Money (31 page)

At the root of these differences between Bagehot and his classical forebears was the way they conceived of money and finance. For there was a ghost haunting the pages of Smith and his classical followers: the ghost of John Locke and his monetary naturalism. Money, the classical economists held with unswerving devotion to Locke, was nothing but gold or silver. As such, it was a commodity subject to the same laws of supply and demand as every other commodity. “[M]oney, or specie, as some people call it,” wrote the French economist Jean-Baptiste Say in 1803, “is a commodity, whose value is determined by the same general laws, as that of all other commodities.”
¹
“Money,” pronounced John Stuart Mill forty-five years later, “is a commodity, and its value is determined like that of other commodities.”
²
Private credit instruments, by contrast, were not money—they were just substitutes for money, and had value only insofar as there was real gold or silver available to redeem them.

The conventional understanding of money led the classical economists to diverge dramatically from the views of Bagehot in three areas. The first was the correct principles for monetary policy in a crisis. If the classical conception of money was correct—if money was gold and silver alone—then although everyone might want it in a crisis,
there was only so much to go round. The Bank of England should therefore protect its hoard by refusing access, or raising the rate of interest at which the Bank would lend out its gold. Such was the policy recommended by the classical economists—a policy which Bagehot had no hesitation in calling “a complete dream,” “a delusion,” and “too absurd to be steadily maintained.”
³
In reality, he explained, this was the very worst policy to pursue, because it was the one most likely to exacerbate the panic. What was in short supply in a crisis was not gold, but trust and confidence—which the central bank had a unique ability to restore by standing ready to swap the discredited bills of private issuers for its own sovereign money. Such was the solution to which the Bank Directors always in the end groped their way reactively in any case. Grasp once that money is not a commodity but credit, and the rationale for making it explicit policy was clear.

These diverging views of appropriate policy in a banking crisis were put in the shade, however, by a broader disagreement over the need for government policy, and especially monetary policy, to manage the macroeconomy more generally. The conventional view of money as a commodity medium of exchange was one of the pivotal assumptions behind perhaps the single most famous proposition associated with the classical school—an alleged economic law of nature as practically important as it was counter-intuitive, articulated by Jean-Baptiste Say in his
Treatise on Political Economy
in 1803. If money was a commodity, Say wrote, then there was no real distinction between sovereign and private money: gold is gold, whether minted or not. What is more, since the choice of commodity which serves as the medium of exchange is quite arbitrary, there can never be any danger of a shortage of money, since the enterprising mercantile class will always be able to improvise an alternative.

So far, so familiar. But combine these acknowledged facts with Smith’s theory of the market and one had a key that unlocked the canonical question of macroeconomics: what is the origin of slumps? Smith had shown how the interaction of supply and demand will, in the absence of interference, generate a price that will clear the market. Since money is just a commodity subject to the same laws
as other commodities, Say explained, this argument about how individual markets work can be generalised across all markets at once—including the market for money. Grant the conventional view of money, in other words, and Smith’s theory implies that the uninhibited market mechanism will generate a set of prices that will clear all markets in the economy at once, so that everything which is produced is consumed. This in turn implies, as Say put it, “a conclusion that may at first sight appear paradoxical, namely, that it is production which opens a demand for products”; or in the more familiar modern version, that supply creates its own demand.
⁴

This result, known as Say’s Law, became enormously influential as a central organising principle of classical macroeconomics. If Say’s Law holds, then recessions cannot be caused by a shortfall of demand. They must instead derive from problems on the supply side: natural disasters that wipe out harvests; unexpected factory outages; striking workers; the discovery of disruptive new production technologies; and so on. The popular explanation—indeed, the evidence of first appearances—that it is a shortage of money that causes a downturn must be an illusion. The fact that buyers do not have enough money with which to buy can only mean that they do not have enough produce to sell. Supply creates its own demand: so naturally if there is an interruption to aggregate supply, then—and only then—aggregate demand will flag to the same extent. The result will be a fall in the overall value of the economy’s output; in other words, a slump.

So Bagehot’s monetary economics implied a radical divergence from the precepts of the classical school not just over the correct policy to stem financial crises, but over the correct policy to prevent recessions. The basic policy implication of Say’s Law was that there is no point in attempting to boost aggregate demand per se. Since the origins of recessions must necessarily be on the supply side, it is on policies to improve supply that anti-recessionary policy should concentrate—if it should do anything at all. Regulations that hinder hiring should be repealed; taxes and tariffs reduced; and so on. Attempting to bolster national output through monetary policy, however, would be putting the cart before the horse. It is because
production increases that more money is demanded and will be supplied—not the other way round. And in fact, given that most recessions creep up on the economy unawares, and are over fairly rapidly, the policy that Say’s Law really recommends for the government finding itself in the teeth of a recession is even simpler. Since supply-side conditions generally can’t be changed much over the short term, it is really best to do nothing at all.

Bagehot’s economics, by contrast, implied that the commonly held view that recessions are the result of people not having enough money was, to be blunt, quite right—and that Say’s Law, therefore, was the economics of clever fools. When the economy fell into a crisis, the demand for sovereign money did not obey the same rules as the demand for commodities. It did not collapse as output flagged and confidence wilted. Quite the opposite: sovereign money’s unique character meant that the demand for it increased. The paradox had been understood by practitioners at least since the crisis of 1825, when the prosperous Newcastle timber merchant and economic pamphleteer Thomas Joplin had summed it up concisely: “[a] demand for money in ordinary times, and a demand for it in periods of panic,” he had written, “are diametrically different. The one demand is for money to
put into
circulation; the other for money to be
taken out
of it.”
⁵
The correct remedy for an incipient recession is therefore not the policy fatalism implied by Say’s Law. It is a larger supply of sovereign money to meet the excess demand and restore confidence. And fortunately, as Bagehot pointed out, the supply of sovereign money is in the real world a matter of central-bank policy.

There was one final consequence of the haunting of classical economics by Locke’s view of money that was to prove in the long run even more influential than its implications either for central-bank policy in a financial crisis or for the right macroeconomic policy to combat a recession. Indeed, it was this consequence of the conventional view of money that would ultimately lead to the great distraction to which Lawrence Summers referred. For the intellectual debt the classical economists owed to Locke was much larger than just the idea that real money is gold and silver. It also included the most
fundamental feature of Locke’s understanding of money: the idea that economic value is a natural property, rather than a historically contingent idea.

This proposition had a profound consequence for the nature of classical economic analysis. In essence, it vastly simplified the task of understanding the economy. For if it was possible to take the concept of economic value for granted then economic analysis could, indeed should, proceed without worrying about money at all. Economic value had, after all, existed in the state of nature, long before the invention of money, or banks, or any of the other complications of modern finance. Money itself is simply one out of the universe of commodities which has been chosen to serve as a medium of exchange and so minimise the inconveniences of barter. As such, no one wants money itself: what is really wanted is the commodities that can be bought with money. This being the case, the simplest and best method of analysis is to begin by ignoring money. Economic analysis should proceed in what economists learned to call “real” terms. Money can then be added on afterwards, if it is a subject of interest for its own sake—or not, if it isn’t.

This was the attractive invitation generously made by Locke’s monetary naturalism, and the classical economists eagerly accepted it. Modern finance may look as though it is of great economic importance, conceded Smith. But in reality “what the borrower really wants, and what the lender really supplies him with, is not the money, but the money’s worth, or the goods which it can purchase.”
⁶
The economics of production and the distribution of income can therefore safely be analysed in terms of those goods alone. Of course it was true that almost every sale and purchase in a modern economy is settled with money, admitted Say. But when one really thinks about it, “[m]oney performs but a momentary function in this double exchange; and when the transaction is finally closed, it will always be found, that one kind of commodity has been exchanged for another.”
⁷
But as usual, it was the great systematiser John Stuart Mill who stated the implications most clearly. “Great as the difference would be between a country with money, and a country wholly
without it, it would be only one of convenience; a saving of time and trouble,” he wrote, “like grinding by water power instead of by hand.”
⁸
As a result, money was relegated to the middle of the third book of Mill’s standard textbook and banished to the exotic fringes of the discipline. Since the quintessential economic topics of production, distribution, and exchange are all governed by the key concept of value, which is logically prior to money, everything worth knowing about them could be discovered by the analysis of the “real” economy. “There cannot, in short,” Mill concluded, “be intrinsically a more insignificant thing, in the economy of society, than money.”
⁹

Nothing captures more succinctly the difference between the economics that the classical economists built using the conventional understanding of money, and the economics which Bagehot sought to popularise with the publication of
Lombard Street
. And nothing, in light of the crises of either 1866 or 2008–9, could be more patently absurd.

An observer innocent of the subsequent history of orthodox economics would no doubt assume that the consequences of Bagehot’s devastating assault on the unrealistic apparatus of the classical school were swift and deadly. It is hardly surprising, she would think, that Bagehot would be the first name on Lawrence Summers’ list of authorities to whom the leadership of the greatest economy on the planet would turn in the midst of the worst financial crisis in history. Bagehot, after all, finally threw off the intellectual shackles of the classical school and brought analytical rigour to the practical business of how money works in the real world. He explained how the principles of central-banking policy could be deduced from a proper understanding of a monetary economy. And he showed why the classical insistence that a slump cannot be due to a shortage of sovereign money was wrong—and how it derived from the mistaken view of money as a thing. Surely the abstruse and irrelevant doctrines of the classical school, with their bizarre blind spot
for the world of money and finance, collapsed like a house of cards in the face of the terrible hurricane of 1866. Presumably, Bagehot’s alternative perspective went on to become the foundation for all subsequent macroeconomics.

The innocent observer would be forgiven for shortening her odds still further, given the dazzling efforts of another member of Summers’ alternative canon: the dominant economic thinker of the first half of the twentieth century, John Maynard Keynes. Money and finance were central to everything Keynes wrote. In the early 1920s he became “absorbed to the point of frenzy” in an attempt to discover the ultimate origins of finance in ancient Mesopotamia—an episode he would later mock as his “Babylonian madness” and admit had been “purely absurd and quite useless.”
¹⁰
In 1923, however, he published
A Tract on Monetary Reform
, in which he argued that the monetary turmoil of the period during and immediately after the First World War demonstrated the central importance of inflation and deflation for both economic growth and the distribution of wealth and incomes. The stability generated by the nineteenth-century orthodoxies of the Gold Standard and laissez-faire, which the classical economists had alleged to be a scientific necessity, had been exposed as a special case entirely contingent upon the particular social compact of the pre-war world. The post-war experience had revealed the general rule to be that deliberate management of the monetary standard was needed to meet challenges of growth and distribution. It was an argument for putting money at the centre of economics and economic policy—and one of which John Law, for one, would have heartily approved.