The quantity of money

After considering what is money and how it is created, the next step is to look at how much there is, how the quantity changes over time, and what this is telling us. We are in luck because we can look at real data.*

Below I plot the amount of money in circulation in the UK over the last 3 decades. Money is a bit difficult to measure because it depends on what counts. This plot is for the broadest measure called M4 which includes credit and bonds. You can read about it and download the data from the Bank of England website.

When I saw this data I was shocked. Yes we all know that the global financial crisis was a big event and we are still reeling but I had not fully appreciated how dramatically things changed around 2008. Is this the end of neoliberal capitalism as some are suggesting? Look at the curve before 2010. The money supply keeps on growing. This could be regarded as normal. [Note added 17/08/2017: The growth in the money supply is demand driven. Money is created by households, business and governments borrowing on the basis of a promise to do something.] During the Lawson boom of the late `80s, the money supply was growing so fast that inflation rose to 8 percent and interest rates were increased to 15 percent in order to slow the rate of increase which led to the 90-92 recession. A classic boom and bust. But even during the bust, the money supply kept on growing – just at a slightly slower rate. And after 1992, the money supply kept on growing. As Raghuram G. Rajan said in his book Fault Lines, the policy was to “let them eat credit”, and we did. But then in 2008 everything changed.

The phase transition

In 2007-08 we knew we were in trouble and in 2009 the Bank of England decided to inject new money via quantitative easing (indicated by the black bars). The amounts were big – £200 billion in 2009 – but in terms of the total money supply it was a drop in the ocean and did very little. After 2010 the money supply began shrinking again – this was not normal. In 2011 and 2012 the Bank of England did more quantitative easing. Again the amounts were big but it had no noticeable effect. There was a bit of a pick up in 2016, then we had the referendum, more quantitative easing, but still the rate of money growth was no better than the ’90-92 recession.

Looking at the graph as a whole, the difference, before and after 2010 is stark – physicists call this a phase change, economists might call it a complete failure of monetary policy. So what exactly did change? The best explanation has been given by the economist Richard Koo (this is one of my favourite economics talks of all – my favorite moment is when Koo says “we live in a very strange world”). He calls our debt hangover a balance sheet recession and it works like this: For money to be created there needs to be borrowers but after 2010 there were too few borrowers, because rather than borrowing, people, companies and government were all trying to pay down debt, destroying money in the process. Consequently, rather than the normal phase where the money supply grows exponentially over time, after 2010 we observe an anomalous phase where the money supply is at best flat and at worse actually falls. It could have been fine if only households had decided to save but when individuals, companies and government all decide to pay off their debts at the same time then the economy stalls. Keynes called this, the paradox of thrift – saving is a virtue unless everyone does it.

Exactly the same kind of debt overhang or balance sheet recession happened in Japan after 1990. The lesson from Japan is that there is no quick fix. You can move the debt around, from private to public but the only way out is growth. Japan at least has a relatively strong manufacturing base, and relatively low inequality which both help growth.

What did not work?

In the UK, the government had hoped that by reducing corporation taxes they would encourage companies to borrow, to invest, to raise productivity and grow the economy, but it did not happen. At the same time they were trying to reduce government spending.  The Oxford economist Simon Wren Lewis calls this, “the most damaging UK macroeconomic policy mistake in my lifetime”. The problem is that if households are paying down debt and governments are reducing spending then comsumers have less surplus money and there is a lack of demand. If there is no demand, companies have no incentive to invest and the virtuous circle of rising production, rising wages and rising demand cannot begin. Also, by lowering corporation taxes, companies can increase profit without trying. If you look at the graph in Follow the money you can see that only corporations are sitting on a surplus. Households are back in the red which cannot last long.

End game

To end I will switch to a recurring theme. Throughout history, empires or economies fall not because the workers stop working, but because the elite become lazy, greedy, or corrupt. Economies stall when the elite focus on rent extraction rather than production. The historian Mikhail Rostovtzeff sums up the problem in this passage:

The prevailing outlook of the municipal bourgeoisie was that of the rentier: the chief object of economic activity was to secure for the individual or for the family a placid and inactive life on a safe, if moderate, income. The creative forces which [….] produced a rapid growth [….] suffered a gradual atrophy, which resulted in an increasing stagnation of economic life.

Rostovtzeff, M., The Social and Economic History of the Roman Empire, OUP 1957.

Sound familiar? The rentiers of today are the CEOs, the banks, the buy-to-let landlords, the stock market investors. They have no need to innovate, no need to find new ways to create wealth, because they are doing just fine while the rest are struggling. Until we rebalance tax incentives away from rent extraction towards production, until we switch power away from the financiers and back towards entrepreneurs and small business, and address the failing ratio of wages to capital, until then we cannot expect a more favourable outcome.

*In science there is data. Sometimes there is a theory – a hunch. Scientists test hunches by collecting data and then decide if a theory is useful. A theory without data remains no more than speculation. If economics wants to be a science, it can only do so by focusing on the data. Repeat after me. “No science without data.”

The Duopoly of Money Creation

How is money created?

Fiat money is created from nothing on the basis of a promise – a promise to deliver goods or service in the future. Another word for promise is debt – I prefer promise. Only if we believe in these promises does money have value. The teacher promises to teach. The roofer promises to mend the roof. Money creation facilitates things getting done, but create too much too fast – by promising more than we can deliver – and it looses its value. Therein lies the problem.

Money is created either when the government spends, or when a bank makes a loan. We can think of government spending and bank loans as the beginning of two interconnected money circuits, see Figures below. The government and bank circuits form the duopoly of money creation.

The money circuit

After money is created it flows [1] through the economy and eventually is returned to the issuer. In the government circuit, money is returned to the government via the payment of tax, as in Figure 1. In the bank circuit, money is returned to the bank by the repayment of the loan, see Figure 2.

Figure 1: The government spend and tax circuit. The difference between spend and tax equals private sector saving and is known as the deficit. 

When all the money is returned the quantity of money goes back to zero except that in practice the rate of new money creation is higher than the rate of money cancellation, such that we hardly notice the creation and annihilation process and instead the total amount of money in the economy grows (imagine the lines in Figures 1 and 2 getting thicker over time). Ideally the growth in the money supply should match the growth in economic activity, such that prices remain roughly stable and we maintain confidence in the value of our promissory notes. Control of the rate of money creation and destruction in the government and banking circuits are known fiscal and monetary policy, respectively.

Figure 2: The bank circuit where loans create private debt.

Note that the government circuit is leaky, by design. People are allowed to save – hoard promises – and avoid tax. The part of the government spend that is saved leads to a deficit on the governments books (red in Figure 1). Savings can serve a useful purpose but it is odd that we tolerate other leaks, like lower taxes on capital gains and tax havens, I shall come back to leaks and the deficit in a later post.

Why two circuits?

The obvious question is, why do we need a duopoly? Why do we need both a government circuit and a banking circuit? Why do we need both fiscal and monetary policy? As money is a collective good, should we transfer all money creation powers to government and demote private banks to the role of intermediaries as some propose? Or could we hand over all money creation to private banks as the free market fundamentalists would prefer?

Many people are shocked to learn that banks and government are the source of all money, in particular, that banks create money. By allowing the equivalence of bank money and government money, the government and hence all of us underpin the banking circuit and so we have a democratic right to keep them under control and to take a share of their profits. Still banks do provide a useful service, and those looking for the failings of the modern world as a failure of this system of money miss the real culprits. The duopoly is optimally designed to meet our needs. We just need to manage it better.

The reason for the duopoly is relatively easy to understand. Money creation needs to serve both individual need and those of the country as a whole. The bank circuit exists to serve individuals, while the government circuit exists to provide services to everyone.

  • Two circuits are necessary because there are individuals (private) and collective (common or public) interests.

We do not really want government to get involved in private consumption like car loans and we do not really want the vested interests of private banks to extract rent from public need, so two separate dedicated money circuits are required.

Economists often call our collective interests public goods. The most familiar examples are security and defence, health and education. Education is a public good because its consumption is intended to benefit society as a whole and not only the individual receiving the education. We educate people to become engineers and doctors so that we can all benefit from their expertise in the future. Other examples of a public good include transport and energy – we build roads or power stations such there is a net benefit to everyone.

Democratic control of money creation

We can still ask why we need a separate money circuit to provide public goods? There are many good reasons, but perhaps most important of all is that we should be granted a say on our collective interests – this is the essence of democracy. We elect a government to manage our collective needs. Capitalism and democracy are also a duopoly – each with their dedicated money circuit. The capitalist banking circuit represents private interests but fails completely in the provision of public goods. The democratic government circuit fills the gap. The duopoly of capitalism and democracy exist in parallel to support and complement each other.

The failure of the private interest bank circuit to provide public goods is easiest to understand by looking at specific examples. For example in health care, the market solution is to operate on the patient offering to pay the most. Even worse, the market may deliberately create a scarcity in order to charge a higher price. A market cannot operate effectively in matters of life and death, as Kenneth Arrow – a highly-respected pioneer of neoclassical economics – wrote:

the laissez-faire solution for medicine is intolerable.

The government solution in health care take a long-term perspective and addresses the scarcity in trained doctors such that more patients can be treated. Markets only operate effectively if there is genuine competition. For example, we need at least two – preferably more – companies operating on every bus route in order to give commuters a real choice, but this just creates overcapacity and congestion. In situations where competition is not viable, where demand is unlimited like health, and supply delivers societal benefits then collective democratic control is the optimal solution.

What can go wrong?

The duopoly of individual (or private) and collective (or public) needs leads naturally to the duopoly of monetary and fiscal policy. Those looking for the failings of the modern world as a failure of the system of money miss the real culprits. The failure lies in the inability of politicians to regulate the banks and to appropriately use fiscal policy.

The art of economic management is to balance fiscal and monetary policy. An over dependence of one or other is doomed in the long term. Since 1980 both the US and UK abandoned this balanced approach that had worked well up to the oil crises of the `70s. Over reliance on the banking circuit and bank deregulation led eventually to the private debt bubble that burst in 2007-08. Rather then correct their mistake, politicians left it to the central bankers to sort out the mess. The bankers, limited to monetary tools, turned to quantitative easing, but nearly a decade on, with interest rates still stuck at their zero lower bound, we still look on aghast, waiting for someone to wake up to the complete failure of monetarism – if only the younger Milton Friedman could come back to explain it to us all. In 1969, he said [2]:

The available evidence . . . casts grave doubts on the possibility of producing any fine adjustments in economic activity by fine adjustments in monetary policy – at least in the present state of knowledge . . . There are thus serious limitations to the possibility of a discretionary monetary policy and much danger that such a policy may make matters worse rather than better.

In contrast, fiscal policy is a far more powerful, and some may say more dangerous, beast. The collective has an ability not available to any individual. Only the collective has a super charge card where all the spend comes back via tax – the teacher does not cost anything as long as the money spent on them is also spent. In fact, more likely is that the collective will make a profit on employing the teacher by crowding in more economic activity (a multiplier greater than 1). Fiscal policy is intended to get things done. Let’s get on with it!

[1] As Marcus von Skym says: the most important property of money is to flow.

[2] Milton Friedman and Walter W. Heller, Monetary vs. Fiscal Policy, W. W. Norton and Company Inc., New York 1969.

A brief history of money

The following is an extract from the unpublished book:

Peoplons, Charmons and the Strange One: the uncertain science of economics

by C. S. Adams, Illustrated by Cohenbaum.

Tokens of exchange:

In the economist’s book of myths and legends, money was invented to solve the “double coincidence-of-wants” problem in a pair-wise economic exchange. Paul the baker wants a beer, but Mary the brewer already has a loaf of bread. Instead Paul gives Mary some gold coins or tokens which are exchangeable for something else later on. Problem solved.
Continue reading “A brief history of money”

Lower tax equals a worse life

Let’s be clear, lower tax means lower prosperity, worse public services, worse health and worse education.

The evidence is in the data. The graph below (updated 2017-06-08 following suggestions in the comments) shows outcome measured using the UN’s inequality-adjusted human development index (IHDI) as a function of input measured using tax as a percentage of national income (GDP) using data collated by the Heritage Foundation. IHDI is a number that measures income, life expectancy and years in education.* The higher the score the better. Top of the IHDI league table (see here) is Norway (which despite its oil wealth also has high taxes), bottom is the Central Africa Republic. The UK (in colour) is currently 13th, better than the US, but not as good as Germany, Australia or any of the Scandinavian countries. Included are all countries where data is available which includes more than 95% of global population.

The line assumes a diminishing return with increasing tax. However the exact form of this line is a bit arbitrary as we do not know what kind of correlation to expect. We could argue that countries above the line are getting relatively good value for money whereas those below the line could do better although there is a large country-by-country variation that depends on individual circumstances, such as Norway has oil as well as high taxes.

A simple linear fit gives a Pearson correlation coefficient r = 0.77. This tells us that prosperity outcome is roughly proportional to government input – the size of the governments spend and tax circuit. The more you spend and tax, the better the quality of life, the better your life expectancy and the better your education.

The conclusion is clear. A vote for a tax party of low tax is a vote for a worse life, worse health and worse education. On Thursday, why not vote for prosperity instead?

* IHDI also includes a correction for inequality but in most cases there is not much difference between the HDI and IHDI.

The best of times, the worst of times – back to the ’70s?

Regardless of the power cuts, stagflation, the IMF loan, the sick man of Europe, the question, Do you want to go back to ’70s? is as ridiculous now, as asking someone in the ’70s if they want to go back to the ’30s. Even if we wanted to, we cannot turn back time – ignoring all the medical and scientific advances that have improved our lives since. The consistent story of economic history is that thanks to advances in knowledge, we have been getting gradually richer and richer as the graph below shows.

Plotted in the top graph is the average UK weekly income since 1765 adjusted for inflation based on data from the Bank of England.* The dark shaded areas indicate the World Wars, the light shaded regions financial crises. Unsurprisingly, the graph shows that – despite a few bumps along the way – we are richer now than in the ’70s, just like we were richer in the ’70s than we were in the ’30s or the 1870s! More importantly, and what matters in terms of policy, is the rate at which we get richer, i.e., where is the steepest part of the graph?

To find out, below the main graph I have plotted the slope or rate of wages growth per year (grey dots). This fluctuates wildly from year to year so I have added a decadal average (large black squares with a vertical bar to represent the scale of the fluctuations). Each of the black squares is centred on the turn of decade from 1770 to 2010. Some things of note are that in terms of income growth:

1. The best decade was 1965-75.

2. The worst decade was 1785-95. **

3. The second worst was 2005-15.

In terms of recent history, the interesting question is why was 1965-75 so good and 2005-15 so bad? Let’s consider 1965-75 first. Was it just that we were paying ourselves too much. No! This would show up as a hangover, and 1975-85 was pretty good too. The reason that income growth was so high around  1970 is because this era coincided with peak productivity growth and as any economist will tell you:

prosperity = productivity

The economist Paul Krugman – winner of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel in 2008 – put it like this in 1994:

Productivity isn’t everything, but in the long run it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.

The Bank of England data set also includes productivity so below I plot income growth (top graph) together with productivity growth (bottom graph).

The wage growth plot is the same as before but for productivity growth (which is very volatile) I have used a moving average. Roughly the ups and downs in the income growth and productivity growth match just as Krugman said they should. In particular, it is clear that peak income growth around 1970 correlates with peak productivity growth also in 1970.

A puzzle is why productivity growth started to decline after 1980, dropped off a cliff in 2008, and has not recovered since causing the stagnation in wages that we see now.*** One argument is that all the easy gains had been made, another is that financialisation has crowded out real production as I discussed previously.

Yes we are richer now, but if we want to get back to the productivity gains of the past we should look at what worked well in the ’70s – e.g. the higher income share of labour (see Chart 15 in this speech by the Chief Economist of the Bank of England) – and what is not working now – e.g. lack of investment.

And while we are on the subject of the best of times, have a listen to this!

*  For those that care about such things I have used a logarithmic scale on the vertical axis such that each factor of ten takes up the same amount of space. If I use a linear scale, the graph hovers around bottom until 1950 and then shoots up.

** Adam Smith died in 1790. A tale of two cities was set around 1780.

*** The situation in the US since 1970 is even worse because average growth has not kept pace with productivity growth.

Graph of the day

The Institute of Fiscal Studies has helpfully done an analysis of the manifesto proposals of the main parties (see here). The graph below is their analysis of how current Conservative plans will influence the income of people in different parts of the income distribution. It shows, the richest 10% just about managing, while the poorest 10% loose 9% of their income.

The manifesto does nothing to address this – not what you might expect from the claim on page 9 to “abhor social division, injustice, unfairness, and inequality.” But then, what politicians say is one thing, what they do is another.

In the interest of balance, I should add that the next page of the IFS report shows that Labour is better but could have gone much further (see here). The case for a progressive spend and tax policy is strong. For evidence, have a look at Sweden.

Follow the money

There is one simple rule that most economists agree on:

prosperity = productivity

The Chancellor understands this – productivity was mentioned 10 times in his recent Spring Budget speech. He said:

Simply put, higher productivity means higher pay.

and went on to say that Britain’s problem is a productivity problem

We are 35% behind Germany and 18% behind the G7 average. And the gap is not closing.

So what is going wrong and who is to blame? Is it the 99% or the 0.1%? I would say the latter. Let me explain why.

Continue reading “Follow the money”