Consumer Monetary Theory (CMT) is a framework for understanding the role of money in giving consumers access to the economy’s output.
The economy exists for the benefit of the people. A well-functioning market economy serves us all. It promotes our well-being by producing goods and services for us to consume. We are all consumers.
Consumption is the sole end and purpose of all production; and the interest of the producer ought to be attended to, only so far as it may be necessary for promoting that of the consumer.
— Adam Smith | The Wealth of Nations | 1776
Without someone to consume the economy’s products, there’s no point in having any products. The consumer is central to the market economy because the people come first. Workers and firms are important only insofar as their products benefit actual people.
Money as a Pricing Standard
A market economy requires a standard unit of value in which to set the prices of its products. The use of spendable standard-value tokens makes it a simple matter for people to pay those prices. This standard unit and its standard-value tokens are the things we call currency and money.
As John Hicks explained in A Market Theory of Money, markets and money go hand in hand. You can’t have one without the other. A market will always find a standard unit to use as its currency.
[T]he function of money as a standard, if it is no more than a standard, is to make it possible to form a price-list, in which the values of a number of commodities are reduced to a common measure.
— John Hicks | A Market Theory of Money | 1989
We consumers spend our standard-value money tokens — that is to say, our dollars — to buy goods and services from the economy’s producers. People who lack access to dollars can’t be consumers. They can’t buy goods and services. They can’t buy food. The market economy cannot promote their well-being.
Our dollars represent claim tickets against the economy’s production. Whenever we spend a dollar, we claim for ourselves one dollar’s worth of the economy’s productive output. Consumers are continually buying and using the goods and services that support their livelihoods. They’re redeeming their money tokens in exchange for the economy’s products.
As consumers pump money into the economy, the economy pumps back out food, books, cars, computers, etc. Money flows in one direction while goods and services flow in the opposite direction.
The Income Theory of Money
For the economy to set reliable prices, people need to know what a dollar is worth. The dollar’s purchasing power and, therefore, the general level of consumer prices must remain steady, at least over the short-run. That is to say, one dollar has to be able to claim the same amount of stuff tomorrow as it did today.
Stable currency implies that the flow of consumer spending remains commensurate to the opposite flow of production. If spending levels change, then production levels must change to match, and vice versa. Whenever spending outstrips production, prices increase; we see inflation. Whenever production outstrips spending, prices decrease; we see deflation.
Because reliable prices are important to the smooth functioning of markets, institutions have necessarily emerged to maintain the currency’s stable purchasing power. These institutions are called central banks and their monetary policy influences the financial sector so as to modulate the spending flow to ensure that it continues to match the production flow.
The framework for describing prices and the general price level in terms of flows is called the Income Theory of Money.
The income theory of money is a theory of nominal prices. Its aim is to explain the process of the determination of monetary prices in the market economy. It is a flow oriented approach which distinguishes it from the stock orientation of the naive quantity theory of money.
— Josef Menšík | The Origins of the Income Theory of Money | 2014
The Quantity Theory of Money provides an alternative explanation for the general price level. Unlike Income Theory, Quantity Theory focuses on the amount of money tokens “in existence.” This, of course, requires that there actually exists a definable quantity of money tokens. We call this hypothetical quantity the “money stock.” Quantity Theory imagines that the money stock continually passes through the economy from person to person at a turnover rate called the “velocity of money.” The money just keeps circulating at that velocity.
On the face of it, Income Theory and Quantity Theory appear to be two different ways of describing exactly the same thing. Indeed, under Quantity Theory, we can derive the spending level simply by multiplying the money stock by its velocity. And if the velocity is fairly steady, then the money stock itself can even stand in as a proxy for the spending flow. To understand changes in the general price level, we need look no further than the money stock.
The problem with this clever description is that money does not circulate. Money flows in a direction from consumers to producers. Furthermore, the money stock is not so easy to define either in theory or in practice. This makes it difficult for Quantity Theory to map onto reality in any meaningful way.
By contrast, Income Theory focuses on spending, which is where prices are actually paid. Income theory works regardless of whether prices happen to be paid using official, or measurable, money tokens. To buy a ten-dollar hamburger, you could pay with a ten-dollar bill, with ten dollars’ worth of jelly beans, or even with a scrap of paper that says “I owe you ten dollars.”
It doesn’t matter how you make the payment. It still counts toward the economy’s spending flow. All that matters is that the price is denominated using the standard currency unit. You paid the price and that price is the price.
Consumers vs. Producers
“Consumer” and “producer” are roles that people play in the economy. While it is true that producers ultimately serve consumers, it is also true that some people do both. Workers are people who consume and produce. They contribute their labor to the economy in exchange for money.
We could imagine a world in which everyone consumes exactly in proportion to what they produce. In such a world, everyone is a worker. Each worker produces something, gets paid for it, and buys stuff from other workers. Naturally, those who contribute more labor are the ones who are able to consume more goods and services. Money is recycled perfectly and the Quantity Theory of Money starts to look a lot more plausible.
In this world, dollars merely serve as a medium of exchange that facilitates trade and allows people to benefit from the fruits of each other’s labor. Unfortunately, this is impossible. The real world doesn’t work that way. It can’t.
Perhaps there was a time in history when the market economy behaved more like a system of mutual exchange among workers. But with the industrial revolution, the idea that consumers and producers were the same people became largely a fiction. Industrialization caused the market economy to become less like a system of exchange among workers and more like a system of distribution from producers to consumers.
Despite industrialization making this more extreme, it has always been true and will always be true that some people produce more than they consume while others consume more than they produce. The possibility of accumulating money (financial wealth) acts as an incentive for people to produce in excess of their consumption. People enjoy having the power to claim more goods and services than they’ll ever actually claim. This is a feature, not a bug. Producers are motivated by profit to make more than they take.
Meanwhile, the rest of us get to take more than we make. In theory, consumers can access some amount of the economy’s production without having to work for it. Producers are happy to siphon off money while consumers enjoy the benefit of the economy’s products. This is a good thing. As I said before, the economy exists for the benefit of the people. The more benefit we receive, the better off we are. That’s kind of the whole point.
What ultimately makes this possible is that market incentives induce us collectively to produce the output we collectively want to consume. It doesn’t matter who happens to be doing the work, or how much each individual happens to be working. As long as producers want to produce, consumers can consume.
The Wage-Price Gap
An efficient labor market does not continually recycle the economy’s money back to consumers. Recall that producers are always siphoning off their profits. But consumer spending hasn’t gone to zero, so consumers must be getting their money replenished somehow.
During World War I, British engineer Major C.H. Douglas noticed that it was impossible for workers to collectively spend their wages to buy the full product of their own labor. There would always be a gap between wages and product prices. Troubled by this observation, he devoted the rest of his life to explaining this problem and developing his “Social Credit” economic framework.
[T]he persons who want and cannot do without the goods which the productive and industrial system can, and is anxious to supply, have not in their possession the tickets, the possession of which is essential before these goods, under present conditions, can be handed over.
— C.H. Douglas | Social Credit (revised edition) | 1933
This was an important insight. Producers won’t produce what consumers lack the money to buy. Douglas proposed to close the wage-price gap by issuing new money and handing it out to everyone in what he called the National Dividend: an income stream unconditionally paid to every individual person.