Money, production, and profit
Households, companies, and banks mainly interact the one with the others so as to pay out wages, to transfer monetary savings, as well as to allow for consumption. Wages and corporate gains are the motor driving individuals, companies, and banks to produce, distribute, and purchase the national product. In this context, money is a required component of any economic system. Yet, economists disagree with each other about the way in which economic players interact as well as about the nature of monetary and real incomes. Thus, this chapter shall propose a study of production, consumption, and banking, in hopes of a new consensus on the basic laws underlying economic phenomena. This chapter aims to prepare the ground for a study of corporate profits. In this light, the investigation shall seek to explain the relation between money and the real economy, focusing on productive activities, on consumption, and on the role of commercial banks as intermediaries between households and companies. An inquiry shall also be made about the historical and theoretical scope of central banks, with particular regard to the Bank of England and to the Federal Reserve System. What are the laws of production, consumption, and banking? What are the functions of commercial and central banks? What is the link between households, companies, and banks?
Bank money and the real economy
Production, consumption, and commercial banks
Traditionally, economists have thought of money as the currency in circulation; that is, banknotes and coins. It comes as no surprise, then, that most theories treat money as a physical object. Even at our times, whenever thinking of money, the one-dollar bill springs to mind. However, currency in circulation is just one side of the story. After all, today’s massive use of electronic means of payment shows that scriptural money is by far larger in amount than banknotes and coins. One can even go further by asserting that some economies are transitioning very quickly toward a cashless future. On this regard, for instance, Sweden is in the lead. As argued by
Wheatley (2017) in a study for the International Monetary Fund, banknotes and coins account for only 15% of payments in Sweden, a country where cash is used by less than half of commercial banks and has fallen ‘by nearly 15 percent between 2007 and 2015. Even homeless sellers of Stockholm’s street magazine accept mobile payments’ (Wheatley 2017: 32-3). What is money, then? What relation holds between money and output? What is the relation between money, production, and consumption?
History influenced the general opinion about money. As recalled by Smith in his Wealth of Nations (1776 : 41), the incomes of the Saxons, in ancient times, did not consist of money, but ‘in kind, that is, in victuals and provisions of all sorts’; metal money was started being used only later on, under William the Conqueror. Iron was already used by the inhabitants of Sparta to facilitate the commerce of goods, and it was Servio Tullio who first coined money in Rome, using ‘a Roman pound of good copper’ (Smith 1776 : 42). Also, at the time of Alexander the First, the Scots already used ‘a pound of silver of the same weight and fineness with the English pound sterling’ (Smith 1776 : 41). Over time, gold, silver, and paper money, for instance, have been used by the richest nations to facilitate production and trade.
Then, it is not surprising that money has usually been identified with a physical medium. Broadly speaking, economists (see, for instance, Phelps 1961; Friedman and Schwartz 1963; Brunner and Meltzer 1971; Phelps and Taylor 1977) usually refer to money as a stock whose quantity would determine the amount of money supply in circulation and under the form of demand deposits (for recent critiques of the quantitative theory of money and monetarism, see for instance Keynes 1936 ; Desai 1981; Cen-cini 2005; Krugman 2016; Rochon and Rossi 2018; Rossi’s forthcoming a, forthcoming b analyses). The conception of money as a physical medium of exchange and means of payment is so widely diffused that its status is almost that of an axiom.
Interestingly, according to some authors, money is not of a physical nature, but scriptural; that is, a number in bank books without intrinsic value. On this regard, Bernard Schmitt (1960, 1975, 1984, 1986, 1996) was followed, among others, by Alain Parguez (1975, 1996, 2001), Alain Bar-rere (1979, 1990a, 1990b), Alvaro Cencini (1984, 1988, 2001, 2005), and Augusto Graziani (1989, 2003). As Rossi (2007: 18) points out:
[m]oney does not need to be reified into a precious metal in order for it to be a means of payment: it would be enough [...] a double-entry book by means of which [...] economic transactions are recorded and settled with a mere book-entry device.
According to these authors, money is of a numerical nature, with no intrinsic value. Money is ‘a pure symbol, a stroke of the pen in the bank’s balance sheet’ (Realfonzo 1998: 43). It is on double-entry bookkeeping, which has existed since the 13th century, that this analysis of money is founded.
As odd or against the tide as it may appear, money is far from being the physical object described in most of the economic literature. Banking systems are based on scriptural money, which is issued by commercial banks, in the first stance, so as to allow for companies to pay out wages. The creation of money takes place alongside productive activities; better said, production is the raison d’être of money creation. Hence, production and money creation must always be understood on logical grounds: without money, output would have no monetary value; without output, there would be no reason for money to be issued.
Think of a commercial bank and name it Nantucket Bank, after one of the oldest commercial banks in America. As any commercial bank, Nantucket Bank holds assets and liabilities corresponding to the credits and debits toward its clients. Assets include loans, securities, reserves with the central bank, cash, and other items. Liabilities include deposits, borrowings, and others. As the laws of double-entry bookkeeping require, the amount of assets and the amount of liabilities on any balance sheet must always match. This means that the value of assets is always equal to the value of liabilities.
Now, it is no mystery that loans are granted on the basis of the amount of deposits held by the bank on behalf of its clients, according to the saying ‘deposits make loans’. What is unknown to most people is the fact that a certain kind of loans gives rise to new deposits, according to the saying ‘loans make deposits’. This kind of loan is made thanks to the activation of credit lines, or, in other words, when wages are paid. The payment of wages, in fact, does not rely on previously existing deposits. For the sake of clarity, an example may be of help.
Suppose a firm requests the bank to credit workers’ accounts with wages, relying on a credit line that the firm has previously obtained and backed by securities (on this topic, see for instance Rossi 2007: 25). Workers are credited with wages amounting to $100. The bank grants credit to the firm and simultaneously registers deposits of workers for the same amount. As soon as the payment of wages is made, the stylized balance sheet of Nantucket Bank will be affected as follows (Table 1.1).
Table 1.1 The stylized balance sheet of commercial banks
Source: author’s elaboration from the Federal Reserve (2016a). A stands for 'increase’.
As soon as wages are paid to them, workers are credited with an amount of bank deposits that is matched by a net credit of the bank toward the company. This event triggers, so to speak, the creation of wage-income. Resulting from the activation of a credit line, the payment of wages gives rise to an increase in the overall level of the assets and of the liabilities on the books of Nantucket Bank. Wage-income has thus formed. Workers are credited, while the firm is debited. To the bank accounts of workers corresponds a security on the financial market, namely a certificate of deposit, whose real object is the output produced and warehoused within the company. Interestingly, the terms ‘output’, ‘product’, and ‘goods’ also refer to services, for ‘goods and services are both examples of economic goods’ (Solow 2012: 271). The remuneration of workers coincides with the production costs incurred by the company, which are the objective, monetary value of real output. Identifying wages as the measure for output value is equal to defining a product-wages relation where money functions as a unit of account for wages - Keynes (1936 ) used the expression ‘wage-unit’ to refer to the measure of output value. Keynes’s (1936 : 20) words can easily be borrowed here: ‘the income derived in the aggregate by all the elements in the community in a productive activity necessarily has a value exactly equal to the value of the output’.
Now, the payment of wages always confers to wage-earners as a whole the right to purchase produced output. Whenever wage-earners use their credit cards, for instance, they spend their income to purchase a product or a service. Consumption allows companies to cover the production costs they have sustained on the labor market, also known as the market for productive services. Through consumption, goods and services leave the warehouses of companies and are allocated among their final users to satisfy their needs; the flow of money that is credited on corporate bank accounts allows for a reduction in the debts of companies toward the bank. Again, an example may be of help.
Think of a territory, which we call Nantucket. It well may be an island, an estate, or simply a university classroom. Suppose that Seafarer Co. is the sole company at Nantucket. Wage-earners at Seafarer Co. produce ten tons of seafood chowder. Hence, the output produced at Seafarer Co. is made of chowder. At the beginning of January, Seafarer Co. obtains the opening of a credit line by Nantucket Bank. At the end of the month, the credit line shall be activated and wages shall be paid. For the sake of simplicity, suppose all entries in Nantucket Bank’s balance sheet to be nil. Suppose also that only scriptural money is used; that is, neither coins nor banknotes exist (nonetheless, some comments on banknotes and coins shall be made further on). At Nantucket, wage-earners include all kinds of workers, without any social class distinction: for instance, workmen, employees, managers, consultants, and so on. In this sense, workers include entrepreneurs. The entrepreneur indeed should be regarded as a worker providing his services. ‘It ispreferable to regard labour, including, of course, the personal services of the entrepreneur and his assistants, as the sole factor of production’ (Keynes 1936 : 213-14). It has to be noted that this is far from meaning that the company makes no profit. As argued later on, income is made not only of wages, but also of profit. In the real world indeed, as soon as output is sold, companies usually expect to make profits. Suppose also that, at Nantucket, for a number of reasons, some individuals do not work and receive a share of wages from wage-earners. For instance, some children receive tips by their parents to buy fresh chowder at the local market. Thus, it shall be assumed that bank deposits are constituted in favor not only of wageearners, but of households broadly speaking.
Money is simultaneously a company’s debt and a credit of workers considered as a whole, both toward the banking system (Schmitt 1966: 286-7). The remuneration of labor (nominal wages) constitutes the monetary form of global output, and, if companies’ profit is zero, it confers to workers the right to purchase the whole of real product. An example may help clarifying this point. Suppose that households spend the totality of wages altogether to purchase seafood chowder. In this context, if the company does not seek to gain from the sale, the selling price of output shall be equal to production costs. Households shall purchase the totality of consumption-goods. The price of $100 being equal to production costs of $100, households dispose of the sufficient and necessary income to purchase ten tons of seafood chowder. Nothing remains unsold after the sale.
Accounting entries in Table 1.2 show this process. Entry 1 refers to the payment of wages. Seafarer Co. is debited, and households are credited by the bank. This is respectively shown in the assets and in the liabilities of the bank’s book. Entry 2 concerns income expenditure. When households spend their monetary income, Seafarer Co. covers its production costs and is able to pay back its debt to the bank. As soon as all the debit-credit relationships are extinguished, as shown in entry 3, monetary income is finally spent, and households benefit from using the goods they have purchased. The asset and the liabilities in the balance sheet of Nantucket Bank decrease accordingly.
Table 1.2 Wage payment and consumption
Nantucket Bank (Massachusetts)
Source: author's elaboration from Cencini and Rossi (2015).
What is worth inferring with the help of double-entry bookkeeping is that the nature of money is twofold, for it is a numerical flow (money-as-a-flow or vehicular money) and a numerical stock (money-as-a-stock).
On the one hand, vehicular money is used as a means of payment in every single transaction. Money, as a vehicle, is instrumental to credit and to debit the accounts of income-earners. For instance, in the banking system a bookkeeping entry accounting for the payment of wages is instantaneously positive and negative, and it implies the debit-credit of every single agent. The final expenditure of wages is an operation in which money is again used, as a vehicle. In the former case, income is created, meaning that bank deposits increase; in the latter case, income is definitively spent, since the relationship credits-debits between workers and the company is definitively extinguished, meaning that bank deposits decrease accordingly. Vehicular money is also used in all other payments. Consider, for instance, what happens when individual A orders his bank to lend or transfer $1,000 to individual B on his behalf. The outcome of the payment is as follows: a reduction of $1,000 takes place in A’s bank account and, at the same time, the same amount of income is registered in B’s bank account. Money, as a vehicle, is instantaneously spent and created. One will observe that, in this example, the vehicular use of money does not change the overall deposit level; namely, the use of vehicular money does not alter income levels. Thus, to be true, when a transfer is made from agent A to agent B, it is a matter of substitution rather than distribution. The result of the payment is in fact the substitution of a certain amount of monetary income from one bank account to another.
On the other hand, money-stock, namely bank deposits, defines the unity of a stock of goods and of their monetary form, where ‘real’ goods are the object of every payment. Between the payment of wages and their final expenditure, a double stock does exist: namely, a stock of goods and a stock of financial securities (deposit certificates) corresponding to the amount of bank deposits. The ‘causality runs from money as a flow (means of payment) - the primum mobile - to bank deposits (stock of wealth)’ (Rossi 2003: 345). As money ‘covers’ the physical product, a numerical form is given to real output. An absolute or numerical value of output originates when wages are paid, since goods and services are monetized thanks to the union of money and output. Output is then demonetized with consumption, when production costs are covered by the company and its debt is paid back to the bank. As soon as the company sells the product, the company covers production costs. Assuming that no further wage payments have been made, the level of bank deposits decreases accordingly. Once national output has been deprived of its absolute or monetary value, only a subjective value-in-use is left into the real world.
It is crystal-clear, therefore, that money is essential to productive and consumption activities. It is thanks to money creation and to its integration with output that heterogeneous, physical products become homogeneous, economic products. It is thanks to money expenditure, further, that homogeneous, economic products are turned, once again, into heterogeneous, physical products. Thus, money builds a temporary bridge between production and consumption. Money matters for its being a bridge between current and future economic activities. Once wages are paid, wage-income is deposited in bank accounts in the guise of a temporary, monetary capital and, simultaneously, as a physical stock within companies. As soon as wages are finally spent, the income level decreases by the same amount. At this point, the entire society does benefit from a product with a subjective value-in-use. It turns out that, being the numerical form of goods and services, money cannot be conceived as a commodity. Neither can money and output be two separated magnitudes, for they are in fact the two faces of the same reality. In economics, money and output are then the terms of an identity that is always true independently of time. Far from being a mere truism, the relationship between demand (bank deposits) and supply (real output) must be read as an identity. What allows for the temporary existence of monetary and real deposits is money.
In this volume, banks shall be referred to as if, acting as pure intermediaries between wage-earners and companies, they neither pay wages on their own behalf nor make any gain. These assumptions are motivated by mere didactical purposes. Usually, banks not only serve as intermediaries between households and companies, but they also act as any other company remunerating their employees and seeking profits. As a matter of fact, in any developed economy, banking activities are such that the banking industry makes a huge deal of business, employing hundreds of thousands of professionals. For instance, according to the US Department of the Treasury, the ‘U.S. banking system is estimated to employ almost 2.8 million Americans’ (2017: 21). In 2016, through their intermediation, US banks helped companies produce a gross domestic product of almost $18.6 trillion (World Bank 2017: 1). As of June 2017, the financial system of the United States included about 5,900 banks and 5,800 credit unions, whose assets in the previous year totaled $21.4 trillion and $1.3 trillion, respectively (U.S. Department of the Treasury 2017: 21). Acting as any company, banks pay out wages relying on credit lines that are activated whenever banking services are provided. Banks also make profits the same way as profits are made by companies. Yet, when they are considered as companies producing and selling services and financial products, banks do not substantially differ from any other firm, so that the analysis of their economic activity is included in that of companies in general. What interests us here is to stress the role played by banks as intermediaries, which is why we shall consider them only in this function, at the service of the economy as a whole.
Now, what can be learned from the previous observations?
Traditional economic theories state that production is an activity that takes place over time. However, this traditional conception of production gives way when money enters the scene. It can be maintained that one should think of production not only in terms of the result, the product as a new value-in-use, but also bearing in mind the role money plays in the process of production. From a physical point of view, it is certainly true that, for productive activity to be undertaken, a period of time is necessary over which raw materials and energy are transformed into goods and services. Yet, it must also be added that only when wages are paid are goods and services monetized. It is when wages are finally spent, then, that goods and services are demonetized. In this light, production and consumption are events in which income is respectively created and finally spent. Thus, consumption cannot be understood unless it is identified as a complementary part of production, and vice versa. The physical product acquires an economic nature as soon as it acquires a numerical, monetary form. When income is finally consumed or spent, the economic product leaves its place once more to a physical stock with a subjective value-in-use. In production, the physical product is first transformed into income via wages payment; through consumption, the product is ‘expulsed’ from its monetary form and subsists only as a physical object. Production gives rise to a net income that is spent with consumption.
Between production and consumption, a temporary capital survives, the nature of which is twofold, being monetarily deposited in the bank’s books and physically warehoused in the company. Such capital, which is made of the savings of households, is temporary, since it will be spent over time on the product market by the legitimate holders or by borrowers. This credit represents the right of households over a real capital that is stocked within the company. The financial capital deposited within banks is the credit title of households on the physical stock deposited within the company (the debt of which is registered as a bank’s asset). When savings are spent, the company covers production costs and thus is able to pay back its debit toward the bank. When this happens, deposits decrease accordingly.
If the product were monetized and demonetized simultaneously, income would be created and spent at the same time. However, such an assumption would be too strict to allow for the financial intermediation of banks as well as for the development of a complex and articulated economy. Indeed, thanks to the intermediation of banks, production and consumption are two separate events, yet the two faces of the same reality. Whether right or wrong, Henri Bergson is attributed to have thought that ‘[t]ime is a device to prevent everything from happening at once’ (see Robinson 1962; Forstater 2013: 36). His words may be borrowed to assert that banks, by issuing money, prevent production and consumption from happening at once.
Figure 1.1 may be of help. The figure shows the evolution of bank deposits over a period of two months, with $100 are paid at instant 0 - let us say, December 15 - and another $100 paid at instant 1 - January 15. For the
Figure 1.1 Bank deposits
sake of simplicity, suppose that wages are finally spent altogether at instant 2 - February 15. Within the time between instants 0 and 2, the amount of deposits constitutes a temporary financial capital. Bank deposits represent the temporary capital that exists between the moment in which income is created (wage payments) and the moment in which income is definitively spent. Therefore, in any given moment of time, the level of deposits depends on the total sum of previously created incomes that have not yet been spent. The income level over a given period depends on the total sum of global deposits during that time interval.
For instance, if total income amounts to $100 and households spend $70 in purchasing goods and services, firms are credited with $70 and households are debited to the same extent. The amount of bank deposits after the purchase equals $30. As a result of consumption, firms are still debited on the Assets of banks’ balance sheets ($30); households are credited for the same amount on the Liabilities of the balance sheets (see Rossi 2003: 345). The remaining income of $30 will be definitively spent when the product is entirely sold by firms to households.
It is certainly true that income-earners can always exert the right over their demand deposits. As a matter of fact, they always have the right to spend the income they have been credited through production. A certain amount of time elapses, though, between the constitution of a deposit in favor of an income-earner, and the moment when she/he spends it. Meanwhile, banks legitimately lend a certain amount of income to their clients (this topic shall be examined further on in the volume). If Mr. Smith, for instance, earns $100, bank technique is such that his income can be lent to
Mrs. Marple, who is a borrower. Mrs. Marple, who spends $100 to purchase goods and services, will be able to pay out her debt toward the bank as soon as new income forms on her bank account. In that precise instant, Mr. Smith will be able to spend $100, too.
Now, commercial banks, acting as intermediaries between households and companies, always manage monetary transactions as well as monetary deposits. Still, new issues must be investigated at this point. Are commercial banks alone capable to manage the national monetary system in a sound manner? As regards instead the central bank, what is its role? Have commercial and central banks proven to ward off economic and financial troubles both from national economies and globally? An answer shall be provided by a short history of banking systems, since their early expansion in the 17th century to the present day.