John Law, Monetarist or Keynesian?

John Law's monetary thought is largely contained in two works, Essay on a Land Bank (1704), and Money and Trade (1705). The first of these works, Essay on a Land Bank, was a proposal to the English parliament of the day advocating the use of a land money in lieu of silver money. The content of the essay is best seen in Law's opening sentences:

Money and Trade, written one year later, was also a land bank proposal, this time to the Scottish parliament. Many such proposals were published at the time but Law's proposal stood out due to the intellectual depth of his argument. Contrary to most of his contemporaries, Law had substantial theory behind his policy proposal. He went back to the very nature of money as shown in the above quote, and in the opening paragraph from Money and Trade:

Thus Money and Trade, while written for the same reason as Essay on a Land Bank, went further by exploring the relationship between money and trade and the potential methods for increasing the money supply. This was because of the "great Scarcity of Money" which Law perceived to be the main reason for the depressed state of the Scottish economy at the time.

Many elements of the theory behind Law's policy proposals coincide with the generally accepted views of contemporary economists. Not only is his account of the functions of money standard today, but he has been credited by Schumpeter and other economists with being the first writer to give such an account of the four functions of money. His definition of money in Money and Trade accounts for the functions of money as a measure of value, a medium of exchange and a standard of deferred payment:

That Law was aware of the fourth function of money, money as a store of value, is obvious from his support for land money, which was based on it having greater stability of value than silver money. He goes on to add that for "money to be qualified for exchanging goods and for payments need not be certain in its value." Here he is not denying the store of value function but actually postulating that there exist wider forms of money, such as stocks and debentures, which solely fulfil the medium of exchange role of money. While herein lies one of the flaws of Law's thinking and of his Mississippi system, it is also an important recognition of the concept of liquidity.

When it comes to the analysis of the role money plays in the economy and monetary policy, history has treated Law rather unfairly. Various commentators have dubbed him an inflationist and even worse a Keynesian. However, it shall be contended here that Law was in fact a precursor of modern monetarism. While Law would certainly not have subscribed to all the major tenets of monetarism, he had a remarkable comprehension of price determination and the Quantity Theory of Money. In Essay on a Land Bank Law, he stated that if the quantity of money is greater than the demand for it, money would be less valuable. Murphy notes that Law was the first writer to use the term 'the demand for money' to analyse the determination of inflation. Moreover the supply and demand analysis with which Money and Trade begins is extended to an analysis of money, with Law clearly stating what determines the value of money and hence the level of prices:

The clarity of the argument and its reiteration in other parts of the book demonstrates Law's understanding. Furthermore Law illustrates his argument using the example of the inflation of the preceding two hundred years in Europe which he blames on "The Spainiards (who) bring as great Quantities into Europe as they can get wrought out of the Mines". This was his main reason for advocating a land bank, as he believed that land money would have a more certain value than silver money because it does not increase in value. This continual emphasis on the need for monetary stability echoes Friedman, who said that the two most important things that monetary policy could do is to prevent money itself from being a major source of economic disturbance, and to provide a stable background for the economy.

A further element of Law's theory that accords with monetarism is his recognition of the international dimension when it comes to price determination, or what is now known as the 'Law of One Price'. This is how he explained the fact that "Goods differ little in Price, from what they were when Money was in greater Quantity." It is because "the Value of Goods or Money differs as the Quantity of them or Demand for them changes in Europe; not as they change in any particular Country."

Law believed that there was a relationship between the money supply and the real economy. He thought that money did have real effects on the economy and that the depressed state of the Scottish economy at the time was due to a scarcity of money. Chapter 2 of Money and Trade is titled "Of Trade, and how far it depends on Money. That the Encrease of the People depends on Trade. Of Exchange", and in it Law writes:

This is one of the main tenets of Law's system, that wealth depends on trade (trade being a synonym for economic activity) and trade depends on the money supply. Vickers states that Law only gives one possible transmission mechanism on which this relationship depends. That is that an increase in the flow of money would raise demand which would then raise supply. This mirrors basic Keynesianism which inspired demand management policies for a large part of this century.

However, it can be argued that Law also thought there was a 'money in advance' requirement as subsequently argued by Clower and Leijonhuvfud. This argument states that there is demand in the economy which is unrealised because of an inability to financially support that demand; it is in effect only notional demand. Employers may want to hire more labour, but this can only be financed by what the labour produces. Individuals may want to purchase more goods and services but this can only be financed if they get a job. Thus, money is needed to turn these notional demands into effective demands and so an increase in the money supply could have real effects on the economy. In Money and Trade, Law noted that money is needed to pay wages and to buy goods. His example of an island, which switched from a barter to a monetary economy, also illustrates this point.

Nicholson notes that it was during Law's time in Holland that his views on money matured. He would have observed that in Holland there was an abundance of money to drive trade owing to its banking system, and this would have contrasted gravely with the situation in Scotland.

Law also pre-empted the Keynesian multiplier by observing that when consumption increased as a result of increased employment the economy would be stimulated further.

So there seems to be a contradiction at the very heart of Law's theoretical system. He appears to switch from a pseudo monetarist theory to a Keynesian theory and Keynesian policy measures. At the very root of the problem is blatant support for an expansionary monetary policy to stimulate the economy coupled with a belief in the price forming activity of money.

Such an assumption means that the expansionary policy Law advocated is consistent with the Quantity Theory. Friedman himself said that "changes in money income mirror changes in the nominal quantity of money. But it tells nothing about how much of any change in Y is reflected in real output and how much in prices. To infer this requires bringing in outside information." So, if real output is at full employment level, supply will be inelastic and prices will increase. Or, like Law's assumption, if supply is elastic to changes in demand, output will increase and prices will be constant. Law's policy measures can now be analysed in terms of his own money supply/money demand framework. Law proposes that money demand will increase as trade increases. Thus, a transmission mechanism emerges whereby an increase in the money supply will increase real economic activity which will subsequently increase money demand. This ensures that the money supply will not rise out of line with money demand so that there will be no inflationary consequences.

Thus, this reconciliation of Law's policy proposals with neo-classical economics illustrates that Law's thinking did not leave out the real economy. Rist has criticised Law for doing so, while being himself stuck in a crude form of metallist cum mercantilist thought. In fact the actual systems that Law proposed were designed to be linked to the real economy. Under his land bank proposals, banknotes were directly linked to the productive earning powers of the land, and even his wider forms of money, like shares, were still linked to a productive capital base.

Therefore, Law's system appears to be internally consistent. Whether it passes the second test of being a close description of reality depends on the feasibility of the elasticity of supply assumption. This is not an absolute assumption, in the opinion of the author, and obviously depends on the economic climate of the time. When one takes into account the condition of the Scottish economy at the time of Money and Trade, the assumption does not seem so absurd. However, it is quite an optimistic assumption and in general, supply will not rise by enough so as to avoid a stimulus to inflation. Therefore Law's policy proposals have to be treated with extreme caution.

It should be noted that the flaw in Law's thinking, in relation to the Balance of Payments is not of direct relevance here. His belief that an increase in the money supply would increase exports and so lead to a trade surplus, is crucially dependent on two further assumptions. The first was about the expansibility of foreign demand, and the second that domestic consumption remained at the same level. This is in addition to the assumption about the expansibility of production.

Law gives another reason in Money and Trade why money demand and money supply will remain matched thus avoiding inflation:

Law is stating that there can be a reflux of notes to the issuing authority so as to ensure that the money supply equals money demand. Vickers criticises Law for this assumption, noting that the authorities are not in any way compelled to take back notes, and furthermore that the demand for notes for trade purposes is related to the actions of the monetary authorities. While these criticisms are valid, they relate to Law's policy proposals and do not undermine the monetary theory that is being examined in this paper.

In Essay on a Land Bank Law describes the same reflux process and states that the level of interest has to stay constant and that if there are more notes than demand for them, at that level of interest, then they will be returned. He does not suggest that the authorities are capable of setting the money supply so as to equal money demand; in fact, he states that "the Parliament could not justly know what sum [of money] would serve the nation" This again echoes modern monetarism, which recognises that monetary policy could be used to offset economic disturbances, but believes that such measures are likely to aggravate the situation due to lack of knowledge about the economy, and so advocates a monetary growth rule.

In fact, Law's proposal for the monetary authorities to expand and contract the money supply, in order to maintain monetary stability, mirrors the pragmatic approach to monetary policy that is used in Western capitalist economies. Although such active policies are not supported by monetarism, as explained above, they in no way violate the Quantity Theory.

So it has been shown that Law's monetary theory is coherent, except for the flaw in relation to the Balance of Payments. However, the consistency of his theory relies on a rather dubious assumption, which does not adequately describe the real world. It should be remembered that all economic theories are based on assumptions about the real world and that the feasibility of such assumptions is a relative phenomenon. Therefore, Law's theory should not be dismissed because of his supply assumption.

Turning to Law's policy proposals and actions there are a number of flaws which can shed further light on his monetary theory.

It has already been mentioned that the main reason Law advocated a land bank was because "Land has a more certain value than other Goods" including silver, the currency of the time. This was due to the fact that silver was fixed in supply and had inelastic demand. Furthermore, as paper money was to be issued against the land, when its demand changed, money supply could be changed as well, as shown before.

However, Law was ultimately mistaken about the stability of the value of land and it represents the major flaw in his proposal. The real value of land will change due to productivity improvements and changes in the factors of production ratio. Curiously, Law noted the fact that land was capable of improvement but neglected to follow up the argument. Furthermore, land itself is heterogeneous. Ironically, the potential instability of the value of the proposed money is the very issue over which he criticised Chamberlain and others.

However, the puzzling issue regarding the stability of the value of land, is that Law also proposes an increase in the paper money that is issued against the land. This will automatically increase the monetary value of the land. With money demand rising to meet money supply, commodity prices will remain constant and thus the monetary relationship between land and commodities will be forced out of its natural equilibrium. This will have disturbing effects on incentives and decrease the efficacy of the market system. Furthermore, the artificially increased prices in the property sector of the economy could result in a speculative bubble that would have devastating effects on the whole economy. This pattern has become familiar in the recent boom and bust cycles that have scarred various parts of the world. Ultimately this fallacious policy is a result of Law's monetary theory. As Cesarano has shown, Law was a theoretical metallist, but due to his concern about the lack of money in the Scottish economy of 1705, he headed towards practical cartalism.

The infamous Mississippi System is for what Law is best remembered. The apparent folly of the system and the damage that it caused, has led some commentators to completely dismiss Law. However, as has been shown so far in this paper, his monetary theory was cogent and quite remarkable for the early eighteenth century. The history and flaws of the system have been well documented, but for the purposes of this paper a short look at the system will reveal more about Law's monetary theory.

Galiani echoes most economists when he faults Law for issuing an excessive quantity of money. Ultimately this was the failure of the system, that the money supply was expanded too far too soon. It has to be noted that Law was attempting to solve a financial crisis as well as a monetary crisis, as the French government was highly indebted at the time. There was also great pressure on him to pursue such excessive policies from the Regent, and two powerful groups, the financiers and the rentiers, were strongly opposed to him. However, despite these facts, Law still has to accept responsibility for the failure of the system, and his overexpansion of the money supply seems to cast doubts over his monetary theory.

Law had continuously multiplied the monetary wealth of many people in a short period of time without much consideration for the real economy. When he recognised this and tried to remedy the situation, it was too late. This whole experiment seems to show that Law believed too much in the capabilities of money and assumed away the role of money demand and the real economy. In the context of the earlier analysis of his monetary theory, Law must have believed that his elasticity of supply assumption would hold.

This paper has shown that John Law pre-empted much of modern monetary economics. It has also shown that the reconciliation of his monetarist and Keynesian tendencies depends on an elasticity of supply assumption that reflects Friedman's remark that the main differences between the two schools of thought are empirical and not theoretical. Law's theory is both accomplished and consistent; however, it does rely on a rather doubtful assumption about supply. While this is not cause to dismiss his monetary theory it does mean his policy proposals should be treated with respect. When Law finally got a chance to implement his ideas, it exposed an overemphasis on the real effects of money and a neglection of the real economy. This is what has ultimately led to his popular, and perhaps misguided, classification as a Keynesian.