BEE Partner, South Africa Economy Watch

A ‘transformational growth’ perspective (Nell, 1998a) would suggest that these principles are connected in an evolutionary pattern: as technology developed, production and employment took on new forms, and came to require different kinds of financing (Nell, 1998b). To keep pace, the monetary system also had to adapt and develop in new ways.

This took place in several stages. In the first instance, as transactions became more complex, metallic money proved inconvenient. Paper claims to gold could be used more easily, and came to replace gold. But bankers noticed very early that a given supply of gold could support a larger amount of circulating paper, since only a fraction would be presented for conversion at any given time. Convertible paper based on a fractional reserve, however, is fiduciary money. It is based on the trust the public has in the banks.

But governments famously had difficulty raising money. Taxes were not only hard to collect at the best of times, but too much effort put into tax-collection could lead to revolt. An alternative was to print money. But how to give it value? The answer, as Chartalists remind us, was to require it back in taxes. However, when governments most needed to print money, it was hardest to give it value, precisely because of the difficulties in the first place of collecting taxes (Davies, 1996). Fiat money required the consolidation of state power, in particular, the ability to impose and collect taxes.

A further possibility for governments was to borrow. Indeed, the Bank of England arose precisely for the purpose of financing the Crown.¹⁷ But the Bank was thereby made into an intermediary between the public, other banks, and the Crown. It was in a position to guide, even to dominate, the financialscene. And bank deposit money required some form of state-backed support for the banking system. It obviously required universal clearing, but it neededmore. It needed guarantees.

As information became more reliable, more easily verified and transmitted,creditworthiness could be checked more efficiently, so credit could be extended more widely until selected credit instruments became acceptable insettlement of debts (Hicks, 1989). With improved communications, funds could be moved more rapidly, and, although this was at first rare, after the telegraph, instantaneously. As production became more sophisticated, new and more flexible forms of financing developed for its service. Metal and convertible paper, however, adjust through changes in the value of the circulatingmedium — which is to say, prices and money wages must vary.¹⁸

This works well in a craft economy with stable output and employment andflexible wages and prices. But it will not do in a mass production economy with volatile employment and output and in which prices and wages are inflexible, or only rise. Monetary arrangements capable of adjusting morequickly are necessary.

So the system shifted to bank deposits, that is, pure accounting money.

Banks can issue lines of credit so that they advance loans and create deposits on demand. But pure accounting money has no value; it can only measure andrecord value. The crucial implication is that the system moved from money of intrinsic value, which adjusted through flexible prices in the conditions of thecraft economy, to accounting money provided on demand in mass production. As we shall see, the state, either actively or by default, must fix and maintainthe value of this money.

In short, while we tend to think that monetary theory has developed,becoming deeper and more complex, this is only half the story. Taken by itselfit is misleading. It is certainly true that early monetary writers seem to hold to an unsophisticated quantity theory, while later writers have a deeper appreciation of liquidity, and still later writers see the role that liquidity plays in portfolio composition. Yet most of these writers may be faulted for failing to understand the endogenous flexibility of the money supply, a fact that has onlycome to the forefront of understanding fairly recently.

What is misleading is the failure to see that monetary relationships themselves have developed historically. The development of monetary theory is largely a reflection of the historical development of the monetary system. Specifically, the monetary system developed from one that adjusted throughthe same price mechanism that (weakly) stabilized commodity production and labor markets, to a system that had no adjustment mechanism at all, leaving itinflation-prone. In the first system, some versions of the quantity theory make good sense, and, in the short-run, money is exogenous in some respects. As the system develops, however, credit becomes increasingly important and more and more ‘money-like,’ more liquid. So liquidity becomes more significant in practice, and therefore takes on a greater importance in theory. Still later, withthe replacement of price-adjustment by multiplier-accelerator systems, money becomes significantly endogenous.

In the first system, covering the greater part of US history, unbalanced government budgets did pose some sorts of problems, problems particularly important in the nineteenth century. In the second system that came to maturity during World War II, unbalanced budgets posed few, if any, problems. In the first system, the value of money was fixed by tying it to commodities (gold and silver, for example), and stabilized by the price mechanism (supplemented by Mint or bank policies). In the second, the value of money has no anchor, and there are no stabilizing market forces. In the first, government is small and tends to be neutral; in the second, government is large — it must be large in order to do the job of stabilizing — and is a major force in the markets.

Another important change follows from the changes in the determination of the value of money. Before 1933 the value of both kinds of money was anchored and regulated by a connection to gold. As a result, the rate of interest was also determined in the market. But today the value of money is a matter of historical accident, that is, it is exogenous to the market. And — as we shall see — this implies that the same is true of the rate of interest. This does not mean that market forces are irrelevant to either. Quite the contrary, a variety of market forces bear on them; yet neither is set by market forces in any particular market.

The connection between the market determination of the value of money and the market determination of the rate of interest is important, not leastbecause the demise of the former brings an end to the latter. We can review this more closely.

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