Relay: Victoria Chick on Money, Banking and the forgotten Keynes

Positive Money conference, January 2013, London

I’ve chosen to look at this from the standpoint of academic economists, because I am one and that’s what I know, and there’s some interesting things, I think, to say about that. The rest of academics would look to us for answers, claiming this was our area of expertise and we ought to be able to enlighten them. It is a very strange fact of Fate that I’ve been in this business long enough for the kind of understanding that you’ve been exposed to through “Where Money Comes From” and this new book constitute a return to what I was taught as an undergraduate.

Dennis Robertson, a Cambridge economist, used to say, “Highbrow opinion is like a hunted hare. If you stand in the same place long enough, it will come around again.” Well, it has come around again. The shocking thing to me is the amount of energy that people in Positive Money and places like that have to expend to get a point of view across that was taught tome as an undergraduate and then forgotten. So there has been a deliberate regression. Well, deliberate? There has been a regression from the understanding which pertained in the late Fifties and early Sixties, and now we’re fighting to restore that understanding. That is a very peculiar state of affairs, and I hope to give you a few ideas, nothing more, as to how it might have come about.

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The question has to be treated in two parts. According to a very strange split in the way that money is talked about in academic economics. First of all, it has a role to play in what we call “macroeconomics.” And I think most of you have a fairly good idea of what that is. It is the theory of the economy as a whole and the policies that you might use to change the economy in some way from time to time. Then, quite separate from Macroeconomics, there are always courses in Money and Banking. Macroeconomics is sort of thought of as a core part of economics, and money and banking a kind of optional, slightly frivolous thing that some people spend a little time thinking about.

So what I have to say will fall into those two parts. But they are, it turns out, connected. In macroeconomics, money in the mainstream of economics has a very limited sphere of influence. And it doesn’t connect at all well even with the kind of money and banking which is taught as this frivolous option that I spoke of. Keynes – John Maynard Keynes – in his famous letter to George Bernard Shaw said, when he was writing the General Theory, that he thought what he was writing would revolutionize the way the world thought about economic problems.

And later on in a small article he spelled out what was different about the kind of economics he was creating from what had gone before. He said, “I want to talk about a money production economics. And the kind of economics we have been doing is about a real, exchange economy.” That was his basic contrast. That was what he thought would be his big revolution. His was the theory in which money permeated the entire economy. Labor bargains for money wages. Saving and investment were analyzed by him in money terms. The rate of interest was a monetary phenomenon and it was determined by exchanges of money assets. All these aspects are missing from today’s mainstream economics, as they were from the economics that surrounded Keynes when he was writing. We have gone back in mainstream economics to talking about a real, exchange economy, which has an extremely limited role for money.

Classical economics, or pre-Keynesian economics, models everything in real terms. It’s “real” wages, that is, the amount of goods money can buy, and so on down the line. Money is only brought in at the very last minute to determine prices. So the role of money is separate from this whole analysis of the real economy. It has this little role to play in determining the price level. The term “pure” economics, as used by Alfred Marshall and Walras, meant the economics of this real economy, this barter economy. So by implication money is profoundly “impure,” I suppose.

And the idea was that money was neutral. It didn’t really affect these real relationships. All it did was determine price. Prices could be anything, it didn’t really matter. The real relationships were set up by the system elsewhere, without money, the pure economy, the barter economy, the exchange economy.

This kind of system – dividing the economy between the real and the monetary – was known as the “Classical Dichotomy.” On the monetary side, you had the Quantity Theory of Money. The quantity of money determined prices. Full stop. End of story. Not very interesting, actually, for a role for money.

Now, Keynes showed that the Quantity Theory of Money was based on enormously restrictive assumptions which were very unlikely to pertain in practice. But Milton Friedman – whose name I’m sure you know, too – was able to use the QT as the foundation of his Monetarist revolution in the late Sixties, early Seventies. And as I am sure you know, the Monetarist revolution touched the heart of Margaret Thatcher and found its way into monetary policy.

Monetarism – you may not know, but you ought to – is also the basis for the construction of the euro (Can’t be very good, then, can it?) and determines the way the ECB is doomed to function, and is responsible for inflation targeting more generally in the Western World. And it could be said to be the foundation also of Quantitative Easing, though that interpretation is open to some dispute.

Monetarism and the Quantity Theory of Money and the Classical Dichotomy are all over Western economies like a kind of skin disease. Quite extraordinary. And the Keynesian story, in which money influences everything that happens, has been forgotten, which I think is a tragedy.

Now this simple, sequestered role of money in an analysis which uses the Classical Dichotomy gives rise to some wonderful supporting rhetoric. After all, it must be more interesting to study the “real” economy than the monetary economy. And the “real” economy is a “pure” economy. Money is imagined to be only a veil thinly drawn across the real economy, not affecting anything. And anybody which thinks it does affect anything is subject to “money illusion,” which is a terrible mental illness.

Now, How does this happen? What is the appeal of this way of analyzing the economy? We know, if we keep our common sense about us that money does affect everything. One reason pertains to academic economics and not to common sense people like yourselves: Economics does not really understand its discipline to be historically situated. It thinks of itself as uncovering universal truths. And it therefore fails to recognize the institutional basis of its theories.

The Quantity Theory of Money was devised in the days of circulating gold coin, not in the days when the banks were overwhelmingly the suppliers of money. And yet the Quantity Theory of Money has been carried forward, and as I have told you, has influenced major institutions to this day. The idea that money should have something do with the determination of prices has a certain intuitive appeal. And of course, it DOES have something to do with the determination of prices. But the Quantity Theory of Money says that its ONLY function is to determine prices, and prices are determined solely by the quantity of money. And that is going far too far.

Another possibility of money of explaining how Macroeconomics has come to this pass is sheer laziness. Hayek, an unlikely source for what I am going to read to you, put it like this.

The task of monetary theory is much wider than is commonly assumed. Its task is nothing less than to cover a second time the whole field which is treated by pure theory [“pure” theory, real theory, yes?] under the assumption of barter, and to investigate what changes in the conclusions of pure theory are made necessary.

So if you want to take money seriously, you have to do the whole thing again.

Now I think Keynes DID do the whole thing again, and he has been wiped off the face of mainstream economics. He’s not taught. Nobody knows what he said. Nobody reads his book. We’ve regressed to pre-Keynesian economics.

Let me turn to this separation between Macroeconomics and Money and Banking that is enshrined in the academic curriculum. As I said, when I was a student in the late Fifties and early Sixties, it was widely understood, absolutely taken for granted, that the causality went from loans to deposits. Loans create deposits. Now students are all taught that banks lend on deposits, that deposits create the ability to lend, and banks respond to that. This is a regression, which people like Ben are trying to redress or reverse.

And again, I tried to think of reasons why this idea of deposits pre-existing and determining the volume of loans has such a tremendous appeal, and why the idea that loans create deposits is so difficult for people to grasp.

One factor is that there is a great fault in the language that we use, or a great bias in the language that we use in relation to banking. The word “deposit” is a hangover from the days of the goldsmiths who took bags of gold for safekeeping. And you’ll find if you look closely that much of the Neoclassical theory of banking still regards banks as kinds of glorified safes, which they clearly are not.

Add to this the failure to understand banks as a system, as an interrelated system. You heard much in the breaking of the crisis about the lack of systemic understanding, of the risks that the banks were running. If one DID think systemically, one would realize easily the check you deposit in your bank came from somebody else’s deposit. It’s not new money at all. It’s just moving around. Then if you think systemically, or macroeconomically, about banks, there are very few sources of new money to the system, EXCEPT when banks are all expanding their balance sheets together. So the language is bad.

And we also speak of “lending money.” Banks do not lend money. It may feel like that when you get a loan. But that’s not what they’re doing. They don’t have a pot of money which they are passing on. What they’re doing is accepting your IOU and agreeing to pay your outgoings while you don’t have any money in your account in an overdraft system. In a loan system, they simply write up your account.

This leads us to another point, which is very powerful, which illustrates that it is in the banker’s interest not to let you know what they are doing, because you really wouldn’t like it. That they have too much power. And others, including academic economists, might not like the power of bankers to be recognized either. They know that if they expose the bankers, they will be in deep trouble, and their funding will be cut, and all kinds of terrible things will happen to them. So they go along with it. You’ve all seen “Inside Job,” I take it. It is a kind of Inside Job problem.

Furthermore, there is a long history of wanting to believe that money is something real. The idea that bankers can manufacture money with the flick of a pen is just too unpalatable. And that leads to rejecting it. The idea that should depend for its money-ness only on the fact that we all accept it, is just too freaky for words. So it doesn’t come into the textbooks. It would also make it very clear that money is very fragile. Once that trust is breached, the whole thing could collapse.

But then, finally, there is a connection between that macroeconomic separation of money from the rest of the economy and the difficulty of making people understand that banks create money out of nothing, that loans are the engine of the creation of money. A deep-seated and long-standing idea in macroeconomics is that saving is necessary before you can have investment. Read the reports of the World Bank, and they all talk about insufficient saving for development. It’s absolute nonsense if the banks can create money.

And it was the ability of banks to create money out of nothing that led Keynes to say, “No, Savings is not the engine of growth in the economy. Investment is. Investment comes BEFORE savings.” And it’s the banks that permit that to happen.

So that brings me full circle. To tie those two strands together. They are related. If macroeconomics is going to regress to a pre-Keynesian form, so also did the understanding of banking have to regress. And that is what is happened.