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.
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.”