The money economy: mercantilism, classical economics and Keynes' general theory - Special Invited Issue: Money, Trust, Speculation and Social Justice - Part 2: Trust and Money

American Journal of Economics and Sociology, The, Oct, 1998 by G.R. Steele

I

Introduction

The use of money released mankind from close dependence on nature and local markets; but, in facilitating a high degree of specialization and exchange, money has caused individuals to rely on the entrepreneurial success of others. Yet, even those normal hazards of business and trading relationships can be exacerbated by an untrustworthy monetary system. Price signals - the means by which diverse activity is coordinated - are corrupted by monetary disturbances. The nature and detail of that disruption is the focus of monetary economics, where a primary requirement is to identify ideal conditions whereby economic coordination may best be achieved.

The influence of money is described as "neutral," when it neither impedes nor enhances activity in real sectors of the economy. With neutrality, markets and money are analogous to engines and lubricating oil. The fundamentals of free exchange or engineering can be explained in the absence of money or lubricating oil, but the practicalities remain. Neutral money, like a frictionless engine, provides a conceptual benchmark. It is an abstraction, the conditions for which can "never be given in the real world." So, there is no corresponding stratagem: no "maxim which is immediately applicable to the practical problems of monetary policy" (Hayek, 1935, p. 129). The concept of neutral money is simply an enabling device to reach a greater depth of understanding of the essential problems of the money economy.

In practice, money cannot be neutral. Not least for the fact that it does not exist in a pure form,(1) the presence of money necessarily intrudes on the circumstances of real resources allocation and exchange. Whether in the context of classical economics or that of more recent macroeconomics, many of the economic "bads" that are associated with business cycles and international payments disequilibria originate in monetary disturbances. Yet, the explanations that are provided by classical theory are very different from those of Keynes' General Theory. So, it is necessary to exercise judgment on their respective plausibility.

II

Classical Economics: Say's Law and Mercantilism

In attempting to reach such a judgment, an obvious starting point is the proposition (that is, Say's Law of markets) that supply creates its own demand. This has come to epitomize classical economics, for the simple reason that it was selected by Keynes for sacrifice to his new principle of effective demand.(2) Jean Baptiste Say had expounded and elaborated upon Adam Smith's great work (The Wealth of Nations, 1776); and the significance of Say's Law of markets rests with its contradiction of the mercantilist case against free trade.

Mercantilism originated during the transition from the feudal economy to merchant capitalism and international commerce, in the sixteenth and seventeenth centuries. A strong central authority was considered essential to the expansion of markets and it was a mercantilist imperative that the power of the state should be enhanced by an accumulation of national wealth. Here, a general concern with business recession had become focused in a particular fear that productivity might outstrip consumers' purchasing power. Mercantilists argued that nations compete for business opportunities; they asserted that a nation prospers only at the expense of other nations and they concluded that a trade surplus provides the wealth necessary to support the international prestige and power of the state.

According to Say's Law, the mercantilist fear of a general glut is unfounded, for the reason that individuals produce goods either for personal consumption or to buy other goods. Supply and demand are concepts that relate to a nexus of diverse commodities, so the idea of general overproduction is rendered meaningless. Recessions resulted, not from any general overproduction,(3) but from the overproduction of particular items beyond their levels of demand. In a market system, this implied a deficiency in the production of some other items, so that business recessions were symptomatic of a necessity to redeploy (or to reprice) productive factors.

The argument against mercantilism and in favor of free trade applied to domestic and international markets alike. The efficiency gains from specialization and the division of labor implied that variety in the composition of consumption was almost entirely dependent on trade. Consumption and investment goods were acquired generally through the production of other items with the implication that production created not only a supply of goods but also (by a willingness to trade) a demand for goods. Free trade allowed the creation and distribution of a greater diversity of goods, and export sales were retarded only by a refusal to allow foreign goods access to home markets. As a corollary, the mercantilist assertion, that prosperity requires preferential access to foreign markets and the protection of domestic markets, was also phony.

III

Classical Economics: Money and Interest Rate Determination