Early Monetary Issues

Early Monetary Issues

For a time at least Malthus's population theory seemed to settle an important question in classical economics, the question of the labor supply. After Malthus, population came to be the chief determinant of wages, and in subse­quent explanations of labor's aggregate share of annual output emphasis was placed on the wages-fund concept. An issue that proved more difficult to settle was the monetary question, namely what effect, if any, money has on eco­nomic activity.

Preclassical Monetary Theory

From roughly 1650 to 1776, monetary theory consisted primarily of two strands of thought. One strand asserted that "money stimulates trade" and numbered among its proponents John Law, Jacob Vanderlint, and (Bishop) George Berkeley. This argument stressed the effect of money on output and employment, largely ignoring the possible relation between money and prices.

Like many early theories, the money-stimulates-trade argument was a use­ful first approximation. Underlying the theory was the idea that, given a vol­ume of trade, there is an appropriate amount of money required for transac­tions purposes. Money is an important determinant of aggregate spending, which in turn determines the levels of output and employment. This theoretical progression is the element of truth in the money-stimulates-trade doctrine. But it does not go far enough, especially in two critical respects. First, as previ­ously noted, it ignored the possible effects of money on the price level. And second, it overlooked the role of expectations in the decision-making process. This last matter sharply divides Keynes (see Chapter 19) from the money-stimulates-trade theorists of the seventeenth and eighteenth centuries. Unlike his forebears, Keynes did not assert that money holds the key to solving un­employment. However, like them, he saw money as the key to explaining un­employment.

Although we have already discussed the mechanics of the quantity theory of money, we take this occasion to mention once again the name of David Hume (1711-1776), at whose hands the quantity theory of money took the form of its commonly accepted version. It was Hume who at­tempted a reconciliation of the money-stimulates-trade theory with the quan­tity theory of money. Moreover, it is in Hume's economic writings that the concept of neutral money emerges for the first time. As Keynes observed, "Hume had a foot and a half in the classical world" (The General Theory, p. 343n.).

Eighteenth-century attitudes toward money cannot be understood in a his­torical vacuum. The century opened with the monetary experiments of John Law, "who was inspired by the idea that an abundance of money is the royal road to wealth" (Rist, History of Monetary and Credit Theory, p. 103). After the collapse of Law's system, most of the enlightened men of that epoch— from Cantillon to Hume, from Quesnay and Turgot to Smith, and in the next century, from Thornton to Ricardo—de-emphasized the importance of money, insisting that labor and natural resources are instead the fundamentals of wealth. Paradoxically, the business community continued to believe in a me­tallic currency even while the theorists argued against it.

The eighteenth century was one in which Europe was ravaged by war; con­sequently there was a great deal of pressure on the economies of Europe to expand the money supply. Scarcely had forced paper currency been estab­lished in England at the close of the century when everybody began to ponder ways and means of returning as quickly as possible to metallic currency. There may be some lessons for the present in this past experience. Adam Smith clearly taught that the only things that count in the advancement of wealth are the resources nature provides for man's activity and the use he makes of them through his labor and inventions. But this is not enough. It must be kept in mind that human beings live in society and that society is based on a set of reciprocal exchanges. The greater part of these exchanges can only be effected after an interval of time, which introduces some uncertainty about the future. The goods that offer the best possibility of guarding against the uncertainties of time are precious, rare, durable, indestructible objects, such as gold. Such ob­jects therefore necessarily play an important role in all human societies in which the future is a reality.

As a rule, economic analysis underestimates the place taken by the future in economic activity. The thought of the future is never far from the minds of the industrialist, merchant, and business person. They continually focus their vi­sion on the future as regards prices, markets, and sources of supply and de­mand. Stable money is an important bridge between the present and the fu­ture. Only because of stable money (or in its absence other stable and precious objects) can persons wait, reserve their choices, and calculate their chances. Without it, they are completely afloat in a sea of uncertainty.

In the modern age, controversies over "hard money" versus paper curren­cies are rare, although this may be changing. What has been more durable as a theoretical issue is the controversy over money's "neutrality" or "non-neutrality." The neutrality of money refers to the fact that changes in the money stock have no effect on relative prices. In their zeal to discredit the mercantilist idea that money constitutes wealth, early monetary theorists gave the impression that money is a veil that hides the real forces of productivity, which alone account for genuine economic wealth. All that monetary changes do is change the price level in proportion to the change in money. Hume's ex­position of this view is classic:

If we consider any one kingdom by itself, it is evident, that the greater or less plenty of money is of no consequence; since the prices of commodities are always propor­tioned to the plenty of money__It is a maxim almost self-evident, that the prices of everything depend on the proportion between commodities and money, and that any considerable alteration on either has the same effect, either of heightening or low­ering the price.. .(Writings on Economics, pp. 33, 41).

It is one thing to isolate the effects of money changes on the price level while ignoring the concomitant effects on relative prices, but it is quite another to deny that monetary shocks have any effect whatsoever on relative prices. Not all early monetary theorists were naive in this regard. Cantillon saw quite clearly the relative price effects of money, and Hume also worked out a domestic adjustment mechanism that described the short-run as well as the long-run effects of a change in money. He observed that an in­crease or decrease in money supply impacted upon employment, output, and productivity, as well as on prices (Mayer, "David Hume and Monetarism," p. 573). Finally, Gary Becker and William Baumol found virtually no support for the view that early monetary theorists unequivocally endorsed the "neutral money thesis." They thereby concluded that the whole idea was basically a "straw man" constructed for the convenience of neoclassical monetary theo­rists ("The Classical Monetary Theory," p. 376).