This chapter examines the concept of money. The existence of money is what makes economics hard.Understanding its influence on economic activity is the main source of disagreement among economists. Thischapter seeks to outline the different perspectives and their implications while applying it to understandmacroeconomic balances -- such as the budget and trade deficit -- that affect our lives. The discussion isnecessarily abstract at points, because money is an abstraction, but the implications are real.

1.1 THREE FUNCTIONS OF MONEY1.1 THREE FUNCTIONS OF MONEY

Money is commonly thought to perform three functions: amedium of exchange, a store of value, and a unit of account. As amedium of exchange, money facilitates economic transactions.Instead of directly exchanging the things we produce andconsume, money acts as a common denominator of value thatallows us to compare unlike things with the same metric. This isimportant when we want efficient transactions among anonymousindividuals exchanging diverse products.

As a store of value, money allows us to separate the activities ofproduction and consumption. We can work now (produce “value”)and spend the accumulated value of our work as we choose. Unlikeother “value containers,” money is not subject to rust or rot (As the

Romans observed, pecunia non olet [money does not stink]); it is not limited by its physical form. This is a keypillar of modern societies, whose significance will be explained more below.

Finally, as a unit of account, money acts as a scorecard that permits the valuing of intangible values or itemsthat are not exchanged in markets. It serves an accounting function. For example, if one was conducting acost-benefit analysis, one needs something commensurate to weight the costs and benefits of environmentaldestruction versus economic development. In addition, one may want to know the value of a property for thepurposes of assessing taxes or as collateral for a home equity loan. Without money as a standard unit ofaccount, these actions become difficult. The full implications and tensions of these functions will be explainedin the balance of this chapter. For the moment, it is only important for the moment to know they exist.

1.2 COMMODITIES & ASSETS1.2 COMMODITIES & ASSETS

To organize the following discussion, a distinction will be made between two types of entities transacted ineconomic exchanges: assets and commodities. Simply, commodities are things. They have objective, defined,and homogeneous qualities. Two items of the same commodity are, for all intents and purposes, identical; theonly consideration is quantity. In contrast, assets are notions. Their value is subjective, loosely defined, andoften intangible and heterogeneous. Two individuals may ascribe the same asset a different value based onperceived qualitative differences.

Some examples of commodities include a bushel of apples, a gallon of gasoline, orsheets of paper. The key to identifying a commodity is that one can easily describe itwith a scalar. We do not think that one ounce of gold is any better than anotherounce of gold, but we do think that three ounces is three times more valuable thanone ounce. In other words, we only care about quantity and quality differences areeither small or non-existent or we are indifferent to them.

MONEY MONEY

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Common examples of assets include publicly traded stocks, real estate, “brand name”merchandise, advice, religious salvation, currencies and relationships. The key toidentifying an asset is that two people viewing the same item may hold differentvaluations of it. For example, two girls involved in the “boyfriend market” may placewildly divergent values on the same boy. For one, he may be a dreamboat; to theother, he may have “cooties.” However, the boy remains the same. The differencesexist in the eyes of the beholder. The value of assets depends ultimately on subjectiveperceptions of value. These are perceptions are subject to revision and change, even ifnothing has materially changed in the asset itself.

Why does this matter? First, markets, as described by economists, are good at handling commodities, but poorat assets. The conventional supply-and-demand chart has two axes labeled “price” and “quantity.” Thispresents no problem when describing the market for commodities because the key elements are price andquantity. However, when quality differences and subjective perceptions enter in, it is less suitable. Althoughsome address this by noting the presence or absence of substitutes, preference changes, and expectations, theseare still largely ad hoc gadgets to the core model. In short, the fair, competitive, and efficient market modelimplied by supply-and-demand analysis may work fine to describe the markets for raw materials andagricultural products (and to a lesser degree manufactured goods), but it may be ill-suited to describeeconomies dominated by financial asset transactions and the production of professional services.

Second, when economic analysis developed in the 19th century, itmay have been an acceptable simplification to treat markettransactions as commodity exchanges (barter) and money as simplyanother commodity in these transactions. However, this may not beapt in the modern economy, which is increasingly dominated by theexchange of assets. This may explain why economics has been largelyunsuccessful in incorporating the activities of the financial sector inbroader economic models. A few numbers to illustrate this point:the value of international merchandise trade of goods and services(commodities) has been $13 - $16 trillion in recent years, while thevalue of global financial assets has been estimated to beapproximately $140 trillion. These assets rest on a relatively smallfoundation of goods and services. The chart shows how much of“asset” money rests on the narrow base of “commodity” money.

Third -- and perhaps most important for this chapter -- money, strictly speaking, is an asset; its value dependson the subjective perceptions of its users, but we often use AS IF it was a commodity, just like any other goodand service. If you can grasp this intuition and understand the tensions it implies, you understand most ofmonetary economics, but it remains hard, nonetheless.

1.3 “FICTITIOUS” COMMODITIES1.3 “FICTITIOUS” COMMODITIES

Money is what economic historian Karl Polanyi called a “fictitious” commodity. By fictional, Polanyi didnot mean that it is “false” or “untrue,” but that it is a human construct, like language and mathematics andnot a natural element of every economy. Before continuing, it may be helpful to quote from Polanyi in full:

. . . labor, land, and money are essential elements of industry; they also must be organized in markets;in fact, these markets form an absolutely vital part of the economic system. But labor, land, and moneyare obviously not commodities; the postulate that anything that is bought and sold must have beenproduced for sale is emphatically untrue in regard to them. In other words . . . they are notcommodities. Labor is only another name for a human activity which goes with life itself., which in itsturn is not produced for sale but for entirely different reasons, not can that activity be detached from

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Polanyi’s point is threefold. First, labor, land, and money are not real and therefore evaluating themempirically is meaningless: they are fictions, social constructions. Second, these fictions are useful, evennecessary, to have the modern economic system we have. Therefore, their existence should be evaluatedinstrumentally by what purposes they serve and how effectively they serve these purposes. Finally, he impliesthat there is a process of commodification through which entities which were not and were not consideredcommodities become to be treated AS IF they were. The completion of this process allows human societies toaccomplish things that were impossible, even inconceivable, before. For example, before money is acommodity, the notion of lending it for interest makes no sense. If one cannot lend money, debt, credit, andother financial instruments are impossible.

1.3.1 LABOR1.3.1 LABOR

Before examining money as a fictitious commodity, it may be helpful to consider the other two major fictitiouscommodities and how views have changed about them historically. First, labor. While you would not knowit from reading or watching historical fiction, by far the most common employment relationship for most ofhuman history was either serfdom or slavery. In other words, the idea that one’s labor -- and more specifically,one’s time -- was something that could be bought and sold to an employer would have struck most of ourancestors as quite odd. In part, this was due to technical limitations: you cannot sell your labor until it couldbe quantified in time, which required the existence of reliable, mechanical clocks, unavailable until the17th/18th century. However, the bigger problem was conceptual: labor was not divisible from the laborer.Therefore, you could only purchase the whole person, not just their labor.

This had important implications for certain occupations: doctors were often trained slaves owned wholly bytheir masters and required to provide medical care not only for their master, but all members of the household,including other slaves. Likewise, teachers, as we know them today, did not exist. Instead, wealthy individualspurchased tutors for their children, and, instead of paying them a salary, often just incorporated them into thehousehold. The persistence of this mode of thinking can be seen in the nature of labor contracts as late as the19th century. For example, if one engaged a labor contract for seven days, but was fired or quit on the sixthday, you did not receive 6/7ths of your wage: you were entitled to nothing because the labor contract (as awhole) had not been honored. Likewise, as Chapter 10 of Karl Marx’s Capital (“The Working Day”) suggests,once one had agreed to become employed, your employer had a claim to not some, but all, of your time, hencethe fierce disputes over the length of the working day in the 19th century. It is not accidental that the rise ofcapitalism and the market economy accompanied the dissolution of feudal ties and the emancipation of slaves.To this day, certain types of labor contracts are illegal, such as prostitution and organ sales, because they arelegally indifferentiable from slavery.

1.3.2 LAND1.3.2 LAND

The second fictitious commodity is land. Land, and the natural resources in it, is not a commodity because itis not produced; it just is. Additionally, equal quantities of land do not share objective, defined orhomogeneous characteristics: an acre does not equal an acre. An identical house in two different locations islikely to have a different price. Finally, one cannot uproot a unit of land, bring it to a market and exchange

the rest of life, be stored or mobilized; land is only another name for nature, which is not produced byman; actual money, finally, is merely a token of purchasing power which, as a rule, is not produced atall, but comes into being through the mechanism of banking or state finance. None of them isproduced for sale. The commodity description of labor, land, and money is entirely fictitious. Nevertheless, it is with the help of this fiction that the actual markets for labor, land, and money

are organized; they are being actually bought and sold on the market; their demand and supply are realmagnitudes; and any measure or policies that would inhibit the formation of such markets would ipsofacto endanger the self-regulation of the system.

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it for other commodities. This intuition was commonplace among premodern societies, including Europe.However, the best illustration may be the bemusement among the indigenous peoples of North America whenEuropean explorers and settlers offered to “buy” land -- such as the reputed purchase of Manhattan for $24 intrinkets -- or the purchase of Louisiana Territory by the American government from France. However, even ifone was a European noble, one did not purchase (or sell) land. To the extent that Europeans had a notion ofland ownership, it was the belief that land was nature, the handiwork of God, who had provisionally placed itin the stewardship of humans, beginning with the king, who distributed it among his vassals, and so forth,until it was finally distributed to serfs to till. At any time, someone higher in the feudal food chain couldexpropriate the land, or assert eminent domain, and reclaim title to it. Therefore, no one was able to buy andsell it to others as a commodity. This understanding is perhaps best exemplified in the “moral economy”practices of landlords. If a peasant experienced a poor harvest, it was customary for landlords to adjust the“rent” extracted from their tenants. Land did not exist as a resource to generate income, but existed primarilyto provide the materials of sustenance for those occupying it.

In addition, much land was not the property of individuals, but held in common, especially grazing lands andwoodlots. Although anyone could go into a forest and sell wood they felled (the “woodcutter” found in manyfairytales), one could not exclude others from entering a forest and chopping the wood they needed to provideenergy. The wood was a commodity; the forest was not. Similarly, shared grazing lands -- “the commons” --were a regular institution of agricultural settlements. The notion that one could assert ownership, and thereby,buy and sell property did not emerge until the Enclosure Movements during Tudor England. The popularliterature of the time suggests how unnatural many found these developments:

Oliver Goldsmith’s poem The Deserted Village (1770) eulogizes the destruction of rural villages that resulted

Speaking from a later time, George Orwell summarized the process by which land was commodified

Recently, the Peruvian economist Hernando De Soto has argued that the failure to assign property rightsthrough the commodification of land has been a major source of third world poverty. Reasonable peopledisagree about whether this has been a positive development or not. More will be written in the chapter onproperty rights. For our current purposes it is only necessary to recognize that it has been a change.

1.3.3 MONEY1.3.3 MONEY

Money is a measure of economic value, just as an inch measures length. As a result, the practice of borrowingand lending money at interest confused many premodern thinkers: how could one buy and sell an inch? Whatwas transacted was not an inch of something, but the inch itself. Anyone who made money from money wassuspected of theft and fraud. The income they gained must be extracted from honest and productive labor.During the Middle Ages, the sin of usury -- lending money at interest -- was enforced. The iniquity of usurywas the foundation of many anti-Semitic canards, such as Shakespeare’s character of Shylock in The Merchantof Venice (an association that unfortunately has continued to present day). While the Dan Brown conspiracytheories of The DaVinci Code are overblown, the suppression of the Templars may have been due to theirinvolvement in financial intermediation. Likewise, the Renaissance bankers, such as the Medicis and the

The law locks up the man or woman who steals the goose from off the commonBut lets the greater felon loose who steals the common from off the goose

Ill fares the land, to hastening ills a prey, where wealth accumulates and men decay . . . A time there was, ere England’s griefs began, when every rood of ground maintained its manFor him light labor spread her wholesome store, just gave what life required, but gave no more . . . But times are altered; trade’s unfeeling train usurp the land and dispossess the swain

Stop to consider how the so-called owners of the land got hold of it. They simply seized it by force,afterwards hiring lawyers to provide them with title-deeds. In the case of the enclosure of thecommon lands, which was going on from about 1600 to 1850, the land-grabbers did not even havethe excuse of being foreign conquerors; they were quite frankly taking the heritage of their owncountrymen, upon no sort of pretext except that they had the power to do so.

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Fuggers, officially represented their activities as charges for providing foreign exchange to cloak their bankingactivities. Similar proscriptions existed in China and India as a result of the Confucian and Caste socialsystems. To this day, banks in the Muslim world are organized to avoid the Islamic religious ban on charginginterest.

However, this is not simply a function of religious doctrines. There is a long political history in the UnitedStates of antipathy towards banks, from Jefferson-Jackson’s wars against the Banks of the United States, thePopulist-Progressive crusades against the “Money Trust,” to the contemporary Occupy and Tea Partymovements. The conviction that money is simply a veil for the exchange of other commodities and that it issterile (unproductive) runs deep.

1.3.4 NEW FICTITIOUS COMMODITIES1.3.4 NEW FICTITIOUS COMMODITIES

In recent years, a new form of fictitious commodity has arisen that can be loosely grouped as intellectualproperty rights (IPRs). The goal of this new breed of commodity is to make ideas ranging from creative worksto the patenting of scientific research. Ordinarily, ideas are not commodities. If I share an idea with you, I cannot make you “not think it.” Ideas, whether in the form of a new song or patented pharmaceutical, are notuniform, objective, and homogenous. The question of whether Paris Hilton should be able to copyright thephrase, “That’s Hot!” or whether the Disney Company should be able to legally bar individuals from using thelikeness of Mickey Mouse created nearly a century ago is contested or be able to buy and sell the right to usethese images and phrases is contested. In addition, as every student has experienced, what level of similarityin the arrangement of the written word constitutes plagiarism? The notion of plagiarism as an academic offensestems from the notion that the words constitute an idea that is the property of their author and must be fairlycompensated in coin or credit. In addition, publishers sell editions of textbooks, long after the original authorhas ceased involvement in the writing and revisions, charging students exorbitant fees.

However, perhaps of greater concern is the commodification of emotion and genetic information. Associologist Arlie Hochschild noted several decades ago, as our economies shifts toward larger numbers ofservice and professional jobs, emotions and personality become part of the labor contract. “Actingprofessionally” and suppressing emotions while doing work is more than simply your addition of labor to thefinal product, but is not explicitly compensated. Needless to say, emotions and personality are not commoditiesgenerated for the purposes of commerce. Another horizon on the field of fictitious commodities is geneticmaterial now that the human genome has been coded. If a certain genetic sequence can be used to provide adesirable (or remove an undesirable) trait, who owns it and who can profit from its sale? It could belong toeveryone, since the genome was coded using public money and we all participated in the process of geneticevolution, the physician who performs the procedure, or the individual(s) who own(s) the desirable genes.

2.0 THE ORIGINS OF MONEY2.0 THE ORIGINS OF MONEY

We know that there was a time where money played a small role in the economy; we know that money is nowindispensable to the operation of modern economies. This section looks at what changed and how economieschanged. It presents two stylized “just so” stories of the emergence of money. The first focuses on theemergence of money exchanges out of barter; the second views money as a formalization of creditarrangements. Each emphasizes a different function of money. The “barter” story views money as simplyanother commodity, while the “credit” story focuses on money as a medium of exchange. Ironically, the“barter” story presents money as a commodity that solves an exchange problem, while the “credit” storyunderscores the exchanges in which money is the commodity! Neither narrative is important as history, buteach can help illustrate dimensions of monetary exchanges in the present day. After detailing the “barter” and“credit” stories of money’s origins, a synthetic account will try to resolve the seeming tension between the two.

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2.1 BARTER2.1 BARTER

The barter story about the origins of money start from a premise that there is natural inclination to trade inhumans. The impetus for this assumption is Adam Smith’s The Wealth of Nations. In Book I, Chapter 2, Smithnotes

As the father of modern economic thought, Adam Smith’s assertion of human’s instinct to trade has been takenas axiomatic and most economists go no farther than this. There is some anthropological and historicalevidence that this is true. Archaeologists have found pottery and other artifacts spread over wide regions,suggesting trade or exchange well before the first coins and currencies can be found. There are someethnographies of “primitive” peoples that suggest that barter, or at least gift-exchanges, are foundational totheir common life. However, how does this explain the origins of money?

If there is a mutual coincidence of desires -- I have exactly what you want and you have exactly what I want --a simple bilateral exchange can occur. I have flints, you have cloth, let’s make a deal. Of course, this fortuitouscircumstances does not occur automatically or proximately: there is no guarantee when I go to market thatsomeone will want exactly what I have to sell. A&P sells tomatoes and grapes, but I cannot go into an A&Pstore with the tomatoes from my home garden to pay for my purchase of grapes. This problem can be solvedif a third party can be found who is willing to buy and sell the items to facilitate the trade. Consider thediagram below.

We have three individuals -- Alex, Andrew andAnthony -- each comes to market wanting to sell aparticular commodity and buy another. Alex wantsto buy chickens and has grain to exchange. Andrewwants to buy cows and has chickens to sell. Anthonywishes to purchase grain and has brought his cows inexchange. For the moment, let us assume a fairexchange rate of 1 chicken = 4 grain and 1 cow = 7grain. Our three individuals run into the firstproblem: there is no mutual coincidence of wants.They want to sell grain, chickens, and cows and thereare grain, chickens and cows for sale, but they do notmatch. Anthony wants grain -- and Alex has grain --but Alex only wants chickens and Anthony, cows.Therefore, no one can simply swap mine for yours.

I am sure that you have arrived on the likely solution to this problem: Alex, Andrew and Anthony can satisfytheir needs through two-stage swaps. For example, Alex can first swap 12 grain for 3 chickens with Andrew,and then Andrew can use the 12 grain to purchase a cow. While each person received some of what they wanted,they were not able to use all of their buying power. While Anthony received 7 grain, he still has two cows thathe must take home and feed because he could not sell them. Although Alex bought 3 chickens he wanted, hehas 3 grain that he must store. Despite gaining a cow, Andrew has 5 grain that he did not want and 2 unsoldchickens. Since the commodities are not divisible (what is 1/100th of a cow), their transactions are inefficient.

The division of labour . . . is the necessary, though very slow and gradual consequence of a certainpropensity in human nature . . . the propensity to truck, barter, and exchange one thing for another.It is common to all men, and to be found in no other race of animals, which seem to know neitherthis nor any other species of contracts . . . Nobody ever saw a dog make a fair and deliberate exchangeof one bone for another with another dog. Nobody ever saw one animal by its gestures and naturalcries signify to another, this is mine, that yours. I am willing to give this for that . . . it is by treaty,by barter, and by purchase that we obtain from one another the greater part of those mutual goodoffices which we stand in need of is this same trucking disposition which originally gives occasion tothe division of labour.

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Inefficient transactions are bad not only because one did not receive the commodity you wanted, but becausethe commodity you wished to sell may keep its buying power. You may have to expend more resources to storeyour commodity, or as in this case, feed your animals, all which cost scarce resources.

2.1.1 MONEY & EFFICIENT TRANSACTIONS2.1.1 MONEY & EFFICIENT TRANSACTIONS

Imagine the same transaction by adding one commodity: money. Assume that $1 = 1 grain. Alex can now sellall 15 grain bushels for $15; Anthony can sell his cows for $21 dollars; Andrew can sell his chickens for $20.They can use the proceeds to purchase 4 chickens, 2 cows, and 15 grain with $3, $6 and $6 left respectively.Everyone was able to buy the maximum amount of commodities their purchasing power allowed and theyavoid additional storage costs for unwanted commodities. In this set of exchanges, money acted as simply oneadditional commodity that everyone was willing to accept. However, what is this “magical” commodity?

The answer: money. However, what is significant about thinking of money as a commodity? If money is simplya commodity like all others with objective, defined and homogeneous characteristics, then money exchangesare not different than barter, just more efficient. Money exchanges exist only because they are more efficientby reducing transaction costs. Money is a “pass through” commodity (“veil”) for the underlying exchange ofother commodities. This exchange from The Simpsons makes this point.

2.1.2 COMMODITY MONEY CHARACTERISTICS2.1.2 COMMODITY MONEY CHARACTERISTICS

Historically, we know that many things have been used as money: shells, cattle, ironnails, pigs, whale’s teeth, women (in gift-exchanges) and precious metals. A famousstudy (Radford 1945) of prison camps during WWII showed that POWs usedcigarettes as a form of currency. An ideal currency has six characteristics:acceptability, divisibility, durability, limited supply, portability and uniformity. Acurrency does not need all characteristics, but the more of these six it has, the morelikely a commodity is to supersede other commodities as the currency of exchange.

The previous example illustrated the value of acceptability, divisibility and durability. The problem Alex,Andrew, and Anthony faced was because some of them wanted certain commodities, while others wantedsomething else: there was nothing that everyone wanted. The remainders from the exchanges show theimportance of divisibility: it is difficult (if not impossible) to trade 4/100th of a cow for 42/73rds of a chicken,etc. While one bushel of grain was equal to $1, grain is not as durable as common forms of currency. Limitedsupply -- scarcity -- is essential to maintain the rate of exchange. If money grew on trees, few would accept itas currency because it devalues commodities. The final two -- portability and uniformity -- simply facilitateexchanges by making it something that can be carried in large amounts and will be recognized as a currency.

2.2 CREDIT MONEY2.2 CREDIT MONEY

The barter version of money’s origins is a nice story, but it has one problem: there is little historical evidencethat this happened. The main examples of barter occurred because money exchanges broke down, such asRadford’s example of the POW prisoner camp. When most households produced for their own consumption,exchange was not a major feature of economic life. However, we do find many examples of gift-exchanges orcredit economies, which calls into question whether money must be a commodity. The proponents of the“credit” theory make one key insight: money is debt. Without debt, there is no real money.

Homer: Aw, twenty dollars? I wanted a peanut!Homer’s Brain: Twenty dollars can buy many peanuts.Homer: Explain how!Homer’s Brain: Money can be exchanged for goods and services

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“Credit” comes from the word, “to believe” and this critical to understanding the difference between a simplecommodity exchange and credit exchange. When commodities are bartered, there is no need for belief: theitems exchanged are the evidence of the transaction; seeing is believing: I get this, you get that. In creditexchanges, one party gets a tangible commodity (and a debt), the other receives a credit. The creditor mustbelieve that the debtor is willing and able to honor the obligation. Money is the marker of the obligation.

This may best understood as the practice of giving gifts. When we offer a gift, we do not expect somethingreturn. Gifts are a token of a relationship and what we expect is that our token will be reciprocated sometimein the future. We believe that our gift we be reciprocated, but we do not know. Failure to reciprocate is not abreach of contract, but the ending of relationship. The opening dialogue form the movie The Godfatherillustrates the difference between a commodity exchange and gift-exchange.

Bonasera begins by treating it as a commodity exchange and asks the price of the commodity, “justice.” Theoffer of money insults Corleone, because he sees it as a gift exchange, premised on “friendship.” Thecommodity is free conditioned on friendship, but friendship is priceless.

The first exchanges were between bands of strangers. The offer of a gift sent the message: “I am friendly, Iexpect you to reciprocate.” This allowed for the mutually beneficial exchange to occur. Adam Smith --originator of the barter theory -- in his description of the market’s “invisible hand” notes that “. . . it is notfrom the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner . . .” However, forthose who rely on the credit theory, benevolence -- literally, good will -- is essential. Why? In gift exchanges,only one party receives something tangible, the other receives a promise -- an IOU -- to pay. Modern money issimply a sophisticated form of gift exchange. Cash money is ultimately government debt that private actors arewilling to trade because it has the “full faith and credit” of the government. Money is simply trading the debtpromises of sovereign governments in lieu of our own.

Two key conceptual differences in the operation of commodity money and credit must be noted. First, ifmoney is a commodity, there is no problem with simply hoarding its value and keeping it out of thecirculation. Trade will continue using whatever other commodities are available. However, if it is a credit/debt,then it must continually circulate to facilitate transactions. The decision to hoard precludes the transactionsof others. In barter exchanges there is not relationship between buyer and seller; once the commodities changehands, the relationship ends. In credit exchanges, there is always a debt residual that implies an ongoingpledge to continue exchanges. Second, barter exchanges occur in only one time period, the present. Availablestocks of commodities limit exchanges; short-term supply and demand and budget constraints govern themarket. In credit exchanges, there is a present and a future, allowing individuals to “borrow” against theirfuture and bring demand forward to buy goods and services in the present. The present is limited, the futureis not. This is a sustainable “Ponzi scheme,” because tomorrow is a day that never comes.

2.2.1 THE KULA RING2.2.1 THE KULA RING

Bronislaw Malinowski’s famous ethnography of the Trobiand Islands, Argonauts of the Western Pacific, gives

Bonasera: I ask for justice . . . How much shall I pay you?

Don Corleone: Bonasera, Bonasera. What have I ever done to make you treat me so disrespectfully? Ifyou'd come to me in friendship, then this scum that wounded your daughter would be suffering this veryday. And if by chance an honest man like yourself should make enemies, then they would become myenemies. And then they would fear you.

Bonasera: Be my friend – Godfather.

Don Corleone: Good. Someday, and that day may never come, I'll call upon you to do a service for me.But until that day – accept this justice as a gift on my daughter's wedding day.

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an excellent case of how gift exchanges operated in the past,but also suggest how modern money works. The TrobiandIslanders faced a unique problem. They were a ring of islands-- the Kula Ring -- with no central location to serve as aphysical market. They were limited to bilateral exchangesbetween neighboring islands on the island ring’s periphery.The map to the right shows the geography of the islands andthe lines show the trading circuit. As a result of theirgeography, they could not barter actual commodities in aphysical market. However, there were able to engage in tradeand develop a form of money. How?

The Trobiand Islanders used totemic bracelets and necklaces(see below) as a form of currency. These bracelets andnecklaces would circulate clockwise and counter-clockwisearound the Kula Ring. At each island, they would be exchanged for whatever cargo the island could provide.

That island would then take the necklace or bracelet tothe next island in exchange for their cargo. Eventually,they would complete the cycle. In doing so, the cargoalso make its circuit around the islands even thoughno direct economic exchange occurred. There was noprofit: the “gift” of the necklace or bracelet was equalto the cargo, regardless of quantity, so there was notunderlying or implied “exchange rate” of thecommodities transacted.

The mechanics of the Kula Ring parallels the “circular flow” model of the economy. In the circular flow model,goods and money circulate in opposite directions between households (consumers) and firms (producers).Since every person’s income is also

2.2.2 CIRCULAR FLOW MODEL2.2.2 CIRCULAR FLOW MODEL

The mechanics of the Kula Ring parallelsthe “circular flow” model of the economy.In the circular flow model, goods andmoney circulate in opposite directionsbetween households (consumers) and firms(producers). Since every person’s income isanother individual’s expenditure, the flowof money is equal to the value of goods. Thismodel shows the principle of “no freelunch” at the economy level, because anydecision to reduce purchases requiressomeone else to produce less. If the flow ofmoney stops due to hoarding as a stock, itallows impedes the cycle of goods andservices in the economy. Likewise, thehoarding of bracelets or necklaces in theTrobiand economy would bring economicactivity to a screeching halt.

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2.2.3 KULA RING REDUX2.2.3 KULA RING REDUX

In the Trobiand Islands, all islands were both producersand consumers. Money exists, but no island controlsthe supply of money or supports itself by producingmoney. In modern economies, there are entities thatproduce and control the money supply -- namely banksand sovereign governments. What would the Kula Ringand the circular flow model look like if they included afinancial sector (banks)? Before examining thisproblem step-by-step, let us look at a complete circularflow model. As you can see, government and financialinstitutions lie outside the simple circular flow ofmoney, goods and services. This status is largely due totheir shared ability to create money. Governments do sothrough seigniorage -- mint currency -- and issue debtagainst future tax receipts; banks via fractional reservebanking. This does not mean they wield unlimitedpowers, but it does make them fundamentally differentthan all other economic players.

Let us return to the basic Kula Ring model where we have a flow of trade goods paralleled by two circuits ofmoney -- necklaces and bracelets -- as shown on the left. Let us add in a “financial intermediary” (bank) “C”that transacts in money, but does not buy or sell goods and services. This is shown in the center diagram above.“C” is willing to maintain the circuit, even though it has no interest in buying or selling any commodities,perhaps for a nominal transaction fee. Nominally, there is no difference between the economy show in the leftand center diagrams. The other participants -- A, B, D & E -- experience no difference in their access to desiredcommodities, the ability to sell their wares, or make transactions.

The third diagram on the right, however, shows the key position held by financial intermediaries. They can goon a “capital strike” and refuse to make money available to the economy either by refusing to take deposits ormake loans, preferring to hoard their money reserves. If money is viewed simply as one among manycommodities, this strike is no different than any producer who refuses to sell to markets. However, if moneyis a “special” commodity necessary to facilitate all transactions, the circular flow of the economy shuts downif governments and financial intermediaries do not provide liquidity.

Credit: Nicholas Szabo, George Washington University �Shelling Out: The Origins of Money� http://szabo.best.vwh.net/shell.html

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2.3 HIGH & LOW MONEY: A SYNTHESIS2.3 HIGH & LOW MONEY: A SYNTHESIS

The barter and credit accounts of money’s origins are both reasonable, but have strikingly different premisesand conclusions about what money is and what its impact is. They exemplify the functions of money as a storeof value and a medium of exchange respectively. How can they be reconciled?

One way is to think about the social structureof premodern, agricultural societies that existedprior to the Industrial Revolution. While thereare variations from place to place, the diagramto the right is a good first approximation. Onthe eve of the Industrial Revolution, the greatmass of individuals lived in small, self-contained villages societies that produced mostof their consumption -- food, clothing, shelter-- within the village unit. As a result, theirengagement with markets was primarily barterexchanges within village communities. Thesevillage communities were economically andsocially isolated: before the transportationrevolutions, most settlements were “foot-scale”-- limited by the distance one couldcomfortably travel in a day, about 10-mileradius area (about the area of school district).As tightly-knit communities, there was oftenimplicit trust and therefore little need to formalcredit exchange arrangements. To the extentthey existed, they were revolving-credit associations or credit collectives, akin to the “microfinance”organizations such as Muhammad Yunus’ (Nobel Laureate) Grameen Bank. Money was not needed as a storeof value -- surplus, if there was any, was consumed at harvest festivals, nor as a unit of account and of onlylimited use of it as a medium of exchange. Karl Marx, successful as a sociologist where he failed asrevolutionary, describes the position of the 19th century peasantry

However, above the mass of peasants lay stratified social and occupational layers that needed money. Long-distance merchants required some form of money because they handled trade with diverse products at adistance and needed money as both a store of value and a unit of account. In addition, certain occupations,such as the nobility-warriors and clergy, required money to valorize their services. Security and salvation, asimportant as they maybe, are not barterable tangible commodities. The imposition of taxes and tithes, whichmust be paid in coined money, served the purpose of material support for these groups but also required a formof commodity money. A glimpse of this process can be found in the Christian New Testament in Jesusconfrontation with the “money-changers.” The money-changers did not “change money,” but took the in kinddonations (commodities) from peasants and gave them money in order to pay taxes to secular authorities ortithes to religious ones. The general antipathy to money-changers (and tax-collectors) is that they performed

The small-holding peasants form an enormous mass whose members live in similar conditions but withoutentering into manifold relations with each other. Their mode of production isolates them from one anotherinstead of bringing them into mutual intercourse. The isolation is furthered by . . . poor means ofcommunication and . . . poverty . . . Each individual peasant family is almost self-sufficient, directlyproduces most of its consumer needs, and thus acquires its means of life more through an exchange withnature than in intercourse with society. A small holding, the peasant and his family; beside it another smallholding, another peasant and another family. A few score of these constitute a village, and a few score villagesconstitute a department. Thus the great mass of the . . . nation is formed by the simple addition ofhomologous magnitudes, much as potatoes in a sack form a sack of potatoes.

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these “services” at a considerable mark-up. If you think of the “fees” charged by your wireless phone or creditcard company, you can appreciate the sentiment. The Ancient Greeks had a similar practices double-suingtemples as treasures as in the case of the Delian League where the tribute paid to Athens were cloaked asreligious offerings. Modern examples existed in Europe’s overseas colonies. The imposition of taxes on colonialsubjects often precipitated the movement from subsistence agriculture (not traded or monetized) to theproduction of cash crops (traded and monetized) with deleterious social and environmental consequences. TheAmerican bimetallism (Gold vs. Silver) debates of the late 19th century also reflected this tension. ThePopulists, mostly workers and farmers, wanted a currency that served as a “medium of exchange,” while theRepublicans and Bourbon Democrats, aligned with financial interests, valued currency mainly for its “store ofvalue” and “unit of account” functions. Silver was superior as a medium of exchange; gold as a store of valueand unit of account.

Historically, there were usually two monetary systems co-existing side-by-side: one whose principal goal wasto serve as a medium of exchange, the other to act as a store of value. This Janus-faced system presented onlyminor problems when economic activity was primarily local with segmented markets. However, the emergenceof national and international markets forced everyone to use the same currency form of money and the tensionsmanifested in debates over the proper form of money. Both the barter and credit accounts of money’s originsare true, but incomplete, explanations of money. The telling of stories reveals more about the narrator than thestory’s subject. The choice of focusing on one version of the money story often shows “what side you are on.”

3.0 MONEY: STERILE OR FERTILE3.0 MONEY: STERILE OR FERTILE

The appearance of money as a (“fictitious”) commodity is what makes capitalism possible. Slavery is aneconomic system premised on the control of labor; feudalism is a system founded on the control of land; theoperation of Capitalism depends on the control of money. As unjust as slavery and feudalism were, it is nothard to understand why they could work: we can grasp why controlling people or land would be economicallyproductive. Land produces food and natural resources; labor is synonymous with work. It is less clear whymoney is productive, whether green pieces of paper or coined precious metals. The dominant view was thatmoney was sterile: it represented value, but could not generate value. This view originates in Aristotle

Aristotle probably had in mind the debt peonage of Greek peasants precipitated by the advent of coinage andwas a major impetus for the Solon’s reforms that created Athen’s democratic constitution. However, the notionthat money is merely a veil for the exchange of commodities and cannot produce wealth (or impact economicactivity) was influential into modern times and still influences economic theory. Contemporary concerns about“printing money” and the view of inflation as theft align with the view that changing the value of money istheft of the value of the commodities transacted. This section presents two views on the “sterility” and“fertility” of money. The first, associated with Marx, sees money as the instrument of exploitation that allowscapitalists to extract value from workers. The second, associated with Hume, Simmel, most recently, MattRidley, argues that money and commerce promote peace, tolerance, and the growth of ideas, all which addvalue to money exchanges.

3.1 MARX & MONEY3.1 MARX & MONEY

When interpreting Marx it can be difficult to parse when he is simply engaging in a reductio ad absurdum ofClassical economic writers such as Adam Smith, David Ricardo and Jean-Baptiste Say (all proponents of a

The most hated sort (of wealth getting) and with the greatest reason, is usury, which makes a gain out ofmoney itself and not from the natural object of it. For money was intended to be used in exchange but notto increase at interest. And this term interest (tokos), which means the birth of money from money is appliedto the breeding of money because the offspring resembles the parent. Wherefore of all modes of gettingwealth, this is the most unnatural.

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barter-commodity theory of money) or he intends a serious empirical description of how economies actuallyfunction. As a result, it is not clear if his writings are to be taken literally or simply as means of showing howabsurd Classical Economics is, even by their own assumptions. Therefore, caveat lector.

Marx begins by taking two elements of Classical Economics: Adam Smith’s “Labor Theory of Value” and Jean-Baptiste Say’s “Say’s Law.” The first posits that the value of commodities ultimately derive from the labor inputnecessary to produce them. The second (although there are many versions of “Say’s Law”) argues that supplycalls forth its own demand, implying that in the aggregate that the two sides of the exchange should be equalsince one person’s income is another person’s expenditure. Marx then identifies two exchange circuits. The first,C1-M-C2, notes that individuals first produce commodities (C1), which they exchange for money (M), whichthey is used to purchase another commodity (C2). According to Say’s Law, C1 = M = C2. The use of money didnot add anything to add or subtract from the value of the commodities.

The second, M-C-M*, begins with money instead of commodities. Money (M) is used to purchase a commodity(C) and the transformed back into money plus interest (M*). Where, Marx asks, does this increment of interestcome from? Consider the second circuit as bank deposit. If I deposit money at a bank and they give me 2%interest on the deposit’s principal, where did the 2% come from? We know the bank probably took our depositand made a loan (bought a commodity) and the borrower paid the bank interest, a portion of which wasreturned to us. Still, why would the money have increased in value? Why did the borrower have to purchase theright to make a transaction? And, why did we profit simply by entrusting our money in the bank’s care?

Marx returns to Smith’s Labor Theory of Value and its assertion that all economic value comes from labor. Ifthe incremental value does not come from the transaction it must have been skimmed from the value of thecommodity, or, taken from the source of value of the commodity: labor. The owner of capital (money) is ableto siphon off the “surplus value” of labor and add it to his stock of capital (money). Contrary to the claim ofthe Classical Economists that both parties benefit equally from an exchange, Marx argued that one side(capital) systematically ripped the other (labor) off. This process of extracting surplus value through monetaryexchanges is what Marx meant by “exploitation.” Exploitation is made possible by virtue of the moneyeconomy.

3.1.1 MARX & THE MARSHALL PLAN3.1.1 MARX & THE MARSHALL PLAN

The classic example of an entity that “makes money from money” is abank. While it is customary to think of a bank as a business with tellersthat takes deposits and makes loans, it may be more useful to definebanks functionally. A bank is an entity that has net long-term monetaryassets and short-term monetary liabilities. With this definition, we maythink of postwar US as a bank. Generally speaking, the US borrows“low” by issuing public and private debt (= bank deposits) to the world,and lending “high” by purchasing equity (= bank loans) incorporations from around the world. The difference is pocketed and amajor source of American wealth. In essence, the American economyhas become like Marx’s capitalist, able to “make money from money”and not “making things.” This development is tied to the twinprocesses of financialization and deindustrialization. As the chart to theleft shows, in 1950, manufacturing and finance consisted of 29.3% and10.9% of GDP respectively. By 2005, the shares had reversed.

Manufacturing produces only 12%, while finance occupies 20.4%. As a share of corporate profits, the trend iseven more striking. In the early 1950s, manufacturing was the source of 60% of profits, while finance was lessthan 10%. By 2005, finance made 50% of corporate profits, while manufacturing dropped to nearly 5%.

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Marx’s CMC/MCM* framework can help us understand whathappened in the American economy. Prior to World War II(really World War I), the US was a “CMC economy” organizedto produce commodities for sale. London, not New York, wasthe world’s financial center, nor was the US dollar the world’sreserve currency. Then, from 1914-1945, the rest of the civilizedworld decided to blow itself up, destroying their productivecapacity and borrowing large sums to finance their war efforts.At the end of these three decades of conflict, the US found itselfin a curious and envious position: it now controlled 80% ($26Billion of $33 Billion) of the world’s gold stock, equivalent, atthat time, to the world’s monetary base. The global economywould not be sustainable if the US hoarded its medium ofexchange as a commodity. To its credit, the US embarked on aseries of policies to redistribute the purchasing power bybecoming “banker to the world” and transforming itself into a“MCM* economy”

The US rebuilt Japan, recapitalized its European allies throughthe Marshall Plan and the World Bank, it established a networkof foreign military bases ensuring that its resources would bespent abroad, it promoted consumerism and debt to spendthriftAmericans, and established favorable terms for its trading partners through the Bretton Woods system thatpegged the dollar to gold, but allowed other currencies to float against the dollar. The sum of these policies wasthat it made American banking more competitive and American industry less competitive relative to itseconomic counterparts. European and Japanese manufacturers took advantage of favorable exchange rates toexport to American markets, while American manufacturers faced exchange-rate headwind. However, thestrong US dollar made it easy for American banks to lend on favorable terms around the world and for

Americans to purchase equity in foreigncorporations. Not surprisingly, wages forworkers in manufacturing stagnated, whilecompensation in the financial rose in the US.This process accelerated since the 1980s asfinancial deregulation, free trade, andliberalization of international capital marketsallowed American bankers to take full advantageof their economic position.

3.2 INTEREST’S VALUE3.2 INTEREST’S VALUE

The economic argument for interest on money usually describe interest as the opportunity cost of money(although that implies that money is scarce, which it is not). Some argue that financial intermediaries create amore efficient allocation of capital by choosing which projects merit funding and the return is their share ofthis efficiency gain. Others would note that investment carries risk and the return is the reward for thewillingness to shouldner risk. Since these points will be dealt with in greater detail elsewhere, it will suffice tosimply list these explanations.

A second line of argument is that exchanges produce positive externalities for society and therefore thefacilitators of these exchanges are entitled to a share of the social benefit. For example, there is a long standingargument that trade and commerce reduce conflict, if only because it is bad for business. Another argument is

US as World’s BankerAdapted from H. Schwartz

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that monetary exchanges promote tolerance, most commonly associated with sociologist Georg Simmel’s ThePhilosophy of Money. Credit exchanges imply a social relationship where some are trusted and others are not.When becomes the basis for social interaction, the only color people see is green. Therefore, individuals fromdeclasse minority groups can rise as long as they can show they can deliver the goods (make money). Simmel,writing at the beginning of the 20th century observed that

While there still may be things that money cannot buy, money, as a unit of account, permits the pricing of thepriceless. The “value of a statistical life” (VSL) has been estimated by economists to be approximately $6.9million. This concept is used by regulatory agencies to make cost-benefit analyses of safety precautions andenvironmental regulations. To the extent that tolerance and clear-thinking are social (and economic) goods,the providers of money may be entitled to a private share of the public gain.

3.2 SEX FOR IDEAS3.2 SEX FOR IDEAS

The explanations above all note an extant value that is monetized throughinterest charged on money, but they do show how money can create new value.The monetary exchange still appears to be a zero-sum swap of two commoditiesas shown in the illustration to the right. In the beginning one person has a redapple, the other a green one; at the end, one person has a red apple, the other agreen one: nothing has changed to the total value. However, this may be anarrow view of what occurred in this exchange. Recently, science writer MattRidley has suggested that ideas are shared when people trade material

commodities. Unlike commodity swaps,swapping ideas is not zero-sum, but likelypositive sum. When two person share ideas, asshown in the illustration to the left, neither losestheir original idea and both gain another idea.Ideas are not simply nebulous thoughts, but can be embodied in materialcommodities that people exchange. Ridley calls this process of exchange “sex forideas” because the intercourse of ideas allows them to reproduce not as replicas,but as improved versions. For example, imagine two cooks charged withmaking chicken soup for each other. As accomplished chefs, they are perfectlycapable of making good soup for themselves and have no need of trade.However, if they do, they not only consume the soup, but encounter the “idea”-- the recipe -- of their counterpart, and thereby, improve their own production.

The notion that economic growth is fundamentally driven by the advancement of knowledge, ideas, andtechnology has not been lost on economists. “Endogenous growth theory” argues that growth is not fosteredsimply by greater inputs of factors of production -- land, labor, and capital -- but from technological progress,i.e., the growth of ideas. What cultivates economically useful ideas. Endogenous growth theorists believe thatprivate investment in R&D is the main source of technological improvement. Alternatively, Schumpeterianeconomists point to entrepreneurs who produce the “creative destruction” that drives technical and economicchange. Both hold that there must be proper incentives for individuals to innovate. In practice, this means tocommodify ideas by strengthening protections of intellectual property rights through patents and copyrights.In addition, they suggests that ideas come when individuals compete for the monetary advantages of firstdiscovery, which often means secrecy and exclusive access. In this view, innovation is strictly a productionfunction and not a result of the exchange of ideas.

Money expresses all qualitative differences of things in terms of ‘how much?’ Money, with all its colorlessnessand indifference, becomes the common denominator of all values; irreparably it hollows out the core ofthings, their individuality, their specific value, and their incomparability. All things float with equal specificgravity in the constantly moving stream of money.

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3.2.1 RED QUEENS3.2.1 RED QUEENS

Ridley presents a different view. Innovation is rooted in consumption, notproduction. It is the result of cooperation, not competition. Openness andsharing, rather than exclusivity and secrecy, is more likely to generate newideas. Before looking at the full implications of Ridley’s argument and somenoted examples, pro and con, consider Ridley’s main research background inthe evolution (and superiority) of sexual reproduction in animals. In asexualreproduction (and monoculture and cloning), the offspring are replicas oftheir parents. Species with superior survival traits reproduce and populatethe ecosystem. In sexual reproduction, offspring are similar, but not thesame, to parents. As many children are acutely aware, they did not inherit

just their parents high-quality DNA,but a lot of the “junk” DNA as well. Still, some evolutionary biologistshold that sexual reproduction provides evolutionary advantages: why?Sexual reproduction, by scrambling the genetic material, fools parasitesand predators, which are far more numerous than hosts. Long-termsurvival of species depends on not just being “best-adapted” in theshort-term, but the ability to maintain the advantage in co-evolution ofpredator-prey (host-parasite) pairs. The reason that sexualreproduction has evolved to be pleasurable is that it grants anevolutionary advantage because it produces robust, not optimal,offspring. This process is known as the “Red Queen Hypothesis” afterAlice in Wonderland’s Red Queen, who spoke the memorable line that“it takes all the running you can do, to keep in the same place.”

3.2.2 MONEY, CONSUMER CULTURE & INVENTION3.2.2 MONEY, CONSUMER CULTURE & INVENTION

Let us pull some strands together. Money facilititates exchange and consumption. Consumption, notproduction, is the seedbed of invention. Ideas are embodied in material commodities. Through exchange the“small differences” in similar commodities are learned and recombined to produce new ideas. Therefore, thesocial process of shopping is critical to producing new ideas, technologies, and knowledge that are key toeconomic growth. As a result, commerce is not sterile, but fertile; it has the ability to create “new” value.Producers do not simply develop new products that are then “evaluated” in markets by consumers; consumersthrough the “compare-and-contast” process of shopping may be generating new innovations.

We can broaden the point to human learning. It is common to think that knowledge precedes doing -- wecannot take action before knowing what to do -- but Ridley implies that the sequence is reversed. Considerlanguage acquisition in young children. They do not learn to speak because they are explicitly taught, but bylistening to adult conversations (consuming spoken language) and mimicking speech. Many individuals whowould flunk grammar tests have a near perfect intuitive sense of the spoken grammar of their native language.Many observe that the path to better writing is through reading (consuming written language) and practice bywriting journals and multiple drafts (hint! hint! hint!). The writer George Orwell claimed to hone his writingcraft by copying Henry James’ Tropic of Cancer in long-hand. One may also view teenage experimentationwith different “identities” (manifested in hairstyles, wardrobe, musical and artistic tastes, etc.) as necessarysamplings that serve as the prelude to “inventing” their adult selves. Some findings in cognitive science suggestthat intelligence is really just the memorization (through experience) of diverse things. In economics, thisprocess is known as “learning-by-doing” and is thought of a major source of endogenous growth. However, arethere concrete economic examples that this is how innovation actually occurs?

Some work in behavioral economics shows that, to promote creative work, the drives for autonomy, mastery,and purpose are more effective than material incentives. In fact, some studies evidence that greater materialrewards induce worse performance. There is some evidence for this is the area of software design, where “opensource” products such as Linux, Apache, Mozilla (Firefox), OpenOffice, Wikipedia, GNU compiler, GIMP, andMoodle, perform as well, at lower cost, and produce more “breakthroughs” than their proprietarycounterparts. A comparative study of the technology clusters of Route 128 (Boston) and Silicon Valley foundthat cross-firm sharing of information and ideas was critical to Silicon Valley’s preeminence, despite Route128’s initial advantages. Microsoft’s innovation strategy under CEO Steve Ballmer was to use its monetaryadvantages to “buy out” small innovators or beat its competitors to market. Arguably, this has been a failedstrategy. Another key test of this idea is the competition between Google and Apple. Google has embracedopen source platforms for smartphone and tablet “apps”, such as Android, and user-generated content, suchas YouTube, while Apple has pushed for more uniformity and top-down control in its “App Store” and I-Tunes.Finally, the future of net neutrality, which fostered the creation and dissemination of user-generated content,looms large on whether this innovative environment will continue.

In manufacturing, “flexible production” regimes, such as Italy’s “Third Italy” and Japan’s “Total QualityControl” put an emphasis on networked, horizontal organization and worker and consumer input into thedesign and production process. Arguably, they have been more creative and innovative than their conventionalcounterparts. In R&D, free, accesible research provided by university and government-sponsored researchcenters like the National Institutes of Health have been foundations for America’s innovative edge. Even in theprivate sector, research centers insulated from economic pressures, such as AT&T’s Bell Labs, IBM’s WatsonCenter, and Xerox’s PARC have been the engines for innovation.

Historically, nations that have shut themselves from commerce experience declines in innovation, even“forgetting” technologies. A main reason cited for the “Rise of the West” was European interstate competitionand commerce that lead to the development of new technologies, allowing them to outpace far advancedcivilizations in South and East Asia. Specifically, the Tokugawa decision to close Japan to foreigners andforeign trade and Ming-Qing Dynasty’s policies of limited contact with foreigners was a major reason for lackof technological progress during these periods.

Finally, consumer culture and consumerism with its penchant for variety and diversity may be essential toinnovation along lines suggested by the “Red Queen Hypothesis.” Even “wrong” ideas are important, as J.S.Mill argued, because they clarify our understanding of what is right (and why it is right). The “marketplace forideas” is important not only for the expression of opinions, but also for allowing the material products thatembody these ideas to be shared. Insofar as money is a critical element of these processes, it may be a key partof economic development.

4.0 MONEY & BALANCES4.0 MONEY & BALANCES

As a store of value, money allows individuals to transfer value across time and space. This property has manyadvantages: it separates the time-space link of production and consumption and allows us to allocatepurchasing power over time and expands the extent of markets. However, it poses one big disadvantage. Oncepurchasing power can be distributed temporally and spatially, there is no guarantee that production andconsumption, supply and demand will be balanced in the present. In short, the possibility of temporalimbalances (inflation & unemployment) and spatial imbalances (trade deficits and surpluses) can causeeconomic activity to be more unstable. This does not mean that they will be unbalanced -- they can be inbalance dynamically -- but its makes is possible. Money is governed by two “prices”: the interest rate -- whichorchestrates the aggregate balance of investment and consumption in the present and future -- and theexchange rate -- which influences the location of production and consumption.

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Although it is common to discuss the interest and exchange rate as the prices of money, they are not pricesinsofar as their level is NOT set in market (although there are implied prices in the level of the bond and foreignexchange markets). This is because money is not scarce by nature, but only scarce by choice. The quantity ofmoney supplied is a choicemade jointly by banks and governments. This does not mean that they should adjustthe money supply at whim or without limit, but simply acknowleges that they can increase or decrease it supplyif desirable.

The diagram above is a visual schema of the section’s topics. We will begin at the center with the circular flowmodel of an isolated, moneyless economy. It will present Say’s Law that states why production andconsumption should be in balance. In addition, we will present the “quantity theory of money.” Next, we willlook at the horizontal “temporal” flows of money and their “internal” balance. While this will describe theIS/LM model and debt-deflation, the details of fiscal and monetary policy will be discussed in another chapter.In the next section, we will describe the vertical “spatial” flows of international trade and foreign exchange.Finally, we will look at the model as a whole and interaction of the internal and external balances through theMundell-Fleming (Trilemma) Model and Swan Diagrams.

4.1.1 SAY’S LAW4.1.1 SAY’S LAW

Say’s Law --The Law of Markets -- is equally one of the most important and divisive concepts in economics,both technically and normatively. If you find it convincing, you likely hold conservative political views, find“supply-side” economics, “real business cycles,” and “structural” explanations of unemployment convincing,and believe that money is a neutral or irrelevant to explaining economic activity. In addition, you are likely tosupport a “commodity-barter” model of money. If you do not find it convincing you are likely political liberal,find demand-management and Keynesian economics convincing, and believe that money is central tounderstanding economic activity. Therefore, a neutral statement of Say’s Law is difficult.

For myself, I tend to fall on the liberal reception of Say’s Law, but I do think that Say wrote something 1) true,but also, 2) incomplete and 3) ambiguous. So, contextualizing Say’s argument is necessary to understanding.In my view, two contexts are needed to understand Say’s Law on its own terms. First, that is was written todebunk the now long forgotten economic theory of Mercantilism. Second, it is best known as the foil to J.M.Keynes General Theory and Keynesian economics more generally. The Mercantilists argued that national

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wealth increased through the accumulation of gold. Say,like other Classical economist such as Smith and Hume,wanted to emphasize the “real” productive capacity (the“supply-side”) of the economy to show that hoarding goldand protectionst trade policies was not a path to greaternational wealth. Later, during the second half of the 19thcentury, Say’s ideas (and others) become fused with thedoctrines of laissez-faire, Social Darwinism, and Victorianmorality that gave his economic ideas a different coloring.It was this later version of Say’s Law to which Keynes wasprimarily responding with its opposition to governmentintervention to ameliorate the economy, its misapplicationof Darwinian biology to social, political, and economicaffairs, and the penchant to ascribe moral meanings to economic outcomes. Put in modern terms, Say’s Lawargues that the best way to grow the economy is to increase productive capacity by encouraging investment,not stimulating consumption. Investment can be encouraged by lowering taxes on capital, reducing regulation,using or improving technology, increasing skills or education (human capital) or fostering entrepreneurship.Economic problems stem from “real” (non-monetary) shocks or temporary mistakes that come from themisallocation of productive resources.

Simply put, Say’s Law argues that supply will create its own demand, an economic version of “if you build it,they will come.” We can work either to satisfy 1) our own needs or 2) the needs of others. If it is for our ownneeds, then it is not sold into the market and has no impact. However, if we work more than necessary to

satisfy our own needs, it is due to the desire to finance the purchase of goodsproduced by another. If we increase our supply/production, we are alsocreating demand/consumption. In total, supply will equal to demand and realdemand cannot exceed supply.

The intuition can be understood by imagining a glass filled with water.The productive capacity of the economy is like the glass container; the liquidis akin to its purchasing power. One could fill the glass to the brim, butanymore would be pointless and wasteful. The only way to “grow” theeconomy is to make the glass larger (or fix some structural flaw -- a crack -- inthe glass). This can only be accomplished by diverting some of currentproduction into savings (investment) and away from current consumption. Ifwe think of the economy as divided into many different sectors, eachrepresented by a smaller glass, we can understand why there may be shortagesor gluts of individual commodities. Expenditures on any commodity competewith expenditures on other commodities. There can be a misallocation, but

not a general shortage. Money’s only function here is to facilitate commodity exchange, but it does not add orsubtract from the value of the underlying commodities. Here is Say in his own words.

The other implication of Say’s Law is that any unemployment of resources, including labor, is by choice. Thereis no, long-term voluntary unemployment. Individuals “choose” leisure, preferring the opportunity cost oftheir time over the income their labor would provide if employed.

SAY’S “SEVEN” LAWSAdapted from William Baumol

1) Effective demand is limited by and equal to its output, because production provides the means to purchase output.

2) Expenditure increases when output rises3) Investment is more effective than an equal amount of consumption to raising the wealth fo a community

4) Over time, communities will find demand for increased output

5) Production of goods, not money supply, is the primary determinant of demand.

6) Any excess of one good implies a deficit of another good7) Supply and demand are always equated by a rapid and powerful equilibration mechanism.

It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a marketfor other products to the full extent of its own value. When the producer has put the finishing hand to hisproduct, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he lessanxious to dispose of the money he may get for it; for the value of money is also perishable. But the onlyway of getting rid of money is in the purchase of some product or other. Thus the mere circumstance ofcreation of one product immediately opens a vent for other products . . . Money performs but a momentaryfunction in this double exchange; and when the transaction is finally closed, it will always be found, thatone kind of commodity has been exchanged for another.

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4.1.2 QUANTITY THEORY OF MONEY4.1.2 QUANTITY THEORY OF MONEY

Another way to conceptualize Say’s Law is through the “quantity theory of money.” The quantity theory ofmoney is a simple formula to analyze economic aggregates. It has four components: the quantity of money incirculation (M), velocity (turnover) of money (V), the price level (P) and the real value of goods produce (Q).The equation sets the money stock and flow equal to the value of goods and services as follows.

The left side of the equation gives us aggregate demand or purchasing power in terms of money. The right sideis equal to the aggregate production of the economy. We can determine the money supply by dividingproduction by the turnover rate, yielding the following equation.

The velocity of money (V) is assumed to be constant and the realvalue of aggregate production is fixed in the short-term. Asconstants, they drop out of the equation, resulting in a direct, linearrelationship between the money supply and the price level. If themoney supply is increased, it will have a directly proportional impacton prices, causing them to rise (inflation). If more money chases thesame aggregate of goods and services, the result will be higher pricesall around, but no improvement in the real value of goods andservices. This relationship is shown to the right. The increased moneysupply decreases the value of money and raises the price level.

4.2.1 INTERNAL BALANCES & TIME4.2.1 INTERNAL BALANCES & TIME

Money allows use to “store value,” allowing us to separate the activities of production and consumption. Whenwe are hungry, we do not have to “produce” food, i.e., go out to our garden and harvest the produce, but canuse money that we earned at an earlier time to buy it and “consume” it. Likewise, we are not limited in ourconsumption buy our current production. If I want to attend college, but, like most people, do not earn$100,000 per annum to pay for it, I can still “consume” the education now, and “produce” later by workingand pay the tuition bill. This is only possible because we live in a money economy that lets us “store” the valuefrom our productive time.

At any given time, there are some people who are producing more than they are consuming AND there arepeople who are consuming more than they are producing. This is not a problem because the first group --“savers” -- can lend their excess to the second group -- “borrowers”. Net savers are sending their presentproduction forward to pay for future consumption, while net borrowers are pulling forward their futureproduction to pay for current consumption. It becomes a problem when the flows of total saving and the flowsof total borrowing do not produce a stock of purchasing power in the present that employs available resources.If people, in aggregate, decide they would, on balance, rather spend money later than now, purchasing powerin the present will be deficient. While it remains true that income = expenditure, if the outflow of expenditure(savings) to the future is greater than the inflows of expenditure from borrowing from the future (loans) andthe stocks of past savings (returns on investments), we have an imbalance of production and consumption thatwill produce unemployment (consumption < production) in the present. Likewise, if the inflows to the present

M*V = P*Q

M = P*QV

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exceed the outflows, then there is an imbalance of production and consumption in the present that willproduce inflation (consumption > production). Maintaining a balance that reduces both unemployment andinflation is the “internal balance” of the economy.

Let us walk through this idea again with the help of a visual aid. Recall the analogy of Say’s Law as a glass thatrepresented the productive capacity of the economy and the liquid representing the purchasing power. Insteadof one glass, let us imagine three for the past, present, and future periods. When we save, we are “pouring”some of the liquid from the “present” into the “future,” leaving less purchasing power in the “present” to buywhat is produced today.

Another way to create an imbalance in the present is debt. Debt is borrowing come due and can be thought ofas a payment from the present to the past. When we pay down our debts, we are not consuming currentproduction. Although one person’s debt is another person’s credit, if a bank does not issue a new loan, anduses the revenue from incoming loans simply to repair a hole in their own balance sheet, it does not chase thecurrent production of goods.

These imbalances have balancing counterparts. The counterpart to saving is borrowing, which allows thefuture to “pour” some of its purchasing power into the present. Similarly, the counterpart to debt is investmentand savings. Savings we sent into the “future” arrive later as payments from the past into another present. Thedirection and magnitude of the flows is the short-term interest rate set by the open market activities of theFederal Reserve Bank and the long-term bond market in government securities for the long-term interest rate.Other things equal, a high interest rate will encourage saving and discourage borrowing, causing a flow fromthe present to the future, while a lower interest rate will encourage borrowing and discourage saving causing anet reverse flow from the future to the present. In our glasses example, the interest rate is similar to the angeof tilt of the glasses. The greater the angle of tilt, the greater magnitude of the flow. Tilt toward the future,promote saving; tilt to the present, encourage savings. The goal is to have an interest rate that promotes theemployment of productive resources (especially labor) and promotes real growth in the economy’s productiveresources in the future.

4.3 THE IS/LM FRAMEWORK4.3 THE IS/LM FRAMEWORK

How does one strike the proper balance of consumption and production in the present and future? TheSwedish economist Knut Wicksell coined the concept of a “natural rate of interest” that would be the interest

Imbalance caused by saving

PASTPAST PRE S

E NT

PRE S

E NT

FUT UREFUTURE

Imbalance caused by debt

PASTPAST

PRE SE NT

PRE SE NTFUT UREFUTURE

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rate that would maintain the dynamic balance of money across periods of time. However, money, especially inthe age of fiat money, is not a scarce resource: banks and governments can expand or contract the supply ofmoney through their policy decisions. Therefore, money’s “price” cannot be determined by simply supply anddemand considerations. At any given time, banks and governments can announce a short-term interest ratethat is either above or below the hypothetical natural rate, creating too much or too little demand for producedgoods and services.

Although money’s “price” (the interest rate) is not decidedthrough a market mechanism, we can imagine a hypotheticalmarket for money where the price is the equilibrium between the“demand” for money (investment-savings) and the “supply” ofmoney (loans to finance consumption) and plot them on anordinary supply and demand chart, where the interest rate is theprice and the economy’s productive capacity is the relevantquantity. This chart -- IS/LM diagram -- is shown to the left. The“demand” for investment-savings (IS) slopes downward. At highinterest rates, individuals are more willing to send money to thefuture via savings, making it unavailable to support presentproduction of income. They want money, not goods and services.However, at higher rates of interest, banks are more willing tomake money available due to the higher return to their money

stocks. As a result, they are more willing to supply money to the economy. There is a key difference herebetween the argument of Say’s Law and the IS/LM framework. In Say’s Law the size of the economy -- thevolume of the glass container -- is set first by its productive capacity, which then dictates the amount ofpurchasing power. However, in the IS/LM model, the interest rate sets the availability of money, which thenin turn, determines how much income will be generated in the present period.

4.3.1 LIQUIDITY PREFERENCE4.3.1 LIQUIDITY PREFERENCE

A key insight of the IS/LM framework is its explanation for why peoplemight want to hold money or have cash balances. For Say, no onewould want to hold money, preferring to trade it as quickly as possiblefor some desired commodity available in the market; money is given uplike a “hot potato.” However, in the real world, we know that peopledo maintain cash balances with high liquidity such as checking ormoney market accounts. We also know that professional investorstypically hold part of their portfolio in cash or forms of commoditymoney (gold). Why?

We can begin to answer this question if we recall the various functionsof money. The first is need for money for transaction -- money as amedium of exchange. This is the notion embraced by Say’s Law. Wehave a certain amount of things we wish to buy, which requires a certain amount of money. Therefore, asshown on the chart to your right, it is a near vertical (inelastic) demand curve. We want a certain quantity, anymore would be pointless, any less would be perilous. As a result, we will also pay any price for base quantityof money as shown by individuals who go to loan-sharks or pay high interest-rate credit cards because notdoing so would deprive one of some perceived necessity. Individuals do not contract punitive interest ratessimply to look at green pieces of paper in their wallet. The second derives from money’s function as a store ofvalue. When we produce goods and services, we could store our wealth in a variety of ways. For example, I maystore my wealth in strawberries and hope that I can find a dentist with a taste for strawberries who is willing

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to do root canals for strawberries. However, if I holdmy wealth in money, I can be reasonably certain thatmost people will take it in return for their goods orservices. Storing my money at a bank, even at a low rateof return, or paying a simple free for a credit/debit cardis simply more convenient than carrying around bagsof gold to pay. Like the transactions demand formoney, this demand curve is vertical (inelastic),because the interest rate it is essentially a transactionsplus storage fee. The third draws upon money’sfunction as a unit of account. In deflationary economicenvironments, when real prices of goods and servicesare dropping, one can speculate on the value of moneybeing worth more in the future than it is now. If goodsand services are cheaper in the future because prices aredropping, the same amount of money will purchasemore in the future. This is the basis for those whoinvest in gold. Gold, they feel, will hold its value -- because it is used as a unit of account -- while othercommodities and assets lose value. This purpose for holding onto cash balances is speculative. If ones sumsthese curves together to identify the total demand for money, on finds a “L-shaped” curve like the one shownabove.

Liquidity preference -- the preference to hold a liquid asset like money over a more illiquid (and perhaps morevaluable) asset -- is fundamentally forward looking. It is the comparison of the present over the future or viceversa. A key element of this calculation is uncertainty. Future prospects do not necessarily have to be bad forindividuals to want to hold cash balances, they need only be uncertain. As a result, the perception of economicuncertainty or volatility in the future can have real impacts on the economy today

4.3.2 LIQUIDITY TRAPS4.3.2 LIQUIDITY TRAPS

The IS/LM framework also identifies the potential problem of liquidity traps. A liquidity trap is whereincreases in (money) supply will have no effect on the price of money and therefore cannot raise or lower thecost of savings or investment. Using ordinary monetary policy (the purchase and sale of securities), the interestrate cannot go below 0%, the “zero lower bound.” Therefore, after one has reached 0% interest, further

increases in the supply of money will not lower the levelof savings or raise the level of consumption. Individualswould rather hold onto money (savings), becauseholding a cash balance is worth more than a) spendingmoney on goods or services now, because they aredecreasing in value or b) investment opportunities withpositive returns on investment.

We can think through this problem using the chart tothe left. The dotted purple line is the level of outputrequired for full employment. Reflecting the zero lowerbound, the LM curve is flat at 0% interest. Theintersection of the IS & LM curves is below the level ofproduction needed for full employment. Increasing themoney supply (moving the LM curve to the light blueline), does not change the point of intersection.

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4.3.3 INFLATION4.3.3 INFLATION

The previous discussion of liquidity preference focused primarily on situations and circumstances wheredemand is deficient due to a lack of purchasing power to buy current production. By reversing the flows,purchasing power could be greater than current production, which will drive up prices (inflation). However,inflation can be thought of as the reverse side of liquidity preference is inflation. If prices of real goods andservices are rising quickly, money is losing value relative to them. One would prefer not to have a cash balanceat all, because the balance would decline as money depreciated. At high levels of inflation, money even losesits function as a medium of exchange.

4.4 DEBT DEFLATION4.4 DEBT DEFLATION

While liquidity preference is a forward looking problem with the internal balance, debt deflation is a backwardlooking balance issue. Debt are payments from the present to redeem liabilities incurred in the past. As aresult, they compete with current consumption for purchasing power: If I am paying down my student loan, Iam not purchasing a flat-screen TV with that purchasing power. While it is true that any person’s debt issomeone else’s credit and so there is no net loss, simply a redistribution, of purchasing power, one can defaulton debts, retired debt does not necessarily produce new credit, and debt contracts (typically) are stated innominal terms, but are paid with the proceeds of real goods and services.

The intuition of debt deflation can be understoodby thinking of student loans. In 2004, roughlyfour years before the financial crisis, many highschool seniors understood that their productivity(or at least earnings) would be enhanced byobtaining a college degree. However, the cost of acollege degree was beyond what they could financefrom their current income, so, not surprisingly,they took out loans (incurred debt) to financetheir education. Many of these students graduatedin 2008 into the worst labor market in ageneration and were not able to repay their debtdue to the lack of income. Many were locked outof the labor market by older workers delayingretirement due to their own accumulation of debt.Moreover, many only found work in jobs thatunderused their human capital. As a result, demand for current production decreased, as debts were paid down,creating even less demand for current employment. The chart above shows the same dynamic graphically forthe financing activities of firms. The impact of debt on consumer behavior was shown in recent years whenthe moratorium of foreclosures (and slowed the payment of debt) freed money for consumer purchases,spurring some increase in economic activity.

The economist Irving Fisher first proposed the idea of “debt-deflation” as an explanation for the GreatDepression in the 1930s, but recently, this process has been termed a “balance sheet recession” to distinguishit from normal business cycle fluctuations. Instead of trying to employ all available economic resources,individuals and firms attempt to delever (reduce debt) and repair their balance sheets. Even as debts are paiddown, there is no demand for new credit, shrinking demand in the economy and creating disinflationarypressures as individuals cut prices to raise revenues to pay debts. As a result, the real burden of the debt risesbecause the debt contract is stated in nominal terms, but the proceeds of good and services to service the debtshrink as prices decline. In addition, even as debts are paid down, the individuals and firms receiving the debt

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may not have the same propensity toconsume. A recent study of high and lowdebt countries in the United Statesshowed that high debt counties hadlower automobile sales and employmentgrowth than comparable low debtcounties. Studies by the IMF also supportthe importance of debt in explainingconsumption loss. The below left chartshows that higher levels of debt correlateswith greater consumption loss, countryby country. The chart to the right showsthat high debt nations have much greaterconsumption losses than low debtnations during recessions.

In addition, once begun, this process canbegin to feed upon itself as debt reducesthe demand for money which then inturn reduces the demand for the currentproduction of goods and services. Ineconomics, this feedback process isknown as a Kiyotaki-Moore credit cycleand is illustrated in the charts below.

5.0 EXTERNAL BALANCES5.0 EXTERNAL BALANCES

The economist Charles Kindleberger once marked that anyone who spends too much time thinking aboutinternational money goes mad. Perhaps no economic topic provokes so many incorrect statements andprescriptions by so many otherwise intelligent people as the “external balance” between domestic andinternational money. When economics models were developed in the 19th century, foreign currencies werenot traded; the international currency was gold because all major economic powers adhered to a gold standard,more or less. It was common to describe foreign trade as simply a form of barter: the US produced corn, Japanproduced microchips and they traded corn for microchips. However, it is more accurate to say that the USproduces corn (and dollars) and Japan produces microchips (and yen), and therefore, there is another market

EmploymentGrowth

AutomobileSales

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that sets the “external” balance of dollars and yen.Discussions of international economics often focus oninternational “competitiveness” and stress “real” factors-- labor costs, education levels, and the costs ofinternational commodities -- while overlooking themonetary terms of trade. The critical balance is thebalance of payments of which the trade balance is onlyone component. As the chart to your right illustrates,there are many different international monetary flows --many that have little to do with the exchange of goodsand services (exports and imports) -- that can affect theinternational balance of payments. The thinking aboutinternational money parallel the previous section’sdiscussion of domestic money and its role in the creationof potential imbalances between consumption andproduction.

5.1 PRICE-SPECIE FLOW MECHANISM5.1 PRICE-SPECIE FLOW MECHANISM

The original economic thinking on trade had a simpleformula: exports good, imports bad. If exports exceededimports, the balance was gold and accumulating goldwas the same as accumulating wealth. No one thoughtthat money stocks had any effect on real economicactivity, but this position was criticized by David Humewho laid out the price-specie flow mechanism. The price-specie flow mechanism can be thought of as Say’s Law orthe “quantity theory of money” (Sections 4.1.1 & 4.1.2above) applied to international trade.

The accumulation of money stocks (gold) by nationsrunning trade surpluses, Hume argued, would raisedomestic prices as more purchasing power chases thesame stock of goods and services. In parallel, the outflowof money stocks from countries running trade deficitswould lower prices as less purchasing power chased the same stocks of goods and services. This developmentwould make goods and services produced in the trade surplus country more expensive to foreigners and foreigngoods and services less expensive to domestic consumers. This would eventually rebalance trade and monetaryflows. Trade posed no net loss in wealth: imports would eventually lead to more exports and exports financedthe purchase of imports. What consumers lost in terms of income, they would regain in lower prices onimported goods and services. Therefore, the only real source of wealth were the stocks of real factors thatnations competitive or not.

5.2 MUNDELL-FLEMING5.2 MUNDELL-FLEMING

The fly in price-specie flow mechanism’s ointment is money. For Hume, international money could be reducedto flows of gold specie, but in the modern global economy, there are many national currencies whose supplyis controlled by each nation’s central bank or government. Therefore, there is also a market setting the termsof exchange between various national currencies. In terms of international economic policy, each nation wants

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three things: control of their domestic money supply, stableexchange rates, and access to capital markets. The problem theyface, however, is that it is only possible to have two of thesethree options. You can have capital mobility and stableexchange rates, but only at the cost of impaired monetary andfiscal policy (Europe). You can have capital mobility andmonetary policy, but only if you let your currency float (USA).You can have stable exchange rates and effective monetary andfiscal policy, but only by reducing capital mobility (China). Tounderstand why, we must add the foreign exchange rate to thedomestic IS/LM model of money’s supply and demand. Theforeign exchange rate can be thought of as the global interestrate and can be drawn as a horizontal line that intersects withthe domestic IS and LM curves, as shown in the diagram toyour right. If the domestic interest rate is below the global interest rate, savers would rather put their moneyin foreign financial institutions. For example, if the Bank of Japan offered 7% interest on deposits, while theUS Federal Reserve only offered 4% interest, savings would gravitate toward the Bank of Japan and away fromthe US Federal Reserve. Conversely, if the domestic interest rate is higher than the global one, it would attractsavings and investment. The IS (Capital Mobility), LM (Monetary & Fiscal Policy), and FE (ForeignExchange) curves correspond to one of the three options of this trilemma. Economic policymakers can controlthe position of two of them, but not the third.

For example, if a central bank increases the money supply (lowers theinterest rate) to stimulate the economy, it will shift the LM curve to theright. As a result, the IS and LM curves will intersect below the level ofthe prevailing exchange rate. Two things can happen. First, theexchange rate could fall to the level of the IS/LM intersection. Ifexchange rates are allowed to float, this will happen naturally, becauseincreasing the money supply lowers the domestic currency’s value vis-a-vis foreign currencies. This will have the effect of increasingconsumption (the rightward shift in the equilibrium) by shiftingproduction from foreign to domestic production through the weakeningof the exchange rate.

Second, the IS curve could shift outward to preserve the prevailing exchange rate, i.e., allow it to remain fixed.If the exchange is fixed, this means that investment-savings (capital) will move abroad to seek higher returns.While this would expand output, it might spark a “bank run” as investors pull out their capital out of domesticbanks, contracting credit extended by banks. Only capital controls that impede the outflow of capital preventthis and so it sacrifices capital mobility.

Another adjustment scenario is an outward shift of the IS curve whetherto attract foreign capital for investment or due to a foreign nation’sdesire to depress their own currency by propping up your own currencyin order to promote their exports. Once again, two things can happen.First the exchange rate could rise to the level of the IS-LM intersection.If exchange rates float, this will happen as the result of “market” forces,because inflows of foreign capital will increase the demand for thedomestic currency relative to foreign currencies. This will increaseconsumption, but only partially, because it shifts production fromdomestic to foreign production by strengthening the exchange rate, but

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depress consumption via a higher interest rate.

Second, the LM curve could shift outward to preserve the exchange rate at its previous level. If the exchangerate is fixed, this means that the money supply will expand to absorb the inflow of capital. This will drive updomestic prices as more money chases the same stock of goods and services. While this will increase assetvalues, such as home and equity prices, it will also create inflationary pressures on ordinary goods and services.This could be prevented by “sterilizing” (keeping out of circulation) foreign capital inflows or loweringinterest rates or government spending, but to do so would cede control over domestic monetary and fiscalpolicy.

5.3 TRILEMMA5.3 TRILEMMA

The Mundell-Fleming model shows what options are available fornational governments in managing international money; it does nottell which sets of choices are the best. Different nations in differenteconomic circumstances can reasonably choose different combinationsof options. From the late 19th century until WWI -- the first age ofglobalization -- the major economies opted for a gold standard regimeof fixed exchange rates and capital mobility and central banks wereeither non-existent or played passive roles. The borrowing costs offighting the WWI rendered the gold standard impossible andcontributed to the causes (hyperinflation and deflation) of the GreatDepression. As a result, many nations desired more monetaryautonomy to combat the vicissitudes of the business cycle. AfterWWII, the Bretton Woods System created a system of fixed exchangerates (pegged to the US dollar) and monetary autonomy throughoutmost the world. The American burden of maintaining this systembecame too much, and in the 1970s, it abandoned the gold standardand allowed the dollar to float. Since the 1990s, the reemergence of thegold standard economy through the adoption of the “Washington Consensus” policies of deregulation, capitalmarket liberalization, free trade, property rights, and lower taxation in concert with the “second age ofglobalization” has appeared. The charts below show that developed countries’ policy choices have diverged,opting for greater capital mobility and currency stability, while allowing monetary autonomy to wither.Conversely, policy choices in the developing world have converged to greater balance between the three.

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Some observers, such as Harvard economist Dani Rodrik, argue thatthe trilemma is not simply an economic choice, but has additionalimplications for the choice of political institutions. The gold standardsystem that prevailed before WWI and since the 1990s, has reinforcedthe economic status of nation-states, while permitting the integrationof national economies. However, democratic control over these forces,as witnessed by the decline of labor unions and the insulation ofeconomic decisionmaking from democratic oversight, has largelydissipated. The Bretton Woods system that reigned from the end ofWWII to the 1970s, allowed the resurgence of democracy within thefriendly confines of the nation-state (and insulated from internationaleconomic competition). In between, efforts at constructing globalfederations -- WTO, EU, G-7/G-20, UN, ILO & IMF -- deal withinternational issues from climate change to child labor to regulatoryharmonization to international debt have been attempted. However,since they have often threatened the prerogatives of the nation-state(and powerful groups within nation-states), these organizations of international governance have been largelyineffective and not particularly democratic. The increasingly common sentiment that governments are nolonger accountable or responsive to their citizens while battered by international forces such as globalizationare consistent with the inadequacy of political institutions to grapple with the economic trilemma ofinternational economic affairs.

6.0 INTERNAL & EXTERNAL BALANCES6.0 INTERNAL & EXTERNAL BALANCES

How can we resolve both the internal balance betweeninflation and unemployment and the external balancebetween trade surpluses and deficits? In the previous section,the trilemma laid out the potential choices facing economicpolicymakers, but did not indicate what choices wereoptimal; the best choices depends on the situation andcircumstance. A Swan Diagram, named after the Australianeconomist Trevor Swan, provides a simple method ofdiagnosing one’s situation. The diagram puts the twobalances on each of its axes. On the horizontal axis is theinternal balance. The internal balance can be gauged inseveral ways. Essentially, it is the relationship of currentconsumption to current production. First, by the size of thepublic budget deficit. If the private sector is in balance, thesource of the imbalance is public spending over publicrevenues (taxes) or the budget (fiscal) deficit. Alternatively, one could use excess unemployment.Unemployment would suggest that spending (demand) is less than the economy’s productive capacity(supply). The external balance is on the vertical axis. This can be measured in several ways. Narrowly, it canbe measured as the trade deficit -- the value of exports minus the value of imports. Broadly, it can be measuredas the current account (balance of payments) deficit, which incorporates all international monetary flows.

The fiscal deficit divides the space into two zones. The northwest corner is the “unemployment zone,” createdby insufficient spending. The southeast corner is the “inflation zone,” generated by too much spending.Likewise, the trade deficit divides the space into two zones. The northeast corner is the trade/current accountdeficit zone created when imports exceed exports. The southwest corner is the trade/current account surpluszone made when exports exceed imports. Added together, these overlapping zones create four archetypal

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problem areas: trade deficit + unemployment, trade deficit + inflation, trade surplus + unemployment, andtrade surplus + inflation. The point where the two lines cross is the point where both the internal and externalbalances are in balance; all other points represent some type and magnitude of imbalance.

Where do contemporary countries fall on the SwanDiagram and what policies would this recommendto them to recover their internal and externalbalances? The illustration to your right issuggestive where several economies are currentlylocated. Beginning in the north quadrant, we findthe USA, with higher than normal unemploymentand persistent trade deficits. In the south quadrant,we find America’s mirro image: China. China, forthe past decade, has run large and persistent tradesurpluses and experienced significant assetinflation, especially in housing and equity prices.To the right, we find Greece, a country runningtrade deficits and experiencing high inflation.Finally, Japan is low-inflation, low-unemploymentcountry that runs persistent trade surpluses (atleast with the USA), placing it in the lower leftquadrant.

What policies should each of these countries take to rebalance their economies? For the USA, the policy mixshould include increased government spending (fiscal policy) and currency devaluation. China, once again, asmirror image, should do the opposite. It should impose some austerity and allow its currency to appreciate.Greece should impose some austerity and devalue its currency. Greece’s problem, however, is that it cannotdevalue because it does not control its own currency (and it no longer controls its own monetary policy and ithas lost access to capital markets). Japan should be increasing government spending and allow its currency toappreciate. However, each of these countries is now doing the opposite of what this model suggests. The USAmaintains a strong dollar and has embarked on mild austerity measures. China has only recently allowed itscurrency to appreciate, but also has initiated a new raft of government spending measures. Japan’s yen hasappreciated, despite the government’s efforts to prevent it, and its government spending has been fitful. Lackof its own currency has precluded the devaluation option for Greece, but it has been equally unsuccessful inreducing its high costs.