Financial Markets, Money, and the Real World

This book should be a classic in economics. Paul Davidson combines dazzling clarity and a passion for economic truth and common sense in illuminating the dark thickets surrounding today’s free enterprise system. Professional economists and concerned citizens should both pay heed to this fine book.

Paul Davidson comes to a series of correct conclusions about the connection between financial markets(national or international) and economic growth in the real sector of the economy,be it national economies or the world or international economy.However,the conclusions that he arrives at do not follow from the analysis that he has written in this book.Davidson correctly concludes that liquid financial markets will not be stable or optimal.However,he completely fails to tell the reader that his conclusions are redundant and had already been arrived at in a more general theoretical structure first by Smith in 1776 and then by Keynes in 1936.

Adam Smith,in his The Wealth of Nations,correctly stated a macroscopic Law of the Markets.It is composed of two parts.The first part deals with a type of an economy composed of individual saver-investors without any developed banking system and/or financial markets or an economy where these individual savers-investors do not make use of the existing banking system.The second part deals with a type of an economy with a private central bank,uniform currency,and a banking system where the individuals now place their savings in the banks.The banks now make the decision in how to allocate these savings to borrowers in the form of loans and/or long term lines of credit availability.Investment(I) will always equal savings(S) at an optimal position on the boundary of the Production Possibilities Frontier(PPF) curve if the economy is of the first type described above and there exists,in Smith’s words,” tolerable security “(limited uncertainty or ambiguity).However,the second type of economy will not obtain a position on the boundary of the PPF where I=S is an optimal result if either of the following kinds of policy outcomes are allowed to occur:(1)-The commercial banks make loans to projectors(Keynes’s speculators-rentiers),prodigals,or imprudent risk takers.Smith makes it crystal clear that the savings will not be invested in productive outcomes that add to Gross national(domestic)product but will be”… wasted and destroyed”.The economy will be operating at a position inside the PPF.Second,(2)the rate of interest on loans must be fixed in the long run at a relatively low rate permanently a little bit above the existing equilibrium rate charged to creditworthy(prime)customers.If either (1) or (2) is violated than long run economic growth,both nationally and internationally,will be sub optimal and the economy will not be operating on its boundary.It is obvious that Adam Smith’s Law of the Markets is vastly more advanced than J B Say’s later version,described by Keynes in the General Theory in 1936 as “Supply creates its own Demand” or “Income creates its own Expenditure “.

A careful reading of the last 3 chapters of the GT,especially pp.321-327,339-349,350-353,and 375-379 of the GT ,reveals that Keynes’s conclusions are identical to those of A Smith-Maintain a low,fixed rate of interest permanently in the long run and cut off all loans /credit availability to speculators and rentiers.Keynes rejects Say’s Law of the Markets but accepts the fully developed Law of A Smith once the condition about the existence of uncertainty(ambiguity) is made..

None of this analysis appears in Davidson’s book except the correct rejection of J B Say’s Law.Keynes’s additional add on to Smith’s theory is to show that ,in many instances,there will NOT be the ” tolerable security “that Smith felt would lead individual decision makers to worry only about risk and not uncertainty.The interested reader should get his hands on The Modern Library edition (Cannan) and carefully study pp.294-340 of the WN,especially pp.339-340,where Smith adds on to his system of thought the above two conditions required for aggregate optimality that he did not discuss earlier in the book.

The world economy has been subjected to one financial crisis after another over the last 30 years precisely because the international currency and exchange markets,the World Bank,the International Monetary Fund,the Export-Import bank,the world’s major commercial banks and financial institutions,the Federal Reserve System,etc., have been making hundreds of billions of dollar loans to speculators,prodigals,and imprudent risk takers while not making sufficient loans available to Smith’s ” sober” individuals ,who will make productive use of the savings and transform them into actual goods and services.This result is precisely and exactly what Smith predicted-the aggregate savings will be wasted and destroyed and no productive investment will occur.
Economists,such as Davidson and the Post Keynesians,are ignorant about Smith’s Law,as well as Keynes’s extension of it to deal explicitly with the uncertainty of the future by showing mathematically in chapter 21 of the GT that the existence of a speculative demand for money(M2,L2)>0 automatically means that the economy can not be on the boundary.Smith’s Law of the Market is the same as Keynes’s law of the market-unless the elasticities e and ed subscript ,on p.306 of the GT,equal 1,tolerable security will not exist because the speculators,imprudent risk takers,and prodigals are receiving massive loans to play their leveraged buyout games with that create the turbulence and volatility that has been established to exist by B.Mandelbrot over the last 50 years in one article after another.