Supply of Money Unidentified

It will be instructive at this point to go back in economic history and reflect briefly on the validity and effectiveness of monetary policies essentially based on ‘the supply of money’. Let us start from the capitalist premise that the important variable for determining the level of employment and the rate of change of the price level is the state of aggregate demand. The Radcliffe Committee was appointed by Britain’s Chancellor of the Exchequer in May  ‘to inquire into the working of the monetary and credit system and to make recommendations’. The Committee investigated the way in which money was supposed (according to the prevailing monetary theory) to influence that variable. This led inevitably to a consideration of the direct and indirect impact of money on economic activity. It was argued that in a highly developed financial system with many financial intermediaries, grave theoretical difficulties were posed in identifying or labelling some quantity as ‘the supply of money’. The inference is frequently made that the Committee itself did not or could not define the supply of money for England. At various places in the Report of the Committee the words ‘supply of money’ are placed in quotation marks followed by phrases like, “however that is defined” or “whatever that may be made to mean”, giving rise to the inference that the quantity could not be defined.

A subsequent paper by Sayers, one of the Committee members and widely believed to have provided the theoretical substructure for the Radcliffe monetary theory, raises the issue whether money can in fact be defined. We read: “The difficulty of identification has derived from the twofold nature of money…as a medium of exchange and as a store of value…”. Makinen does not agree with the problem as posed, but that does not mean that the problem has been dealt with satisfactorily in some other way.

If money is indefinable or includes a broad category of ‘assets’, it may be impossible to discuss the monetary policy actions of central banks, or the monetary policy tools to achieve stability objectives, which centre on commercial banks, may be inadequate and require supplementation. Additionally, if money can not be defined, monetary policy is impossible, or depending on how money is defined, radically different theories may be advanced concerning the way in which money influences economic activity.

It can be argued that the level of employment and the rate of change of the price level are more closely linked with the rate of transformation of money to capital than only to the supply of money, however that is defined. Abolition of interest and of its derivative, speculation, closes the gap between money as potential capital and actual capital. It also provides a simple way of defining money exclusively as the medium of exchange with the potentiality of becoming actual capital.

Economic growth is closely geared to the amount of capital incorporated with other factors of production but not to the amount of money as such. Consider this analogy: gasoline is used in automobiles to move people from one point to another; it needs to be properly placed in a suitable environment, the ‘internal combustion engine’, before it can do that work of moving people. The demand for gas is directly geared to the number and capacity of ‘engines’ properly placed in cars. Millions of barrels of gasoline might be available and yet people wait in long lines waiting to be moved. Those lines of people cannot be reduced until the engines are supplied that use the gasoline. In the same way, it is the ‘institution’ of the firm that is able to transform money (potential capital) into actual capital. This leads us to the very important question, ‘What role, if any, does money play in the process of economic growth?’. Do we develop a ‘better’ theory of long-term economic growth on the basis of an expansion of the stock of money or of the stock of capital? Another, related, question is: ‘How much money of the available stock undergoes the legal process to become capital?’. By allowing speculation to take place, be it on money or stocks, what goes into the speculation whirlpool does not do any good to the society, but harm, unless diverted into the institution of firms using other factors of production co-operating with actual capital. The production capacity of a firm hinges directly on the value of its assets. At the aggregate level it is the value of the assets of the firms existing at any given moment, which determines the production capacity of a country, not the supply of money. Furthermore, the higher the ability of a country to transform money into capital the greater would be the rate of economic growth, and, the higher the speed of this transformation the greater the ability to absorb unemployed labour. This transformation, obviously, takes time and effort. It is in this sense, as I understand, that time is generally believed to be the essence of capital and not of money. Capital, in a firm, is locked-in for an unspecified period of time for as long as the firm can survive in the industry. Unlike capital, money is perfectly liquid, implying that it can change place very fast. If time is not allowed to be sufficiently long, capital cannot generate output; hence no profits.

The essential ingredient of capital is time. Capital does spring from time via money. In other words, capital and time are closely associated. However, we need not go all the way with the Austrians and accept that capital is time. To close the gap between stock of money, paid as the remuneration of factors of production, serving as the medium of exchange, and actual capital have sometimes been recommended by imposing high taxes on so-called ‘capital gains’. Whether such recommendations would guarantee full employment is dubious. In an Islamic framework abolition of interest and of speculation on any durable goods is a powerful tool to achieve this important goal. In general equilibrium analysis more attention has to be paid to capital and its return as profit than is customarily done. The theory of capital can be treated as an extension of static equilibrium theory to take account of time. Technical progress and economic growth take place in time and are closely related to capital, not to money. Production is possible without money, as can be imagined in a barter system, but not without capital. This statement is not to be taken as belittling the importance of money in a money-based economy. Money has the potentiality to be converted into capital. In a money market, time, however short, produces the rate of interest; in a capital market it produces rate of profit, or internal rate of return (IRR), separate from the rate of interest.

The amount of capital, or assets, using our upcoming terminology, is much easier for authorities to measure than to measure the stock of money, as was made clear by the Radcliffe Report. Firms are required, by laws and regulations, to provide tax authorities with their annual financial statements, namely, balance sheets and profit and loss statements. The amount of capital, which according to our discussion is closely tied with fixed assets, net of depreciation, can easily be measured using these statements. It does not need to be loosely and unsatisfactorily defined and estimated. The market price of stocks centres on the going, as well as expectations about the future, rate of interest, and it sets the boundary around which interest rate would fluctuate. This process can go on until bubbles burst and for as long as the issuing firm is in existence.

By abolishing interest and integrating money in capital theory an interdependent market system will develop which is, let me admit it, likely to be a very complicated construction, in which all the most important specifications will normally play a part in influencing economic activity. But simple answers to complex problems are not always the best answers. The type of economic system that would thereby develop will be a different and much more complicated one than has ever been analyzed. Nevertheless, we are led to conclude that it will surely reward our effort with higher economic growth and less (if any) instability. It will surely produce new problems, but problems are always there to be solved.

Source: Prof. Iraj Toutounchian, Integrating Money in Capital Theory: A Legal Perspective Towards Islamic Finance. Republished with permission