Reinventing liberal economics

CooperIn a recent post I expressed frustration that conventional economics seems to have survived the meltdown of 2008 almost unscathed, as evidenced the chatter around the discussion of monetary policy. I mentioned one book, George Cooper’s Money, Blood and Revolution, that sought challenge it. On the strength of that the publisher sent me a review copy – and I have read it. It is interesting because the paradigm shift Mr Cooper advocates gives coherence to the idea of liberal economics, after its original conception turned out to mean libertarian economics.

Mr Cooper’s main thesis is that economics is a science that is in crisis (as opposed to the alternative view that it should not be considered scientific at all). He compares it to four specific cases of sciences in crisis: astronomy before Copernicus, anatomy before William Harvey established the principles of blood circulation, biology before Darwin/Wallace’s idea of evolution by natural selection; and geology before the acceptance of continental drift. Nearly a third of the book is devoted to developing this idea, before he gets to the discipline of economics itself.

The geology example is close to my heart. My father is a geologist, and I studied it at my first stint at university, at Cambridge in 1976-78 (I studied History in my final year – another story). My father had accepted the idea of continental drift – the notion that the continents are moving across the surface of the earth – by the 1960s, before the scientific establishment completely accepted it. By 1976 the idea of plate tectonics was conventional wisdom, and continental drift was treated as an obvious fact. What had made the difference (actually not mentioned by Mr Cooper) is that mapping of the ocean floor showed that the oceans were spreading, neatly illustrated by stripes of different magnetic polarity, following reversals in the earth’s magnetic field when the ocean crust was formed. It was new, killer evidence.  Mr Cooper rather suggests that it was looking at existing evidence in a new way that led to the revolution. But that is a minor quibble – there was growing opinion behind the continental drift idea before the oceanographic evidence emerged.

The book is not a heavy read. It is less than 200 pages and it goes at quite a clip. It is well written, apart from a couple of quibbles. He uses the word “experimental” in place of “empirical” for real-world evidence. Perhaps his publisher advised him it was more accessible, but in my book experimental means carrying out experiments. There is a branch of experimental economics, but it is tiny. Empirical evidence in economics is gleaned from examining the shape of the real world, only rarely with controlled studies – a bit like astronomy, geology and evolutionary biology, in fact. His use of “principle” when he means “principal” looks accidental but I counted two instances.

This lightness of touch has advantages and disadvantages. It will help him with general readers; it will leave professionals picking holes. His focus is on the former since he judges that the demand for a paradigm shift is likely to be strongest from those outside the discipline. But we still need people in the discipline to flesh out the new ideas.

Moving on from the idea of scientific revolutions, Mr Cooper then explores the state of current economics, describing all the main schools of thought, each with ideas incompatible with others. I found this section illuminating and enjoyable. He could perhaps have brought out more the capacity for professional economists to engage in double-think – for the same people to hold incompatible ideas in their own heads, never mind the presence of warring factions who look on the same facts in different ways.

But Mr Cooper rightly says that it is not enough to prove the existing ideas wrong; you have to replace them with new ideas that work better. He outlines a new system of thought, based on two new concepts: competition and circulation of wealth.

Economists have much to say about competition, but it turns out that what they mean by the word is an artificial, anaemic version of the concept, operating within tightly constrained rules, where the object is to maximise individual welfare. The real human competition that drives human behaviour is about survival and status; it is about getting ahead of the other guy and staying there. Crucially it is about relative position and not absolute wealth. If competitive behaviour dominates, then human society will tend to stratify into a feudal system with a hereditary elite maintaining its dominance by force. Since such feudal societies are very common, including in newly developed social systems like that of North Korea, it is clear that such competition often dominant. It undermines the idea of libertarianism, which advocates minimal government and regulation, since these last two are required to counteract the tendency to feudalism.

Cooper’s second idea, that of circulation, stems from the observation that feudal societies are economically inefficient (look at North Korea again). Once the ruling elite have secured their status, they hold the rest of society in a static position so as not to present a threat. Economies are drained of vitality because the poor have no spending money, and the elite tend to hoard their wealth rather than spread it around. Democratic societies, on the other hand, have developed institutions, like progressive taxation, universal welfare and so on that recycle wealth from the wealthy to the rest, and competitive elections that ensure that political elites are recycled too. This creates a productive tension. Competition gives people the motivation to build successful businesses (and political careers) and innovate; governments recycle the wealth thus generated to prevent it from stifling the system.

This is a very liberal view. The right sees only a limited role for government and taxes, and does not accept that the presence of a very wealthy elite stifles the wellbeing of society. The left thinks that competition is destructive and tries to stifle it through excessive government. Liberals understand that people must be free to compete, but that government institutions are required to prevent all the power accumulating to the wealthy.

What does that mean in policy terms? Mr Cooper is particularly critical of the idea of monetarism – the management of the economy through regulating money and credit in the economy as a whole. He thinks this idea is largely to blame for the crisis, and it won’t help us out of it. The extra spending power it creates goes to the wrong people, i.e. the very wealthy. They either let the new cash fester unspent, or use it to create an asset bubble. Spending power needs to go the other end of society, which means Keynesian stimulus, focusing especially on productive investment. This sounds quite sensible. I am personally deeply sceptical of monetarism, though I don’t take the argument quite as far as Mr Cooper does.

How to take this new paradigm forward? It is starting to happen. Politicians and economists are talking a lot more about the distribution of wealth; this needs to be put back at the heart of macroeconomics – as it was two centuries ago with the ideas of Thomas Malthus. The publication of and interest generated by Thomas Piketty’s Capital in the 21st Century is big step in the right direction. This adds a lot of flesh to the high level analysis, and may provide the first evidence of magnetic stripes on the ocean floor.

But there is a problem at the heart of economics which Mr Cooper barely considers, and which has to fixed. It is the public’s insatiable desire for economic forecasts, both to gauge the general economic weather, and to answer what-if scenarios (such as global warming). So far the only practical way of delivering these is through the use of neoclassical models using the ideas of independent, rational agents, optimising behaviour and equilibrium. The whole infrastructure of these ideas has to be taught to economics students to satisfy this demand. It is no use just saying that forecasting is going to be more difficult. If the discipline is to be regarded as a science, then new methods must be developed. I suspect that economics has much to learn from weather forecasting – another system that is never allowed to achieve equilibrium. Weather forecasts require very big computers which are able to model complex interactions between many component parts. Work is needed on something similar – massive multi-agent models, using insights into real human behaviour.

Beyond that, I would like to see ideas on human behaviour, such as tendencies to cooperation and competition, developed in a much more realistic and nuanced context, harnessing the disciplines of anthropology, sociology and psychology – replacing the rather crude Darwinism that Mr Cooper advances.

That said, liberals everywhere should take Mr Cooper’s ideas seriously.

 

The glorious irrelevance of Paul Krugman

The economic crisis that started in 2007 exposed deep flaws in conventional macroeconomics. This was wonderfully exposed by Adair Turner, as I have posted before. But many of the macroeconomics’s big beasts seem to plough on regardless. Most shameless of these is Nobel Laureate and New York Times columnist Paul Krugman. This has become apparent in the latest kerfuffle to take the world of macroeconomists: the idea of “secular stagnation”.

This can get very technical very quickly (indeed the technicality of it is something of a hiding place), and I will try to spare my readers of these technical details. The idea of secular stagnation that is the natural rate of interest in many developed economies is less than zero, and has been for some time; since about 2003 according to some, or the 1990s to others. The natural rate of interest is that which is required to balance the supply of savings with their consumption in investment projects. If this rate is negative, then actual interest rates are doomed to be above this rate, and hence not enough investment happens. And because of this, growth rates are dragged down to stagnation levels, while the surplus savings are pumped into assets, creating bubbles, or else excessive debt-fuelled consumption occurs. If you want to read more about there is this excellent article by Gavyn Davies in the FT. This is behind the FT paywall. More accessible in is the speech by Larry Summers, another big beast of old macroeconomics, that set the whole fuss off, which is on YouTube. Unfortunately this takes quite a bit of reading between the lines to understand its implications. And then there is Mr Krugman, who weighs in after the speech with this blog post. This much the most accessible article in all senses – Mr Krugman is one of the best people at explaining economics ideas there is.

Mr Krugman says that his idea encapsulates what he has being saying or feeling for years; and having read him for years, I have no reason to doubt him on that. mr Krugman’s main interest is in an  old battle: that between his own liberal-inclined system of “Neo-Keynesian” theory, and the “Neo-Classical” approach favoured by conservatives. To him the crisis and its aftermath simply proves that the Neo-Classicists were wrong. He is right there, but that’s a very old story.

The interesting point is that neo-Keynesianism failed too. It failed for two main reasons. First was that it ignored the implications of the financial system, and levels of debt, in particular. And second it stuck to a theory of money and monetary policy that had barely moved on from the days when most transactions were settled in notes and coins. This blinded them to the scale of the crisis that was building, and blinds them still to the effectiveness of different policy options. In particular they place too much faith in the usefulness of a loose monetary policy, and an obsession with the rate of inflation. Their support for loose fiscal policy is much better grounded. There is not a hint of these problems in Mr Krugman’s writing.

There is something very striking about Mr Krugman’s article. He doesn’t seem that bothered about the forces that driving the economic statistics. There is a bit of speculation that it is something to do with an aging population, but no attempt to get behind the implications of this. Instead he obsesses with good old-fashioned fiscal and monetary policy: the idea being that we need to fix short term problems, and that the more fundamental, structural issues, such as inequality, finance and the efficiency of government, can be fixed in due course later. His signature policy idea is that the rate of inflation should be raised deliberately so that negative real interest rates can rise, which will then help the economy back to growth. Mr Krugman has long advocated just such a policy for Japan and feels entirely vindicated that the Japanese Prime Minister Shinzo Abe is now following his advice.

This insouciance towards the details of what is happening to economies is quite wrong-headed, though. He is right that growth rates in the developed world are stagnating, and that this problem dates back to well before the crisis of 2007. But we need to have a better idea of why. If it is for fundamental reasons, such as demographics and the changed nature of technological innovation, what is the point trying to take the economy to a place that it cannot go sustainably? And surely policy solutions must be sensitive to the complexities of an evolving economy? If labour markets work in a very different way, thanks to technological change and globalisation, then the old assumptions about inflation could be wrong. We are in danger of misreading the implications of a low inflation rate, and policies designed to increase its level could have malign effects. In Japan, employers are refusing to raise wages in the face of increased inflation expectations, so Mr Abe’s policy is starting to unravel.

Mr Krugman comes through as gloriously irrelevant to modern policymakers. Right some of the time, wrong on other occasions, and with nothing to say on many crucial questions, his ideas are so disconnected from the realities of the modern economy that they have become quite useless. Macroeconomics needs to learn and move on. The likes of Mr Krugman and Mr Summers should either embrace new ideas or bow out.

 

The Twitter launch tells you all you need to know about financial markets

Yesterday Twitter launched itself onto the financial markets by offering a small proportion of its share for sale. The company sold them for $26 each. By the close of the day they were being sold for $44; during the day they had been even higher. Last week The Economist carried out a sober assessment of what they thought the shares were worth. They thought that investors should not pay more than $18. So what is going on?

No new information was revealed last week that might raise the share valuations. Instead we get a lot candyfloss arguments about why investors should buy the shares: arguments that taste sweet but disappear as soon as you try to digest them. There is talk of growth potential and strategic value – but studious avoidance of how much these are already built into the price. For those of us brought up to believe that share values reflect the discounted value of future cash flows this sobering. But serious money is behind the price movements. Who is buying at these stupid prices?

The answer is that people are buying because they think they will increase in value in the short term, and that they can sell out at a profit before any trouble starts. They are not watching long term value; they are watching the other guy. This logic may make some sense for an individual investor (or perhaps more correctly “trader”), but collectively it is madness. It simply leads to asset price bubbles. And there is a lot of it about.

This leads to a massive source of instability at the heart of the world’s financial system. But what to do about it? The first thing to say is that the world’s central bankers should stop treating asset price bubbles as a minor aberration of the system whose damaging effects can be contained. They are the big deal: a more important source of instability than the consumer price inflation that they still tend to focus on. Such policies as quantitative easing should be assessed in that light.

You can’t and shouldn’t stop people speculating on financial assets with their own money. Ultimately this leads to more realistic prices. What fuels bubbles is when people speculate with other people’s money: “leverage” in the jargon. Banks and financial institutions should lend money for proper investment projects, and a modest amount for purchases of existing property for people to live in or use productively. They should not be lending to speculators. Since 2008 people are more aware of the dangers. Alas we have a long, long way to go.

Monetary policy is a useless collective noun

At the time of the financial crisis of 2007 and 2008 it was commonplace to say that modern economics, especailly the macroeconomic variety, was in crisis, and needed a fundamental rethink. Alas, the vested interests of established economists have prevailed. Very little rethinking has occured, and this mainly tweaking rather than anything big. This is most striking in the area of monetary policy. The debates now going on in Japan and Britain remind me of the academic papers and discussions that I read about while an economics undergraduate at UCL in 2005-08. Circumstances have changed (in Britain anyway) but not the economics.

Economists of complain that amateurs are guilty of the fallacy of composition: to assume that was is true for a household, say, is also true of all households grouped together in a single economy. It may sensible for a single household to save more of its income to repay debt: but if a whole economy tries this at once, it could be disastrous. But economists are guilty of their own fallacy, though one for which I have not found a commonly used name. I will call it the fallacy of collective nouns. It is idea that by collecting together a group of disparate elements and giving them a name, that you have created a new entity that allows you to ignore its component parts. Most macroeconomic concepts are such collective concepts: GDP, inflation, and so on. Such collectives are useful only up to a point, and then you have you have to look at their component elements. And yet most macroeconomists, even very intelligent and distinguished ones, can’t bear to let go of their collective concepts and carry on using them long after their usefulness has ceased.

This is clearly the case with the idea called “monetary policy”. The conventional idea is that an economy has something called a “money supply”, which can be manipulated through policy instruments under the control of a central bank. In turn this money supply affects the behaviour of the people that form the economy with fairly predictable effects on things like consumer prices,wages, investment and output. All of this is very questionable in a modern economy. It is much more helpful to think of the particular components of “monetary policy”: central bank interest rates, state purchases of its own and other bonds, bank regulation, and so forth, and how these affect the various parts of the economy acting through the financial markets.

The conventional economic thinking runs something like this: the economy (Britain and Japan in particular) is stagnating with relatively low levels of inflation, but high or rapidly rising levels of government debt. In order to pay back this government debt you need to break out of the stagnation and grow, or (whisper it) let inflation make the debt more affordable. To do this you need to “loosen” monetary policy and increase the supply of money. With more money in their pockets, people go out and spend more, leading either to growth or inflation. To do this the central bank lowers interest rates, and where this does not work, use other measures like Quantitative Easing. Cue lots of debate about the relevance of inflation targeting and its alternatives (nominal GDP targets for example), all well within the comfort zones of economists.

There are very many problems associated with this line of reasoning. It is far from clear what money is. However it is clear that commercial bank accounts form the most important part of it, and this is a function of commercial bank policies, not those of a central bank, whose influence is increasingly marginal. It isn’t clear that large bank balances lead to increased spending, least of all on constructive economic things like consumption or proper investment (as opposed to chasing up the value of assets in fixed supply). Rising prices do not necessarily make debt more affordable: that requires rising income for the people holding the debt. And it goes on.

All the verbiage around “monetary policy” is clouding the issue. There are two problems being faced the British and Japanese economies: weak output and excessive debt. Weak output in turn has two components: using spare capacity (i.e. that created simply because of slow demand) and strucural problems. In Britain there is a big argument about how much of the problem is spare capacity and how much is structural. If it is largely spare capacity then simple macroeconomic solutions may have merit: you just need to boost confidence a bit to lift demand. But even here it is not self evident that any of the loose money policies will be much help. In Japan there seems to be even less spare capacity.

I can’t help thinking that what policy makers really mean by “loose monetary policy” is higher wages. Increasing consumer spending power through increasing wages will lift confidence, and even if it is not based on increased productivity, it will make debts easier to pay off, including public debt through higher tax revenues. This lurks behind a lot of the talk about greater tolerance for inflation. But in Britain we have the wrong sort of inflation: rising import costs through a lower pound, and increased government charges. This really isn’t helping. If policymakers want higher pay it would be better to throw away the weasel talk about loose money, and talk about pay. There is some evidence for that in Japan, but this only serves to show how difficult the policy is in practice.

The Japanese government also deserves some credit for the fact that it is not advocating looser monetary policy by itself, though you wouldn’t guess that from much of the coverage here. It is one of three prongs, the other two being fiscal stimulus and structural reform. There is plenty of scope for structural reform in Japan, and this gives their economic policy some hope for ultimate success if they follow it through. But it is the prospect of quick and easy solutions through fiscal and monetary policy that is exciting people.

In Britain a chronic trade deficit shows major structural problems, no doubt partly as a result of reduced North Sea oil. This requires the economy to be producing different things, not just more all round. Loose talk using economic collective nouns is making this harder to see and address.

David Graeber’s Debt the First 5,000 years – the emperor has no clothes

Graeber DebtOne of the books I received for Christmas was David Graeber’s Debt, the First 5,000 Years. Mr Graeber is an American anthropologist, now working at Goldsmiths in London, who has been active in the anti-capitalist Occupy movement, and describes himself as an anarchist. The book promises to give some intellectual heft to the anti-capitalist case, by examining the origins and history of debt and money, and how we need to rethink it. So far so good. But after the book promised so much at the beginning, I can hardly contain my disappointment with its limp ending.

The book starts well enough. He immediately focuses on modern economics’s weakest point: the theory of debt and money. He may labour the nonsense of the economist’s creation myth of a barter a economy a bit too much: economists aren’t really interested in history after all. But economists’ confusion over the role and meaning of money is evident; personally I wouldn’t use the barter myth to illustrate this, but the way economists still talk about printing preses and helicopter drops when trying to explain monetary policy. Mr Graeber runs his hand across the soft underbelly of economics, but then, instead going in for the kill, he throws away the knife. He rejects the whole, quantitative, mathematical language of economics. He thinks that the discipline’s attempt to preserve moral neutrality is in fact condoning immorality and violence. Like it or not, numbers and mathematics are central to our society’s workings, and rejecting these tools out of hand leaves Mr Graeber’s arguments with very little purchase.

The full, awful implications of this are not immediately clear, however. Mr Graeber puts the question of money and debt into an anthropological context, and this is a good read. I found his categorisation of human interactions into three types very illuminating. These types are exchange, what he calls “communism” and hierarchical. The exchange relationship is the typical arms length commercial one: one item is exchanged for another, typically money, and there are no further implications for the relationship between the parties; it ends with the transaction. A communistic (or perhaps communal would be a less provocative word) transaction is typical of close communities: transactions aren’t exchanges, those who are able give to those who are in need, all a part of a wider, long term relationship. Relationship is also key to hierarchical transactions, but it is one of authority. A lower individual pays tribute to a higher one, while the higher one may cast beneficence to those beneath. Mr Graeber is careful to say that none of these is inherently superior to the others, and any society needs to use all three. But he complains that the modern world puts exchange relationships on a pedestal at the cost of communistic ones, costing the quality of human relationships.

All this leads into a broad historical narrative – the 5,000 years – of the Eurasian continent. Originally money develops as a credit relationship, and is not seen as a thing in itself: its accounting function is the critical element, and it is woven into the fabric of society, based on trust. But then the idea of precious metals, gold and silver in particular, becoming money in its own right rapidly took hold across the entire continent. The effect, in his telling, was malign. Money existed independently of states and relationships. Soldiers could loot money from one place as they destroyed it and spend the proceeds elsewhere. It facilitated both the running of armies and trading of slaves. Sinister, cynical empires came to dominate the world in Europe, India and China in the centuries before and after Christ.

These empires then broke down (or changed nature in China) as precious metal (bullion) money was drained from the system. In Mr Graeber’s telling this has much to do with the new world religions (Christianity, Islam and Buddhism) in what he calls the Middle Ages. His account is admirably even handed in its geography, rather than the customary focus on Europe. In this age Europe is a barbaric offshoot from the civilised worlds of the Middle East and China. Credit becomes central to commerce, which operates independently of the state, and is based on trust. This is something of a golden age to Mr Graeber, though not the European end.

This unravels in the Renaissance, with the Europeans leading the way. Gold and silver is looted in America and then traded with the Chinese. An age of violence and destruction is born, as trust is no longer required in trade and commerce.  Then, in the 17th and 18th centuries the malign instruments of modern finance, bonds and shares, are invented in order to fuel society’s appetite for war. Meanwhile, the slave trade takes off, destroying African society amongst other victims. An age often portrayed by western historians as one of progress, Mr Graeber portrays as one of a descent into destruction. This is deliberately provocative, but he has a point: this is an age of war, colonialism and slavery.

And it is here, as the industrial revolution begins, that Mr Graeber’s account runs out of steam. All the building blocks for capitalist society are in place, and its evil roots clear; he almost says “and the rest is history”. He swiftly moves on to his final chapter, where a new era begins with the collapse of the Bretton Woods system, and with the inevitable collapse of capitalism in its wake. I was expecting to read an account of the era of economic growth, but there’s practically nothing there. And the awful truth dawns. Up to this point I had been giving Mr Graeber the benefit of the doubt, for all his provocations. But the emperor has no clothes. When it comes to describing the modern world he is utterly out of his depth and as a result anything of consequence he has to say (and there are some) seems a matter of random chance. An example is his idea that the purchase of US Treasury securities, which will always be rolled over rather than repaid, is in fact paying tribute to the primary military power. the USA. He spots a problem with this account: the Chinese are amongst the largest buyers, and they are power rivals. He then has to concoct a story that this is part of a long term Chinese game. This is really very silly. The Chinese are buying US Treasury stock because they are running a big trade surplus and there is nowhere else for its surplus dollars to go; the power transfer implied is minimal; but the trade surplus is an important element of the Chinese development strategy, which involves building up production in advance of consumption, and in the great scheme of things the dollar surplus isn’t that important to them; it’s only money – if they lost the lot in a crash tomorrow, how much does it really matter? The Chinese seem to have grasped Mr Graeber’s message about money rather better than he has himself. Mr Graeber’s lack of economic literacy has him floundering to comprehend what is happening around him.

His thesis is that modern capitalism is a typical bullion economy based on power and violence, and the absence of trust, with exchange and hierarchical transactions driving all else out. Most people in developed economies are little better than slaves, tied to their employers and struggling to pay off debt. Debt is used to enslave people. But this system is fundamentally unstable and is in the process of collapsing.

But after the emperor-has-no-clothes moment there is no aspect of Mr Graeber’s thesis that doesn’t look questionable. Is is really true to say that capitalist transactions are based on the ultimate sanction of force, and not on trust? Is it not trust that distinguishes advanced capitalism in say, Denmark, from the less developed versions in Russia and China?

And he misses the whole issue of growth. This process, driven mainly by increased productivity, has improved the lives of countless millions – and is genuinely popular with most people in both the developed and developing world. It is by no means evident that today’s workers can be compared to Roman and African slaves. And debt has played a critcal role in lubricating this growth process, by allowing investment: payment now for a later gain. The whole culture of investment is omitted from Mr Graeber’s analysis: debt for him has but one purpose: to enslave the debtor by forcing him to make a promise he cannot keep.

Mr Graeber’s failure is underlined by the absence of any practical ideas about how the world should change to make it better. His only idea is a Jubilee: a systematic forgiveness of debt. But he hasn’t thought about the social chaos that would result as all savings were wiped out. The modern way of doing a Jubilee is called hyperinflation. It is hardly evident that the phenomenon that created Nazism is necessarily helpful to the development of society and the empowerment of the poor.

Is there anything to be retrieved from Mr Graeber’s spectacular collapse when confronted with the modern economy? He happens to be right about an awful lot of things. Money is best regarded as an abstract concept, a social invention without underlying reality. Debt also is a social convention that can outlive its usefulness, and should not be treated as sacred promise. The exchange method should not be idealised as model for all life, as Chicago School economists do. And economic growth in the developed world does seem to have hit natural limits, whose consequences we still don’t understand. Capitalism may indeed collapse if it continues in its current form.

But the answer is not to condemn capitalism as the work of Satan, and hope for something better to turn up. Mr Graeber’s work is pure antithesis. Progress is made by synthesis: by taking capitalism and making it better. And you can’t do that by rejecting the discipline of economics, for all its manifest faults.

The meaninglessness of “money supply”

Where are modern economists most at sea?  Some may think it is their over-reliance on GDP to represent the welfare of an economy.  But economists are quite comfortable with the theory of all that, even if they often fail to put it into practice.  No, the real problem is money supply.  It used to be a central concept, but now it is useless.

Economistsused to be very confident about it all, even while I was taking my Economics degree in the mid 2000s.  Their ideas had been developed most famously by Milton Friedman, the 100th anniversary of whose birth is being celebrated this year.  He was the first to say that managing the money supply was a critical part of managing an economy as a whole.  He was an iconoclast at first but gradually the idea became conventional wisdom.

The imagery that economists used to explain money’s role was endearingly folksy but also revealing.  Money was explained in terms of dollar bills or pound notes.  To increase the supply of money, a central bank simply printed more of it.  The role in macroeconomic policy of increasing money supply was often talked of in terms of a helicopter drop of bundles of banknotes.  If an economy was suffering from unemployment, then people would rush out of their homes, grab the cash dropped by the helicopter, spend it, and soon the unemployed would be back in work with no harm done!  (Of course if there was no unemployment, people would spend the new money, but the result would be inflation).  Friedman thought that the Great Depression of the 1930s could be simply explained by a lack of money (banks kept on going bust), and not a lack of government expenditure.

But it’s obvious to everybody that cash plays a very small role in a modern economy.  The money we spend is in bank accounts, and often spent via credit cards; pound notes just don’t come into it.  But economic theory hasn’t caught up.  It is simply assumed that modern money could be managed by a central bank in an analogous way to printing banknotes.  A couple of theories were used to justify this.  First was an idea of a “monetary base” of deposits held by commercial banks at the central bank, which limited the amount of money these banks could supply to their customers, but this clearly did not reflect reality.  A more enduring theory was based on the central bank controlling money supply through the interest rates it set on the deposit, and influenced through “open market operations”.  Raise interest rates  and money supply would fall as people moved money into interest bearing securities.  This seemed to work – though it was hard to reconcile it to the complexities of what was actually going on – the line between non-interest bearing “money” and interest-bearing securities being hardly a firm one.  There was no no better idea, though, and an elaborate macroeconomic theory was constructed on the back of of it.

Two ideas were central to this theory.  First that people responded to an increase money supply by spending more (or a decrease by spending less), and second that the money supply could be controlled centrally.  If an economy was suffering from a lack of demand, you could correct this by loosening the money supply, as an alternative to fiscal policy – increasing government spending or reducing taxes.  This was irrestiable to the polical right, who hated the idea of using taxes and public spending to manage the business cycle – since this raised the size of the state sector.

But the idea is now in tatters, though some economists don’t seem to realise it, especially those of an amateur sort, which unfortunately seems to include the UK Chancellor of the Exchequer, George Osborne.  Both assumptions are problematic.  First, do people respond to an increased money supply by spending more?  What if, in the banknotes in the helicopter example, people are so frightened about the future that they simply grab the banknotes and stuff them into their mattresses?  There is no extra spending, and no effect on unemployment.  This is an old challenge.  Maynard Keynes talked of increasing money supply in a recession as “pushing against a string”.  With money now a much more complex thing held in bank accounts, this problem is worse.  It can be quite rational to leave money in a bank account without wanting to spend it – especially when interest rates are low.

That could be used to explain why very loose money policy by central banks in the developed economies currently has had so little effect, which is indeed what people like the US economist Paul Krugman are saying.  But in fact money supply itself does not seem to be responding to the central banks’ wishes.  It has been shrinking even as interest rates fall.  This causes certain commentators angst – pleading for central banks to loosen policy yet further.

But how is money actually created?  Apart from notes and coins it is mainly created by commercial banks.  They do so by advancing their customers money.  If you borrow £1,000 from your bank, the bank simply adds the money to your current account, increasing the overall money supply, and the bank puts a loan on the asset side of its balance sheet.  No central bank or other authority plays any role in this.  And if banks decide to cut back their lending, money supply shrinks.  What counts is not money supply but credit.

Governments and central banks can use the creation or withdrawal of money to wreck an economy, as Zimbabwe has done, but not to fine tune it.  The sensation of doing so in the 1990s and early 2000s was in fact an illusion.  What actually counts is mood and the supply of credit.  Movements in the money supply follow what is going on in the economy at large rather than lead it.

There is in fact no alternative for policy makers but to get their hands dirty in the detailed workings of the banking system as a whole, rather than simply adjust central bank interest rates.  As the world’s banking crisis continues to rumble on, nobody argues with this – but there is a distinct air of crisis management and an absence of strategy.

What people in practice mean by “monetary policy” is series of policy interventions, such central bank interest rates, bank regulation, managing government debt, credit policy, exchange rate interventions, and so on.  Each of these interventions has its impact – but it is disinctly unhelpful to view this impact in terms of any concept called “money supply”.

But we are left with a theoretical vacuum in economics.  We know credit and banking are important parts of an economy, and critical to an understanding of the business cycle.  But how on earth to manage them?  Giving commercial banks free reign subject to a few central bank interventions does not look a good idea any more.

Time to rethink the Bank of England

It seemed a great idea at the time.  Independent central bankers managing our economy on a strictly technical basis, preventing politicians from mis-managing it for short-term ends.  Alas, even if this was not an illusion then, it surely is now.  Central bankers across the world are becoming politically controversial.  Meanwhile their policy decisions, be they changes to the interest rates under their control or buying bonds (“quantitative easing” – QE), either have no effect on the real economy or do not have the effect intended.  But the recent coverage of the Bank of England’s latest interest rate decision shows than most observers are still stuck in the old narrative.  The present system is obsolete; the real question is what the Bank’s role should now be.

Monetary policy, as now conceived, arose in the 1980s, after confidence in economic policy collapsed, amid a toxic combination of high inflation and high unemployment in most countries.  Out of this wreckage came the idea that the economy at large responded to changes in the money supply, which influenced the decisions people made in output and employment, and in prices and wages.  By managing the money supply we could manage the overall economy.  And what was more, we could make this a relatively objective, technical process, by limiting growth to what the economy was able to produce, and keeping inflation into a nice, tidy band.  Fiscal policy, taxes and public spending, were pushed into a relatively minor role, and became politically suspect.  A new economic orthodoxy grew, sometimes called neo-Keynesianism, with Economics students given new sets of diagrams to learn, while economic modellers translated this into more complex mathematical equations.   Then, in 2007, it all went horribly wrong.  Two basic problems are now quite evident.

The first is trying to understand how exactly monetary policy works.  Its advocates had always been vague about this, their case based mainly on historical correlations rather than actual, practical mechanisms.  To the public, policymakers talked about printing presses, as if it was all about the number of banknotes printed and put into circulation…which was clearly nonsensical in a modern economy.  During the 1990s the process focused on the setting of interest rates, with the central bank using its power as banker of last resort to manage interest rates on the overnight deposits made by commercial banks, a process which indirectly affected the supply of money.  While I was studying economics at UCL (in 2005-08) our lecturers admitted this was pretty thin.  Long term interest rates were more important, and yet the central bank’s influence over these was marginal.  More important, as electronic money and “shadow banking” exploded, it was not at clear how central banks were supposed to manage the volume of money supply at all; even defining it became impossible.  The whole thing completely fell apart in 2007 when the interbank market seized up, leaving the central banks’ instrument of management broken.  The central banks pulled their levers one way, and yet the actual supply of money, in practice if not in statistical definition, went the other.

The second problem with monetary policy is more fundamental still.  Real people and markets don’t respond to changes in money supply as they theoretically should.  The main effect of policy changes seems to be on the prices of shares and property – not the amount people consume.  So loosening policy merely inflates asset prices, having little effect on output, prices and employment.  Alan Greenspan, the US Federal Reserve’s previous chairman even seemed to make a virtue out of this – suggesting that strong share prices helped sustain investment and consumer demand.  But this leads central bankers into a very dark place, as the Economist’s Buttonwood column has recently pointed out.  What on earth are central bankers doing trying to manipulate asset prices?  Surely asset prices should be set by a properly functioning free market?

So central banks have comparatively little influence on the real economy, and what influence they do have is mainly on asset prices, rather than on employment and consumer prices.  Accept this and you quickly see that asking them to manage inflation as we do in the UK (or inflation and employment, as in the US) is absurd.  It may not even be healthy to confine inflation to a narrow band – there can be perfectly good reasons why it is right to allow inflation to run ahead at a particular time in a particular economy, or, indeed, to let the supposedly wicked deflation to run.  Central banks’ role should be much more limited.  They should control seigniorage (profits made on the creation of currency) and ensure that the markets for money are orderly.  And that’s about it.  Even managing exchange rates is toxic, as the Swiss are finding.

This is the best reason for raising interest rates in the UK (and US) at present.  They are so low that money markets can’t do their job properly – it is much healthier if savers can expect some rate of return.  And, frankly, asset prices are too high anyway.  Not that anybody on the Bank of England’s MPC seemed to offer anything like this reason for raising rates in their  minutes.  George Osborne still seems to believe that the Bank can help him out if fiscal policy seems to be too tight.  The level of denial remains astonishing.  The game goes on; it’s not going to end well for the Bank, I fear.