Why does paper money have value? The answer is because it is legal tender. You discharge your contractual obligations and pay your taxes by using it. Your landlord can't refuse to accept it in discharge of your rent. Nor can your creditor refuse it in discharge of your debt. On the other hand, if you can't pay in cash, your landlord or creditors could get a court order and render you homeless and distrain valuable possessions of yours.
Communist countries- like the Soviet Union- had money and an income tax. You could go to jail if you didn't pay your income tax with money in Moscow just the same as in Montreal or Milwaukee. Also, you needed money to buy stuff. That's why paper money in Communist and Capitalist and every other sort of country that could be found in the Twentieth Century had money and that money had value for that country's people.
Prof. Prabhat Patnaik is an Indian Economist. He is not aware of this fact.
His book 'the Value of Money' begins thus-
Patnaik is asking two different questions. One is- why is paper money valuable? The answer is, because 'social arrangements' in Communist and Capitalist and every sort of country includes specifying that this paper money is 'legal tender' and must be offered and accepted in settlement of specific contractual or legal obligations.
The other question Patnaik is asking is what determines changes in the value of money- i.e. what you can buy with it? The answer, regardless of type of economic system, is changes in the supply of the goods and services which are available for sale. A Capitalist country which is under siege may see a dramatic fall in the availability of goods. Money would become less valuable as prices rose. This is called 'inflation'. The same thing may happen in a Communist country. However, instead of prices rising, queues might get longer and so some people might end up with unspent cash in their pockets. This is called 'repressed inflation'. In both cases money has become less valuable.
Changes in the law or the strictness with which the law is enforced can make money less valuable. Pablo Escobar, at the height of his career, was burying huge bales containing hundreds of millions of dollars in paper currency, in remote locations in his home country. Why? This was because the Americans were making it difficult for him to store his money in Banks. Cash had first to be laundered before it could enter the Banking system and thus be held in a convenient manner. It is said that much of that money which was buried in the ground simply rotted away. It had no value. Why? It was because its status as 'legal tender' had been compromised. The long arm of American law enforcement had rendered it worthless.
Mainstream economists understand all this. Indeed all ordinary people going about their daily business are mainstream economists. Why? Because they 'economize' by buying cheap and selling dear and acting prudently.
However there are some pedagogues who teach economics who don't understand this at all. They think some mathematical model they teach is real and what we see in the world is an illusion. Thus they don't understand that money has value because of the law relating to how debts can be paid or Bank accounts opened. Instead, these stupid pedants think money has value, not because of real life law enforcement, but by some magical power possessed by arcane mathematical equations.
This is utterly mad. Suppose you see a small child drawing a picture. You say 'what is that a picture of?' and the child says 'this is a picture of a cat'. Should you go to the kitchen to get some cream or other food for that cat? Of course you should! Without food of some suitable kind that small child's cat will starve to death. You would be guilty of cruelty and neglect to a small and cute little animal. Prof. Patnaik is not a cruel or neglectful man. He thinks human beings are starving because of some stupid equations. This is perfectly sensible. If the picture of a cat is not given food, the cat will starve. Similarly, if Patnaiks did not publish books, the wrong equations may get fed and this will cause or has caused some terrible calamity.
Money has value for two different reasons- we can buy stuff with it or we can put it in the Bank or buy Treasury Bills which will yield us interest income. The 'price' of saved money is the interest rate.
The simple 'neo-classical' story of the Economy is that people borrow more when the interest rate is low and they save more when the interest rate is high. Borrowed money is spent. Saved money is not spent. However, borrowing and saving are brought into equilibrium by the interest rate so economic activity, as a whole, remains the same.
Patnaik takes a different view. He thinks the demand for money depends on what you can buy with it- i.e. the goods and services available. To some extent this is true. If there are no goods and services to be had, you would not want money. This is why you don't take your bill-fold when you jump into the Sea to go scuba diving.
The more cool stuff there is the more cash you want so as to buy stuff you like. We can say the demand for money is complementary to the availability of goods and services. That is why, when people move from remote villages where there are no shops, to bustling cities with all sorts of nice goodies, they tend to become a lot more interested in having money.
However, that is not the end of the story.
Suppose you are blind and a friend is helping you do your grocery shopping. You say 'please pick out a loaf of bread'. Your friend does so. He then says 'hey! We're passing the butter section. Since you bought bread, you must want butter'. You may reply, 'No. I don't use butter for health reasons. I have a tub of margarine in the fridge. What I want is some cheese slices. Could you please get me a packet.'
Here, cheese is a 'complement' for bread but butter is not. Why? For health reasons, margarine is a better substitute for it.
In general, demand depends on the price or quality of the substitute. The complement only matters if no superior substitute obtains.
Patnaik, we will see, does not get this. He does not understand that the 'demand for money' depends on the closest substitute for money which is an interest bearing Bank Account or a T.Bill or other type of riskless asset which is highly fungible (i.e. it can be quickly and at very low cost be turned into cash).
The 'price of money' is the 'opportunity cost' of holding money. Opportunity cost means the closest substitute foregone. For butter, it is margarine. For holding money, it is the interest foregone by not holding T.Bills. The Demand for money is downward sloping with respect to the interest rate. At low interest rates one may not bother to buy Bonds because the reward is so small. But, equally, people will want to borrow to spend now and pay later because the penalty is also small. So low interest rates should be associated with rising economic activity while high interest rates will choke off economic activity.
Patnaik thinks 'the market for money' yields the general price level. This is not the way the actual world works. The Supply of Money at any given point is generally fixed. Prices which have been contractually fixed- e.g. rents, wage rates, and durable goods produced by big companies- are 'sticky'. Excess demand may lead to shortages while excess supply might result in unemployment and higher inventory or reduced capacity utilization. Some 'open markets'- like that for perishable commodities or high storage costs- may see wide fluctuations in price.
What about money? Well, if there were wild fluctuations in the interest rate there would be some very unwelcome 'macro' implications. People on floating rate mortgages, as well as a lot of businessmen, would be on a 'famine or feast' roller-coaster ride. The exchange rate would come under pressure and is likely to fluctuate widely causing havoc to export industries. This type of volatility creates a climate of uncertainty where people get scared and start avoiding any type of risk. Economic activity is likely to fall.
For this reason, Countries tend to use the interest rate and fiscal policy to try to stabilize the economic environment. Capitalism figures out sophisticated ways of insuring against fluctuations in the interest rate or the exchange rate so that people feel more confident. Of course, this could go wrong. These 'financial derivatives' could become toxic. Big financial behemoths may go bankrupt creating 'contagion risk'. Something like this happened after the sub-prime crisis. Some feared a repeat of the Great Depression of the Thirties. However, once Governments assumed a lot of the 'downside risk' and began 'quantitative easing'- i.e. pushing money into the Financial Sector so it recovered solvency- no great cataclysm unfolded.
Patnaik was writing at a time when it was not wholly obvious that there would be no 'Crisis of Capitalism'. Nevertheless what he writes is a travesty of 'mainstream economics'. It is the interest rate, not the General Price level which goes up or down so as to 'clear' the money market.
Patnaik is being silly. In Econ, the price of money is the interest rate.
No doubt, if there's a lot of cool stuff you may want to buy, you'll have more cash- this is called the Transactions demand for money and it depends on the price level. Suppose you are off to meet your friends for a bite to eat. If you are going to an expensive joint, you take more money with you. But if you're just going to get fast food, you don't need to fill your wallet in advance. Contra Patnaik, the higher the prices, the higher the 'Transactions demand'. When a family is shopping for the daughter's wedding they make sure to have a lot of cash in advance because one buys expensive items for such occasions. If they are going to the thrift store, they need less money.
In addition to the 'Transactions' and 'Precautionary' Demand there is also a Keynesian 'speculative demand' for money. At low interest rates there can be a 'liquidity tap'. People hold money in the expectation that bond prices can't remain so high permanently. Thus pumping money into the economy is 'like pushing on a string' because the velocity of circulation goes down as the stuff just sits idle. It has no expansionary effect.
Patnaik thinks mainstream economists focus on money only as a means of exchange and not as a store of wealth. This is true. Few will be foolish enough to hold money- save for a speculative purpose- when they could hold an interest bearing, highly liquid, riskless asset. Patnaik may himself keep his money under the mattress but he is a fool to do so. Inflation is eating away at it and he is also foregoing interest payments.
Patnaik then says something wholly false viz. money can't be a medium of exchange without being a store of value. It can and is by mandate of law. We are obliged to use money to settle our contractual obligations and pay our taxes and make other legally required payments. Money is a medium of exchange because it is legal tender. When I take a ride in a taxi, I can't insist I should be allowed to pay the fare with copies of my book. I have to pay in money or risk prosecution.
Patnaik has not found any logical contradiction in mainstream economic theory. He had lived through demonetization in India and should have known that a banknote which was still a medium of exchange- because it could be used to credit a bank account- could cease to be a store of value. Normally, a currency note has some value even after the passage of years. But if it has been demonetized and the redemption date has passed it has no value at all. People have papered their walls with Confederate Dollars or Tzarist Rubles.
Patnaik says there is a logical contradiction with the 'real balance effect' (when prices fall, those with currency notes are better off). This is not the case. 'Inelastic price expectations' are not assumed. Muth Rationality suffices- i.e. so long as most people are sensible and notice that things are cheaper and so the money in their wallet buys a lot more, they do in fact buy more, other things being equal.
Patnaik then introduces his own view which is that the value of money is given from outside the economy. For a very small country, like Luxembourg, this is certainly true. In every market, its people are price takers- save for one or two very localized services. Thus if the hair-dressers of the country put up their prices then some people take a ten minute bus ride to save a little money. Also foreign barbers relocate to Luxembourg and this pushes the price back down
For large nations, however, things are not that simple. Unemployment could be caused by wages remaining too high because of Trade Union militancy. Buildings may stay empty because local property taxes are too high. Businesses find their debts are crushing them and so they can't invest and grow. In this scenario, a gentle reflation- i.e. a rise in the general price level can enable markets to clear and people to get back to work. This is the 'mainstream' Keynesian story. Monetarists and supply siders may tell a different story about how sensible Government policies can change expectations which become self-fulfilling as people regain confidence.
Patnaik's ignorance of the fact that money is legal tender. which is why it is the medium of exchange, led him to find wholly fatuous 'logical contradictions' in the mainstream view.
He then offers a wholly foolish theory of his own.
Suppose Luxembourg has its own currency which is linked, in a Walrasian manner, to all other markets. Then if some prices rise in Luxembourg- perhaps because low paid waiters and barbers and cleaners form a cartel and raise their hourly rate- then, the value of the currency will fall because those citizens who prefer to take a ten minute bus ride to a neighboring state to get a haircut, or a meal, are selling their own currency to buy the foreign currency. This pushes its exchange rate down.
This shows that even in a small country which is a price taker, the 'value of money' relative to other currencies or its own internal Price level is endogenously, not exogenously, determined.
Say's Law is about the interest rate making Savings and Borrowings equal so that aggregate activity remains the same. It doesn't work if there are wage and price rigidities or externalities obtain. Patnaik is foolish for mentioning it.
Suppose we live in a world where God fixes the value our currency notes. Would we hold them as property? No. We would hold riskless, fungible, interest yielding bonds denominated in our currency if we thought God wanted our currency to be strong. Otherwise we'd switch to similar bonds in the currency that God prefers to see rise. Only if we are foolish or careless or if the interest rate was very low ('liquidity trap') would we hold the currency. But this would be termed speculation because we are taking a risk- though we may not realize it because we are as stupid and ignorant as Patnaik.
Suppose we live in Patnaikland- a country of cretins. For some reason people produce more 'ex ante'- i.e. they open their restaurants and hair salons and factories earlier in the morning hoping to sell more goods and services. It soon dawns on them that they can't sell more unless they drop their prices. Otherwise 'ex post'- the final outcome will be worse because they wasted precious resources pursuing a foolish dream. Just as they are about to drop their prices so as to recoup their costs and avoid a decrease in wealth, these cretins remember that the great Cretin Economist Patnaik had ordained that the purchasing power of the currency must be determined from outside. Obviously, this means that cretins can't drop prices, like normal people, because this would violate the law promulgated by Cretinous Economics.
The reason nothing of this sort happens in real life is because ordinary people are good economists when it comes to running their own lives.
Why is Patnaik being such a great big cretin? The answer is he trying to market his book under the rubric of 'Grievance Studies' within the sub-category, elderly Brown people pretending rich White people only stay rich coz they are stealing stuff from very very poor Brown peasants. This means some virtue signalling cretins in the West will buy the book and pretend to read it. Patnaik thus gets to make a little money.
Interestingly, he stipulates that Evil White Capitalists don't actually have to rape poor Brown peasants. It is enough for them to know that poor Brown peasants are available for rape for them to have the confidence to keep the show on the road.
Why does Capitalism not rape the pre-capitalist sector right away and once and for all? Why does it wait till it runs out of steam? Is it lacking in greed? If so, we should praise Capitalism for preserving the virginity of the pre-capitalist South. True, Capitalism will rape some of what it preserves when it 'runs out of steam', but it will then carefully curate the rest of the pre-capitalist realm for prudential reasons so as to have something to rape next time its spirits flag.
Communism, by contrast, would eliminate the Virginal pre-capitalist sector in a voracious manner. Thus, with Capitalism- according to Patnaik- the starving peasantry of the Global South gets raped less and thus gets to keep some virginity.
Patnaik does not explain where precapitalists will get the money to pay the Capitalists for cool stuff which displaces the things they made themselves. I suppose Capitalism stuffs a little money into the back-pockets of those it bends over. This explains why very poor, agriculturally involuted, darker skinned peasants keep having so many babies. Patnaik has told them they'll get a little money for all the deflowering the Capitalists will get round to doing next time their economic system runs out of steam.
The odd thing about Patnaik- who is very, very old- is that he comes from a place with a lot of very poor peasants. Why does he not want them to improve their lives by raising their productivity? If they do so and are Nationalistic, Evil White Capitalists won't be able to rape them whenever their spirits flag. What is the point of writing a book in English mentioning a lot of Dead White Men which says 'boo to Capitalism'? This won't deter Capitalism at all. On the contrary, Patnaik is putting naughty ideas in Capitalism's head.
Oh. I see. Patnaik thinks he is putting naughty but stupid ideas in Capitalism's head, does he? But, in that case he should write in a sensible manner and show an awareness of Econ 101. This sort of tosh won't do.
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