The Evolution of Money

by David Orrell

  Furthermore, velocity varies across the economy, so the average may not be very informative—any more than the average wind speed in your country tells you about the local weather. The link between money supply and economic output is also spongy and complicated, as shown for Canada in the figure in box 7.1. By concentrating on high-powered money, the theory downplays the role of private bankers, who adjust their lending based on their predictions of the future. It sees private debt as just a temporary imbalance between debtors and creditors that cancels out in the aggregate, and has little to say about the credit crises that periodically emerge. Above all, like mainstream economics in general, it treats money as an inert placeholder rather than an active substance with its own dynamics. Monetarism is less a way of thinking about the behavior of money than a way to stop thinking about money by assuming it can be made stable.

  Box 7.1

  Moneyfication

  The literal meaning of “mortgage” is “death-pledge” or “death grip.” However, in the years following the financial crisis, this has not dissuaded borrowers in many countries from taking advantage of record-low interest rates to invest in real estate, driven by the promise of gains and a fear of being locked out of the market. In Canada, the government is heavily involved in this process, since apart from maintaining a relaxed monetary policy it also offers cheap mortgage insurance to banks, which means they can lend out more money. In 2008, it even instituted a program to buy mortgage securities that was similar in nature to the TARP in the United States but received much less public notice or debate.*

  All this lending led, as intended, to an unprecedented boom in prices. Houses have come to be so aligned with money—so moneyfied—that they are seen as investments (i.e., numbers) as much as homes (i.e., physical places with roofs); and the housing stock—with its graphite kitchen counters and renovated basement suites—has become a kind of physical representation of money supply. While selling mortgages is a profitable activity for banks, homes are unproductive assets, and the new lending appears to have contributed little to either velocity or inflation (the calculation of which excludes asset prices). The growth in money supply has therefore outpaced GDP, creating what looks like a dangerous credit bubble that leaves borrowers—and the economy as a whole—highly exposed to an economic shock or rise in interest rates (as graphically illustrated by the real estate decline in Alberta that started in late 2014, after the price of oil collapsed).† This is part of a wider phenomenon in advanced economies, in which credit creation tends to go not toward business investment but toward household consumption or (especially) real estate.‡

  This type of private debt has traditionally been viewed as benign by economists for a number of reasons. One is that, unlike public debt, it is driven more by market forces and so—according to theory—should self-regulate. Another reason is that the debt is backed by assets—what can be more “real” than real estate?—but this breaks down in a crash, when home prices fall but debt levels remain high. Debt is also seen as something that cancels out between borrowers and lenders, but this ignores the money creation role of banks: when a bank loans money, it gains a new asset on its books, so the net money creation is positive instead of canceling out. Finally, this view of debt ignores the asymmetry between lenders (banks) and borrowers (households). The latter may drive economic growth, but they can’t rely on bailouts when things go wrong.

  The growth of the money supply (solid line) in Canada, compared with credit and GDP (in trillions of Canadian dollars). Since 2005, the growth in the money supply has outpaced GDP (circles), even though inflation has been low, contrary to what one might expect from quantity theory. This growth is largely due to household lending, which as a fraction of GDP increased from 32 percent in 1971 to 90 percent by 2015. (Statistics Canada)

  *Hilliard MacBeth, When the Bubble Bursts: Surviving the Canadian Real Estate Crash. (Toronto: Dundurn, 2015), 90.

  †This increase in mortgage lending is symptomatic of a real estate bubble, according to David Orrell, “The Problem with Predictions,” World Finance, November 6, 2013.

  ‡Martin Wolf, “Hair of the Dog Risks a Bigger Hangover for Britain,” Financial Times, February 13, 2014.

  Animal Spirits

  An alternative to monetarism was provided by John Maynard Keynes, whose ideas were especially influential in the period following World War II and were back in vogue after the GFC. Keynes trained as a mathematician but was aware of the limitations of mathematical models and emphasized the importance of psychological factors in propelling the economy: most “decisions to do something positive,” he wrote, “can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”

  Keynes was also fond of pointing out the economy’s paradoxical qualities. These included the so-called paradox of thrift. During a recession, people save more and consume less. Rather than being used as a medium of exchange, the physical quality of money as a seemingly secure store of wealth reasserts itself. As John Law had earlier noted, people “hoard up those Signs of Transmission as a real Treasure, being induced to it by some Motive of Fear or Distrust.”14 While the act of saving seems sensible and even virtuous, the fact that no one is spending money has the effect of making the recession worse—in quantity theory terms, the velocity of money grinds to a halt. Monetary policy in itself cannot address this problem, since making money cheaper does not help if no one wants to borrow it. Keynes therefore argued that during recessions the government should actively intervene by spending money on public projects like railways or other infrastructure to boost consumption. In other words, fiscal policy is more important than monetary policy. (The IMF made similar recommendations in 2014 to boost growth in the eurozone.)

  Friedman complained that, as a result of Keynes’s influence, “It became a widely accepted view that money does not matter, or, at any rate, that it does not matter very much.”15 Indeed, Keynes seemed to treat money in a rather idealized manner, and again downplayed the power of financial intermediaries such as banks, and of money itself. In “Economic Possibilities for Our Grandchildren” (1930), for example, he wrote: “The love of money as a possession—as distinguished from the love of money as a means to the enjoyments and realities of life—will be recognised for what it is, a somewhat disgusting morbidity, one of those semi-criminal, semi-pathological propensities which one hands over with a shudder to the specialists in mental disease.”16 But could the Spanish lust for New World gold or phenomena such as financial bubbles really be put down to bizarre cases of psychological morbidity when they affect such a large proportion of the population? As Glyn Davies notes, “The Keynesians … tended to ignore or play down the importance of money, while the monetarists focused their monocular vision solely on the narrower ranges of money.”17

  A dissenting viewpoint was provided by the Austrian economist Friedrich Hayek, who was based at the London School of Economics and later the University of Chicago, and who argued that the economy was so complicated that the government should avoid dabbling in it altogether. “The curious task of economics,” he wrote, “is to demonstrate to men how little they really know about what they imagine they can design.” In his book The Denationalisation of Money, he argued that the state should give up its “age-old prerogative of monopolizing money”—which he described as “the source and root of all monetary evil”—and allow multiple private currencies to coexist. This would allow market forces to correct relative values in cases in which “the national monetary authorities misbehaved.”18 Today, when the vast majority of currency trading is purely speculative, we are concerned at least as much with the misbehavior of traders. An example was the recent scandal in which it turned out the London Interbank Offered Rate (LIBOR), used as a marker for interest rates, was being manipulated by a cartel of bankers.

  As discussed further later, other “heterodox” economi
sts offered a range of opinions about the role of money, but their contributions were marginalized, and mainstream economics in the mid-twentieth century solidified into a fairly unified approach with neoclassical theory and assumptions at its core. Keynesian ideas were amalgamated into the model by equations that attempted to relate quantities such as money supply, savings, investment, and so on into a single package. This approach was exemplified by Paul Samuelson, whose textbook Economics, first published in 1948, sold in the millions of copies to students all over the world and was translated into more than forty languages. Samuelson’s aim was to express the core economic theories in a self-consistent mathematical framework, based on the two related principles of maximization and equilibrium. Firms and individuals, he believed, act rationally to maximize utility, and this drives markets toward a stable equilibrium. The balance is perturbed only by occasional shocks, such as new technologies, and a steady background rate of economic growth. Again, money was not important to this analysis because “if we strip exchange down to its barest essentials and peel off the obscuring layer of money, we find that trade between individuals and nations largely boils down to barter.”19 (This did not stop Samuelson from exploring the properties of money in his academic work; for example, his “overlapping generations” model provided a theoretical argument for how money can serve as a store of value between generations.)20

  The English economist Joan Robinson famously called the neoclassical synthesis “bastard Keynesianism” because of the way in which it effectively neutered those ideas of Keynes that did not fit easily into the neoclassical mainstream—especially his emphasis on the type of uncertainty that resists mathematical quantification.21 Critics also noted that the preference for complicated mathematical models had a profound effect on the type of questions that economists addressed. Issues such as social justice or power relationships that had once concerned classical economists, but were hard to quantify, were dropped from the mainstream. The fact that money itself was left out of the model also made it less than useful for people like future Bank of England governor Mervyn King, who noted: “The basic New Keynesian model … lacks an account of financial intermediation, so money, credit and banking play no meaningful role. Those omissions obviously limit the ability of the model to help us understand the trade-offs between monetary policy and financial stability.” (As economist Steve Keen pointed out, the model is not really new Keynesian; it is better described as new Samuelsonian.)22

  Weaponized Theories

  Gold is valued because it is beautiful but also (being chemically inert) extremely stable and resistant to decay. The same might be said of mathematical equations, with their combination of strength and sterility. With its heavy emphasis on mathematics, neoclassical economics was seen as the gold standard of the field—and the Arrow–Debreu model, created by Kenneth Arrow and Gérard Debreu in the 1950s, was often called its jewel in the crown.23 This model was a mathematical description of an idealized economy, similar to that proposed by Walras in the nineteenth century, whose basic components are lists of goods, firms, and households. The model computed the total supply and demand for the available products at the specified prices. Money was not explicitly included because this was essentially a simulation of a barter economy, but one in which barter is perfectly efficient in the sense that buyers are always matched to sellers. There was no need for banks or loans or finance.

  The authors of the model managed to show that, under certain idealized conditions, the model economy had a stable fixed point that was optimal in the sense that nothing can be changed without making at least one person worse off. This finally appeared to justify both Walras’s assertion that idealized market economies would have a stable equilibrium and the idea going back to Adam Smith and before that the invisible hand would lead to an optimal arrangement of prices. It also had clear political implications. During the Cold War, a mathematical “proof” that the invisible hand of capitalism rather than the state fist of communism was the best guide to organizing society was a useful result.24 Like the Apollo space missions, which beat the Russian competition to the moon in another Cold War showdown, it seemed to show that the American model was supreme. The model may not have included power, but it certainly had power.

  The Arrow–Debreu model was in fact funded by grants from the Office of Naval Research, and the authors had also worked at the Pentagon-affiliated consultancy firm Rand.25 During this period, the Department of Defense was pumping funds into all kinds of scientific programs in an attempt to gain technological supremacy over its Soviet rival, and one of these recipients was the subject of mathematical economics. In 1965, Rand created a fellowship program in economics at the following institutions: Harvard, Stanford, Yale, University of Chicago, Columbia, Princeton, and University of California. Ever since, these institutions, along with MIT, have tended to dominate battles for funding, publication, and deciding what constitutes “good economics.”26 Economic theory became an intellectual tool of American might that—coupled with the need for countries to obtain dollars to pay for oil, and therefore open their markets—helped U.S. corporations gain unfettered access to world markets, all without the need (mostly) for military conquest.27

  Of course, it was not just the military that subsidized the development of mainstream economics. The primary lesson of neoclassical economics is that markets set prices correctly—which is very attractive for the portion of society that controls most of the wealth, including banks. Frederick Soddy observed in 1934 that “orthodox economics has never yet been anything but the class economics of the owners of debts.”28 Such work doesn’t need to be funded directly, but can be favored and promoted in all kinds of ways—which may explain why Adam Smith’s theories, which extol the self-regulatory properties of free markets while ignoring the role of money, have proved so popular over the years. The close connection between Wall Street firms and university economics departments was more recently documented in the film Inside Job (2010).

  Superrational

  The Arrow–Debreu model was impressive because it managed to prove its conclusions using only a minimalistic set of assumptions. Unfortunately, these assumptions included not only things like rational utility-maximizing behavior, negligible transaction costs, money-free trade, and so on, but an even more demanding requirement: everyone in the economy had to compile a list of all the available future states of the world and figure out the prices in all of those worlds. This was of course highly unrealistic, since the future is completely uncertain and we all have different ideas about what will happen.

  One might imagine that such unrealistic requirements would have led to the abandonment of equilibrium theory, but instead the opposite happened: the idea that market forces drove the economy to an optimal equilibrium became increasingly well entrenched as the main result of neoclassical economics. This equilibrium approach was exemplified by the Chicago school of economics, based at the University of Chicago. The group, which was headed by Milton Friedman, became famous for its free-market ideology, opposition to taxes, and a confidence in the ability of markets to self-regulate their way to optimal efficiency. As Gary Becker wrote in his book The Economic Approach to Human Behavior: “The combined assumptions of maximizing behavior, market equilibrium, and stable preferences, used relentlessly and consistently form the heart of the economic approach.”29 Friedman and Becker’s colleague Robert Lucas pushed the idea of rational economic man to its limits with his theory of rational expectations, which says that people are not just rational but also have a perfect mental model of the economy in the sense that they don’t make systematic errors. Markets have to be at equilibrium, because disequilibrium can be caused only by irrational behavior. If people are unemployed, it is not because they are the victims of circumstances, but because they have rationally chosen not to work at available wages.

  This Chicago school model was soon being rolled out to countries around the world from Chile to South Africa. Even today, tools developed by neoclassical e
conomists remain the gold standard, especially in the realm of macroeconomics. For example, policy makers continue to rely on so-called dynamic stochastic general equilibrium (DSGE) models, which are similar in design to the Arrow–Debreu model but incorporate shocks to equilibrium to assess how a change in government policy will affect the economy. As the Bank of England’s Andrew Haldane observes, these models enjoy a number of “aesthetically beautiful properties.” In particular, they typically encode an equilibrium that is “unique, stationary and efficient,” a view of the economy that is “ordered and rational,” and result in dynamics that are “classically Newtonian, resembling the damped harmonic motion of Newton’s pendulum.” Unfortunately, as we have argued elsewhere, this “simple and beautiful” elegance comes at the expense of realism.30

  In particular, as former deputy governor of the Bank of Canada William White points out, “An important practical aspect of [DSGE] models is that they make no reference to money or credit, and they have no financial sector.”31 The model used by the Bank of England to simulate the economy before the recent banking crisis, for example, had the singular disadvantage of not including banks. In fact, as White observes, “such crises were literally ruled out in DSGE models by the assumption of self-stabilization.”32 The result, according to Haldane, is that DSGE models “have failed to make sense of the sorts of extreme macro-economic events, such as crises, recessions and depressions, which matter most to society.”

  Intrinsic Value II

  For most scientists, the acid test of a theory is not its mathematical elegance but its ability to make accurate predictions. Newtonian physics has been deemed a success because it can predict things like the course of a spaceship. In contrast, the predictive ability of general equilibrium models has been shown to be little better than random guessing.33 Forecasts of important indicators such as GDP or oil prices are routinely made, and routinely miss. In the words of economist Alan Kirman: “Almost no one contests the poor predictive performance of economic theory. The justifications given are many, but the conclusion is not even the subject of debate.”34 So how did economics manage to avoid this test? The answer was a theory that said markets were inherently unpredictable—not so much because they were too complex or messy, but because they were too perfect.