Economics and monetary theory – النظرية المالية و الاقتصادية

In my postgraduate days, I was immersed in attempts at developing a new monetary theory. The fact that money had no role to play in the economic theory of the day was, when one simply looked casually at the world, patently ridiculous.

Fighting this corner from within the discipline of economics left one incapacitated as a result of the very nature of the subject. Change is coming, but it is coming via the relatively new entrants to the subject through anthropology and sociology.

Heterodox economics theory is now growing in terms of its presence, but it cannot replace orthodox theory because, on my view, orthodox economic theory is itself a social phenomenon. It is a function of the institutions we, as human beings, have created since WWII, and it is only when these institutions change, that orthodoxy will change.

The future is political.

Remarkably, in its first quarterly bulletin for 2014, the Bank of England began to break with the orthodox monetary vision, when it finally owned up to the fact that “the majority of money in the modern economy is created by commercial banks making loans” (McLeay 2014). But that wasn’t all, for then the Governor of the Bank of England wrote a series of Op-eds in the Financial Times focusing on “Shadow Banks” (a catch-all term for all non-bank financial institutions), suggesting that debt creation between those institutions also created money (“inside money”) (Carney 2014).

But will this admission that money is debt, rather than one simple commodity among the plethora of commodities in the “real” economy, lead to major institutional changes, or is it merely an admission of the failure of both the “quantity theory of money” of the 1980s and its offshoot the “rational expectations theory of inflation” of the 2000s, and of the need to define money properly in order to regulate it?

In other words, having identified the causes of money, are we simply now going to focus on its consequences and leave the causes alone? To alter the parameters within which the causes of money function, in order to finally alter the boom-bust character of capitalism (particularly as it has functioned since the 1840s) and the financialisation of the world economy that has led to the social polarisation we have today, which will lead to ever greater crashes, polarisation and instability, is a matter for fundamental social and political change.

It is unlikely, therefore, that the Bank of England, in terms of its institutional remit, can possibly be going in that direction. In which case, there will be no change because, having identified the causes of money, it is clear that, in the current circumstances, they cannot possibly be controlled.

This page on the website focuses on the struggle to understand money, one of our most important social technologies since time immemorial, but to understand it from within economic theory, and concludes with some of the implications of actually coming to understanding it, in terms of how economics relates to wider social theories.

<<Keynes and Babylonian madness>>

During the Methodenstreit – the debates on methodology in the field of economics in Germany and Austria in the 1880s – the German Historical School produced figures such as Georg Friedrich Knapp who produced ideas on money that were opposed to Adam Smith’s orthodox conception of money as a commodity, and to those such as Carl Menger and Ludwig von Mises who followed in Smith’s wake and who saw money as a commodity chosen from a process of free exchange based on individual preferences.

Knapp saw money as a token (Lat.: “charta”, hence his was a “Chartalist” theory) which instantiates an abstract concept of valuableness, as distinct from “value”, the validity of which precedes its purchasing power, in virtue of a valuableness or “validity” established in the political arena between the state and its individual members.

This idea meant that money as “unit of account” precedes its role as “medium of exchange”, and that this aspect cannot possibly be produced by any amount of free interplay of economic interests in the marketplace. This is the approach in fact taken by Keynes in his Treatise on Money (1930), where he writes unequivocally that:

Money-of-Account, namely that in which Debts and Prices and General Purchasing Power are expressed is the primary concept of a Theory of Money” (Keynes 1930: 3).

Keynes, on his own account, had thrown himself in the 1920s into a frenzy of amateur numismatics (he called it “Babylonian madness”), which branched out into the various discoveries by philologists and assyriologists in the archaeological finds of cuneiform Mesopotamian palace records (Keynes 1924). He read Knapp and endorsed his “chartal” theory of money at the beginning of the Treatise on Money. He also read Mitchell Innes’ closely related credit or debt theory of money (Mitchell-Innes 1913: 377-428), which he reviewed favourably in the Economic Journal (Keynes 1914: 419-421).

So from Knapp in particular, Keynes acquired the idea that money “is the measure” and is not “the thing to be measured”. From Innes, Keynes, again in the Treatise on Money, verges on a pure credit theory of money when he says that as banks make loans, and thus issue claims against themselves, they create deposits, and therefore money: money is thus socially constructed (Keynes 1930: 24-30, see also Ingham 2004: 50-2).

<<Keynes and Keynesianism>>

When it came to writing the General Theory of Employment, Interest, and Money (1936) [GT], however, Keynes sought to explain his view of money on orthodoxy’s own terms. Clearly, there was enormous resistance to the idea that money was not a commodity and was instead, in the words of the Bank of England in 2014 we saw above, “created through lending”. Edwin Cannan’s view would be typical of orthodoxy, in such writing as:

If cloak-room attendants managed to lend out exactly three-quarters of the bags entrusted to them…we should certainly not accuse the cloak-room attendants of having “created” the number of bags indicated by the excess of bags on deposit over bags in the cloak rooms” (Canaan 1921: 24-36, see also Schumpeter 1954: 1113-14).

Keynes would essentially try to convey a picture of the “natural law” account of economic theory as something existing in a Platonic Heaven and, as such, as an ideal which could never really be reached. Nevertheless, it was a concession to the extent that a Platonic Heaven was alluded to, in order to assuage the proclivities of the mathematically-inclined.

This led to the fact that no sooner than GT was published, it would be bowdlerised. We can see Keynes’ concessionary approach taking shape as early as his Tract on Monetary Reform (1932) when discussing the “Quantity Theory of Money”. In this theory, Irving Fisher had denied that the price level could be a function of “industrial and labour combinations”, and reinforced the idea of money and the economy as real physical things, by showing that money was that “generalised” commodity the quantity of which it was that impacted the “general” price level (Fisher 1911).

Keynes writes that “This Theory is fundamental. Its correspondence with fact is not open to question”, and he goes on to analyse equilibrium holdings of money in an economy from the “utility” aspect (Keynes 1932: 74-8). But then he adds the point that things may not be quite as simple as at first conceived, for the parameters in the quantity of money equation are, after all, a function of “economic and social organisation”, which he sees in turn as potentially a function of the quantity of money. The truth of the “Quantity Theory of Money” may not be in question, but this applies, it turns out, only “in the long run”:

[emphases in the original] “But this long-run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that we the storm is long past the ocean is flat again” (Keynes 1932: 80).

In fact, for Keynes, what the early readers of GT failed to grasp was the message that it was the short-term that was supposed to be understood as the “general case”, and this problem arose largely because he allowed them to pass straight through it into the mythical “long-term” ideal represented in orthodox “natural law”. Nevertheless, Keynes had set out in GT to revamp orthodox economic theory, the postulates of which he thought could only describe a “special case” of what GT held to be “general”:

[emphasis in the original] “… the emphasis [is] on the prefix general…. to contrast the character of my arguments… with those of classical theory… upon which I was brought up and which dominates the economic thought, both practical and theoretical, of the governing and academic classes of this generation, as it has for a hundred years past” (Keynes 1936: 3).

He wanted to say that the (long-term) equilibrium paradigm of orthodox economics was untenable, although in GT, just as in the Tract on Monetary Reform, he still argued within the framework of the theory he wanted to demolish; and in GT, he in fact specifically uses Marshallian demand and supply analysis (Keynes 1936: Ch.2, 2-22). His Cambridge colleague, Piero Sraffa, on the other hand, who reverted to the Ricardian paradigm of understanding value from the aspect of production, maintained that it would be better that Marshall’s theory be entirely discarded in this case (Sraffa 1930: 93).

The bowdlerisation of Keynes in the counter-revolution that followed the publication of GT was therefore hardly surprising, where Keynes’ theory would re-integrated into the successor theory of “classical” economics, dubbed “neo-classical”, reducing neo-Keynesianism to a simple application of “special features” (like the multiplier and liquidity preference) within the “classical” framework.

The process of bowdlerisation started with John Hick’s contribution and his “suggested interpretation” of Keynes’ theory (Hicks 1937). This interpretation was subsequently taken up by various economists, culminating in Alvin Hansen’s canonisation of the so-called the Income-Expenditure Model (IEM) as the core model of the neo-Keynesian counter-revolution, which came to be known as the ‘neo-classical synthesis (Hansen 1953). In fact, Bob Clower would write by 1965 that he was both “impressed and disturbed by the close resemblance of some [‘Keynesian’] doctrines to orthodox economics” (Clower 1965: 270).

Where it had been Keynes’ intention to bring out the importance of money in economic processes – denying that it was a “veil” – the neo-classical synthesis would drive Harry Johnson, as well, to query:

“… why a theory in which money is important should have turned into a theory that money is unimportant” (Johnson 1961: 15).

All the arguments of the IEM are in fact displayed in real terms, which are divided through by the GNP deflator, and this in order for the model to abide by the ‘classical’ postulates of rational behaviour, which required the absence of the “money illusion”, which the idea of money as a “veil”, required.

Furthermore, the IEM reversed Keynes’ understanding of the generality of his theory, by suggesting that his theory was the “special case” and classical theory, the general case, in virtue of the restrictions on free markets postulated by Keynes that we saw above, in particular in respect of the labour markets. On the classical view, and in opposition to Keynes, free markets, rather than any form of intervention or restrictions, were prescribed as the correct cure for economic depression. When it came to the labour markets, this meant that the cure meant that there needed to be a reduction in wages. This view was voiced among others by Lionel Robbins*1, who had become Chair of Economics at the LSE in 1929, and who subsequently appointed Friedrich von Hayek to the department in 1931, specifically “to fight Keynes” (Kresge and Wenar 1994: 75-98). The Keynes-Hayek debates in the early 1930’s in fact became the most prominent policy debates of the time.

Axel Leijonhufvud points out the contradictions that emerge if we are indeed to consider the GT a special case of classical theory, based on such ideas of postulated ‘restrictive’ conditions:

“… Is it not rather strange… that a model with wage–rigidity acknowledged to be its main distinguishing feature should be accepted as crystallizing the experience of the unprecedented wage-deflation of the Great Depression” (Leijonhufvud 1968: 49).

<<The Classics>>

We must ask, however, what is meant by the “classical” theory that Keynes was reacting to. In short, who were the “classics”?

The term was first used by Karl Marx in Misère de la Philosophie [Poverty of Philosophy] in 1847 to describe Adam Smith and David Ricardo, in the context of what he called the “fatalism” among economists as to the inevitability of industrial capitalism (Marx 1847/1896: 171). For Marx, the “classics” were those fatalistic economists who had judged capitalism to be a co-operative phase between all elements of society, as it emerged from a state of feudalism. By comparison, what Marx called the “romantics” among fatalists, were those economists of his day who, while regurgitating the same theories as the “classics”, cynically accepted a mature industrial capitalism with workers and bosses now in conflict, as a natural state of affairs (such as Thomas Malthus).

But then Marx himself subsequently joins the pantheon of the “classics”, when Thorstein Veblen invented the term “neo-classical” in 1900 to describe a shift in economic thinking about the ground for the determination of value away from the Ricardian paradigm of production or the primacy of the cost side, which becomes the modern understanding of “classical economics”, and towards the subjective preferences of the individual or demand side of the economy as the relevant determinants of value, thus understood as the “neo-classical” economics (Veblen 1900).

The problem with this definition with hindsight, is that the neo-classical “founders” such as Heinrich Gossen, William Stanley Jevons, Philip Wicksteed, and Léon Walras hadn’t in fact represented a sufficient break with that other “classical” economist John Stuart Mill, to warrant such a clear-cut definitional difference. Economics for them was not a standalone science, but rather one which, while using marginal analysis in the production sector, still needed to be contextualised in a wider sociology in regard to determining factor returns. Also they were radical reformers, and thus interventionists, to a man.

It was Alfred Marshall who represented the true break with the past, when economics came to be seen as a standalone discipline, addressing the economy as a whole in virtue of his multi-sectoral “comparative static” treatment of the subject*2. In fact, it is to this Marshallian mechanically-modelled economic system that Keynes, in his 13th December 1935 preface to GT, refers when he writes about his struggle to break with tradition that:

The composition of this book has been for the author a long struggle of escape…”

Thus for the “classics”, in Keynes, one really ought the read the “Marshallian synthesis”, which was a synthesis of the various elements of the theories of the so-called neo-classical “founders”. What Keynes had specifically found difficult to accept here had been the Marshallian premise that facts and expectations could be set out in calculable form:

[emphasis in the original] “The orthodox theory assumes that we have knowledge of the future quite different from what we actually possess. This false rationalisation follows the lines of the Benthamite calculus” (Keynes 1937: 222).

This is not a condemnation of mathematical calculation per se, rather it is a comment on the fact that important factors in the economy are left out of the economic modelling of the classics because they are not calculable. For both Sraffa and Keynes, Marshall’s system was abstract and wholly unrealistic. As a matter of fact, Keynes sees that calculations are inevitable in decision making:

“… individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits” (Keynes 1936: 162).

So, Keynes exclaims thus what he finds at the root of what is wrong with classical theory:

I accuse the classical economic theory of being itself one of these pretty polite techniques, which tries to deal with the present by abstracting from the fact that we know very little about the future” (Keynes 1937: 215).

Leijonhufvud sees Keynes’ “struggle for escape” as specifically relating to the problems with the comparative statics of Marshallian period analysis (Leijonhufvud 1968: 53). Comparative static models unlike dynamic models do not specify how fast variables adjust, and so prices appear there to react infinitely fast as compared with output, and the same goes for output as compared with the capital stock in the productive sector. This state of affairs is built into the very construction of the model, since in Marshallian analysis the length of the short-term is defined as the time it takes for quantity supplied to come into adjustment with demand at the short-term equilibrium price.

This then translates into the misguided and supposedly ‘commonsensical’ notion that prices can be altered more easily than the rate of output. Keynes’ reversal of these priorities, such that we have an economy whose dynamics are determined by quantity adjustments – specifically changes in real income – rejects this dogma:

The revolutionary impact of Keynesian economics on contemporary thought stemmed… from Keynes’ reversal of the conventional ranking of price and quantity velocities” (Leijonhufvud 1968: 67).

It isn’t surprising then that Keynes’ idea about short-run price inflexibilities would be interpreted by those steeped in orthodox (Marshallian) theory, as “monopolistic restraints” causing “wage-rigidity” in the economy.

<<The Keynesian revivalists of the 1960s>>

The Keynesian revivalists of the 1960’s, principally Bob Clower and Axel Leijonhufvud, responded to this and explained that the outcomes of Keynes’ model were not due to institutional factors, but to the very nature of the workings of markets.

The reason for this different understanding is that the classical model of the economy is worked out as a model with perfect information, whereas Keynes seems (implicitly) to reject the idea of information flows occurring costlessly between sectors. It is this feature of economies which causes disequilibrium states to persist, such as the classic case of the “involuntary unemployment” of the Great Depression which gave rise to Keynes’ ideas in GT.

Clower calls “Walras’ Law” the general equilibrium condition which implies that the numéraire value of one of the excess demand functions in the system can be inferred from the values of the others: it reflects Keynes’ explication of classical theory which assumes that “supply creates its own demand”, although Keynes actually brings this up in reference to “Say’s Law” (Clower 1965).

What Clower calls “Say’s Principle”, on the other hand, tells us, according to him, that no transactor consciously plans to purchase any commodity, without at the same time planning to finance the purchase. “Walras’ Law” is then seen as a special case of “Say’s Principle”, where purchases are planned without considering that the individual may or may not be able to raise the funds in other markets.

From this, Clower sets out the “dual decision hypothesis” which describes the difference between “notional” demand and “effective” demand, where consumer demand in a particular sector is affected automatically by its need to be funded through the sales of goods and services in other sectors. An inability to raise these funds leads to an “income-constrained” process which determines outcomes. George Richardson remarks on this state of affairs as follows:

“… no one can decide upon his optimal activity without knowledge of what others (who are in the same difficulty) will do” (Richardson 1959: 232).

Classical market theory is clearly not endowed with a free information system (pace Léon Walras’ auctioneer), since the oft-repeated platitude that prices are a mechanism for communicating information appears to omit to mention that what is really being sought are not such prices, but equilibrium prices. Richardson adds that:

“… the… ‘general equilibrium of production and exchange’ cannot be properly regarded as a configuration towards which a hypothetical perfectly competitive economy would gravitate… the activity required of entrepreneurs would require a certain minimum of information… [where] the availability of such information is a function of the nature of economic arrangements or system postulated; and… the conditions necessary for adequate information are incompatible with perfect competition” (Richardson 1959: 223).

As a result of this, disturbances in an economy are necessarily communicated in an environment of inelastic price and wage expectations rather than institutional rigidities. It is this which leads to Keynes’ “involuntary unemployment” – a core feature of the Great Depression – as people engage in a search for jobs if they are laid-off or if they refuse jobs because of a reduction in the money wage being offered (Alchian 1969).

Clower’s dichotomy between “notional” and “effective” demand, in fact hides behind Keynes’ point that the classical model mistakes the ex post result of economic activity, with an ex ante situation:

“… the conclusion that the costs of output are always covered in the aggregate by sale-proceeds resulting from demand, has great plausibility, because it is difficult to distinguish it from another similar looking proposition which is indubitable, namely that the income derived in the aggregate by all the elements in the community concerned in a productive activity necessarily has a value exactly equal to the value of the output” (Keynes 1936: 20).

<<The Nature of Money>>

Going back to the subject of Harry Johnson’s comment about the irony of the neo-Keynesians attempting to represent what is essentially a monetary model as a real one, we find the essence of the importance of money in Chapter 4 of GT, which focuses on the fact that you cannot aggregate the output in an economy without assigning prices to each of the elements: it’s all a matter of having to deal with “apples and oranges”, rather than one fungible substance.

We have from this fact then, the primacy of money arising as a necessary unit of account. In “economic” terms, its other roles as either a medium of exchange or as a store of value are subsidiary aspects of this general aspect. As anthropologists and sociologists are now wont to tell us, Knapp was right when he wrote that money as a medium of exchange arises from the state specifying how it wants its taxes to be paid (Ingham 2004: 47-8). Max Weber viewed Knapp’s theory as correct and “fundamentally important”, although incomplete, because ancient history tells us that a state could accept many forms of tax payments, and thus the unit of account and the medium of exchange roles are in fact entirely separate (Grierson 1977: 17; Graeber 2011: 39).

So when we get to Chapter 4 of GT, and face the problems of aggregating the output of an economy, we come to the point then that the core problem the classics experienced with their understanding of unemployment, was that labour negotiates with employers for money wages, not for real wages as the IEM model would have it. In the wage-bargain, employers are not negotiating with workers in their own product, therefore they cannot immediately “see” the demand for their products in such negotiations.

So we must be talking about a money-exchange economy, where the means of payment is different to all other goods in that it is traded in all markets, and where the classical assumption that rational behaviour implies the absence of ‘money illusion’ is wrong.

<<Money as a store of value & its relation with investment>>

Keynes asks the question as to why anyone other than a lunatic should wish to use money as a store of value (Keynes 1937: 218). That, on the contrary, Keynes sees it as rational to hoard cash, brings up that other aspect of money as a “store of value”. Keynes’ own immediate followers (post-Keynesians such as Joan Robinson, rather than neo-Keynesians), were confused by this aspect when they interpreted paper securities as interchangeable with cash on the basis of a somewhat smooth monotonic function, where the interest rate was determined by “risk”.

That isn’t how Armen Alchian understands Keynes’ meaning (Alchian 1969).

For Keynes, the interest rate was a premium offered on investments through the securities markets to induce people not to hoard cash. Alchian describes liquidity as the relation between the proportion of the highest obtainable cash value which can be realised on an asset and the time spent in marketing it, such that an asset whose full market value can be realised at zero transaction cost is perfectly liquid. Whereas in “classical” general equilibrium models all goods are perfectly liquid, and money is just another good. The fact that there may exist a potential barter bargain of goods for labour services agreeable to all parties, is totally irrelevant. In economies relying on a “means of exchange”, the excess demand for wage goods corresponding to an excess supply of labour is merely – using Clower’s term – “notional”.

The reason why we hoard brings us back to Keynes’ point about the fact that we cannot calculate expectations in any simplistic way. The fact that we distrust our own calculations and conventions about the future means that we need a repository for our purchasing power that will permit us to enter any market at a moment’s notice. Where cash loses this quality, say in hyperinflationary conditions, it may be that even land – that traditionally “most illiquid” of assets if one takes the description of stores of wealth from the post- Keynesians – becomes money.

To understand the financial markets as the post-Keynesians did is perversely to mistake the “store of wealth” aspect of money for a risk-taking desire for speculative gain based on the premise of calculable risk, rather than to admit Keynes’s point about the general problem of the incalculability of uncertainty. It is this which leads to a risk-averse desire to hold a “neutral” good.

The point is then that there must be a separation between money and other financial assets, and therefore between savings (which includes hoarding) and investment (which does not). This in turn means that investment is a key to the understanding of the levels of output and employment in an economy, because it is the most unreliable of all the factors that feed into the economy, as it depends on our views of the future about which we know so little:

Given the psychology of the public, the level of output and employment as a whole depends on the level of investment… not because this is the only factor on which aggregate output depends, but because it is usual in a complex system to regard as the causa causans that factor which is most prone to sudden and wide fluctuation” (Keynes 1937: 223).

<<The Keynesian revivalists of the 2010s and Sraffa>>

When Sraffa and Keynes disagreed with Marshall’s system, each went his own way. Sraffa didn’t react to GT after it was published, but given the path he was taking, he clearly didn’t agree with what was essentially Keynes’ continuation, if not of the Marshallian system, then at least, of the Marshallian idiom. After all, it was this failure to “escape” completely, which led to the neo-Keynesian misunderstanding of his purpose.

Sraffa had maintained that Marshallian economics described a theory of value which didn’t correspond with the facts, principally because a supply curve which didn’t reflect increasing returns was unrealistic (Sraffa 1926). In GT, on the face of it, the supply conditions are indeed Marshallian, with the presumption of perfect competition, giving us firms which offer quantities of their product in line with marginal cost.

However, according to Man-Seop Park, we can go to a world of free rather than perfect competition and substitute Sraffa’s theory of value for Marshall’s in GT and remain consistent to both the Sraffian and Keynesian systems (Park 2012). From the Keynesian point of view, there is clearly an implicit theory of value in that the state of short-term expectation provides us with a set of equilibrium prices. While this may shift from day to day, these prices are nevertheless objective and reflect what Mark Hayes calls the long-period, fully adjusted position:

Keynes tacitly assumes that short-term expectations are fulfilled in Chapter 3. This tacit assumption is unnecessary because the principle of effective demand is itself a theory of the formation of short-term expectations by the equilibrium of supply and demand” (Hayes 2013: 205).

Furthermore the theory of imperfect competition with cost-plus pricing can be acknowledged in order to acquiesce to Sraffa’s criticisms of Marshall, together with the recognition of time as a factor in production. This means that if short-term expectations are determined by supply and demand, this must mean supply by employers of labour and demand by dealers in goods (as opposed to final demand by consumers, or ultimate investors). This is consistent with Keynes if one considers his correspondence with Ralph Hawtrey, where he writes:

The only thing that really matters is that the given state of expectation, whatever it is, does produce by its effect on the minds of entrepreneurs and dealers a determinate level of employment…. The market is regularly engaged in assessing in terms of an exact numeral a complex of rather vague probabilities” [Keynes’ correspondence quoted in Hayes 2013: 221-2).

Thus the principle of effective demand is itself a theory of the formation of short-term expectations by the equilibrium of supply and demand. This new Keynesian revivalism comes together with Sraffian ideas, which are not concerned with dynamics, but with a so-called “long-period” position. This position in GT means the equilibrium employment that arises when the capital stock has fully adjusted to a given state of expectations such that, in Sraffian terms, capital equipment is being utilised at the “normal level”. If Park sees Sraffa’s prices as “fully-adjusted”, they can only exist in entrepreneur’s minds as expectations:

As Keynes notes, even if there are no formal forward markets, one can expect this set of prices to be discovered by trial and error, given the state of long-term expectations and the propensity to consume. This framework can equally well accommodate the Sraffa price equations under conditions of free, rather than perfect, competition” (Hayes 2013b).

<<Rational expectations>>

All this begs the question as to the response of classical general equilibrium economists to post-Keynesian and Keynesian revivalist thesis by integrating expectations into their models. It is not fully appreciated that these so-called “rational expectations”, introduced by John Muth in 1961, are simply a postulate*3.

Muth himself saw this theory as a reaction to the “bounded rationality” models of Herbert Simon which sought to alter the “maximising” behaviour of the “classical” individual:

It is sometimes argued that the assumption of rationality in economics leads to theories inconsistent with, or inadequate to explain, observed phenomena, especially changes over time (e.g. Simon…). Our hypothesis is based on exactly the opposite point of view…” (Muth 1961: 316)

It was also a convenient and non-empirical manner of completing the picture of a dynamic economy:

To make dynamic economic models complete, various expectational formulas have been used. There is, however, little evidence to suggest that the presumed relations bear a resemblance to the way the economy works” (Muth 1961: 315)

The same is true of the “efficient market hypothesis” which followed on from these ideas (Fama 1965, Samuelson 1965). This hypothesis simply asserted that financial markets are efficient in that individual agents cannot consistently achieve returns in excess of average market returns given all of the information publicly available.

All these different postulates ensure that the extension of traditional models to situations of uncertainty and expectations consist of well-behaved mathematical functions: in turn these functions generate equilibrium results. In the context of “rational expectations” well-behaved mathematical functions implies inferences that are linear, a state space of latent variables that is assumed to be continuous, and latent and observable variables that have a “normal” or Gaussian distribution.

If the investment demand which drives the Keynesian economy in the manner described earlier, cannot be reduced to rational expectations in this sense, it is because behavioural models here would need to take the endogeneity of both preferences and uncertainty into account (Glaeser, E. L., D. Laibson, & B. Sacerdote 2002), or would face the problem of endogeneity with a notion of strategic interaction (Camerer 2003). It is clear that a relaxation of the assumptions of orthodox general equilibrium models in modern research shows that models of markets with endogenous uncertainty invalidate the basis on which modern “derivative” financial instruments are created (Chichilnisky 1996).

<<Economics and wider social theory>>

If, after studying Keynes and the Keynesian revivalists, we find that, contrary to orthodox economics, the key to understanding the economy is the complex functioning of money, then the key to understanding money is to see it from the perspective of its reflection of debt relations. Adam Smith’s idea that money was a technological innovation that permitted advance from the debilitating effects of a barter economy is superseded by the idea that it was an innovation that permitted the re-arrangement of power relationships in society:

No example of a barter economy, pure and simple has ever been described, let alone the emergence from it of money; all available ethnography suggests that there never has been such a thing” (Humphrey 1985: 48).

The answer to why this is the case begins with the anthropological evidence which shows that tribal society functioned effectively on social debt without either a barter or money system (Chapman 1980).  The significance of this is that money  is a subsequent introduction of the state as a successor to the tribal form of social organisation, which establishes money as a “unit of account” for its own purposes, against which tokens are traded to settle debt owed to the state and from that, systematising social debt.

If this account provides us with a critique of the thought of a liberal society dominated by orthodox economics where money is considered as a “commodity” as a “medium of exchange” first and foremost, it is one which is entirely different to, for instance, a Marxian critique which focuses on the struggle between the proletariat and the industrialist. The Marxian critique of liberal society, while at one time spectacularly successful, was only so in virtue of the sheer force of application of the doctrine, rather than in virtue of a correct understanding of fundamental processes, or a correct rendering of social categories to help us think.

The Weberian concept of the struggle between creditor and debtor, which has been overlooked in favour of Weber’s ideas about religion, has much more support in the evidence about capital and money, than the Marxian approach (Cain and Hopkins 1986: 505). Weber perceives as above the central role of money as a “unit of account”, in order to assign money values to all goods and service (Eintausch in Betracht kommenden Güter und Leistungen in Geld) (Weber 1922: 42).  The value of money is thus the outcome of social and political conflicts between the main interests in the economy. In that the value of money will thus depend on a conflict of interests, and it is these rather than the ‘ideas’ of the economic administration that will dominate the world’ (daß „Interessen” der einzelnen, nicht „Ideen” einer Wirtschaftsverwaltung, künftig wie heut die Welt beherrschen warden) (Weber 1922: 109). It is a struggle for power between man and man (den Kampf des Menschen mit dem Menschen) (Weber 1922: 49).

A much older critique of society is contained in the Abrahamic religions of the Middle-East which arose from the Semitic tribal communities situated between the two empires of, on the one hand, the successor states of Greece, Rome and Eastern Rome (Byzantium), and on the other, Iran (Persia). Those religions contained in their admonitions over usury at the core of their ethics, a critique of the role of money in society which was non-existent in the state (imperial) cultures, but subsequently became influential as those Abrahamic religions were variously adopted by the societies of those empires.

The admonitions of these religions in respect of usury can be understood in the context of the Weberian conception of the role of money, and the struggle between creditor and debtor. The prohibition of interest democratises monetary relations, by avoiding intermediaries in the money creation process.

Furthermore, by also demystifying money, such a society  correctly addresses money as primarily an abstract concept of a “unit of account” (completely separate from the physical tokens that are that “media of exchange” that emerge with the context of the original abstract concept). The state then provides a function in providing that concept in the first place, but doesn’t have to be an all-encompassing state such as in Babylonian or Ancient Egyptian experience.

It can in fact exist in the context of a multi-layered and complex system of local power relationships that together provide society with the concept of “valuableness” (as opposed to “value”) at the base of money. So taxes can be paid to many different entities together without necessarily needing a hegemonic state except in name (this concept comes back to the notion of Jizya (tax) in Islam).

The unity of the system can thus be provided by a legal system whose principles as seen as “prior” to the implicit coercion of political bodies in society. Graeber describes how the Islamic legal system provided courts  which became the basis of the only truly global trading empire (see Chaudhuri 1985: 187) ever not to have been based on the ambitions of a state:

Islamic regimes did employ all the usual strategies of manipulating tax policy to encourage the growth of markets, and they tried periodically to intervene in commercial law.  Still, there was a very strong popular feeling that they shouldn’t. One freed from its ancient scourges of debt and slavery, the local bazaar had become, for most, not a place of moral danger, but the very opposite: the highest expression of the human freedom and communal solidarity, and thus to be protected assiduously from state intrusion” (Graeber 2011: 278).

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  1. Robbins writes: “the consequences of inflexibility have been particularly apparent in the labour market… it would be a mistake to say that the existence of a large body of unemployment is necessarily due in the first instance to wage rates which have been pushed above the point at which employment would be normal… But in general it is true to say that a greater flexibility of wage rates would considerably reduce unemployment “ (Robbins 1934/1971: 185-6)
  2. This was the case despite the fact that Marshall didn’t work within a general equilibrium framework with a marginal rate of substitution between factors of production, although factor returns were linked to the marginal efficiency of capital and the marginal utility of labour. Philip Wicksteed did discuss the marginal rate of substitution in The Coordination of the Laws of Distribution (1894), but Wicksteed does not see these marginal rates of substitution as being aimed at a ‘grandiose’ explanation of distribution of the Social Dividend, rather only a partial equilibrium analysis of factor use in the face of given factor prices and a given rate of interest
  3. See Muth 1961 reprinted in ‘The new classical macroeconomics, Volume 1’, International Library of Critical Writings in Economics, Vol. 19, Aldershot, UK: Elgar (1992) pp. 3-23. This assumed considerable importance when Robert Lucas applied it to macroeconomics in Lucas 1972. However, it was eventually shown to be inapplicable to aggregate behaviour in Sonnenschein 1972, Mantel 1974 and Debreu 1974. The origin of “rational expectations” goes back to Louis Bachelier who wrote The Theory of Speculation in 1900 to attempt to show that actions of individual agents in stock markets mimic the random movements of physical particles displayed in the “Brownian motion” of particles suspended in a fluid. This application of a ‘normal’ or Gaussian distribution to human behaviour became the basis of “rational expectations”