Demand Signals

Economics, in some sense, is the study of choices. The study of how your choices and my choices affect economic variables and economic outcomes. This is, in part, why economics cannot be completely separated from other social science disciplines concerned with human behavior, such as history, psychology, sociology, political science, and anthropology.

One advantage of capitalist economies over other modes of production is the freedom it gives to its citizens to participate in economic life--to make choices mostly free from constraints. This freedom isn't without necessary prerequisites, qualifications, or undesirable results, however.

Instead of being organized around a central planner, our economy is organized around 'demand signals'. Production decisions aren't made by the state, but by producers usually thought of as capitalists but are really more likely small business owners, CEOs, Boards of governors, etc. They obtain funds, at least initially, from banks through loans or from the public through sales of stock. In order to obtain those funds, they must have some prospects for selling their proposed product. This puts production decisions largely in the hands of bankers, who estimate the expected rate of return on the proposed investment, or stockbrokers who do the same. For the former it means getting the loan paid back, the latter a rise in the share price.

Yet both are looking at expected rate of return, a hard to gauge variable that because it is based on uncertain expectations of the future depends more on current sales or current demand. This is where our choices come in, or our demand signals.

You see, we demand with our money and the purchase of a good or service sends a signal to the producer or to the bankers making lending decisions. That signal is usually to invest more in that product or service--to increase investment, or to raise the price of that good or service to obtain more profits with which they too use to purchase goods and services to send signals to their suppliers. It is this interconnected web of demand signals using paper money (or money from bank accounts) that organizes real output in our economy.

We don't have a central organizer or planner who has to guess how much to produce, or to guess how much we want or need of any one product or service. We send signals through 'the market' and 'it' organizes production along those signals.

There are many implication or conclusions to be drawn from this.

Why Does Money Matter?

You may have noticed that I post a lot about money, particularly this "modern money" stuff and you may be wondering why I care so much about money. I have long been fascinated with money, particularly with what gives it its value. I remember way back in middle school wondering why green pieces of paper had value, or why gold was so valuable (a topic I wish to explore more in a follow up post). I never really got what I thought were adequate answers nor did I seek it further until my interest turned toward economics in college. Now after four years of undergrad and a couple years in grad school, I understand why money matters and I think you should too.

To be clear, I am not saying love of money (greed) is a good thing...it isn't, but rather understanding just what money is and how it affects our economy is crucial to achieving our economic, political, and social objectives.

So what is money? The most often told story is that money is a commodity that evolved out of a barter economy. For example, tradespeople in small villages started using seashells or gold or whatever to exchange for goods that each made so as to avoid the problem of barter economies. The butcher wants shoes, but the shoemaker doesn't want meat, so the butcher would have to trade meat to someone for something that the shoemaker wanted in order to obtain shoes. This problem is called the 'double coincidence of wants' and money is thought to have sprung up as a medium of exchange to eliminate this problem. All could exchange their goods for seashells or gold or whatever which could then be exchanged for any other commodity one wanted.

This story seemed plausible to me at first, it does seem logical, but as I learned more I quickly became unsatisfied with this explanation. This view hinges precariously on everyone accepting the commodity to be used as money. It also assumes barter economies existed and doesn't translate well to today's fiat money system because the commodity used as money is thought to be intrinsically valuable (gold) which also poses a problem for those who used seashells.

Another view believes that money is a social unit of account tracking credits and debts, just like an inch measures distance, or a gallon measures volume. One dollar is a unit of account, a measurement of credits/debts. Thus money is always a two-sided affair, it is an IOU, with a creditor and a debtor. Having money means that one has claims to another's goods/labor/cup of sugar/whatever that other gave in the IOU. From this view, one can see that anyone can create money, it is the matter of acceptance that is key. I can issue IOUs all I want, but in order for them to become 'money', someone must accept them. Which means they must accept that my word is good. If I don't my 'money' defaults.

Sectoral Balances

Phew! After a tough April I am back in action! I hope to be blogging more regularly now, and I have a lot of ideas I am excited to share with all of you.

One area I will continue posting about is the still common misunderstandings surrounding government debt. At the heart of it is a misunderstanding of money. If we can understand money, then we can better understand government debt. I hope to make this more clear in the coming weeks, but for now I thought this video might prove to be helpful.

It was made by undergraduates at Lewis and Clark college in Portland, Oregon. The video explains sectoral balances using accounting identities and principles. It shows why the government cannot go bankrupt like a household or business can and subsequently that sound, responsible government finance means something different than sound, responsible household finance.

Enjoy!

Money

Long ago, in the development of the economy, money emerged as a medium of exchange to facilitate the trading process. Many different currencies were used, but some were more attractive than others. Precious metals were popular currenices because of their properties. They were easily divisible and shaped, could be transported without much hassle, they didn't deteriorate, and were relatively cheap to store. When a central government develops and taxes the people, they demand their taxes to be paid in a particular currency, say gold, and so gold becomes the most widely if not only used good as currency. All other goods' value become expressed in terms of gold. (Today, we use fiat or paper currency because that is what the government demands for taxes).

Still, at that time, money was mostly used as a medium of exchange, or put in another way, as a means to an end. The ends were consumption goods. People and eventually businesses produced goods in order to obtain other goods. The purpose of producing shoes, was to obtain food and other necessities. Once necessities were met, production could go towards obtaining luxury items. This is where the problem of distirbution really becomes perplexing as I noted in a previous post.

Once people and businesses were no longer concerned about obtaining necessity goods, they could focus on accumulation, but what good to accumulate? Accumulating the good of their production would be real wealth for they could be traded for other goods, but holding goods as wealth is a risky prospect. Eventually they'll have to pay taxes, and will need to acquire the mandated currency. This currency is also the most liquid good to hold, that is, it can most easily be traded for any other good on the market. So people and businesses desire to accumulate the mandated currency. Now, money is no longer sought as a means to an end, but as an end in itself.

In the field of economics we describe this as the M-C-M' process. The original process was C-M-C', or produce a commodity (C) and sell it for money (M) in order to buy another commodity (C'). As money became sought as an end, the process became inverted. Money (M) was used to invest in producing a commodity (C) in order to obtain more money (M').

This distorted desire for money as an end, I argue, is not only a moral problem (the worship of a false god), but an economic one. Production is now an incentive of obtaining more money and not of meeting man's needs. Work is no longer providing for one's family, but for the obtaining of wealth. Some of the purchasing power is taken out of the economic system and not put back in because of this sordid love of money. It is used for dangerous speculative gain of more money, rather than for the obtaining of food for the hungry or shelter for the homeless. Overproduction occurs chasing after this wealth, and unemployment occurs because businesses are afraid to part with their wealth. They are no longer concerned and perhaps were never concerned with the good of the people and providing for their needs, but rather they are concerned with procuring more money and this distortion is partly a result of the competitive capitalistic process. Because in this process one either makes a profit or goes out of business, grows or dies, eats or gets eaten.

Our final end is to be face to face with God in heaven, and all ends sought for on earth should help us to obtain this end. Money is not one of these ends; it does not satisfy our hunger, or provide us with shelter, it does not exercise our intellect or help build relationships, and it does not bring us closer to God. It is only good as a means for obtaining those things that do.

Further commentary from the Michael Journal