Inflation vs Deflation I

Since I agreed to start the debate, I did not go back and re-read Nate’s initial and inadvertent post on the subject to which I linked last week.  This is not a response to that post, but as will soon become readily apparent, is a reversion to the foundation for our difference of opinion.

There are, as those who will recall my pair of YouTube videos on the subject, a variety of definitions of inflation.  The Neo-Keynesians alone have no less than five: theoretical, official, textbook, practical, and core.  It’s not necessary to get into any of them now, however, because they all eventually point to the same subject, and ultimately, the same question: what is money?  This is the crux of the matter, because despite the various opinions concerning the subject of inflation, what it is, and precisely what causes it, there is no extant theory of economics that takes serious exception to Milton Friedman’s statement that “inflation is always and everywhere a monetary phenomenon”, the outdated and long-disproven Keynesian notion that it is a phenomenon somehow inversely related to unemployment notwithstanding.

In reviewing the various definitions of money and looking at everything from Richard Cantillon to the three major current schools, Samuelsonian, Friedmanite, and Austrian, it rapidly became clear that the Austrian School economist, Joseph Salerno, had already walked the path that I was beginning to tread in his excellent paper “Two Traditions in Modern Monetary Theory: John Law and A.R.J. Turgot”, which is the first essay in his book Money, Sound and Unsound.  In this essay, Salerno shows that there are fundamentally two competing ideas about money, neither of which are even remotely new, as both monetary doctrines predate Adam Smith.

Of the first tradition, which dates back to John Law, Salerno writes:

In 1705, Law published his principal work on money, entitled Money and Trade Considered: With a Proposal for Supplying the Nation with Money. Law’s “proposal” was intended to provide his native Scotland with a plentiful supply of money endowed with a long-run stability of value. The institutional centerpiece envisioned in Law’s scheme resembles a modern central bank, empowered to supply paper fiat money via the purchases and sales of securities and other assets on the open market. Also strikingly modern are the theoretical propositions with which Law supports his policy goals and prescriptions.

Law initiates his monetary theorizing with two fundamental assumptions about the nature and function of money. The first is that if money is not exactly an original creation of political authority, it ideally functions as a tool to be molded and wielded by government. Law believes that the State, as incarnated in the King, is the de facto “owner” of the money supply and that it therefore possesses the right and the power to determine the composition and quantity of money in light of the “public interest.”

Writes Law:All the coin of the Kingdom belongs to the State, represented in France by the King: it belongs to him in precisely the same way as the high roads do, not that he may appropriate them as his own property, but in order to prevent others doing so; and as it is one of the rights of the King, and of the King alone, to make changes in the highways for the benefit of the public, of which he (or his officers) is the sole judge, so it is also one of his rights to change the gold or silver coin into other exchange tokens, of greater benefit to the public.…

Translating Law’s statement into modern terms, money is an “instrument” that is or should be deliberately designed to achieve the “policy goals” considered desirable by political money managers and other government planners.

Law’s second basic assumption is that money serves solely as a “voucher for buying goods” or an “exchange token.” Thus, for Law, “Money is not the value for which goods are exchanged, but the value by which they are exchanged: The use of money is to buy goods and silver, while money is of no other use.” In other words, money is a dematerialized claim to goods having no valuable use in itself.

It is more than a little startling to read Law’s statements, particularly in light of the smug, self-satisfied way we hear the same sentiments echoed more than three hundred years later by those who think themselves clever for realizing that money has no intrinsic value, and therefore, cannot possibly serve as a store of value in its own right, as it only possesses the exchange value conferred upon it by the power of the State.

Salerno notes that the Law monetary tradition is the dominant one, and comments: “The neo-Keynesians, monetarists, and supply-siders, differ among themselves in important areas of theory and policy, but all share most of Law’s fundamental ideas about money.”  He goes into some detail concerning the primary factors the three schools share concerning money and monetary policy, which include:

  1. Money as a policy tool
  2. Money as an exchange token
  3. Stabilization of the price level
  4. The resource costs of a commodity money
  5. The supply of money as a political monopoly

I will not go into detail to support Salerno’s conclusions, but a brief glimpse at the most influential textbook in modern economic history, Paul Samuelson’s Economics, should suffice to prove that they are fair and accurate.

“There are two distinct functions of money: as a medium of exchange and as a standard unit of value….  We may summarize our analysis of the use of money by listing its two essential functions: (1) as a medium of exchange and (2) as a standard unit of account or common denominator of values.”
Economics, pp 57-58

The second and competing monetary tradition traces back to Turgot, the man whom Joseph Schumpeter and the Austrian School tend to regard, with Richard Cantillon, as the true father of modern economics, whose rightful place in the history of economic thought has been usurped by Adam Smith.  Of the Turgot tradition, Salerno writes:

Turgot flatly rejects Law’s primary contention that money is merely an exchange token, whose supply must be manipulated by the political authorities in order to achieve selected policy goals. According to Turgot money is essentially a medium of exchange and the unit in which relative prices are expressed: “These two properties, of serving as a common measure of all values [i.e., the unit in which all prices are expressed] and of being a representative pledge of all commodities of a like value [i.e., the medium of exchange], include all that constitutes the essence and utility of what is called money.…”

As Turgot points out, however, these two functions of money can only be performed by an article which is already widely used, valued, and exchanged under barter: “… all money is essentially merchandise. We can take for a common measure of values only that which has a value, and which is received in Commerce in exchange for other values: and there is no pledge universally representative of a value save another equal value.” Since money thus necessarily originates as a useful commodity from within the market economy itself, Turgot emphatically denies the possibility that “a purely conventional money” without a pre-existing purchasing power can be imposed from outside the market. According to Turgot, “It is not in virtue of a convention that money is exchanged against all other values; it is because money itself is an object of commerce, a part of wealth, because it itself has a value, and in trade all values are exchanged against equal values.”

 So, the primary factors of money in the Turgot tradition are:

  1. A medium of exchange
  2. A unit of expression
  3. An object of commerce i.e. an exchangeable good
  4. A tool of economic calculation
  5. An intrinsic store of value

Having laid out the two primary definitions of money, I now turn it over to Nate to declare which of these two competing traditions he holds to be money, or if he has some third definition of money he believes would be better utilized concerning this debate.