Living in the Age of Keynes

The path to prosperity

In 1935 John Maynard Keynes wrote to his friend George Bernard Shaw: “I believe myself to be writing a book on economic theory which will largely revolutionize, not I suppose at once but in the course of the next ten years – the way the world thinks about economic problems.”

That book, The General Theory of Employment, Interest and Money, published the following year, would go on to fully realise Keynes’s expectations. After World War Two, following Keynes’s analysis, policy makers and economists around the world used fiscal and monetary tools to pursue the goal of ‘full employment’. Keynes gave his name to both the economics and the age itself.

It is conventionally said that this Keynesian Age was brought to an end by the Stagflation of the 1970s. To the extent that responsibility for ‘economic management’ was simply transferred from politicians with primarily fiscal tools to central bankers with monetary tools this can be argued. But there is another sense in which we never left the Age of Keynes.

The first substantive chapter of The General Theory is chapter two, ‘The Postulates of the Classical Economics’. Here Keynes ridicules a set of beliefs which he ascribes to an ill-defined group of ‘Classical economists’. For these Classicals income was either spent on consumption or saved. These savings, as capital, were invested with the two quantities, savings and investment, being equilibrated by the interest rate. As Keynes’s Classical mentor Alfred Marshall put it:

“[I]t is a familiar economic axiom that a man purchases labour and commodities with that portion of his income which he saves just as much as he does with that he is said to spend. He is said to spend when he seeks to obtain present enjoyment from the services and commodities which he purchases. He is said to save when he causes the labour and the commodities which he purchases to be devoted to the production of wealth from which he expects to derive the means of enjoyment in the future.”

Keynes, by contrast, saw no such essential unity between savings and investment. In The General Theory he wrote that the “decisions which determine Saving and Investment respectively are taken by two different sets of people influenced by different sets of motives, each not paying very much attention to the other”.

It was possible, Keynes argued, that investors driven by mercurial “animal spirits” could become so pessimistic that the Marginal Efficiency of Capital (the expected return on their investment) could plunge below the interest rate (the cost of funding that investment) so that no investment would take place. The Marginal Efficiency of Capital could, indeed, sink so low that nominal interest rates couldn’t offset it, giving rise to the ‘liquidity trap’ and monetary impotence. Marshall’s link would be broken and aggregate demand would fall.

For Keynes, the way to guarantee the continued investment which not only guaranteed aggregate demand in the present but also increased prosperity in the future, was for the government to underwrite the profitability of investment by acting as spender of last resort, via fiscal stimulus, to prop up the Marginal Efficiency of Capital.

This was the polar opposite of the Classical view. Whereas Keynes believed that spending made you rich enough to save, the Classicals believed that saving made you rich enough to spend. Though Keynes would have agreed with the father of the Classicals, Adam Smith, that “Consumption is the sole end and purpose of all production”, they took totally different routes to get there.

This stems from a striking difference in attitudes to saving. Adam Smith, anticipating Marshall, wrote, “What is annually saved is as regularly consumed as what is annually spent, and nearly in the same time too; but it is consumed by a different set of people…by labourers, manufacturers, and artificers”. Keynes, by contrast, said that “whenever you save five shillings, you put a man out of work for a day”.

Is it Smith or Keynes’s attitude towards consumption and saving which animates western policymakers today? Since 2008 we are supposed to have seen ‘The Return of the Master’. In truth he never went away. We’ve been living in the Age of Keynes for decades.

This article originally appeared at The Commentator

IDS is the heir to Beveridge

A jolly nice chap

“Iain Duncan Smith is scum” announced a former friend of mine on her Facebook wall recently. Actually, as anyone who has met him will attest, IDS is a perfectly affable chap. But he is sceptical of the present size and nature of Britain’s welfare state. This, apparently, makes him “scum”.

Between 2001 and 2007 British government spending increased by 54 percent in real terms. In nominal terms the coalition is actually raising spending even further, from £661 billion in 2010 to a projected £729 billion in 2015. What cutting is being done is coming from above target inflation so that, in real terms, spending will fall by 2.7 percent. And remember, that’s a real terms cut of 2.7 percent after a real terms increase of 54 percent.

But the reaction from sections of the left to this bare snipping has, as with my former friend, been nothing short of demented.

Nick Cohen frequently says very sensible things but at the end of the day he writes for the Observer and he has to sing for his supper – hence a steady flow of silly articles about barely existent ‘austerity’ and mythical ‘Tory cuts’. In a recent article he wrote that “Iain Duncan Smith’s universal credit poses a serious threat to women’s independence.” You actually have to ask how independent someone who is dependent on state welfare actually is in the first place, but to have done so would have been to intrude on the usual orgy of hysteria which accompanied the article.

One of Cohen’s Facebook friends commented, “Yes, yes, yes. Duncan Smith has a nasty agenda, fired by his own sense of Christian mission. A very creepy man.” Another warned that “The Tories especially are making attacks on the poorest, that are remarkably similar to the sort of thing the eugenicists of the nineteenth century used to say.” Sections of the left are currently consumed with lunatic levels of fear and loathing.

It never seems to occur to these people that someone could question the present size and nature of Britain’s welfare state from any motivation other than pure evil. It never enters their minds that someone might be critical of the welfare state as it stands for the simple reason that it is a massively expensive failure.

“Flat rate of subsistence benefit; flat rate of contribution”;

“Unemployment benefit will…normally be subject to a condition of attendance at a work or training centre after a certain period”;

“National assistance (a means tested benefit) is an essential subsidiary method in the whole plan…The scope of assistance will be narrowed from the beginning and will diminish”;

“Assistance…must be felt to be something less desirable then insurance benefit; otherwise the insured persons get nothing for their contributions. Assistance therefore will be given always subject to proof of needs and examination of means; it will be subject also to any conditions as to behaviour which may seem likely to hasten restoration of earning capacity”;

“The proposal to adjust benefit according to the rent actually paid by individuals should, provisionally, be rejected”.

These quotes, recommending conditions on eligibility for welfare, proposing a reduction of benefits over time, supporting the notion that benefits must not match employment income, and rejecting housing benefit, do not come from someone like Iain Duncan Smith who the contemporary left would brand as evil. They come, in fact, from the Report of the Inter-Departmental Committee on Social Insurance and Allied Services of 1942, written by William Beveridge, which laid the foundations for the welfare state.

Beveridge’s plan was, as James Bartholomew writes,

“very simple. Everyone would make flat-rate contributions to a national insurance scheme. Those who fell ill, became unemployed or reached retirement age would, in return, receive flat rate payments. That is it. The rest was detail”.

John Maynard Keynes reportedly told his friend Beveridge: “The Chancellor of the Exchequer should thank his lucky stars that he has got off so cheap”.

Keynes was wrong. Over the years Beveridge’s safety net became a vast hammock. Since the welfare state got under way in earnest in 1948, social security spending as a percentage of GDP has increased from 4 percent to nearly 14 percent; a 250 percent increase.

Source: IFS

Those on the right and this coalition government are often accused of launching an attack on the welfare state bequeathed us by Beveridge and the Attlee government. That ship has long since sailed. Beveridge’s welfare state died decades ago when it became the bloated, expensive, counterproductive monster it is today. And it wasn’t the right that killed it, the left did.

There is a new film out by dreary, overrated Marxist Ken Loach titled The Spirit of ’45. In it, among other things, Loach calls for the Brits of 2013 to resist coalition welfare reforms and redouble their commitment to state welfare spending. But that is not the spirit of 1945. The spirit of 1945 was of work, contribution, and insurance.

And that appears to be the spirit of 2013 too. As a recent report by the National Conversation found: “Wherever they stood on the political spectrum, we were told that the welfare system was broken, and that no one party held the answer to fixing it… A key concern, shared by respondents from different backgrounds, was the degree to which the modern welfare system had moved away from Beveridge’s original plans for social insurance. With the gradual erosion of Beveridge’s contributory principle, governments found themselves paying out ever larger welfare disbursements to people who had never paid into the system”.

Sensing this even Ed Miliband has begun making noises about “recognising contribution”.

Iain Duncan Smith is not “scum”. Rather, unlike Loach and Cohen and his loony friends, he is the heir to Beveridge. If the spirit of ’45 lives on anywhere, it is in the coalition’s welfare reforms.

This article originally appeared at The Commentator

John Maynard Keynes, in the long run

John Maynard Keynes, 1883 – 1946

“In the long run we are all dead”. So said John Maynard Keynes, born 120 years ago on Wednesday, in one of the most misquoted phrases in economics.

It comes from Keynes’s Tract on Monetary Reform, from 1923, in a discussion about the economic long and short run. If a factory closes you can say that in the long run its workers will find jobs somewhere else but in the short run there may be considerable unemployment and it was this that Keynes was concerned to tackle. Thus, the full quote is: “But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again.”

Indeed, Keynes thought much about the long run. One of his most celebrated pieces of writing was an essay titled The Economic Possibilities for Our Grandchildren (1930) and he was one of the architects of the post-World War II Bretton Woods monetary system.

But this isn’t to say that Keynes had any coherent idea about the long run. He didn’t. In The Economic Possibilities for Our Grandchildren he observed that, since the Industrial Revolution, “the average standard of life in Europe and the United States has been raised, I think, about fourfold” and predicted that “the standard of life in progressive countries one hundred years hence will be between four and eight times as high as it is today”. In large part he attributed this, correctly, to “the accumulation of capital which began in the sixteenth century”.

But this capital accumulation was simply assumed by Keynes, not analysed. In The General Theory of Employment, Interest and Money (1936) he speculates on the future possibility of “a society which finds itself so well equipped with capital that its marginal efficiency is zero and would be negative with any additional investment”, blithely asserting that it would be “comparatively easy to make capital-goods so abundant that the marginal efficiency of capital is zero”. The Solow growth model theorists are derided for their characterisation of technological change appearing exogenously as “manna from heaven” but that is exactly how Keynes conceptualised the accumulation of capital and capital goods.

In fact financial capital is that part of income not spent on current consumption; saving, in other words. Capital goods have to be produced and maintained. If they had no value, as Keynes posits in his Utopia, they would not be produced. Include the cost of maintaining them and they would be even less likely to be produced.

This lack of understanding of the process of capital accumulation, which he himself put front and centre of his theory of increasing wealth, was a constant in Keynes’s writings. In The Economic Consequences of the Peace (1919) Keynes wrote that, during the 19th century, which he later characterised as an “epoch of enormous economic progress”,

“There grew round the non-consumption of the cake all those instincts of puritanism which in other ages has withdrawn itself from the world and has neglected the arts of production as well as those of enjoyment. And so the cake increased; but to what end was not clearly contemplated. Individuals would be exhorted not so much to abstain as to defer, and to cultivate the pleasures of security and anticipation. Saving was for old age or for your children; but this was only in theory,—the virtue of the cake was that it was never to be consumed, neither by you nor by your children after you.”

This is drivel. The cake was consumed, not least by Keynes himself who wrote of the pre-1914 era that “The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he may see fit, and reasonably expect their early delivery upon his doorstep”. And while Keynes was a-bed, per capita consumption of milk, meat, butter, sugar, and tea all rose between 1860 and 1913. The grandchildren and great grandchildren of those who had flocked to Milton’s “dark, satanic mills” in the early days of the Industrial Revolution were beginning to consume such soon-to-be-household names as Oxo, Lipton, Rowntree, and Pears.

The end, even if Keynes couldn’t see it, was to extend to the inhabitant of Stepney the opportunities enjoyed by the inhabitant of Bloomsbury. This was made possible, as Keynes recognised, by “the accumulation of capital” which came, as Keynes failed to recognise, from saving. Keynes, aping his friend Lytton Strachey, derided the Victorians for not consuming the cake in its entirety but they understood better than Keynes that it was out of those leftovers, those savings, that they would bake a bigger cake tomorrow.

Keynes was concerned about the long run but he had no conception of how we would get there. He simply extrapolated past trends into the future without stopping to consider what factors were at work behind those trends. To paraphrase, economists set themselves too easy, too useless a task if they simply tell us the ocean will be flat tomorrow without checking the forecasts.

By consuming the whole cake today without regard to the provision of tomorrow’s dinner, in Keynes’s long run we’d all be hungry.

This article originally appeared at The Commentator

Why do smart people still choose Keynes over Hayek?

The ridiculous and the sublime

On October 17th a group of concerned economists wrote to the Times. The current economic woes, they wrote, were down to insufficient spending/increased saving. “[W]hen a man economizes in consumption”, they argued, “and lets the fruit of his economy pile up in bank balances or even in the purchase of existing securities, the released real resources do not find a new home waiting for them.” Crucially, “In present conditions their entry into investment is blocked by lack of confidence.” The government should step in and spend to make up the shortfall they said.

On October 19th another group of economists replied with their own letter to the Times. They believed that the cause of the economic problems was monetary mismanagement which had created “a deficiency of investment-a depression of the industries making for capital extension, &c., rather than of the industries making directly for consumption.” They argued for the necessity of increased saving to readjust this and explicitly rejected any role for government spending, writing that “many of the troubles of the world at the present time are due to imprudent borrowing and spending on the part of the public authorities.”

But this was October 1932 and the letters were written by John Maynard Keynes and Friedrich von Hayek. It says much about the essentially static nature of economic knowledge that an 80 year old debate remains so compelling today that it continues to inspire radio shows, debates, books, and even rap-offs.

Keynes’s economics, in a nutshell, argues that of the two components of ‘effective demand’, consumption and investment, investment is prone to volatile swings. As Keynes put it, investment spending was reduced when their expected payoff, the Marginal Productivity of Capital, dipped below the cost of financing them, the interest rate.

Why might this happen? “Animal spirits” was Keynes’ answer; “Don’t ask me guv” in other words. Whatever it was that tipped investors from optimism into effective demand-sapping pessimism is exogenous to the model; it cannot be accounted for by it.

Either way, the policy prescriptions of the Keynesian model are obvious. Financing costs must be held down with low interest rates and the Marginal Productivity of Capital must be underwritten by a government guarantee to purchase, with deficit spending if need be, whatever output industry might produce. Low interest rates and deficit spending. That is the Keynesian prescription for prosperity.

Hayek’s theory is very different. For Hayek, when low interest rates cause an expansion of credit, this credit flows into some parts of the economy before others. This blows up bubbles in the affected part of the economy, be it in housing, internet stocks, or tulips.

At some point, Hayek argues, the inflationary effect of this credit expansion overwhelms any wealth effect and interest rates begin to rise. With no further credit available to purchase the bubble assets the prices of these assets and their attendant industries collapse. This is the bust.

A major difference between Hayek’s theory and Keynes’s is that for Hayek the bust as well as the boom is endogenous to the model, it is explained by it. The bust isn’t caused by “animal spirits” switching inexplicably out of the clear blue sky, but by the predictable outcome of actions undertaken in the boom.

As Hayek’s model is radically different from Keynes’s, radically different prescriptions follow from it. Viewing the cycle as a whole Hayek believed that preventing a future bust was as important as fighting the current one and he proposed measures to limit the ability of banks to swell credit, his favoured solution being competing currency issue by banks.

More immediately, Hayek argued that as the bubble assets and attendant industries had been pumped up by unsustainable injections of inflationary credit, they could only be liquidated; any attempt to preserve their value would only prolong the bust or, as bad, set another cycle in motion. Sound money and non-intervention was the prescription of Hayek and his fellow Austrian Schoolers.

Looking back over the last few years you have to ask how intelligent people, examining the evidence, can still choose Keynes over Hayek. In both Britain and America we had monetary policy makers working to keep financing costs down with low interest rates. We had governments running budget deficits and applying fiscal stimulus to economies which were already growing. We followed the Keynesian prescription for prosperity and we still ended up with a bust – a bust which Hayekians, with their superior model, saw coming.

The answer lies in the prescriptions. Keynes, with his cheap credit and shower of borrowed money, is a pleasant prospect. Indeed, Paul Krugman, one of the most uncompromising modern Keynesians, believes that “Ending the depression should be incredibly easy”, all we need is cheaper credit and more borrowing. Just, in fact, what we had going into the crisis.

Hayek, on the other hand, offers a more painful prospect. As his mentor Ludwig von Mises put it:

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved”

Which of these vistas would you prefer to gaze upon?

But these theories should be judged not on how warm and fuzzy they make us feel but on how accurate they are. On that score Hayek wins hands down yet some still cling doggedly to Keynes. It’s for the same reason the aunt who gives you chocolates is preferred to the aunt who makes you do your homework.

This article first appeared at The Commentator

Barack Brewster’s Millions

Who ya gonna call in November?

Films have often been vehicles for communicating complex ideas and philosophies in coded parables. The dreary films of Marxist filmmaker Ken Loach aren’t much more fun than ploughing through all three volumes of Das Kapital but they do, at least, take less time.

When, in The Shootist, John Wayne’s character, J B Books, says “I won’t be wronged, I won’t be insulted, and I won’t be laid a hand on. I don’t do these things to other people, and I require the same from them”, he was saying roughly what it took Robert Nozick 300 pages to say in Anarchy, State, and Utopia.

But I wasn’t expecting any such heft when I sat down to watch Brewster’s Millions at the weekend. As a child of the 1980s I might have seen this film around 20 times but this time I noticed something new in it; it is a parable for Keynesian economics.

It tells the story of washed up baseball player, Montgomery Brewster (Richard Pryor), who is left $300 million by an eccentric relative. There is one catch: first he has to spend $30 million in 30 days with absolutely nothing to show for it; “you’re not allowed to own any assets. No houses, no cars, no jewelry. Nothing but the clothes on your back!”

Brewster uses a raft of tricks to spend this money, some of which will be oddly familiar to anyone who has been watching economic policy making over the last few years.

Brewster’s first act is to go on a hiring spree offering vastly inflated wages. No, not public sector employees, but a team of security guards. Later he gets into his very own crackpot environmental, or ‘green tech’, scheme when he buys an iceberg with the aim of floating it to the Middle East to bring relief to supposedly drought stricken Arabian farmers.

“What thirsty Arab farmers?” his friend Spike (John Candy) asks, “There aren’t any, because there aren’t any farmers in the desert!” If only John Candy had been on hand before Barack Obama blew $535 million on Solyndra.

Finally he hosts an expensive exhibition game between his old team, the Hackensack Bulls, and the New York Yankees. The Bulls are kitted out in new uniforms and flown in by helicopter. Brewster should, of course, have re-designated some of the major roads in New York as special lanes for his game; then he could have wasted as much money as the London Olympics.

If it sounds fanciful to see any economics in this flurry of pointless spending, consider the words of John Maynard Keynes himself:

“If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is”

A different attitude to wealth creation is on display in one of the classics of 1980s cinema, Ghostbusters.

Three government employees spend their days trying to seduce their students with phony experiments and running away from ghosts. When this dismal level of productivity proves too low even for the public sector they are sacked and go private, though not without misgivings.

As Ray Stanz (Dan Aykroyd) warns Peter Venkman (Bill Murray), “Personally, I liked the university. They gave us money and facilities. We didn’t have to produce anything! You’ve never been out of college. You don’t know what it’s like out there. I’ve worked in the private sector. They expect results.”

Spotting a gap in the market (“We are on the threshold of establishing the indispensable defense science of the next decade. Professional paranormal investigations and eliminations. The franchise rights alone will make us rich beyond our wildest dreams”) the three borrow some money and set up the Ghostbusters.

Soon they are raking in $5,000 a night, getting coverage from Larry King and Time magazine, and taking on a black member of staff, no affirmative action needed.

Then up pops Walter Peck of the Environmental Protection Agency. “I want to know more about what you do here” he demands. “Frankly, there have been a lot of wild stories in the media and we want to assess for any possible environmental impact from your operation, for instance, the presence of noxious, possibly hazardous waste chemicals in your basement. Now you either show me what’s down there or I come back with a court order!”

With Venkman an unlikely John Galt the government steps in, shuts down the thriving private sector enterprise, and the town is flooded with ghosts.

Where Brewster’s Millions is an object lesson in the wasteful uselessness of Keynesian economics, Ghostbusters is one of the most pro free market films ever made, a hymn to the genius of capitalism and the clumsy damage wrought by government.

Or, to quote another economist, Milton Friedman, “If you put the federal government in charge of the Sahara Desert, in five years there’d be a shortage of sand”

These differing attitudes are on display in the US Presidential election. With the American economy slowing to stall speedthe question each of the candidates must answer is “Where is the growth going to come from?”

With his background in law and ‘community organising’ it’s no surprise that Barack ‘Brewster’ Obama doesn’t know, pinning his hopes on ever more government spending of the Solyndra sort.

Mitt ‘Venkman’ Romney, by contrast, is at least paying lip service to private sector led growth of the Bain Capital sort. The difference is that Bain made money and Solyndra went bust. Do Americans want their economy run by Monty Brewster or the Ghostbusters? That will be the question this November

This article originally appeared at The Commentator

Overrated: Paul Krugman

“Snake oil, £14.99!”

When Friedrich von Hayek became a Nobel Laureate in economics in 1974 he said: “The Nobel Prize confers on an individual an authority which in economics no man ought to possess.” The truth of this is demonstrated daily by the case of Paul Krugman.

Krugman and his supporters whip out his Nobel Memorial Prize in Economic Sciences like a Top Trump of Diego Maradona. It is awarded annually — so why the special fuss about a prize Krugman won four years ago? His Nobel is being used to intimidate opponents. Any opposition to Krugman with his Nobel Prize is opposition to science itself.

Why Krugman generates so much opposition isn’t hard to fathom. From his perch in the New York Times he says one ridiculous thing after another. In the British context Krugman’s risible thesis is that the economy is struggling because the government isn’t spending enough money, that austerity is driving us back into recession, and that the solution to our debt crisis is to borrow and spend even more money.

But there is no austerity. British government spending has fallen from record highs by only about 1 per cent since the coalition took office. This has tipped us back into recession? Most private sector companies could save that by switching to cheaper copier paper.

Krugman argues that we need vast government spending to get us out of the recession. But Britain is running a budget deficit of more than 8 per cent of GDP, one of the highest in the developed world. The government is spending more than 400 million borrowed pounds every day; the national debt is increasing by more than £5,000 every second.

And yet, with all this extra borrowing and all this spending Britain’s economy is still tanking. Perhaps this suggests that massive deficit spending isn’t the answer. That’s one interpretation. Not for Krugman. To him the problem is that even the record levels of borrowing which will see Britain’s national debt increase by 60 per cent, from £1 trillion to £1.6 trillion, by the next election, are not enough. We need to borrow more. That, he claims, would solve our debt crisis.

Krugman’s new book (its recommended retail price an aggregate demand boosting £14.99) is called End This Depression Now! (Norton) as though that hadn’t previously occurred to anyone else. Indeed, it’s possible that if George Osborne decided to increase borrowing to 10 or 12 per cent of GDP we might have a quarter or two of growth. Labour managed to boost GDP growth to 1 per cent by dumping £160 billion of borrowed money into the economy.

But after that? Don’t ask Krugman. He follows John Maynard Keynes who, accurately but none too helpfully, observed: “In the long run we are all dead.” Actually, if you did ask Krugman, you might get a response like the one he gave when the dot com bubble burst: “To fight this recession the Fed needs . . . soaring household spending to offset moribund business investment . . . Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.”

That worked out fine, didn’t it? Well yes, in Krugman’s terms it did. Sure, we are now living with the effects of the bursting of that bubble but we did get a few good years of rocketing property prices which made us all feel as though we were getting richer just by sitting in our homes. And now that bubble has burst we just inflate a new one somewhere else. And when that bursts we inflate a new one. And when that bursts . . .

This is where the Keynesian ignorance of the long run demonstrated by Krugman leads you: lurching from one catastrophe to the next with a series of increasingly expensive quick fixes of ever shorter duration which do nothing to address the underlying problems.

The economic problems of Greece, Spain, and Britain are not that the deficits of 7 per cent, 7 per cent and 8 per cent their governments are respectively running are not high enough. Greek labour costs are higher than elsewhere and Greece doesn’t export very much. Spain has unemployment of 24 per cent thanks to a labour market which makes job creation almost impossible. Britain is  already one of the most indebted nations on the planet.

These fundamental problems are ignored by Krugman and his followers. In his 1994 book Peddling Prosperity Krugman accused the supply-side economists of the 1980s of being “cranks” selling “snake oil” because, he said, they offered politically expedient economic non-remedies with no   basis in fact. Hypocrisy, thy name is Krugman.

As for that Nobel Prize, Paul Krugman won it for his work on international trade patterns, not his crackpot Keynesianism. Sir Paul McCartney won an Ivor Novello award for writing “Yesterday”. That doesn’t mean sentimental schlock like “Mull of Kintyre” is worth listening to.

This article originally appeared in Standpoint

The euthanasia of the rentier: Why the assault on savers must end


Take that thrift!

With the British economy flat lining, America’s stumbling, and Europe’s in a nosedive, the clamour is growing for policymakers to ‘do something’. The Bank of England is, once again, being urged to deploy the weapon of Quantitative Easing – the spending of newly created money on long term assets.

Would this do any good? It hasn’t so far. The truth is that money is not wealth, goods and services are, and a central bank simply producing more money does not make us wealthier. But if central banks can’t create more wealth by creating more money they can redistribute the wealth there is.

This has been happening in Britain for nearly four years. Between October 2008 and March 2009 the Bank of England slashed interest rates from 5 percent to the historic low of 0.5 percent. When this failed to reignite economic growth the Bank resorted to £325 billion worth of QE. Whereas the Bank usually works on the short term end of the Yield Curve when setting the base rate, with QE it set out to pull down the long term end.

The stated aim was to put money into banks to get them lending again. I’ll leave it to you to judge how far the programme has succeeded in that aim, but one predictable side effect has been to lower returns all along the curve.

And this matters. With policymakers pulling every trick to keep interest rates everywhere as low as possible, Britain’s savers are being ravaged. On one estimate they are being robbed of £18 billion per year. Simon Rose, of pressure group Save Our Savers, puts the figure savers have been stripped of at £100 billion since the start of the crisis, “a staggering amount of money” he says “given that it would pay for the Olympics ten times over.”

The Bank’s monetary shenanigans haven’t boosted growth (cheerleaders have fallen back on the old argument that they have, at least, staved off catastrophe – again, I’ll let you be the judge). They have caused a vast transfer of wealth away from Britain’s savers and towards debtors and zombie banks and this is bad economic policy for reasons of growth and stability.

An entrepreneur with an idea must spend money on premises, wages, and all kinds of other possible outlays before seeing a single penny in revenue. The only way the entrepreneur can fund this outlay is from savings, either their own or other people’s channeled through a financial institution.

An increase in saving allows this period between embarking on production and sale of the product to lengthen (or fund other production periods for other goods). The lengthening of the production period, in turn, permits more stages of production,increasing ‘roundaboutness’ as the Austrian economist Eugen von Böhm-Bawerk put it.

Take shelter, a basic human need. Without the savings to sustain us over a prolonged production period, the period between embarking on production and using the shelter must be short, perhaps as long as it takes us to find a cardboard box. But with savings we can extend the production period and introduce many more intermediate stages. We can purchase land, draw up plans, purchase materials, hire labour etc.

The story of human material progress can be characterized as the lengthening of production processes enabling ever more intermediate steps. In short, savers are the difference between a three bed terrace and a cardboard box.

This much is not controversial; almost all economists agree that saving is an indispensable ingredient of increasing wealth. But the attack on savings risks shorter term instability too.

Lowering the base rate and QE works the same way, just on different ends of the Yield Curve; assets are purchased from banks with money newly created by the Bank of England.  From the point of view of a bank there is no difference between money deposited with it by savers and money it receives from the Bank of England in return for financial assets; it can lend out and earn profits on both.

But from the point of view of the wider economy there is a huge difference between the two types of ‘savings’. When savers deposit their funds with a bank they are doing so because they wish to withdraw this money in the future to fund consumption then. The resultant fall in interest rates, which makes it possible for firms to borrow to invest in the means to supply this future consumption, represents the actual time preferences of economic agents.

The ‘fake savings’ of Bank of England deposits, however, represent no such thing. While they can be lent and borrowed to fund investment projects with longer production periods there has been no change in the time preference of economic agents. There will be no real savings to purchase the output of these enterprises in the future.

When this is revealed these unprofitable enterprises will be liquidated causing recession. It is, thus, only the deposits of savers which can provide the capital which allows for longer production processes and increasing wealth on a stable and sustainable basis.

In his ‘General Theory’ in 1936, John Maynard Keynes looked forward to “the euthanasia of the rentier” when interest rates would be driven to zero and capital would be free and abundant. This nonsense, as much as anything else he said, represents a threat to our economic growth and stability. The assault on savers must end.

This article originally appeared at The Commentator

Why the euro is working

It’s just misunderstood

The euro is a disaster. The single currency is falling apart because it does not have a central fiscal authority or a central bank capable of acting as lender of last resort standing behind it. Because of this it was doomed from the start and everybody knew it.

This line of thinking, stretching from the pages of the Telegraph to the New York Times, is so widespread that it might seem ridiculous to challenge it. Indeed, I subscribed to it myself. But lately I’ve been having second thoughts. Is it, in fact, possible that the euro is working in exactly the way it ought to be?

Let’s go back to basics and look at what we want our money to do. As I wrote recently

“The textbook functions of ‘money’ are familiar to anyone with a smattering of economics; a medium of exchange, a store of value, and a unit of account. But each of these functions is entirely dependent upon money maintaining its value. If the value of the pound fluctuates it is no more useful as a unit of account or measure than a twelve inch ruler which kept changing length. Money which declines in value is a poor store of value.

Historically, when its value declines beyond a certain point people stop storing their wealth in money and trade it for commodities as quickly as possible. This acceleration in velocity of circulation exacerbates the decline in value and can trigger hyperinflation. And money which is rapidly losing value can cease to fulfil the function of medium of exchange if people refuse to accept it, legal tender laws or not.

So the value of money must be maintained for it to serve its functions and value is determined by supply and demand. Money is demanded for transactions, buying and selling. A few coin collectors aside, people do not demand money for its own sake but because they wish, at some point in the future, to exchange it for goods or services.”

So what is the greatest threat to this maintenance of purchasing power which we desire from our money? Historically it has come from currency issuers, almost always governments, who have issued excess amounts of currency to pay their bills and caused a decline in the purchasing power of everyone else’s money in the process.

In the last century this was taken to lamentable extremes. John Maynard Keynes wrote in 1931 that “A preference for a gold currency (which could not be produced at will by monetary authorities) is no longer more than a relic of a time when governments were less trustworthy in these matters than they are now”

The following decades proved Keynes’s faith in politicians to be grossly misplaced. We’ve all heard of the Weimar inflation but over the twentieth century the dollar and the pound lost about 90 percent of their value. This didn’t happen smoothly. As D R Myddelton writes, during the Keynesian golden age “The pound’s purchasing power halved between 1945 and 1965; it halved again between 1965 and 1975; and it halved again between 1975 and 1980. Thus the historical ‘half-life’ of the pound was twenty years in 1965, ten years in 1975 and a mere five years in 1980”

As a result of such monetary mismanagement many countries sought a way to get their politicians’ hands off the printing press. No one was willing to go the whole hog and reintroduce the gold standard (which had tied the issue of currency to the amount of gold the issuer held) but the German model, with the Bundesbank independent from the government, was widely copied.

The whole point, to repeat, was to remove from government the power to print excessive amounts of money to cover their own expenses and, in doing so, ruin everyone else’s money. That considered, the euro is actually performing well.

Given the dire state of several eurozone economies, this may seem a bizarre thing to say. But can Spain’s horrific unemployment really be blamed on the euro when it hasn’t been under 8 percent since 1979? Is it really the fault of the euro that the Greeks chose to pay their pastry chefs, radio announcers, hairdressers, and steam bath masseurs (among 600 other “arduous and perilous” professions) a state pension of 95 percent of their final salary when they retire at 50?

Spain’s unemployment predates the euro and won’t be solved until a labour market which makes it practically impossible to hire and fire is reformed. Greece’s politicians have to stop promising Greeks that they can spend one third of their life retired, living on money borrowed from the Germans. ‘Reforming’ the euro can’t help with either of these. Indeed, by forcing governments to address these structural issues the euro could be seen to be doing them a service.

But these steps will have to be taken against the backdrop of a debt crisis. This is where calls for the European Central Bank to act as lender of last resort or for fiscal union to match monetary union are heard. The fatal flaw of the euro, these people say, is that it cannot be produced at will by governments to pay their bills.

But then, that is, and always was, the whole point. If a given country cannot pay its bills, is the solution for it to run the printing press and devalue everyone’s money or is it for that government to stop making spending commitments it can’t keep?

Countries like Greece are faced with massive borrowings in a currency which they cannot produce at will. Those who argue that this represents a fatal cleavage between monetary and fiscal policy and that a single fiscal policy must stand behind a single currency to bridge it are arguing that the solution is to put the power to make spending commitments in the same hands as the power to print money. The lessons of history are that this does not end well.

This article originally appeared at The Commentator

The euro – lessons from history

Dinner money

When currencies and monetary arrangements have broken down it has always been because the currency issuer can no longer fight the lure of the seigniorage to be gained by over issue of the currency. In the twentieth century this age-old impulse was allied to new theories that held that economic downturns were caused or exacerbated by a shortage of money. It followed that they could be combated by the production of money.

Based on the obvious fallacy of mistaking nominal rises in wealth for real rises in wealth, this doctrine found ready support from spendthrift politicians who were, in turn, supported by the doctrine.

Time and again over recent history we see the desire for seigniorage allied with the cry for more money to fight a downturn pushing up against the walls of the monetary architecture designed to protect the value of the currency. Time and again we see the monetary architecture crumble.

The classical gold standard

At the start of the twentieth century much of the planet and its major economic powers were on the gold standard which had evolved from the 1870s following Britain’s lead. This was based on the twin pillars of (1) convertibility between paper and gold and (2) the free export and import of gold.

With a currency convertible into gold at a fixed parity price any monetary expansion would see the value of the currency relative to gold decline which would be reflected in the market price. Thus, if there was a parity price of 1oz gold = £5 and a monetary expansion raised the market price to 1oz = £7, it would make sense to take a £5 note to the bank, swap it for an ounce of gold and sell it on the market for £7.

The same process worked in reverse against monetary contractions. A fall in the market price to 1oz = £3 would make it profitable to buy an ounce of gold, take it to the bank and swap it for £5.

In both cases the convertibility of currency into gold and vice versa would act against the monetary expansion or contraction. In the case of an expansion gold would flow out of banks forcing a contraction in the currency if banks wished to maintain their reserve ratios. Likewise a contraction would see gold flow into banks which, again, in an effort to maintain their reserve ratios, would expand their issue of currency.

The gold standard era was one of incredible monetary stability; the young John Maynard Keynes could have discussed the cost of living with Samuel Pepys without adjusting for inflation. The minimisation of inflation risk and ease of convertibility saw a massive growth in trade and long term cross border capital flows. The gold standard was a key component of the period known as the ‘First era of globalisation’.

The judgement of economic historians Kenwood and Lougheed on the gold standard was

One cannot help being impressed by the relatively smooth functioning of the nineteenth-century gold standard, more especially when we contemplate the difficulties experienced in the international monetary sphere during the present century. Despite the relatively rudimentary state of economic knowledge concerning internal and external balance and the relative ineffectiveness of government fiscal policy as a weapon for maintaining such a balance, the external adjustment mechanism of the gold standard worked with a higher degree of efficiency than that of any subsequent international monetary system

The gold exchange standard and devaluation

The First World War shattered this system. Countries printed money to fund their war efforts and convertibility and exportability were suspended. The result was a massive rise in prices.

After the war all countries wished to return to the gold standard but were faced with a problem; with an increased amount of money circulating relative to a country’s gold stock (a problem compounded in Europe by flows of gold to the United States during the war) the parity prices of gold were far below the market prices. As seen earlier, this would lead to massive outflows of gold once convertibility was re-established.

There were three paths out of this situation. The first was to shrink the amount of currency relative to gold. This option, revaluation, was that taken by Britain in 1925 when it went back onto the gold standard at the pre-war parity.

The second was that largely taken by France between 1926 and 1928. This was to accept the wartime inflation and set the new parity price at the market price.

There was also a third option. The gold stock could not be expanded beyond the rate of new discoveries. Indeed, the monetary stability which was a central part of the gold standard’s appeal rested on the fixed or slow growth of the gold stock which acted to halt or slow growth in the currency it backed. So many countries sought to do the next best thing and expand gold substitutes to alleviate a perceived shortage of gold. This gave rise to the gold exchange standard which was put forward at the League of Nations conference in Genoa in 1922.

Under this system countries would be allowed to add to their gold reserves the assets of countries whose currency was convertible into gold and issue domestic currency based on this expanded stock. In practice the convertible currencies which ‘gold short’ countries sought as reserves were sterling and dollars.

The drawbacks were obvious. The same unit of gold could now have competing claims against it. The French took repeated advantage of this to withdraw gold from Britain.

Also it depended on the Bank of England and Federal Reserve maintaining the value of sterling and the dollar. There was much doubt that Britain could maintain the high value of sterling given the dire state of its economy and the dollar was weakened when, in 1927, the Federal Reserve lowered interest rates in order to help ease pressure on a beleaguered sterling.

This gold exchange standard was also known as a ‘managed’ gold standard which, as Richard Timberlake pointed out, is an oxymoron. “The operational gold standard ended forever at the time the United States became a belligerent in World War I”, Timberlake writes.

After 1917, the movements of gold into and out of the United States no longer even approximately determined the economy’s stock of common money.

The contention that Federal Reserve policymakers were “managing” the gold standard is an oxymoron — a contradiction in terms. A “gold standard” that is being “managed” is not a gold standard. It is a standard of whoever is doing the managing. Whether gold was managed or not, the Federal Reserve Act gave the Fed Board complete statutory power to abrogate all the reserve requirement restrictions on gold that the Act specified for Federal Reserve Banks (Board of Governors 1961). If the Board had used these clearly stated powers anytime after 1929, the Fed Banks could have stopped the Contraction in its tracks, even if doing so exhausted their gold reserves entirely.

This was exacerbated in the United States by the Federal Reserve adopting the ‘real bills doctrine’ which held that credit could be created which would not be inflationary as long as it was lent against productive ‘real’ bills.

Many economists, notably Ludwig von Mises and Friedrich von Hayek, have seen the genesis of the Depression of the 1930s in the monetary architecture of the 1920s. While this remains the most debated topic in economic history there is no doubt that the Wall Street crash and its aftermath spelled the end of the gold exchange standard. When Britain was finally forced to give up its attempt to hold up sterling and devalue in 1931 other countries became worried that its devaluation, by making British exports cheaper, would give it a competitive advantage. A round of ‘beggar thy neighbour’ devaluations began. Thirty two countries had gone off gold by the end of 1932 and the practice continued through the 1930s.

Bretton Woods and its breakdown

Towards the end of World War Two economists and policymakers gathered at Bretton Woods in New Hampshire to design a framework for the post war economy. Looking back it was recognised that the competitive devaluations of the 1930s had been a driver of the shrinkage of international trade and, via its contribution to economic instability, to deadly political extremism.

Thus, the construction of a stable monetary framework was of the most utmost importance. The solution arrived at was to fix the dollar at a parity of 1oz = $35 and to fix the value of other currencies to the dollar. Under this Bretton Woods system currencies would be pegged to gold via the dollar.

For countries such as Britain this presented a problem. Any attempt to use expansionary fiscal or monetary policy to stimulate the economy as the then dominant Keynesian paradigm prescribed would eventually cause a balance of payments crisis and put downward pressure on the currency, jeopardising the dollar value of sterling. This led to so called ‘stop go’ policies in Britain where successive governments would seek to expand the economy, run into balance of payments troubles, and be forced to deflate. In extreme circumstances sterling would have to be devalued as it was in 1949 from £1 = $4.03 to £1 = $2.80 and 1967 from £1 = $2.80 to £1 = $2.40.

A similar problem eventually faced the United States. With the dollar having replaced sterling as the global reserve currency, the United States was able to issue large amounts of debt. Initially the Federal Reserve and Treasury behaved reasonably responsibly but in the mid-1960s President Lyndon Johnson decided to spend heavily on both the war in Vietnam and his Great Society welfare program. His successor, Richard Nixon, continued these policies.

As dollars poured out of the United States, investors began to lose confidence in the ability of the Federal Reserve to meet gold dollar claims. The dollar parity came under increasing pressure during the late 1960s as holders of dollar assets, notably France, sought to swap them for gold at the parity price of 1oz = $35 before what looked like an increasingly inevitable devaluation. Unwilling to consider the deflationary measures required to stabilise the dollar with an election due the following year, President Nixon closed the gold window on August 15th 1971. The Bretton Woods system was dead and so was the link between paper and gold.

Fiat money and floating exchange rates

There were attempts to restore some semblance of monetary order. In December 1971 the G10 struck the Smithsonian Agreement which sought to fix the dollar at 1oz = $38 but this broke down within a few months under the inflationary tendencies of the Federal Reserve. European countries tried to establish the ‘snake’, a band within which currencies could fluctuate. Sterling soon crashed out of even this under its own inflationary tendencies.

The cutting of any link to gold ushered in the era of fiat currency and floating exchange rates which lasts to the present day. Fiat currency gets its name because its value is given by governmental fiat, or command. The currency is not backed by anything of value but by a politicians promise.

The effect of this was quickly seen. In 1931 Keynes had written that “A preference for a gold currency is no longer more than a relic of a time when governments were less trustworthy in these matters than they are now” But, as D R Myddelton writes, “The pound’s purchasing power halved between 1945 and 1965; it halved again between 1965 and 1975; and it halved again between 1975 and 1980. Thus the historical ‘half-life’ of the pound was twenty years in 1965, ten years in 1975 and a mere five years in 1980”

In 1976 the pound fell below $2 for the first time ever. Pepys and Keynes would now have been talking at cross purposes.

Floating exchange rates marked the first public policy triumph for Milton Friedman who as long ago as 1950 had written ‘The Case for Flexible Exchange Rates’. Friedman had argued that “A flexible exchange rate need not be an unstable exchange rate” but in an era before Public Choice economics he had reckoned without the tendency of governments and central banks, absent the restraining hand of gold, to print money to finance their spending. World inflation which was 5.9% in 1971 rose to 9.6% in 1973 and over 15% in 1974.

The experience of the era of floating exchange rates has been of one currency crisis after another punctuated by various attempts at stabilisation. The attempts can involve ad hoc international cooperation such as the Plaza Accord of 1985 which sought to depreciate the dollar. This was followed by the Louvre Accord of 1987 which sought to stop the dollar depreciating any further.

They may take more organised forms. The Exchange Rate Mechanism was an attempt to peg European currencies to the relatively reliable Deutsche Mark. Britain joined in 1990 at what many thought was too high a value (shades of 1925) and when the Bundesbank raised interest rates to tackle inflation in Germany sterling crashed out of the ERM in 1992 but not before spending £3.3 billion and deepening a recession with interest rates raised to 12% in its vain effort to remain in.

Where now?

This brief look back over the monetary arrangements of the last hundred years shows that currency issuers, almost always governments, have repeatedly pushed the search for seigniorage to the maximum possible within the given monetary framework and have then demolished this framework to allow for a more ‘elastic’ currency.

Since the demise of the ERM the new vogue in monetary policy has been the independent central bank following some monetary rule, such as the Bank of England and its inflation target. Inspired by the old Bundesbank this is an attempt to take the power of money creation away from the politicians who, despite Keynes’ high hopes, have proved themselves dismally untrustworthy with it. Instead that power now lies with central bankers.

But it is not clear that handing the power of money creation from one part of government to another has been much of an improvement. For one thing we cannot say that our central bankers are truly independent. The Chairman of the Federal Reserve is nominated by the President. And when the Bank of England wavered over slashing interest rates in the wake of the credit crunch, the British government noisily questioned its continued independence and the interest rate cuts came.

Furthermore, money creation can reach dangerous levels if the central bank’s chosen monetary rule is faulty. The Federal Reserve has the awkward dual mandate of promoting employment and keeping prices stable. The Bank of England and the European Central Bank both have a mandate for price stability, but this is problematic. As Murray Rothbard and George Selgin have noted, in an economy with rising productivity, prices should be falling. Also, what ‘price level’ is there to stabilise? The economy contains countless different prices which are changing all the time; the ‘price level’ is just some arbitrarily selected bundle of these.

An extreme example, as noted by Jesús Huerta de Soto, is the euro. Here a number of governments agreed to pool their powers of money creation and invest it in the European Central Bank. The euro is now widely seen to be collapsing. So it may be, but is this, as is generally assumed, a failure of the architecture of the euro itself?

Let us remember that the purpose of erecting a monetary structure where the power to create money is removed from government is to stop the government running the printing presses to cover its spending and, in so doing, destroy the currency.

The problem facing eurozone states like Greece and Spain is presented as being that they are running up debts in a currency they cannot print at will to repay these debts. But is the problem here that these countries cannot print the money they need to pay their debts or that they are running up these debts in the first place? The solution is often offered that either these countries need to leave the euro and adopt a currency which they can expand sufficiently to pay their debts or that the ECB needs to expand the euro sufficiently for these countries to be able to pay their debts. But there is another solution, commonly called ‘austerity’, which says that these countries should just not run up these debts. As de Soto argues, the euro’s woes are really failures of fiscal policy rather than monetary policy.

It is thus possible to argue that the euro is working. By halting the expansion of currency to pay off debts and protecting its value and, by extension, preventing members from running up evermore debt, the euro is doing exactly what it was designed to do.

There is a growing clamour inside Europe and outside that ‘austerity’ alone is not the answer to the euro’s problems and that monetary policy has a role to play. The ECB itself seems to be keen to take on this role. But it is simply the age-old idea, based on the confusion between the real and the nominal, that we will get richer if we just produce more money. Germany is holding the line on the euro but history shows that far sounder currency arrangements have collapsed under the insatiable desire for a more elastic currency.


ANDERSON, B.M. 1949. Economics and the Public Welfare – A Financial and Economic History of the United States 1914-1946. North Shadeland, Indiana: Liberty Press

BAGUS, P. 2010. The Tragedy of the Euro. Auburn, Alabama: Ludwig von Mises Institute.

CAPIE, F., WOOD, G. 1994. “Money in the Economy 1870-1939.” The Economic History of Britain since 1700 vol. 2: 1860-1939. Roderick Floud and D.N. McCloskey, ed. Cambridge: Cambridge University Press, pp. 217-246.

DRUMMOND, I. 1987. The Gold Standard and the International Monetary System 1900-1939. London: Macmillan

FRIEDMAN, M. 1950. “The Case for Flexible Exchange Rates” Essays in Positive Economics. 1953. Friedman, M. Chicago: University of Chicago Press, pp. 157-203.

HOWSON, S. 1994. “Money and Monetary Policy in Britain 1945-1990.” The Economic History of Britain since 1700 vol. 3: 1939-1992. Roderick Floud and D.N. McCloskey, ed. Cambridge: Cambridge University Press, pp. 221-254.

HUERTA DE SOTO, J. 2012. “In defence of the euro: an Austrian perspective”. The Cobden Centre, May 29th

KENWOOD, A.G., LOUGHEED, A.L. 1992. The Growth of the International Economy 1820-1990. London and New York: Routledge

KINDLEBERGER, C.P. The World in Depression 1929-1939. London: Pelican

MYDDELTON, D.R. 2007. They Meant Well – Government Project Disasters. London: Institute of Economic Affairs

ROTHBARD, M. 1963. America’s Great Depression. BN Publishing

SAMUELSON, R.J. 2010. The Great Inflation and its Aftermath – The Past and Future of American Affluence. New York: Random House

SELGIN, G. 1997. Less Than Zero – The Case for a Falling Price Level in a Growing Economy. London: Institute of Economic Affairs

TIMBERLAKE, R. 2008. “The Federal Reserve’s Role in the Great Contraction and the Subprime Crisis”. Cato Journal, Vol. 28, No. 2 (Spring/Summer 2008), James A. Dorn, ed. Washington DC: Cato Institute, pp. 303-312.

VAN DER WEE, H. 1986. Prosperity and Upheaval – The World Economy 1945-1980. London: Pelican

This article originally appeared at The Cobden Centre

Money demystified: Stopping Keynes’s one man in a million


It’s on diversion

I’ve found that if I write an article about taxes, whether its avoidance or the 50p band, it’s likely to generate angry replies. But when I write about monetary matters, interest rates or Quantitative Easing for example, there is often a silence. Perhaps this is because few people share my interest in it, perhaps it’s because they think it less important than I do. Or perhaps, to borrow from Keynes, it’s because monetary policy works “in a manner which not one man in a million is able to diagnose”?

The textbook functions of ‘money’ are familiar to anyone with a smattering of economics; a medium of exchange, a store of value, and a unit of account. But each of these functions is entirely dependent upon money maintaining its value. If the value of the pound fluctuates it is no more useful as a unit of account or measure than a twelve inch ruler which kept changing length. Money which declines in value is a poor store of value.

Historically, when its value declines beyond a certain point people stop storing their wealth in money and trade it for commodities as quickly as possible. This acceleration in velocity of circulation exacerbates the decline in value and can trigger hyperinflation. And money which is rapidly losing value can cease to fulfill the function of medium of exchange if people refuse to accept it, legal tender laws or not.

So the value of money must be maintained for it to serve its functions and value is determined by supply and demand. Money is demanded for transactions, buying and selling. A few coin collectors aside, people do not demand money for its own sake but because they wish, at some point in the future, to exchange it for goods or services.

Under our present system money is supplied by the central bank. If people demand money to facilitate transactions why do central banks supply it? The motivations of the central banks who supply money are not the microeconomic ones of meeting transaction demand but macroeconomic ones which can change from time to time such as spurring GDP growth, decreasing unemployment, lowering inflation, exchange rate stability, or some combination of a couple of these. This is monetary policy.

Monetary policy is shrouded in mumbo jumbo but can be understood by anyone. Quantitative Easing, lowering the discount rate or the repo rate, Operation Twist, all of these monetary maneuvers executed by central banks essentially boil down to the same thing: the increase or decrease in the supply of money and credit to achieve some, one or two of the macroeconomic goals mentioned above.

When central banks reduce interest rates they purchase financial assets from banks with newly created money who then lend out some portion of this new money thus lowering interest rates. On the rarer occasions when they want to raise rates they do the opposite. Quantitative Easing is remarkably similar; it only really differs in that instead of buying short terms assets the Bank of England buys long term assets all of which, so far, have been UK government debt. Banks, in theory, then lend some portion of this new money out thus lowering these longer term interest rates.

There’s an obvious concern here. If money has to hold its value in order to fulfill its essential functions and if money supply is a crucial determinant of that value then won’t the tinkering about with the money supply affect its value?

But there’s another concern. Almost all the economic thinking upon which modern monetary policy is based models increasing the supply of money and credit as a once-and-for-all rise in everyone’s money holdings, proportionate to how much of the money supply they held before. This scenario is rather odd theoretically. If it’s true then monetary policy can have almost no traction and is pointless, all we will see are proportionate increases in price levels.

This line of theorizing is followed, it seems, simply to avoid thinking about the unpleasant consequences of monetary policy; the covert redistribution of wealth from the less well connected to the insiders and the permanent redistribution of wealth from those, like pensioners, on fixed incomes.

These consequences follow inevitably from the inclusion of time, an integral part of human existence and of sound economics as cause and consequence can only take place through time. If we include time we can look at how these expansions in the supply money of money and credit come about when central banks purchase assets from a bank. This bank now has money to lend out which it does. Its interest rates may fall but so will its borrowing costs (what it pays the central bank). As we see today, such action can lead to the sort of false profits which trigger multi million pound bonuses.

But there is a further benefit to these early receivers, these insiders. They receive this new money when prices are at the old level; it takes time for them to rise. As such, these early receivers are able to use new money to buy goods, services and assets at the old prices. However, as they spend this money and it is then spent by the second receivers, and then the third receivers’ etc prices are bid up. By the time the new money reaches those farthest from the monetary injection, the politically least well connected, often the poorest, the new money will have lost this power. They will simply face higher prices.

This is how monetary policy works. Central banks cannot create wealth but they can redistribute it. And the system confers a tremendous power upon those who exercise it. They are Keynes’s one man in a million and it’s in their interests, via mumbo jumbo, to keep it that way. Don’t let them.

This article originally appeared at The Commentator