Economic Entropy



Courtesy of Professor Antal E Fekete @

Social Circulating Capital

When does a river cease to be a river? At the moment it gets within sight of the sea. As the river is descending to sea level significant and conspicuous changes occur. The salinity of the water increases sharply and, with it, the ecology changes. Water molecules lose their potential energy and their kinetic energy is converted to entropy.

Similarly, the flow of myriad goods from producer to market also undergoes a remarkable metamorphosis when it gets within sight of the consumer. Adam Smith was the first to notice this interesting phenomenon. He formulated the concept of social circulating capital. By this he meant the mass of finished or semi-finished consumer goods which has reached sufficient proximity and is moving sufficiently fast to the ultimate cash-paying consumer so that its destiny of being consumed presently can no longer be in doubt.

The analogy between the flow of goods to the final consumer and the river emptying into the ocean can be profitably extended to include economic entropy. The risks and uncertainties, so characteristic of processing in the earlier stages of production, all but disappear by the time the maturing goods become part and parcel of social circulating capital and sale at the going price can be taken for granted. Speculation and other forms of risk-taking give way to the highly predictable automatic processes of distribution. In particular, established retail prices do not normally change in response to changes in demand because of the increase in economic entropy, measuring the reduction of uncertainty and risk.


The vanishing of uncertainty and risk, the emergence of social circulating capital, and increase in economic entropy are manifested in a most dramatic fashion through the appearance of liquidity. To Adam Smith liquidity was tantamount to the spontaneous circulation of real bills that he observed in Manchester and Lancashire\. It refers to the qualitative difference between goods carried by the trade at virtually no risk in anticipation of sale to the final consumer at established prices, and other goods carried at considerable risk in anticipation of an eventual appreciation in value. Continue reading

The Wisdom of Adam Smith for our Own Times

Courtesy of Professor Antal E. Fekete @ Professor

─ A Rejoinder ─

Let us celebrate the 291st birthday of the great Scottish economist together and let us rehabilitate his Real Bills Doctrine!

Antal E. Fekete

New Austrian School of Economics

Richard Ebeling in the June 3rd issue of the Daily Bell under the same title contributed a much needed reminder of the relevance of Adam Smith’s wisdom to our contemporary world. I am not going to speculate whether the omission of not mentioning Adam Smith’s Real Bills Doctrine was accidental or deliberate. However, it is well known that post-Mises Austrian economists have taken a disdainful view of the Real Bills Doctrine and it would have been nice to have Ebeling’s coherent articulation of their position. I can do no better than revisiting Adam Smith’s great contribution to the theory of money and credit (which, significantly, received the nihil obstat of Carl Menger a hundred years later) for the benefit of the Daily Bell’s readership.

Consumption as a source of credit

Adam Smith’s insight that consumption, next to savings, is another fundamental source of credit was one of the great discoveries of economics, comparable in importance to Carl Menger’s subsequent discovery of marginal utility as the source of value. We owe the concept of social circulating capital (SCC) to Adam Smith. By this he meant that part of the flow of consumer goods in most urgent demand that is moving sufficiently fast to the ultimate consumer so that it will be removed from the market in 91 days (the length of the seasons of the year in our temperate zone). For example, items like bread, seasonal garments and firewood in winter will unquestionably be consumed in definite quantities and do thus belong to SCC; items like grain held for speculative gains, unsold garments left over from the previous season and firewood in summer do not. Producers and distributors handling goods that form part of the SCC enjoy special privileges and have special responsibilities due to the special place their product occupies in the constellation of economic goods. They don’t have to face uncertainties and don’t have to carry risks all other producers and distributors have to face and carry. They do not finance their production under the relatively harsh terms of the interest-rate regime. They can finance it under the relatively more lenient terms of the discount-rate regime.

SCC has been compared to a great river that empties into the infinite ocean of consumption. The salinity of water undergoes important changes downstream as the river gets within earshot of the ocean. Fish habitat prospering in these waters changes. Similarly, important changes occur in the type of credit financing production and distribution of goods downstream as the ultimate consumer is getting ready to remove them from the market in less than 91 days. In particular, the gold coin need not be saved in advance of production. Financing is done retroactively with the gold coin released by the ultimate consumer. Continue reading

Disequilibrium Analysis of Price Formation – Part 3


Courtesy of Professor Fekete @ NASOE:


In dismissing the supply/demand equilibrium theory we must explain price formation in the retail trade on the basis of disequilibrium principles. As we shall see, the adjustment mechanism works not on the prices of goods but on the marginal productivity of social circulating capital as measured by the discount rate. (We must sharply distinguish between the discount rate and the rate of interest. The former is regulated by the propensity to consume, the latter by the propensity to save. Either rate may move while the other is stationary; if both move, then they may move in the same or in the opposite direction.) An autonomous increase in demand for consumer goods has no inevitable effect on prices but will, instead, lower the discount rate. A lower discount rate is synonymous with an increase in social circulating capital, that is, the supply of consumer goods. In other words, an increase in demand automatically brings out an increase in supply; a decrease has the exact opposite effect. There is no such thing as an auto- nomous change of supply in the retail trade: supply is closely regulated by demand through the discount rate. The myriad of goods passing through the hands of the producers and distributors on its way to the market undergoes remarkable changes when it gets within sight of the consumer. The uncertainty and unpredict-ability characterizing production at the earlier stages disappear, as if by magic, and are replaced by increasing certainty and predictability to the effect that the goods will finally be removed from the market by the ultimate consumer. There is a dramatic reduction in the risks involved in handling merchandise as it enters the gravitation of consumption. This fundamental observation motivates the following concept.

Social circulating capital

That mass of provisions and finished or semi-finished goods which has reached sufficient proximity, and is moving sufficiently fast, to the ultimate cash-paying consumer so that its destiny of being consumed presently could no longer be in doubt, is called social circulating capital. It does not include semi-finished goods that will not reach the consumers within 91 days (the length of the seasons of the year). Nor does it include goods that are moving too slowly or not at all (e.g., a store of goods held in anticipation of a price rise; goods to be sold on an installment plan; specialty and collectors’ items, such as the surgeon’s knife or artwork, which may or may not find an ultimate buyer within 91 days). As we shall see, the volume and composition of social circulating capital is completely flexible. The dividing line between items that do or do not belong to it is subject to the change of the whim and fancy of the sovereign consumer on the shortest possible notice. Skipping ropes, as a rule, are not a part of social circulating capital — except during periods of skipping- epidemic among schoolgirls. Continue reading