The Elgar Companion to Post Keynesian Economics ...

The Elgar Companion to Post Keynesian Economics, Second Edition

Edited by

J.E. King Professor of Economics, School of Economics, La Trobe University, Australia

Edward Elgar Cheltenham, U K • Northampton, M A , U S A

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Circuit theory 87 Keynes, J.M. (1921), A Treatìse on Probability; reprinted in Keynes, Collected Writings, Volume V i l i , London: Macmillan for the Royal Economie Society, 1973. Keynes, J.M. (1936), The General Theory of Employment, Interest and Money; reprinted in Keynes, Collected Writings, Volume VII, London: Macmillan for the Royal Economie Society, 1973. Loasby, B.J. (2003), 'Closed models and open systems', Journal of Economìe Methodology, 10 (3), 285-306. Nuti, D.M. (2009), 'Akerlof and Shiller, Animai Spirits: a misnomer for their sound economics', Department of Economics, University of Rome 'La Sapienza', Short Notes No. 1. Shackle, G.L.S. (1961), Decìsìon, Order and Time, Cambridge: Cambridge University Press. Shackle, G.L.S. (1972), Imagination and the Nature of Choice, Edinburgh: Edinburgh University Press. Simon, H. (1955), 'A behavioral model of rational choice', Quarterly Journal of Economics, 69(1), 99-118. Townshend, H . (1937), 'Liquidity premium and the theory of value', Economie Journal, 4,1 (185), 157-69. Luckett, D. anp/R. Taffler (2008), 'Phantastic objects and the financial market's sense of reality: a psychoanalytic contribution to the understanding of stock market instability', International Journal of Psychoanalysis, 89 (2), 389^112. Vercelli, A. (1991), Methodological Foundatìons of Macroeconomics: Keynes and Lucas, Cambridge: Cambridge University Press.

Circuit Theory The debate on Keynes has mainly focused on the principle of aggregate demand. and on the analysis of macroeconomic equilibrium with involuntary unemployment. This is in homage to the traditional interpretation, which holds that Keynes's innovative force exploded with the General Theory (1936), the work in which he broke with neoclassical theory and with most of his own earlier work. However, it is also possible to maintain that the General Theory should be read as a continuation of the analysis put forward by Keynes in A Treatise on Money (1930) and in other works before and after the General Theory. According to this interpretation, Keynes's analysis should be considered part of the theory of the monetary circuit (what Keynes called the 'monetary theory o f production'), which should also include contributions from the first half of the twentieth century by, among others, Knut Wicksell, Dennis Robertson and Joseph Schumpeter (Realfonzo 1998). I n the second half o f the century, starting in particular from the teachings o f Keynes and Schumpeter, the theory of the monetary circuit was put forward again and developed mainly by Italian- and French-speaking scholars, such as Augusto Graziani, Marc Lavoie, Alain Parguez and Bernard Schmitt. I t has subsequently been supported by Riccardo Bellofiore, Biagio Bossone, Alvaro Cencini, Francis Cripps, Giuseppe Fontana, Guglielmo Forges Davanzati, Claude Gnos, Wynne Godley, Francois Poulon, Riccardo Realfonzo, Louis-Philippe

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Rochon, Sergio Rossi, Elie Sadigh, Mario Seccareccia and others. The theory o f the monetary circuit has aroused growing interest, generating productive debates (for instance, see Deleplace and Neil 1996; Rochon and Rossi 2003; Fontana and Realfonzo 2005) and further historical and analytical studies. While significant differences persist on specific points, most o f the theoreticians o f the monetary circuit follow substantially the same approach, remaining within the sphere o f Post Keynesian theory. As far as the basic analytical approach is concerned, the theoreticians of the monetary circuit reject the methodological individualism typical of neoclassical doctrine and adopt a socio-historical method: the study of individuai behaviour is subordinate to the macro approach. The^implest model of the monetary circuit, with a closed economy and no state sector, can be described i n the following way. Let us consider three macro agents: banks, firms and workers. Banks have the task of financing the production process through the creation o f money, and o f selecting business plans; firms, through access to credit, buy factors o f production and direct the production process, making decisions on the quantity and quality of output; workers supply labour services. The working of the economy is described as a sequential process, characterized by successive phases whose links form a circuit o f money. A clear understanding o f the circuit theory can be obtained from Figure 3:

Banks

Initial finance

Final reimbursement

Firms Purchasing of labour services Purchasing of consumption goods

Savings Workers

Figure 3

The monetary circuit

Circuit theory 89 The phases in the circuit are: 1. 2.

3. 4.

5.

banks grant (totally or in part) the financing requested by firms, creating money (opening o f the circuit); once financing has been obtained, firms buy inputs; considering firms in the aggregate, their expenditure coincides with the total wage bill; at this point money passes from firms to workers; once labour services have been purchased, firms carry out production; in the simplest case, firms produce homogeneous goods; at the end o f the production process, firms put the goods on the market. I t can be envisaged that firms set the sale price following a mark-up principle. Supposing workers have a propensity to consume equal tc/òne, firms recover the entire wage bill and maintain ownership of a proportion (corresponding to the mark-up) of the goods produced. I f the propensity to consume is less than one, once the workers have purchased consumer goods they must make a further choice about how to use their savings, either hoarding (increase in liquid reserves) or investing (purchase o f shares). I f ali the money savings are invested in shares on the financial market, firms manage to recover the whole wage bill; once goods and shares have been sold, firms repay the banks (closure of the circuit).

Starting from this synthetic description, the remarks below concern the nature and role of monetary variables, the volume of production and employment, the distribution of income and macroeconomic equilibrium (Graziani 1989, 2003; Lavoie 1992; Parguez 1996; Realfonzo 1998, 2006). According to the theory o f the monetary circuit, money is a pure symbol - merely a book-keeping entry (or a certificate) - with no intrinsic value, created by the bank in response to a promise o f repayment. The bank is defined as the agent that transforms non-monetary activity into activities that are money. This approach therefore holds that it is the decision to grant credit that generates deposits ('loans make deposits'). The money supply is endogenous, in that it is essentially determined by the demand. On a theoretical level, the banking system could create money endlessly. I n its turn, the demand for money can be broken down into two distinct parts: the demand for money to finance production (which Keynes called the 'finance motive') and the demand for liquid reserves (dependent on the well-known transactions, precautionary and speculative motives). According to the theory o f the monetary circuit, what mainly distinguishes entrepreneurs is their access to bank credit. I n fact, money - as Schumpeter said - is the lever through which power over real resources is

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exercised. From what has been said, it follows that monetary circuit theory rejects traditional principles o f the exogenous nature of the money supply and the neutrality of money, as well as the quantity theory of money. The volume of production is autonomously fixed by firms, based on the expected level of aggregate demand. Naturally, production decisions taken by firms may or may not be supported by banks. I f there is credit rationing by banks, firms are unable to translate their production plans into real production processes. To make the matter more complicated, it can be shown that the production decisions taken by firms are also influenced by the possibility o f equity rationing. One conclusion drawn by theoreticians of the circuit is that the financial structure of firms is not neutral with respect to production decisions. The employment level depends on firms' production decisiahs and therefore on aggregate demand. The labour market is thus described, according to Keynes's teaching, as the place where any shortage in aggregate demand is dumped (generating involuntary unemployment). Macroeconomic equilibrium is compatible with the presence of involuntary unemployment. According to the theory of the monetary circuit, as in Keynes's originai work, in the labour market bargaining concerns only money wages. I n fact, the price level (and therefore the real wage) is known only at a later phase, when workers spend their money wage in the goods market. This obviously does not mean that, at the time when they bargain for their money wage, workers have no expectations about the price level, but their expectations are not necessarily confirmed by the market. Consequently, there may be a difference between the ex ante real wage (expected by workers) and the ex post real wage (the actual real wage). I f workers' expectations about the price level are confirmed, the expected real wage coincides with the actual real wage. I n a model with two types of goods (consumer goods and investment goods) this happens when voluntary saving equals investment. When investment exceeds voluntary savings there is a positive gap between the expected real wage and the actual real wage, which gives rise to forced saving. As far as the firm's profit is concerned, monetary circuit theory accepts the thesis that firms as a whole 'earn as much as they spend'. I n fact, given the mark-up (which in turn may be made to depend on the industriai concentration ratio), the higher the level of production (and therefore the expenditure on inputs), the higher the firm's real profit. I n a model with two types o f goods - consumer goods (wage goods) and investment goods - decisions about the composition of production determine the distribution o f income. The higher the demand for and production of investment goods, the higher the profits for firms. Thus scholars of the monetary circuit reject the marginai theory of distribution in favour of a KaleckianPost Keynesian approach.

Circuit theory 91 In the theory of the monetary circuit there is a strict distinction between the money market and the financial market, and between the two interest rates that are set there. I n the money market, banks and firms negotiate and the interest rate constitutes the price firms have to pay to obtain initial finance. The money interest rate is basically a 'levy' on the gross profit of entrepreneurs. I t should be underlined that, in the simple model here described, firms can at most repay the initial finance to banks but not the interest as well. I f there is hoarding, firms will not even be able to repay the initial loan in money. I t is possible to envisage that in this case firms may decide either to settle their debt with the banks in goods, or to remain indebted to them. I t is worth emphasizing, however, that this inability on the firm's part to repay the debt in money terms is not an inevitable feature of monetary circuit models. Indeed, as soon as one moves on to more complex models - with a state sector and/or an open economy, or to models in which firms start production at different times (not simultaneously) - this feature disappears and in theory it is possible that, at the closure of the circuit, firms are able to repay their entire debt (interest included). I n the financial market, workers and firms negotiate and the interest rate constitutes the price firms have to pay to raise the money not spent on the goods market. I t is, in fact, through the goods market and the financial market working in conjunction that firms try to obtain the final finance, in other words to recover the liquidity initially spent on purchasing inputs. From what we have seen, it can be deduced that for circuit theorists there is a sort of logicai hierarchy between the money market and the financial market. I n fact, the financial market could not operate at ali unless the money market had already been operating. This means that while the individuai firm can freely choose whether to get financing through the money market or through the financial market, for firms as a whole no such choice is possible. This is so unless there is a public spending deficit and/ or a surplus in the balance o f payments such that enough money will flow, through workers' decisions to buy securities, into the financial market. Within the contemporary theoretical debate about fiscal and monetary policies, monetary circuit supporters criticize the prescriptions of the socalled 'New Consensus model' (Forges Davanzati et al. 2009). According to the circuit theory, output is demand driven both in the short and in the long run, and there is no endogenous mechanism that guarantees full employment. For this reason, fiscal policy is eftectual for increasing the level of economie activity and employment. I n particular, an expansive fiscal policy increases - thanks to the wide multiplier o f state expenditure - aggregate demand, firms' expectations, private investments and employment. However, the size of the effeets o f fiscal policies on production and prices depends also on the way public expenditure is financed (through

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taxation, government bonds or the creation of money). A t the same time, state interventions promoting high levels o f the Employment Protection Legislation Index determine an increase in real wages, and hence i n labour productivity and output. The New Consensus arguments are also criticized on the side of monetary policies. According to the monetary circuit approach, monetary policy cannot guarantee price stability. I n fact, restrictive monetary policies could not reduce demand and inflation i f agents have positive expectations; at the same time, those policies could be very counter-productive since they could generate a negative effect on output in the long run. On the contrary, inflation can be controlied by public policies aimed at a reduction of degree of concentration o f firms, monopoly power and the mark-up. /

RICCARDO REALFONZO

See also: Banking; Fiscal Policy; Italy; Keynes's Treatìse on Money; Monetary Policy; Money; New Neoclassica! Synthesis.

References Deleplace, G. and E.J. Neil (eds) (1996), Money in Motion, Basingstoke: Macmillan. Fontana, G. and R. Realfonzo (eds) (2005), The Monetary Theory of Production: Tradition and Perspectives, Basingstoke: Palgrave Macmillan. Forges Davanzati, G , A. Pacella and R. Realfonzo (2009), 'Fiscal policy in the monetary theory of production: an alternative to the "new consensus" approach', Journal of Post Keynesìan Economics, 31 (4), 605-21. Graziani, A. (1989), 'Lhe theory of the monetary circuit', Thames Papers in Politicai Economy, Spring. Graziani, A. (2003), The Monetary Theory of Production, Cambridge: Cambridge University Press. Lavoie, M . (1992), Foundations of Post-Keynesian Economie Analysis, Aldershot, U K and Brookfield, VL, USA: Edward Elgar. Parguez, A. (1996), 'Financial markets, unemployment and inflation within a circuitist framework', Economies et Sociétés, 30 (2-3), 163-92. Realfonzo, R. (1998), Money and Banking: Theory and Debate (1900-1940), Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Realfonzo, R. (2006), 'Lhe Italian circuitist approach', in P. Arestis and M . Sawyer (eds), A Handbook of Alternative Monetary Economics, Cheltenham, U K and Northampton, MA, USA: Edward Elgar, pp. 105-21. Rochon, L.-P. and S. Rossi (eds) (2003), Modem Theories of Money: The Nature and Role of Money in Capìtalìst Economies, Cheltenham, U K and Northampton, MA, USA: Edward Elgar.

Competìtion The importance of competìtion is a centrai tenet of economics. Its benefits figure prominently in the standard texts o f the discipline, where competi-