On Monday (Pushing a String; Ineffective Monetary Policy, 22 September 2025) I wrote about how, in circumstances of economic depression or structural recession, monetary policy is ineffective as the sole policy to induce a country’s economic recovery.  Here I look at the historical antecedents of today’s monetary policy narrative.

Understandings of Money

Human understandings of money go back to the prehistoric development of accountancy, the world’s first profession. (Other professions, by definition, require at least some basic method of accounting.)

There are three broad historical concepts of money: money as wealth, money as a veil, and money as circulating promises. (If we think of coins as a promise, it is the sovereign whose head is on the coin who gives value to that coin, and not the amount of silver or gold that the coin contains. If we think of banknotes, the promise is made by the senior banker whose signature is on the note.)

For the first two concepts, money is a commodity with innate value (such as gold or silver) which is co-opted to act as (among other things) a medium of exchange. For the third (correct) conceptualisation of money, it’s a social technology which arose out of the practice of accountancy and its derivative, banking.

In the intellectual history of money, the important decades were those either side of the year 1700. The two most important names are the English philosopher John Locke (advocate of commodity money) and the Scottish radical banker John Law ( advocate of bank money). Discussion of events in those times is beyond the scope of what I’m writing here; but I recommend the book Money, the Unauthorised Biography (2013), by Felix Martin.

(I would also like to mention here John Law’s banking rival, Richard Cantillon, of  Irish Catholic upbringing and living his professional life in Paris and London. He made his money through the financial crisis of 1720 by pioneering the practice of short-selling, made famous to lay-audiences by the movie The Big Short; this made Cantillon very unpopular with his many rivals who lost their money only to watch Cantillon become very rich. Cantillon went on to write the most important economic treatise of the first half of the eighteenth century – Essay on the Nature of Commerce in General – in English; it is a book that particularly plays up the importance in the new capitalism of entrepreneurship. The book was written in English, but only the French translation survived; Cantillon was murdered – a crime believed to have been instigated by one of his many enemies – in a fire in his London home, with the fire consuming the original manuscript. The French translation was able to be published, however, and eventually the book was retranslated into English. When I was reading Cantillon’s retranslated book many years ago, I was struck by the frequent use of the word ‘undertaker’ to mean ‘entrepreneur’. Later, in the 2000s, US President Bush apparently claimed that “the trouble with the French is that they have no word for ‘entrepreneur’.” I could not help but think of Cantillon.)

The differences in conceptions of money can be summed up as the philosophers versus the bankers. The philosophers, and their economist ‘descendants’, prevailed in a misframed and misadjudicated debate. The bankers, in reality, were more correct. Misunderstandings about money are as prevalent today as they ever were.

It is true that even modern money can be construed as a commodity; a ‘silver’ florin – still in circulation in New Zealand as a 20c coin – buys much less today than it did in the past. Using CPI inflation as a proxy for monetary inflation, the Reserve Bank’s inflation calculator tells me that a florin’s purchasing power was 120 times greater 125 years ago than it is today, a result of an average annual inflation rate of 3.9%. (In New Zealand we also have a crown still in circulation; it’s the 50c coin. In the 1950s and 1960s New Zealand did not then have a crown coin, but it did have a half-crown coin [25c today] in circulation alongside the florin [20c] and the shilling [10c]; these still-existing New Zealand coins reference the principal coins used by the merchants of Sweden, Netherlands, and Austria – all ‘G10’ nations in the 1750s.

Nevertheless, that is despite its superficial history as a commodity, money is in its essence a technology, not a commodity. While money is a technology of trust, hence the explicit or implicit signature, it is a technology whose power is based on its circulation. ‘Currency’ is like an electric current; it must flow in order for it to perform its function.

Money as Gold or Silver or modern equivalents such as Bitcoin and Real Estate

The idea that money is wealth is known as ‘mercantilism’. Belief in merchant capitalism – the mercantile system, mercantilism – drove the European global commercial expansion from around 1490 (Columbus) to 1790 (French Revolution). Nevertheless, mercantilism is to economics what alchemy is to chemistry; hence most economists know nothing about mercantilism, just as most chemists know nothing about alchemy, and as most doctors know nothing about humoral medicine. Both belief in alchemy and in belief in humoral medicine represent critical pathways in the evolution of those modern scientific disciplines.

The present United States president is an unreconstructed mercantilist, in that he believes – by fair means or foul – his country becomes wealthy (aka ‘great’) by ‘making money’ through the exploitation of land and labour and foreigners. In particular, unreconstructed mercantilists want their countries – as presiders, or through their identification with their national ruling class – to make money at the expense of their rivals.

In this crude understanding, money is conceived not as a circulating medium but as a stash of wealth. Monetary policy, as such, is simply to augment that hoard. Modern ‘assets’ such as real estate (land considered as a financial commodity) and cryptocurrencies represent modern developments in the ‘money as wealth’ paradigm; hence the ‘mining’ of cryptocurrencies is an exploitation of nature (through its wasteful use of electricity) just as is gold and silver mining. For our monetary system – connected to silver and gold only in the abstract – those metals may as well still be under the ground as in bank vaults.

Money as a Veil

The (incomplete) debunking of mercantilism was performed most notably by two Scotsmen: David Hume around 1750 and Adam Smith in 1776. Smith pointed out that nations could best accumulate money through free market mechanisms (rather than through extortionary mechanisms), relying in part on capitalists’ innate patriotism as a determinant of their enlightened self-interest.

It’s Hume to whom I wish to turn. He was the first to fully conceive of commodity money as a ‘veil’. The idea was that money is simply a scarce and durable commodity, such as silver or gold; silver was the more important monetary commodity in his time. (Anyone visiting Fremantle, Australia, should not miss the Shipwrecks Museum, which features many silver coins recovered from the Batavia and other ships of the Dutch East India Company.)

The idea, today known as the crude quantity theory of money, was that the price of silver (as a commodity) was effectively the price of circulating money. So, when silver was scarce, the price of silver would be high, the price of silver coins would be high, and therefore the prices of all goods and services (and of labour) would be low (ie low relative to highly-valued silver coins). Cabbages and carriages and personal services would be cheap; wages would be low. And, when silver was relatively abundant, the price of silver would be low, and therefore the prices of all goods and services would be high. Cabbages and carriages and personal services would be dear; nominal wages would be high. It didn’t really matter if prices were high or low; the economy would work just the same. Hence the notion of money as a veil.

When the price of silver was falling there would be inflation. When the price of silver was rising, there would be deflation. While neither inflation nor deflation were huge problems, both were destabilising; the biggest concern was that, with inflation, the purchasing power of hoarded money would decline. Thus, it was seen as preferable that prices were either low or high, but not rising too much. (The ruling classes – the owners of private and royal treasure hoards – clearly quite liked deflation, while hating inflation.) Royal hoards of silver and gold belonged in the sovereign’s ‘Treasury’.

Hume developed the veil idea into a theory of monetary economics as applied to international trade. (While the modern concept of a nation as a territory defined by its borders was only just emerging in Hume’s time, the G10 of the 1750s were: Great Britain, France, Spain, Austria, Netherlands, Sweden, Ottoman Turkey, Russia, Mughal India, Qing China; all imperial powers, some waxing others waning.) Hume also noted that money had some real value; not as absolute wealth, but as circulating oil, as lubricant.

Countries with balance of trade surpluses would accrue silver ‘reserves’, whereas countries with trade deficits would deplete their silver reserves. The quantities of money in circulation – especially silver coins or ‘specie’ – were assumed to be a constant proportion of those reserves. (And, as a more tacit assumption, private stashes of silver were presumed to be at a stable proportion to public reserves.) Hence, there would be predictably more money circulating in a country following an inflow of silver; and less money in a country when there had been an outflow of silver. The mechanism, as stated by Hume, came to be known as the price-specie flow mechanism.

Based on earlier mercantilist habits of thought, all countries’ ruling classes wanted inflows of silver and wanted to avoid outflows. In effect, Hume claimed, it wasn’t such a big deal. The international monetary system would self-regulate. Countries with inflows of silver would experience rising prices; countries with outflows of silver would experience falling prices.

The world economy would self-regulate as if it was under ‘thermostatic’ control. Costs of production would fall in deficit countries, and would rise in surplus countries. Hence deficit countries would increase their exports and decrease their imports; surplus countries would decrease their exports and increase their imports. Money flows would reverse, until those cost discrepancies were eliminated; it’s an elegant mechanism.

There were three problems. At an increasing rate, and especially after 1750, un-understood bank money was growing rapidly, so – for that reason and others – the money supply in the growing G10 countries (especially Great Britain) had become increasingly detached from the silver supply. Second, price levels never varied proportionately with the quantity of money; the velocity of circulation (ie turnover) of money varied substantially in the short-and-medium term, with new forms of un-understood money making up for long-term shortages.

But, at the time, the main issue was the resistance to inflation (rising prices) on the part of the nations’ ruling classes. In particular, in the eighteenth century, the G10 economies were highly protectionist; Great Britain became the worst offender, mercantilist trade barriers morphed into open warfare. Later, in the nineteenth century, silver (and gold) flows between nations were minimised through the use of international credit arrangements; the unbelievers in bank money allowed full use of the banks so as to shore-up their countries’ ‘wealth’. Indeed, at the end of the nineteenth century in Great Britain (now the United Kingdom), prices in 1900 were half of what they were in 1800 despite massive increases in the actual money supply.

The more people believed in commodity money the less important it became. I remember learning from a lecturer of mine (indeed a recent persona in New Zealand’s monetary policy governance) that the most sophisticated treatise on money in the whole of the nineteenth century was An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, by banker Henry Thornton, written in 1802. Meanwhile, ‘monetarism’ became the intellectual weak link of the Ricardian classical system (reflecting the tradition of the philosophers rather than the bankers). And the huge disputes about money in the 1840s, between the currency school and the banking school, were settled by the elites in favour of their favoured philosophical narrative rather than through truthful observation.

There was also elite resistance to deflation (falling prices) on the part of nations with depleted reserves of silver and gold. While deflation boosted the (largely unrealised) purchasing power of the treasure hoards of the small numbers of rich people, falling incomes to peasants and other workers diminished the local demand for goods and services, leading more to business failures and the concentration of ownership of economic assets in favour of the already rich.

The International Financial Game

In the second half of the nineteenth century, the formal gold standard emerged; although most money was neither silver nor gold, then bank money (especially paper money and bank deposits) in the Euro-capitalist would be treated as if it was gold. In principle, countries’ gold reserves would be shuffled across the floors of the bank of England’s vaults in accordance with countries’ trade deficits and surpluses; with the Bank of England being tantamount to a global central bank.

But short-term finance – much like inter-bank finance today – would stabilise countries’ money supplies; meaning that countries with trade surpluses would not experience monetary inflation, and countries with trade deficits would not experience monetary deflation; so those patterns of destabilising surpluses and deficits would not be resolved. Money as a thermostatic veil had become completely ineffective. Further, international money flows were increasingly divorced from imports and exports; much more they had become cross-border flows of ‘investments’, profits, interest, rents, and royalties.

This process was not well understood at the time; today we understand it by focussing on ‘current account’ balances rather than ‘trade balances’. Indebted countries today are countries with repeated large current account deficits. (Thus, New Zealand is easily one of the most indebted countries in the world; although the New Zealand government has low indebtedness by international standards. One of the puzzles of our time is why professional and media commentators focus so much on government indebtedness and so little on national indebtedness.)

To make up for the by-now irrelevance of the price-specie-flow mechanism, the leading lords of finance – especially those who became governors of the emerging central (Reserve) banks – developed the first international-rules-based order.

Countries experiencing more inflation (rising prices becoming more common after around 1905) saw themselves as becoming ‘less competitive’, so – rather than addressing root causes – the rule for them was to instigate a price deflation by placing downward pressure on their money supplies. The principal means to do this monetary deflation was to jack-up interest rates; to raise the rate of interest at which the leading banks or central bank would lend to other banks, thereby reducing banks’ willingness to make new loans and in turn diminishing the amount of money in circulation.

The deflation mechanism, a response to the implicit overvaluation of the problem country’s exchange rate, was expected to force a downward adjustment of prices and wages in such countries. We saw exactly this mechanism of internal devaluation at work in Greece in the mid-2010s as it’s bearing the burden of the Euro-crisis. The Euro currency is an effective system of fixed exchange rates between member nations; therefore the only solution to an overvalued exchange rate is a costly internal devaluation. We note that nations such as Germany and Netherlands try not to follow the same rules by having an internal revaluation; this means that the Euro-zone as a whole has uncorrected current account surpluses.

Monetary policy as we know it today, through interest rate manipulation, was born. A major problem was that the whole capitalist free-market economy depends on prices – including interest rates – adjusting freely in accordance with market forces; interest rate manipulation is contrary to capitalist freedom. The hijacking of interest rates for an interventionist purpose disabled a central feature of self-adjusting liberal market economies.

The rules of the game that applied in the early twentieth century created a powerful ‘deflationary force’, interrupted for a while by World War One during which those rules were suspended. The financial lords did generally raise interest rates in accordance with the rules, but were often reluctant to lower interest rates when those same rules required them to do so. When inflation was relatively low, however, rather than ‘reflate’ or ‘inflate’ their nations economies the lords of finance and their political masters saw this as an opportunity to run trade surpluses and to thereby augment their national gold hoards; in the 1920s, France and the United States were the biggest culprits. This one-sided adherence to the rules led directly to the Great Depression, the suspension of the gold standard, and the return to war. But the rules could never have worked; they were predicated on a stable relationship between money in circulation within each country and that country’s prices.

Post World War Two

After WW2, the gold standard was revived under American leadership as a gold-exchange standard, with the value of the US dollar pegged to gold, the other ‘hard currencies’ pegged to the $US, and the other currencies (such as the £NZ) pegged to hard currencies (eg the £NZ was pegged to the £UK). There would be periodic devaluations (mostly) or revaluations (occasionally, as in New Zealand in 1948 and 1973); although the $US could neither devalue nor revalue. This last issue led to the end of the gold-exchange standard in 1971, when Richard Nixon suspended the convertibility of the $US to gold; this enabled the $US to devalue, a monetary matter necessitated by the Vietnam War and the associated American current account deficits. What happened next was a mix of a US-dollar standard (whereby, the $US was treated ‘as if’ it was gold) and a floating exchange rate mechanism, meaning that the free (or free-ish) foreign exchange market would set the price of participating countries’ currencies. New Zealand became a participant in 1985.

The New International Financial Game

A world of free-market currencies represented a new international financial game, with rules in the same spirit as the price-specie-flow mechanism (as described in the 1750s by David Hume) and the gold-standard interest-rate rules developed in the years just before 1900.

The idea was that trade flows (or at least ‘current’ flows, distinct from ‘capital’ flows) would be the principal determinant of currencies’ exchange rates, and that countries with current account deficits would see depreciating exchange rates (albeit with some inflation) and thereby increases in ‘competitiveness’, and that countries with trade surpluses would see appreciating exchange rates (albeit with some deflation, or at least disinflation) and thereby face decreases in ‘competitiveness’.

From the late-1970s, the world of monetary policy and finance saw a return to the ‘economic liberalism’ which peaked in the 1920s; this time under the misleading names of ‘monetarism’, ‘neoliberalism’, ‘public choice’, ‘rational expectations’, ‘economic rationalism’ and ‘free-market economics’. The momentum for this financial coup-d’etat had been gathering in the 1960s, through the work of Milton Friedman and other members of the ‘Chicago School’; indeed, the revival of monetarism probably go back to Friedrich Hayek (also at Chicago, though not a direct colleague of Friedman), author of the popular 1944 anti-Keynesian book The Road to Serfdom. The Chicago School went on to manage the economic program of the neofascist Pinochet regime in Chile; more the politics of serfdom than the economics of freedom.

The name ‘monetarism’ harks back to David Hume, though misleadingly. Milton Friedman’s monetarists treated money as a veil when it suited them. For example, in the inflationary 1970s, Friedman offered a simple solution based on the crude quantity theory of money. Whatever the causes of a bout of inflation, restricting the growth of the quantity of money in circulation to say 5% per annum would bring the inflation rate down to 2%, he argued. Friedman was offering a counter-deflation, a cover-up rather than a solution. Yet, in his simplistic narrative of the 1930s’ Great Depression, A Monetary History of the United States, 1867–1960, he claimed that the quantity of money was anything but a veil. Money, for Friedman, became simultaneously everything and nothing.

Friedman, and Hayek too, favoured ‘quantitative tightening’ over the more overtly interventionist jacking-up of interest rates.

Neoliberalism – the ‘new right’, commonly called ‘neoconservatism’ in the United States – was the revival of 1920s’-style ‘economic liberalism’ under post-Nixon conditions. Its stated mantras were ‘free-market’, ‘more-market’, ‘private-good public-bad’. The neoliberal microeconomists readily joined forces with the monetarist macroeconomists in the advocacy of authoritarian mandates to suppress the market ‘signals’ that were interest rates and inflation.

The opposite of the economics of ‘freedom’ is the economics of ‘intervention’. Yet neoliberalism in its various guises is very much the politics of economic intervention; just certain types of intervention, such as asset privatisation, monetary policy with a high interest-rate bias, and the minimisation of public goods’ provision.

‘Public choice’ became a name for ‘private preference’. And ‘rational expectations’ became the underpinning of ‘credible’ – ie unnuanced and unforgiving – monetary policy to override allegedly irrational expectations; we had to believe that the awful monetary medicine prescribed for us was good for us, regardless of the evidence or the ethics. Rational expectations were imposed because the mandated public authorities were required to tell us what our expectations should be and why they had to be ‘corrected’. ‘Economic rationalism’ meant authoritarian dogmatism rather than democratic pragmatism, especially in relation to matters of money, inflation, interest rates, private ownership; and, increasingly, in relation to public debt. Economic rationalism was idealism in the philosophical and utopian meaning of that word.

Just as the rules of the gold-standard game were perverted – both because they were based on false premises, and because they were corrupted by mercantilists seeking perpetual trade surpluses – so the rules of the floating exchange-rate game have been perverted. There are two ways to manipulate the original trade-based rules. The first manipulation is for countries to defend their exchange rates by central banks using foreign reserves to buy domestic currency when the market price of the domestic currency is falling. This is called a ‘dirty float’, meaning a nation’s authorities acting to prevent the depreciation that was intended to be a central aspect of the mechanism. This has been generally a biassed form of intervention; the converse policy to inhibit an appreciation was used much less often (though was used to great effect by the Bank of England in 1932 after the pound was floated in 1931).

The more familiar intervention to pervert the rules has been the use of jacked-up interest rates to attract foreign money, thereby maintaining the living standards of the monied classes through an overvalued exchange rate (meaning cheaper imports and overseas travel). This is the policy that has created massive private debt in Aotearoa New Zealand, and some other countries; while also containing the growth of government debt. Lots of spending on imports by New Zealanders has increased GST revenue as well as creating income tax revenue in, for example, retailing and wholesaling. Such huge blowouts of private debt are the flipside of what has been euphemistically called ‘foreign investment’; money inflows not arising from exports, many of which – known as the carry trade – amounted to ‘speculation’ or ‘arbitrage’. The interested authorities and commentators have effectively covered-up these increases in national debt by relentlessly focussing on government debt; indeed to the point of labelling government debt as ‘national debt’.

This kind of monetary policy intervention – a perversion of the floating exchange-rate game – is tantamount to a Ponzi scheme whereby new national debt is required to service existing debt. The scheme has changed since 2023, with New Zealand relying on non-trade money inflows other than the ‘carry trade’; an important example is that of money brought in by immigrants.

While the likes of New Zealand hijacked ‘the game’ by trying to maintain an overvalued exchange rate, other countries – especially the modern mercantilists like Germany, Netherlands, Sweden, China – sought to maintain undervalued exchange rates. Sweden did it in the 2010s by having zero and negative interest rates. Germany and Netherlands play a game within the rules of the Eurozone. And China moved from a low fixed exchange rate against the US dollar to a dirty float of the renminbi. These countries, less so China since the global financial crisis, accumulate money hoards through current account surpluses, just as France and the United States ‘played’ their trade surplus game by undermining the gold standard rules of the 1920s.

Important Change in Understanding of Monetary Policy since the 1980s

In the late 1980s, banking and other retail financial services changed far more than is commonly realised. While this is true worldwide, changes in New Zealand, well illustrate the key points.

Back in the day – the early 1980s and before – term loans, including mortgages, were contracted at a certain interest rate for the life of the loan. When the focus of monetary policy turned to interest rates and away from quantitative policy levers, the understanding was that higher interest rates would deter new debt; and lower interest rates would increase new debt, including new mortgage debt. The understated presumption was that lower interest rates would increase the uptake of new loans in all sectors, yet there was a second (also understated) presumption that governments would not be responsive to changes in monetary policy; thus, monetary policy was perceived as only applying to the business and household sectors. Yet a rational government should be at least as price-sensitive when undertaking debt as a rational business.

Something else happened in the late 1980s. As the big trading banks absorbed the various retail non-banks (such as building societies, savings banks, and then finance companies) mortgage finance underwent a fundamental change. As well as the majority of mortgages now being issued by the increasingly powerful bank oligopoly – the one-stop shops – the interest rates would only be contracted for short periods; time durations well short of the maturity date of the loan. Long-term finance was now being priced as if it was a series of short-term loans.

An important but rarely stated implication of this change was that the average interest rate of a 30-year mortgage would be the average of the short-term interest rates over those thirty years. So in a world of economic cycles through which short term mortgage interest rates fluctuate between say 3% and 7%, then the average interest rate would be 5% regardless of what the interest rate is at the time the loan is issued. On the basis of the ‘rational expectations’ mode of thinking (which also took-off in the mid-1980s) the interest rate should not have any impact on the quantity of new mortgage lending, because the expected average interest rate would be 5% regardless.

We still chatter in the media and academia as if high interest rates do discourage new mortgage lending, and low interest rates do encourage more. For example, there is a widespread supposition that new mortgages issued in 2021 were substantially facilitated by the low interest rates prevalent then; and that, therefore, if interest rates had been significantly higher in 2021 then the short-lived housing bubble that year would not have happened. But this does not survive the ‘rational expectations’ test; if the critical factor in 2021 really was unusually low short-term interest rates, then the bubble will have been caused by irrational expectations of average interest rates over the duration of the mortgage.

This century, the perception of tight money policy as a deterrent to new lending has gradually given way to the perception that mortgagors have become the ‘meat in the monetary policy sandwich’; the perception that monetary policy works through targeting the discretionary day-to-day spending of this narrowing cluster of middle class and upper-working-class households.

Though less discussed in mainstream media, there also remains the widespread perception that tight monetary policy works through restricting the growth of business lending, especially small-business lending; lending which was always based on short term debt. One irony here is that reduced small-business lending encourages more mortgage lending by banks, especially given that under the one-stop banking-shops the same institutions are now doing both types of lending. We saw that particularly in the years 2004 to 2008, when increased mortgage lending stimulated a real estate bubble despite a tightening monetary policy implemented through the Reserve Bank imposing higher interest rates. It is likely that something similar happened in 2021; banks pushing new mortgages (regardless of the interest rate at the time) because of the huge risks then-associated with small business lending.

New Zealand Exceptionalism

New Zealand central bankers gloried in being at the vanguard of these changes in global monetary policy intervention. In the late 1980s, the monetarists – very much in control in New Zealand as a result of the financial reforms of the mid-1980s – pushed the ‘money-as-a-veil’ idea, that CPI-inflation was a simple derivative of the increasing quantity of money, that inflation could therefore be made ‘illegal’, and that the Reserve Bank would become the monetary police. In the absence of evidence of its efficacy – inflation in New Zealand was lower in the 1990s than in the 1980s, though there was no evidence that the new framework for monetary policy had caused inflation to be lower (there was a general decline in global inflation in the 1990s) – ‘direct inflation targeting’ became prevalent practice internationally. New Zealand features in American macroeconomics’ textbooks for that reason.

While the notion that underpinned New Zealand’s 1989 Reserve Bank Act was precisely the naïve presumption that underpinned Hume’s price-specie-flow mechanism in 1750, in the world of the 1980s the only way to implement such policy was through the creation of an independent monetary police-force. And the only way those police in most countries could (at that time) contemplate performing their task was through the interest-rate lever. The transition from free-market monetary economics to manipulative monetary oversight was now complete, undertaken by interventionists who claimed to be free-market ideologues. (Alan Greenspan, Federal Reserve Bank chairman in the United States, was indeed a member of Ayn Rand’s ‘objectivist‘ inner sanctum.)

Next Week

My next article looks at good monetary policy in the last 100 years, especially New Zealand in the 1930s (NZ after 1933 and 1934 and 1935), Keynes’ monetary and fiscal balance, Social Credit, reserve asset ratios, Japan’s recovery from crisis, and Modern Monetary Theory. I will mention the recent ‘labour mercantilist’ idea of Roger Douglas and Robert MacCulloch. And will mention that idea’s Australasian precursors; and the  associated problems with wealth funds, especially Sovereign Wealth Funds. And I’ll mention Ricardian equivalence, with its much-touted reason given by economic liberals to justify fiscal conservatism, thereby putting all their policy eggs into monetary policy.

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Keith Rankin (keith at rankin dot nz), trained as an economic historian, is a retired lecturer in Economics and Statistics. He lives in Auckland, New Zealand.

In practice, democratic political reforms are usually incremental, though typically seen as part of a process leading to wider and more embedded improvement. Reforms are ‘evolutionary’ – indeed, in a technical sense – in that they improve the ‘fitness’ of democratic society.

Unlike biological evolution, which is a fully blind process, the process of democratic evolution is only partially blind. There is an inchoate sense of ‘destination’ about political reform – or at least the idea that reforms take societies to better places, if not the best place.

The Problem of the Local Optimum

Important concepts in evolutionary theory are those of fitness landscape and local optimum. We can think of a contour map, with better places (eg with respect to democracy) being those at higher altitude, and the best place being the highest attainable altitude. Whereas a local optimum may be a hill, the actual optimum is somewhere else, a mountain.

In a blind process, a local optimum can be thought of as the endpoint of a sub-optimal trail randomly followed. In a process with vision, however, it is possible to ‘know’ that you – or your society – are at or approaching a local optimum, and therefore to know that you could have taken a better path. A part of that knowledge is that, to get on the best path – or even simply a better path than the one you are on – you first have to retrace at least some of your steps.

The more vision you have when you make a choice that takes you on an improvement pathway, the less likely you are to make a suboptimal choice. If you can see that the path you are contemplating takes you up a hill – or even a mere hillock – while another path takes you up the mountain that best represents the optimal policy outcome, then that sightedness minimises the chance that you will make the wrong choice.

Sometimes the difference between a hill and a mountain is subjective. A sighted person with one set of beliefs may consider ‘Object A’ to be the mountain, and another sighted person with a different set of beliefs may consider ‘Object B’ to be the mountain. Object A upholds the benefits of one belief-system; Object B the benefits of another belief system. There is conflict.

In other situations, the mountain fully incorporates all the benefits of the hill, while having some benefits that the hill does not have. In this case, all rational sighted persons – regardless of their differing values –  would choose the path to the mountain (‘Object M’) over the path to the hill (‘Object H’).

There may however be sequencing issues. The mountain M may offer benefits X, Y , and Z. (These three should be understood as uncontested benefits; as agreed benefits, though the relative importance of each benefit may be subject to disagreement.) The hill H may offer benefits X or Y; or both. A person whose narrow or impatient vision is particularly focussed on benefit X or Y may choose the hill over the mountain, despite the fact that both choices give both benefits.

(In posing this set of binary choices – Option M versus Option H – each choice involves comparable cost; the choice is based on the ‘seeing’ of the benefits. However, choosing H and then reversing that choice involves additional cost; it’s cheaper to make the better choice first up. Having noted that, it is also costly to delay making a choice; an inferior choice might be better than making no choice. The opportunity cost of choosing H over M – and then settling on H  – is Z. The opportunity to have Z in addition to X and Y is lost.)

Democratic Benefits X, Y, and Z

In what follows, X is reducing the voting age to 16, Y is making the income tax scale more progressive, and Z is the simple adoption of the Universal Income Flat Tax mechanism (UIFT). Before looking at these benefits together, it is necessary to comment on them individually. In doing so, I make the claim that all three represent objective enhancements to democracy. I also understand that – in today’s querulous social environment – there will be initial objections to all three of these suggested benefits. Nevertheless, I am sure that a substantial majority of people believe that democracy is a desirable system of social organisation, and that more democracy is better than less democracy. I believe that the arguments in favour of these benefits are persuasive, at least through a democratic lens.

Last month, the matter of the voting age was in the news: eg Teenagers ask court to lower the voting age, and note this 2018 petition. As I see it, there are three major democratic benefits associated with this reform. First there is a simple extension to the franchise. While this is a valid argument, it is the least persuasive reason because this argument becomes problematic if extended to even younger ages.

The second benefit (Y) is that it makes sense to have a single age that defines adult responsibility; and I am inclined to believe that the arguments in favour of 16 are stronger than 18 or 20 or 21. (Having a single age defining legal adulthood does not refute the fact that there is a life stage from around 16 to under 25 in which older people – especially parents – continue to have duty of care towards their young people. Nor does it suggest that organisations – such as the police force – cannot set their own age limits for recruitment.)

The third benefit is that, at age 16, people for the most part are still at school and living with their parents; and are still relatively open to civic guidance from their elders (including grandparents). So, 16 or 17 is a good age for young people to enter the world of democratic participation, facilitating a cultural bias towards participation over abstention.

On the matter of progressive taxation, the central issue is conceptually simple. It is that, for higher incomes, a person’s disposable income (ie income after taxes and public benefits) should be lower as a percentage of their gross market income (ie income before taxes and public benefits). Essentially, it means that taxes should rise as a percentage of market income as market income increases. This commitment to ‘progressivity’ is one of the core principles of the ‘liberal democratic’ tradition that was forged in the nineteenth and twentieth centuries.

The particular measure which is widely advocated on the political left in New Zealand is that New Zealand’s income tax scale should be extended with the inclusion of an additional tax bracket; something like a tax rate of 40 percent that would kick in at an annual income threshold of about $150,000. Australia has such a tax bracket, as do many other countries. It would in principle increase the progressivity of New Zealand’s income tax scale; and New Zealand has one of the least progressive income tax scales among developed liberal democracies. As in case X (the voting age), there are limits. While a new income tax like this may enhance democracy, further extensions of the ‘taxing the rich more’ concept become democratically (and otherwise) problematic.

On the matter of the simple adoption of the Universal Income Flat Tax mechanism (UIFT), there is no contest to the argument that this is an extension of democracy. By reimagining the existing progressive tax  scale, and filling in the few ‘cracks’ so that no adult is economically disadvantaged, this is a wholly desirable democratic reform that enables every economic citizen to receive a weekly public equity dividend (of $175) in exchange for an income tax rate of 33 percent. (All people earning over $70,000 per year already gain the full $175 weekly benefit; they can calculate their disposable incomes by reducing their gross weekly incomes by 33%, and then adding $175.)

(Note that existing critiques of proposals for a Universal Basic Income are critiques of policies that have substantial differences or add-ons compared to the simple UIFT proposal. Right-wing critiques of ‘big-bang’ UBI proposals mainly focus on financial costs, financial priorities, and labour supply disincentives. Left-wing critiques of these UBI proposals mainly focus on financial priorities, income inadequacy for the most disadvantaged, and the lack of help for people with special needs that exists in some UBI proposals.)

This simple reimagination proposal (UIFT; Benefit Z) has a small financial cost – the cost of filling the few cracks that inevitably exist in present bureaucratised income support regimes – and many financial and non-financial benefits.

The problem I am concerned about here is that, if either of the other proposals (Benefits X or Y) is implemented first then, then the subsequent costs of Benefit Z are raised. Both Benefits X and Y – on their own – reflect sup-optimal pathways towards the greater goal of democratic reform.

The Young Person Problem

Most of the ‘cracks’ in the present ‘bureaucratic regime’ are people aged 18 to 24. While a few are in secondary school, most are either in tertiary education or low-wage (often casual) employment. Of those in tertiary education, most do not qualify for a student allowance on account of their parents’ incomes. (Instead they have the option of a nine-month student loan ‘living allowance’.) Of those in low-waged employment, they get nothing like the unconditional $175 per week that many of their parents receive.

This means that the financial cost of the simple UIFT proposal relates mostly to people under 25 years old.

The natural age to treat as the age of adulthood at present is 18, given that it is the age of enfranchisement, and that 18 is the age for which income-tested ‘Working for Families’ ‘tax credits’ are no longer payable, on children’s behalf, to their parents.

By decreasing the age of enfranchisement from 18 to 16, that would require the UIFT mechanism to displace Working for Families at age 16 instead of at age 18. All 16 and 17 year-olds would qualify for the larger benefit. Thus, the financial cost of a subsequent UIFT would be raised by the cost of paying public equity dividends to 16 and 17 year-olds. This in turn increases the chance of the UIFT – Benefit Z – being rejected on the grounds of financial cost.

It means that it would be better to introduce the UIFT before reducing the age of adulthood to 16. Once a UIFT (Benefit Z) is in place and seen to be neither too expensive nor employment-discouraging, then the later argument for reducing the age of democratic entitlement to 16 should be unproblematic.

To get onto the optimum pathway – the trail to mountain M rather than the trail to hill H – Benefit Z should come into force before Benefit X.

The Progressive Tax Problem

In 2020, it would be simpler and less costly to implement simple UIFT – Benefit Z – than in Australia. In Australia, the tax rate would have to be 37 percent (rather than 33 percent), but that’s not the problem. Australian economic citizens would get a public equity dividend of $240 per week, and pay 37 percent tax on all their income. The bigger problem is Australia’s top tax rate of 45 percent levied on annual income in excessive of $180,000. Australia already has Benefit Y.

If the 45% tax was to be retained upon introducing UIFT, then Australia would have a two-rate rather than a single-rate tax scale. It would mean that people with declared earnings of more than $180,000 per year would experience a clawback on their public equity dividend. That would be undemocratic – to deny a rich person a public equity dividend would be as undemocratic as to deny them the vote. Yes, rich people too have rights.

The more sensible thing to do in Australia would be to simply wipe the 45% tax rate, as redundant and inefficient. That could be politically unpopular though, especially with voters on the left whose principal policy ethos is to transfer (redistribute) money in a targeted way from the rich to the poor.

So, if New Zealand introduces, in 2021, an Australian-style top tax rate, then the pathway to a simple UIFT would be impeded by the practical requirement to abolish that new top rate. It means that, if the second-mentioned of the democratic reforms – Benefit Y – was introduced first then we would be on Pathway H, climbing the sub-optimal hill rather than the more-optimal mountain.

Pathway M – to the mountain – is reached with least cost by implementing Benefit Z first; and X soon after, once any fear of Z has been dispelled. What of Benefit Y? Well, a natural part of the UIFT mechanism is to raise the tax rate and to raise the public equity dividend, under circumstances that economic productivity is increasing or that the income distribution is too unequal. If we properly understand the definition of progressivity, then it turns out that UIFT gives us an efficient way to achieve Benefit Y. The requirement is that simple UIFT is implemented first, and that its underlying capability to counter inequality is employed.

Summary

In our eagerness to make small changes that enhance our democracy, we may be encouraged to make small ad hoc reforms that subsequently make the more important reforms more politically difficult and more financially expensive to implement. So long as we choose to not be blind – so long as we reject wilful blindness – we can see both the mountain and the hill which represent socio-economic improvements. If we start climbing the hill rather than the mountain, then the mountain becomes further away and more difficult to reach. That’s why vision is an important decision-making tool, and why we should understand ‘vision’ to be ‘seeing’ rather than ‘believing’.

“I think you have to recognise money comes from somewhere. It doesn’t just come from a big money tree.” Judith Collins 2020

“Someone has to pay the bill – there aren’t little pixies at the bottom of the garden printing cash.” John Key 2009

These messages from two different National Party leaders are like saying that babies come neither from the ‘stork’ nor the ‘cabbage patch’. And – as with sex creating babies – we can be very coy about talking about where money does come from. In a sense – albeit a nonsense – both money and babies are ‘conceived in sin’.

We also have issues about where money goes. Thus, when money is fraudulently obtained, we too easily expect it to have been hidden away somewhere, as buried treasure. When the Ponzi schemers and other bad boys of finance are brought to justice, we would like them to return the money. It’s part of our naïve notions – fuelled by National Party leaders and others – that money is a kind of zero-sum game, and that money, like Adam and Eve, was created by God.

A Fifty Billion Dollar Conjuring Trick?

For New Zealand’s May 2020 Budget, the central theme was a new $50 billion pot of money (‘rescue fund‘). As in all emergencies that affect everyone – not just the poor – there is always money when it is needed. The homilies about pixies and money trees are for the gullible.

When such large sums are created with one stroke of the electronic pen, the narrative that follows is not a reasoned discussion about the process of money creation. Rather, it’s the narrative of the ‘inevitable reckoning’; how and when are we going to ‘pay the money back’. In this 2020 case, because New Zealand has come through the Covid19 emergency better than expected, Finance Minister Grant Robertson has recently intimated that not all the money will be required. Perhaps $10 billion will disappear back to where it came from, sooner rather than later?

While the technical process of money creation varies from country to country, and varies substantially through history, it is appropriate here to focus on the NZ$50 billion rescue fund. And we need to note that almost all money in the world is held in as bank deposits; not as coins or banknotes.

The Reserve Bank in 1960

If this was 1960 the money would then have been about £2 billion. The government then would have simply drawn on its technically unlimited (but not practically unlimited) overdraft facility at its bank, the Reserve Bank of New Zealand. It would have withdrawn that money and put it in a ‘pot’; a deposit account created for the purpose of funding the emergency. And if the £2 billion was not enough, the government would have drawn further on its overdraft facility, putting additional new money into the ‘rescue pot’.

This £2 billion would be ‘new money’ – not gold bars from the Reserve Bank’s vaults. It would be written up in the Reserve Bank’s balance sheet as both a new asset (a new loan to government) and a new liability (a new deposit by government).

As well as being the government’s bank, the Reserve Bank is the banks’ bank. So, as the government spends the money from its account, it goes into people’s bank accounts, which means that it goes into the banks’ banks’ accounts at the Reserve Bank. From the Reserve Bank’s viewpoint, the money – initially created as that £2 billion loan to government – goes from one bank account to other (private) bank accounts. Later, when taxes are paid, money goes from the private accounts at the Reserve Bank into one of the governments accounts at the Reserve Bank. (If the new money facilitated new economic activity, then this would be new tax revenue; tax revenue which otherwise would not have been collectable.)

Before such new money is spent – eg while it is in the rescue pot – the government could be said to be in debt to the owners of the Reserve Bank. Because the owners of the Reserve Bank are the same people as the ‘owners’ of a democratic government, the new money is owed by the people to the people.

As the new money is spent, and ends up in private sector accounts, then the government incurs a financial deficit and the private sector incurs an equal financial surplus. This is all normal public finance in action; it’s just that in this ‘rescue’ case, the sum of money is larger than usual.

What would be very harmful would be if the government tried to ‘pay the money back’ after it had been spent. That would represent the wanton destruction of money that was supporting – circulating through – the wider economy.

The Reserve Bank in 2020

The process of money creation through government borrowing became more convoluted in New Zealand, after 1985. The key difference from 1960 is the statutory independence of the Reserve Bank. It means that the government would no longer borrow from the Reserve Bank; it meant that government borrowing would instead take the form of ‘bonds’ sold to financial businesses, such as Westpac or ANZ Bank.

For the most part, when there is an emergency requirement for money – such as the $50 billion rescue fund – the Reserve Bank and the Government both take a ‘dovish’ (opposite to ‘hawkish’) position. For the Reserve Bank, a ‘dovish’ stance is called ‘easy monetary policy’ and a hawkish stance is ‘tight monetary policy’. For the government, a dovish stance is called ‘expansionary fiscal policy’; especially a willingness to increase government spending – and government trust – through increased government borrowing. A ‘hawkish stance’ is ‘contractionary fiscal policy’ – ‘austerity’ – a desire to cut back on government spending and the setting of tight conditions on recipients of government money.

What it means is that the Reserve Bank buys existing bonds (especially government bonds) from the commercial banks, and the commercial banks buy new bonds (promises) issued by the government. In other words, the government borrows from the commercial banks and, at about the same time, the Reserve Bank lends to the commercial banks. The net effect is the same as in 1960; the government borrows from the Reserve Bank. The difference is that government and Reserve Bank are constitutionally independent parties to these transactions.

Conflict

The process gets interesting – and often problematic – when the Reserve Bank and the government take different positions. Such conflict exists today. Generally, since 2008, central banks (eg the Reserve Bank) have taken a dovish stance towards money creation. In 2009, governments were equally dovish (though the New Zealand government was less dovish than most). From 2010 many governments became hawkish – austere – especially in Europe. The result was ultra-low interest rates as central banks tried to lend to governments, but governments were reluctant to accept the cheap new money. Even now, in  2020, many governments are far from dovish – especially the ‘frugal four’ in northern Europe (Netherlands, Sweden, Denmark, Austria). The New Zealand government today is moderately hawkish; for example it is not sharing its emergency fund with local governments, forcing local governments (which do not have comparable borrowing privileges) into inappropriate spending retrenchment.

When the present process became the worldwide norm – from the 1970s to the 1990s – the more usual problem was hawkish central banks and allegedly dovish governments. (The new monetary environment was created by hawkish governments, however, of which the Lange-Douglas New Zealand Labour government was one.) The result was very high interest rates in the 1980s.

New Zealand had a significant episode of conflict in 1997, when the Reserve Bank was hawkish, but the finance ministers were dovish; Winston Peters was committed to substantial new government spending and Bill Birch had already legislated for a tax cut.

Quantitative Easing

When interest rates are near zero, a dovish Reserve Bank must resort to quantitative easing as its main method of increasing the money supply. Quantitative easing is this active policy by central banks to buy promises (bonds) held as assets by the commercial banks. It makes central banks an active ‘player’ in ‘secondary financial markets’ (more later).

For the most part in the 2010s, the New Zealand Reserve Bank was able to decrease interest rates, creating incentives for all parties (not just government) to borrow and spend. The commercial banks have practically unlimited overdrafts with the Reserve Bank; lower interest rates are the banks’ incentive to use those overdraft facilities to expand their lending to governments, businesses, land speculators and other private borrowers.

Because New Zealand’s central governments were fiscally hawkish in the 2010s, most of the new money was pushed into the private sector. New Zealand’s main economic problem became the reluctance of the government to make use of the available new money, leaving almost all of it instead to private borrowers.

The Economy and the Casino

When new money is created by central banks, it can circulate in the economy (spending, employment, income creation) or in the ‘casino’; or it might not circulate at all (or circulate very slowly). By far the most effective way of getting new money to circulate in the economy is through the government borrowing the new money, and spending it. When governments – in the 2010s – said there wasn’t any money, they were wrong, very wrong. The Reserve Bank supplied money became even cheaper, and circulated in the casino rather than in the economy.

The ‘casino’ is the secondary financial marketplace. Secondary markets are markets for items that already exist (eg used cars). The most important examples include the sharemarket and real estate (especially the residential land market). In general, there are three main classes of secondary markets: financial assets (shares and bonds), real estate, and commodities (such as gold and silver). Prices go up in these markets when large swathes of new money are injected into the casino rather than to the economy. It’s not the fault of dovish central banks that this happens; rather it is the fault of hawkish governments favouring austerity over responsibility. It’s because governments are choosing to not have the money to do the many things that governments could be and should be doing.

In 2020, the casino remains as active as ever.

Where does the money go?

For the most part, the money goes nowhere; it sits idly, on rich people’s balance sheets, or circulates in the casino until it is destroyed in a financial crisis. Money is destroyed in the exact opposite process to which it is created, when the assets of central banks are repaid or otherwise devalued. (Much of the world’s money was destroyed  in the 2008 global financial crisis, and had to be recreated through quantitative easing.) Governments cannot force people to spend money; indeed hawkish governments ask people to not spend (ie to save) their money.  Thus, new money is regularly needed to replace idle money as well as to facilitate a growing economy. Money that goes straight to the casino may never circulate in the economy; it inflates asset prices and eventually dies in a financial crisis. Much money that goes into the economy ends up in the casino – just think of what happens to money spent on Apple products – but at least such money does economic work before it ends in the casino.

Reform

The most important reforms will only take place when enough of us make an effort to understand money, and to appreciate just how trite the featured comments by Judith Collins and John Key really are. When we understand that money is our most important social technology – and not stardust or some alchemical wealth potion – then we can become the masters rather than the servants of money.

Yes, there are situations when there can be too much money in circulation in the economy, and inflation can result – examples include Germany in the early 1920s, Hungary in the mid-1940s, and Zimbabwe in the mid-2000s. But these are few and far between, and are symptomatic of other severe problems in those places and at those times. The much bigger problem is to ensure that governments properly respond to the incentives set by central banks, while noting that central banks themselves are not immune from making mistakes.

By far the most coherent school of commonsensical monetary and fiscal policy is called ‘modern monetary theory’ (MMT). I don’t particularly like the name – because the school is really about the shortcomings of government fiscal policies – and not the shortcomings of modern central banks. The best known economists in this school include (Taiwanese) Richard Koo (who coined the term ‘balance-sheet recession’ to explain Japan’s experience in the 1990s), (American) Randall Wray (who has been a regular contributor to the Sydney conferences of the Australian Society of Heterodox Economics), and (Australian) Bill Mitchell who is speaking this Sunday afternoon (via Zoom) to the New Zealand Fabian Society.

What is Money?

Money is a mystery. To most of us we receive it, we spend it, we save it, we borrow it. And if we don’t have enough, we are in trouble.

Many of us think of money as if it is tangible, like gold; something that is naturally scarce, and that must be won through toil. Those of us who think like that tend to resent beneficiaries, who, as they see it, live off the toil of others. Exceptions are made for the capitalists (and landed proprietors) who earn money through what they own rather than what they do, who don’t have to toil, because they or their ancestors must have been sufficiently productive or unscrupulous to gain a get-ot-of-toil-free card. (The correct name for this category of work-exempt people is rentiers; the word capitalist is too ambiguous.)

This understanding of money is untenable today, and never in history was actually true. Rather money is – and always has been – a set of circulating promises. Money is, and always has been, a social technology. Gold was created by supernovae (exploding stars), so is part of nature. Money was, and is, and will be, created by people, and represented on a balance sheet.

What makes money different from other promises is that the signatory is understood to be a formal authority. Even electronic money has an implicit signature, and maintains its character as an authoritative promise. To be money, a promise must be free to circulate in a social environment, it must have an imprimatur of authority, and must be accepted by all sellers in all markets. While nowadays most of our money is held as bank deposits – neither notes nor coin – it is the number (eg 10) that matters.

If we look at a $10 banknote, we see that it is an explicit signed promise; signed by the principal of the issuing Bank; in most countries, the Reserve Bank. (In the old days such a banknote was a guarantee to exchange it for coin. In practice, we almost never used that guarantee. Coins themselves are implicit promises; promises by whoever’s head is featured on the coin.) Monetary promises can be exchanged, directly, for goods and services. (Other promises should first be exchanged for money, then be used to buy goods and services; though they may be accepted by some people as if they were money. Market exchanges that do not use money are barter.)

The meaning of that number 10 is socially constructed; it means that the holder can buy an amount of goods or services that is fair (consensually appropriate) for the number 10. We understand that, in another time or another country, a different amount of goods and services may be fair for the number 10.

Promises are essentially costless to create. Any individual or organisation can produce signed promises. Such a contractual promise is a ‘bond’, an ‘agreement with legal force’. In principle, bonds can be bought and sold, with such transactions not necessarily involving the person(s) who signed them. There is an industry and an associated academic discipline that is devoted to transacting in and studying promises. It is called ‘finance’.

Banking and Bookkeeping

Money is created when any bank purchases a promise that is not money; the most obvious case is when it makes a loan in return for a promise to service that loan. In this case the bank is buying a new promise. In other cases, it may be purchasing a promise that already existed. Indeed, when a bank buys a mortgage (a ‘pledge’, an example of a promise) from another mortgagee (mortgage owner) money is also being created. If the seller is another bank, then the act of a bank selling a promise extinguishes an equal amount of money. But if the seller is not a bank, then the write-up of one bank’s balance sheet is not matched by the write-down of another’s. New money is created.

In summary, when banks buy promises (eg a loan is issued), money is created. When banks sell promises (eg a loan is repaid), money is extinguished. Banks are in the business of buying and selling promises.

In most countries the Reserve Bank is the monetary authority, and is owned by the subject people of that country. The New Zealand Reserve Bank is a cooperative, owned by ‘the public’ who ‘enjoy’ its services. Likewise, the Government is the organisational embodiment of ‘the public’. Both Government and Reserve Bank are public institutions. Their principals – their owners – are the same, ‘the public’.

The Reserve Bank ensures that enough money is being created through both its supervision of the other banks, and through its own direct action in buying or selling promises.

When a country needs more money, but there are not enough loans being made by the commercial banks, then the Reserve Bank can buy promises from the Government. If there are already plenty of government promises in circulation, then the Government is not a party to these transactions. Otherwise, the Reserve Bank can buy new promises by the government. So, in situations when the Government needs more money, and the Reserve bank independently judges that the Government should have more money, and that there is an economic need for more money to circulate, then the money is created when the Reserve Bank lends to the Government.

At this point, many people worry about the future economic burden, because the government will have to repay these loans. This putative burden, misleadingly known as the public debt (misleading because it is a credit as well as a debit, owned as well as owed), is commonly called the ‘country’s debt’ or the ‘national debt’.

There is nothing to worry about. First, the government is only required to service these loans, and if the interest rate on the loans is zero, then no actual payments are required. Second, for every debtor there is a creditor. If one party (eg the government owes money), then it must owe money to some other party. All debts owed by the government to the Reserve Bank are in fact owed to the shareholders of the Reserve Bank. The People owe the money to the People. So, when the people repay what they owe, they are also being repaid what they are owed.

With respect to the Covid-19 emergency, there is no limit to the amount of money that can be created to address the problem. Further, although the mechanism is debt, any money we repay, we repay to ourselves. Increased public debt during a public emergency need not be a public burden.

Money is lubrication oil, not petrol.

Tis the oil, which renders the motion of the wheels more smooth and easy.
David Hume, ‘On Money’, 1752

As a social technology, money can be thought of as an economic lubricant. Thus, it lends itself to the analogy of a car, an automobile.

A car’s oil sump holds its lubricating oil. For those of us who have changed the oil or topped up the sump, we use a dipstick to determine whether we have the correct amount of oil. The dipstick has two marks; the correct oil level should be somewhere between the two marks.

We may think of the Reserve Bank’s monetary policy committee as the mechanic who manages the oil level of a car. Monetary policy is like reading a dipstick. We should imagine a sump that has excess capacity; that is, the ability to hold more oil than the car requires. Thus, for our car, it is technically possible for there to be both too little oil, or too much oil.

The flow of oil can be impeded by leaks or blockages. Blockages represent structural problems in the economy, which are not part of this discussion. Leaks represent the withdrawal of lubricant from its circulation through the cars moving parts. In a monetary sense, leaks represent the hoarding of money, the non-spending of money, its withdrawal from circulation. Such leaks make the oil level in the sump too low. While, in the long run it would be nice to fix these leaks, it is the role of the Reserve Bank to top-up the sump – the balance sheet of the banking system – to compensate for monetary leakage. It does this through an active process of double‑entry book‑keeping. This process is essentially costless; money supply is infinitely elastic (though socially constrained), unlike the gold supply which is not at all elastic.

(Using the car analogy, we can imagine two kinds of leaks; one where the oil leaks onto the road and is lost permanently, or oil that leaks into some kind of container attached to the car and that can technically re‑enter circulation though is not available to the mechanic. Part of the job of the mechanic is to watch out – and adjust for – for the re‑entry of leaked money.)

Any kind of economic crisis represents a new and large leak. The link may be exogenous (eg caused by an external shock such as a new coronavirus), or endogenous (created by internal financial failings, as in the 2008 Global Financial Crisis).

There are two other kinds of crisis that are of concern to monetary macroeconomists. One is the possibility that the sump is overfull. In the quote below the result is a cappuccino froth.

What happens if oil level is too high?
It’s true that overfilling the crankcase with oil can damage the engine. When you overfill the crankcase by a quart or more, then you risk “foaming” the oil. If the oil level gets high enough, the spinning crankshaft can whip the oil up into a froth, like the stuff that sits on top of your cappuccino.
found via Google

To some macroeconomists (the classically-minded ones) this froth is called inflation, is dangerous, and is an inevitable consequence of an overfilled monetary sump. To other macroeconomists (such as myself), this leads to a reduction of the rate of flow of the lubricant relative to the supply of lubricant (called a reduction of ‘velocity’); not a perfect situation, but also not much to worry about. Whether for a car or for the economy, having too much lubricant is a far less serious crisis than having too little lubricant.

The fourth crisis is an undiagnosed structural crisis – one of undiagnosed blockages rather than leaks. The car will run much as if it was losing oil, though it isn’t. While adding more lubricant may or may not create harm (eg stagflation; simultaneous inflation and recession), it is unlikely to fix the problem.

(Blockages may be the economic equivalent of ‘fatbergs’, created by inappropriate by inappropriate items being flushed into sewers. Organisational bureaucracy may be an example here. More generally, blockages come under the generic label ‘market failure’, and require public intervention to address.)

Public Debt is a Solution, not a Burden

Technically, money created during a crisis is public debt. But, so long as the Reserve Bank at the apex of the banking system is publicly owned, it is also a public credit.

When a recovery from a crisis is well under way, private businesses (and later households) take on more debt, economic activity increases, as do taxation revenues. This means that the level of public debt will naturally fall. The Reserve Bank may sell government bonds, and purchase more commercial (business) bonds.

Also, typically for a crisis, the commercial banks have a substantial capacity to increase lending – to buy new promises from businesses. It means that, in the recovery, more of the total money supply will appear on the balance sheets of commercial banks, and less on that of the Reserve Bank. Tax revenues will increase, allowing Government to reduce its emergency debt.

What needs to be avoided is a public austerity programme which seeks to reduce government debt as a goal in itself. Rather, fluctuating public debt – which is mainly what the people owe themselves – needs to be understood as a stabilisation process. In a crisis – when the amount of money circulating would otherwise be too low – public debt should dominate the Reserve Bank’s balance sheet, and the Reserve Bank’s balance sheet dominates the combined banks’ balance sheet.

With double‑entry bookkeeping, total assets equal total liabilities, by definition. The liabilities of the combined banks’ balance sheets are the money supply. There is no upper limit to the amount of money that we have, and there is never a need for governments to undermine the monetary process through premature attempts to reduce the amount of money the public owes itself.

Governments service and manage public debt by raising the public debt when tax revenues are constrained, as in an economic crisis. And by reducing the public debt when rising tax revenues allow, that is when the private economy is thriving.

A headline in the New Zealand Herald (31 March) said:

‘Generations’ of Kiwis to pay for economic recovery, says Finance Minister Grant Robertson

It is nonsense. There is no technical upper limit to the money supply; there is no upper limit to the amount of money we can owe to ourselves. Emergency public debt is not like taking gold from the vaults, and then requiring generations to repay that gold through toil.

Many Kiwis, with reluctance, will change their career paths. Some others may choose a better work‑life balance than they experienced in the 2010s. Average living standards are a function of economic productivity. There is no connection between the high public debt and low productivity. While Gross Domestic Product may be lower than before, there is no reason to believe that productivity – that living standards – will be lower in a post-Covid19 world.

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https://www.nzherald.co.nz/nz/news/article.cfm?c_id=1&objectid=12321026

The Weekly Overview is written by Tony Alexander, Chief Economist at the Bank of New Zealand. The views expressed are my own and do not purport to represent the views of the BNZ. This edition has been solely moderated by Tony Alexander. To receive the Weekly Overview each Thursday night please sign up at www.tonyalexander.co.nz

The Weekly Overview is written by Tony Alexander, Chief Economist at the Bank of New Zealand. The views expressed are my own and do not purport to represent the views of the BNZ. This edition has been solely moderated by Tony Alexander. To receive the Weekly Overview each Thursday night please sign up at www.tonyalexander.co.nz

This week we take a look at the dual long-term challenges facing farming – protein alternatives and environmentalism.

The Weekly Overview is written by Tony Alexander, Chief Economist at the Bank of New Zealand. The views expressed are my own and do not purport to represent the views of the BNZ. This edition has been solely moderated by Tony Alexander. To receive the Weekly Overview each Thursday night please sign up at www.tonyalexander.co.nz