What Type of an Economic System is ‘Irrational’ Enough to use
Money Contracts?
A fundamental axiom of neoclassical theory is the neutrality of money.
Hence economic agents in a neoclassical world are presumed to make decisions
based solely on ‘real’ valuations; they do not suffer from any ‘money
illusion’. Thus in a ‘rational’ classical world, all contracts should be made in
real terms and are always enforceable in real terms.
The economy in which we live, on the other hand, utilizes money contracts
– not real contracts – to seal production and exchange agreements among
self-interested individuals. The ubiquitous use of money contracts has always
presented a dilemma to neoclassical theory. Logically consistent mainstream
classical theorists must view the universal use of money contracts by modern
economies as irrational, since such agreements, fixing payments in nominal
terms, can impede the self-interest optimizing pursuit of real incomes by
economic decision makers. Hence mainstream economists tend to explain the
existence of money contracts by using non-economic reasons such as social
customs, invisible handshakes and so on – societal institutional constraints
which limit price signalling and hence limit adjustments for the optimal use
of resources to the long run. For Post Keynesians, on the other hand, binding
nominal contractual commitments are a sensible method for dealing with true
uncertainty regarding future outcomes whenever economic activities span a
long duration of calendar time.
In order to understand why there is this fundamental difference in viewpoints
regarding the use of money contracts, one must distinguish between a
money-using entrepreneur economy and a cooperative (barter) economy. The
distinction between a cooperative economy and an entrepreneur economy
was developed by Keynes in an early draft of the General Theory (see
Keynes, 1979, pp. 76–83). A cooperative economy is defined as one where
production is organized such that each input owner is rewarded for its real
contribution to the process by a predetermined share of the aggregate physical
output produced. Examples of cooperative economic systems include
monasteries, nunneries, prisons, or even an Israeli kibbutz. In each of these
cooperative economies, a central authority or a predetermined set of rules
governs both the production and payments in terms of real goods distributed
to the inputs. There is never any involuntary unemployment of monks, nuns,
prisoners, or workers on a kibbutz. Say’s Law prevails. This is the world of
classical analysis.
An entrepreneur economy, on the other hand, is a system that has two
distinctly different characteristics. First, production is organized by ‘a class
of entrepreneurs who hire the factors of production for money and look to
their recoupment from selling the output for money’ (Keynes, 1979, p. 77).
Second, there is no automatic mechanism which guarantees that all the money
paid out to inputs in the production process will be spent on the products of
industry. Hence entrepreneurs can never be sure that they can recoup all the
money costs of production. As Keynes (1979, p. 78) pointed out, ‘it is obvious
on these definitions that it is in an entrepreneur economy that we actually
live to-day’. In an entrepreneur economy, by definition, Say’s Law cannot be
applicable.
In our entrepreneur economy, market-oriented managers of business firms
organize the production process on a forward-money contract basis; that is,
they hire inputs and purchase raw materials for the production process by
entering into contractual agreements to pay money sums for delivery of
specific materials and services at exact future dates. These managers of
production processes expect to recoup these money outlays by selling the
resulting output for money on either a spot or forward contracting basis.
When we speak of ‘the bottom line’ in our economy we are essentially
indicating that entrepreneurs are motivated by pursuing cash inflow from
sales that will equal or exceed the money outflows spent on production costs.
In an entrepreneurial economic system, the earning of income (as defined
by Keynes above) is directly associated with the existence of these money
contracts which permit entrepreneurs to ‘control’ both the sequencing of
inputs into production activities and the cash outflows of firms. These contractual
money payments give the recipient claims on the products of industry.
The reader should recall that in some economic discourse, the term income is
not only associated with current output, but also with a welfare aspect as
measured by the current services available to the community. Since some
services available to the community in any period will flow from pre-existing
durables, the use of the income term in its welfare garb is not compatible
with the use of income as the value of current output, except if all the goods
produced are always non-durable. Since the term ‘income’ is associated with
contributions to the production of current output in the economy, therefore
aggregate income is equal to the money receipts arising from the contractual
sale of services and current products. (Profits occupy a sort of halfway house,
since they are not directly determined by factor-hire contracts. Instead they
are the residual due to the difference between the contractually determined
receipts on the sale of products and the contractual costs of the hired factors
of production.) Income-in-kind payments should be conceived of as the combination
of two separate contractual transactions, namely money income
payments to factor owners from the employer, with a simultaneous purchase
commitment of goods by the factor owner to the employer.
Although Keynes defined the economy that we live in on the basis of the
use of monetary contracts for hire and sale, this definition does not per se
explain the existence and ubiquitous use of this human institution. In order to
provide an explanation for the widespread use of money contracts, we must
delve into how entrepreneurs make decisions, and recognize the difference
between risk and uncertainty – a difference that is essential to Keynes’s
analysis of involuntary unemployment.
Money Contracts?
A fundamental axiom of neoclassical theory is the neutrality of money.
Hence economic agents in a neoclassical world are presumed to make decisions
based solely on ‘real’ valuations; they do not suffer from any ‘money
illusion’. Thus in a ‘rational’ classical world, all contracts should be made in
real terms and are always enforceable in real terms.
The economy in which we live, on the other hand, utilizes money contracts
– not real contracts – to seal production and exchange agreements among
self-interested individuals. The ubiquitous use of money contracts has always
presented a dilemma to neoclassical theory. Logically consistent mainstream
classical theorists must view the universal use of money contracts by modern
economies as irrational, since such agreements, fixing payments in nominal
terms, can impede the self-interest optimizing pursuit of real incomes by
economic decision makers. Hence mainstream economists tend to explain the
existence of money contracts by using non-economic reasons such as social
customs, invisible handshakes and so on – societal institutional constraints
which limit price signalling and hence limit adjustments for the optimal use
of resources to the long run. For Post Keynesians, on the other hand, binding
nominal contractual commitments are a sensible method for dealing with true
uncertainty regarding future outcomes whenever economic activities span a
long duration of calendar time.
In order to understand why there is this fundamental difference in viewpoints
regarding the use of money contracts, one must distinguish between a
money-using entrepreneur economy and a cooperative (barter) economy. The
distinction between a cooperative economy and an entrepreneur economy
was developed by Keynes in an early draft of the General Theory (see
Keynes, 1979, pp. 76–83). A cooperative economy is defined as one where
production is organized such that each input owner is rewarded for its real
contribution to the process by a predetermined share of the aggregate physical
output produced. Examples of cooperative economic systems include
monasteries, nunneries, prisons, or even an Israeli kibbutz. In each of these
cooperative economies, a central authority or a predetermined set of rules
governs both the production and payments in terms of real goods distributed
to the inputs. There is never any involuntary unemployment of monks, nuns,
prisoners, or workers on a kibbutz. Say’s Law prevails. This is the world of
classical analysis.
An entrepreneur economy, on the other hand, is a system that has two
distinctly different characteristics. First, production is organized by ‘a class
of entrepreneurs who hire the factors of production for money and look to
their recoupment from selling the output for money’ (Keynes, 1979, p. 77).
Second, there is no automatic mechanism which guarantees that all the money
paid out to inputs in the production process will be spent on the products of
industry. Hence entrepreneurs can never be sure that they can recoup all the
money costs of production. As Keynes (1979, p. 78) pointed out, ‘it is obvious
on these definitions that it is in an entrepreneur economy that we actually
live to-day’. In an entrepreneur economy, by definition, Say’s Law cannot be
applicable.
In our entrepreneur economy, market-oriented managers of business firms
organize the production process on a forward-money contract basis; that is,
they hire inputs and purchase raw materials for the production process by
entering into contractual agreements to pay money sums for delivery of
specific materials and services at exact future dates. These managers of
production processes expect to recoup these money outlays by selling the
resulting output for money on either a spot or forward contracting basis.
When we speak of ‘the bottom line’ in our economy we are essentially
indicating that entrepreneurs are motivated by pursuing cash inflow from
sales that will equal or exceed the money outflows spent on production costs.
In an entrepreneurial economic system, the earning of income (as defined
by Keynes above) is directly associated with the existence of these money
contracts which permit entrepreneurs to ‘control’ both the sequencing of
inputs into production activities and the cash outflows of firms. These contractual
money payments give the recipient claims on the products of industry.
The reader should recall that in some economic discourse, the term income is
not only associated with current output, but also with a welfare aspect as
measured by the current services available to the community. Since some
services available to the community in any period will flow from pre-existing
durables, the use of the income term in its welfare garb is not compatible
with the use of income as the value of current output, except if all the goods
produced are always non-durable. Since the term ‘income’ is associated with
contributions to the production of current output in the economy, therefore
aggregate income is equal to the money receipts arising from the contractual
sale of services and current products. (Profits occupy a sort of halfway house,
since they are not directly determined by factor-hire contracts. Instead they
are the residual due to the difference between the contractually determined
receipts on the sale of products and the contractual costs of the hired factors
of production.) Income-in-kind payments should be conceived of as the combination
of two separate contractual transactions, namely money income
payments to factor owners from the employer, with a simultaneous purchase
commitment of goods by the factor owner to the employer.
Although Keynes defined the economy that we live in on the basis of the
use of monetary contracts for hire and sale, this definition does not per se
explain the existence and ubiquitous use of this human institution. In order to
provide an explanation for the widespread use of money contracts, we must
delve into how entrepreneurs make decisions, and recognize the difference
between risk and uncertainty – a difference that is essential to Keynes’s
analysis of involuntary unemployment.
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