Part 3: The regression theorem, trade and production and the Say’s Law

Money must have a pre-existing price on which to ground its demand, but if supply and demand determine the price, how can it be that this demand depends on a pre-existing price? Mises solved this confusing circular trap in 1912 with his regression theorem.  


Today’s demand and supply for money determine today’s price (or purchasing power) of money, but this demand depends on a pre-existing price of money, that is, on “yesterday’s” purchasing power. Yesterday’s price of money was determined by yesterday’s supply and demand, but this demand was grounded on the already known purchasing power of money of the day before yesterday and so on and so forth. It may look as if the circular trap leads as to a regression without end, but “what we must do is to push the temporal regression to that point when the money commodity was not used as a medium of indirect exchange but was demanded purely on its own direct consumption use (..) The demand for gold on the last day of barter was purely a consumption use and had no historical component referring to any previous day , for under barter, every commodity was demanded purely for its current consumption use, and gold was no different. On the first day of its use as a medium of exchange, gold began to have two components in its demand (…): first, a consumption use as had existed in barter and, second, a monetary use, or use as a medium of exchange, which had a historical component” in its demand. ¹ 

What happens to today’s paper money? We have to remember that paper money was not introduced suddenly by governments to substitute gold as “money”. The gold standard of the XIX century disappeared gradually, starting in WWI. Before that, notes circulated as “money substitutes” (substituting gold) and theoretically banks were supposed to redeem them for gold coins to the holders of those notes. During WWI many governments inflated their supply of paper and bank currency to such an amount that they would have not been able to pay this sum back in gold, so they just went off the gold standard. After a failed attempt to restore the pre-war monetary system  during the 1920’s, the monetary chaos of  fluctuating fiat currencies of 1931-1945 followed. In 1945, the Bretton Woods system established a pseudo gold standard in which a key currency, the dollar, was the only one redeemable in gold to foreign governments and central banks at 35$ an ounce of gold. The exchange rate of the other currencies were fixed to the dollar. Due to America’s inflationist monetary policy, the dollar was not worth 1/35 an ounce anymore and as other governments had the right to redeem their dollars in gold, America  started to run out of gold reserves and the unsustainable system broke down in 1971. The last link to gold was lost, beginning our era of paper money. ²

There is another important aspect that makes money such an unusual good, but first we have to know what makes the other usual economic goods usual. The more goods we have at our disposal, the better:  More consumer goods make us better off in the present, and more producer goods make us better off in the future; because improved productive processes now will make new, better and/or cheaper consumer goods available later. Rich societies enjoy better infrastructures,  more and more varied and sophisticated consumer goods, higher-quality housing, more modern and better equipped businesses, better education and medical care… than poorer countries. Popular culture tends to confuse  money with wealth, so it follows that rich countries have “more money” than poor countries, but this is too simplistic . Rich countries are rich (or regions, counties, cities, or households) , because they produce valuable goods and services highly demanded by consumers around the world. The more intense is this demand, the more and more valuable goods are consumers willing to exchange in return for this production and thus the wealthier will producers be. Because one thing is true: Production precedes consumption. The ultimate goal of trade is to exchange real goods for real goods, money is just an intermediary. Households (the parents for example)  “sell”  or “export” their labor in order to be able to “buy” or “import” all the other goods that they and their children demand (food, housing, car, clothes, leisure, assurance, schooling…). They are actually specializing in one area of production (she is an architect and he is a truck driver for instance) and exchanging their “production” for all what they can’t produce efficiently on their own, which is absolutely the rest of everything. Considering that households and individuals are the basic economic agents, cities and towns are just the sum of them living within their limits, counties are just the sum of the cities  and towns within their limits, regions are just made up of counties, countries consist of regions and continents of countries. And as it is the case with households; cities, counties, countries and continents produce that what they are best at, export/sell it and import/buy the rest. 

Imagine that an entrepreneur establishes an enterprise in a once poor and depopulated town. The business thrives and she or he hires directly more workers, this is what you see, but the beneficial effects are largely indirect. The new production/supply originates  new consumption/demand in an amount equal to its value: The enterprise sells its production and with the returns hires workers (who move to the town), pays wages (which are spent in the town and the surrounding area sustaining therefore new businesses and jobs), purchases inputs from distant suppliers (that enlarge their facilities and create new job opportunities),  pays dividends to the shareholders around the world (who spend the new income in consumption or reinvest it in new businesses)… All this is the Say’s Law, which implies what we have already said before: Production is the cause of consumption, so that an increase in production leads to higher consumption spending. In other words, the new supply of the good produced by the established firm originates new income and in that way it originates new demand for a wide range of goods, such as the ones demanded by the new workers (housing in the town, supermarkets, cars…), the new inputs and services (such as accounting services) demanded by the firm, the new goods and services demanded by the new firms created due to the original new demand of the latter groups… This process exemplifies a genuine process of economic growth that benefits a lot of people, scattered around the region, the county, the country and the world, without actually knowing the original source of this new demand for their products that makes them better off. 

To finish with Say, we will cite some excerpts from the original French edition of his book A Treatise in Political Economy, written in 1803.³

 

“ c’est la production qui ouvre des débouchés aux produits “ /  It’s production that opens vents to other products.

“l’achat d’un produit ne peut être fait qu’avec la valeur d’un autre”  / The purchase of one product cannot be done but with the value of another one.

“les produits s'échangent contre des produits” /  Products are paid for with products.

“ un produit terminé offre, dès cet instant, un débouché à d’autres produits pour tout le montant de sa valeur.” / A finished good offers, from the first moment, a market for other goods for an amount equal to its value.

Quotations, references and comments

¹ Murray N. Rothbard, The Logic of Action One: Method, Money, and the Austrian School, page 306. Published by Edward Elgar Publishing Limited (1997).

² Applying the regression theorem to paper money, we can go back to the period where redemption was suspended and the value of paper money became independent of gold. People’s money demand was still grounded on the price of money of the day before, the unusual thing was that, without the brake to inflation that gold was, the price of money was constantly going down due to the unstable money supply.

³  Jean-Baptiste Say, Traité d’économie politique, Paris 1803. The source of this quotations is Wikipedia, http://fr.wikipedia.org/wiki/Loi_de_Say.  I have translated them to English.