Authors: David Smith
Free Lunch (17 page)
To understand Keynes’s breakthrough, without getting bogged down in the complexities of
The General Theory
, it is necessary to return to my ‘most useful equation in economics’. This was the one that said GDP = C + G + I + X - M, where C is consumer spending, G government spending, I investment, X exports and M imports. Let’s ignore X and M for the moment and concentrate on the others. What happens when C is depressed because of high unemployment and I is weak because businesses cannot see any prospect of good times returning? Is it inevitable that GDP (gross domestic product – the economy as a whole) has to be weak, the more so because a government seeking to cut its cloth to suit its means would have to reduce spending in line with weaker tax revenues? Keynes said no. In these circumstances governments should do precisely the opposite. They should increase spending, particularly on public works (which would mean, on modern definitions, pushing up I, because of higher government investment). By boosting G and the public sector’s part of I, GDP would automatically be increased; economic growth would be restored.
Could it really be so simple? After all governments do not create wealth, they merely redistribute the money they raise from taxation. Would not Keynes’s solution result, if not in inflation, then in only a temporary fillip, after which the economy would be in even more trouble than before?
Keynes came up with many memorable phrases, ‘in the long-run we’re all dead’ being one of the most famous. Even more pertinent, in this context, is this one from
The General Theory:
If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig up the notes again (the rights to do so being obtained, of course, by tendering for leases of the note-bearing authority) 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.
The point was that additional government spending, at the right time, would ‘prime the pump’, triggering higher growth elsewhere in the economy, and the mechanism by which this occurred was probably one of Keynes’s most important contributions. The multiplier, already touched upon, ensured that this additional spending by government rippled through the economy. Suppose a public works programme employs 100,000 previously unemployed people at £500 a week. That means an extra £50 million of income. Not all of that will be spent, but if 90 percent of it is (the workers have an average propensity to consume nine-tenths of their income), there is £45 million of extra spending which generates wages for factory workers, lorry drivers, shop-workers and others. The multiplier, the size and strength of which will be determined by the propensity to consume, also ensures that at least part of the initial injection of public money feeds back to the Treasury in higher tax revenues. The multiplier also offers a strong reason why the ‘classical’ remedy to unemployment, reducing wages to price workers back into jobs, would not work. Apart from the fact that it is hard to get workers to accept wage cuts, even when prices are falling, wage cuts would, by reducing income, also mean lower spending power, or ‘aggregate demand’.
This all sounds fine but was there not a more direct route to stimulating the economy, through cutting interest rates? The next chapter will go into some detail about how this process usually works but Keynes’s essential point was that, at the time he was writing, interest rates had lost their potency. In his view a situation could develop where interest rates were as low as the authorities could push them but still too high to stimulate investment, because businesses were too gloomy about prospects – in Keynes’s words, they lacked ‘animal spirits’. In other words, it was possible for the economy to be caught in a so-called ‘liquidity trap’. Even when interest rates were at their lowest practicable level, perhaps even zero, nobody wanted to borrow. In these circumstances increasing money and credit would not help. All that would happen was that ‘idle’ balances would build up in banks. If all this sounds a bit far-fetched, Japan since about 1990 has been a living example of an economy caught in a liquidity trap, where interest rates have been effectively cut to zero without stimulating the economy, not least because of falling prices, or deflation. Interestingly, the Japanese government tried ‘Keynesian’ remedies on a number of occasions, with tax cuts and public works programmes. They did not work, mainly because by keeping interest rates too high at the start of the 1990s the Bank of Japan had allowed a situation of deflation – falling prices (and with it falling confidence) to develop.
There is a lot more to Keynes and
The General Theory
than this brief summary has allowed. Students who delve a little deeper will quickly encounter the so-called ‘IS and LM framework’, developed by Keynes’s followers Sir John Hicks and Alvin Hansen. They will get used to dealing with aggregate demand and aggregate supply. Further reading will reveal a fierce debate about whether Keynes’s
General Theory
was in fact general, or merely applied to the special case of the inter-war years. They will also find that he is villain to as many people as he is hero. Keynes may have saved capitalism from itself in the 1930s but to his critics he also ushered in the era of big government and inflationary deficit financing (the Treasury view did not die completely). General readers with the time and interest should read Robert Skidelsky’s excellent three-volume biography of Keynes.
Bretton Woods
Before leaving Keynes, it is worth touching briefly on what he did after
The General Theory
. Apart from harrying politicians and debating vigorously with his critics to ensure his ideas were taken up, he was soon, despite a heart attack in 1937, back in active government service. In 1940 he published
How to Pay for the War
, an ingenious plan involving temporary taxation (to prevent a wartime inflation because of the pressure on resources), with a refund to taxpayers once the war was over. There were hints of this in Kingsley Wood’s 1941 Budget, but it was more explicitly Keynesian in other respects. Keynes’s bigger role was in international negotiations, mainly with the Americans. Rightly, he saw America’s wartime ambition as supporting its old ally militarily but, when it came to financial assistance, to do so on terms that would ensure Britain’s displacement by the United States as an economic superpower. Keynes saw it coming, both in America’s Lend-Lease assistance to wartime Britain and in the US loan that was to tide the economy over in the post-war period. Ironically the defeated European powers, which received Marshall aid, ended up as the stronger economies in the post-war period. Some say that Keynes’s failure to change America’s approach contributed to his early death.
Before that, he had been Britain’s chief negotiator at the Bretton Woods conference in the summer of 1944. Bretton Woods, a sprawling and now once more elegant hotel in the White Mountain National Park in New Hampshire, was chosen as the location for a conference that would shape the world’s financial system in the post-war period. It was clear by then that Germany would be defeated, although it was to take nearly another year for the task to be completed, so it was necessary to create a framework that would avoid the problems of the inter-war years. Keynes had a radical plan, the establishment of a world central bank which would create credit and settle payments between countries in its own currency, to be called ‘bancor’. Once again he was ahead of his time, too far ahead for the American team and its Treasury secretary, Harry Dexter White. Bretton Woods gave birth to a bank of sorts, the World Bank, and to the International Monetary Fund. It also gave the world the fixed-but-adjustable exchange rate system that was successful for twenty-five years after the war. Currencies were fixed against others, within narrow bands, but could be adjusted in exceptional circumstances. Britain had two such adjustments under the system, devaluing the pound in both 1949 (from $4.00 to $2.80) and 1967 (from $2.80 to $2.40). Gallingly for Keynes, this system had echoes of the gold standard he so despised. Called the gold exchange standard, it survived until America, under Richard Nixon, suspended the convertibility of dollars into gold in 1971.
Although Keynes did not get his way at Bretton Woods his contribution was immense. Some say the international monetary system he envisaged would still be in place today, but who knows? As with everything else he did, he was impossible to ignore.
And now, as Keynes leaves us with a flourish, it is time to come right back up to date. The economic picture is almost complete and the guests are feeling rather full. It is time to talk about something that often comes up at the dinner table, and can be the cause of indigestion – bread in common parlance, money to you and me.
Sooner or later, vulgar though it may be, most dinner-table conversations get round to money. It is perhaps surprising that we have come so far without talking about it explicitly, although we have explored those other favourite topics – mortgages and house prices. Without money, after all, what would we be, mere primitives exchanging half a dozen cows for a new wife? Cattle, in fact, played an important part in the development of money. Chattels, as in ‘wife and chattels’, and capital, as in capital investment, or even the name of Marx’s most famous work, come from the same Old English roots as cattle. Some apparently primitive societies used money in a highly sophisticated way, even if their money was rather different from ours. On the island of Yap in the South Pacific very heavy stones were used as money, which had the virtue of making them hard to steal, while in the New Hebrides they used feather money, and what could be easier to carry around? In Borneo, by tradition, human skulls were used as money, and if this sounds gruesome to us, it was because they happened to be their most prized possessions. Whales’ teeth were used in Fiji. Manillas, forms of ornamental metal jewellery, were used in West Africa as recently as 1949. Even in modern economies, in particular circumstances, other things have replaced conventional money. Cigarettes, or perhaps these days drugs, are the main currency within prisons, where cash is of limited use. Cigarettes also became the currency of choice during the great European hyperinflations of the twentieth century, particularly in Germany. Cigarettes, it seemed, held their value better than money.
It can be fun, if only on a rainy afternoon, to trace the way in which currencies came to have their names. A pound was called a pound for fairly obvious reasons – it was the amount of silver that weighed a Roman pound, or
libra
(hence lira as well, and the fact that the letter ‘l’ was used to denote both). A mark was also a measurement of weight – two-thirds of a pound. A drachma meant a handful of grain. The unit of currency in medieval Britain was the penny, whose symbol until decimalization in 1971 was the letter ‘d’, from the Latin
denarius
, which spawned many currency names, notably the dinar. Quite why the pound became the pound sterling from about the twelfth century, maybe a little earlier, is less certain. We know that sterling originally described a penny, so one pound sterling was actually a pound of sterlings. Why sterling? One suggestion is that it was a corruption of ‘starling’, another that it derived from ‘easterlings’, northeastern European merchants. Nicholas Mayhew, a coin expert from the Ashmolean Museum at Oxford who has written widely on the subject, favours the explanation that it derives from ‘ster’, a Middle English word implying strength and stability.
What does money do? We may wonder. Carl Menger, in his classic 1892 article ‘On the Origins of Money’, conceded that the fact that every individual and every business ‘should be ready to exchange his goods for little metal discs, or for documents representing the latter’ appeared to be ‘downright mysterious’. The paragraph above tells most of the story. Money’s primary purpose is as a medium of exchange. Therefore it has to be generally acceptable. Cigarette money would not be much use in a nation of 95 percent non-smokers. Acceptability is more important, in general, than something many people get hung up on – whether a particular form of money is legal tender. Legal tender simply means what people are required to accept, under the law, in payment of debts. That can vary. A penny is legal tender in most uses but anybody trying to settle a £1,000 bill in pennies could legitimately be refused. For generations, kilt-wearing Scotsmen down for the rugby have been outraged when London taxi drivers have refused to accept their Scottish banknotes. The cabbies are perfectly within their rights. While generally accepted north of the border, Scottish banknotes are not legal tender even in Scotland.
Money must also be a store of value, which is one reason why durable metals were used as money, and why it took time for paper money to be trusted. There are plenty of examples of food being used as money but, like any perishable good, it suffers from a certain basic disadvantage. Money should also be a unit of account. As long as people are able to assess the value of things in terms of the number of cigarettes they would cost, there is nothing to stop cigarette money acting as a unit of account. In his article, Menger also explained why precious metals were peculiarly suited to act as money. They were, he pointed out, widely coveted and scarce in relation to the demand for them. You might turn up your nose at accepting a plastic token as payment, but never gold or silver.
From money to Mastercard
The story of banking is older than that of money itself, or at least coinage. In Mesopotamia or ancient Egypt, banks were storehouses for grain or other commodities. Receipts, promises to pay, issued for the deposit or transfers of grain became used as currency. Paper money, for that is what it was, therefore goes back a long way. Ancient civilizations had relatively sophisticated banking systems. We know from the Greek and Roman coinage that has survived that the amount of money in circulation was considerable. We also know that the coinage was only part of a more extensive monetary framework, including banks. The history of money is not, however, a smooth one. Paper money appears to have died out when the Roman empire crumbled, and was not revived, at least in Europe, until about the twelfth century, given an impetus by the crusades – when a way had to be found to make payments for supplies and equipment and to pay allies. Banking services, already developing rapidly in Italian city-states such as Rome and Genoa, became international. If we now fast-forward to England in the seventeenth century, and the Civil War (1642–51), wealthy people stored their jewellery, bullion and other valuables in the secure strongboxes or safes of goldsmiths. As in ancient Egypt, paper money was the consequence of such deposits. A cheque – an instruction to the goldsmith to pay – could effect a transfer of money from one person to another. Receipts given on the deposit of valuables could be exchanged. By about 1660 these receipts had become banknotes. Similar developments occurred in other countries.
So far, however, there is nothing about paper money, apart from the fact that it is lighter and more convenient to carry, that distinguishes it from the gold and other valuables that it represents. That difference started to occur when the goldsmiths began to realize that most of the valuables in their safes never left the premises. As long as people were confident that when the time came they would be able to withdraw their gold, they were happy to conduct their business in gold’s paper form. And as long as the goldsmiths could be confident that not everybody was going to want to take out their gold at the same time, they could issue many more banknotes – drawn on gold – than there were quantities of the precious metal in their vaults. It sounds like trickery but it is the basis of modern banking. The Scotsman John Law, at one time described as the richest man in the world, took this process forward in the early eighteenth century by persuading the French royal court to adopt what was then the most sophisticated paper money system in the world. Because the scheme was linked to shares in the Mississippi Company, a highly speculative venture, the experiment ended disastrously. But the paper money era was born.
Except in circumstances like these, the issue of paper money should not be confused with the fact that banks still have to ensure that their deposits and loans are in rough balance. The same applies, of course, to cash now. I remember being quite shocked as a child when I discovered that if everybody wanted to take his or her notes and coin out of the bank at the same time there would not be nearly enough to go round. Sometimes, of course, depositors test that process to the limit, when there is a run on the bank, which is when the central bank has to step in as lender of last resort, often supported by other banks keen to maintain confidence in the system. When there is a run on the system as a whole, the central bank can respond by printing more money. The result of that is likely to be inflation, of which more below.
The process by which banks expand the amount of ‘money’ in the economy by building on a relatively small monetary base is known as ‘credit creation’. The amount of money that is in circulation is, in turn, determined by what is known as the ‘money multiplier’. If, by custom and practice, banks find that they need to hold 10 percent of loans and deposits in the form of cash, the money multiplier is 10 – there is ten times the amount of money in circulation, cheques drawn on the bank for example, as there is hard cash. In practice, most countries operate on the basis of an even smaller proportion of cash – certainly less than 10 percent – and on money multipliers of between 10 and 20. A central bank that wanted to slow lending in the economy, perhaps because the economy was in danger of overheating, growing too fast, and running into an inflation problem, could impose tighter ‘reserve requirements’ – increasing the amount of cash (and deposits with the central bank) that the banks have to hold.
What about plastic money? Apart from the fact that debit and credit cards have led people to economize even further on the use of cash, they are just an extension of the earlier variations of non-cash money described above. A debit card is simply a plastic version of a cheque. A credit card is slightly different, being a loan, usually a short-term one, from the bank to its retail customer, while the store receiving a payment usually has to pay the bank a merchant’s fee for the privilege of doing so (although they would also typically pay the bank for processing a cheque). The underlying principle is, however, no different from other forms of credit creation.
Money and monetary policy
That’s enough history, certainly enough ancient history. Everybody knows what money is, but what is monetary policy? Every month, for two days, nine men and women gather together in a special committee room deep inside the Bank of England overlooked by a portrait of Montagu Norman, one of its legendary governors, who went a little peculiar towards the end of his twenty-four-year (1920–44) term. These nine are collectively known as the monetary policy committee (MPC). While the Chancellor of the Exchequer and his Treasury team are sorting out fiscal policy in SW1 – Whitehall – the MPC is fixing monetary policy in EC3, the City. This now seems entirely natural but, as most people will be aware, is a very recent phenomenon. Gordon Brown came to the Treasury in early May 1997 after Labour’s election victory on an apparent policy of seeing how the Bank performed for a while before considering the question of independence. Within five days he had apparently seen enough. The Bank was given responsibility for monetary policy, for setting interest rates at the appropriate level to achieve the government’s inflation target, 2.5 percent.
Why was this such a big deal? After all, similar arrangements had worked in America, where the Federal Reserve System has a Federal Open Market Committee to set interest rates, and in Germany, where the Bundesbank, which came into being in the 1950s after the second of Germany’s post-war hyperinflations, had established a deserved reputation for sound money and low inflation. The Bundesbank, in turn, provided the model for the European Central Bank. New Zealand and Australia had established broadly similar arrangements. South Africa was in the process of doing so. It was a big deal in Britain because no previous Prime Minister, even if urged to do it by his Chancellor of the Exchequer, had considered that central bank independence was appropriate for Britain. Britain is a nation of homeowners: nearly 70 percent of all property is owner-occupied. It is also a nation of small and medium-sized firms. Most homeowners and small and medium-sized firms borrow on the basis of variable interest rates. If interest rates double, they feel the impact immediately. Despite strong academic evidence that independent central banks were associated with better economic performance – low inflation, greater stability and somewhat faster economic growth – Britain’s politicians had always considered interest rates too important to hand over to unelected bankers. To understand why it happened, it is necessary to review briefly the catalogue of errors that preceded Bank of England independence.
The seven ages of monetary policy
There are the seven ages of man and there are the seven ages of modern UK monetary policy. It is a good way of looking at the trials and errors that got us to where we are today. Other countries have groped for the ideal monetary policy, although few have done so as ineptly as Britain. If we go back a quarter of a century or so, to the 1970s, this was a time of enormous turbulence for the world economy and near-disaster for Britain. It is also my first age of modern UK monetary policy – reluctant monetarism. In 1976 a near-bankrupt government had to call in the International Monetary Fund. This was the occasion for the burying of post-war Keynesianism. Peter Jay, sometime British ambassador to Washington and economics editor of
The Times
and the BBC, drafted a speech for his father-in-law, James Callaghan, for the 1976 Labour Party conference, which contained the immortal words ‘I tell you in all candour that you can’t spend your way out of recession’. The IMF’s prescription contained two main elements. It insisted on sharp cuts in public spending – the biggest by any government in the post-war period. And it forced the government to adopt monetary targets, to control the money supply or, more particularly, two measures of ‘money’, one called sterling M3 and the other domestic credit expansion. There is no need to worry about the detail of what these were. The essential point was a simple one. To stabilize the economy and to control inflation (which had risen above 26 percent during 1975) it was necessary to control the money supply. There will be more on this when we meet Milton Friedman in the next chapter but the basis of this policy was straightforward – just as you cannot drive a car without petrol, you cannot have inflation without money. The faster money is printed and credit allowed to grow, the higher will be inflation. Targeting the money supply was by no means trouble-free. The Labour government found, as many governments have, that it was not possible to control the money supply and the exchange rate simultaneously. By the time it lost the 1979 election inflationary pressures were starting to build up strongly. Even so, this reluctant monetarism helped to save the economy.