The Classical economists, David Ricardo, Karl Marx and, to a lesser degree, John Stuart Mill disagreed with both the "pure" Quantity Theory of Hume and the real bills doctrine of Smith. They possessed what is known as a "commodity theory" or "metallic theory" of money. Money, in their view, was simply gold, silver and other precious metals. In this sense, the price of money was just like that of any other commodity: cost of production. Or, more explicitly, they regarded the long run value of money to be quite directly the costs of extracting from mines the precious metals that either constituted commodity money (coins) or the gold that underlay convertible paper money. Thus, fiat money, where notes are neither a commodity nor convertible to it, remain outside the scope of their theory. For instance:
Thus we can understand Ricardo's position in the Bullionist Controversy). John Stuart Mill was equally explicit at this point:
But how would Ricardo, Mill and company explain phenomena such as the Elizabethan Inflation? David Ricardo (1811, 1817) claimed that the "price" of money was the exchange rate between currency and commodities. Letting letting pm represent the value of money and P the price level, then pm = 1/P. Now, according to Ricardo, under normal, long-run conditions, the value of money, 1/P, is equated with the cost of production of money (gold/silver). If we denote this cost by C, then obviously it must be that pm = 1/P = C in the long run. Along the lines of Ricardo's theory, then, the Great Elizabethan Inflation arose because of a "change in technique" in gold production during this period. What change? Plentiful new mines in the America and English piracy on the Spanish Main in this period brought in much gold and silver to Europe and England. Instead of being forced to build large, expensive mines in deep German mountains, the same amount of gold and silver could be obtained with a cheap, well-armed ship and a Sir Francis Drake at the helm. Thus, moving from European mines to pirates and American mines represented a "change of technique" in the acquisition of gold. As the falling costs of gold arising from the sudden discovery of cheaper techniques or new sources of cheap gold mean a fall in C. Thus, holding everything else constant, pm > C, price of money (gold) is greater than the cost of production. This implies there are excess profits in the "gold" industry. By Ricardo's short law of excess profitability, these high profits will induce greater entry into the gold production business (i.e. greater conquests in America, more intensive exploitation of Andean mines, more buccaneering on the high seas). This will bring greater gold into the country. In the long-run, the price of gold must be brought down to equate cost. But when we say that pm must be brought down, then we immediately are implying that the price level, P, must rise as pm = 1/P by definition. Thus, a falling cost of money induces an increase in the supply of money as well as itself raising P as the market price of gold (1/P) must fall in line with its lower cost-of-production. The Elizabethan Inflation and the influx of American gold accompany each other, like the Quantity Theory claims, but now the causation is rooted in cost of production. The Quantity Theory relationship from money to prices only "seems" to be true because that is how the short-run adjustments work themselves out. Do we have "neutrality" nonetheless? In a sense, that question cannot be asked as money is gold and gold is a good. We have neutrality only in the sense that the prices of all goods are determined by cost of production and a change in the supply of money is an effect and not a cause of changes in cost of production. There is neutrality only in this sense. Thus, when everything is adjusted to its long run values, the price of gold relative to other goods is different, i.e. P is higher, and that has been accompanied by a rise in money supply. The only way the question can be asked properly in the short run and in the following terms: suppose C falls, profits in the gold business rise and that induces increases in money supply. The long-run law says P must rise so that 1/P will fall to equate C. But are we sure that this will happen in full? In other words, are we sure that the increase in the money supply will have no other effects on any other long-run prices (e.g. price of iron in terms of corn, or price of wheat in terms of beef, etc.)? In a sense, this question was not really answered well by either Ricardo or Mill because they themselves were a bit confused by it. Naturally, Ricardo would have claimed that if the costs of production of beef declined, then all long-run prices should readjust themselves not only with relation to beef but also with relation to themselves. But when it came to a fall in the costs of gold production, the issue of "neutrality" seemed to raise its head when in fact it should have been treated in the same way. In other words, Ricardo should have answered "obviously not! everything must readjust!". But Ricardo did not really say this - at least not in 1810 when he was furiously involved in the Bullionist debates and had yet to sit down and write his theory of value and distribution (1817). However, this confusion was also true of John Stuart Mill - who in spite of adopting Ricardo's theory of commodity money, nonetheless had an obvious soft-spot for the old Quantity Theory of Hume and at times would seem to argue one, and then the other theory. But this whole issue becomes particularly understandable when considering interest rates. Hume (1752: p.296) and Smith (1776: p.354) had argued that money does not affect interest rates in the long run (although it may affect it in the short). We then find David Ricardo's High Price of Bullion (1810), as well as in J.S. Mill (1848: p.431), arguing fiercely for the same neutrality position. We can perhaps understand it in this context. At issue was the issue of non-convertible money and not a reduction in the costs of gold. Now the issue of neutrality makes sense as we have broken the commodity theory of money. With a potentially infinite supply of money but no change in the cost of production of any goods, the price of all commodities must rise while leaving output unchanged. This is obvious by Say's Law: all real demand is equal to all real supply; unbacked paper money is not "real supply" thus there cannot be a change in "real demand". We only have an "artificial" rise in prices along the lines Hume had argued. Thus interest rate - the price of "real" loanable funds - should not change. They did allow for short-run effects though. Consider what Mill wrote on the issue of interest rates:
That "something" is the increase in loans - as currency are issued as loans by banks. Hence, "though as currency these isues have not an effect on interest, as loans they have." (Mill, ibid). Is this a slip? Not quite: what Mill argues is that the quantity of money stock itself does not influence interest, but the growth of money stock does because banks are issuing credit. Thus, the rise in the quantity of loans, by the Ricardo-Mill scenario, will reduce interest - what Wicksell would later call the "money rate of interest" (see below) - in the short-run. But only in the short-run. As Ricardo writes:
Thus, like everything else, this non-neutral effect of money on interest will be eliminated in the long run. This remarkable idea of money and credit influencing prices is remarkably akin to Wicksell's and indeed, its first exposition was by Henry Thornton (1802), Ricardo's partner in the Bullionist Controversy. A final caveat was introduced by the Classicals: i.e. the possibility of "differential effects" of increases in money. In other words, as Mill (1848: p.335-6) outlines, a money expansion does not give equal purchasing power but works itself through the economy slowly and differentially: a foreigner arrives with new gold, pays the baker, the baker then pays the his laborers, etc. While this process is happening, the price of bread, wages, etc. will change relative to other goods, depending upon where the money expansion began. This is a "real effect" but is it temporary as well? Mill then makes the peculiar claim that it is "exactly as if a change had taken place in the tastes and wants of the community. If this were the case, then until production had accomodated itself to this change in the comparative demand for different goods, there would be a real alteration in values, and some things would rise in price more than others." (Mill, 1848: p.336). This is peculiar since Mill seems to be claiming that the differential effects of money supply will affect the real economy permanently. He then goes on to try to rescue the neutrality proposition by arguing that "these effects however, would evidently proceed not from the mere increase in money, but from the accessory circumstances attending it." (Mill, 1848: p.336). Again, as in the case of interest, it seems that this is a flow phenomenon and possibly temporary. But he never comes around to actually saying that it works itself out later. Quite the contrary, he then changes tack and returns to the contrivance of a "pure money increase" free of differential effects - in the sense of "to every pound, or shilling, or penny in the possession of any one, another pound, shilling or penny were suddenly added" (Mill, ibid). In this case, yes, the pure neutrality result holds true, but not, it seems, in any other. This peculiar and brave addendum implies that Mill believed the neutrality to be a theoretical contrivance - true if we conduct a "pure money increase", but not true in reality when there are permanent differential effects. As he stresses:
His strange admission about differential effects, which seems to fly in the face of all that he had been written before, is paradoxical yet precocious. What is even more interesting, however, is that Mill, far more than Ricardo, seems to focus on the traditional Quantity Theory with money-to-prices causaility and is almost on the verge of resurrecting Hume's doctrine in full. Years later, Marx was to follow the Ricardian line of a "metal" theory of money more closely. But, in Marx, money can break up the exchange process and could have temporary short-run effects which could nonetheless be a prolonged punctuated crisis - the famous C-M-C' turned into M-C-M'. Marx, thus, also flirts with non-neutrality, but turns back to it in the long-run. Where Marx truly differs from Quantity Theory is in the causality, affirming without ambiguity that changes in price induce increases in the money supply, and not the other way.. |
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