If all people would go on a certain day to the banks and change their money into gold, there wouldn't be enough gold to change all the money for gold. It is not necessary that all the money be backed by gold, because once the amount of money is sufficiently reduced, it wouldn't make sense to change it.
Gold is only the anchor, and this anchor can't be manipulated arbitrarily, because the amount is fixed naturally. It is obvious therefore that the amount of paper money can increase if the productive potential can satisfy the demand, in other words, if there is no demand driven inflation. There is no direct relationship between the amount of money and the amount of gold. Nevertheless, this kind of system bears great risks. If the amount of money is reduced through the mechanism described before, prices decrease, but the credits taken by companies are nominal values, they don't decrease.
That means, that the companies earns less, but have to pay back the credit based on the nominal price. Secondly, the reduction of the amount of money will lead to a higher need for money for transaction purposes, and less money can be used for investments. This will result in a rise in interest rates, fewer investments and higher unemployment.
This is the Keynesian monetary mechanism. For more details see the booklet downloadable from start page of this website. Due to these and other negative effects on the economy, the gold standard system has been finally abandoned in all countries. Besides the arguments already put forward against this type of monetary system, there are some others. This system tends to reduce inflation to zero. An inflation of zero is not possible in market economies. Only if prices can increase, they can signal scarcity, see allocation of productive resources. Zero inflation would mean, that other prices decrease, so that the average doesn't change.
That would have a negative impact on employment. If we consider international trade, the gold standard system becomes still more problematic. If a country imports more than it exports, it will pay in the long run with its own currency. That's obvious. They will not have enough foreign currency to pay for their own one. The supply of this currency on the foreign exchange market will increase, the price of this money decrease with the effect that people will change this currency by the respective central bank in gold.
The amount of this money will decrease; prices will fall, what leads in general to an increase in unemployment. This will reduce the imports, and the current account will be balanced again. In this system, the prices bear the burden of structural adjustments. Due to the fact that all currencies can be converted into gold with prior fixed exchange rate, the currency exchange rate is fixed as well. Imbalances are corrected through the prices. In a system with flexible exchange rate, the adaptation to imbalances in the balance of trade is corrected by a change in the exchange rates.
David Ricardo, as well as all the other classical and neoclassical authors, doesn't distinguish clearly between capital and money. That's the basic problem and all the errors in thinking derived from that fundamental error. From a physical point of view capital and money is the same thing: gold o paper money. If gold is capital, then it can be used for investment purposes and the more gold people save, in other words, don't consume, the more can be invested and the bigger the economic growth. However, if gold is money, a means of payment, then more gold leads only to an increase in inflation.
To simplify things, gold is gold and paper money is paper money. The question is not where is comes from, if it is the result of not consumed income of the past or just if it was found on the beach. If it can be used for investments or if it will lead to inflation depends uniquely and exclusively on the productive potential. If there is one, it can be used for investment purposes, and if this is not the case, it will lead to inflation. Simply put, if Francis Drake, a pirate at the service of the Queen, captures a Spanish ship and sends the gold to England, the amount of gold has been arbitrarily increased.
If this will lead to inflation, as in Spain, or to an increase in the national income, as in England and France in the 18th century, depend on the productive potential. Same thing with gold or paper money as a result of non-consumed income of the past. If there is a productive potential it can be used for investment purposes, if there is none, more investments will lead to inflation. The effect on the interest rates is in both cases the same.
If Francis Drake leaves his gold ingots somewhere on the beach of England or the English save more, in both cases the amount of gold would increase and the interest rates would decrease. The decreasing interest rates will have the effect, that even less profitable investments can be realised if there is a productive potential.
It is to assume that the classical authors do not understand the issue. We can't, therefore, say that they assumed full employment, would make sense. In case of full employment, capital, not consumed income of the past, is really something different than money. In case of full employment consumption and the production of consumption goods, it must be reduced in order to produce more capital goods. In this case, it makes a difference if the gold is just found on the beach or if it is the result of former saving, reduced consumption.
In any other situation, it doesn't make any difference. This paragraph suggests that David Ricardo didn't really understand the difference between capital, not consumed income of the past, and money. After a well regulated paper money is established, these can neither be increased nor diminished by the operations of banking. It is easy to see that this is wrong, although we have to admit that at least he defines the term capital. They create money "out of nothing".
Let's illustrate it with an example. Someone finds a gold ingot on the beach, money created out of nothing and hired a programmer to programme an app that scans any kind of text in any language and translates it into another language. Not very realistic, if we want a readable text, but let's say that this is possible. Let's assume that the programmer needs some resources while he programmes this app. An old computer he got for free and some food. Once the app is finished, it can be sold for the thousand-fold of the sum paid for the food. The example is a little bit extreme, but google actually is very close to that.
The same investor, who finds the gold ingot on the beach, can invest as well in a hairdresser salon. The value of the hairdressers working there is not much more than the food, clothes etc. The utilisation rate of the machinery will be increased a bit because more clothes, food etc. It is, therefore, pretty clear that growth doesn't depend on the existing capital, but on what is done with this capital.
David Ricardo money theory
The affirmation that an increase of money can't increase capital is, therefore, meaningless. Who possess the money, wherever it comes from, decides what is produced, and this have a massive impact on growth. The one who find the gold ingot on the beach can activate resources. He can take away food from the hairdressers, to stick with this stupid example, and give it to the programmer, who is thousand times more productive.
To illustrate it with a more realistic example. Google could have taken a loan actually, they were financed at the beginning by a venture capital and use the programmers from Microsoft in a more productive way. If the growth of capital doesn't depend on the existing capital, the capital can't be the limit of the productive potential. That means, that even in a situation of full employment, "operations of banking" have an impact on growth. That is something that Adam Smith already realised, see balance of trade , although he was not aware that this brings down the whole classic theory.
It is not the capitalist who decides how the resources are allocated, but the one who have the money, wherever it comes from. We will return to the topic in the chapter about Joseph Schumpeter. David Ricardo has the same problem as his colleagues nowadays. He completely neglects the impact of know-how. Labour is a homogeneous factor, and labour is accumulated in capital. What is actually accumulated in capital is know how, not labour.
The problem is that know-how and the production of know-how can't be presented in a model, and there is a strong tendency in economics to ignore everything that can be presented in a model. The growth of innovation is something unpredictable, spontaneous, accidental and can't, therefore, be modelled. If we accept that something unpredictable like know how has a heavy impact on economic growth, we must accept that it is impossible to predict economic development. In the next paragraph, especially in " A circulation can never be so abundant as to overflow; for by diminishing its value, in the same proportion you will increase its quantity, and by increasing its value, diminish its quantity Adam Smith assumed that in case that the national income shrinks, some money is superfluous and can be used to buy goods in foreign countries.
This is true if the means of payment is universally accepted, as it is the case with gold, see balance of trade. If we follow his logic, the labour accumulated in one gram of gold must be the same as the value accumulated in the commodity that can be bought for this gram of gold.
That contradicts his second statements that the value increases or diminishes depending on the amount available. Gold and silver, like all other commodities, are valuable only in proportion to the quantity of labour necessary to produce them, and bring them to market. Gold is about fifteen times dearer than silver, not because there is a greater demand for it, nor because the supply of silver is fifteen times greater than that of gold, but solely because fifteen times the quantity of labour is necessary to procure a given quantity of it.
The quantity of money that can be employed in a country must depend on its value: if gold alone were employed for the circulation of commodities, a quantity would be required, one fifteenth only of what would be necessary, if silver were made use of for the same purpose. A circulation can never be so abundant as to overflow; for by diminishing its value, in the same proportion you will increase its quantity, and by increasing its value, diminish its quantity. There is no explanation given for the sentence " Following this theory, an increase in the amount of money will lead to an increase in prices, to inflation and a decrease in the amount of money to falling prices.
This is not true. Money has an impact on the real economy and with money idle resources can be activated. See arguments put forward above. Besides that, this is not the scenario presented by Adam Smith. In the scenario of Adam Smith the national income shrinks and not the amount of money. Therefore, part of the money is superfluous for transactional purposes and can be used, if foreign countries have the same currency, to import commodities.
It seems that David Ricardo didn't get the message. If gold or silver is the means of payment or, at least, the anchor of paper money, he assumes that prices will rise if the amount increases This is the simple quantity theory of money. The reality, however, is much more complicated. David Ricardo could had know by observing reality that his thesis didn't fit with reality because David Hume already realised that fifty years before in the essay On Money, see balance of trade.
David Hume realised that the inflow of gold leads to more economic activity in England but not in Spain. If there is a productive potential, idle resources can be activated with money. If the increase in the amount of money leads to a higher demand that cannot be satisfied, it will lead to inflation. This statement is empirically wrong and theoretically not plausible. The other statement is wrong as well. A reduction in the amount of money will reduce the amount of money for investment purposes. The percentage of money needed for transaction purposes will be higher and the percentage of money for investment purposes lower.
This will lead to an increase in the interest rate. Investments will decrease and unemployment increase. This will lead to a lack of demand, and therefore, prices will fall, although not proportionally. He assumes that prices, wages, prices of commodities, interest rates etc. That's not going to happen.
A reduction of money will have a lot of other consequences. A reduction in the amount of money or, to be more precise, a reduction in the money supply is actually possible today. At the time of David Ricardo, it is not very clear how that can happen. This is only possible if some people export money. Central banks can increase the reserve requirement , the increase in interest rates etc.
This will reduce the amount of money. Central banks will do that if they want to "cool down" the economy because due to bottlenecks in some parts of the economy there is the risk of inflation. In a globalised economy almost any demand can be satisfied. Bottlenecks are actually a rare phenomenon. The last inflation was cost driven, due to a sudden increase in the oil price.
It is true that the actual production depends on the machines, raw materials, capital to pay the workes, etc.. This capital will be disinvested, reconverted into money. However, only if the "capitalist" can substitute his machines, buy new raw materials and employ the workmen once again the money he earns is of any use. If he can invest it again with the money from disinvestment, he can do it as well with borrowed money or money derived from "operations of banking".
Once again, saving the accumulation of capital must be understood in real terms. Saving is the production of capital goods instead of consumption goods. In this sense, and only in this sense, saving means a reduction of consumption. However, this is only needed in the case of full-employment.
In the event of unemployment, if there are idle productive resources, both, capital goods and consumption goods, can be produced. Any other definition of saving is misleading and leads to countless errors in thinking. In case of unemployment, investments can be realised with money, wherever it comes from, and saving is a problem because it reduces still more the already insufficient demand. We see that as well if we take a closer look at the quantity theory of money. This theory can be expressed in a mathematical equation. Price level is the difference, in a percentage, at the original price level and the actual price level.
This must correspond to the amount of money multiplied by the circulation velocity how many times a coin goes from one hand to another. The higher the circulation velocity, the less money is needed. This very famous equation doesn't describe any casual relationships and doesn't distinguish between a situation of full employment and a situation of unemployment and it doesn't describe either any monetarist transfer mechanism. How money interferes with the real world, see the little book downloadable from the start of this website.
David Ricardo assumes that an increase in the amount of money will lead to an increase in the price level. It is possible as well that it leads to an increase in the real national income. David Ricardo assumes that the amount of money follows the increase of the national income. It is the other way round. Given a certain price level, the national income follows the amount of money. First the amount of money is increased by the bank system and then the national income increases. That is possible but have a lot of side effects.
From a realistic point of view, the real national income can only increase if the amount of money increases. An increase in the amount of money is a condition for an increase in the real national income. It could be argued that David Ricardo assumes full employment, but that would contradict one of his basic assumptions, the assumptions that labour is disposable at any qualification in any amount, in other words, full employment is inexistent. The amount of money can only be increased if there is a demand for money and there is only a demand for money if some people want to invest.
The banking system can offer as much money as they want, if there is no demand, they can't extend the amount of money. It is obvious that they would like to do that because banks live from borrowing money and it would be great if offering more money is enough to borrow more money. However, that is not the case. It is the demand for money that determines the offer of money and not the supply. The quantity theory of money is not really a money theory. It just describes an equilibrium.
However, if we want to move from one equilibrium to another, we need to know the casual relationships. When the amount of money is increased, given a determined national income, the money disposable for investment purposes will increase, the interest rate fall. This will lead to higher investments because the hurdle to overcome for an investment is lower. There is a debate in economics whether low-interest rates present a risk.
This argument is put forward by the Austrian school. The argument is that low-interest rates change the expectations concerning the profits. They are higher, if interest rates are low. This will lead to a significant demand in capital goods, that the supply can't satisfy. The prices of capital goods will increase again. This would be no problem if other investors would be prevented through higher prices of capital goods from investing. However, this is the assumption of the Austrian school, due to the fact that all invest at the same time and once engaged the process can't be stopped, the investments won't be profitable and many companies go bankrupt.
The argument is not very logical, because if we take this argument seriously, the only way to prevent people from buying things they can't afford is by high prices. Following this logic, high prices are always good. The higher, the better. However, it is obvious that people who possess money are interested in high-interest rates, they want money to be kept scarce. The complaints about today's monetary policy of the central banks, the European ECB as well as the American FED, come mostly from pension funds and insurance company. Their business is to collect money from savers and borrow it to someone else.
This business becomes difficult the more money is "printed" by the central banks. The interest of the savers, high-interest rates, don't fit with the interests of the economy as a whole, low-interest rates. It is obvious that pensions funds, insurance companies and banks would never say that low-interest rates are simply against their interests. They will argue that low-interest rates are risky, but this is pure ideology. Principles of Political Economy. Thomas Malthus. James R.
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Economic growth depends on know how and innovation and not on "capital"
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