In the previous section, we saw how economic theories changed from Classical to Keynesian to Monetarist over the course of the 20th century. These changes were driven by historical events. Taking this historical context into account deepens our understanding of economic theories. This contrasts with the conventional methodology of economic textbooks, which treats economic theories as scientific laws, which are universally applicable to all societies. In this section, we describe one of the central lessons which emerges from the study of money over the millennia.
The transition of economic theories from Classical to Keynesian to Neoclassical can be seen as a miniature illustration of the Quality-Quantity Pendulum, which is a consistent pattern relating to money observed over millennia. Modern economic theory strips theories of their historical context, depriving us of critical insights into both theories and history. Before studying the QQ Pendulum, we will pause to discuss how this defective methodology was adopted by economists.
The Battle of Methodologies: As Geoffrey Hodgson has detailed in his book entitled “How Economists Forgot History”, a challenger to the dominant historical and qualitative methodology emerged in the late 19th century. The new methodology was quantitative, mathematical, and empirical, in imitation of scientific methodology. The devastation of World War 1 destroyed the prestige of the traditional approach to social science, so that this scientific approach became the dominant methodology in economics by the 1950s. This ahistorical approach blinds us to the fact that all social theory is developed to analyze a particular society situated in a particular historical context. Treating it as a universal scientific law, invariant across time and space, is hugely mistaken.
Lessons from History: In this section, we will discuss some insights about the nature of money, and monetary economies, derived from the study of history by Glyn Davies in “A History of Money: From Ancient Times to Modernity”. Davies writes that: “… despite the antiquity and ubiquity of money its proper management and control have eluded the rulers of most modern states partly because they have ignored the wide-ranging lessons of the past or have taken too blinkered and narrow a view of money.” For example, Keynesians and Monetarists agree that a contraction of the money supply was the immediate cause of the Great Depression of 1929, whose ill effects persisted until the outbreak of World War 2 in 1942. From a broader perspective, a study of the history of money should have made both the nature of the depression, and the remedy, abundantly clear. Unfortunately, as the previous quote indicates, policymakers ignored the lessons history teaches us about the role of money, and made errors which caused misery to millions for decades.
Money as a Social Institution: A study of history shows that money has played a central role in shaping history across the centuries. Also, history teaches us money is not purely a transaction technology; it is deeply embedded in the social fabric of society. The use of money requires building social consensus on the trustworthiness of monetary institutions. Building this trust requires building high-quality institutions and mechanisms that guarantee the value of money in the eyes of the public. The quality of money refers to the public trust and social consensus both on the value of money, and the stability of this value across time.
High Quality Money: History provides us with an incredibly diverse set of examples of monetary institutions which provided society with trustworthy money with stable value across time. Cattle and cowries in Africa, paper money in China, Wampum in America, and Yap stones in the Pacific Islands, were used as money for centuries. Many systems even survived in competition with modern monetary systems. So, we conclude that there are a wide variety of ways to create high-quality money.
The Gold Standard: One of the ways to create high-quality money is to use gold or silver. These metals have characteristics – discussed in textbooks – that make them particularly suitable for use as money. There is very little public awareness that there are many different varieties and conflicting interpretations of what the “gold standard” means. The best reference for this is Morrison’s England’s Cross of Gold: Keynes, Churchill, and the Governance of Economic Beliefs. The strictest form of the standard – the use of actual gold – has been very rare, historically. Coins of minted gold have been far more popular. The mint certifies the quantity and quality of gold in the coin, making it far more convenient for public use.
Minted Money and Token Money: The highest quality of money comes from minted coins, which have a value equal to the content of the metal (gold or silver). This is because the coin itself is the guarantor of its own value. There is still the question of what it is about gold and silver that creates a nearly universal consensus on their intrinsic value. Perhaps the answer is that love of gold and silver has been built into human nature, as Quran (3:14) suggests.
The numismatic evidence from buried coins shows that high quality gold coins are almost always followed by “debased” coins – coins with significantly less gold content than the face value of the coin. History tells us of the varied reasons for such debasements. Most often, the high expenses of wars require vast amounts of money, beyond the available stocks of gold. Governments resort to debasement to get more money from the same gold stock. Since gold is very valuable, even the smallest gold coins are not useful for daily transactions. So, token monies, made of copper or other cheap metals, are often used for small change. The metal value of these coins is not equivalent to their market value; instead, these coins are considered as fractions of the gold coins, and can be exchanged for them.
From Quality to Quantity: The Quality-Quantity Pendulum is a theory that illustrates the historical shifts in economic focus between the quality and quantity of money. The lesson of history, repeated across the globe, and across the centuries, is that the temptation to expand the stock of money – more quantity – proves irresistible in the long run. A modest expansion of money stock via small dilutions of gold content or small issues of token money, brings major economic benefits. Small expansions of money stock beyond gold content do not cause noticeable changes in public trust which is the central guarantor of the value of money. However, over a longer period of time, the temptation to expand the quantity beyond safe limits becomes irresistible. Events like wars, private greed, or government needs, lead to over-expansion of the money stock. An excessive quantity of money causes inflation, a loss of value, and a breakdown of public confidence in money. The drive to expand the money stock leads to a low quality of money. But large fluctuations in the value of money disrupt lives, and cause distress to all members of a monetary economy. As a result, consensus builds on monetary reforms required to create high quality money. Eventually, excess money is removed from circulation, and a high-quality money is restored, to complete the swing of the pendulum between quality and quantity.
The Pendulum of Economic Theories: Many authors have noted that history is a battle between the creditors and the debtors. In eras of high-quality money, money is scarce, and the creditors are few and powerful. They propagate pro-creditor economic theories which favor “sound” money: high quality with restricted quantity. However, the need for expansion of money stock becomes overwhelming in many different scenarios. Then, pro-debtor economic theories emerge. These favor the expansion of the money stock, and cite numerous advantages from doing so. Creditors argue in vain against these theories and warn that they will lead to ruin. The benefits from expansion are immediate and obvious to all in the short run. But in the long run, the creditors’ gloomy predictions turn out to be valid. Over-expansion destroys the quality of money, and also the reputation of the pro-debtor economic theories.
This drama has played out over the centuries in many different guises, and with different terminologies in use to describe the two opposing schools of thought about money. Confusingly, the quantity theory of money (QTM) advocates the maintenance of high-quality money, and argues against expansions of the money stock to bring prosperity to the masses. As opposed to it, the Real Bills Doctrine (RBD) argues that the money supply should be expanded to finance productive investment.
The RBD versus the QTM, the Anti-Bullionists versus the Bullionists, the Banking School versus the Currency School, Keynesians versus Monetarists, and most recently, Minsky’s Financial Fragility Hypothesis versus the Real Business Cycle theories, are all illustrative of the quantity-quality controversy which spans centuries of monetary history.
Long-Run Versus Short-Run Perspectives: Davies emphasizes that this quantity-quality pendulum becomes discernible only in the long run. Over any short period of time, spanning a few decades, the immediate benefits of one or the other school of thought seem overwhelming. When tight money is creating recession and unemployment, the benefits of looser money seem obvious to all, and tight money adherents find little support for their positions among the masses. However, in periods of high inflation, the harms of loose money again appear obvious, and tight money policies gain public support. Over any short period of time, one or the other policy seems obviously superior. It is only a long-term examination of history which shows the regularity with which the pendulum swings between the two poles.
There are three conclusions we would like to draw from the quantity-quality pendulum, which emerges from the study of millennia of monetary history.
- The study of equilibrium in monetary economics is an illusion. A stable and high-quality money creates an irresistible temptation towards expansion, leading to a breakdown in quality. Excessive money stock destabilizes the value of money and creates powerful forces which seek to stabilize its value and create high-quality money. At no point in the trajectory of the monetary pendulum do we see any resting place, or equilibrium.
- The value of money rests on the social consensus created by confidence in the monetary institutions governing the creation of money. History is full of examples where this confidence was weakened or strengthened, leading to changes in the value of money. Recently, a crisis of confidence in the Euro was stemmed simply by an announcement by Mario Draghi that he would do “whatever it takes” to stabilize and protect the Euro. Conventional treatments of money pay no attention to these psychological aspects of money.
- The historical perspective provides deeper insights into monetary theory than conventional methodology. When the Great Depression created tight money, Keynesian theory favoring expansion of money stock emerged and became popular. Inflation in the 1970’s led to rejection of Keynesian theory and a return to the tight-money policies implemented by Volcker. Conventional methodology searches for absolute scientific truths, without realizing that truth may be relative to a particular historical context.
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