Markets are places where we exchange goods and services with one another. However usually we don’t experience markets like that: for most of us for most of the time, markets are where we exchange goods or services for money – either buying something or selling something. Nevertheless, what is going on underneath is the exchange of goods and services with other people or businesses, even if it is not visible to us; money is just a sort of lubricant that makes complex swaps easier.
This chapter is an attempt to visualise those exchanges or ‘swaps’ that are going on underneath, and to explore some of the consequences of the market being essentially a set of many swaps. The chapter is illustrated with some numerical examples; should they be hard to follow, the Summary (5.7) gives the general idea in plain English.
In a free market, goods are exchanged by mutual preference between actors in the market. I swap product ‘A’ for your product ‘B’, because I’d prefer to have B instead of A and you would prefer to have A instead of B. These exchanges often involve long, complicated and interconnected chains of swaps. For trade to occur, complete closed chains of swaps must exist; missing elements can break the whole chain. We don’t see these extraordinary swap chains because in a real economy we use money as an intermediate good: I swap A for dollars (or euros or gold coins ...), and then use the dollars to buy B. Provided money is flowing properly in the global economy (without building up huge trade imbalances), it really is the case that if I as say a computer programmer working in the UK, buy a pineapple from Costa Rica, then a few minutes of my work writing software, have somehow been swapped for the work of a pineapple farmer. Of course the farmer doesn’t end up with my bit of software (heaven forbid!) but a chain of swaps passes it to someone who does want it, and results in the farmer getting some quite different product that he or she wants (or more realistically, a contribution towards buying it). Clearly such complex swaps would be very difficult to organise, perhaps impossible, without money as an intermediary.
We’ll start by trying to visualise an economy that works only by barter with no money involved at all, and consider the implications of trade being by a series of swaps. Later we’ll re-introduce money.
The diagram in Figure 5.1 explores the exchanges that occur in a very simple imaginary economy. We shall suppose that it operates based only on barter with no use of money, by people swapping things.
The purpose of this model is to allow us to visualise how an economy works without referring to money. It illustrates that:
Modelling the economy as a series of swaps, we can explore why economies can easily operate at below their full potential if some of the actors run out what they regard as advantageous swaps before others do. In these examples we assume that products are exchanged on the basis of how long it takes to make them, e.g. when swapping bread for shoes, you expect to swap the quantity of bread made in time X for the quantity of shoes that can be made in the same amount of time. As described in Chapter 3 in the discussion of value and the ‘labour theory of value’, this tends to happen in a real economy because of competition. If tailors are getting very favourable swaps (or in real life, high prices) because there is a shortage of clothes, then other artisans will be tempted to retrain as tailors, the shortage will diminish, and the swaps revert to being in the ratio of the labour required to make the products involved. We also noted in Chapter 3, that the labour theory of value can apply to resource owners as well, provided that they don’t have a monopoly of the resource concerned.
We’ll now look at an example of how a reduction in what one actor in the economy wants to consume, has wider effects. The starting situation for our example is shown in the diagram in Figure 5.2. The farmer wants ½ day’s worth of bread and nothing else. The grain she supplies for that is sufficient to satisfy the wants of both artisans, earning the baker some shoes in the process.
But now consider what happens if the farmer’s desire for bread drops to a ¼ day’s worth. The result is shown in the diagram in Figure 5.3. The small ‘change in demand’ has had a surprisingly large effect: it has rippled through the economy denying the shoemaker bread and the baker shoes. Total production (the same as total work) has slumped from 2 days to 1 ... by far more than the ¼ day’s reduction in the farmer’s work that was the cause. Table 5.1 shows the difference in production before and after the drop in the farmer’s bread consumption.
We can easily imagine reasons why the farmer might choose to produce less grain than the farm is capable of growing. Perhaps as well as its grain fields, the farm has extensive pasture where the farmer’s children’s ponies graze. The farmer and his family could plough up the pasture to plant more grain, but they have no incentive to do so if the grain they already produce is sufficient to earn them what they want. Similarly, in the real economy people who own resources can choose to keep them rather than expend or utilise them, if that is what they prefer. If an artisan isn’t producing as much as the rest of the economy wants, other people can set up in that trade; but if a resource owner isn’t producing as much as the rest of the economy wants, the shortfall cannot be made up unless there are competing owners of the same type of resource who step in (or in extremis, by taking the resources against the owner’s will – a government might nationalise them, or in wartime, requisition them). All inhabitable land is already owned, and by relatively few people; most of us – even if we own a house with a garden or yard – have only a negligible amount. Some resource owners are able to achieve a degree of monopoly allowing them to charge more for their product than the value of the labour it took to produce – the Organization of the Petroleum Exporting Countries (OPEC) is a cartel of oil producers who cooperate to adjust production levels and thus maintain prices. Yet it does not follow that all resource owners are in a strong position. They may find themselves competing with each other to try to swap what they produce for all the other goodies the world’s economy produces and thus driving down the prices they receive – think of the fluctuating fortunes of the world’s coffee producers.
Of course the starting position could be the second diagram, and the farmer’s desire for bread grows by a ¼ day’s worth, resulting in the first diagram. Then that increase of ¼ day in the farmer’s work ripples through the economy increasing total production (total work) from one day to two days. This phenomenon of a small increase in spending having a larger knock on effect was described as the multiplier by the economist John Maynard Keynes. In our example the multiplier is 4 because an increase of ¼ day in the farmer’s work results in an increase of 1 (i.e. four times more) in the total work in the economy. Observe that the size of the multiplier depends on the length of the chain of swaps: if in the increase of demand case (going from the second scenario to the first one), the baker simple ate the extra ¼ day’s worth of bread that she produces instead of trading it for shoes, then those shoes would never have been produced. The real economies that we live in, with their millions of products, may have some very long chains!
We have supposed that the amount of grain the farmer supplies drops from ½ day’s worth to a ¼ day’s worth, because her desire for bread has dropped to a ¼ day’s worth and to get that she only needs to trade ¼ day’s worth of grain. This is a drop in demand or ‘wants’.
Another possibility is that farmer supplies less grain not because she wants to but because of a resource shortage – perhaps there is a drought and the farm is no longer capable of growing a ½ day’s worth of grain, and can only manage to produce a ¼ day’s worth. There is still a knock on effect on the rest of the economy but for a different reason.
Next we will consider how adding in a new ‘want’ – a product that wasn’t there before – can create more economic activity. Look at the diagram in Figure 5.4 which shows swaps between two artisans.
Shoes are traded for shirts. The tailor would actually like a whole day’s worth of shoes, but the shoemaker is only interested in trading for half a day’s worth of shirts and will only offer half a day’s worth of shoes for them. However, the shoemaker would like half a day’s worth of music if only it were available.
Hey presto! A musician has arrived in the village – a singer. She offers music in exchange for the shirts that she wants. The diagram in Figure 5.5 shows what happens. To get the music he’d like, the shoemaker has to offer her shirts and to get those he has to offer more shoes to the tailor.
She works only ½ day but the total production has grown by 1½ days, more than doubling as the effect ripples through the economy. We can imagine that something similar happens in the real economy when a desirable new product like the motor car, television or smartphone gets released onto the market. We can also imagine the converse: the drop in production that occurs if people don’t want those products any more – though manufacturers are careful to try to avoid such a situation by releasing endless new models. The change in the production figures with the arrival of the musician are shown in Table 5.2.
Notice again how the increased production due to the addition of the singer, depends on the length of the chain of swaps that it creates. If she wanted not shirts but shoes, then she could just do a single swap with the shoemaker who still has to produce an extra ½ day’s worth of shoes, but as these are swapped directly with the singer instead of to get shirts, no extra shirts are produced.
We can quantify this rather easily. If someone produces an extra X day’s worth of goods just for their own consumption (and without any exchanging anything with others to obtain raw materials either, so zero swaps), then total production grows by X. If they exchange all the extra goods for something else (one swap), then total production grows by 2X, and so on. We can see that ‘multiplier’ is given by the length of the chain (or in other words, the number of swaps). In the case of our example, the chain is 3 long, so the multiplier is 3. The new production X is ½ because the singer has introduced an extra ½ day’s worth of goods (music), and thus total production grows by 3X which is: 3 ×½ = 1½.
However, these are simple examples; in a real economy, the singer would want a whole range of goods in exchange for her music, and the chains of swaps would fan out and also diminish with the number of steps. Even with our simple example you can see how they might diminish: suppose the singer wants both shoes and shirts in equal quantities, so the shoemaker can supply part of what she wants directly and needs less from the tailor, and thus the total increase in production is lower, being: singer ½ + shoemaker ½ + tailor ¼ = 1¼ (instead of the 1½ we had before).
Viewing the economy as a set of swaps makes it obvious that there is no guarantee of full employment. Even assuming that all mutually desired swaps are made, that’s no guarantee that everyone will be fully employed, particularly if they don’t have much to offer at the outset – perhaps only unskilled labour. We can state the condition that must be met for full employment that applies to a swap economy, as follows:
For full employment to be reached, we need the following to be true for all levels of employment from the starting level of employment up to the employment of the last unemployed person: ‘That there exists a chain of mutually desired exchanges that links the ultimate consumer(s) of what is produced by additional labour, with the extra people employed to carry it out.’
Expressing that in more normal English, what this says is: ‘for every worker we add to the workforce right up to full employment, we need people in the economy who are willing to offer what that worker wants (food, housing, etc.) in exchange for his/her labour, because they want the product of that labour.’
While this sounds a very demanding condition, we should remember that humans are adaptable and will actively try to find a product or service that they can offer that others will want.
Real economies normally use money as an intermediate good, which makes swapping much easier. Taking our original 8-person exchange economy, let’s suppose that all of those 8 are given a sum of money – 100 silver coins each perhaps. Now they don’t have to exchange their products by arranging complicated chains of swaps with each other – they can sell what they produce (swap it for money) and then buy what they want (swap the money back for produce from one of the others). The diagram in Figure 5.6 shows the same 8-person exchange economy that we saw earlier in Figure 5.1, but now redrawn to show money being used as the way to trade instead of barter.
If they continue to exchange products in the same quantities and proportions as before (the prices reflecting the same relative values they placed on the products when they swapped without using money), then nothing really changes: money moves to and fro in a symmetrical way so that no-one gets any richer or poorer in cash terms over time.
If instead someone decides that now that they have money they can buy things without having to sell anything, they will obviously pretty soon run out of money.
What about the opposite: someone is producing and selling but doesn’t spend all the money they are earning? Money then piles up with this person, which means that one or more of the others is running out of money. Eventually those others can no longer buy anything, production in the economy drops off, and the sales our frugal saver was making will dry up.
Thus while introducing money into the economy does mean that we can have temporary imbalances in trade (someone can sell something and then keep the money from the sale for a while before spending it again), nevertheless over time trade must balance, just as it does in our imagined barter economy that operates without money by swapping goods directly. That means that eventually in an economy with money, everyone needs to spend as much as they save. If they don’t do so, then the effect is the same as someone in the barter economy no longer wanting to swap: they will reduce production to the level of the swaps in the economy that are still mutually desired. This conclusion is standard macroeconomics but sometimes surprises the wider public since we are always being advised to save.
The need for trade to balance over time does not mean that there cannot be large inequalities in wealth. In our example 8-person economy, the mine owner could spend less than he earns for a period until most of the 100 silver coins that each of the eight people in the economy had at the start, have ended up with him, and the other seven have only a handful of coins left. As they run low on money, the others will have to adjust their spending to match their earnings, and trade will adjust to a level at which it is balanced. However, the economy could simply bump along at that level, the mine owner remaining cash rich compared to the others.
While trade needs to balance over time, that may be quite a lot of time. At an individual level, this may be a lifetime: it’s common for people to save through much of their adult life and then spend in old age (especially on medical expenses and personal care), finally leaving an inheritance that gets spent by the next generation. Countries can also run balance of trade deficits for many years which are balanced by foreigners bringing money in to buy up land or businesses. At some point however, there will be no more land or businesses to sell – though that might be decades into the future.
In the real world, inequality is so high that it is very easy for even the moderately affluent, let alone the mega-rich, to accumulate savings. To maintain economic activity we need them to spend what they earn on consumption of the goods and services the economy produces. Investing money in buying things that already exist from other rich people – such as houses, company shares or paintings by old masters – doesn’t cause any new production, it just shuffles the money to another rich person.
So here’s an idea: if the rich person’s savings are gumming up the economy, why not lend some of that money to poorer working-people to spend? Consider our 8-person economy above: we gave each person 100 silver coins to use for trade, but let’s suppose that the mine owner has been spending less than he earns and has ended up with the lot, all 800 silver coins! No problem: he lends all the others 100 coins each at the ‘modest’ interest rate of 1 coin per trading day. However, if nothing else changes and the mine owner continues to spend less than he earns, all the money will just end up back with him again but this time even faster because of the interest he’s being paid.
The economy is now gummed up again but the mine owner doesn’t want to lend to the others a second time because they still all owe him the 100 silver coins he lent them before and now cannot even pay the interest. A new wheeze occurs to him: he will buy the houses the others live in from them for 100 silver coins each – that way they will have some money to spend, can resume paying interest on the 100 he lent them, and they can rent their houses back from him so that they still have a place to live. The deed is done, but ... if the mine owner continues to spend less than he earns, all the money will just end up back with him again and this time yet faster still because he’s now being paid interest and rent!
What next? Maybe he could lend them money to buy their houses back, secured against the house if they fail to keep up interest payments. Does this sound sort of familiar? Think sub-prime mortgages. And in any case, such a scheme still won’t give them any spending money to maintain economic activity. Perhaps the mine owner should use his political connections to call for a government bailout to repay the bad debts: a bailout paid for by taxes – but taxes on incomes of course, not wealth because that would annoy rich and powerful people like ... well himself for one.
To keep the economy moving, financial tricks like those outlined above, can at best only give us a stay of execution but ultimately cannot work. The rich have to be persuaded to part with their money, either by tempting them with an Aladdin’s cave of consumer goods – much of our economy is dedicated to that – or by taxation.
We said in the barter examples in this chapter that the relative value of products was set mainly by the hours of labour that went into them. When money was introduced to replace barter, we assumed that prices would settle to the same relative values. But what sets the absolute value, the general level of the prices to be charged?
Money originated when people found that they could escape the complexities of barter by finding some generally desired and reasonably portable intermediate good, like silver or gold. The candidate needs to be valuable in its own right and take a significant amount of effort to find or produce; the two things go together because if it were easy to create money, then people would do so, and it would lose its rarity and thus its value.
When you use as money something that is intrinsically valuable like gold, then there is a clear mechanism for how to set the prices of goods – shoes, shirts, bicycles, whatever. The gold can simply be traded in the ratio of the amount of work it took to make the product, compared to the amount of work to mine and smelt the gold used in the gold coins that are offered in exchange. When paper banknotes were introduced they were initially just a note of ownership or IOU (I Owe You) for gold held by the bank, which in theory at least, the bearer of the note could retrieve, so a link to gold remained. Thus the use by countries of precious metals to back their money continued – with gaps - until fairly recent times: the UK leaving the gold standard in 1931 and the USA in 1971.
Nowadays, banknotes and their digital equivalents in bank computers, have no intrinsic material value and are not linked to precious metals. Yet modern currency can still be seen as a sort of IOU: the money shows that you are owed a certain quantity of the economy’s products, which you claim when you spend it. It is the confidence that others will honour that IOU and hand over goods in exchange, that gives money its value. To maintain that confidence, governments have to control the quantity of money and act to prevent forgery. If governments start to finance themselves by printing large numbers of extra banknotes, there will clearly be inflation: prices will rise because a larger amount of money is chasing the same amount of goods. Even with gold or silver, the same thing would happen if the metals suddenly became much easier obtain. Thus the value of money depends on the amount in circulation compared to the amount of goods produced and traded. To explore that a little more, it is said that money has three properties or functions, being a:
However, the last of these properties needs to be treated with care, because money doesn’t really store value at all, it only stores promises. An example of a real store of value is a stash of nuts that you collected in the autumn and that are still good to eat the following spring – ask any squirrel. That’s quite unlike banknotes you store in the autumn, which only have any value in the spring because there are other humans in the world who are willing to redeem them in exchange for actual food or other goods that they possess. Money does not and cannot transmit wealth from one whole generation of humanity to the next, only real wealth does so – things like infrastructure, farms, nature, knowledge and art. Money is a zero-sum game when passed on from one generation to the next: if one fund is made bigger then another has been made smaller by the same amount, so what is passed down is the distribution of stuff among humans, not the total amount of stuff in the world – the amount of actual stuff such as land and other assets passed on stays the same, money just affects who owns it.
Understanding that money is only an IOU or promise, helps us to understand why the value of money in circulation is related to the quantity of goods the economy produces. Suppose that in the eight-person economy shown in figure 5.6, the community decides to make everybody rich, by issuing everyone with banknotes with a total face-value of a million silver coins. The next day no-one goes to work because as millionaires they can just buy everything they need ... except that they can’t because nobody is producing anything! So they then agree to continue to work, trading at the original produce prices. However, given that everybody now has lots of cash, someone is bound to buy more than they usually do, leaving less or nothing for other people to buy. But since everyone else also has spare cash, they all soon start offering to pay more so as not to go home empty-handed, and they also put up their own prices. Eventually prices and the incomes of sellers, will have to settle at a new higher level appropriate to the amount of money in circulation.
To put that in a more general way: If you have Money-IOUs that will buy you far more goods than would be your fair share of production, you are naturally going to be tempted to redeem them, rather than try to limit yourself to what you guess would be your proper share. Therefore, across society as a whole, the value of money in terms of the goods it will buy, has to adjust (and will via market forces) until the rate at which the population are inclined to redeem ‘Money-IOUs’ (banknotes), is the same as the rate at which they are earned.
From the above reasoning we can see why the value of money is not arbitrary but depends on the relationship between the amount of money and the amount of production – so changes in either can result in changes in prices. If for example a government attempts to finance itself by printing money, it will result in inflation – prices of goods generally will rise.
In terms of production there are many changes that could affect prices. Some examples based on the illustrative eight-person economy of artisans and resource owners shown in figure 5.6, are:
Of the above, the most striking development in terms of price changes is point (1). Technology has produced an explosion in productivity; many manufactured and agricultural products have become far cheaper in real terms after correcting for inflation, with some even being cheaper without any correction. For example early PCs in the 1980s could cost a few thousand Pounds, while a far more powerful modern PC can be bought for a few hundred of today’s much less valuable Pounds. Over those forty or so years, prices would have fallen on a wider range of products in money terms as well as real terms, were it not for the fact that as productivity has increased, governments have put more money into circulation, causing an inflation that offsets the falls. The effect of mass-produced ‘stuff’ having become so much cheaper is to make things where the labour involved has not changed, relatively more expensive, e.g. employing servants, or paying for a builder. The cost of repairing things, being labour-intensive, has become a much greater fraction of the cost of buying a new replacement, thus encouraging a throw-away culture.
We will return to the subject of prices when we take a look at inflation and the money supply in Chapter 23.
Free markets regulate themselves and are said by economists to provide the ‘optimum’ distribution of goods and services. The self-regulation is certainly a great benefit as it allows decentralisation and initiative by individual businesses to fill gaps or offer new products. The ‘optimum distribution’ occurs if we assume that all actors in the market are ‘perfectly informed’; in our swap model that means that everyone knows what swaps are possible and all that are mutually desired are made. However it is a funny sort of ‘optimum’! If some of the actors in the market are extremely rich and others are dirt poor, then the rich have reshuffled their enormous quantity of goods and services to the most preferred arrangement and the dirt poor will emerge with perhaps a slightly different meagre set of goods to that they started with. It may be an ‘optimum’ outcome, but that’s not the same as a ‘good’ outcome – such as the dirt poor ending up instead with a decent livelihood.
The market is not an amorphous blob where you can sell anything for money provided the price is low enough, and buy anything if you pay enough. What really goes in a free market is the exchange of goods and services between people or businesses, via a series of complicated swaps, in each of which both parties want to make the trade. Money facilitates this, allows short-term imbalances (you don’t need to sell and buy at the same moment) and hides the complex chains of swaps involved.
Viewing the economy as a set of swaps helps us to understand how a change in what one person or business wants (a change in demand), can have a knock on effect on the rest of the economy that is much greater than the initial change – the effect economists call ‘the multiplier’ – and that the same is true for a change in resource availability. We can also see that there isn’t some specific natural level that the economy works at. The level of production depends on what the various actors in the economy want, and importantly, may be limited by the wants of one or a few of them being fully met, while production is still at a lower level than needed to meet the wants of others. What that means in practical terms is that in a very unequal world, production will be at a level at which the wealthy have what they want and can’t think of anything more to buy, even though that may be a long way below the level required to meet the basic needs of the rest of the world’s population.
Introducing the use of money instead of barter, does not, in the long term, allow us to escape the consequences of the economy being a set of swaps and production being therefore limited to the result of those swaps that are mutually desired.
Having explored how markets operate, we’ll next consider what it’s like to live in one.
