Lecture on First Steps towards Understanding Macroeconomics, on Friday 4th May 2018 in AR Kemal Rm at PIDE, by Dr. Asad Zaman, VC PIDE. 1hr 20m Video Lecture, (shortlink: bit.do/azifa – on Islamic WorldView Blog)
3100 word summary of lecture:
Part 1: Power/Knowledge – How Macro Theory is shaped by the Powerful
Why Understand Macro? If we understood macroeconomics, we would be able to understand the reasons for the major economic events currently going on all around us. For instance, increasing inequality, effects of austerity, Brexit, inequities of post-Bretton Woods dollar based financial system, impacts of emerging economy of China on global finance, and many other questions of vital importance for conduct of economic policy. Unfortunately, standard courses in Advanced Macroeconomics currently being taught at leading universities throughout the world are worse than useless for this purpose. Many leading economists have admitted that we need to replace the “entire edifice” of contemporary macro, that our leading models are strongly in conflict with everything we know about reality. For one sharp critique, see David Romer “The Trouble with Macroeconomics”, where he says that theorists completely ignore the strong disagreement between their theories and reality, and are content to build mathematical models which have no relation to the real world. Leading macro textbooks teach student how to do advanced mathematical manipulation, but teach nothing about the events going on around us, which is why economists were taken by complete surprise when the Global Financial Crisis occurred. According to all the macro models in use then (and which continue to be used today) such an event was impossible.
Textbooks teach Myths About Macro: It is not just that what is taught in the textbooks is irrelevant. It is actually misleading, and we can argue that it is deliberately so. Learning the truth about how the economy works would be harmful to the rich and powerful who benefit enormously from the myths that are taught in modern macroeconomics textbooks, and widely believed throughout the world. Many, many myths taught as realities could be listed, but perhaps the central one among them is the “Neutrality of Money”. According to this widely believed myth, money plays no important role in the economy, except to affect the price level. If we double the quantity of money, the prices will be double and there will be no other effects on the real economy. In other words, “money is a veil” and we have to see through this veil in order to understand the workings of the real economy.
Suppression of Keynesian Knowledge: Nothing could be further from the truth. As Keynes realized a long time ago, money is not neutral in the short run or in the long run. In fact, the quantity of money is of critical importance in the economy. Unfortunately, all the discoveries of Keynes were suppressed and hidden from view; see my essay on Understanding Macro-economics: The Keynesian Revolution. Briefly, Hicks and Samuelson came up with a distorted version of Keynesian theory, which re-instated the neutrality of money, and became widely known as Keynesian economics, even though it had very little to do the real Keynesian theories. So the place to begin our study of Macroeconomics is with the understanding of the role of money in an economy.
The Critical Importance of Money: The central Keynesian insight is very simple and very easy to understand. As Keynes wrote: “The difficulty lies not so much in developing new ideas as in escaping from old ones.” Economies need money to function. Running all the businesses requires money, and if there is an insufficient amount, businesses will not be able to function, leading to a recession. Reduction of activity level will also lead to unemployment, which causes great personal harm to people who are unemployed. It is the job of the government to provide money in sufficient quantities so that there is full employment. Just as too little money is dangerous, so too much money is also harmful. When money is available in sufficient quantities for the needs of the economy, then excess amounts lead to inflationary pressures, which causes many different types of harm. One of these harms is lack of stability in the value of money. Thus, Keynesian theory is exactly opposite of the idea that the quantity of money does not matter. The exact quantity of money is extremely important for the economy. It is the job of the government to manage the quantity at exactly the right amount, neither too much nor too little. One caveat needs to added – it is not just the quantity of money which matters; it also matters WHO has the money. If there is a lot of money, but it is in the wrong hands, recessions might still take place. Similarly, depending on how the money is distributed, different types of economic effects might occur. So while in a general sense Keynesian theory holds, careful consideration of the different classes in the society, and which classes hold the money, is required for a more accurate analysis of the impact of changes in the quantity money.
Suppression of Dangerous Knowledge: It is important to re-emphasize the money is far from neutral – money is all important in the functioning of the economy. This is so obvious that even a child could understand this. So the next question of importance is: how and why has this knowledge been suppressed? Even an economist of extraordinary stature like Keynes could not get his ideas about money accepted by economists, even when Keynes is so obviously right, and when the dominant ideas of conventional mainstream economics are so obviously wrong. It is important to understand the answer to this question. Lack of knowledge about how the financial system works is extremely beneficial to the financiers. As many who have learned about the monetary system have remarked, “if people knew how financiers make money, there would be a revolution against it tomorrow.” Today, according to OXFAM statistics, around 60 people own more than half the total planetary wealth. These super-rich people have enough wealth to fund and buy universities, foundations, professorships, Nobel prizes, and to ensure that capitalist ideologies are taught in the guise of theory, while powerful alternatives are completely suppressed and ignored in the mainstream profession. They are powerful enough so that they could succeed even in suppressing the views of someone famous and extremely respected like Keynes – so much so that leading economists like Krugman, and many others, do not even know what Keynes said. The counterpart of this spreading of ignorance in the name of knowledge is that it makes the truth is extremely powerful. Since the majority of professionals are not just ignorant, they believe the wrong theories, a little bit of knowledge can easily refute these theories and also shed a huge amount of light on history. In fact, we cannot understand twentieth century history without understanding this fundamental fact about money: that it must be provided in exactly the right amount needed by the economy – both too much money and too little money are harmful, though in different ways.
The Gold Standard: Once we understand this fundamental Keynesian insight, it becomes easy to understand that the use of gold as money cannot be a good idea. This is because gold supplies increase due to discoveries and mining of gold, at a rate which has no match to the needs of the economy. If the economy needs an exactly correct amount, which keeps increasing in a growing economy, then gold will not do a good job as money. The economy will perpetually be in recession when gold stock is too low, and in inflation when the gold stock is too high. Histories of use of gold as money can be used to document this phenomena – too strict enforcement of gold standards has typically led to recessions, and often governments have invented alternative forms of token money to create the additional money needed by the economy.
Fractional Reserve Banking: One of the most important inventions which has been done for this purpose is the fractional reserve banking system. Because people use currency notes backed by gold, instead of gold itself, it is possible to print a lot more notes than the actual amount of gold, while claiming that each note is backed fully by gold. This way, a limited amount of gold can be used to create a large amount of currency – this is the meaning of “fractional reserve”. Of course, this is a fraud in an obvious sense – the issuer of the notes is making promises that are impossible to keep. As a practical matter, it is rare for all holders of promissory notes to demand payment at once, which would cause crises. To compound the problem, private banks can also create money in the form of credit, without having any actual backing of gold. The many problems that this leads to are discussed in my paper on “ The Battle for the Control of Money” To summarize, money is created by sovereign fiat. Gold backing is merely a way to generate trust, but is not required. As long as considerations of international trade are not involved, domestic currency created by sovereign fiat is ideal for the needs of the economy – much better than gold, which is not adaptable. In practice, gold-backed currency emerged, and the problem of matching money to the needs of the economy was solved by the use of fractional reserve banking, which permitted expansion of money far beyond the quantity of gold, while maintaining a pretense of gold backing for all of the currency.
Business Cycles and Financial Crises: Briefly, business cycles are caused by private sector creation of money which acts exactly opposite to the needs of economy. For private credit creation the best time is when the economy is booming – however at such times it is important to reduce the money stock, instead of increasing it. Similarly, creation of private sector credit is reduced in recessions, when in fact the economy needs more money to climb out of recession. The pro-cyclical behavior of private sector money creation exacerbates the business cycle and frequently leads to monetary crises. A recent IMF paper counts over 300 monetary and banking crises in the past three decades. However, economists who have taken money and banks out of their models because of the illusion of neutrality of money are unable to forecast or even understand these crises. Lord Mervyn King, former governor of the Bank of England, has said that our current financial system is among the worst imaginable because it is so crisis prone, and has called for creation of a new kind of financial architecture.
Part 2: Understanding History of Capitalism
Armed with this minimal amount of theoretical knowledge, we can now understand the bare outlines of the events of the 20th Century, especially with respect to the emergence of the international financial architecture which currently dominates the globe. Essential to understanding modern capitalism is Karl Polanyi’s The Great Transformation: The Political and Economic Origins of Our Times. For a brief summary, see my post on the Summary of Polanyi’s GT, and also Resources for the Study of Polanyi’s GT. For the present talk, we pick out the essentials relevant to understanding 20th Century history.
The Great Transformation: The Industrial Revolution in England created the possibility of production of massive amounts of surplus. Traditional societies were based on principles of self-sufficiency, simple living standards, community, social responsibility. Furthermore, production and consumption were necessities, but life was meant for higher purposes such as arts, athletics, literature, and pursuit of excellence in different dimensions. These traditional values were not compatible with creation of surplus, since this was of no value to a self-sufficient society, which did not value production and consumption as goals of life. Excess production provided governments and merchants with a large amount of power, which was used to reshape society in directions which were favorable to the emerging market society. This required a revolutionary change in multiple dimensions of human existence, which is what Polanyi calls the Great Transformation. Political, economics and social institutions were transformed radically, along with ways of thinking and acting, as market society emerged to displace traditional societies. Market societies values production, consumption, and wealth above all traditional human pursuits; this is what allows the production and creation of massive amounts of surplus. Mercantilism was an intermediate stage during the transition between traditional society and the Market Society which later emerged. During the Mercantilist era, the emphasis was on the utilization of all resources to maximize production. The race to maximize wealth and power enabled by excess production, combined with continuous warfare, created a military revolution in Europe which gave them weapons and military tactics superior to those existing anywhere else on the planet.
The Long Nineteenth Century: Europe Colonizes the Globe: The capabilities of excess production necessitated the search for markets to sell this surplus. Initial attempts at trade failed, since self-sufficient societies all around the globe did not have much demand for European products. The military power created by industrialization provided the alternative solution of conquest. Discovering that they had superior military capabilities, the Europeans suspended their centuries of continuous inter-Europe warfare, and went out to conquer the globe. In the brutal process of colonization, they destroyed indigenous economies, and political and social institutions. All resources – human and natural – were mobilized for use in enhancing production for the colonizing countries. The colonizers carved out spheres of influence, to avoid conflict with each other in the process of the rape of the globe. By the beginning of the twentieth century, almost 85% of the globe was under European control.
Emergence of the Gold Standard: Surplus production led to the emergence of Haute Finance, in the form on international bankers who facilitated trade by arranging finance across the globe. This was a mysterious entity which kept its hands hidden but exercised a powerful effect on global politics. Trade within a colonial empire was based on the hard currency of the colonizer and soft currencies of the colonies. The fractional reserve system allowed haute finance to create wealth for themselves, and also to provide sufficient money for the needs of the economy. As European economies grew immensely rich by utilizing global resources for production, and through exploitation of their colonies, they also started to trade with each other. We have discussed earlier that trade within an empire can be done using a fiat currency which acquires value merely because the sovereign state decrees that this note will be legal tender for all commercial transactions and taxes. However, international trade cannot be done in this way because sovereign fiat does not extend across state boundaries. There are many ways to carry out international trade, but it is of essential importance to understand that any international trading system is artificial – it must be created by consensus on some set of rules which is agreed upon by all parties – that is all the sovereign states which agree to trade. This is why we refer to “Global Financial Architecture”. The trading system has to be designed according to artificial rules, agreed upon by consensus. Relative power of trading parties forms an important element in creating this consensus. A simple set of rules for trading emerges using a gold standard. All international trades must be settled in gold. Countries trade with each other using hard currencies, and imbalances are settled by the country with deficit redeeming its currency held by the trade surplus country for gold. This system of international trade inter-acts with the domestic system of money creation via fractional reserve. Within a country, there is never a danger of insufficiency of gold backing for a currency, since the currency works by sovereign fiat. The country may simply suspend payments in gold to citizens, as the USA did on multiple occasions, without any damage to domestic money. However, this same device is not available on the international front. As long as the volume of trade is small relative to the domestic economy, surpluses and deficits can be settled in gold without any serious consequences. However, by the end of the nineteenth century, substantial amount of globalization occurred, creating high volumes of international trade. This created a monetary policy dilemma: the needs of domestic economy may require expanding the money, but needs of global trade require ensuring that money is adequately backed by gold, preventing the required expansion of money stock. In practice, stability of money was beneficial to the powerful haute finance, as international trade provided them with vast benefits. Damage to domestic economy was hurtful to the laborers and the lower classes, and did not affect the wealthy upper class elites greatly. Consequently, countries everywhere adopted measures to keep currencies stable, adequately backed, and ignored or neglected needs of domestic economy (this is what is meant by austerity: keeping deficits low to sacrifice needs of domestic laborers in favor of global financiers.) However, in a booming global economy, this did not cause serious disturbances or problems.
Causes of World War I: As Polanyi has shown, haute finance managed to prevent major wars between European powers, and to ensure that international trade was maintained even through periods of war, and even between warring countries, as this suited their interests. However a number of new factors entered the calculus in the early twentieth century, which led to the breakout of World War 1 in 1914. First, the conquest of globe ended the possibilities of further expansion through further colonization. Second, all of the European powers had acquired massive armies in the process of conquering the colonies and also to defend against large armies of neighbors. Third, the Triple Entente created between Britain, France, and Russia, which countered the Central Powers of Germany, Italy, Austria-Hungary broke the system of balance of powers, which required the existence of at least three separate powerful states. For these, and other reasons, World War 1 broke out in 1914, causing massive death and destruction, completely ruining European economies. In particular the massive war expenses depleted gold reserves, and led to a breakdown of the gold standard.
Failure of Attempts to Restore the Gold Standard: Post World War 1, there was a massive effort to re-create the Gold Standard, to go back to the pre-war system, which had created tremendous prosperity for all of Europe. However, for various reasons, this effort failed. One of the reasons was the need to rebuild the domestic economies destroyed by the war. This required investment, using loans and deficit spending. However, expansion in fiat money was not compatible with maintaining a stable exchange rate in the international markets. The needs of the domestic economy were in very severe conflict with the needs for global trade. This time, the importance of rebuilding domestic economy was prioritized, leading to failure in the attempts to stabilize currencies against gold. needed to create stable exchange rates required for international trade.
For part II of the lecture see: Critical Importance of Global Financial Architecture Part II
For main page, see: Mini-Course on MacroEconomics