The Theory of the Monetary Circuit: A Critique

by Philip Pilkington

Article of the Week from Fixing the Economists

In a series of comments on my previous post involving myself, Neil Wilson and Oliver it became clear quite quickly how closely my asset-pricing framework is tied up with the Post-Keynesian theory of endogenous money. Oliver suggested that I look into the Theory of Monetary Emissions (TME) — a forerunner of the modern ‘Circuitist school’ of monetary theory. In this post I consider how and why my approach differs from the Circuitist theory through a reading of Sergio Rossi’s excellent paper The Theory of Monetary Emissions which can be found in A Handbook of Alternative Monetary Economics.

I will not here deal with the theory of the monetary circuit itself. It is, in all respects, basically identical to the Post-Keynesian theory of endogenous money and can be summarised aptly in the phrase: loans create deposits. Where it departs from the latter is, and this will prove important in what follows, in its tendency to think primarily in terms of models — a tendency which readers of this blog will know I find objectionable. For me good theory starts from the ground up and the desire to build little models should take a back seat.

The first place in which my approach and the TME differ is in what we count as ‘income’. In the TME, as in the national accounts, ‘income’ is only the income that arises out of real production. Rossi cites Cencini in this regard,

[T]hrough the payment of wages, money and output meet, fusing in a unique object called ‘income’. By putting money and output together, money acquires a real content [hence value], and output is given a monetary form. In other words, money measures (numerically) goods, and goods define the real content of money. (p124)

I should also note that I don’t really like the Marxist or even Hegelian overtones that sometimes appear in Circuitist theory. Phrases like ‘the real content of money’ strike me as being far too metaphysical and should, I think, be abandoned. Such observations will tie in later on when I discuss my project as being to establish a general theory that can be ‘plugged in’ to basically any other theory.

Anyway, that aside, it is clear that my definition of income differs from the TME definition. In my framework I discuss two different concepts: real income/savings/investment and financial income/savings/investment. The former bears an identical definition that the Cirtcuitists and the national accounts hold to — namely, money spent into circulation that contribute to real production/output/aggregate demand. The latter, however, is that money which is spent into circulation merely to engage in the exchange of financial assets and thus drive their price.

Financial income can, of course, have effects on real income. If I buy a portfolio of shares this year worth $10,000 and sell them next year for $20,000 my purchasing power has increased by $10,000 which it would otherwise have not. My consumption will likely rise too; in economics this is called the ‘wealth effect’. The reason that I refer to this as income is because, for all intents and purposes, it is. The $10,000 I make in capital gains is no less or more income to me than the $50,000 I make in the same year in the form of a salary.

I really see no reason for not referring to it as income. Certainly I see good reason for not counting this capital gains as part of output — otherwise stock market rallies would directly increase GDP which would be absurd. But I think to pretend that this is not income of some form is a bit silly. It clearly is income and we can make this point without counting capital gains as part of GDP; that is, we can do this by counting my original purchase of the shares as financial investment (If) and the money I accrue from the sale of the shares the next year as financial savings (Sf) and then we distinguish these from real savings and investment (Sr and Ir, respectively).

This provides us with a much ‘cleaner’ framework in that we can use many of the old national income identities in a slightly modified but ultimately familiar way. So, for example, total income in a given period will be both financial and real investment plus consumption,

But real income — that is, output/GDP — will only be real investment plus consumption,

Now, the second place where the TME and I substantially disagree is how we conceptualise price changes. For the TME inflation and, one would conclude, asset price inflation are ‘pathological’ phenomena. Again, this reeks of metaphysics to me. What on earth do the TME adherents mean by ‘pathological’? After all, some inflation may be a good thing in a capitalist economy for any number of reasons. And it is not at all clear that changes in asset-prices are inherently pathological — indeed, I would argue to the contrary: they are an ever-present and extremely important aspect of a functioning capitalist economy even though they can get out of hand from time to time.

The Wikipedia article on ‘Quantum Economics’, another name for TME, sums up this metaphysical view of inflation nicely,

Inflation is the situation where global demand numerically exceeds global supply. This situation is at odds with the logical quantum identity between demand and supply – inflation is pathological. To have inflation there must be some money devoid of purchasing power, which quantum economists call empty money, that increases or inflates global demand only numerically without altering the substantial identity between D and S.

What the TME really mean by ‘pathological’ is, so far as I can see, what many economists who, to my mind, have taken a wayward path mean by ‘pathological’; that is, something like “a phenomenon that does not fit neatly into my theoretical framework”. To me this is a very wrong-headed approach to good theorising and reminds me of what the German philosopher Theodor Adorno said of the error of a priorism in contemporary philosophy when he wrote in his Aesthetic Theory,

It is no accidental failing on the part of individual thinkers… that today philosophical interpretations… fail to penetrate the construction of the material to be interpreted and instead prefer to work them up as an arena for philosophical theses: Applied philosophy, a priori fatal, reads out of material that it has invested with an air of concretion nothing but its own theses. (pp446-447)

This seems to me precisely what the TME adherents do when they consider price changes to be ‘pathological’ when they are, in fact, absolutely essential aspects of any capitalist economy. What the TME adherents are doing is sneaking normative judgments in through the backdoor and proclaiming:

“capitalist economies should function as our models says they should function and anything that doesn’t fit in the model is a pathology”.

As Adorno wrote:

this “reads out of material that it has invested with an air of concretion nothing but its own theses”.

Indeed, one might say that the TME falls somewhere close to the old natural rate of interest theory or Austrian business-cycle theory in that they seem to imply that ‘bad’ credit expansion that does not increase ‘real production’ will result in some sort of inflationary chaos that disturbs what would otherwise be a perfectly balanced system. That perfectly balanced system, I would say, only exists in their own imaginations.

In my framework asset-price changes — and that includes demand-pull inflation which is effectively just a higher bid for a good or service — are perfectly non-pathological. Yes, they may do damage to the system as a whole when taken in the context of a given economic constellation, but they may also provide the system with increased growth potential, for example, or better income distribution. It all depends. We cannot make an a priori judgement about such issues based on simplistic models as the TME adherents do. Rather we must understand the phenomena in as clear a manner as possible and then use this understanding in a pragmatic manner whenever we encounter such issues in reality. This, again, is why I refer to my theory as a general theory — and this is why the reader will find it devoid of normative and metaphysical language.