The Theory of the Monetary Circuit: A Critique


In a series of comments on my previous post involving myself, Neil Wilson and Oliver it became clear quite quickly how closely my asset-pricing framework is tied up with the Post-Keynesian theory of endogenous money. Oliver suggested that I look into the Theory of Monetary Emissions (TME) — a forerunner of the modern ‘Circuitist school’ of monetary theory. In this post I consider how and why my approach differs from the Circuitist theory through a reading of Sergio Rossi’s excellent paper The Theory of Monetary Emissions which can be found in A Handbook of Alternative Monetary Economics.

I will not here deal with the theory of the monetary circuit itself. It is, in all respects, basically identical to the Post-Keynesian theory of endogenous money and can be summarised aptly in the phrase: loans create deposits. Where it departs from the latter is, and this will prove important in what follows, in its tendency to think primarily in terms of models — a tendency which readers of this blog will know I find objectionable. For me good theory starts from the ground up and the desire to build little models should take a back seat.

The first place in which my approach and the TME differ is in what we count as ‘income’. In the TME, as in the national accounts, ‘income’ is only the income that arises out of real production. Rossi cites Cencini in this regard,

[T]hrough the payment of wages, money and output meet, fusing in a unique object called ‘income’. By putting money and output together, money acquires a real content [hence value], and output is given a monetary form. In other words, money measures (numerically) goods, and goods define the real content of money. (p124)

I should also note that I don’t really like the Marxist or even Hegelian overtones that sometimes appear in Circuitist theory. Phrases like ‘the real content of money’ strike me as being far too metaphysical and should, I think, be abandoned. Such observations will tie in later on when I discuss my project as being to establish a general theory that can be ‘plugged in’ to basically any other theory.

Anyway, that aside, it is clear that my definition of income differs from the TME definition. In my framework I discuss two different concepts: real income/savings/investment and financial income/savings/investment. The former bears an identical definition that the Cirtcuitists and the national accounts hold to — namely, money spent into circulation that contribute to real production/output/aggregate demand. The latter, however, is that money which is spent into circulation merely to engage in the exchange of financial assets and thus drive their price.

Financial income can, of course, have effects on real income. If I buy a portfolio of shares this year worth $10,000 and sell them next year for $20,000 my purchasing power has increased by $10,000 which it would otherwise have not. My consumption will likely rise too; in economics this is called the ‘wealth effect’. The reason that I refer to this as income is because, for all intents and purposes, it is. The $10,000 I make in capital gains is no less or more income to me than the $50,000 I make in the same year in the form of a salary.

I really see no reason for not referring to it as income. Certainly I see good reason for not counting this capital gains as part of output — otherwise stock market rallies would directly increase GDP which would be absurd. But I think to pretend that this is not income of some form is a bit silly. It clearly is income and we can make this point without counting capital gains as part of GDP; that is, we can do this by counting my original purchase of the shares as financial investment (If) and the money I accrue from the sale of the shares the next year as financial savings (Sf) and then we distinguish these from real savings and investment (Sr and Ir, respectively).

This provides us with a much ‘cleaner’ framework in that we can use many of the old national income identities in a slightly modified but ultimately familiar way. So, for example, total income in a given period will be both financial and real investment plus consumption,

eq1But real income — that is, output/GDP — will only be real investment plus consumption,

eq2Now, the second place where the TME and I substantially disagree is how we conceptualise price changes. For the TME inflation and, one would conclude, asset price inflation are ‘pathological’ phenomena. Again, this reeks of metaphysics to me. What on earth do the TME adherents mean by ‘pathological’? After all, some inflation may be a good thing in a capitalist economy for any number of reasons. And it is not at all clear that changes in asset-prices are inherently pathological — indeed, I would argue to the contrary: they are an ever-present and extremely important aspect of a functioning capitalist economy even though they can get out of hand from time to time.

The Wikipedia article on ‘Quantum Economics’, another name for TME, sums up this metaphysical view of inflation nicely,

Inflation is the situation where global demand numerically exceeds global supply. This situation is at odds with the logical quantum identity between demand and supply – inflation is pathological. To have inflation there must be some money devoid of purchasing power, which quantum economists call empty money, that increases or inflates global demand only numerically without altering the substantial identity between D and S.

What the TME really mean by ‘pathological’ is, so far as I can see, what many economists who, to my mind, have taken a wayward path mean by ‘pathological’; that is, something like “a phenomenon that does not fit neatly into my theoretical framework”.  To me this is a very wrong-headed approach to good theorising and reminds me of what the German philosopher Theodor Adorno said of the error of a priorism in contemporary philosophy when he wrote in his Aesthetic Theory,

It is no accidental failing on the part of individual thinkers… that today philosophical interpretations… fail to penetrate the construction of the material to be interpreted and instead prefer to work them up as an arena for philosophical theses: Applied philosophy, a priori fatal, reads out of material that it has invested with an air of concretion nothing but its own theses. (pp446-447)

This seems to me precisely what the TME adherents do when they consider price changes to be ‘pathological’ when they are, in fact, absolutely essential aspects of any capitalist economy. What the TME adherents are doing is sneaking normative judgments in through the backdoor and proclaiming: “capitalist economies should function as our models says they should function and anything that doesn’t fit in the model is a pathology”. As Adorno wrote, this “reads out of material that it has invested with an air of concretion nothing but its own theses”.

Indeed, one might say that the TME falls somewhere close to the old natural rate of interest theory or Austrian business-cycle theory in that they seem to imply that ‘bad’ credit expansion that does not increase ‘real production’ will result in some sort of inflationary chaos that disturbs what would otherwise be a perfectly balanced system. That perfectly balanced system, I would say, only exists in their own imaginations.

In my framework asset-price changes — and that includes demand-pull inflation which is effectively just a higher bid for a good or service — are perfectly non-pathological. Yes, they may do damage to the system as a whole when taken in the context of a given economic constellation, but they may also provide the system with increased growth potential, for example, or better income distribution. It all depends. We cannot make an a priori judgement about such issues based on simplistic models as the TME adherents do. Rather we must understand the phenomena in as clear a manner as possible and then use this understanding in a pragmatic manner whenever we encounter such issues in reality. This, again, is why I refer to my theory as a general theory — and this is why the reader will find it devoid of normative and metaphysical language.


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Philip Pilkington is a macroeconomist and investment professional. Writing about all things macro and investment. Views my own.You can follow him on Twitter at @philippilk.
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17 Responses to The Theory of the Monetary Circuit: A Critique

  1. Ramanan says:

    On top of doing totally incorrect accounting you mix behaviour too.

    “Financial income can, of course, have effects on real income. If I buy a portfolio of shares this year worth $10,000 and sell them next year for $20,000 my purchasing power has increased by $10,000 which it would otherwise have not. My consumption will likely rise too; in economics this is called the ‘wealth effect’. ”

    While wealth effect exists, you get it backward. The fact that you liquidate some asset doesn’t induce you to consume more. Rather, if you want to consume more, you liquidate some assets.

    Look if what you say is true, QE should have expanded aggregate demand like crazy but didn’t – not just because the units who sold bonds more would have consumed more (according to you) but also because of the resulting multiplier effect of the initial expenditure. But it didn’t.

    Read Keynes’ discussion of “two-stage decision” again.

    • Wrong accounting? I thought we cleared that up…

      Regarding the wealth effect, stop being so pedantic. It may work either way. I may take the decision to consume so I liquidate. Or I may liquidate because I think the price has peaked and then consume. Lay off it, Ramanan. Your criticisms are better when they’re not so finicky and juvenile.

      And yes, QE increased AD through the wealth effect. See: rising stock market and good sales in high-end stores. I don’t see why it should have raised AD “like crazy”. But it did raise AD through the wealth effect. I think this is pretty well recognised. But it also tends to peter out because of the low-yield environment it creates. That’s another day’s discussion.

    • QE/Stock market wealth effect clear from AD distribution:

      Mid-tier department stores such as Macy’s Inc. M -0.21% and Kohl’s Corp. KSS +0.68% fared particularly badly, suggesting that middle-class consumers are losing confidence in the economy and turning to discounters like Wal-Mart Stores Inc. WMT -0.45% and Dollar General Corp. DG +0.43% , as they did in the recession years of 2008 and 2009….

      There were some bright spots in the June rundown. High-end retailers remained resilient, with Nordstrom Inc. COST -0.08% posting an 8.1% increase in same-store sales, far above the 4.7% analysts projected. Saks Inc. reported a 6% rise when 4.7% was projected. The retailer said strongest categories during the month included women’s shoes, men’s private brand, tailored clothing and shoes, and cosmetics and fragrances.

      • Ramanan says:

        As I said I did not deny the wealth effect but the question is one of scale.

        According to your bizzare accounting theory, any proceeds received from sale of financial assets is counted as income.

        The wealth effect happens due to capital gains and the wealth itself which includes financial assets in non-liquidated form.

        So if I had purchased a security for $100 and sold it for $105, my capital gain would be $5 and since the consumption function depends on income, capital gains and wealth, I may consume a fraction of the $5.

        But in your scheme of things the entire $105 is counted as income!!

        Normally people consume a good fraction of their income and since you call proceeds out of sales of financial assets as income, that implies – that one should also consume a significant part of $105. Which is nonsense.

        The wealth effect is consuming a fraction of $5 not a significant part of $105.

      • Ramanan says:

        These things are systematically done in Godley/Lavoie without the need to take issues with Circuit Theory.

      • According to your bizzare accounting theory, any proceeds received from sale of financial assets is counted as income.

        As financial income.

        But in your scheme of things the entire $105 is counted as income!!

        No it wouldn’t. You’re reading things into my work that I haven’t written… again.

        These things are systematically done in Godley/Lavoie without the need to take issues with Circuit Theory.

        Actually, G & L’s theory of price increases is extremely primitive. That’s what I’m trying to remedy.

      • Ramanan says:

        You yourself say “I really see no reason for not referring to it as income.”

        But I am going to drop this now.

        All the best.

      • When you have a consumption function in my approach you divide it between the real income and the financial income. Presumably the multiplier would be lower for the latter. G & L are doing the same thing. They’re just using different — and, in my opinion, less formalised — notation.

      • Oliver says:

        when I liquidate an asset I certainly view the money I receive as income. I can spend it just as well as that which comes from my paycheck.

        That does seem like an odd comment from someone who openly supports the school of ‘QE is just an asset swap’.

        But, supposing you’re referring to capital gains, whether liquid or illiquid, as opposed to liquidated assets in total, I still can’t make out an answer in your theory as to why capital records gains in the first place and which part of those gains are determined by the so-called fundamentals. Sorting asset classes into those that are more prone and those that are less prone to speculation does not address that issue, imo.

        I also looked into Mazzucato and Lazonick. I don’t see anything in their approaches that contradicts the very general concept that human endeavour and nothing else adds value to goods. Value which can then find its numerical expression in money and other financial assets. That holds even if if one decides not to delineate or address any ‘pathologies’. To my mind, Keynes, Mazzucato and others are using the same concept when they distinguish between productive and unproductive investment. I mean, how does one define productive? The term may be less politically loaded than ‘value’ or ‘labour’ but they’re all fundamentally related. And I don’t think there’s a way around questions of value for an economist.

      • I don’t really understand your first question.

        Value can be added without labour. If a famous person wears a certain type of shoe, for example, it’s value increases. The labour theory of value is ghastly metaphysics.

      • Oliver says:

        Well, I admit I’m not well read in the original theory, but my reading of it through TME would account for such subjective valuation. The important part being that it is not a naturally inherent quality of the shoe but essentially what humans make of it. That subjective value is subsequently ratified by the wages and profits paid out by the shoe company, thus giving numerical value to their produce. But I see what you’re getting at, it isn’t the input by the shoemakers that creates the value, it’s the market feedback. So it’s senseless to put labour at the beginning of a (mental) model.

      • NeilW says:

        “I still can’t make out an answer in your theory as to why capital records gains in the first place and which part of those gains are determined by the so-called fundamentals.”

        Margin debt is the easiest way of seeing why.

        Debt incurred to buy assets increases the price of those assets. The reason I can spend the $105 of gains as income is because somebody else expanded a bank’s balance sheet somewhere to the tune of at least $105.

        But I might not, I might just hold that $105 as cash or bank deposits because I’m scared.

        The reason QE ends up as just an asset swap is because it the people looking to *buy* bonds that are crowded out and have their behaviour changed. These people are not in a spending mood and just back off to bank deposits.

        The people who are selling bonds would have sold anyway and their behaviour stays the same. Possibly they may sell slightly less bonds and their wealth increases.

      • Oliver says:


        Debt incurred to buy assets increases the price of those assets.

        The house I’m looking to buy has a price tag on it that doesn’t change when I borrow the money to buy the house. The valuation comes before the act of money creation.

        The reason I can spend the $105 of gains as income is because somebody else expanded a bank’s balance sheet somewhere to the tune of at least $105.

        …and their debt with it, presumably with an eye to repaying it some day.

        The reason I can spend anything as income, i.e. on consumption, is because it’s a gain to me that has no liability attached to it. And in the end, the original debtor would have to be the receiver of my consumption spending for him to be able to repay his debt.

        Further, as opposed to a wage which I receive for something I have done, a capital gain I receive for something I haven’t done. It’s a rent that I can either just feel good about (the wealth effect) or spend when I cash out. The reason for this is either a mirage, aka asset price inflation with, depending on who the underwriter is, a corresponding tendency to self-correct. Or because someone else added value without receiving a corresponding income for it.

        So, taking on new debt to buy an existing asset can be one of three things: an act of commiting my future income stream to ‘work off’ my debt or an act of hoping that others will work off my debt for me so that my capital gain will pay for the debt incurred. Or hoping that inflation will eat my real debt faster than my interest payments do. Or a combination of the three.

        I don’t see a problem in making that distinction nor in saying that rentierism shouldn’t take overhand nor that inflation should be sought as a policy option when all else fails rather than as a default setting.

        Is that too heavy on the moralism for you?

      • That’s funny. When I used to work in a real estate agent’s office part time in college we used to take BIDS on the houses we were selling. The price was usually something like the minimum that the owners would accept — a “floor” — and then bidding would start from there. During the bust the asking price was more like a “ceiling”. The bids would often depend on the access to funding that the buyer had — indeed, we used to have a financial adviser on site to discuss loan availability and interest rates prior to their considering making a bid.

        Perhaps the housing market has changed in the past few years though. Perhaps administered pricing is now the norm. I doubt it though. 😉

      • Oliver says:

        True, I had new houses in mind that are usually sold off plan at an administered price. At least round here they are. Existing houses are often auctioned, although that’s a newer development. Not sure that changes the argument (if there is one :-)).

  2. Oliver says:

    That was quick!

    My reaction to TME was / is similar. I just enjoy playing the devil’s advocate on both sides… And when they’re not busy defending their little base model, especially Rossi’s writing is actually much lighter on the moralism.

    Re: devoid of normative and metaphysical language.

    I’m not sure that changing the language will necessarily change the underlying concepts. All concepts have normative elements, so it’s best to identify them. In fact, burying heavy normative impliations under technocratic gibberish and / or maths seems to be a speciality of economics. That isn’t to say that there aren’t less confining and thus more general ways to approach a problem than what TME proposes. But, imo one does need at least a concept of what money is and, thus of what money isn’t, for a theory to have explanatory power. And I must say, the labour theory view does offer at least a template against which one can view, if not necessarily judge, contemporary finance. The question of who makes money vs. who adds value is as current as ever.

    Re: ‘bad’ credit expansion that does not increase ‘real production’

    This seems to be a basic conservative fallicy, not only within TME. Namely that a reduction in quantity of finance will automatically lead to an increase in overall quality of output AND distribution. Very much wishful thinking, I’d say!

    • 1) Yes, my impression of the Circuitists has always been one of modellers. I’m sure there are some that take it less seriously, but I prefer the Kaldor-Moore approach. It’s far more pragmatic.

      2) I see what you mean and I don’t totally disagree. But I really don’t think that my theory — or the Keynesian theory of output — has any normative overtones. At worst it “frames” the argument in a way that “normalises” certain assumptions (e.g. that an increase in investment is always good when this might not be strictly true, for example, in an arms race etc.). But I think this is much superior to explicitly building highly normative conceptions into your theory by demanding that reality mirror your thought experiments in some way — and dismissing the aspects of reality that do not as “pathologies”. I really dislike this tendency a great deal. It is a tendency that results in closed-minds, dogmatics and bad prescriptions that are chalked up as crankishness by policymakers.

      3) As to the labour theory of value, I think it’s one of the worst offenders of what I laid out in (2). It’s SO normative it really turns me off. If you want a good approach to this you should check out the work of Bill Lazonick. He’s really good at distinguishing between what he calls “parasitic finance” and “productive finance”. Marianna Mazzucato is also working in this direction. This work is empirically based, not theologically based as I think that the LTV is.

      4) Yes! Again, I refer to the work of Lazonick and Mazzucato. They really are taking this in a more practical and far less theological direction.

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