. Hicks (1979) has explicitly endorsed this subjectivist explanation of the origin of money which is a restatement of the Mengerian theory of money denying any role to the State and objective constraints.

The non neutrality theorem contradicts, therefore, the essentiality of money. Money was always born in the wake of private property and the demise of the command power of the despotic state when a former non monetary economy collapsed. The new mode of production requires the existence of money. It is the State which complies with this objective constraint by starting to issue money for itself and endorsing banks’ liabilities. The monetarized State convinced society to use it as means of acquisition by imposing tax liabilities that must be discharged in money and the settlement in money of penal obligations imposed by courts. Banks’ liabilities are endowed with the nature of money because they are convertible in State money and are used to pay taxes and fines. They are, therefore, denominated in the State-decreed units of accounting wealth. In the long-run a specific money survives, a money denominated in a specific State unit, as long as society is certain that it complies with the requirements of the mode of production. Each temporary holder must be certain that money has a value, an extrinsic value, reflecting the creation of real wealth by firms and State outlays financed by the creation of this specific money.

Unemployment exists when holders of the labour force are rationed in terms of income by firms which are the private proprietors of the stock of productive real resources. Income rationing is both a shortage of available jobs and a wage squeeze. It is rooted in the fundamental inconsistency between income desired by holders of the labour force and income firms want to pay because it fits their profit target. Usually, firms’ required income is lower than labour force holders’ desired or required income. Herein, is the proof that unemployment, in the Keynesian and Post-Keynesian sense, cannot exist in a non monetary economy. It only exists in the capitalist economy that bestows on firms the power to determine employment and the wage-rate. Capitalism is indeed the monetary economy but it would be grossly misleading to explain unemployment by the role of money.

An Explanation of Unemployment

in a Monetary Economy

A/ Circuitist model of

the monetary economy 2

Firms determine the level of employment under three stringent financial constraints imposed by banks as leaders of the Rentiers Class.

Banks impose the rate of interest on their loans.

Banks cannot be passive suppliers of money because as long as there is no perfect socialization of credit, banks are Rentiers targeting some increase in their wealth out of their credit activity. Banks increase their wealth in any circuit period by an amount equal to the share of their net revenue on profit which is saved and therefore invested in the acquisition of stocks. Firms are obliged to sell a share of their equity to banks just to finance the deficit generated by banks savings (Parguez 200l b). Banks net revenue is the discrepancy between their gross income and their costs. Banks gross income is the sum of interest of new loans and the yield of their stocks which are firms outstanding stock of accumulated debt to banks. It is sensible to assume that Banks as Rentiers target the same rate of return on all their assets (new and past debts of firms), which implies that the rate of return on stocks, the so-called long-rate of interest, is instantaneously adjusted to the rate of interest on loans.

If we abstract from wage-payments, Banks costs are equal to interest income they pay to their own creditors who are savers holding perfectly liquid wealth, the so-called money held as a store of wealth. In a true monetary economy banks do not need liquid savings to create money. They just consent to comply with savers thirst for liquidity. They are therefore free to impose on liquid savers the rate of interest they want to meet their wealth target. Banks constraining power explains why they instantaneously adjust the rate of interest on liquid savings to the central bank own rate of interest. Central bank rate being the price of liquidity banks have to pay to be provided with reserves, it determines the price of liquidity banks impose on savers craving for liquidity.

Assuming that banks desired saving rate is equal to unity, their targeted accumulation of wealth reflects the net income they have to exact. Central bank rate being exogeneous, for a given stock of liquid savings and equity held by banks, the targeted rate of interest on loans is determined by banks targeted increase on their wealth. The higher the banks desired growth of their wealth, the higher must be, ceteris paribus, their targeted rate of interest.

Firms are obliged to pay the rate of interest which has been targeted by banks. There are no alternatives for firms, either they get money from banks to carry on their expenditures or they cannot spend at all and they do not exist anymore. In a true monetary economy, abstracting from State deficit and households net debt, firms can never accumulate money or rather liquid capital. Profits arise from previous outlays financed by banks creation of money and they are entirely spent to pay back the share of initial debt reflecting desired investment. Firms relationship to banks reflects labour-force holders (non-Rentiers household) relationship to firms. Firms desired or targeted wage-bill resulting from their targeted profit is the sole source of income and therefore of outlays for labour-force holders; which implies that labour-market cannot exist in a monetary economy. Firms are imposing on labour- force holders the level of income they want whatever could be the «rational» or desired consumption. For the same reason, banks as the leading component of the Rentiers class impose on firms the rate of interest they want and firms are obliged to take care of this rate of interest as a given or exogenous data. The effective or expressed demand for money by firms reflects the rate of interest and is instantaneously met by an equal creation of money; the so-called supply of money is always identical to the demand for money.

Banks create an amount of money equal to firms effective outlays, including interest on past debt, the wage-bill and investment, plus interest charged on new loans (Flux phase of the monetary circuit). In the reflux phase, firms sell equity to banks to pay back the debt reflecting interest on loans, which generates banks targeted accumulation of wealth.

Banks impose the minimum rate of return exacted by firms

In a monetary economy, firms exact a rate of return which is the ratio of their costs, the sum of the wage-bill and interest payments to banks and non-banks holders of stocks, to profits. The level of the rate of return reflects firms ability to catch a profit out of the payment of its costs and accounts for its efficiency. It is therefore a major determinant of the value of stocks. The higher the rate of return, the more stock-holders are ready to take buoyant bets on the future and the higher must be the value of stocks.

To attain their targeted growth of their wealth, banks must therefore oblige firms to maintain a minimum rate of return for a given targeted rate of interest. It is a credit worthiness norm to which firms must abide by to be granted loans. Like the rate of interest, the banks required rate of return is exogenous relative to firms.

Banks impose the price level

In a true monetary economy, nobody is affected by the neo-classical monetary illusion. As leader of the Rentiers class, banks want to maintain the real value of their wealth accounting for its implicit purchasing power in commodities. In any circuit period, there is therefore a unique price level fitting banks targeted growth of wealth which must be unchanged over time. It is part of the credit worthiness norm imposed on firms which means that were firms cheating banks by charging a higher price, they would be either short of credit in the future or they would have to pay a higher rate of interest and attain a much higher rate of return.

For a given targeted price level, banks determine the more suitable set of rate of interest and rate of return fitting their wealth target. As soon as banks believe that, beyond some level of the rate of interest raising it must induce a fall in assets value, they rely on an increase in the required rate of return when they want a higher growth of their wealth.