As an American engineer who has spent the last six years digging into the inner workings of economic theory and the history of economic thought, I’ve come to a very troubling conclusion: There has never been a sound theory of economics and America’s vanishing prosperity is a direct result. To fill the resulting intellectual gap, I’ve constructed a new model as a starting point for what I feel is a much needed national debate over the theoretical foundations of economic theory. The implication, as will be argued below, is straight forward: Only a closed economy is the optimal form of capitalism. By closed, I mean one protected by sky-high tariffs, with the exception of geographically-limited goods.
In order to keep the discussion as simple as possible, I will treat economic theory’s ultimate goal as one of achieving maximum national prosperity. Though raising our standard of living gives us a single point of focus, the intellectual path leading there is faced with a conundrum, because economic theory is not one single line of thought. Economic theory has splintered into numerous warring schools of thought: 1) Neoclassical, 2) New Keynesians, 3) Post-Keynesians, 4) Rational Expectations, 5) Monetarists, 6) neo-Keynesian, 7) Walras/General Equilibrium, 8) Austrian, 9) Marxists, 10) Circuitists, 11) Chartalists, 12) Classical, 13) Institutionalists, 14) Real Business, 15) Historical,and so on.
These various schools have some commonality which allows us to classify them by their theories of product price formation. In short, the mainstream subscribes to subjective barter-driven (supply and demand) models, while the heterodox schools revert to an objective model built on cost of production derived from labor content and the associated wages. Placed in chronological order, the objective schools spanned the 1700 and 1800s along with a few present day holdouts (e.g. Marxists), while the subjective schools rose to prominence starting in the late 1800s. The essential teachings of the mainstream line of thought can be summarized in the following three sentences: 1) Microeconomics is a supply and demand (barter) driven model in which relative product prices and wages are assumed to be instantly and infinitely flexible, 2) Macroeconomics builds on barter-based micro and concludes that unemployment is the result of wages being too rigid (“sticky”) and too high, 3) And finally, international economics, again counting on stone-age barter dynamics, tells us that free trade will make the whole world richer (but you might lose your job in the process–economists excluded). Consider yourself a newly knighted economist.
Unfortunately, in my little bubble of reality, barter-based models can only survive in traditional textbooks with the incomplete and defective economic definition of money known as the Quantity Theory of Money (QTM). Money thus becomes an afterthought in economics, or a veil as it is often referred to. The idea is perhaps best illustrated by a proposition based on historical observation: A nation with abundant gold coins will have higher prices than an identical nation with very few gold coins. Essentially, this is the idea behind gold-laden Conquistadors returning home and inducing inflation in Spain. As a result, it shouldn’t surprise the reader that the sixteenth century Spanish Salamanca School developed early theories of QTM. Yet, it would be more than another century later before QTM would gain a solid footing with the musings of Scotsman David Hume whose QTM models would plant the seed for defective economic reasoning for the next 200 years in my opinion. With Great Britain as the early home of eminent economists such as Smith (father of free markets economics), Ricardo (father of free trade theory), Marx (father of anti-capitalism economics), Jevons (father of subjective economics), Malthus (father of subsistence economics), Marshall (father of industry sector economics), and Keynes (father of unemployment economics), Hume’s idea would procreate until it would find its resting place within Walras’ grand vision of supply and demand economics across an entire nation (never mind that an invisible auctioneer is needed to make it work). Keep in mind that our major political parties have traditionally subscribed to Hume’s economics in the form of free trade since the 1960s (GOP conversion from protectionists to free traders took place roughly in that time frame).
To begin to understand why I consider QTM the core failure of economic theory, let’s begin with a simple model of money which ultimately turns QTM and therewith modern economics on its head. Begin by imagining two factories, one which makes bread and the other which makes cheese. Instead of a bank, imagine a smartly-programmed computer which creates loans out of thin air for credit worthy customers. In other words, the factory owners request a loan from the computer in order to pay the worker’s wages. Next we assume for simplicity there is no profit or interest paid, and the workers spend all their income. Thus all bread and cheese is produced and then sold. Once this occurs, all loans are paid off. Notice a key point here. The quantity of money (credit/debt) circulating in the economy is determined by the need to pay wages, not by some huge stock pile of money in a bank vault as traditional QTM would have us believe. Viewed more abstractly, the potential money supply (credit) is infinite–the computer has no limit on the quantity of loans it can create. As long as the borrower is credit worthy, it will create the loan. Under traditional QTM one would expect hyperinflation as a result of an infinite quantity of money, yet we can see it is wage payments which determined the needed amount of money in the system. In fact, there is no resulting inflation at all in this simple model, because all credit is eventually extinguished by the final loan payment.
At the risk of getting long winded and going out on a theoretical limb, let’s add interest payments and profits, a topic which has created 200 years of confusion. They too can ultimately be traced to nothing more than additional credit. To grasp this in simplified form, simply image the banks creating an additional loan to the factory owner to cover his own personal expenses until he can realizes his profit upon final sale of goods. The same logic can be extended to the bankers themselves who have bills to pay while they wait for the loan repayment and interest. Thus, neither interest nor profits are ultimately inflationary, since they too amount to a repaid loan.
The core logic behind this computer banking model of an economy is essentially that promoted by the Banking School in the bullionist debates of 19th century England, the French and Italian Monetary Circuit Schools, Marxists, and Post-Keynesians. These schools effectively reverse the causality of money’s introduction into an economy from that of traditional and modern economics. Regrettably, though the Post-Keynesians have one foot in reality, their obsession with capitalism’s inherent instability does not allow them to recognize that it is precisely the monetary ruler which gives capitalism its inherent stability at full employment in a closed economy. Let’s see why this might be the case.
First, recognize in the simple model above there is yet no explanation of wage formation. Mainstream theories suggest wages must be infinitely and instantly flexible, meaning there must be no restriction as to high or low the average wage can rise or fall. Consider what this really means: Money as a measure is meaningless. It is void of content, by definition. In the end, to keep the prehistoric logic at least consistent, it is concluded a minimum wage is the source of unemployment (barter breaks). I in contrast argue precisely the opposite, building on James Steuart’s (1700s–before Smith) notion of money as an “arbitrary scale”. Thus a minimum wage is absolutely necessary to assign worthless credit/paper/fiat money (infinite in supply) its value. If this is obvious to the reader, make note that in spite of my collection of over 200 textbooks, I have yet find this key observation made regarding money, wages, and the minimum wage (gladly stand corrected). Also keep in mind, a scale must be rigid for it to serve any useful purpose. In contrast, modern monetary theory builds on money made of Bungee cord material, creating intense intellectual confusion among numerous schools of thought. For example, New Keynesians are forever scratching their heads as to why wages show signs of stickiness, when in my interpretation wage stickiness is a genetic monetary trait inherited from the very definition of money.
But the line of reasoning cannot end here, because Steuart’s money logic, though headed in right direction, never reaches the final destination. Steuart, like Smith, Ricardo, and Marx were trapped in a culture of English subsistence wages (pitied by American observers at the time) whose origins stem from their export intensive society (mercantilists). What they fail to see is that not only is money an arbitrary scale, but that this scale can only function properly in a closed economy; it is ultimately a “domestic arbitrary scale.” More concisely it is an “arbitrary domestic measure of labor”. In other words, money is a domestic phenomenon, not the international one that Hume helped convince his followers of. This is the critical mistake of the “free markets” lobby. They fail to distinguish between free domestic markets (good thing) and free international markets (bad thing).
To see why this might be the case, we have to consider several important of aspects typically not considered when defining roles for money. The traditional definition of money is that of a store of value, medium of exchange, and unit of account. Notice that none of these definitions cover the introduction of money into the economic system as our simple computer-bank model above did. In our computer model, bank deposits are all ultimately a form of debt (exceptions due to bankruptcy will not be considered here). To begin to appreciate the domestic aspect of money, let’s modify the computer-bank model by introducing a productivity gain in the cheese factory. Say a genius figures out how to make the same amount of cheese with half the labor. Assume for simplicity everyone is making the same wage, and as a result, the cost of cheese is cut in half, implying that half of the cheese workers now are unemployed. Thus “rigid” wages are necessary for productivity gains to be fully realized in the product price reduction and to identify the superior competitor. Critical to this dynamic is the recognition that the consumer is now flush with cash which is directly proportional to the wage savings resulting from the equivalent amount of unemployed workers. This saving, the consumer can now spend in a different sector. For example, the unemployed workers can now enter the work force at the new ham factory which springs up to take advantage of the freed up labor. By defining money as a rigid domestic scale measuring domestic labor content in a good, we have laid the foundation for healthy economic growth. Free trade, on the other hand, where $1 worth of imports, could say mask the equivalent of $20 of American labor it displaces is a highly destructive element to this normally growth healthy process. The size of this miscalculation is shocking: https://rescuingeconomics.wordpress.com/2016/04/15/trade-deficit-delusions/ .
Note the implications. In a closed economy, domestic money in the form of an arbitrary rigid scale restores full employment that results from productivity gains. Consider also that in this closed model, a productivity gain which required short-run unemployment ultimately raised the standard of living of all the workers. At the start, the standard of living consisted only of bread and cheese, and at the end of the growth process we had bread, cheese, and ham. In contrast, in an open economy, which no longer relies on the workers consuming what they produce, a productivity gain could result in long term unemployment. For example, if an exporter replaces his workers with robots, he has nothing to lose (he still has foreign buyers). In fact, I have argued elsewhere that exports ultimately make a nation poorer, not richer (English subsistence wages of the 1800s; the Luddites were right). To grasp this, simply envision a nation exporting 90% of its output with no imports. The factory owner can still maintain a profit, but the workers can no longer reap the fruits of its labor. Note also the need for a common language as workers move from sector to sector (cheese to ham). This critical language aspect is overlooked in discussion of the Euro and is precisely why it amounts to a form of dysfunctional free trade (i.e. Italian worker cannot move readily to Germany where the superior competitor which has displaced him might be located). In addition to money as a domestic definition, wage formation has a domestic element too. Keynes introduced the final critical observation that wage formation is a relative comparison process. In other words, an American steel worker compares his potential salary to another American steel worker, not to that of countless foreign competitors. Again, under free trade this normally healthy process is disrupted.
Consider also the impact on government taxation. Assume in our little bread, cheese, and ham economy, we have a government that taxes the three industries at a 25% rate. Thus the government is able to consume 25% of the bread, cheese, and ham. And instead of living high on the hog in early retirement or pushing paper around, this government provides roads and bridges for the three industries. All is well. But now, assume the industries are destroyed by free trade. What is government to do? It issues bonds to the foreign importer and buys his products for the moment, completely oblivious to the plight of ruin of his own country. Government debt creates the illusion of national prosperity for those in government. But how is the government to pay off its debt to the importer? It can’t export roads and bridges to settle the trade deficit. The importer cannot setup shop here, since his peers have a price advantage. If I was a betting man, I’d place my chips on the outcome that the entire finance structure will eventually come unglued, because finance ultimately rests of national wealth production, and not vice versa.
But financial intellectual confusion is nothing new. Hume’s ideas were put to the test under the Articles of Confederation in the form of free trade and ultimately proved a disaster. It was for this reason that Daniel Webster argued that the primary reason we created our Constitution was to stop free trade. In the same vein, Marx suggested the fastest way to destroy capitalism is with free trade. The slave-owning South were the defenders of free trade; the industrial North was led by the protectionist Lincoln. If this isn’t a red flag for wage theory, I’m not sure what is.
When all is said and done, the process of industry sector formation and growth is the essence of an economy. Factories are the fruits of industrial, electronics, and chemical revolutions (the work of genius from which we all benefit). The productivity gains mean that all other sectors rely on them. Superpowers are defined by them. China has tossed economic textbooks into the dumpsters, because they understand one thing: Factories ARE the economy. Without them we ultimately return to subsistence farming.
Under a fixed exchange regime as is the case with China and the USA, QTM is the magic glitter that is suppose to bring us balanced trade and economic bliss. But if QTM is flawed nonsense, then trade deficits will never disappear, factories will not return, but instead bring unimaginable ruin.
Apparently, it is still a matter of debate as to whether or not Hume was an atheist, but maybe he would have reconsidered his argument in light of Leviticus’ command that measures be “just.” Because money is ultimately a measure of labor, the preceding argument I believe suggests only in a closed economy can money function properly as a “just measure.” Our decline, I am convinced, is the direct result of not honoring and understanding this command.
Footnote: For those interested in additional essays see the tabs on the top of the page or menu (mobile) and older writings at http://www.economicpopulist.org/content/myth-middle-class-economics-5665. As always critique is very welcome.