Rudy Fritsch of the Gold Standard Institute has responded to my earlier post. While Fritsch raises a number of points including seasonal variation in money demand, and the inability of the price system to adapt to changes in supply, demand, and consumer preferences, I am going to be selective in what I respond to because for me there is one major issue that he and Fekete are grossly mistaken about: in the Miltonic example that I cited, Fekete has argued that there are not enough savings to support an increase in production and that real bills can in essence substitute for actual savings. I am going to limit my response to that issue because I don’t want to dilute my response by delving into other areas.
Misunderstanding of Savings
The real bills advocates consistently demonstrate a mis-understanding of actual savings. While money is used to effect saving, we not save money and saving is not a monetary process. The stream of final goods reaching the market is available for savings. Saving is the consumption of some final goods to fund the production of capital goods. In a monetary economy, we use money to save but to understand saving is a real process. Out of the final goods reaching the market some are “destructively consumed” and some are “reproductively consumed”. The total supply of saving is the latter category. In a monetary economy, these decisions are carried out using money but it is only the stream of goods made available for “reproductive consumption” that is available to fund investment.
James Mill has a very good description of the real meaning of saving:
The two senses of the word consumption are not a little remarkable. We say, that a manufacturer consumes the wine which is laid up in his cellar, when he drinks it; we say too, that he has consumed the cotton, or the wool in his warehouse, when his workmen have wrought it up: he consumes part of his money in paying the wages of his footmen; he consumes another part of it in paying the wages of the workmen in his manufactory. It is very evident, however, that consumption, in the case of the wine and the livery servants, means something very different from what it means in the case of the wool or cotton, and the manufacturing servants. In the first case, it is plain, that consumption means extinction, actual annihilation of property; in the second case, it means more properly renovation, and increase of property. The cotton or wool is consumed only that it may appear in a more valuable form; the wages of the workmen only that they may be repaid, with a profit, in the produce of their labor. In this manner too, a land proprietor may consume a thousand quarters of corn a year, in the maintenance of dogs, of horses for pleasure, and of livery servants; or he may consume the same quantity of corn in the maintenance of agricultural horses, and of agricultural servants. In this instance too, the consumption of the corn, in the first case, is an absolute destruction of it. In the second case, the consumption is a renovation and increase.
Fritsch states “Money that could be used as savings under Real Bills would by necessity have to be used to support the clearing function”. In the same passage Fritsch states that:
Furthermore, all other things being equal, if more of the total stock of money is available for investment, aka savings, then interest rates experience downward pressure. If less cash (relative to the total stock) is available, because it is used for clearing, interest rates tend to rise.
The essential problem with this view is to look at savings and investment in terms of the money stock. This approach leads to the fallacy that conserving money is the same economizing real resources. What limits production of final goods is the total quantity of real resources available for investment. The total stream of final goods reaching the market is divided into consumed goods and saved goods. This division is carried out using money but it is not the money that is saved, it is the final goods. Reducing the monetary cost of some activity only makes more resources available for saving if the real cost is reduced. The clearing process does not conserve any real resources, it only enables the system as a whole to operate with lower money demand.
Interest rates are not, as Fritsch says “driven by the ratio of savings to cash”, they are driven by the consumption:saving ratio. This ratio can remain unchanged as money demand moves up and down.
If the same set of transactions can be carried out with less total cash flow, that does not mean that they consume fewer real resources. To know whether or not a process consumes fewer real resources, we need to know the prices and quantities of the goods. For Fritch’s point to be valid, it would have to be the case that when firms adopted clearing to reduce their money demand, that all the same resources were available to them at the old low prices.
As an individual if I could find a way to reduce the money expenditures on one activity then that would leave funds available for other activities. However, to extend this reasoning to the entire economy is a fallacy of composition. Changes in systemic money demand due to clearing do not make more real resources available for production because there are offsetting price changes to a system reduction. The error in analysis comes from a failure to take into account the seen and the unseen effects. What Fritsch misses here is that there are offsetting adjustments to the reduction in money demand elsewhere in the system – the prices of goods, generally increase. Real costs of production for the clearing firms would only be reduced if there were no offsetting effects in the price system to the adoption of clearing.
While it is true that the economy is not in an equilibrium, arbitrage opportunities to appear the price system responds to them. In particular, the price changes initiated by the introduction of clearing into a non-clearing economy would be arbitraged away. If some sector of the economy or subset of firms began using clearing to lower their money demand, even if initially the changes in prices appeared initially in the goods that these firms traded, if they to continued to use clearing, the resulting changes in relative prices between the clearing firms and the non-clearing firms would open up arbitrage opportunities between the clearing and the non-clearing part of the economy. There is no reason to think that these price changes would permanent and not arbitraged away.
If some technological innovation reduces the real cost of production then real resources become available for some other use. For example, suppose that a car could be produced with half as much steel – then the steel would be available for some other use in the economy. But reducing the monetary flow through a production process — as clearing does — is not the same as reducing the real cost or production. Reducing the money flow through a process does not make any real resources available for another other use. The changes in money demand are offset by changes in the price system and real costs are not changed.
Suppose that there are a several production functions for a car, of the form X tons of steel, Y pounds of rubber, Z hours of labor, use of K robots,…. There is always some ability to substitute among different factors of production and to substitute capital for labor or vice versa. The only way that the real cost of producing a car could change with clearing is if there was a way to substitute a real bill for X pounds of steel to produce a car made out of real bills.
I believe that there is an unstated assumption in Fekete and Fritsch’s work that, when the quantity of money or near-money is increased (through bills) that quantities of goods somehow adjust upwards rather than prices adjusting upwards. If I am right about this it raises a huge set of issues around how these goods can be produced without additional real factors of production. He may be thinking that the real bills themselves serve as a factor of production that can substitute for real labor and capital. This is consistent with Fekete’s statement that savings alone are not sufficient to fund production but that real bills can.
Low Interest Rates
Low, steady interest rates are clearly conducive to production; projects that would be sub marginal at higher rates of interest become profitable if rates are low and steady. Real Bills thus free Gold for longer term investment. Real Bills circulation is essential to a workable Gold Standard.
“Low steady interest rates are clearly conducive to production” as Fritsch says only if those interest rates reflect the scarcity of actual saving. A monetary system which achieves the objective of lowering interest rates to stimulate investment through monetary means do not in reality make sub-marginal production projects marginal because there is not sufficient real savings to complete them; such projects only appear to be viable so for a time. I won’t provide an explication here of the Austrian Business Cycle Theory (ABCT) but there is plenty of literature on-line for those who wish to investigate.
Update 2010-11-7In my original post I had incorrectly identified the author of the response as Michael Fritsch. The author’s corrected name is Rudy Fritsch. I have updated the title of the post as well to reflect my error.
One of the key empirical findings supporting Milton Freidman’s attack on the Keynesian system was a wealth of data from various countries showing that money demand tends to be stable.
There are situations where money demand changes suddenly. The most obvious example is during the contraction phase of the business cycle, where people become more risk averse and prefer to hold cash rather than assets. If you accept the Austrian theory of the Business Cycle, the boom and bust is a feature of fractional reserve banking and therefore not a problem for a 100% reserve system.