Simple Model Explains Complex Keynesian Concepts

[[For a 95m Video Lecture on this post, and related materials, see:   Models and Reality  ]]

In the context of the radical Macroeconomics Course I am teaching, I was very unhappy with the material available which tries to explain what Keynes is saying. In attempting to explain it better, I constructed an extremely simple model of a primitive agricultural economy. This model has a lot of pedagogical value in that it can demonstrate many complex phenomenon in very simple terms. In particular, Keynesian, Marxists, Classical and Neo-Classical concepts can be illustrated and compared within our model. We will show the failure of all neoclassical concepts of labor, Supply and Demand, equality of marginal product, value theory —  the whole she-bang — in an intuitive and easy to understand plausible model of a simple economy.

An agricultural economy produces only one good, say corn, using a simple fixed proportions production function. One Laborer working on One Acre of Land can produce 10 units of corn. All the land is owned by Landlords, and they do not do any work themselves. Rather they hire laborers to work their land. The economy functions according to the following rules. At the start of the period, Landlords hire laborers and pay them the going market wage rates in money. Then goods are produced and the market for goods opens. The Landlords retain some of the goods for themselves – this is their profit, or equivalently, their rent. The rest of the goods are put up for sale in the market. The laborers are the only consumers and they purchase the goods with the money they have earned in wages. That ends the period.

First let us consider a static one period economy. To fix ideas and have some concrete numbers, let us assume that there are ten landlords, and each of them owns five acres of land. Suppose the going wage rate is RP 100. Suppose there are only 40 laborers, and that each landlord hires 4 laborers – each would like to hire 5 laborers, but there are not enough laborers to fulfill the total demand for 50 laborers. This model is for a land surplus economy. We will consider the case of labor surplus later.

The landlords will hire 4 laborers each, and pay them Rp 400 as total pay. They will each produce 40 units of corn. All 10 will produce a total of 400 units of corn. They keep some portion of the corn for self-consumption – this portion is the profit. They sell the rest on the open market. We will consider a variety of assumptions which can be used to determine the “self-consumption” (which equals profits and rent).

Assumption A: To start with, let us take a very simple assumption – there is a maximum limit to what one landlord can consume of corn. Set this limit to be 10 units of corn. This is a real economy which produces only food, and food can be consumed only upto a limit – later we will consider more complex situations.

Coming back to the agricultural economy, each landlord produces 40 units of corn, and consumes 10 units. He has 30 units of corn left for sale. All 10 landlords have a surplus of 300 units of corn for sale. The consumers are ONLY the laborers, who have earned a total of  Rp 4000 = 40 x 100. In a one period static economy, they have no use for money, except to buy corn. So all of the wage income will be spent for corn. Thus the price of corn will be 4000/300 = 13.33 Rp per unit. Each laborer can buy 7.5 units of corn with his wages, and this will clear the market. All 300 units will be sold for a total of 4000 Rp, which will exactly re-coup the wage bill paid to the laborers by the Landlords. The profit to the landlords is the 10 units of corn which they did not put on the market, but which has a market value of 10×13.33=133.33 Rp.

Even though this is an extremely simple economy, we can use it to illustrate extremely complex phenomena, regarding which the latest microeconomic textbooks only create confusion.

Neutrality of Money: In this simple one period static economy, money is neutral. It disappears from the calculations. The amount of money paid by the landlords, is exactly recouped from the sales. The amount of money does not matter. If the wage is 1000 Rp, or 500 Rp, inflating the nominal wages and prices by the appropriate factor will lead to exactly the same result – provided that every landlord can afford to pay the initial wage bill. In primitive economy, the quantity theory of money holds perfectly in this economy. The amount of money only affects wages and prices, and exactly in proportion to the quantity. Money has no real effects on the economy. However, money will have real effects if some of the landlords are liquidity constrained and have to borrow in order to pay the initial wage bill of the laborers. This case will be considered later.

Say’s Law: Whether or not Say’s Law holds in this economy is not clear. One way to say that it holds is to consider the total Wage Bill of Rp 4000, and add to this the Profits of the Landlords, which are 1333.33. This amounts to a total earnings generated from production of Rp 5333.33, which is exactly sufficient to purchase the 400 units of corn produced at the market price of 13.33. So the earnings generated by the production process create the demand in exactly the right amount required to purchase the entire amount produced. This is exactly Say’s Law. However, there are many reasons why this point-of-view is wrong. We present one of these arguments below.

Utility of Food: It is reasonable to consider the utility function for food in ABSOLUTE terms, or as a cardinal utility function. Suppose that the marginal utility of corn is MU(C)=110-10C – the first unit of corn consumed yields 100 units and MU decreases linearly until the 10th unit yield 10 units while the 11th unit leads to 0 utility. This is why landlords upper limit for consumption of corn is 10 units. We now resurrect an ancient distinction between USE value and EXCHANGE value, which has been confined to the dustbin of history by modern economics. The USE value of corn has to with biological functions of food in relation to nutrition and health, and these are captured within the cardinal utility function. The EXCHANGE value (or market value) of food is determined by the market conditions to be Rp 13.33 in the above economy. While the USE value is fixed by biology, the market value can vary considerably depending on how we change specifications of how the market works. Use Value is determined by internal psychological and physiological conditions, while Market Value is determined by external market conditions related to production costs, supply, and demand. So, the two cannot be the same.

Complexity: This very simple economy clearly displays the phenomenon of complexity, which is ignored by standard treatments of economics. Suppose that one landlord decides to sell one of the units of corn he has kept for self-consumption – presumably, he can get Rp 13.33 for this unit, which is why the “value” of the 10 units of corn that has been kept for self-consumption has been evaluated to be 13.33 x 10 = 133.33 at market prices. HOWEVER, this market price is an illusion, in the sense that the amount retained by the landlords CANNOT be sold at the going market price. If some additional amount is put on the market, the price will decline by an exactly offsetting amount to keep the gross earnings from sales of the landlords equal to 4000, the gross wage bill.

The Aggregate Production Function: This economy illustrates clearly that the aggregate production is not just the sum of the separate production functions. Each Landlord has a Leontief-type Production function which is C= 10 min(L,5). However the aggregate production function is just constant – total production is fixed at 400 units of corn, because the total amount of labor available to the economy as a whole is 40 units. The marginal product of labor for one Landlord is 10 units of corn. However, any labor hired by one Landlord is one unit lost by someone else, so on an economy-wide basis, the concept of marginal product is not well-defined – that is, if an additional laborer comes into the economy from the outside, he would have a marginal product of 10 units of corn, but in a closed economy this is not possible. The properties of the Aggregate Production function at full employment level are radically different from the properties of the Production functions of individual Landlords. However, when there is unemployment, the properties of the sum of Landlord Productions are the same as that of the Aggregate Production function.

Wage is Less Than Marginal Product of Labor: The marginal product of labor is 10 units of corn, while the real wage is 7.5 units of corn, under the assumptions outlined. For each landlord, they are will to hire additional labor – they have surplus capacity, with one additional acre of land which could accommodate an additional laborer, and make profits. However, the total labor force within the economy is already occupied. In principle, this would lead to an increase in demand for labor, and an increase in the wage. However, increasing nominal wage will not solve the problem. It will only cause inflation in wages and prices. This is a Keynesian phenomenon mentioned in Chapter 2 of Keynes General Theory. The behavior of nominal wage does not govern the behavior of the real wage. The nominal wage is the object of negotiation between the landlord and the laborer. Given observed scarcity – every landlord wants to hire – nominal wage will go up. However, regardless of how the nominal wage is fixed, the real wage will always be exactly the same as the surplus production remaining after the self-consumption, which is 30 units per landlord, and 300 in the aggregate. Thus, excess demand for labor at going nominal wage cannot lead to increase real wages, which might induce entry of more labor, as per classical supply and demand mechanisms in the labor market. Also, the demand for labor at the firm level cannot be aggregated to derive the demand for labor at the industry level. “Complexity” refers to the fact that the whole is not the same as the sum of the parts. Even though the wage is less than the marginal product of labor, the industry as a whole cannot hire more labor, because the sum total of all labor available is already employed by the industry. What is true at the firm level is not true at the industry level.

The Paradox of Thrift: The one period static equilibrium described above can be repeated across periods. In every period, Landlords hire labor and pay them going wage. They consume 10 units of corn, while the laborers purchase the available surplus, ending up with 7.5 units each. The landlords recoup all of the wage bill from the sales of corn. Money washes out of the system, since payments to laborers exactly equal their spending, and the same is true of the landlords. So, there is no inherent tendency towards change in this fairly egalitarian society. However, suppose we introduce some uncertainty into the system. The minimum amount of food required for sustenance is one unit of corn. The laborers decide that there is some risk of not finding a job next period, so they should save some money, so as to be able to buy food next period even if they cannot find a job. In current equilibrium, they are spending their earning of Rp 100 by buying 7.5 units at 13.33 Rp per unit of corn. They decide to buy only 5 units, and save money on 2.5 units of corn, to allow them to survive without a job in the next period. Now the total demand for corn from the laborers is 5 x 40 = 200 units, while the total amount which has been produced is 300 units. Technically, with excess supply, the price of corn will decline. Under the assumptions that we have made, the price could even go to zero, since the surplus cannot be eliminated if laborers have decided to restrict consumption to 5 units, while the landlords have maximum consumption of 10. Let us assume that the price of corn goes down to Rp 10 only, while 100 units of corn remain unsold. The laborers had PLANNED to buy 5 units at 13.33 Rp and spend 66.66 Rp while saving 33.33 Rp. So Ex-Ante Savings were supposed to be 33.33 Rp. However, their collective decision to save leads to a decline in price of corn, enabling them to buy 5 units at 50 Rp, and creating and Ex-Post Saving of 50 Rp. However, next period, the landlords will reconsider their hiring and production decisions. They produced total of 40 units, consumed 10, and has a surplus of 30 units for sale. However, they were only able to sell 20 units. Instead of hiring 4 laborers to produce 40 units, they will now plan to hire only 3 laborers each, in order to produce on 30 units, which will give them a surplus of 20 units, which is what could be sold last period. They have also suffered a monetary loss. They paid 400 Rp to hire 4 laborers, but earned a revenue of 20 x 10 = 200 Rp only. The laborers have saved 200 Rp to use in the next period. Come next period, the demand for labor is only 30 units while 40 laborers are available. The precaution of the laborers has turned into a self-fulfilling prophecy – their anticipation of the possibility of future risk of joblessness has created joblessness! This is Keynesian uncertainty in operation. The desire to save by the laborers reduced the effective demand, and this led to unsold surplus food. This surplus signaled the producers to cut back on production, creating unemployment.

The Marxist Case, Subsistence Wages: We have put an artificial upper bound on the consumption of landlords – this creates surplus production, which must be sold to laborers. Now we remove this bound. Suppose that the landlords do not eat corn – they export corn abroad, and use the revenue to by luxury goods from abroad. Suppose that the subsistence wage is 1 unit of corn – laborers need this much to survive and will not work for less. We can isolate the domestic economy from the international economy by assuming the Rp are used for wages, and in the domestic market for corn, only. The laborers have zero demand for foreign products. We assume that the laborers have no outside options – they must work or starve to death. (Parenthetically, this is what occurred in England after the Enclosures deprived peasants of access to common lands. As Polanyi and others have noted, this is what created the market for labor.) Now the landlords will pay the laborers some nominal wage – just enough to enable them to buy one unit of food. They will also reserve one unit of food for the domestic market, to ensure that the laborers are fed. From the 40 units of production, they will have 36 units of surplus product. All of this surplus will be sold abroad at international prices, and the revenue will be used to create a luxury lifestyle for landlords based on foreign imports. The international price of corn need have no relationship to the domestic price of corn in this model. The domestic price of corn must be maintained at a relatively low level, sufficient to ensure that the nominal wages of laborers allow them to subsist, even if the international prices are high. If the landlords get greedy, and sell too much corn abroad to make excess profits, large scale discontent among laborers can lead to revolutions. Corn is the wage good, and the real wage is computed by taking nominal wage and dividing by price of corn. However, the profits of landlords come from selling surplus corn in international market and using revenues to buy imports. The profits and prices they face have no relationship with domestic price of corn.

Value Theory: So, what is the value of corn? We can distinguish three different values. One the use value to the laborers – it means the difference between life and death. So for them, they must work at whatever wages necessary, to earn enough to buy subsistence quantities. The domestic exchange value of corn is determined by the customary nominal wages, and the political requirements to ensure that domestic price is sufficient to enable the population to eat. The international value depends on the global economy, and the demand of the landlords for foreign goods. So our model differentiates between use value to laborers, domestic exchange value, and international exchange value, and allows all three to be different. Incidentally, we have assumed that Landlords don’t use corn, otherwise the use value to landlords could enter as a fourth factor into this equation.

Supply and Demand: Conventional supply and demand theory fails miserably at explaining the determination of prices and wages within this model. Note that this is a single good model, so that the issue of partial equilibrium versus general equilibrium does not arise. The problem arises from the timing sequence and the complexity issues. The nominal wages are settled at the beginning of the period in the wage bargain between laborers and landlords. It is on the basis of these nominal wages that production decisions are made, and the prices of the goods emerge. So the real wage is an endogenous variable, a product of decisions made about the real wage. This is exactly what Keynes writes in Chapter 2:

The traditional theory maintains, in short, that the wage bargains between the entrepreneurs and the workers determine the real wage  … Now the assumption that the general level of real wages depends on the money-wage bargains between the employers and the workers is not obviously true.

This is exactly what our model demonstrates. In the first model, the nominal wages can be set to any level, but the real wage will always come out to be 7.5 units of corn. The bargain about nominal wages between the laborers and the landlords does not determine the real wage. So it follows immediately that the supply and demand for labor cannot be given in terms of “real” variables – neither for laborers, nor for the landlords. Keynes also mentions, without making it an issue, that the wage goods which determine the real wage for laborers are different from the goods consumed by landlords, so the two would have different price deflators. This is also the case in our model.

Supply and Demand theory fails in our model for a LARGE number of reasons. First, consider the supply of labor. In this primitive economy, labor has no outside options, and must work to survive. So they will accept any NOMINAL wage offer, and hope that the money they earn will enable them to buy enough food to survive. At the beginning of the period, when wages are paid, production decisions have not been made, and supply and demand conditions which will exist at the end of the period are not known – they are both determined by the decisions being made at this stage. So profit maximization assumed in textbooks is IMPOSSIBLE – it requires the Landlords to be able to forecast what will happen next period, which depends on a large number of random variables outside their control. If we ask a laborer how many hours of labor will you supply at a given NOMINAL wage, he cannot provide an answer to this question. This is because he does not know how many real goods he will be able to buy with this wage in the next period. Furthermore, the price of the wage goods in the next period cannot be known or predicted because it depends on this decision about the nominal wage which has to be made now. So the supply curve for labor cannot be defined in terms of the nominal wage. It may be possible to define it in terms of the real wage, which is what textbooks do. But this is not legitimate, as pointed out be Keynes, because nobody knows what the real wage is, and this real wage is NOT determined by the bargain between landlords and laborers.

[[For a 95m Video Lecture on this post, and related materials, see:   Models and Reality  ]]

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12 comments
  1. paul davidson said:

    there re several things wrong with your simple model that makes it incompatible with Keynes’s General Theory- and therefore unable to explain how a market oriented money-using economy really works.

    For example, you presume full employment. In your model there is no such thing as a demand for liquid assets with the “Essential properties” that Keynes explicitly specified in his General theory. In your model there is no savings and every unit of income is spent on the purchase of producibles

    Probably the basic flaw in your approach is the assumption of the neutrality of money — a fundamental assumption of classical economics and one that Keynes explicitly stated was wrong.

    If you want to provide students with a simple model explaining the difference between Keynes and classical and New Keynesians — use my book WHO’S AFRAID OF JOHN MAYNARD KEYNES?

    • Paul — i think you did not read the model carefully enough. In the one period static model, money is neutral, under the assumption of full information available to everybody. This model is a START POINT, in which we can see how the classical economic theory works and also see how Keynes would differentiate the model. This is the SPECIAL CASE of Keynes where classical works. By making minor modifications, we get to the Keynesian cases. This is my second lecture in Macro, so I am starting off with a simple model. As soon as we introduce two periods and a role for saving, money becomes essential and non-neutral. Also, money savings leads to recession and unemployment, exactly according to Keynes. I do not assume full employment, it come out of the model, exactly as unemployment does when aggregate demand is reduced. I did start with your book on Post-Keynesian Macroecononomic Theory 2nd Edition, but found it too difficult to understand and explain the first chapter. This model is actually a PRELIMINARY to your first chapter — this model can be extended to create the model in your first chapter, and it is fully compatible with your model. It actually builds the micro foundations for it. I will look at you “Who’s Afraid” to see if there is a simpler model in there, when I get my hands on it.

  2. Great post and explanation. As far as your Islamic model is concerned, does any of this matter?

    Whilst your post is attempting to explain Keynes, what your post is also demonstrating from a deeper and more fundamental perspective is the real source of the ‘uncertainty’ which exists for all of us under any type of profit based economy.

    To borrow an example from your post where you said “The laborers decide that there is some risk of not finding a job next period, so they should save some money”. I make the claim that this uncertainty exists because the relations between all economic agents, including with government, are always ‘arms-length’ relations.

    Neither Keynes, nor Marx, nor any other economists for that matter has ever attempted to come to grips with this fundamental aspect of ‘economies’ because they always assume that all relations must be arms-length; I have yet to find any economist who has visions of relations beyond arms-length relations.

    It is the arms-length aspect of all relations which causes the booms and busts of economies and the growing gap between have’s and have-not’s (irrespective of whether we have free markets or not) because all uncertainty stems from arms-length relations and all uncertainty must be insured against (or if it tips over we have civil unrest). When times are good there is more confidence, less uncertainty, and hence less insurance, but the smart money (landlords, owners of means of production, financiers etc) will always insure themselves no matter what because they know that during good times workers begin to entertain ideas of becoming landlords (owners) themselves. This inevitably begins to lead to a shortage of willing workers and then confidence begins to wane and insurances begin to increase, (which in your examples was highlighted by savings by workers, or only providing sustenance wages by landlords). This is why we can never have full employment, no matter what claims economists make.

    Whilst economists are always and everywhere only ever concerned with profit based monetary economies based on arms-length relations, for non-profit economic models to be able to thrive, the very first thing which must be changed is the relation from arms-length relations to trust relations, and this begins with individuals (households) changing their relation with government.

    Using your agricultural economy example, if two of those lots of land was changed from being a private property owners to being owned by government/community, and the government then formed trust relations with any workers who wanted to operate the farms on these lots of land, the need for any nominal wage would disappear for those particular workers, and the real wage would depend on how productive the ‘relation’ between the workers and government becomes – this is how I view an Islamic model, or Custodian model to operate.

    Because the relation is no longer ‘arms-length’, and instead is now based on trust and trust law, the operators (being the workers and the government who are partners) have no need for insurance or to save because there is now no uncertainty, there is no private landlord to satisfy nor is the ability to work and survive based on the personal whim of a private profit seeking landlord; the only ‘profit’ being sought is in the form of a surplus of real goods. Everyone who has taken the time to observe themselves knows that we produce more when we are happy, and we are happier when we have security and certainty and more to the point ‘trust’.

    So, to borrow from your example again, this is how I see a developed economy to function – if the 5 lots represents the whole economy, then 3 lots are owned by private landlords and being operated under capitalism and using capitalist based money, and the other 2 lots are owned by the community as a whole and being operated under a non-profit surplus share arrangements where no money is required. Workers working under the capitalist held land are subject to the whims of the landlords, but they also have the chance to become land owners themselves – this is the carrot that many economic agents run after. The workers working under the non-profit models have no desire for property ownership but are only after security and trust and the ability to produce and express their creative talents under such security and trust. This way everyone can become happy because they operate under the type of model that suits them (I doubt many who operate under the capitalist model are happy, but that is because they see no other alternative).

    Both the profit and non-profit models produce goods and services but they distribute differently; if the profit sector has a surplus it can’t sell, the government can buy some of it up and can distribute it under normal welfare programs or use it to invest further in the non-profit sector, but it would have to do so using non-capitalist based money. If the non-profit sector produces a surplus, the government can sell it to the profit sector or sell it abroad, or use it for welfare purposes.

    This should be the Economists Challenge – to prove whether alternative models can co-exist and operate simultaneously.

    • Very interesting and insightful comments. Social responsibilty versus arms-length (adversarial) contracts are at the heart of the matter, as you point out. The Great Transformation of Polanyi is about this transition. Yes, this also has a lot to do with an Islamic economy. Co-Existence is an interesting and unusual twist. Thanks — i will think about this,and use it when developing islamic alternatives.

  3. This is very good post though of course you deal with a simplified model. You can get Piketty’s ‘(r,g) theory’ out of that as well if its not already in there–landlords vs farmworkers. I like ‘Say’s law’ ( i view it as the same as Walras’ law, and ‘general equilbirum theory’ ). But that only applies to the whole universe where energy is conserved. Its a Hamiltonian system in that case (newton’s laws). That does not apply to the small world most poeple live in–actually all people . Landlords and their tenant farmers all wil die most likely, but the tenants may die sooner.

  4. In the real world money is created as principal debt to a bank to be repaid over a fixed period of time. For 30-year mortgages where interest is paid first, most of the principal is in circulation for 15 to 30 years. What happens during that 15 to 30 years?

    Money that is owed to the bank it came from is spent earned and re-lent as existing money N times after that resulting in N concurrent principal debts of the SAME money. This rather obviously TRUE FACT is ABSENT from ALL economist’s models including Asad’s.

    Economists have but one role in this world – to cover for the bankers and the Ponzi scheme fraudulent money system that serves the powerful. Anyone who assumes the existence of “money” and its “neutrality” as every economist is trained to do has already negated any and all validity to their model and confirmed their subservience to the bankers.

    • “This rather obviously TRUE FACT is ABSENT from ALL economist’s models”

      That’s not entirely correct. There are some who recognize this fact; one economists by the name of Steve Keen was actually asked to testify in Court on this very matter I believe. But you do raise an important point.

      There was a period in time where interest, securitization, leverage, negotiation of debts, and even the use of land as security for debts was forbidden, at least at law (some were allowed in equity in particular situations). It wasn’t until the common law began to absorb the law merchant that some of these prohibitions were relaxed because it became obvious to the law at the time that more and more people were becoming traders (exchanging their time for money) and the more traders the more property owners. This gradual increase of the percent of the population becoming traders of their time meant the law had to relax to accommodate it otherwise it would just choke off and we’d be back to feudalism.

      Now today, we have a system which is trying to accommodate something between 5 and 10 billion people all engaging in commerce and who are all trying to insure themselves against loss. Every individual out there who is engaging in commerce wants to or needs to own property (even if as a form of hedge or insurance) because of things like inflation, taxes, and to pay their own debts, not to mention the forced ownership of property through Superannuation schemes in many countries, and sovereign wealth funds. It’s not possible for so many people on earth to own property without leverage. There’s not enough land to go around so that only leaves financial assets as a form of property and all financial assets are a form of leverage. Every contract which secures property of another on default is a form of leverage. Every piece of government legislation which is passed is a form of leverage; even welfare is a form of leverage. Banks are only doing with money what the rest of us do when we enter into contracts with one another, when we rely on government for legislation, etc. Leverage exists everywhere there is a contract which relies on the law for its enforcement – the leverage is the enforcement.

      Here is a couple of court cases on bank credit:

      http://www.austlii.edu.au/cgi-bin/sinodisp/au/cases/vic/VSC/2004/36.html?stem=0&synonyms=0&query=%22fractional%20reserve%20banking%22

      243. • A similar argument based on “credit creation” was advanced in National Australia Bank Ltd v McFarlane.[6] In that case, the defendant mortgagor contended that unless the lender in a security transaction hands over “bullion, banknotes or coin”, the mortgage is invalid. Byrne J stated:
      “It is apparent to me that this is arrant nonsense. It has no regard to the legal obligations created by a bank loan; it ignores the reality of modern commerce where it is money, in the broad sense of the term, including choses in action, and not only gold, banknotes and coin, or indeed legal tender, which plays a most important part.”[7]

      245. • In Smart v ANZ Banking Group Ltd[10] the appellant, Mr Smart, who gave evidence in the present case, contended that the loan secured by a mortgage was not a real loan but “a paper transaction. Actual money doesn’t change hands, cash money”. Batt JA at p.4 observed that:
      “The argument thus seemed to be that no moneys were lent, but only credit was created by book entry, which, it was said, was unlawful because the only mode of payment was by legal tender …. Mr Smart’s argument overlooks banking and credit altogether. Indeed, it seems to take no regard even of an undoubted fact of commercial life, the use of cheques and bills of exchange. It may be that in economic terms, the respondent bank “lends” its credit by way of fractional reserve banking but it cannot be doubted that in point of juristic analysis money was lent. That is so even in the case of the housing loan; some funds advanced to Mr Smart pursuant to it were by his direction paid to the solicitors for the vendors …. Moreover, there can be no doubt that Mr Smart received value in this and the other funding transactions. A legal liability in Mr Smart sounding in money was created for good consideration. What was done was not unlawful, was real and was not devoid of legal effect. Arnold v State Bank of South Australia (1992) 38 FCR 484 at 485 and 486″.

      http://www.austlii.edu.au/cgi-bin/sinodisp/au/cases/vic/VSC/2009/429.html?stem=0&synonyms=0&query=%22fractional%20reserve%20banking%22

      38 The facts of this case demonstrate the fallacy of Mr Palmer’s assertion that there was no lawful consideration. The moneys advanced by Permanent Custodians were used to pay off an existing mortgage (of about $1.2 million) and other costs associated with the loan and the registration of the mortgage. In addition, Virgin Investments directly received nearly $70,000 by way of bank cheque.[17] Each of these transactions had a value. Virgin Investments was relieved of its indebtedness to the previous mortgagee, creditors were paid out and Virgin received funds which it was able to utilise for its own benefit. Virgin received value as a result of it entering into the loan agreement and the mortgage.

      • The True Fact of which I write was also completely absent from your response. You didn’t “get it”.

        I am the creator of the worldwide hit animated movie Money as Debt (2006) (online in 26 languages) that explained banking to the world public and predicted a debt crisis due to the structure of money itself. It isn’t the nature of bank credit (borrower-created money) I am questioning here, it is the inevitable results of RECURSIVE RE-LENDING, a term and concept entirely absent from economics .

        I repeat:

        Money that is owed to the bank it came from is spent, earned and re-lent as existing money N times after that resulting in N CONCURRENT PRINCIPAL DEBTS OF THE SAME MONEY.

        At one point the WEA invited me to submit a paper about it:
        https://paulgrignon.netfirms.com/MoneyasDebt/MAD2016/WEA-PEEMconference2013-Grignon.pdf

        I email debated Steve Keen, Positive Money and the American Monetary Institute for a whole month about their complete failure to even think about what happens to LOANED MONEY of ANY ORIGIN during the many years it is circulating.

        Here is my report:

        Fuzzy Thinking: Why Positive Money (UK), the American Monetary Institute (AMI), the Chicago Plan, Modern Monetary Theory (MMT) and all “sovereign money” movements are misguided

        https://moneyasdebtblog.wordpress.com/sovereign-money-critique/

        Keen did most of the “debating” and ended the debate with this frank admission:
        “when I have some spare time I’ll take on your misconceptions in a genuine mathematical critique of your silly arithmetic… the only question for me is whether I can be bothered wasting the time to prove you wrong. At the moment, the answer to that question is no. When it’s yes, I’ll write a blog post on the topic. Until then I can’t be bothered reading any more emails from you.”

        I first challenged Steve Keen to prove me wrong back in 2009 … I’m still waiting.

        I also challenged the Bank of England about the omissions from their 2014 confessional Money Creation in the Modern Economy … they declined to answer 3 very simple arithmetic questions.
        Here is my report on that.

        Digging Deeper into Debt-Money
        The Bank of England’s confessional isn’t the whole story

        “… just consider what might happen if mortgage holders realised the money the bank lent them is part of an invisible trap, a game of musical chairs designed by the bankers in which losers are mathematically predetermined to default whenever the creation of new debt to banks slows down, for any reason. The only way to keep the music playing is for all of us as a whole to go further and further into debt to banks forever.”

        http://paulgrignon.netfirms.com/MoneyasDebt/MAD2016/DiggingDeeper_Grignon2017.pdf

        Any reader is invited to PROVE any of my FACTS, LOGIC and/or ARITHMETIC to be in error.
        Given that my facts come from the central banks themselves and the logic and arithmetic are irrefutably simple, no one has to date. They just AVOID the issue.

        Among those I have most recently challenged is Asad Zaman. He dumped it off on a student and I haven’t heard anything from either of them since.

      • “Any reader is invited to PROVE any of my FACTS, LOGIC and/or ARITHMETIC to be in error.
        Given that my facts come from the central banks themselves and the logic and arithmetic are irrefutably simple, no one has to date.”

        I do not dispute your facts. It is obvious to me that what you are saying is correct. I also said this to you about 6 months ago that you are correct. (surprised by Keen though??? on what grounds was he disputing your facts, especially if it comes from the central bank itself)

        What I do ‘not’ agree with is that you blame bankers as the sole reason it exists. I do not accept this. You treat bankers as if they are some isolated group. Many developed countries have sovereign wealth funds and Superannuation schemes which means that they must invest in stocks, which includes Bank stocks, so when Banks profit so does average workers who have Super funds.

        What I blame is the over-reliance on the contract model (capitalism) and that it is today over-crowded and that this is the reason credit must be regurgitated as your explain.

        I therefore do not care for your solution because when I questioned you about it several months ago your solution still involved the seizure of assets if a business fails because you still have everyone operating under the contract model. This to me is the primary reason we are all screwed. The contract model is ‘over-crowded’ and this is why we have the lowest interest rates in 5000 years.

        I am NOT disputing your facts – I am disputing your claims as to the cause. When we all point the finger we do not see the three fingers pointing back at us.

  5. Magpie said:

    Dear Prof. Zaman

    First, I would like to congratulate you for this very interesting post and thank you for making it available to the public.

    I have some observations about the Marxist bit, but instead of going there immediately, it seems best to approach that through your example.

    This is the original situation: there are 10 landlords and 40 labourers, or 4 labourers per landlord.

    For convenience, let me reproduce the individual production function:

    C= 10 min(L,5).

    According to that function, those 4 labourers produce 40 units of corn. Given that there are 10 landlords, the total output the 40 labourers produce is 400 units of corn, of which labourers keep 300 (to divide equally among themselves) while the landlords keep 100 (to divide them equally among themselves, too).

    I trust so far I have not introduced anything foreign to your example.

    Let’s evaluate the the situation in terms of utilities. We can do that because we have the cardinal utility function of food consumption, which allows interpersonal comparisons. The marginal utility function of corn is MU(C) = 110-10C. But the marginal utility function is just the first derivative of the utility function. Leaving aside the integration constant, we find the utility function by integration:

    U(C) = 110C-5C^2.

    Each landlord’s utility is U(10) = 600 utils; each labourer’s utility is U(7.5) = 543.75 utils. (It’s important to highlight that in your example no allowance is made for the disutility of labour).

    Now, suppose land were nationalised: labourers and former landlords have to work the land. Each old farm now has 5 partners: the original 4 labourers plus the former landlord. According to the individual production function output per farm rises to 50 units of corn (500 altogether for the whole economy). Each partner in the farm gets 1/5 of the crop: 10 units of corn per capita.

    With that policy the utility everybody experiences is U(10) = 600 utils. Land nationalisation was Pareto Optimal: nobody is worse off and many are better off. Given that we haven’t been considering the disutility of work, we could leave things at that. But even if one made allowance now for the disutility of work, which former landlords are now experiencing, the former labourers’ welfare gains (600-543.75=56.25 utils each) is likely to outweigh the landlords’ welfare loss.

    By now you may have guessed that when I speak of “land nationalisation” I am speaking of the communist solution to the problems of capitalism: expropriation of the means of production. In this example land is the only mean of production. Labourers in your example were giving capitalists (landlords) ¼ of their output and of their labour power in the shape of “rent” for the use of the means of production (landlords’ land), so that landlords did not have to work. That excedent above what labourers get is the surplus value.

    This brings us to the few things I found slightly troublesome in your example. That result did not depend on labourers needing only 1 unit of corn to subsist. It does not depend either on a foreign market.

    Makes sense?

  6. Asad, thank you, well done. This is my kind of economics – reduce it to a simple situation that you can understand, and then build from it. Much the clearest account of these issues I have seen, as a scientist outsider. I use the same approach – a simplified ‘thought experiment’ – in a short book now accepted for publication by WEA. Current title Economy, Society, Nature: An introduction to the new systems-based, life-friendly economics. I wrote it as a complement to Kate Raworth’s Doughnut Economics, aimed at students and anyone else interested in a systematic account. It sets up the new framework, not even at the level of detail you are covering. I can send you a copy if you’d like, I would value your feedback.

    By the way you also prompted me to read Polanyi, very illuminating.

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