Sunday, 16 January 2011

Quantity Theory of Money and Social Credit

By: Socred - B.A., SCMP

The quantity theory of money can be simply expressed by the equation: MV=PQ, where M is the quantity of money in the economy, V is that money’s “velocity of circulation”, P is the average price level, and Q is real output. Proponents of the theorem generally argue that Q and V are constant, or at least not influenced by the quantity of money. This implies that any change in the quantity of money has a direct relationship with price levels. In other words, increase the money supply and increase price levels (i.e. inflation), or decrease the money supply and decrease price levels (i.e. deflation). The theorem deduces that the fundamental source of inflation is increases in the quantity of money “in circulation”. The theorem also assumes that money is an exogenous variable to this equation.

C. H. Douglas was quite critical of this theory, claiming that, “the velocity of circulation of money is a complete myth”. While econometric models have generally demonstrated a correlation between money and prices in the long run (which is what the theory predicts), there is less of a correlation in the short run, and it should be noted that correlation does not prove causation. Perhaps there is another variable which is causing an increase in the money supply and an increase in inflation over the long run? Before we explore that possibility, let us look at the “velocity of circulation”, what it means, and why Douglas called it a “myth”.

If we rearrange the quantity theory of money (MV=PQ) we see that V=(PQ)/M, and if we assume that PQ equals nominal GDP (an assumption that implies equilibrium), then the velocity of circulation can be calculated by dividing nominal GDP by the money supply. Does this rearrangement of the equation give us the velocity of circulation? Or is this merely an instance of petitio principii (begging the question)? Leaving aside the assumption of equilibrium, let’s explore this “velocity of circulation” in more detail, and why economists believe that money “circulates”.

The early quantity theory can be traced back over 200 years to at least as far back as the philosopher David Hume. (Blomqvist, Wonnacott and Wonnacott “Economics First Canadian Edition”, pge. 248). The early theorists believed that the inflation at the time was due to the influx of gold and silver from the New World. They believed that this increase in the money supply accompanied with a relatively fixed quantity of goods available for sale led to a rise in prices. As we can see, this theory holds that money is an exogenous variable, and the quantity of money is determined by forces outside the equation itself (i.e. an influx of gold from the New World). To what extent gold was actually used as money is a discussion beyond the scope of this essay, but even in the 18th century (and even much further in the past) it can be shown that the vast majority of money was actually credit (*see Alfred Mitchell – Inness, “What is Money”).

One of the events which Douglas claimed led to the development of his analysis was a conversation he had with the Accountant-General of Bengal named J.C.E. Branson. Branson used to have long discussions with Douglas about credit, and one of the things he told Douglas was “Silver and gold have nothing to do with the situation. It nearly entirely depends on credit.” (J.W. Hughes “Major Douglas The Policy of a Philosophy, pge. 34) The idea that money “circulates” goes back to the idea that money is a commodity (such as gold or silver) and goes about circulating through the economy as goods and services are purchased. A good example of the quantity theory is given in The Alberta Post War Reconstruction Committee:

“A wage-earner A. uses a $10 bill of his income to buy two
pairs of shoes from a shoe merchant B., who immediately goes into the
adjoining store and spends the $10 to purchase some shirts from C.,
C in turn immediately goes across the street to grocer D. and buys
some provisions costing $10, grocer D. then takes the $10 bill across
to the local garage E., to buy some gasoline and oil.

The contention is that the $10 bill provided purchasing
power to the extent of $40 during the day by virtue of its "velocity of
circulation" in enabling $40 worth of goods to be purchased by consumers.”

The problem with this theory is the neglect of money as credit (or debt). It implicitly assumes that money just “falls from the sky”, and does not examine how money comes into existence as a debt that needs to be repaid. The vast majority of money is credit created by banks through loans to businesses and individuals. This money does not “circulate”, but instead operates in an “accounting cycle”. Ignoring consumer credit momentarily, which is just a mortgage on future incomes, money flows from the bank to businesses and finally to consumers as income. The income is then spent by consumers on goods and services and flows back to the bank via businesses and in the process cancels all the debt created in order to produce the good or service. In other words, money is not a stock that can be simply added up; it is a flow which has direction (either flowing from the bank to the consumer as income, or is recovered from the consumer in the form of prices and taxes and flowing back to the bank and cancelling debt). Money created as consumer debt also operates in an accounting cycle, but does not involve the intermediary of businesses in the first part of the process. Consumer debt is the futile attempt to cancel a debt with a debt. With consumer debt, money flows directly to the consumer, and is recovered by business through the agency of price and then continues to flow back to the bank as it cancels debt.

If money does not “circulate”, then the whole quantity theory of money is a fallacy. The “velocity” of circulation is merely an example of petitio principii, and is defined within the confines of the equation itself (i.e. GDP/money supply). If the quantity theory of money is a fallacy, then why does there appear to be a direct relationship between money supply and price levels in the long run? This is due to a third factor which influences both. This factor is the increase in overhead charges relative to income as efficiencies in production are realized. Douglas stated in his first article, “The Delusion of Super – Production”, "it may almost be stated as a law that intensified production means a progressively higher ratio of overhead charges to direct labour costs”. According to Douglas’s A+B theorem, prices equal A (income) plus B (overhead charges). If overhead charges are constantly increasing relative to income, then in order to maintain or increase income, prices must rise. Further, since the vast majority of production is financed through the issuance of new credit (i.e. through loans to businesses), the capitalization of industry proceeds with an increase in the money supply. In other words, the fact that overhead charges are increasing relative to income increases prices and the money supply. A third factor is increasing both the money supply and prices: it’s not the increase in the money supply that is causing inflation, but the increase in overhead charges relative to income that is causing both.

If the quantity of money is not causing inflation, and if money is actually a flow instead of a stock, we can increase the money supply and reduce prices. This is done by introducing money as a “reverse flow”. A "reverse flow" of money would cancel overhead costs. This would equate purchasing power with prices and reduce prices. By giving consumers credits directly at the point of retail in the form of a price rebate, we can increase the quantity of money and reduce prices to consumers. The reason for doing this is based upon Douglas’s A+B theorem and his demonstration that the economy is not in equilibrium in any permanent fashion. The quantity theory of money implicitly suggests equilibrium and is at odds with the Social Credit analysis. A price rebate given to consumers is necessary in the Social Credit paradigm because the real cost of production is consumption over an equivalent period of time, and in any technologically advanced society, consumption is always less than potential production. The price rebate is designed to bring consumption and production into equilibrium, and reduce prices. The cries that Social Credit policies are inflationary are explicitly, or implicitly, based upon the quantity theory of money. The purpose of this essay is to help expose the quantity theory of money as a fallacy, and help alleviate some people’s concerns over one aspect of Social Credit policy.