CLASSICAL THEORIES OF MONEY, OUTPUT AND INFLATION

CLASSICAL THEORIES OF MONEY, OUTPUT AND INFLATION

Classical Theories of Money, Output and Inflation A Study in Historical Economics Roy Green Senior Lectllrer in Economics University of Newcastle. New South Wales Australia M St. Martin's Press

Roy Green 1992 Softcover reprint of the hardcover 1 st edition 1992 All rights reserved. No reproduction. copy or transmission of this publication may be made without written permission. No paragraph of this publication m"ay be reproduced. copied or transmitted save with written permission or in accordance with the provisions of the Copyright. Designs and Patents Act 1988. or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency. 90 Tottenham Court Road. London WI P 9HE. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. First published in Great Britain 1992 by THE MACMILLAN PRESS LTD Houndmills. Basingstoke. Hampshire RG21 2XS and London Companies and representatives throughout the world This book is published in Macmillan's Stlldie.f i/l Political CO/lOIll)' series General Editor: John Eatwell A catalogue record for this book is available from the British Library. ISBN 978-1-349-22390-9 ISBN 978-1-349-22388-6 (ebook) DOI 10.1007/978-1-349-22388-6 First published in Ihe United Slales of America 1992 by Scholarly and Reference Division. ST. MARTIN'S PRESS. INC. 175 Fifth Avenue. New York. N.Y. 10010 ISBN 978-0-312-08556-8 Library of Congress Cataloging-in-Publication Data Green. Roy. 1951- Classical theories of money. output and innation: a study in historical economics I Roy Green. p. cm. Includes index. ISBN 978-0-312-08556-8 I. Money. 2, Innation (Finance) 3. Credit. I. Title. HG220.A2G68 1992 332.4-dc20 92-20308 CIP

To Deidre, Otto and Claude

Contents Preface xi PART I INTRODUCTION 1 Aim of the Inquiry Structure and approach 2 The Classical Framework Theory and Method Separability Equation of Exchange The short-run Historical periodisation Price behaviour 3 4 8 9 12 14 15 17 19 PART II METALLIC CURRENCY 3 Mercantilism and the Quantity Theory of Money Origin of Quantity Theory Early attempts A new philosophy International context Hume's Essay Specie-flow doctrine Transmission mechanism A 'Neo-Mercantilist' Critique Indeterminacy Young's reconciliation 4 Classical Theory of the Metallic System Money and the 'Real Economy' Output and circulation Wages share Social surplus 25 26 28 31 33 35 38 41 42 45 48 51 52 54 58 59 vii

viii Contents Money and Price Formation 62 Smith's framework 64 Classical circulation law 67 Ricardo's value theory 68 Money and circulation 70 Invariable measure 72 Marx's approach 75 Functions of money 77 Prices and profits 79 The Inflationary Process 83 Ricardo's quantity theory 85 Classical alternative 87 Ambiguity in Smith 89 Marx's hoarding principle 91 Money and crises 94 Falling rate of profit 97 PART III CURRENCY AND CREDIT 5 Introduction of Paper Currency 105 Credit and Fiduciary Money 106 Case for banking 110 Fractional reserve 112 The Real Bills Doctrine 114 Law's system 116 An 'anti-system' 119 Lending criteria 121 Smith's new orthodoxy 124 6 Theory of the Fiduciary System 128 Thornton's Paper Credit 130 Money and credit 132 Output response 135 Price response 137 A managed currency 139 Overissue and Limitation 143 Inconvertible paper 146 Theory and evidence 150 Banking School 154 Marx's 'quantity theory' 158

Contents 7 Theory of the Credit System 161 Fictitious Capital and Interest 164 Money and competition 167 Interest and prices 170 'Natural' rate of interest 173 Credit Control and Law of Reflux 177 Currency-banking debate 179 Gold drains 182 Concept of money 185 Reflux law 189 Business cycle 192 Speculation 195 'State of credit' 198 Rules or discretion 201 ix PART IV CONCLUSION 8 Theory and Policy 207 Appendix: Price Trends in History 213 References 214 Bibliography 255 Name Index 263 Subject Index 266

Preface Controversy is not new to the field of monetary economics. It is well known that the contemporary monetarist challenge to the 'Keynesian' postwar consensus had its origins in the quantity theory of money formulated by the eighteenth- and nineteenth-century classical school. It is not so well known, however, that the classical school also supplied the most trenchant critics of quantity theory, both as a doctrine and policy. Yet these critics, like their modem counterparts, ultimately failed to make their case. The question is why. This book examines the historical antecedents of monetarism and its critics in significant phases of monetary controversy over a period of two centuries. We find, paradoxically, that the key to understanding the debates of this period lies less in the theory of money and prices than in the approach adopted to the analysis of output in a market economy. From this perspective, the problem facing the critics of classical quantity theory is thrown into sharp relief. It is that, due to the universal acceptance of Say's law, they lacked a theory of output comparable with their theory of value and distribution. As a consequence, however sound their policy prescriptions, their theoretical analysis was fatally flawed, and seen to be so. The implications for modem debate, I shall suggest, are profound. They affect not only the neoclassical revival of quantity theory but also its aftermath in financial deregulation and the unrestrained credit expansion of recent years. Although neoclassical economics does encompass a theory of output, it is one which logically implies a monetarist approach to the relationship between changes in the money supply and the price level. My argument here is that an alternative approach must be founded upon a synthesis of the classical analysis of value and distribution, on the one hand, and the theory of output embodied in Keynes's 'principle of effective demand' on the other. This approach has the merit both of internal consistency and practical support for a policy of credit control which is better equipped to avoid the destructive excesses of restriction and expansion associated with monetarism and the neoclassical orthodoxy. The main body of my research for this book, which is a revised version of a Ph.D. thesis for Cambridge University, was begun as monetarism reached its high watermark in Britain and North America in the late 1970s. It was completed after an interval of some years as policy-makers recogxi

xii Preface nised the inconsistency of the theory with both the experience and future requirements of economic management. The problem with the debate at this time, from the 'viewpoint of my research findings, was that it proceeded almost entirely along pragmatic rather than theoretical lines. There was no sense in which the critics of monetarism, despite its eventual fall from grace, could be said to have 'won'. Nor, as a result, was there any guarantee that it could not simply be resurrected at some future date when it suited the convenience of those self-same policy-makers. The research conducted for the book is therefore an attempt to demonstrate the importance of a theoretically coherent alternative to monetarism in the context of a study in 'historical economics'. During such an extended period of research, it is only natural that I should be indebted to the guidance and constructive criticism offered by many coueagues. lowe a particular debt of gratitude to my supervisors. John EatweU and the late M. M. Postan, both of whom exercised a strong influence on the direction of my work. I also benefited at various stages from the advice of Bob Rowthorn, Murray Milgate, Pierangelo Garegnani, Geoff Harcourt, Chris Gregory and Barry Gordon, and from the helpful comments of my examiners, Bernard Corry and Jane Humphries. The manuscript was typed by Kay Lawrence and read by Gwyn and Miriam Prins. all of whom were my neighbours in the lovely village of Great Eversden. near Cambridge in England. However, any remaining errors are mine alone. I would like finauy to express my appreciation to Trinity College, Cambridge. which made a Research Studentship available to initiate my studies, to Clare Hall, Cambridge, which subsequently appointed me to a Research Fellowship and to my parents who supported me throughout. I hope that this book is worthy of their faith in me. Roy GREEN