The origin of inflation, deflation, unemployment, and their bank accounting solutions

 According to the quantum monetary analysis of economics, in the absence of a bank accounting reform, the measures of austerity, taken by a number of national governments aiming at ensuring social equity and increasing domestic consumption, could postpone the collapse of the economic system, but they will not prevent it from occurring: pathological inflation and deflation will keep on raising, leading to a reduction of money’s purchasing power, and to an increase in pathological unemployment. These events will presumably breed disappointment to such an extent that could frustrate people’s hopes and nourish nationalism as well as authoritarianism.

According to the analysis enabled by quantum economics, the failure to introduce, at a bank accounting level, a threefold distinction between money, income and fixed capital (through the creation of three distinct departments) will raise pathological unemployment up to a working population ratio of one to three, until the economic system of industrialized countries will reach a standstill. As happened during the 1930s, it will no longer be possible to accumulate new capital assets, the consequences of which will likely be devastating and a source of social turmoil.


Alvaro Cencini, Lugano (Switzerland), June 2012

It is often implicitly assumed that economic events can be understood through direct observation. This may be one of the reasons economic analysis is mainly carried out in microeconomic terms. Monetary analysis is no exception. Even though concepts such as income, saving, investment, interest, and capital are mostly considered at the national level, they are almost inevitably arrived at through a process of aggregation of their microeconomic components. If, as is widely believed, macroeconomics were simply the result of such an aggregative process, microeconomic variables would be the only relevant object of enquiry of economic analysis. This would not imply, however, that economists are to limit their analysis to direct observation. In particular, this would not allow them to define money irrespective of its peculiar, immaterial nature. Even at the microeconomic level, money remains a numerical form issued by the banking system. One important point of our analysis is therefore the fact that monetary economics requires a thorough investigation over and above mere factual observation and centred on a clear understanding of the banking nature of modern money.

Another central point is the fact that, unlike what happens both in micro- and in traditional macroeconomic analysis, the concept of equilibrium is not made to play any fundamental role. Indeed, the very idea of a monetary equilibrium is at odds both with the banking nature of money and with the definition of money income. An equilibrium is a (more or less) stable condition in which distinct and opposite forces balance each other. Hence, a monetary equilibrium is a concept presupposing the existence of the demand for and supply of money as two distinct and opposite forces. But, if demand for and supply of money are to define two opposite forces, it is necessary that money exists independently of produced output. It is only in this case, and on condition that it had a positive value of its own, that money could be held as a net asset. The reader will recognise here the assumption made by neoclassical theorists and known in economic literature as the classical dichotomy. Now, modern monetary analysis shows that this dichotomy is an avatar of the old-fashioned conception of material money. Once it has been understood that money is issued as a simple numerical form, it is easy to see that its value is derived from its integration with current output. Thus, money income — the result of this integration — does not exist separately from current output. In fact, money income is current output and current output is money income, the two expressions describing the twin aspects of one and the same object. This being so, it should be clear that total supply (output) and total demand (money income) can no longer be considered as two autonomous entities. The very concept of equilibrium or conditional equality must therefore be replaced with that of identity. Similarly, we can no longer consider the supply of money income as distinct from its demand. As soon as a positive income appears in the economy, it is there to define a supply (of the current output it is identified with) and an equivalent demand. Moreover, because of the banking nature of money, income is, from birth as it were, necessarily deposited within the banking system, which means that it is necessarily demanded (by the agents entered on the assets side of the banks’ balance sheet) and supplied (by the agents entered on the liabilities side). Double-entry book-keeping is a rigorous instrument that leaves no room for hypothetical adjustments between supply and demand, and rings the toll for any analysis based on the concept of equilibrium.

The identity between money income and produced output affects the traditional distinction between micro- and macroeconomics. In fact, every single process of production gives rise to a new positive income (output) and must hence be considered as a macroeconomic event even if it is carried out by a single unit of production. In these conditions it no longer makes any sense to consider the number or size of the economic agents as the discriminant criterion between micro- and macroeconomic events. A more rigorous principle, first proposed by Schmitt, consists in considering as macroeconomic all the events that modify the situation for the entire economic set-up and as microeconomic those events that while modifying the situation of any number of economic agents do not alter that of their set. As already mentioned, production is an example of a macroeconomic event, every new production giving rise to an income that increases the wealth of the whole economic set (as the concept of national income clearly suggests). On the contrary, the purchase of financial assets is a microeconomic transaction even if it is carried out by a large number of income holders, since it simply modifies the distribution of national income among economic agents without altering its amount.

Referring to the microeconomic theory of demand and supply, the theory of non-Walrasian price formation, the theory of efficient rationing and all the other theories that have recently been elaborated by mainstream ‘model’ economists, Morishima has no qualms about considering them ‘as examples of oversophistication which enrich the theorists’ imaginary world’ (Morishima 1992: 167). The Japanese economist is right. Neoclassical economists have been developing oversophisticated models with no bearing on the real world. Despite their increasing mathematical complexity, all these models suffer from the same shortcomings, since they all stem from the same basic assumption, i.e. that economic theory is intrinsically axiomatic. The procedure proper to mathematics, and so often fruitfully applied to physics and other ‘exact’ sciences, has been extended to economics on the arbitrary assumption that economic events can be analysed in the same way as physical events. Now, contrary to what happens in physics, the economic system is entirely a man-made entity. This means that not even a single element of this system may be taken as an axiom. But if everything must be explained starting from scratch, then economic analysis cannot result from the combination of a given number of assumptions according to a series of axiomatic relationships.

Debreu’s analysis is one of the clearest examples of the path followed by most contemporary economists in their search for a rigorous theory capable of gaining respect from the followers of other, more famed, sciences. Mathematics is seen as a necessary requirement for rigour and seriousness, and its use is thought to be essential to economic theory even at the expense of its faithfulness to reality. ‘Allegiance to rigor dictates the axiomatic form of the analysis where the theory, in the strict sense, is logically entirely disconnected from its interpretations’ (Debreu 1959: x). A strange allegiance to rigour indeed, if it allows for the ‘logical’ severance of theory from its economic interpretation. Debreu does not seem to care about the fact that, by relying so much on mathematics, he is constructing an axiomatic theory that has nothing to do with reality. If successful, his exercise would provide a new field for mathematical application, but a field hopelessly removed from the real world of economics. Logically, the neoclassical attempt at determining relative prices through exchange is doomed to failure. Economics is a science in itself, capable of being as rigorous as any other exact science. Yet, it is not through the systematic use of mathematics and through axiomatisation that this end will be reached. It is logic that shows that relative prices are necessarily undetermined, and it is reality that forces us to recognise that the peculiar character of an economic system is money.

Now, money is a very peculiar ‘object’, which has too often been mistaken for a real good. As recent developments in banking theory have confirmed, it would be both anachronistic and wrong to take money as a material thing. This makes things clearer if not easier: money is an immaterial entity issued by banks every time they carry out a payment on behalf of their clients. Referring to the famous economic distinction between stocks and flows, we would say that money is a flow whose instantaneous circulation has a stock of income (or capital) as its object. Banks create the flow but not its object, which is closely related to production. This is to say that money and credit are not one and the same thing. In order to provide their clients with credit, banks need to back it with a positive deposit, that is, with a positive amount of income or capital. Contrary to what happens for the creation of a simple flow (a numerical vehicle with no positive value), the income banks lend is not of their making. Correctly used, double-entry book-keeping does not allow for the creation of income independently of production. Thus, by creating money banks simply provide the economy with a numerical means of payment, the object of the payment being derived from the association of money with current output.

According to monetarism, money is indeed a positive asset allowing barter to be split into a sale and a subsequent purchase. Money is thus conceived of as a stock and the money supply is seen as the quantity of this stock determined, directly or indirectly, by monetary authorities. Yet, if money is identified with a positive asset, then banks are bound to benefit from the extraordinary power to create riches out of nothing, as it were, which is plain nonsense. In reality, banks act as monetary intermediaries, which means that money is issued as a flow any time banks carry out a payment on behalf of their clients. Every payment is a tripolar transaction involving a bank and two of its clients, in which each of the three agents involved is simultaneously a purchaser and a seller on the labour, commodity, and financial markets. As a purely numerical form money never enters a net sale or a net purchase and must therefore be clearly distinguished from bank deposits, net assets and liabilities entered as stocks in the bank’s balance sheet and that can only result from the association between money proper and real output established by production. Knapp’s idea that money is essentially state money is thus contradicted by the fact that, like any other economic agent, the state cannot finance its spending through money creation, that is, by issuing its own acknowledgment of debt. In a logical (as opposed to pathological) system, public spending is constrained by the amount of income the government can obtain through taxation, private loans, and the sale of public goods and services, which simply means that, again like any other agent, the state can finance its purchases only by simultaneous and equivalent sales on the commodity and financial markets. What lies behind the confusion between money and income is the concept of credit money and the wrong belief that when banks create money they grant a positive credit to the economy. This is particularly clear in the monetary analysis of production proposed by the members of the so-called ‘theory of the circuit’. Apparently unaware of the absurdity implicit in maintaining that banks can create positive financial assets out of nothing, these economists claim that production is financed by newly created credit money that firms spend to cover their costs. Their misunderstanding of the very peculiar nature of bank money leads them to believe that ‘having access to bank credit, firms benefit from an almost unlimited purchasing power’ (Graziani 1996: 12, our translation). What has been entirely missed by the theorists of the circuit is the ‘vehicular’ nature of money. Its understanding requires entering the world of purely numerical magnitudes and of double-entry book-keeping. What ‘circuitists’ and post-Keynesian economists have clearly seen is that money is bank money. What they have failed to see is that banks create a purely numerical magnitude that is simultaneously positive and negative, and that this magnitude exists only instantaneously, as a circular flow. Furthermore, most of these authors miss the particular nature of labour and end up sharing the neoclassical view that labour is nothing but a factor of production among others. In reality, as the Classics and Keynes knew well, labour is the only macroeconomic factor of production, and it is through the payment of wages that physical output is given its numerical form and that a positive income first appears. Income is thus a stock (a bank deposit) whose value is positive because it defines money’s real content – produced output – expressed in wage units.

The very nature of bank money is numerical. Real goods and services, on the other hand, are physical (albeit not necessarily material). What of production then? Is it a process of transformation taking place continuously or discontinuously in chronological time? From a physical point of view, it is. But this should not be an economist’s main concern. It is from an economic point of view that economists must analyse production, and from this viewpoint production is the process by which physical output is given its monetary form. The association between money and output being the result of an (instantaneous) payment, production itself is an instantaneous event. Surprising as this may appear at first, it must be recognised that it is the only result consistent with the fact that physical goods and services are given their numerical form (money) only through the payment of their costs of production. Through a process of physical transformation, raw materials are given a new utility-form, but it is through a payment that the newly manufactured objects are transformed into economic goods.

Production and consumption are events of a macroeconomic nature. With the notable exception of Keynes’s monetary approach, production has mostly been analysed as a linear process (sequential Austrian models), as the result of a simultaneous adjustment (general equilibrium models), or as a circular process (input–output models). As is confirmed by the use of production functions and technical methods of production, in all these analyses production is considered as a process of physical transformation that can be represented by a set of functional relationships or as a sequence of fabrication stages. According to this broad approach, production is therefore a process of transformation carried out by a certain number of factors – usually registered under the headings of labour, capital, and ‘land’ – whose costs are covered by firms. But then no distinction is possible between the social (macroeconomic) and the microeconomic costs of production: both from the aggregate and from each single firm’s point of view, production is a process of transformation whose costs derive from the different inputs entering the process. A truly macroeconomic analysis of production is possible only if human labour is recognized a different conceptual status from the other factors, and money is no longer identified with a positive asset. According to a modern interpretation of Keynes’s monetary analysis, production is thus an economic process resulting from labour alone and giving rise to an economic output defined in wage units. Since it is through the association of money with produced output that income is formed, and since income is the specific result of production, it follows that, from a purely economic viewpoint, production is the instantaneous event (the payment of wages) through which produced output is issued as a positive amount of money income. In its most rigorous definition, production is then an absolute exchange since it is the very transaction through which output is changedinto a sum of money income, that is, through which output becomes the object of a bank deposit. The macroeconomic nature of production follows immediately from the fact that each single payment of wages increases the amount of national income currently formed.

The economic nature of production emerges when referred to profits and to their definition as a net surplus. Since Quesnay’s contributions, profit has been identified with a surplus, produced either by nature (as maintained by the Physiocrats), by labour (as claimed by the Classics) or by the process of production itself (Sraffa, Leontief and Pasinetti). The existence of a net product within a process of physical transformation is somewhat mysterious. If production is considered for its physical nature, there is no point in looking for a real surplus. Lavoisier’s principle of transformation applies, and no positive difference can ever appear between outputs and inputs. A critical analysis of the attempt to identify profit with a net surplus leads us to choose between two reciprocally exclusive alternatives. Either we maintain that no net product can ever be formed in the economy (which is thus reduced to an infinite series of processes of physical transformation) or we claim that the whole output of any period is a net surplus. In the latter case, production is considered not as a physical process of transformation, but as a truly economic event in which output acquires its original economic form. Quantum monetary theory stands by the latter alternative.

As far as consumption is concerned, its macroeconomic nature appears clearly as soon as it is related to the final expenditure of income, that is, to Keynes’s identity between total supply and total demand. In contrast with the notions of consumption function and equilibrium advocated by mainstream economists, the macroeconomic analysis advocated here shows that, like production, consumption concerns the absolute exchange between money and output. Interpreted as the expenditure carried out for the final purchase of produced output, consumption is an instantaneous, macroeconomic event defining the destruction of a positive income.

Another important topic concerns the problem of the macroeconomic analysis of capital and interest. Leaving aside the neoclassical idea that capital is a factor of production on a par with labour and land, capital is analysed here according to the principles of the quantum monetary theory of production. In its first and most general form, capital bridges the gap between present and future, that is, between the moment income is created, t1, and the moment it is finally spent (and destroyed), t2At the very instant it is formed, current income is thus saved and transformed into capital-time. From t1 to t2income survives as the object of a financial claim that takes the form of the credit of income holders on banks and, simultaneously, of banks on firms. In its simplest form, capital is therefore related only to the flow of time and to reversible saving. Now, the formation of a truly macroeconomic capital requires capital-time to be transformed into fixed capital. This is indeed what happens when saved-up income is invested in the production of fixed capital goods. It is only when income is thus invested, in fact, that part of current income is changed into an equivalent sum of macroeconomic saving. Invested in the production of instrumental goods, the income initially transformed into capital-time is definitively subtracted from the commodity and financial markets and takes the form of macroeconomic capital, that is, of a capital that has become ‘fixed’ for society as a whole. Firmly built on Keynes’s identity between macroeconomic saving and investment, the analysis of fixed capital is a necessary step towards the understanding of interest. Wrongly conceived of as the price of money or as the price equilibrating supply of and demand for liquidity, interest would still remain an arbitrary magnitude if it were not related to capital accumulation. In fact, even the existence of a positive interest on consumption loans would be difficult to justify if it were not backed by a positive interest derived from macroeconomic investment (saving). As claimed by Wicksell, ‘interest on pure consumption loans […] parasitizes, so to speak, on one of the large social income categories’ (Wicksell 1997: 23-4). This means that, related to an exchange between a present and a future income, consumption loans refer to microeconomic saving and give rise to an interest that is also essentially microeconomic. Being simultaneously positive for an agent and negative for another, the payment of interest on consumption loans is a zero sum transaction, which leaves the amount of social income unaltered. In clear contrast with the microeconomic nature of interest on consumption loans, interest on fixed capital is a macroeconomic income. Through the investment of profits (that is, the ‘capitalist’ form of social saving), part of current income escapes consumption and is transformed into fixed capital. Hence, the accumulation of fixed capital implies a sacrifice by society taken as a whole (macroeconomic saving), and interest is nothing more than the compensation for this sacrifice. The investment of saving (profits) and its transformation into macroeconomic capital defines a final loss of income – which will no longer be available on the financial and commodity markets – and interest becomes the compensation for this loss, an income that, period after period, replaces the saving initially absorbed in the production of fixed capital goods.

An important result of the quantum macroeconomic analysis of capital is to show that inflation and involuntary unemployment are the twin outcomes of an anomalous process of capital accumulation. According to mainstream economists, inflation is due to an unexpected rise in money supply. Prices are both real and monetary. Inflation is identified with a process of continuously rising monetary prices caused by an increase in the quantity of money affecting aggregate demand. Now, a rapid growth in the money supply increases aggregate demand only if money has a positive value, that is, if it is issued as a positive asset. But the value of money is identified to the inverse of the price level. The vicious circularity of the traditional approach is thus patent: it is simultaneously maintained that money is issued already endorsed with a positive value and that this value depends on a price level that is itself dependent on the aggregate demand exerted by money. Another common feature of orthodox analyses is the widespread use of the price index as a standard of inflation. Yet, there are increases in market prices that simply lead to a new distribution of income without modifying money’s purchasing power, which clearly shows how unreliable it is to measure inflation by a persistent rise in microeconomic prices.

The quantum theoretical approach to inflation implies a radical change with respect to traditional analysis. Starting from the identity between global supply (S) and global demand (D), it is shown that a numerical difference between these two terms arises when capital accumulation and amortization are carried out within a system of payments in which no distinction is made between money, income, and fixed capital. Today’s pathological process of capital accumulation and amortization is also the cause of a worrying growth in involuntary unemployment, that is, of a situation in which unemployment rises ‘whatever the behaviour of all economic agents’ (Bradley 2003: 399). As suggested by Wicksell, pathological capital accumulation and over-accumulation leads to a fall in the natural rate of interest. When the natural rate is very close or equal to the market rate of interest, deflation sets in, and the economy starts suffering both from an inflationary increase in prices and from a deflationary rise in unemployment. The coexistence of inflation (D > S) and deflation (D < S) is a mark of today’s monetary disorder. Traditional analysis cannot account for it, nor can it reconcile these two disequilibria with Keynes’s logical identity (D ≡ S). Yet this is precisely what has to be done. Schmitt’s quantum theoretical approach leads to this dialectical reconciliation within a truly macroeconomic analysis of inflation and unemployment.

From a monetary point of view, economics is a science with its own logical laws. The aim of economic theory is to determine what these laws are and to show how they can be implemented. The analysis of capital provides a clear example of the way these laws work. In particular, it helps us to understand what devastating consequences may derive from a failure to abide by them. Let us take, for example, the law according to which an income is destroyed when it is spent for the final purchase of output. If the investment of profits takes place in such a way that profits are spent (on the labour market) for the final purchase of capital goods, the result is the formation of a new deposit. Instead of being destroyed, profits reappear in the form of wages and define a new deposit immediately available on the financial market. This sort of duplication is the sign of an anomaly that inevitably leads to inflation as soon as fixed capital goods enter the process of production and that amortisation is introduced to account for their wear and tear. One of the great merits of Bernard Schmitt is to have shown that in its pathological state the economic system splits up into three sectors and that the more the third sector expands, the greater the danger of deflation and unemployment. According to Wicksell’s intuition, in the pathological state capital accumulates until it reaches a point where the natural rate of interest falls below the market rate. From then on, profits derived from amortisation can no longer be invested in the production of new capital goods, and this triggers a process that eventually leads to involuntary unemployment.

Ono puts it quite clearly: ‘the current prosperity of neoclassical economics has led to the situation where even Keynesian phenomena such as unemployment and stagnation are analysed totally in the neoclassical equilibrium framework’ (Ono 1994: 1). Of course, unemployment and stagnation are Keynesian phenomena only in the sense that they are at the heart of Keynes’s theory. As pathological manifestations of our economic systems, they are no more Keynesian than neoclassical or neoricardian. The real problem is therefore that of establishing which theory is apter to explain the nature of these pathologies. Now, if there can be little doubt about the inadequacy of the analysis of stagnation proposed by those economists who attribute the shortage in effective demand to ‘price-wage rigidities or market imperfections’ (p. vi) or ‘even insist that workers are unemployed because of their own preference’ (p. vi), it is likewise hard to believe that unemployment and persistent stagnation can be explained in terms of equilibrium and speed of adjustment. If it is true that the rate of interest plays a role in the genesis of deflation, this cannot be shown by forcing Keynes’s theory into a neoclassical framework, even if this is done by replacing two fundamental postulates of neoclassical analysis. The time has come to abandon the Walrasian approach and all the different neoclassical interpretations of Keynes’s monetary analysis so as to get to the true origin of the anomalies that hamper the development of our economies.

Positive analysis sets the principles of the reform needed to fulfil the goal set by normative analysis, that is, the creation of an economic system free of any monetary pathology. The development of double-entry book-keeping – made possible by the discovery of negative numbers – is at the origin of bank money, and represents the cornerstone of today’s system of payments. Ricardo (1951-55) is among the economists who have mostly contributed to the understanding of bank money. It is to the Anglo-Portuguese economist, for example, that we owe the distinction between money creation and financial intermediation. Taking over Smith’s concepts of nominal and real money (Smith 1991), Ricardo was able to show that, whereas nominal money is literally created, real money (income) derives from production, which is why credit must be backed by a financial intermediation instead of being wrongly identified with money creation. Keynes’s monetary theory of production further contributed to improve monetary analysis, while bankers should be acknowledged the merit of radically ameliorating the workings of the monetary system by implementing an inter-bank clearing structure to settle inter-bank payments. What really matters is to provide a sound monetary structure in which money plays its role in conformity with its own (banking) nature.

Monetary disorders are caused by the present system of payments’ failure to comply with the logical rules of bank money. The macroeconomic approach to monetary economics is marked by the need to reconsider the role played by the structure of monetary payments in the process of capital accumulation. The time has come to shift attention from behavioural considerations to the working of the monetary structure underlying the whole economic activity. This does not mean, of course, that microeconomics has to be left behind. On the contrary, analyses referred to entrepreneurial decision and economic policy would continue to be elaborated in microeconomic terms. Yet, they would have to respect the logical framework represented by the laws of monetary macroeconomics. Economic agents should be totally free to make decisions, and microeconomic theory can help them towards choosing the most profitable ones. The absence of monetary disorders, however, does not depend on the nature of these decisions, but on the logical compliance of the system of payments with the laws of monetary macroeconomics. It is thus possible to tell apart the field that is proper to macroeconomics and that pertaining to microeconomic analysis. It is also possible to clarify the relationship existing between these two complementary approaches, and show that, contrary to a commonly-held belief, macroeconomics cannot be arrived at through the simple aggregation of microeconomic variables. Macroeconomics is a science in its own merits. It defines a set of logical rules with which the system of payments (national and international) must comply if monetary disorders are to be definitively avoided. Quantum monetary analysis deals with this specific point and shows that, at a national level, monetary disorders can be properly eradicated only through a reform of the banking system based on the structural distinction between monetary, financial, and fixed capital departments.


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