The Capacity-Output Cross, Part I

by Melanie Friedrichs

Saving-money-tips-stacks-of-dollars-cashNearly every economist who has written about money, from David Hume to Milton Friedman, has disagreed about its role in the economy and its influence on real economic growth. Underlying each argument is the same question, asked but never answered: is money causal? Today it seems like everyone’s got a different idea about what money is and where it’s going. The bond sharks fear deflation and depression, the gold bugs fear hyperinflation, and governments fear excess in either direction but disagree about how to keep the economy under control. Yet most college freshman learn that money is “long- term neutral” in economics 101. If money doesn’t matter, why are we worrying? Perhaps because despite the theory that argues otherwise, we know that the glass condos built in Baltimore and houses standing empty post-mortgage market slump are very real and were built because of money. In this post I propose a different way to conceptualize the money’s causal role, derived not from data, but from a comparison and reconciliation of the views of classical theorists.

A Short History of the Theory of Money

The first economists writing in the late 18th century used a thought problem to conclude that money has a causal effect on prices, but no causal effect on output. If suddenly the supply of money in a nation doubled, prices would double as well, and but would produce only a nominal change; real output would remain the same in the long run. However, David Hume also observed that silver arriving from the new world seemed to stimulate industry as European merchants and craftsman scrambled to produce for Spain’s new wealth. Adam Smith lauded the introduction of fractional reserve banking in Glasgow as a significant reason behind the city’s economic development. Both positions seem to suggest that money causes more than a nominal change. Indeed, outside of the academic economics, popular history nearly always paints finance as causal, with increasing bullion facilitating trade in markets near and far, fledgling banks financing the first factories of the industrial revolution, and the Bank of England’s gold standard leading to a century of prosperity and peace. This dichotomy between the received wisdom and the popular legend remained intact into the 20th Century, until the collapse of the gold standard and the deflation of the Great Depression prompted new thought on the role of money.

Over the next sixty years, John Maynard Keynes, the Austrians, the Monetarists, and the neoclassical rational expectations revolution all introduced new theories of money. The debate between different schools of thought still rages, but by the end of the century a strained consensus emerged: money may have an effect on real output in the short run, but in the long run, it is neutral.

The financial crisis of 2008 proved money causal, in a bad way. The modern era is undoubtedly characterized by financial crises of increasing frequency and increasing intensity. As long as there has been credit, there have been crises, but where the first crises in the 17th and 18th centuries affected few beyond those directly involved, crises

now spread far beyond the scope of the original bubble and the ripples last for longer than can comfortably be called the “short run.” Despite the apparent threat posed by greater and faster flows of money, the financial institutions on Wall Street and elsewhere continue to innovate, creating new instruments and new ways of managing risk to increase the movement of money and take from it a greater cut. Recent events make money seem, suspiciously, causal.

The Capacity-Output Cross

Contemporary policy struggles to build solutions from conflicting theories. The Federal Reserve operates according to the ideas of the Monetarists, the White House designs Keynesian stimulus packages, and Ron Paul and the Tea Party advocate for an Austrian- style haircut. No single theory can completely explain the current recession, and no single theory has proposed a palatable treatment. (When haircuts take the scalp at the same time, they are to be avoided.)

All major theories of money still use, implicitly or explicitly, the equation of exchange, used by John Stuart Mill and derived by David Hume that MV = PQ. Money, times its Velocity (or rate of circulation through an economy) equals the real output (or number of final sales in that economy) multiplied by the Price of the goods and services sold. While all theories accept the equation of exchange as an identity, no two agree on the nature of its components or the direction of causality. The capacity-output cross is my way of reimagining of the equation of exchange. It does not directly affirm or reject any theory, but instead offers a simplified model of money that tries to rethink the issue of causality.

Capacity For Exchange (Money)

The Federal Reserve strictly defines the line between M and V, but in the story of money the line matters very little. New systems of coinage, the discovery of gold deposits, and the introduction of fiat money all increased M between 1776 and 2012. But the growth of currency has been complemented at every step by financial innovation and the emergence of institutions. Fractional reserve banking circumvented the constraint of bullion long before the gold standard fell. Stronger governments reduced the risk of theft and spread a safety net for debtors and creditors alike, increasing moral hazard but greasing the wheels of business. ATMs, credit and debit cards lowered transaction costs, and securitized, optioned, repackaged debt managed the risk of default, speeding the exchange of currency and effectively increasing the money available to be spent in a given period. Velocity is always and everywhere a technological, social, and institutional product.

So while at any given point there is certain amount of money, M, there is also a certain ‘institutionally-possible’ speed at which money can circulate. The amount of money available to be spent in any given period is neither M nor V, but M, determined by the money supply, times V, determined by the strength of institutions and the state of financial innovation. Together M and ‘institutionally-possible’ V make up the capacity for exchange within an economy. Capacity for exchange cannot be measured, because it represents potential for exchange, not actual exchange.

Real Output (Production)

Underlying any shift in the capacity for exchange is an increase in real output, Q. The US Bureau of Economic Analysis approximates real output with Real GDP, but like capacity for exchange, real output cannot be measured directly because we have no unit of value besides money. An increase in real output per capita comes directly from innovation or the division of labor, factors that improve efficiency and increase the amount one person can produce. Real output can progress without any money at all, as, for example, when programmers share software open source.

But money does influence production, by facilitating exchange between specialized labor, by creating incentive for innovation, and by pooling savings for projects too large to be financed from one man’s pocketbook. A lack of money can also stunt growth. When John Locke defined money as a “store of value” he argued that people only produce more than they can consume immediately if they can save the value of their surplus production as money. Conversely, output influences money. Societies began using cowrie shells as a unit of exchange because they needed something with which to measure their increasing output. Common sense says money is causal. But does theory?

Output and Capacity

Capacity and real output pull against each other, but capacity grows more quickly because it is easier to change. That is, it is (usually) easier to find money in gold mines or create it with credit schemes than it is to increase the efficiency of production. When capacity was below output, as it was for much of human history, output pulled on capacity, driving the introduction of money, the search for gold, and the spread of lending. Then, sometime around the time of Hume and Smith, capacity crept above output, becoming something of cause as well as consequence. Capacity began to pull at real output, prompting new investment that in turn led to increasing specialization and more innovation. In both periods, the pull went both ways, but the stronger pull was up, and the pull was causal.

The capacity-output cross violently oversimplifies the history of money and growth of real production, but it is suggestive. Neither capacity for exchange nor real output increase smoothly; in the 17th century, silver from Potosi and the introduction of banking in Europe made capacity jump, and today the decisions of the Federal Reserve and major banks change capacity daily. Real output may jump with the introduction of particularly important innovations, like the steam engine or the Internet. There was no single point in time when the two lines crossed, but rather a series of turning points in different places and different markets.

But it is suggestive. The cross divides economic growth into three phases. When capacity is below real output, the economy stagnates or grows very slowly. When capacity approaches and crosses real output, the economy grows rapidly as capacity begins to pull up on real output instead of down—when lack of a store of value stops preventing investment, and an excess of available money starts to entice it. Hume and Smith wrote during this phase. When capacity continues to grow and diverges from real output, the economy enters a phase of increasing instability as money and financial instruments grow increasingly distant from the real assets that underpin their value.

The story is not complete. The capacity-output cross is missing a line and a connection to something measurable. For now it’s only a concept; in two weeks I’ll publish a post here that makes it a theory.

Melanie Friedrichs is an undergraduate studying economics, among other subjects, at Brown University. When she graduates in May she will participate in a two-year fellowship in entrepreneurship as part of the first class of Venture for America fellows.

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