Why monetary reform is not easy to bring home to economists

Why do most mainstream economists not recognise the relevance of monetary reform? Prof Joseph Huber discusses this in the new passages of his paper entitled “Sovereign Money in Critical Context”:

Neutrality of money

Why do most mainstream experts not recognise the relevance of monetary reform? By mainstream economics I mean neoclassical equilibrium theory and Neokeynesianism, or to put it differently, American textbook standard economics. By these standards, money does not appear to be particularly important. Mainstream economics for the most part rests on the assumption of neutrality of money. Making money may actually be seen as the major motive driving the economy. But the economy as such is conceived of as a system of production factors, employed for producing output, and for exchanging the output on markets that are seen as huge barter systems. The function of money in this is to mediate and thus facilitate exchange. Exchanging products and services for money overcomes the otherwise existing constraint of coincidence of wants in time and place. Beyond this, however, money is considered to be of little importance. As John Stuart Mill put it in the middle of the 19th century, money seems to be just a veil over the economy with no structural impact on it. Rapid changes in the money supply represent what economists call a shock. This may, for example, boost inflation, but markets are supposed to be resilient and are expected to rebound to a state of equilibrium.

If one believes in this doctrine of neutrality of money, then of course dysfunctions of the money system are not an obvious subject of concern, despite all financial crises. As a consequence, mainstream economists find it difficult to see why monetary reform might be of relevance. Economic textbooks may well have 600–1,000 pages, but the passages on the monetary system usually count 10–20 pages―which is even a lesser percentage than the fractional reserve base in the present banking system.

There are exceptions, i.e. neoclassical economists who in a way recognised the non-neutrality of money, in particular Irving Fisher as well as the Early Chicago School (Simons, Knight, Viner, P.Douglas, and others), lateron Maurice Allais and Milton Friedman. But that was in the 1930–60s.

Schools of thought that consider money and banking to be non-neutral, are those beyond the mainstream, in particular the Austrian School and Neoaustrians today, who represent a distinct form of classical and neoclassical thinking, as well as Keynesianism and its offspring.[3] However, their specific understanding of non-neutrality is not always obvious.

The Austrian School and the Neoaustrians, from Menger and Mises to Hayek and Huerta de Soto, consider gold-based currencies as neutral, and thus desirable from their point of view, whereas fiat money created by central banks and banks is seen as non-neutral. Deliberate additions to the money supply are supposed to distort price relations and patterns of allocation and distribution. The Austrians, however, never explained how to verify undistorted price relations. Furthermore, they do not give due consideration to the sphere of the economy where structural changes and disproportional trends on monetary grounds can best be shown, i.e. the financial economy, in particular housing and stock bubbles.

Keynes also intended to analyse modern economies as monetary economies. He adopted a number of elements of an advanced understanding of modern money and banking, he supported chartalism (i.e. the state theory of money), and established the research program of a monetary theory of production. The latter can be seen as an alternative program to the Austrians’ capital theory of production. The slogan ‘Money matters’ was coined by Friedman but could equally have been originated by Mises or by Keynes.

In Keynesian lineage, it is the Monetary Circuit Theory where the view of monetary non-neutrality is most advanced today. In the framework of the present fractional reserve system, Circuitists emphasize the ‘power of banks’. The banking industry is seen in a superordinate, powerful and privileged position – superordinate because modern economies, before being able to transact goods and services at all, rely on the prior creation of primary credit and financing; powerful because this gives a high level of economic clout and political influence; and privileged because this enables the banking and financial industries to appropriate a significant share of the economic product, a share that is widely seen as incommensurate with the services provided by this industry.

Assumption of functionality of the existing money system 

Many economists today, basically from all schools of thought, question various aspects of banking and the financial economy, but stop short of recognising the monetary system as the root cause of those questionable aspects.

The historical Currency School towards the middle of the 19th century was the first to attribute financial instability and crises systematically to an overshooting, sometimes also shrinking, supply of bank money.
The Austrian School in the decades around and after 1900 held a similar opinion on the dysfunctions of reserve banking, but blamed them all on central-bank interference and government meddling, while seeking salvation in free banking on a renewed gold standard. They reject any idea of chartalism. Today’s Neoaustrians still haven’t got a clue about the legal and institutional foundations of modern monetary economies.
Keynesianism and the various currents of Keynesian filiation, by contrast, might have been expected to be responsive to criticism of the monetary system. In general, however, this is not the case. Schools of Keynesian descent describe the monetary system not always in an entirely accurate way; or they come up with reinterpretations of the monetary system, such as those put forward by Modern Money Theory (MMT), that are problematic and misleading in their own way.[5]

Keynes and mainstream-assimilated Neokeynesianism partially lagged behind their own insights in that their views are based
– on the category of loanable funds rather than primary credit creation, i.e. saying that ‘investment equals savings’ rather than ‘investment equals some part of the savings obtained on the secondary capital market plus additional bank money created by primary bank credit or primary bank purchases of securities’.[6]
– on the money or credit multiplier model, while in actual fact it is about a system which fractionally re-finances the facts pro-actively created by the banks
– on the assumption that reserve positions or base-rate policies are effective tools of monetary policy.

Keynes, moreover, did not systematically explain economic crises by over-investment and over-indebtedness, or say, in Marxist terms, over-accumulation of stocks of capital exceeding current profits that could service these stocks. Keynes, following Gesell, saw the main culprit in liquidity preference, formerly called hoarding of money, as if it were still about a cash-based economy. In the General Theory the equation of ‘investment = savings’ reappeared as a central element. In a fiat-money bank-credit economy, however, this applies only partially, i.e. it applies to secondary on-lending of demand deposits, but in no way to bank credit and bank purchases of securities. Holding liquidity rather than spending it became a central concern in Keynesian crisis theory through to Circuitism. It may have contributed to paving the way for seeing perpetual deficit spending and debt accumulation as an expression of ‘functional finance’ (Lerner).

Even where Postkeynesianism and its offshoots describe the contemporary monetary system in an accurate way under operational aspects, they apparently consider the system to be functional rather than dysfunctional. In other words, they do not attribute financial instability and crises to the monetary system of fractional reserve banking. Accordingly, they see no reason to think about monetary reform.

Here, too, there are individual exceptions. One is James Tobin, who developed an approach to ‘narrow banking’ different from, yet similar to, 100%-reserve banking.[7] Tobin, very Keynesian in this, thought of a 100%-coverage of deposits by sovereign bonds. Another exception is Hyman Minsky and the financial instability theory. Credit and debt bubbles not only feed from secondary on-lending of existing money, but prior to this from primary bank credit ever more adding to overshooting money supply. Accordingly, Minsky at one time (in connection with the final repeal of the Glass-Steagall Act in the 1990s) thought about a special arrangement of separate banking, namely the separation of money and payment services from the lending and investment business of banks, in order to restrict the power of banks to create primary credit (bank money).[8] It would seem, however, that Minsky did not give further consideration to that idea. Instead, he promoted the idea of the state as ’employer of last resort’. This in fact comes down to the Keynesian concept of compensatory government expenditure aimed at creating jobs (active labour market policies) or creating additional demand that is expected to result in jobs.

Wrong identity of money and credit 

Both Tobin and Minsky stayed within the conceptual limits of a split-circuit system based on deposits and reserves. They did not overcome this horizon in favour of a single-circuit plain sovereign-money system beyond bank money and reserves. This hints to another reason why the mainstream and economics of Keynesian descent consider the present money and banking system to be functional: neglect of the difference between a split-circuit reserve system and a single-circuit money system, or to put it differently, their apparent inability to dissolve the wrong identity of money and credit as already criticised by the historical Currency School. The confusion of token fiat money and bank credit is a core element of banking doctrine.

As a consequence, commentators overlook the fact that money creation and money lending/spending are two different functions, but carried out uno actu in the present credit-money or debt-money system based on fractional reserves. The wrong identity of credit and money also leads critics to deny that in a modern money system the money base or money supply in circulation can be debt-free (not, of course, the loans or securities issued by use of that money). As long as economists stick to the absolutised axiomatic identification of money with credit, their  support for monetary reform is likely to be lukewarm at best.

Partial rather than full chartalism

Apart from deeming the present system functional rather than dysfunctional, there are further explanations for the prevailing intransigence regarding criticism of fractional reserve banking. One such further explanation is partial chartalism, in contrast to complete or full chartalism. Full chartalism includes the three monetary prerogatives of
1. currency (determining the official unit of account)
2. money (creating and issuing the means of payment denominated in that currency)
3. seigniorage (taking the benefit from creating and issuing new money).

Partial chartalism dates back to the ‘state theory of money’ by Knapp (1905). The name of the theory is somewhat misleading because most people will take it for a ‘theory of state money’ which however it isn’t. According to Knapp, a currency needs to be backed by the power of a stable nation-state, otherwise it won’t succeed. The doctrine, however, does not demand that the money, the regular means of payment, must be state money issued by a state agency such as the treasury or the central bank. For money to gain the status of an official means of payment, it suffices that the tax office or the courts accept, or even demand, to be paid in that money. Partial chartalism keeps national, state-guaranteed currencies, but cedes the creation and control of money (means of payment) as well as seigniorage-like privileges largely to the banking industry. Knapp, much like his contemporary Mitchell-Innes, were typical ‘national liberals’ of the 19th century. They saw bank money as a benign and under-control part of what they took for a sovereign currency system. Keynes and his heirs – including Postkeynesians as well as Circuitists and MMTers – have retained such a position of partial chartalism up to the present day. Consequently, sovereign-money reform does not make sense if today’s bank money is mistaken for a subset of sovereign money.

As regards MMT, an additional reason for their intransigence is their version of Postkeynesian sector balances.[9] Models of public-private sector balances were originally devised for spotting imbalances.[10] In MMT, however, the meaning of imbalances is re-interpreted and includes a tendency to fuse fiscal with monetary functions. MMT contends that sovereign debt poses no problem because it equals private fortunes (strangely enough, not asking whose). Moreover, government expenditure (public-sector expenditure) is identified with sovereign-money creation, while private payments to the public sector (taxes) are reinterpreted as the deletion of sovereign money, analogous to paying back credit to banks.

If public debt and public expenditure equal sovereign-money creation, and if a sovereign government allegedly can create as much of it as it deems decent, then it seems to follow that a sovereign government is always solvent and need not default. Deficit spending and sovereign debt thus appear to be monetarily and financially irrelevant and economically only beneficial, while monetary reform, again, appears to be irrelevant and unnecessary.

————————–

[3] Marxism, by the way, even where preoccupied with financial capitalism, made no significant contribution to monetary theory. Not sufficiently understanding the links between money and finance seems to be part of the legacy of neoclassical economics as much as of the political left, since Marx, in the third volume of Capital, in vain tried to come to grips with the controversy over currency and banking theory and their relevance to the economy.

[4] Graziani, Augusto 1990: The Theory of the Monetary Circuit, Économies et Sociétés, Monnaie et Production, 7/1990, 7–36 (8, 29). ―2003: The Monetary Theory of Production, Cambridge University Press, 58–95.

[5] For critical discussions of MMT see Lavoie, Marc 2011: The monetary and fiscal nexus of neo-chartalism. A friendly critical look, University of Ottawa, Dep. of Economics, available at www.boeckler.de/pdf/ v_2011_10_27_lavoie.pdf. – Roche, Cullen 2011: A Critique of MMT, Modern Monetary Theory, http://pragcap. com/mmt-critique, September 7th, 2011. –Fiebiger, Brett 2011: MMT and the ‘Real-World’ Accounting of 1-1>0, PERI Working Paper Series No.279, University of Massachusetts Amherst. www.peri.umass.edu/ fileadmin/pdf/working_papers/working_papers _251-300/WP279.pdf. – Walsh, Steven and Stephen Zarlenga 2013: Evaluation of Modern Money Theory, http://www.monetary.org/mmtevaluation. – Huber, Joseph 2014: Modern Money and Sovereign Currency, real-world economics review, no.66, 2014, 38–57.

[6] Both Michael Kumhof and Steve Keen have recently published articles on this subject:  Kumhof, Michael and Szoltan Jacab 2014: Models of Banking. Loanable Funds or Loans that Create Funds? International Monetary Fund, Working Paper, 30 July 2014. – Keen, Steve 2014: Endogenous Money and Effective Demand, Review of Keynesian Economics, Vol.2, No.3, Autumn 2014, 271–291. – Reply to Keen in the same issue by Lavoie, Marc 2014: A Comment on ‘Endogenous Money…’, 321–332.

[7] James Tobin 1987: The Case for Preserving Regulatory Distinctions,Challenge 30(5):10–7, available at https://www.kansascityfed.org/publicat/sympos/1987/S87TOBIN.PDF. A similar narrow banking approach was proposed by John Kay 2009: Narrow Banking. The reform of banking regulation, publ. by the Centre for the Study of Financial Innovation, London.

[8] Jan Kregel 2012: Minsky and the Narrow Banking Proposal, Public Policy Brief, Levy Institute of Bard College, No. 125, 2012, 4–8.

[9] Cf. Wray, Randall 2012: Modern Money Theory, Palgrave/Macmillan. -Mosler, Warren 1995: Soft Currency Economics, www.gate.net/~mosler/ frame001.htm. – Tcherneva, Pavlina 2006: Chartalism and the tax-driven approach, in: Arestis, Philip / Sawyer, Malcolm (eds.), A Handbook of Alternative Monetary Economics, Cheltenham: Edward Elgar, 69–86. -Fullwiler, Scott T. / Kelton, Stephanie / Wray, L. Randall 2012: Modern Money Theory: A Response to Critics, http://papers.ssrn. com/sol3/papers.cfm? abstract_id= 2008542.

[10] Cf. Wynne Godley and Marc Lavoie 2007: Monetary Economics, London: palgrave/macmillan.