John Stuart Mill’s Monetary Theory

Mill's Monetary Theory and Excess Supply: Say's Law Reconsidered

Concerned with the attacks made on Say's Law by Malthus, Chalmers, and Sismondi, Mill refuted these criticisms in an article titled "Of the Influence of Consumption on Production. Mill defended Say's Law to counter the argument of many underconsumptionists that the economy would be better off if the wealthy saved less and spent more on unproductive consumption. His defense was not equaled until the twentieth century. Mill acknowledged that there may be an excessive supply of individual commodities as the market reacts to changing conditions of supply and demand, but he argued that it was illogical to carry this analysis into macroeconomics and conclude that an excess of supply for all commodities could exist permanently. In his defense of Say's Law, Mill distinguished among three possible economies: a barter economy, an economy in which money is a commodity and no credit exists, and an economy in which credit money exists. By overtly introducing money into the discussion of possible general overproduction, Mill considerably improved the arguments in support of Say's Law previously given by Ricardo, James Mill, and Say himself.

Mill showed very clearly that there can never be an insufficiency of aggregate demand in a barter economy, for a decision to supply commodities presupposes a demand for commodities. In a simple barter economy, an individual or firm will produce and trade goods only out of desire for other goods. For example, a bootmaker will produce and trade his products because he needs clothes, food, and fuel, among other things. If money is introduced, but its only function is as a medium of exchange, the conclusion is the same. If, however, money functions in part as a store of value, then a seller may not immediately return to the market to buy, and although sufficient aggregate purchasing power is generated to give full employment, it may not be exercised in the current period and thus can lead to general oversupply.

In addressing these questions, Mill reintroduced Henry Thornton's sophisti­cated monetary analysis into the classical view by developing a psychological theory of business cycles. Mill showed that when credit is introduced the possibility of general oversupply of commodities may exist. An overissue of credit during a period of expansion aad prosperity may be followed by contraction of credit as a result of pessimism in the business community.

At such times there is really an excess of all commodities above the money demand: in other words, there is an undersupply of money. From the sudden annihilation of a great mass of credit, every one dislikes to part with ready money, and many are anxious to procure it at any sacrifice. Almost everybody therefore is a seller, and there are scarcely any buyers.

The introduction of credit money into an economy, according to Mill, permits the possibility of general oversupply, not because of overproduction in the Malthusian sense of general glut, but because of the changing expectations of the business community. Mill said that any such oversupply will be of short duration and will be followed by full employment as prices change in the economy. The net effect of Mill's discussion of the issues raised by Say's Law and the role of money in an economy is to defend this fundamental part of the classical system against Malthusianlike attacks and to develop a simple psycho­logical theory of business fluctuations based on the interactions between credit money and business confidence.

The Currency and Banking Schools

Mill's views on monetary theory were developed in the context of the times and reflected his methodological approach, in which reactions to practical problems directed theoretical inquiry, instead of theory developing separately from policy questions. The context of the times was an extension of the Bullion Debate and how to deal with the periodic recessions and financial disruptions that were occurring.

The extension of the Bullion Debate is called the Currency School/Banking School debate. The Currency School carried through the Bullionist position, arguing that a mixed paper and gold standard should be subject to unbending rules and operate just as a strict gold standard would. This policy, they argued, was the only way to prevent inflationary printing of money. The Banking School argued that a more flexible monetary policy was needed and that, as long as the Real Bills Doctrine was followed by banks, no control of the issuance of bank notes was needed. Interestingly, Robert Torrens, who was a major advocate of the Anti-Bullionist position, the forerunner of the Banking School position, switched sides and supported the Currency School.

Mill's monetary theory, which involved a modification of Ricardo's strict quantity theory, fit between the Banking and Currency Schools. Mill argued that the Banking School was correct during normal times, when markets were quiet. But he did not agree that the Real Bills Doctrine would always be relevant. He argued that speculative financial booms could occur, and in such times the Currency School's policy of tying the issuance of notes to gold was the appro­priate policy.