EC2034Topic1Themes&Ideas.

Topic 1: Themes and the importance of ideas

A. Keynes.

(i) At the very end of the ‘General Theory of Employment, Interest and Money’ Keynes
wrote his famous comment on the power of ideas:

“… the ideas of economists and political philosophers, both when they are right and
when they are wrong, are more powerful than is commonly understood. Indeed the
world is ruled by little else. Practical men, who believe themselves to be quite
exempt from any intellectual influences, are usually the slaves of some defunct
economist. Madmen in authority, who hear voices in the air, are distilling their
frenzy from some academic scribbler of a few years back. I am sure that the power
of vested interests is vastly exaggerated compared with the gradual encroachment
of ideas. Not, indeed, immediately, but after a certain interval; for in the field of
economic and political philosophy there are not many who are influenced by new
theories after they are twenty five or thirty years of age, so that the ideas which
civil servants and politicians and even agitators apply to current events are not
likely to be the newest. But, soon or late, it is ideas, not vested interests, which are
dangerous for good or evil.”

(ii) It is easy to characterise the period since the First World War as an ongoing
dialogue between Keynesian type ideas and ideas broadly classed as
‘Monetarism’. The pattern would be monetarist type ideas roughly dominant
from 1918 until the 1930’s, though this is not the word that would have been
used; commentators would have regarded themselves as just ‘orthodox’,
following the conventional wisdom established over the course of the 19 th
century. Keynesian ideas might be thought of as dominant from the beginning of
the Second World War, with Keynesian ideas guiding British economic policy
during the war, and guiding policy until the mid-1970’s. This period might be
seen as being followed by a return to orthodox, now called ‘monetarist’ thinking,
associated with the writings of Milton Friedman until the current crisis. Policy in
response to the current crisis is a strange, some would say ‘confused’, mix of
Keynesian and orthodox thinking.

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 The difference between Keynesian and monetarist thinking is often represented as
the difference between a belief in beneficial government intervention using mainly
fiscal policy, and a distrust of government, which would be better advised to rely on
monetary rules to achieve financial stability. This is far too crude a division. It is a
mystery how people came to believe that Keynes thought ‘money didn’t matter’ when
almost everything he wrote was about money and why it DID matter. The basis of his
criticisms of the orthodox position was that it could not guarantee financial stability
and that in times of crisis monetary policy needed to be complemented with other
policies.
It must also be recognised that Keynes was a lifelong Liberal, not a socialist and had
strong libertarian tendencies! Although disagreeing with the economic analysis of
Friedrich Hayek, Mrs Thatcher’s economic guru, he was profoundly sympathetic to
Hayek’s famous attack on government intervention in ‘The Road to Serfdom’, though
being rather doubtful if it was much use when it came to practical issues of policy.

(iii) Throughout the period from 1920 – 1945 there will be fairly continual reference to the
writings of Keynes. As Liaquat Ahmad writes in ‘Lords of Finance’, his study of the
central bankers, Montagu Norman in Britain, Benjamin Strong in America, Hjalmar
Schacht in Germany and Emile Moreau in France, who guided the world into the Great
Depression:

“As I began writing of these four central bankers and the role each played in setting the
world on the path toward the Great Depression, another figure kept appearing, almost
intruding into the scene: John Maynard Keynes, the greatest economist of his generation,
though only thirty six when he first appears in 1919. During every act of the drama so
painfully being played out, he refused to keep quiet, insisting on at least one monologue
even if it was from offstage. Unlike the others, he was not a decision maker. In those years
he was simply an independent observer, a commentator. But at every twist and turn of the
plot, there he was holding forth from the wings, with irreverent and playful wit, his
luminous and constantly questioning intellect, and above all his remarkable ability to be
right.

Keynes proved to be a useful counterpoint to the other four in the story that follows. They
were all great lords of finance, standard bearers of an orthodoxy which seemed to
imprison them. By contrast, Keynes was a gadfly, a Cambridge don, a self-made millionaire,
a publisher, journalist, and best-selling author who was breaking free from the paralysing
consensus that would lead to disaster. Though only a decade younger than the four
grandees, he might have been born into an entirely different generation. “ (L. Ahmad
‘Lords of Finance’ Introduction)

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(iv) Keynes wrote four books on economic problems in the 1920’s and 1930’s which had a
major impact on thinking, though in different ways, and a continual commentary on public
affairs published in newspapers and pamphlets.

a) ‘The Economic Consequences of the Peace’ 1920.

This book catapulted Keynes into the public eye and made him notorious with its argument
that the war reparations imposed on Germany were disastrous and that Germany would
not be able to pay and that they would only lead to more instability and potentially
disaster: he was right!

b) ‘A Tract on Monetary Reform’ 1923.

This is the classic statement of monetary problems immediately after the First World War,
with arguments for stabilisation of internal price levels, rather than the exchange rate, and
prescient warnings of the dangers of attempts to return to the pre-war gold standard: he
was right again! Many of the arguments are explained with innovative developments of
monetary theory. Milton Friedman thought it his best book.

c) ‘A Treatise on Money’ 1930 Volume 1 ‘The Pure theory of Money’, Vol 2 ‘The Applied
Theory of Money’.
This is generally considered to be the clearest statement of orthodox classical monetary
theory i.e. before Keynes’ own ‘The General Theory..’. It was dissatisfaction with this and
in response to the inadequacies of orthodox theory to explain the Great Depression, that
Keynes felt the need to write ‘The General Theory of Employment, Interest and Money’.

d) ‘The General Theory of Employment, Interest and Money’ 1936.

This is the book which revolutionised macroeconomics and laid the foundations of the
subject as it is taught today. It is important to note however that it is a work of pure theory
and NOT a commentary on the Great Depression and policies which should have been
adopted to deal with it. The aim is to explain why orthodox theory deals with the special
case of full employment; this is why it is called the general theory.

e) As well as these, Keynes wrote many popular pieces on economic matters for newspapers,
particularly for the weekly periodical ‘New Statesman and Nation’ which he helped to edit.
These pieces are serious discussions of most of the important economic issues of the time
and many were collected together by Keynes and published as ‘Essays in Persuasion’.
Many of them show the development of ideas which became essential parts of ‘The
General Theory..’. They are indispensable reading, written in Keynes’ wonderful English.

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f) Keynes also collected other pieces he had written in his ‘Essays in Biography’. These are
literary sketches of politicians and other influential characters of the 1920’s, great
economists and his friends, giving vivid background to the era in which in he lived.

(vi) At the end of his life Keynes worked for the British Treasury. His first task was to work
out a way to finance the British war effort. Using many of the ideas he had developed
in the ‘General Theory…’ this was very successful and an essential part of the eventual
war success.

At the very end of his life, driven to prevent as far as he could the financial and
economic disasters which had followed the First World War, he was the chief British
economic adviser/negotiator in the discussions which established the ‘Bretton Woods’
international financial system, the IMF and the ‘World Bank’. The Bretton Woods
system ran successfully until 1971 and the IMF and World Bank are still with us.

He was also the lead British negotiator of American financial aid to Britain after the
Second World War. The effort finally killed him and he died in 1946.

B. Big Ideas.
There are a set of big themes and ideas running throughout this period. They are
often in conflict with each other. Some become dominant and fade to be replaced
by others, but it is surprising how the same ideas keep coming back, usually in
different guises but essentially the same. It helps to appreciate these so that the
economic and financial history of this period is not seen as ‘Just one damn thing
after another’!

(i) The most dominant idea is that free markets are generally the best way to organise
economies.

 Even in the era of Keynesian stabilisation policy this was not in doubt. Keynes himself was
a great opponent of detailed government interference in markets.
 There is a strong line of argument throughout the period that government interference
either in the form of active macroeconomic stabilisation policy or detailed regulation will
only make matters worse than temporary problems with free price adjustment.
 Before the First World War and in the 1920’s and early 1930’s this takes the form of
orthodox economic theory, free markets, free trade and the gold standard. The emphasis
is on balanced budgets and the defence of the fixed exchange rate against gold, to the
exclusion of all other possible objectives.
 We do not consider the economic policies of Eastern Europe where the hope was that
central planning would be more successful than the market mechanism

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  There was increasing government intervention from the 1950’s to mid-1970’s.
 The failure of intervention to combat inflation with incomes policies and stagnation led
to a resurgence of ‘free market economics’.
 Re-emerged at the macroeconomic level as ‘Monetarism’ and the ‘Efficient markets
Hypothesis’.
 At the microeconomic level, deregulation and privatisation.
 From the early 1970’s to 2008 it took the form of the ‘Washington Consensus’ of the
International Monetary Fund.
 The intellectual foundation for this move in America came from the University of
Chicago. At the macroeconomic level the most powerful advocate for ‘Monetarism’ was
Milton Friedman, also from the University of Chicago.
 Older debate from 1930’s between Hayek & Lange
 In Britain Institute of Economic Affairs particularly at policy level was very influential.
 First experiment came with the Conservative government of Margaret Thatcher in Britain
in the 1980’s.
 Financial deregulation
 China & Deng Zhao Ping
 Collapse of Soviet System in Eastern Europe.
 Move back to regulation after current crisis

(ii) The gold standard.

 The gold standard dominated the international financial system in the late 19 th century.
 It seemed to have been successful as growth rose.
 It collapsed on the outbreak of the First World War
 Policy makers were determined to restore the GS and try to recreate the world of the
19th century which they knew!
 They could not conceive of the monetary stability required to make the market
mechanism work without it.
 Essentially because adherence to it controlled of inflation
 Keynes was one of the few who saw the dangers: he was right!
 After Britain returned to the GS in 1925 he published his famous pamphlet ‘The
Economic Consequences of Mr Churchill’.
 Even Keynes found it difficult to resist the attractions of the GS
 Gold standard was the basis of Bretton Woods.
 It continues to hold a fascination for many.

(iii) The Gold Standard is fatally flawed.

 Deflationary with growth
 ‘Fixed’ stock with growing output leads to price falls?

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 Debt deflation
 Can easily amplify macroeconomic disturbance – and did!
 Gold flows between countries in crises make them worse!
 Fundamental constraint on monetary policy in crises
 Interest rates have to rise to preserve the gold stock

(iv) Wars are disruptive!

 During this period there were two world wars which had profound economic and financial
effects as well as political.
 The First World War resulted in:
- The end of 4 Empires, Austrian, Russian, Ottoman & German!
- The Weimar Republic in Germany
- The Bolshevik revolution in Russia
- The end of British financial dominance
- Beginning of American dominance
 The Second World War resulted in:
- The partition of Germany
- The end of the British Empire
- The communist revolution in China
- The period of American dominance
 In Western Europe and the United States the free market has only seriously been
challenged in three periods:
a. The First World War
b. The 1930’s in Nazi Germany and the other European dictatorships
c. The Second World War
 Regulation and command economies: Wars are not run on free market principles: the
module does not consider economies during the wars.
 Wars create panic on their outbreak as investors rush for safety and liquidity.
 This is usually followed by capital controls and a fundamental change to the international
financial system.
 Deficit finance. Wars are expensive! All wars were financed by a combination of taxes,
borrowing (home and abroad), and deficit finance.
 Wars, especially the First World War which changed attitudes to deficit finance.
 NB also the cost of the War of Spanish Succession and the Napoleonic and revolutionary
wars, the paper credit and public debt in Britain paid for by the Industrial Revolution.
 Public expenditure as a share of GDP rose sharply after the First and Second World Wars,
and has not fallen much since.
 Wars leave inherited debt.

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 War debts are often (always?) inflated away so wars are regularly followed by inflation
 The wars also had profound effects on attitudes to government intervention at the
microeconomic level. Governments directed resources to the war effort and this reduced
resistance to the idea of government intervention. This was generally recognised after the
First World War and even more after the Second.
 Wars also changed political objectives. After each war governments were left with an
obligation to pay attention to employment levels.
 Full employment only became a distinct policy aim after the Second World War but it
affected policy after the First.
 The two World Wars were not the only wars to have profound effects during this period
however. The cost of the Vietnam War was instrumental in the collapse of the Bretton
Woods international financial system in 1971 as the world supply of dollars rose to a level
at which the guaranteed conversion of dollars into gold at a fixed exchange rate became
untenable.

(v) The market mechanism can collapse.

 Free markets may generally be OK, but they are subject to catastrophic breakdowns which
are not self-correcting through the usual mechanisms of free market price adjustment.
 They need active support: the question is ‘What form should this take?’
 Monetary policy was an accepted part of economic policy to produce financial stability
from the mid 19thcentury on.
 But ACTIVE monetary policy was severely constrained by the Gold Standard - deliberately!
 The idea of using government fiscal policy to stabilise an economy was an innovation from
the 1930’s
 The appropriate combination of monetary and fiscal policy was even later.
 Policy makers had adopted public expenditure to ease unemployment in the early 1930’s
e.g. Hoover dam
 In this they were ahead of academic economists
 Keynes, and others, had argued for public expenditure to reduce unemployment in the
1920’s e.g. ‘Can Lloyd George Do It?’
 Keynes’ ‘General Theory …’ provided the theoretical justification for the use of fiscal policy.
 But there is nothing in Keynes’ own writings to suggest that he thought ‘fine tuning’, using
such constructions as the ‘Phillips Curve' would be successful and most of his policy advice
was directed at producing monetary stability.
 Orthodox monetarists like Milton Friedman accepted the need for ‘loose’ monetary policy
to counter deep depressions and blamed the depth of the Great Depression on perverse
Federal Reserve policy. (A view first put forward in the 1930’s - Tutorial 2).

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  The financial crisis which began in 2008 has seen the rebirth of “Keynesianism” in the form
of activist monetary policy and at least some fiscal stimulation. But this has been mixed
with a confusing return to the idea of ‘Balanced Budgets’: just like the 1930’s!

(vii) Balanced budgets.

 Balanced budgets were an integral part of the classical gold standard.
 The GS was an anti –inflation system and it was well understood that deficit financing was
not sustainable in the long run
 Balanced budgets were a guiding principle of policy all through the 1920’s and into the
1930’s
 Fiscal stabilisation through budget deficits did not enter into the mind set of policy makers
at the beginning of the Great Depression
 Deficit finance was seen as a threat to the international financial system – as after the First
World War.
 Concern for budget balance has resulted in some strange and disastrous policies in the
1930’s and now!
 In Britain the May Report by the ‘Committee on National Expenditure’ in July 1931
recommended extensive public sector spending cuts, including a cut to the unemployment
benefit, and increased taxation.
 Keynes called it “the most foolish document I have ever had the misfortune to read”.
 In America in 1932 the US Congress increased revenue to balance the budget with the
Revenue Act which was the largest peacetime tax increase in history.
 The Act increased taxes across the board: top earners were taxed at 63% on net income. It
also increased the tax on net income of corporations from 12% to 13.75%. It was wildly
deflationary!
 Budget deficits have, of course, come back into the forefront of policy concern with the
financial crisis and the rescue of ‘Too Big to Fail’ banks and other financial institutions.
 And also with the problems with the EURO and the sovereign debt crisis.
 And we have the same confused mix of policy responses!

(viii) Fixed exchange rates.

 The reason for balanced budgets was that the gold standard was a FIXED EXCHANGE RATE
system
 Maintenance of the fixed exchange rate of each currency against gold, and hence against
each other, was what made the gold standard what it was.
 The ONLY object of policy under the GS was to maintain the fixed exchange rate!
 Government policies of loose money to finance deficits, which raised inflation rates were
inconsistent with the fixed exchange rate

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  Despite the known problems with fixed exchange rates they continue to fascinate policy
makers
 Fixed exchange rates were the basis of the Bretton-Woods system
 When the fixed exchange rate between the dollar and gold became untenable, it collapsed
 The EURO is a fixed rate system
 Similar problems have come back again
 NOTE: the only way to maintain a fixed exchange rate is by intervention in the foreign
exchange market: i.e.
- If a currency is rising, the government/central bank must sell the currency on the foreign
exchange market: this is not difficult as a country can always print more currency – at the
risk of future inflation. This corrects the trade surplus. But inflation effects may have to be
reversed later.
- BUT if a currency is falling, the government /central bank must buy it on the market to
create demand – with foreign exchange or gold. This reduces the money supply and prices
which corrects the trade deficit.
- But this requires price effects to work fast. If the central bank runs out of foreign exchange
or gold, before the price falls take effect, it is lost unless it can persuade other countries to
lend it foreign exchange or gold, usually by raising interest rates.

(ix) Government intervention: regulation

 The gold standard worked on the 19th century principle of ‘Laissez Faire’, with next to no
government intervention
 Unemployment was no concern of government!
 This came under severe strain during the Great Depression which was the result in part
due to lax regulation
 See ‘Wall Street Under Oath’ by Ferdinand Pecora.
 1930’s saw more corporate and banking regulation
- Glass – Steagall Act
- Securities & Exchange Commission
- Compulsory audits and Company Reports
 Much of this was reversed in the 1980’s
 Regulation was discredited in the 1970’s, largely by the abject failure of incomes policies to
control inflation
 But also by low growth in Britain
 But the dubious practices associated with many aspects of the current crisis have led to
more regulation

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(x) Unemployment levels have become an objective of economic policy

 Under the gold standard employment levels were beyond the scope of government policy
 They were what they were because that was necessary to maintain the fixed exchange
rate and the gold standard.
 This became progressively more untenable with the rise of democratic representation of
most of the population
 Particularly in Britain after the Second World War with Churchill’s defeat in the 1945
general election.
 Return of ‘monetarism’ reduced the commitment to full employment: ‘There is no
alternative!’

(xi) The inflation rate as an explicit objective of economic policy.

 Low and uniform inflation was the only policy consistent with the fixed exchange rate of
the gold standard
 This came under strain from deficit finance of wars
 The clearest example of this is the Great German inflation of 1923
 First group of economists to argue that ‘price stability’ should be the main objective of
policy, rather than fixed exchange rates, emerged after the First World War: the leading
advocate was Keynes in the ‘Tract on Monetary Reform’.
 More of a problem once full employment became a policy objective
 But also a very serious problem in the 1970’s
 Failure to control inflation with incomes policies led to Monetarism
 Independence of Central Banks: a return to Gold Standard ideas
 Inflation targeting: a return to one of the basic ideas of the Gold Standard!
 And deregulation as a response to the political difficulties of incomes policies

(xii) Debt
 It is useful to distinguish:
- Government domestic debt
- Government international debt
- Central bank international debt
- Bank/financial institution domestic debt
- Bank/financial institution international debt
- Business debt
- Household debt
 Note: ‘Debt’ is accumulated ‘deficits’!
 They play different roles in the economic drama

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  Under the gold standard debt was a private matter
 Government debts came from borrowing from banks and the general public & were
limited by balanced budgets
 Government, or sovereign, debts became a concern after the First World War which left
the world with the problem of the ‘Debt Triangle’
 It was a serious problem for Britain after the Second World War
 It continues to be a problem after government rescues of financial institutions in the
current crisis
 And usually ends in inflation!
 Private debt as a problem emerged as a problem in the late 1920’s with a credit boom,
particularly in America before the Great Crash.
 Mortgage debt was a problem in USA in the Great Depression.
 And in the current crisis with sub-prime mortgage debt
 Debt itself not the problem: it’s how the problem is dealt with.
 Debt deflation? Why is it a problem? Japan, Europe & Britain (?)
 Corporate debt. Firms repay debt from profits, if prices and costs fall nominal profits fall –
BUT nominal debt stays fixed!

Π = p * Q - c * Q, if p & c halve nominal Πnom = Q ( p – c )/2

 And if Q falls as well the problem is worse!

 Government debt paid for from taxes:

Tax revenue = t p Q, if p & Q fall revenue falls but debt same.

 Fisher and ‘Depressions as debt deflations’!

 Where’s debt in standard macroeconomics?

(xiii) Politics
 Politics is inescapable!
 As a factor in wars of course, but also in the peace process after – particularly the
Versailles ‘Peace’ conference
 The whole EURO project as a political project to end Franco-German rivalry in Europe.
 But it is also inescapable as ‘sovereign’ risk – the danger that governments will default on
their debts
 Politics also enters in other apparently mundane but important ways:
Particular examples:

- The constitution of the Federal Reserve System

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 - The insistence by the US Congress that Hoover’s Reconstruction Finance Corporation
publish a list of banks it had assisted resulted in a bank crisis as depositors withdrew
their money
- Keynes’ failure to understand American politics and that the power of the US
Congress endangered the US loan to Britain after the Second World War.

 In international monetary relations:

- German reparations after the First World war
- Loans to Germany after the First World War
- Loans to Britain in 1927 to support the Gold Standard
- Unwillingness of France to lend to Austria in the Credit – Anstalt crisis
- Suspensions of reparations. Too late!
- The Marshall Aid programme after the Second World War
- American loans to Britain after the Second World War
- The IMF loan to Britain in 1976
- Bailouts and austerity in the current crisis.
- Particularly in the Eurozone with possible political responses similar to the response in
Germany in the 1930’s with governments from the political extremes coming to power.

For example:
o Greece
(From Robert Peston on the BBC website Jan 26th 2015 following the success of Syriza
in the Greek elections).

- The country's economic crisis was caused in large part because its government had
taken on excessive debts.

- So at the time the crisis began in earnest, at the end of 2009, its debts as a share of
GDP were 127% of GDP or national income - and rose the following year to 146% of
GDP.

- As a condition of the official rescues, significant public spending cuts and austerity
were imposed on Greece. And that had quite an impact on economic activity.

- The country was already in recession following the 2008 financial crisis. But since
2010, and thanks in large part to austerity imposed by Brussels, GDP has shrunk a
further 19%.

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 - GDP per head, perhaps a better measure of the hardship imposed on Greeks, has
fallen 22% since the onset of the 2008 debacle.
- “Compromise may prove impossible - Greece rudely ripped from or bolting
from the eurozone is not an impossibility.”

- So austerity has certainly hurt. But has it worked to get Greece's debts down?

- To the contrary, Greek debt as a share of GDP has soared to 176% of GDP, as of the
end of September 2014.

- Now it has fallen a bit in absolute terms. Greek public sector debt was 265bn euros
in 2008, 330bn euros in 2010 and was 316bn in September of last year.

- But it is debt as a share of GDP or national income which determines affordability.

And on that important measure, Greece's debt problem is worse today than it was
when it was rescued.

- To state the obvious, it is the collapse in the economy which has done the damage.
And although Greece started to grow again last year, at the current annual growth
rate of 1.6% (which may not be sustained) it would take longer than a generation to
reduce national debt to a manageable level.

(xiv) Credit based money and the ‘Real Bills’ doctrine.

 A fundamental problem which has a history going back to the beginning of the 18th century
in Europe, and even earlier in China, is ‘How to manage a credit based monetary system’.
 An indispensable part of modern monetary policy is the supply of credit i.e. loans usually
backed by some form of collateral
 The supply of this is not linked in a fixed way to anything of (supposed) intrinsic worth and
limited in supply, like gold or silver.
 The supply of credit money can be increased indefinitely by the decisions of monetary
authorities.
 There is a strong temptation for national governments, and possibly supra-national
monetary authorities, such as the IMF and the ECB, to create more credit money as a
supposedly easy way to solve pressing economic problems.
 These problems may take the form of paying for wars, paying for public expenditure
programmes or rescuing bankrupt financial institutions or countries, with centrally created
credit.
 There are only three ways to meet public expenditure:
- by taxation,
- by borrowing from the public i.e.issuing debt to the public
- by issuing government debt to central banks in exchange for deposits (printing money).

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 The last method ‘quantitative easing’ at the moment, seems an easy solution avoiding
immediate unpopular taxation or unpopular future taxation to pay interest on government
debt.
 But except in exceptional circumstances of high unemployment, the inevitable
consequence is INFLATION
 And inflation is not costless; this method is known as the ‘inflation tax’.
 The Gold Standard was adopted to deal with the ‘Irresponsible chancellor’ problem and
stop this.
 The original mandate of the European Central Bank was intended to do something similar!
 Under the Gold Standard the money supply in a country was deliberately limited by the
stock of gold in a country and the discounting of ‘Real Bills’.

How this worked is where we start next.

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