Sunday, April 26, 2009

Lesson IV – The Price System

How Money Works:
We have seen how it is through a process of cooperation that individual people are able to satisfy their needs in a society. Natural resources are taken and worked upon by different people, with different abilities and skills and tools to work with, and are passed from hand to hand in a process of exchange, until they reach the person for whom the whole process exists, and who is finally to make use of the product – the Consumer.

Sometimes, the functions of production and exchange are separated when the workings of the Capitalist organization of society are considered, and the idea is created that only those who actually labour in producing a physical product are carrying out a useful function. This actually is not true. “Production” - that is, supplying a desired form of wealth to a person willing to consume it, is simply not complete until the wealth itself is transferred over to the consumer, and in this process, those who extract the raw materials, those who ship them, those who process them, those who assemble them,who wholesale them, who retail them, who create the consumer demand for them through advertising, who deliver the product to the consumer's doorstep, are all adding value to the product, all for the sake of one person, and one person only – the Consumer who is going to make use of them. The most magnificent capital projects – dams, hydro developments, great factories, warehouses, stores and so on – would have no purpose, and would have to be abandoned, unless somewhere at the end of the line, there was the Consumer, ready, willing and able to pay for the wealth, no matter what its final form, the he makes use of.

This process of production, as we have seen, requires repeated exchange of the ownership of half finished products, from the hands of those who process them in one manner, to the hands of those who process it in another, each person in the chain seeking first of all to cover his expenditures on the raw materials processed, including the cost of the labour he employs, and in addition, to gain as large as possible return to himself for his initiative and effort in furthering the product one stage nearer to final satisfaction for the consumer. A steady stream of goods and services, in fact, is continually becoming ready for sale – being placed “on the market” - some of which will be bought for final consumption, but a great part of which will be bought by other business enterprises for further processing before being sold to the ultimate buyer.

There is, therefore, at any given moment, a very definite amount in any society which, although owned by definite persons, they are actively seeking to exchange for money on the market. Or, to put the same situation in another way, there will be a definite number of owners of wealth who are anxiously seeking to part with it, in exchange for what is, within certain limits, a perfectly definite sum of money. These persons are not simply big industrialists or merchants. The most important element among them is the enormous number of wage earners in the country, willingly, week by week, month by month, year in and year out, contributing the wealth of their labour and the skills of their education into the process of production for the sake of receiving, at the end of every week, two weeks, or whatever the customary pay period is, an agreed amount of money for the work they have performed. The total amount of what all these people are prepared to sacrifice, for the purpose of holding money, consists of what can be called the “national credit”, or what one writer has called the “Virtual Wealth” of the nation. It is the sum total of all the wealth that the people of a country are prepared at any time to part with, so that instead of having wealth in one form today, they can have a choice of wealth in a number of different forms in the future.

In an earlier lesson, we saw how one form of primitive money system turned part of this national credit - this willingness to part with wealth for money – into money by issuing a private promise to deliver goods, which could be passed to others as money. In a modern money system, the coin or dollar bills issued by the State, or the dollar credits advanced by a bank, are in fact a generalized form of promise, issued on behalf of all who wish to exchange wealth for money, to receive ownership of a proportion of that wealth.

A unit of money, no matter where it comes from, is in fact, a certificate of title that can be passed from hand to hand to a proportion of the total of the virtual wealth, or national credit, of the community. The proportion of the total national credit that each unit of money will buy will tend always to be that proportion of the national credit that the unit of money bears to the total money supply of the nation. Should the national credit be constant, in fact, and the quantity of money units in circulation be doubled, this very fact would tend automatically to cut the value of each money unit in half – a process technically known as “Inflation”.

How Much Money?
The question of “how much money should there be in circulation?” is always likely to be a vexing one, especially in a world that has seen, in many countries, either whole economies come to a standstill and prices collapse below cost of production for lack of sufficient money, or the value of their monetary units collapse completely, when the money supply increased faster than the availability of consumer goods on the market.

In earlier lessons, we have seen firstly that even without any money being in circulation at all, there is a perfectly definite measure that people can make in their minds as to the value of the things around them, at which they are willing either to buy or to sell them.

We have also seen that each unit of money in circulation, whether state issued, bank issued, or even an undetected counterfeit, is a certificate of title to a fractional part of the public credit.

We have also seen that the determining factor in the whole economic process, without which all would come to a halt, is the known willingness of potential consumers to pay a certain money price for the various forms of wealth that they wish to buy.

Suppose, now, that money is taken out of circulation. Maybe consumers cut back on their spending, and start paying off their debts. This actually happened, for instance, when bank loans were recalled during the Great Depression of the 1930's. What will be the result? One of two things. Either the value of every dollar will increase and the price of goods will therefore fall, or the value of the dollar will tend to stay constant, and the amount of the national Credit will shrink. Businesses will be unwilling or unable to offer goods for sale below cost at lower prices, and will cut back output to keep prices from falling.

In actual fact, both events occur. There is a tendency for prices to fall – but prices cannot fall too far, because businesses cannot afford to sell below cost without going into bankruptcy. Businessmen who have invested in plant and stock on the assumption that they will be able to sell at a particular price, including a fair profit for themselves, cannot without going bankrupt afford to sell much below the expected price. What happens instead is that the whole economy goes into low gear, factories run below capacity, workers are laid off, unemployment mounts – in short, there is far less exchange of wealth, and so far less production, than would have been the case had the money supply been greater. In physical terms, Society and its members become much poorer than they need to be.

Increasing the money supply, on the other hand, will first of all permit more and more exchange to take place – production will increase. A limit will be reached, however, where it is not possible to carry on more exchange. Prices begin to rise as the value of the monetary unit falls.

The Happy Mean
Is there, then, a happy mean for a nation's money supply? Yes. This comes when the supply of money is ample enough to carry out all the exchange of goods and services that the people wish to effect by putting their goods and services on the market, yet is not so great that goods and services begin to become scarce in terms of money available at the accepted price level, so that prices start to rise. This level, though it may seem hard to determine, in actual fact is not as difficult to achieve as may be supposed. For one thing, our general level of prices is a fairly stable factor, and profiteering and excessive profits need not be expected, unless there is either a monopoly situation, or obvious scarcities of goods, to make them command a “black market” price. For another, the index of unemployment shows fairly clearly whether or not there is an excessive, or else an insufficient, demand for labour, one of the most universal, but perishable, forms of wealth. It can always be expected that there will be a certain amount of “frictional” unemployment, as people move from job to job, or take time to acquire new skills. We can also expect that as a country becomes richer, more people may choose to retire earlier from the labour force. The index of the people who are “involuntarily unemployed” - that is, qualified for work but yet without employment, shows clearly whether the money supply is sufficient to finance the process of exchange or not.

Also, the framework of Society, and the way in which people receive and spend their incomes, does not change suddenly from day to day. There is in fact a very steady relationship indeed between a nation's Gross National Product in any year, and the money supply. Between 1926 and 1983, for instance, the lowest ratio, in 1966, was 33%, or a four month period of circulation. The highest was the year 1946, resulting from the pressures of wartime inflation, at 58.2% (7 months). In more recent years, ratios of M2 money supply to Gross Domestic Product were a high of 58.14% in 1993, (7 months)(1) but for the years 1988, 1998 and 2003 were all between 50 and 51% (6 months)(2) For a very long period of time, therefore, the ratio of money supply to Gross Domestic Product for the previous year (that is, the total price of goods and services produced in that year) varied to indicate a circulation period between a minimum of four months and a maximum of seven, in spite of extremes of boom and depression. The most usual period in recent years has been around six months.

This simply means that in our present state of society, the average dollar takes a certain fairly fixed time to be received as income by a consumer, spend on the products of industry, and pass through industry until once again it is a payment to a consumer, as wage, salary or dividend income. In the short term, therefore, if we know in physical terms the goods and services that can be turned out by Canadians in any year, there is no great difficulty in calculating very closely indeed the amount of money the country needs to have in circulation in order to have those goods and services produced.

Money, Competition and Prices:
Earlier we saw that the value, and so the price to any individual for any particular form of wealth, was something that varied from person to person, and even at different times. Generally speaking, however, it is true that only a few people will want an article at a high price, and the lower the price is brought, the more people will be ready to buy the article.

Suppose, therefor, that if an article were priced at $1,000.00, ten people would buy it. If it were priced at $100.00, one hundred people would buy it. If it were priced at $10.00. five thousand people would buy it. Suppose also that for ten units, the cost of manufacture is $100.00 per unit. For 100 units, it is $15 per unit, and for 1,000 units, it is $7.50 per unit. We have an interesting study in the arithmetic of business costs. In our imaginary situation: Ten articles cost $1000.00 to make, sell for $10,000.00, yielding profit of $9,000.00 One Hundred articles cost $1,500.00 to make, sell for $10,000.00. yielding profit of $8.500.00 Five Thousand articles cost $39,500.00 to make, sell for $50,000.00, yielding profit of $10.500. It makes surprisingly little difference, therefore, to our producer from the point of view of profit, whether he makes very few articles and sells them at a high price, or a large number, and sells them cheaply. From the point of view of the Consumer, however, it makes all the difference in the world. Mass production means that the price of the article is reduced by 99%, so that 4,990 additional people can enjoy the article in question, in comparison with the restricted output, high cost approach.

How can producers be persuaded to give the public the best value for money, and adopt this high output, low price approach? The classic answer to this is by competition between producers. In our example above, suppose that all the articles were more or less identical. Producer A was trying to sell his at $1,000.00 each. Producer B was pricing his at $100.00, and Producer C at $10.00. A and B would have little chance of selling in competition with C at their much higher prices. In order to obtain a market, they would be forced to lower their prices to something close to C's prices if they want any of their articles to be sold. All the same, it is worth noting that (1) it is this competition between producers that tends to drive the “small man” who cannot easily switch his output and cost structure from producing small quantities at high prices, to large quantities at low prices, out of business; (2) in our example, the market at $10 was only for 5,000 units. If A, B and C are to share equally, they will have only 1,667 units apiece. Their costs per unit may therefore well be higher than if there was only one producer in the field, so that to keep themselves from bankruptcy, the actual price charged to consumers by all three firms may be higher than if only one firm occupied the field.

Limited Supply:
The example we have taken above assumes that it is comparatively easy to produce additional articles as needed. It is typical of modern mass production – say of automobiles, appliances, printed materials and so on – that whether one article or a million be produced, there are fairly definite “setting up” costs, including those of research and design, plant, machinery and so on, that are completely fixed. In addition, there are “run on” costs, chiefly for raw materials, power and labour. These are required, once the plant has been set up, to produce each individual article. The greater the number of articles among which this setting up cost can be shared, the nearer the price of the finished product comes to being no greater than that of the raw materials and labour involved. History probably shows no better example of this than the case of the development of the mass market Model-T Ford car, and also the problems of the U.S. automobile industry in more recent years, as the influence of Japanese and South Korean competition has made it necessary to produce cars of better quality needing less frequent replacement, while matching the substantially lower production costs of foreign industries.

Some products, though, are by their nature in fixed supply. There may only be a certain number of rare stamps or rare paintings, for instance: a certain quantity of a precious metal, or a certain number of shares in a certain company. In such cases, when further production is difficult or impossible, prices are not set by competition between producers, but by competition between consumers. This is the case when production is controlled to gain maximum profit by cartels or monopolies (including some professional associations). The products are allocated proportionately to the total of money that consumers as a whole are prepared to pay for them, and price will have no relation to original cost. That is the key, for instance, to the operation of the Stock Exchange. The volume of shares listed on the exchange is, in the short period, fairly inflexible. Therefore the more persons investing on the exchange, the higher share prices will go, without any reference, for instance, to the earning power of the shares themselves. The small investor is attracted by the prospect of capital gains from rising share prices to put his own money into the investment market – and by so doing, makes prices rise still higher. As soon, though, as any substantial number of people start liquidating their holdings, the reverse process takes place. Prices fall. Paper values are lost, and there is a “crash”, such as that on Wall Street in 1929, or again in 2008, which heralded the onset of the Great Depression.

The Rate of Interest:
Before going on in the next lesson to examine the economic system “in motion”, there is one more factor entering into the costs of production that is of key importance. That is, the rate of interest.

We have seen that people willingly hold money for short periods of time, because it is convenient for them to do without wealth they possess in one form now (such as their labour), in order to have a choice of wealth in a different form in the future. To have to do without wealth for any great length of time, however, is a definite inconvenience, progressively more so the longer the deprivation continues. Yet we have also seen that modern mass production demands the use of “tools” - capital of one sort and another – which Industry must purchase and pay for before any production can take place. If Industry is to acquire this capital, which is a form of wealth, this can happen in two ways. Either people holding funds part with them by lending money or buying shares in a venture – often the case when pension funds invest their retirement savings - or the money is created and lent by a Bank, in which case the whole national money supply is expanded, and, since new production is not yet on the market, the value of the dollar is diluted by inflation, and the general public pays for the investment through loss in the value of the dollars that they hold. The price that the Banks, or other holders of wealth charge for placing money at the service of Industry is known as the Rate of Interest, and is generally expressed as a percentage of the capital sum advanced, payable annually. Sometimes, of course, parting with this wealth means taking the risk of it never being seen again if the business fails, or consumer credit is not repaid, and in such cases, the interest rate charged is made higher by an estimate of the risk involved.

Something that should be noted, however, with regard to this matter of interest, is that the Banker advancing money at interests expects to be paid the sum contracted for, even though the project for which it is advanced may be a failure. If the farmer's crop fails, the Bank will still expect to be repaid in full, the farmer's only defence being to go into bankruptcy. Since money is sterile, and does not breed more money, philosophers such as Aristotle, and religious authorities from Moses to Mohammed and the Pope , have denounced the charging of interest on money without assuming the risk of the project for which it was advanced. Muslim Banking, which avoids the charging of interest, still pays attention to this prohibition. Calvin was the religious leader who overrode Old Testament prohibitions (Ezekiel 18, Psalm 15) to make usury acceptable in the modern Capitalist era. Shakespeare illustrates the concern over the subject in his time in his drama of “The Merchant of Venice”. It is this ability to create money backed by the full liability of the borrower to pay back his debt with interest that has made it possible for the Banking system to progressively replace state issued money with money of its own creation.

The key factor, setting in motion our whole economic system, is the existence of consumers desiring certain forms of wealth, and willing to pay a certain price for them. These same consumers also have labour, skills, or other property to sell, again valuing these at a certain price. These products, and these skills, labour or other wealth which people are continually willing to “put on the market” in exchange for money, have a definite value, and form the “National Credit”. A nation's money supply is in fact a supply of certificates of title to shares in this “National Credit”, though private individuals are generally unable to create such certificates for themselves, even though they are the ones whose skills, labour and property are what in fact give value to the monetary unit, now partly issued by Governments, but mostly as debt through the banking system

In practice, each dollar of the nation's money supply circulates in a fairly constant average period of between four and seven months to convey real wealth in the form of labour or other services from Consumers to Industry (the Business Sector), and real wealth in the form of products or other services from Industry back again to Consumers. If the money supply is increased excessively, beyond the people's willingness or ability to put additional goods and services on the market for exchange, the buying power of each unit of money will tend to decrease. Conversely, if the money supply shrinks, or fails to expand in accordance with ability to expand production, prices to the producer will fall, and the “National Credit” will decrease as workers and machinery become unemployed.

Prices of goods on the market, in the absence of competition, tend to become what will give the greatest return to the producer – this may involve small output, high price, and comparatively little value to the Consumer. Competition between producers tends to lower prices and extend markets, even though in theory it may be slightly less efficient than monopoly production. If supply is restricted, however, (as in the drug trade, when there is vigorous enforcement) competition between consumers has no other effect but to increase price, regardless of cost of production. Interest is the price of “doing without wealth” for a period of time, and generally speaking, the rate of interest reflects the price people expect to receive for doing without wealth now, for the sake of supplying finance to pay for the tools that will bring greater wealth in the future. When advanced as Consumer Credit, e.g. for automobile loans or house mortgages, it represents the cost of providing Consumers with value now, that they will pay for at some future time. There are practical and moral considerations involved when money is advanced to business purposes without assuming any part of the risk of business failure.

* * * * * * * * * * *

1. Define the word Consumer. What is the difference between “Production” and “Consumption”?
2. Is there any purpose to Production without Consumption?
3. What is the “National Credit”. Why does it exist?
4. If the National Credit increases, is the price level likely to rise or fall? Why?
5. What is the effect of too small a supply of money in the hands of Consumers?
6. How best could we determine the ideal quantity of money for the Canadian economy at any time?
7. What is the effect of competition between producers? Between Consumers? How far are these effects either good or bad?
8. What is the general effect of mass production techniques on small business? Why?
9. What is the rate of interest, and how is it justified? Why are different rates of interest charged for short and long term borrowing?
10. Are there practical or ethical problems attached to the charging of interest or loans of money?

* * * * * * * * * * *

V.C.Vickers: “Economic Tribulation”
J.K.Galbraith: “The Great Crash, 1929”
Irving Fisher: “100% Money”
Alec Cairncross: “Introduction to Economics” parts II and III.
Standard economics textbooks on the subject of supply, demand and price.

(1) J.M.Hattersley Brief to the MacDonald Royal Commission, Part 3.
(2) Statistics Canada, Canadian Economic Observer Historical Statistical Supplement 2008.
(3)Benedict XIV: Encyclical “Vix Pervenit”.

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