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Modern economics is incapable of integrating money into its model of the economy. One of the intellectual disasters one would expect to be caught out by the public, leading to the rejection and demise of incumbent economics. But nothing of the kind occurs. Our society is surprisingly tolerant of egregious misconceptions that one would think the mark of less sophisticated times.
Money (properly accounted for) must be excluded from the purview of economics because its inclusion would tear apart the veil of apparent coherence cast over the fragments by which economic theory (ET) purports to describe the nature of the economy.
The crux of the ideological compulsion to hang on to a wrong theory of money's role in the economy is this: traditional ET likes to portray the economy as a network of sub-markets all of which quite naturally clear / attain a state of equilibrium if left alone, thereby achieving equilibrium in the economy as a whole.
I leave aside the fact that markets do not operate as described by ET, and the mechanisms that supposedly make these markets interact to bring about equilibrium in the economy at large do not exist. I have dealt with this in a series of posts beginning with (1) Neoliberal Economics and Its Rival.
More recent mathematically sophisticated theories of a general equilibrium (Walras, Arrow-Debreu) depend for a solution — tantamount to instant simultaneous clearing of all markets — on a level of abstraction requiring where everything characteristic of real markets and a real economy is assumed away.
But the original paradigm which these sophisticated models take up in an effort to prove them mathematically, suffer from a kindred deficiency: they require that all markets clear in a coordinated fashion to achieve general equilibrium in the economy.
While the modern variants simply assume instant coordinated clearance, excluding space and time from the first, classical economics still bothered to demonstrate that economic agents actually behave in a way that conforms to the postulate of instant simultaneous clearing in all markets and in the economy at large.
Their crucial argument is known as Say's Law (or Say's Law of Markets). According to Say's Law money is neutral, i. e. it does not affect real variables like output, employment and real GNP. While this is clearly wrong, admitting money in its actual role into economic theory would introduce a factor disrupting the prestabilised harmony of General Equilibrium economics.
The construction by which Say tries to save the possibility of general equilibrium posits that people produce products / offer services with the products / services in mind into which they intend to exchange their own products / services. In other words: people barter. If these plans (of mutually coinciding supplies and demands) work, there will be no overproduction and equilibrium prevails.
Writes Say (see source below for references):
Every producer asks for money in exchange for his products, only for the purpose of employing that money again immediately in the purchase of another product; for we do not consume money, and it is not sought after in ordinary cases to conceal it: thus, when a producer desires to exchange his product for money, he may be considered as already asking for the merchandise which he proposes to buy with this money. It is thus that the producers, though they have all of them the air of demanding money for their goods, do in reality demand merchandise for their merchandise (Say 1816: 103–105).
Below is a quote in which a certain self-styled "Lord Keynes" ably explains that money as used in the real economy is quite capable of driving a wedge between aggregate demand and aggregate supply, frustrating the move towards general equilibrium.
Classical advocates of Say’s law argued that saving would result in reasonably quick consumption or investment, but that simply does not follow. Money savings can become idle balances (“hoards,” in the terminology of Keynes). But even idle balances of money are not the only cause of a shortfall in demand. We can list the various “leakages” from aggregate income as described above, as well as some other ones, as follows:
(1) People desire to hold money as a hedge against future uncertainty (the “precautionary motive,” in Keynes’ theory), and since expectations are subjective such holdings can vary. In depressions or recessions, people may choose to hold more of their money as cash. In underdeveloped and pre-modern economies, hoarding can take the form of holding money physically outside of banks as cash or coin (Gootzeit 2003: 182). In the Great Depression, the rise in the hoarding of money was a significant factor, as it probably was in pre-1914 downturns in the business cycle (Wicker 1996: 144).
(2) As we have seen, even when people hold money either as individuals or as savings in financial institutions, not all the money will be invested in production of producible commodities (= goods and services). Money can be used to speculate on asset prices. New savings or a rise in savings can be diverted to purchasing of financial assets (or real assets) with the money used to buy such assets then flowing to other speculators, who buy new financial assets or hold money idle in the process of using it in further speculation on assets. Thus there is a “speculative demand” for money that can rise or fall.
(3) In modern economies where savings are held in demand deposits and saving accounts in banks, money is invested by banks themselves. But even here investment by banks will be subject to subjective expectations under uncertainty. In recessions or depressions when expectations are low, banks may simply choose to keep their depositors’ money as excess reserves or use it to buy financial assets on secondary markets. Thus even modern banks can “hoard” by reducing investment and leaving money in idle balances (at central banks or held in reserve for speculation on financial assets).
(4) Money income can be spent on imports causing a trade deficit, which in pre-fiat money days could result in a contraction of the money supply and deflationary pressures.
(5) A government might levy taxes and a run budget surplus without re-injecting that money back into the economy (and effectively destroying it).
Once propositions (2) and (3) of Say’s law above are shown to be false, propositions (4) and (5) collapse completely, and the idea that supply equals demand ex post cannot be possible.
For all these reasons, aggregate demand failures can cause recessions, whenever aggregate demand falls short of supply. Equilibrium will not result and is not necessarily a condition of free markets. Say’s law is a myth.
The source.
Continued here.
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