Money (32 page)

These ideas were already far beyond the pale of classical economics; indeed, they were barely even comprehensible in terms of its moneyless doctrines. In characteristic fashion, Keynes decided that if his ideas could not be made to fit with the orthodox theory, then the theory would have to be made to fit with his ideas. He therefore resolved to rewrite the classical theory wholesale. The result, published in 1936, was his
General Theory of Employment, Interest, and Money
—the work that was to animate macroeconomics and macroeconomic policy-making for the rest of the century.
¹¹

In
General Theory
, Keynes took Bagehot’s criticism of the classical economists a step further. A realistic view of money, he argued, implied the necessity of deliberate management of not only monetary but fiscal policy. Like Bagehot, he located the root of the classical school’s failings in its erroneous infatuation with Say’s Law. The nub of the matter, Keynes argued, was that in a monetary economy Say’s Law need not hold. There is no guarantee that, in the aggregate, supply will always equal demand, for the simple reason that in a monetary economy, rather than having to buy goods and services with their income, people can hold money instead. When prospects look grim, that is exactly what people choose to do in spades—and only the safest and most liquid money, the money of the sovereign, will do.

The experience of the extended international depression of the interwar period had taught Keynes something that was beyond even Bagehot’s broad experience. Proactive policy to boost demand indirectly by ensuring that there is sufficient sovereign money available to quell panic and meet an elevated demand for safety and liquidity is indeed a necessary condition to fight a slump. But when the private sector’s confidence is being constantly eroded by the downward pull of excessive debt, it may not be enough. When that stage is reached, it is time for the direct approach. The government will have to spend if the private sector will not. This was the “basic Keynesian … framework” that Summers explained had come to the aid of policy-makers in the immediate aftermath of the 2008 crash.
¹²
The hour of expansionary fiscal, as well as expansionary monetary, policy will have arrived.
¹³

Once again, events seemed to have exposed the classical school and the conventional theory of money as flawed: just as the crisis of 1866 had refuted the classical theory of crisis management, the monetary instability and mass unemployment of the 1930s had proved the inadequacy of laissez-faire monetary and fiscal policy. And once again, a brilliant thinker and irresistible communicator had been on hand to explain how an alternative framework, founded on a realistic understanding of money and finance, could inform better
policy. But history is replete with records of the extraordinary resilience of intellectual orthodoxies—and the conventional theory of money and the classical economics built on it proved to be an especially robust example. Like many a modernising church, the reaction of the classical school to these troubling practical setbacks and irritating theoretical critiques was not capitulation, but adaptation and abstraction. Money was no longer claimed literally to be a commodity—it was just right to think of it as if it were one. Value was no longer held explicitly to be an intrinsic property of things—though it was still treated as a natural fact. It had to be admitted that sovereign and private money were not, in light of experience, perfect substitutes—but there was no need to abandon the approved creed in favour of dangerous monetary heresies like Bagehot’s or Keynes’ in order to explain this. The moneyless economics of the classical school emerged from the Second World War battered, discredited, and apparently overshadowed by a new and persuasive set of ideas. But emerge it did. And within a decade of the war’s end it received a powerful new tonic—a tonic which not only revived it, but gave it a whole new lease of life.

The classical school had not had to subsist without spiritual nourishment of its own in any case. Only a year after the publication of
Lombard Street
, the French economist Léon Walras had presented a mathematically rigorous formulation of the classical theory of price formation in his
Elements of Pure Economics
.
¹⁴
In 1937, the British economist and future Nobel laureate John Hicks had alleged that the central ideas of Keynes’
General Theory
could in fact be reconciled with classical orthodoxy.
¹⁵
It was in 1954, however, that a paper appeared that was, to those who believed, the discovery of a fifth gospel. The American economist Kenneth Arrow and the French mathematician Gerard Debreu published a formal proof that, given certain assumptions, a market economy would indeed tend to gravitate towards a “general equilibrium” in which a unique set of prices would ensure that there could be no excess demand or supply across all markets taken together.
¹⁶
It was, in other words, a knock-down argument in favour of the canonical classical doctrine—a formal proof of Say’s
Law. What had long been suspected, and disputed back and forth in woolly, literary treatises, had now been proved with stark, mathematical precision. Almost immediately, however, an objection was raised: namely that it could only be proved for an economy without money.
¹⁷
The devotees of the new, general equilibrium theory could barely contain their amusement. Problem? That was the whole point. Arrow and Debreu’s famous proof showed once and for all that money was extraneous to worthwhile economic analysis. Everything important could be logically proven in a model with no money at all.

Arrow and Debreu’s proof of the existence of a general equilibrium rapidly became a fundamental tool for all mainstream research in macroeconomics over the next sixty years. It was true that reality kept butting in. Everyday experience continued to suggest that money and banking were important independent factors in the economy, rather than things that could be blithely ignored. Heretics continued to appear and preach the need to repent and heed alternative visions that took money seriously. But most were marginal figures—dismissed by the mainstream as eccentric cranks like Hyman Minsky, or safely defused as mere purveyors of historical colour like Charles Kindleberger. Once in a while, a savvy operator such as Milton Friedman would emerge and go straight to the policy-makers or even the public to champion the importance of money in economic analysis. But Arrow and Debreu’s tonic proved a potent one: their recasting of the classical framework proved almost limitlessly flexible. It was complained of their original theory that it neglected the fact that the economy is not static, but evolves through time. A dynamic version was developed. It was said that it was overly deterministic, and ignored the fact that the real world is an uncertain place. The tools of classical probability theory were adduced to incorporate the possibility of what statisticians call “stochastic,” or random, developments. It was pointed out that, even then, many of the assumptions required to prove the result required unbelievable assumptions concerning how rational and knowledgeable people are, and how universally and perfectly markets function. Generations of researchers
spent countless hours delicately relaxing each of these assumptions one by one—some of the more reckless even took to relaxing several of them together—and exploring the consequences. There was no objection, it seemed, which the new orthodoxy of so-called dynamic, stochastic, general equilibrium models could not meet.

There was only one fly in the ointment. Everyday central-banking practice remained annoyingly ambivalent towards the so-called “neoclassical” theory. The academic profession might spend its time in transcendental meditation on the mystical abstractions of a general equilibrium theory of the economy, devoid of money, banks, and finance. Policy-makers, however, had to make do with the real world, where these things continued to make as much of a difference as ever and the central bank’s interest-rate policy remained the most important tool available to discipline or encourage the private sector. For several decades there was, as a result, “not much fruitful interaction between economists from the central bank and academics,” as one leading monetary economist put it with charming understatement.
¹⁸
This was clearly an untidy—even potentially an embarrassing—situation. How could modern, orthodox macroeconomics hold its head up as queen of the social sciences if it could not even win over its own policy-makers? Further doctrinal flexibility was required. By the late 1990s, an acceptable way to justify a limited role for monetary policy was at last identified—without, of course, recourse to such heretical notions as credit or liquidity risk.
¹⁹
The coup de grâce was to christen this latest version of the classical theory “New Keynesian”—to suggest that after the latest revamp it represented an adequate formalisation of all the wisdom that the
General Theory
contained. This heady mixture proved irresistible even to central bankers. Their defences were finally breached, and New Keynesian, dynamic, stochastic, general equilibrium models rapidly came to dominate the policy planning of the world’s leading central banks. But at a fundamental level, all these modifications had been mere mopping-up operations. The real battle fought by Bagehot and Keynes had long ago been lost. The elephant in the room—the fact that the primary analytical workhorse of academics and policy-makers
was not a theory of a monetary economy and “lacks an account of financial intermediation, so money, credit, and banking play no meaningful role,” as the Governor of the Bank of England put it in 2012—had, as Lawrence Summers lamented, long since been forgotten.
²⁰

Such was the Lazarus-like destiny of the moneyless economics of the classical school. The fate of Bagehot’s original concerns with the central importance of money, banking, and finance was initially less happy. Once their second coming in the hands of Keynes had been rebuffed by the mainstream, they languished in the backwaters of economic thought. Until, that is, they too were revived by a magic elixir—though one which also proved to have alarming transformative powers—when the worlds of banking and finance embarked on an era of deregulation after the Second World War. The growing importance of the equity and bond markets generated a demand by their participants for a framework in which to think cogently about their investing and trading activity. Theorists with a genuine interest in money and finance therefore discovered a private intellectual reservation opening up in which they could exercise themselves safe from inquisition by the orthodox church of macroeconomics. Unfortunately, enforced seclusion often makes for its own breed of dogmatism. All too quickly this new discipline of academic finance became just as detached from the economic realities that had obsessed Bagehot, Keynes, Minsky, and Kindleberger as post-war macroeconomics was. In its case, the problem was definitely not a lack of attention to the economics of financial claims. Quite the opposite: academic finance elected to concern itself with nothing else. It chose as its exclusive focus of investigation the pricing of financial securities on the private capital markets—the equity shares and bonds that were becoming ever more important as the liberalising policies of the post-war period picked up steam. Its major innovations—the theory of portfolio balance, the Capital Asset Pricing Model, the theory of options pricing—were eagerly adopted by financial practitioners, since investors and their agents were naturally interested in making sense of what they were doing.
²¹
Yet by focusing exclusively on the pricing
of securities on private markets, academic finance developed an exact mirror image of the flaw of neoclassical macroeconomics. By ignoring the essential link between the financial securities traded on the capital markets and the monetary system operated by the sovereign and the banks, academic finance built a theory of finance without the macroeconomy just as neoclassical macroeconomics had built a theory of the macroeconomy without finance.

What was critically missing was the insight of Bagehot, and Joplin and Thornton before him, of the importance of liquidity as a distinct property of credit—the property which makes it money when it exists, and inert bilateral credit when it does not. This was the crucial link between finance and the real economy that Bagehot and Keynes had sought so hard to emphasise, and the rationale for macroeconomic policy—because the sovereign’s liabilities enjoy a degree of liquidity to which no private issuer can aspire. Post-war academic finance, however, gladly abandoned to the macroeconomists the theologically fraught topic of whether and how the sovereign might need to provide liquidity support, and concerned itself only with unlocking the secrets of how the creditworthiness of financial claims traded on private markets affected their price. As such, it felt no need to complicate things with the additional dimension of liquidity, and before long, as one leading scholar has summed it up, “[i]n the … new formulation, it became impossible to conceptualize liquidity risk as a separate category of risk.”
²²
Just as modern, orthodox macroeconomics had ended up as a formal, mathematical theory of the moneyless doctrines of Say, Ricardo, and their classical followers, so modern, academic finance had ended up as a formal, mathematical theory of money in Utopia: a world with an infinite array of substitutable claims, with no mention of sovereign money.

Most people are not that interested in the fine details of what academic economists get up to—and had these abstruse theoretical
developments in macroeconomics and finance remained cloistered in the ivory towers, they would be right to be indifferent. But that is not what happened at all. It is a rare faith that does not at some point become so convinced of its own rectitude that it sets out to convert the world at large. By the late 1990s, the disciples of both modern, orthodox macroeconomics and modern, academic finance were proudly marching out under their respective banners to fight the good fight and evangelise their gospels.