1.2.4 Theory of money

We can read very often that David Ricardo was a follower of the quantity theory of money.The quantity theory of money affirms, to put it simple, that prices increase if the amount of money increases, but money has no impact on the economic activities and is just a veil.

However, it is meaningless to say that David Ricardo was a follower of the quantity theory of money because in the 18th/19th century there was no alternative theory. It 's hard to say that someone is a follower of a certain theory if there are no alternatives and if a certain theory is unanimously accepted.

David Ricardo took the quantity theory of money for granted, and he did not even feel any need to explain it. He just presupposed it.

David Ricardo supposed as well that the reader of his book was acquainted with this theory. If we want to be precise, we should say that David Ricardo supposed a special form of the quantity theory of money. He assumed the gold backed money. (A concept a little bit more complicated than expected by most people as we will see soon.)

The quantity of money supposes and given a certain circulation velocity of money, that prices must increase if the amount of money is increased. We have already seen that in Adam Smith and David Hume, although they didn't realise the impact of this fact on the whole classical theory, see balance of trade, already realised that an increase in the amount of money can as well have an impact on the national income.

Nowadays, we are still in the year 2013; it is easy to see that the quantity theory of money doesn't fit very well with reality. The European Central Bank, as well as the corresponding banks in the United States and Japan, flooded the market with money, but that has no impact on prices. On the contrary. The bigger decrease is deflation, a decrease in prices. The money generated lead to bubbles in the stock market but did not have any impact on prices.

The quantity theory of money can be conceived in two different versions. In the first version paper money (fiat money) is backed by gold and in the second version gold does not back it. In the version of David Ricardo, paper money is backed by gold. In the time of living of David Ricardo only something scarce by nature, something that cannot be multiplied arbitrarily, like gold, could serve as money. Nowadays money is kept scarce by law.

Besides that, only things that have some other characteristics can serve as money. It must be easy to transport them, it must be possible to split them up into small entities and these entities must be homogeneous. Precious stones, for instance, don't have these characteristics. If a big diamond is split up into little ones; the little ones all together are less valuable than the big one.

Copper and platinum would be an option. However, the production of copper is not steady enough and platinum is too seldom. Actually, there are only a few options and if we put aside strange means of payment like shells, pearls finally gold and silver imposed themselves as means of payment.

(Copper coins actually existed, but from the fact that they disappeared, we can assume that people didn't trust these coins.)

David Ricardo was not an entrepreneur. He earned his money on the stock market and what he possessed was money. (Something very different than capital.) His interest was, therefore, the stability of money. Inflation would have reduced his fortune.

His interest was, therefore, to keep money scarce and interest rates high. Entrepreneurs are most of all interested in low-interest rates. He had the same problem savers have today, we are still in the year 2015. Savers want high-interest rates and they don't want that the central banks flood the market with money. The problem is that the interest of savers is opposed to the interest of entrepreneurs. They want to invest and create jobs and, therefore, interest rates have to be low. For a more detailed discussion see interest rates.

As we already said, Keynesian theory cannot be understood if the term capital and money are mixed. For more information, see the booklet downloadable from the start of this website.

The theory of David Ricardo is completely wrong. We don't present it here because it is relevant to the understanding of the real world. We present it to illustrate some basic errors in thinking we find on a daily basis in newspapers, television debates, "scientific articles" etc.

The monetary theory of David Ricardo is often compared to the theory of Milton Friedman. Both argue in favour of a steady increase in the monetary basis. However, monetarism is completely different. Monetarism assumes the same monetary transaction mechanism as Keynes, but under wrong premises, full employment, he gets to the same results as David Ricardo. The problem is that in a situation of full employment, Keynes gets to the same results as well. In case of full employment, an increase of the amount of money will lead to inflation.

In the present state of the law, they have the power, without any control whatever, of increasing or reducing the circulation in any degree they may think proper: a power which should neither be intrusted to the State itself, nor to any body in it; as there can be no security for the uniformity in the value of the currency, when its augmentation or diminution depends solely on the will of the issuers.

David Ricardo, On the Principles of Political Economy and Taxation, On Currency and Banks

Even if we accept that the amount of money can be arbitrarily manipulated by the state, actually not true today, most central banks are independent of the government, it is unclear why it would be better if the amount of money would be kept arbitrarily scarce. That would fit the interests of the people who have money, but wouldn't fit the interest of the economy as a whole.

The stability of the money would be guaranteed if the Bank of England were obliged to change paper money, fiat money, at any moment to gold in a prior fixed exchange rate.

However, that doesn't literally mean that gold backs paper money. The mechanism is a little bit more complex. Let's say that a certain basket can be bought for 100 dollars or five grammes of gold and the exchange rate is 20 dollar for on gramme of gold. In this situation, people have no incentive to change paper money for gold. It doesn't matter if they pay with gold or paper money; they always get the same basket of goods.

This changes if prices, wages and the prices of goods, increase. If prices double and if people earn double, let's assume the best case, they can buy the same basket with the money they earn. However, they can as well change their money into gold and this way, they get two times more gold than before, and if the value of the basket of gold has not changed, and due to the fact that gold is limited by nature, it is very probable that they get the basket twice.

It is, therefore, to assume that many people will change their paper money in gold. This will have the effect, that the amount of paper money will diminish and its value increase until we get to the same situation as before.

It is, therefore not true, that in a gold standard system, all the money is backed by gold. 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. However, capital and gold are two completely different things in the classical/neoclassical theory.

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. For a more detailed discussion see interest rates.

This paragraph suggests that David Ricardo didn't really understand the difference between capital, not consumed income of the past, and money.

The whole business, which the whole community can carry on, depends on the quantity of its capital, that is, of its raw material, machinery, food, vessels, &c. employed in production. After a well regulated paper money is established, these can neither be increased nor diminished by the operations of banking.

David Ricardo, On the Principles of Political Economy and Taxation, On Currency and Banks

It is easy to see that this is wrong, although we have to admit that at least he defines the term capital. ("Operating of banking" refers to the paragraph of Adam Smith, that explains how the Scottish banks increase the amount of money. 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. they need. The utilisation rate of the machinery will be increased a bit because more clothes, food etc. must be produced, but there will be little growth in the national income.

It is, therefore, pretty clear that growth doesn't depend on the existing capital, but on what is done with this capital. 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.

There are actually only two classical/neoclassical authors who mention the importance of know-how, Alfred Marshall and Jean Baptiste Say. 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..." he refers, without mention him, to Adam Smith. 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.

[We will not discuss the other strange assumptions of this paragraph. 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.

David Ricardo, On the Principles of Political Economy and Taxation, On Currency and Banks

There is no explanation given for the sentence "... 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...", but it is to assume that David Ricardo refers to the quantity theory of money. 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 (...for by diminishing its value, in the same proportion you will increase its quantity...) and prices will fall, if the amount is reduced (...by increasing its value, diminish its quantity...). 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. will fall proportionally. 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.

[However, an inflation driven by demand is not a very realistic scenario nowadays. 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.]

The basic error of David Ricardo is his assumption that capital or money is backed by things produced in the past, but actually, money is backed by the things produced in the future. It is true that the actual production depends on the machines, raw materials, capital to pay the workes, etc.. disposable. 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". The person or company who produces the commodities in the FUTURE doesn't care where the money comes from.

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.

real national income * price level = amount of money * circulation velocity of money

Real national income is the national income fixed on an arbitrarily chosen price level. 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.

The equation is a little bit simple but without a rise in the amount of money and/or the circulation velocity of money the real national income can only increase if prices decrease. 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.

From our perspective nowadays, the gold standard is a strange kind of monetary system, but in the context of the 18th/19th century, it makes sense. If their national income is simply unknown, there is no way to find out how much money is actually needed. Therefore, a monetary system is needed which adapt itself automatically to the national income.

We can deduce from this paragraph taken from Wealth of Nations that the relationship between the national income and the money needed to handle it was completely unclear. (We can assume that it was not possible either to determine the national income.)

What is the proportion which the circulating money of any country bears to the whole value of the annual produce circulated by means of it, it is perhaps impossible to determine. It has been computed by different authors at a fifth, at a tenth, at a twentieth, and at a thirtieth, part of that value.

Adam Smith, Wealth of Nations, Book II, Chapter II

Between 1/5 and 1/30 there is a big difference indeed. Based on such an unclear database, no monetary policy in the modern sense is possible.

If there is no clear distinction between the government and the central bank, the government will tend to finance its expenditure by printing money. If that leads to inflation, people will change their money into gold.

[Once again, see above If the conversion rate money/gold is fixed all the prices will rise, wages and the prices of commodities if the amount of paper money is increased. People who want to buy something are therefore better off if they change their money into gold. The price of gold can't increase because the amount is fixed. However, savings in paper money will lose their value. That way the amount of money is reduced again. There is, therefore, an automatic stabilisation mechanism in that system, and it is not needed to know how much money is necessary to handle a certain national income.]

Classical authors on economics are obsessed with the idea that saving is defined as income of the past that was not consumed, is a condition of investments. We have already said that this is at most true in a situation of full employment, see interest rates.

Adam Smith, this is typical of him, is very often on the right path, but loses it once again. In this paragraph, he describes that an increase in the amount of money through "banking operations" leads to higher economic activities.

The commerce of Scotland, which at present is not very great, was still more inconsiderable when the two first banking companies were established; and those companies would have had but little trade, had they confined their business to the discounting of bills of exchange. They invented, therefore, another method of issuing their promissory notes; by granting what they call cash accounts, that is, by giving credit, to the extent of a certain sum (two or three thousand pounds for example), to any individual who could procure two persons of undoubted credit and good landed estate to become surety for him, that whatever money should be advanced to him, within the sum for which the credit had been given, should be repaid upon demand, together with the legal interest. Credits of this kind are, I believe, commonly granted by banks and bankers in all different parts of the world. But the easy terms upon which the Scotch banking companies accept of repayment are, so far as I know, peculiar to them, and have perhaps been the principal cause, both of the great trade of those companies,and of the benefit which the country has received from it.

Adam Smith, Wealth of Nations, Book II, Chapter II

That is what we call today a loan on overdraft, although nowadays no guarantor is needed to get it. The question is where this money, the overdraft, comes from. David Ricardo assumes that the credit granted this way comes from the other customers of the bank, but that is not true. If people deposit money in their bank accounts, and the bank knows that a certain part of this money will not be used, they can borrow it to someone else. In other words, the sums of money in the bank accounts and the circulating paper money is higher than the paper money. Banks can produce money "out of nothing". In times of Adam Smith and today.

Beside that: To issue a bill of exchange, "....had they confined their business to the discounting of bills of exchange...", increases the amount of money as well. A bill of exchange has the same characteristics as money, and there are not even guarantors needed to issue it.

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This seems strange to David Ricardo. David Ricardo is obsessed with the idea that money is determined by things produced in the past. The amount of money is therefore fixed and can't produce "out of nothing".

Adam Smith speaks of the advantages derived by merchants from the superiority of the Scotch mode of affording accommodation to trade, over the English mode, by means of cash accounts. These cash accounts are credits given by the Scotch banker to his customers, in addition to the bills which he discounts for them; but, as the banker, in proportion as he advances money, and sends it into circulation in one way, is debarred from issuing so much in the other, it is difficult to perceive in what the advantage consists. If the whole circulation will bear only one million of paper, one million only will be circulated; and it can be of no real importance either to the banker or merchant, whether the whole be issued in discounting bills, or a part be so issued, and the remainder be issued by means of these cash accounts.

Adam Smith, Wealth of Nations, Book II, Chapter II

For the author it is "difficult to perceive" what David Ricardo didn't perceive. If someone issues a bill of exchange he creates "money". With this money someone will sell him something. If everything works fine, the one who issued the bill of exchange can sell that, to give an example, at a higher prices. He will therefore earn money and with this money he will redeem the bill of exchange. In other words, with money that he created himself he activated idle resources and increased the national income. Money is always backed by things produced in the FUTURE and not by things produced in the PAST.

The money the banks borrows directly to customers, through a loan on overdraft or a normal credit, didn't exist before.

This sentence "... If the whole circulation will bear only one million of paper, one million only will be circulated..." is completely wrong. It is highly irrelevant how much money is circulating. The only interesting point is the productive potential, because money is backed by the productive potential and not by the

For someone whose fortune consisted most of all of money, that was the case of David Ricardo, it is not a pleasant idea that money is actually money, wherever it comes from and whatever is its form: Found on the beach, not consumed income of the past, printed by central banks, issued by individuals, etc.. No matter how much people can save, a central bank can print much more money in a few hours than all of them together can save in one year. The ECB will print in 2015 and 2016 on billion of Euros. That is really a lot of money. People who earn money with money are not happy about that, that's obvious. But it is not the task of central banks to serve the interests of a certain group.

We have already said that there are very big differences between the authors nowadays attributed to the classical theory, see classical theory.

Concerning capital and money all authors belonging to what we call nowadays classical theory are wrong, however there are differences. We can distinguish between theories that are at least correct in a certain situation, full employement, and theories which are completely wrong and absurd.

Adam Smith and Jean Baptiste Say assumes that the interest rate equalises savings and investments. The higher the interest rates, the more people save and the less people invevest; the lower the interest rates, the more people invest and the less they save. The interest rate is therefore considered as a price in the sense of a market economy and will, as any other price, equalise the demand and supply for capital.

This is wrong, interest rates are not a price in the meaning of a market economy, see interest rate, but at least in a situation of full employment it works like a price. The higher the interest rates, the less people will consume and the more they will save. The resources can therefore reallocated for the production of capital goods. This is necessary in case of full employement. In case of full employement the production of capital goods is only possible at the expense of consumption goods. In case of unemployment that is not true. The production of both can increase at the same time and saving is not needed. Investments can be financed with money, wherever this money comes from.

The case of David Ricardo, and later on Karl Marx, is very different. The profit rate falls in the long run, but that has nothing to do with the preferences for saving. The profit rate falls because the "capitalists" have to pay higher wages if the population grows and that reduces their profits, see effects of taxation. For an unknown reason "capitalists" don't have to decide between consumption in the present or more consumption in the future. All the added value squeezed out of the workmen is reinvested. This only increases the general misery, more people living at subsistence level, but "capitalists" like that, for whatever reason. They don't consum and enjoy their lives, they prefer to produce more people living at subsistence level.

However, in both versions, the basic error is the same. It is assumed that "capital", being defined as not consumed income of the past, is the condition for investments, although, only money is needed for investments, wherever it comes from. This sounds at first glance to be an irrelevant theoretical problem, but actually, it is a serious problem.

In many countries, the pension system is based in part or fully on savings. The idea is that people save money during their working live and live from this money after having retired. That only works if the central banks keeps money scarce, something they will no do, if they want to promote investments, as nowadays, we are still in 2015. It is obvious that pension funds and insurance companies complain, see The Economic Impact of Protracted Low Interest Rates on Pension Funds and Insurance Companies.

The falling interest rates are not the only problem. In general, at present and in the future the national income depends on the productive potential, and there is no way to increase the productive potential in the future with today's savings. People can only consume what is produced at the moment.

Even high-interest rates don't guarantee that in the future, the things people need will be actually produced. It is argued that the change of the pension system from a contribution based system to a capital based system, the working generation will pay the pensions of the pensioners, and every single person will live from his own capital stock. It is necessary because of the demographic change, a deterioration of the relationship between working people and pensioners. In the future, if there are not enough people to keep the economy running, the accumulated capital is of no help. (To illustrate the problem with an example.)

We find that equation in any textbook.

M * V = P * Y

M is the amount of money, V the velocity of circulation, P the price level and Y the national income. (See above.)

As many other equations used in economics, this one as well describes an equilibrium and is of little use. It is even compatible with the Keynesian monetary theory. In the equation money is only used for transaction purposes. According to classic theory, there is no money kept out of circulation due to speculation. However, this is not such a big problem. We can say that the existence of money kept out of circulation due to speculation is considered in V.

[For more information about the Keynesian monetarian transfer mechanisms, see the booklet downloadable from the start of this website.]

We are never really interested in equilibriums, although textbooks about microeconomics are exclusively about equilibriums. We want to know how to get to an equilibrium or what are the causes that lead to an equilibrium. An equilibrium is only the effect of causes and depending on the causes these effects can be very different.

One can imagine an infinite number of casual relationships with very a very different impact on the equilibrium although the equation above will always be true. In former times, for instance, governments had the possibilities to print money themselves. Directly, for instance, if they mint coins, or indirectly if they have for instance the supervision of the respective central bank.

If this is the case, there is strong tendency to finance governmental consumption with printed money. In this case, P and M will raise, and the equation is correct.

The situation changes if the government is treated as any other borrower. In this case, he must pay the money back, and the government will be induced to invest in things that are at least profitable in the long run, bridges, roads, canals, buildings and so on. An improvement of the infrastructure will lead to higher productivity and an increase in the national income. In this case, M and Y will rise.

The equation is always correct, whatever happens. It is not even needed to consider the interest rate, crucial for the demand for money. The demand for money will be low if interest rates are high and bigger if interest rates are low, but whatever the interest rate actually is, the equation will be correct.

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1.2.4 Theory of money

Economic growth depends on know how and innovation and not on "capital"