Money: Economists, Banks, and Government

David Graeber is a New-York-born anthropologist with a bent towards economic history.  His views seemed to be too iconoclastic for staid old Yale University and a seemingly successful professorship there failed—controversially—to lead to tenure.  He subsequently settled in at the London School of Economics as a professor of anthropology.  There is an advantage in viewing economics from the perspective of anthropology because that discipline actually requires one to look at economic actors as real human beings, not as the automatons constructed by economists to fit economic theories.  Graeber’s most prominent work was his book Debt: The First 5,000 Years.  In it he makes clear his opinion that economists know nothing about human beings and economic history, and understand very little about their own discipline of economics.  Economics: Money, Markets, Debt,and the Barter Myth discusses many of his findings.  Graeber has returned to the topic of economics with a review of the book Money and Government: The Past and Future of Economics by Robert Skidelsky, an economist of whom he approves.  The article titled Against Economics appeared in The New York Review of Books.

Graeber begins with this perspective.

“Mainstream economists nowadays might not be particularly good at predicting financial crashes, facilitating general prosperity, or coming up with models for preventing climate change, but when it comes to establishing themselves in positions of intellectual authority, unaffected by such failings, their success is unparalleled. One would have to look at the history of religions to find anything like it.”

“To this day, economics continues to be taught not as a story of arguments—not, like any other social science, as a welter of often warring theoretical perspectives—but rather as something more like physics, the gradual realization of universal, unimpeachable mathematical truths.”

However, a real science arrives at unimpeachable truths by constant testing and validation of those truths.

“This is precisely what economists did not do. Instead, they discovered that, if one encased those models in mathematical formulae completely impenetrable to the noninitiate, it would be possible to create a universe in which those premises could never be refuted. (‘All actors are engaged in the maximization of utility. What is utility? Whatever it is that an actor appears to be maximizing.’) The mathematical equations allowed economists to plausibly claim theirs was the only branch of social theory that had advanced to anything like a predictive science (even if most of their successful predictions were of the behavior of people who had themselves been trained in economic theory).”

The validity of these economic models has not been demonstrated, but it has been sold to the media and to the general public as if it had been.  Beliefs are so firmly entrenched that a complete retelling of economic history is required in order to shake them.  This is what Skidelsky sets out to do.

“Ostensibly an attempt to answer the question of why mainstream economics rendered itself so useless in the years immediately before and after the crisis of 2008, it is really an attempt to retell the history of the economic discipline through a consideration of the two things—money and government—that most economists least like to talk about.”

Astonishingly, economists can’t seem to come to an understanding of that fundamental economic quantity called money.  Pundits and politicians love to proclaim that some or other worthy project cannot be pursued because there is no money available.  In Theresa May’s words, “There is no magic money tree.”

“There are plenty of magic money trees in Britain, as there are in any developed economy. They are called ‘banks.’ Since modern money is simply credit, banks can and do create money literally out of nothing, simply by making loans. Almost all of the money circulating in Britain at the moment is bank-created in this way. Not only is the public largely unaware of this, but a recent survey by the British research group Positive Money discovered that an astounding 85 percent of members of Parliament had no idea where money really came from (most appeared to be under the impression that it was produced by the Royal Mint).”

Most economists insist that the money available from banks continues to be corelated to a bank’s reserve holdings, but not all.

“Only a minority—mostly heterodox economists, post-Keynesians, and modern money theorists—uphold what is called the ‘credit creation theory of banking’: that bankers simply wave a magic wand and make the money appear, secure in the confidence that even if they hand a client a credit for $1 million, ultimately the recipient will put it back in the bank again, so that, across the system as a whole, credits and debts will cancel out. Rather than loans being based in deposits, in this view, deposits themselves were the result of loans.”

What this means is that economists can’t say whether the supply of money places a constraint on economic activity, or whether the supply of money is determined by the level of economic activity.  Those “heterodox” economists seem to be gaining the upper hand—at least in principle.

“Before long, the Bank of England (the British equivalent of the Federal Reserve, whose economists are most free to speak their minds since they are not formally part of the government) rolled out an elaborate official report called ‘Money Creation in the Modern Economy,’ replete with videos and animations, making the same point: existing economics textbooks, and particularly the reigning monetarist orthodoxy, are wrong. The heterodox economists are right. Private banks create money. Central banks like the Bank of England create money as well, but monetarists are entirely wrong to insist that their proper function is to control the money supply. In fact, central banks do not in any sense control the money supply; their main function is to set the interest rate—to determine how much private banks can charge for the money they create. Almost all public debate on these subjects is therefore based on false premises. For example, if what the Bank of England was saying were true, government borrowing didn’t divert funds from the private sector; it created entirely new money that had not existed before.”

What emerges from Skidelsky’s history is an endless sequence of conflicts between supporters of QTM (the quantity theory of money) which concludes that inflation is generally a matter of monetary supply and demand, and those who view monetary supply to be a result of economic activity wherein it is created to meet a demand for it and therefore is not directly related to inflation.  Rather, it will be the demand for products, either material or labor, that will drive inflation. 

“To put it bluntly: QTM is obviously wrong. Doubling the amount of gold in a country will have no effect on the price of cheese if you give all the gold to rich people and they just bury it in their yards, or use it to make gold-plated submarines (this is, incidentally, why quantitative easing, the strategy of buying long-term government bonds to put money into circulation, did not work either). What actually matters is spending.”

Nevertheless, the winner of these disputes would be the monetarists who believed inflation could be tamed by contracting the supply of money.

“According to Skidelsky, the pattern was to repeat itself again and again, in 1797, the 1840s, the 1890s, and, ultimately, the late 1970s and early 1980s, with Thatcher and Reagan’s (in each case brief) adoption of monetarism. Always we see the same sequence of events:

(1) The government adopts hard-money policies as a matter of principle.

(2) Disaster ensues.

(3) The government quietly abandons hard-money policies.

(4) The economy recovers.

(5) Hard-money philosophy nonetheless becomes, or is reinforced as, simple universal common sense.”

How is it possible to continue to believe in theories that are over and over proved to be incorrect?  Perhaps it began with Adam Smith.  Graeber provides this perspective from his book on debt.

“Recall here what [Adam] Smith was trying to do when he wrote The Wealth of Nations.  Above all, the book was an attempt to establish the newfound discipline of economics as a science.  This meant not only did economics have its own particular domain of study—what we now call ‘the economy,’ though the idea that there even was something called an ‘economy’ was very new in Smith’s day—but that this economy acted according to laws of much the same sort as Sir Isaac Newton had so recently identified as governing the physical world.  Newton had represented God as a cosmic watchmaker who had created the physical machinery of the universe in such a way that it would operate for the ultimate benefit of humans, and then let it run on its own.  Smith was trying to make a similar, Newtonian argument.  God—or Divine Providence, as he put it—had arranged matters in such a way that our pursuit of self-interest would, nonetheless, given an unfettered market, be guided ‘as if by an invisible hand’ to promote the general welfare.  Smith’s famous invisible hand was, as he says in his Theory of Moral Sentiments, the agent of Divine Providence.  It was literally the hand of God.”

Smith’s corollary to this assumption was that man or government should not mess with what God had created.  Economists would ditch the religious overtones but would embrace the concept of a self-regulating market as dogma and assume that any intervention in market processes could only make matters worse.

“There is a logical flaw to any such theory: there’s no possible way to disprove it. The premise that markets will always right themselves in the end can only be tested if one has a commonly agreed definition of when the ‘end’ is; but for economists, that definition turns out to be ‘however long it takes to reach a point where I can say the economy has returned to equilibrium.’ (In the same way, statements like ‘the barbarians always win in the end’ or ‘truth always prevails’ cannot be proved wrong, since in practice they just mean ‘whenever barbarians win, or truth prevails, I shall declare the story over.’)”

The almost theological belief in markets has consequences for investors.  Quoting from Skidelsky:

“The efficient market hypothesis (EMH), made popular by Eugene Fama…is the application of rational expectations to financial markets. The rational expectations hypothesis (REH) says that agents optimally utilize all available information about the economy and policy instantly to adjust their expectations….”

“Thus, in the words of Fama,…’In an efficient market, competition among the many intelligent participants leads to a situation where…the actual price of a security will be a good estimate of its intrinsic value.’ [Skidelsky’s italics]”

“There is a paradox here. On the one hand, the theory says that there is no point in trying to profit from speculation, because shares are always correctly priced and their movements cannot be predicted. But on the other hand, if investors did not try to profit, the market would not be efficient because there would be no self-correcting mechanism….”

“Secondly, if shares are always correctly priced, bubbles and crises cannot be generated by the market….”

“This attitude leached into policy: ‘government officials, starting with [Federal Reserve Chairman] Alan Greenspan, were unwilling to burst the bubble precisely because they were unwilling to even judge that it was a bubble.’ The EMH made the identification of bubbles impossible because it ruled them out a priori.”

If one believes the amount of money in the system is based on the demand for money, what is to prevent investors from borrowing or diverting ever more money to drive market prices ever higher until valuations become so absurd that some begin to cash out and the market collapses?  “Intrinsic value” becomes meaningless.  Isn’t this a fatal flaw of markets, one that demands some sort of intervention?

Could such a catastrophic event as the Great Recession be capable of shaking some of these economic beliefs?  Apparently not.

“After such a catastrophic embarrassment, orthodox economists fell back on their strong suit—academic politics and institutional power.”

“Breaking through neoclassical economics’ lock on major institutions, and its near-theological hold over the media—not to mention all the subtle ways it has come to define our conceptions of human motivations and the horizons of human possibility—is a daunting prospect. Presumably, some kind of shock would be required. What might it take? Another 2008-style collapse? Some radical political shift in a major world government? A global youth rebellion? However it will come about, books like this [Skidulsky’s]—and quite possibly this book—will play a crucial part.”