This is the first anniversary of the blog, and as it happens I’ve just finished 3 months of posts on one subject and am about to start on the most interesting and important section of the blog. So it seems a good time to pause and write an overview of what has been written so far and review how it’s going.
What to Expect to Find on the Blog
My goal in writing the blog was to write in a way that anyone can understand. And I need to admit that in this I have clearly failed.
The workings of the economy are complex, involving many interacting components. And a lot of people think it’s boring. But the economy affects every single one of us every day and we affect it by the various economic decisions we make. It’s too important an area of human life to be left steeped in the level of ignorance that surrounds it. In my study of economics I have sought to get beyond the ideology and bluster and discover the technical detail of how our economy actually operates.
I am reasonably confident in the understanding I have gained, and my goal was to write about it in a way that clarified the complexity without compromising accuracy. It hasn’t turned out quite as I hoped!
One of the problems in trying to write clearly and accurately for a general audience is that genuine insight rather than superficial understanding requires technical detail. It’s necessary not just to know the names of the component parts and what these terms mean, but also to understand the dynamics of how these components interact. When I introduce a new term or concept I fully explain what it means and how it impacts the functioning of the economy. Gradually, the blog has built up many such descriptions and I couldn’t possibly explain every term or concept every time it comes up. But equally it’s not reasonable to assume that the reader will remember everything explained before, and I want each post to be as accessible as possible to a new reader. I do my best to strike a balance, but over time the blog has simply got bogged down in technical detail. Equally, what you will find is a blog that is not superficial, that does not gloss over important details, and explains what you really need to know.
Linked to this, another challenge is that although I want each post to be straightforward to understand (albeit requiring a bit of effort) I will not compromise on precision and accuracy. Sometimes I find a simple way to say something, but can instantly hear in my head the objections that someone with an in-depth knowledge of the subject would make, and that leads me to refine and clarify, often increasing the length of the post, or even turning what was meant to be one post into two or three!
This is why the blog has taken so long – I had no idea when I started it would take me this long to cover the material so far.
So what I’m saying is that if you’re new to the blog and read any of the old posts you can expect to find them clearly written, covering the detail of how the economy functions in a precise way, without taking short-cuts. In places it’s unavoidably heavy, despite my best efforts, but it is accurate and reasonably well-evidenced.
But what about the content? The blog currently has three main sections so far, accessed from the menu bar above – “Models”, “Money” and “Productivity”. I’m going to briefly summarise each below, and maybe save you having to read them!
I didn’t really know where to start but, as mentioned above, realised that the reader needed to understand certain core concepts. I took an approach that I likened to stripping a car engine and then putting it back together again piece by piece. I started with a model of a very simple economy in which everyone buys the same goods each year and companies produce the same – there’s no innovation, no change, no economic ups and downs – and in which the only form of money is physical cash, with no banks or financial assets. I then considered what would happen in such an economy if one person started to save. The simplicity of this economy was the equivalent of stripping back the engine, and the first piece that I plugged in was saving. Over subsequent posts I moved through a series of more complicated models, adding a new component to this economy each time, covering productivity and investment, credit, inflation (and deflation), the money supply and velocity of money, banks, interbank clearing (this is fascinating and essential to understand, trust me), and financial assets.
This is where many of the technical terms mentioned above are explained, but what is more significant are the dynamics of how they interact.
Let’s take one important example. Pretty much everyone “knows” that the government can’t provide enough for everyone by just printing money and giving it out, as this will cause inflation. (Alternatively, you could say that it can’t fund the NHS or pay off the national debt, etc etc…) The basic logic is that companies cannot instantly increase the amount of goods that they produce for sale, so if you increase the money supply you will simply have more money chasing the same amount of goods, and prices will rise.
However, if you have a situation in which firms are struggling for customers, and therefore are laying off staff, or lowering wages, or going bust, and in which the self-employed likewise are finding their incomes going down, it is obvious that they can respond to an increase in demand, and therefore they won’t put up their prices if there is an increase in the money supply, they will simply be able to sell what they already have the capacity to produce at the price they wish to sell it, avoiding lay-offs, wage cuts and bankruptcies.
Clearly, I am describing our economy since the financial crash. This simple explanation makes it very clear that not only was austerity unnecessary, it was actually the wrong policy. We needed the Government to increase spending to stimulate the economy, and it would have recouped must of that additional expenditure through the increased tax revenues that would come from a growing economy. (This is fully explained in this post on “The Magic Money Tree”.)
To make matters worse, throughout this period until the Brexit vote we had exceptionally low inflation, and sometimes even deflation. The Bank of England was actually trying to cause inflation. So the argument that funding Government expenditure through new money would cause inflation was actually an explanation of why this should be done. (Promoting growth through increasing public spending will cause inflation through its impact on the exchange rate rather than more-money-chasing-more-goods, just as the fall in the pound after Brexit has caused inflation in the UK. The full dynamic is explained here.)
I hope the last four paragraphs illustrate how understanding not just what terms mean, but how the different components of the economy interact, can help us quickly and easily understand what is actually going on under the bonnet of the economy.
And in terms of understanding these dynamics, with every new model I introduced in this section I would explore the impact of saving on the newly introduced components, considering saving in a static economy, in a growing economy, saving in an old-fashioned banking system, and saving through financial assets. The significance of this will be explained below.
At the end of this section I wrote a summary, found here. Ultimately, it’s not essential to read any of this to understand the rest of the blog, but if you were tempted I would definitely suggest starting with the summary.
Very simply, this section explains how money is created, and to some extent how the monetary system works. (To fully explain the monetary system I would also have to cover monetary policy, including quantitative easing, and foreign exchange markets. It was originally my intention to have sections of the blog on these 2 subjects, but it was all taking too long so I skipped this.)
In a nutshell, money is created whenever a bank makes a loan (and destroyed as that loan is repaid). The only limit on banks’ ability to create new money is their having customers seeking loans that they are confident to lend to, and either not giving out significantly more in loans than they receives in new deposits or being able to borrow on the interbank market to make up the difference.
All of this is explained clearly and briefly, yet in sufficient detail, in 4 weeks of posts starting here, so I’m not going to repeat it here.
You may have in your head the model of fractional reserve banking, in which the banks keep a fraction of their deposits in reserve and loan out the rest, with the central bank controlling the money supply by managing the quantity of reserves. This is the model taught in economics textbooks and it is completely wrong, as explained here.
The way money is created is clearly explained by the Bank of England in a short and clear paper in its March 2014 Quarterly Bulletin. The same paper also confirms that economics textbooks are wrong (it says this 6 times). The paper is continually referenced throughout this section.
The correct version of money creation is widely known (outside of orthodox economics) and has been repeatedly described in books and websites. The definitive starting point on this subject in the UK (aside from the Bank of England paper) would have to be the organisation Positive Money. One reason I didn’t start the blog with this section is that it’s been done before so many times, so I tried to be more original with the section on models. However, I couldn’t leave this subject out, and I like to think that the articles on this blog are as clear and as accurate as anything else you will find.
From all this, there is one point that needs to be emphasised. As productivity increases, the money supply needs to increase as well. And in our current system this increase only happens when banks make loans. But as these loans are repaid the money supply is reduced. And therefore our economy needs ever increasing levels of private debt, both to replace the money that is being destroyed as loans are repaid and to create the new money needed for increasing productivity. And there is only so much debt that the private sector can sustain. Every major financial crash has been preceded by extremely high levels of private debt.
It is therefore essential to a functioning economy that a certain quantity of new money is created every year that is not tied to private debt. And the only way to do this is for the public sector to create this money. This is not an excuse for the Government to have as big a deficit as it likes: the amount of money needed is linked solely to the growth in productivity, and the Central Bank could give the money directly to the private sector through, for example, corporate tax breaks. But such payments would still be a public sector deficit.
This is the simple fact, and I hope you can clearly see the logic of this. We need public deficits every year, and everything you see in the media and from politicians railing against deficits is wrong. However, these deficits must be funded by newly created money, with the amount determined by economic factors not by the level of spending the Government desires. (The Government can spend above this limit through taking out debt in the normal way.) The only exception to this is if the economy is over-heating and needs to be slowed down to prevent inflation. All of this is fully explained in this post.
However, while fixing our monetary system is an essential step in creating a functioning economy that produces enough for everyone, it’s just one small part of a much bigger picture. This section was just a foundation for where we’re going.
Armed with an understanding of money, we’re ready to look at the critical issue of productivity. If we are to have an economy that provides enough for everyone then we need to be producing enough. This requires not just raw materials but the infrastructure and systems to produce those goods – the factories, the machines, the transport – not to mention the knowledge and the skilled workforce.
This infrastructure needs to be sustained, and innovation and progress requires new infrastructure. All the expenditure on this is known in economics as investment.
In everyday language we think of investment as buying a share or another financial asset. But in economics it specifically means expenditure on this infrastructure (known as fixed capital) as well as spending on increases in inventory.
The difference between the everday and the economic meaning of the term investment can get very confusing. If you buy a financial asset such as a share in a company, you are not investing you are saving – to access your savings you sell the asset, and you hope that it increases in value by more than the interest you could have earned from a bank. But by saying that we invest in financial assets, it can create the illusion that this expenditure will lead to proper investment in the economic meaning of the word. Indeed, economists say that financial markets intermediate saving to investment. But the vast majority of trading in financial markets is trading in what economist Steve Keen calls second-hand assets. Investment only takes places when a firm issues a new asset and then uses the proceeds for investment expenditure.
All the frenetic demand for assets simply pushes up asset prices, causing the recurrent bubbles we’ve come to know and love. And because financial assets are overpriced, the fundamental value of our savings tied up in those assets (such as pension funds) is far less than we think – but we only get to find out when the next crash wipes the value off those funds. Meanwhile, those inflated prices soak up our savings without redistributing them back to the real economy through investment, productivity falls and our economy slows down. (The constant attention to the dynamics of saving in the Models section of the blog, referred to above, was to lay the foundation for understanding these dynamics.)
This exactly describes the economy right now: asset markets are in a huge bubble that is waiting to burst (causing the next financial crash) yet the economy hasn’t been able to recover from the last crash, with growth remaining pathetically weak, particularly wage growth. Underpinning this is extremely weak productivity growth that concerns and bemuses economists and politicians (described in the 2nd half of this post).
And yes, this blog explains it all. If you think this description is too brief and I haven’t adequately justified my position, there’s 12 weeks of posts in this section for you to read! There’s an incredible amount of technical detail in this, not least in my post two weeks ago where I showed how the undistributed profits of businesses (business saving) should be the primary source of investment funding. I love the meticulous precision of how it all fits together, but I think for most readers it was pretty tough going.
So last week I summarised it all, and if you want to read more about this start there.
But I have to be honest, the new reader could simply jump in to next week’s post, and not read anything I’ve written over the last year (particularly if they’ve read this summary). Obviously I think there’s great value in what I’ve written so far – it represents the results of years of study, and it lays a foundation to understand what is coming up next. But the next section is where it gets really exciting, drawing on some of the most brilliant recent research that I’ve only read myself in the last year. We’re now getting to the business end of the blog.
Where’s This All Going?
The upcoming section of the blog will explain how the functioning of financial markets is failing to channel funding to investment, leading to low productivity and therefore weak economic growth (it may be a couple of weeks until I get up and running with this). This will clearly point to the kind of changes that need to take place to create an economy that creates enough for everyone.
This won’t be as dry as it sounds – there have been dramatic shifts in financial markets this century, which you will find shocking when you read about them. These changes are driven by, and have in turn fuelled, the sharp growth in extremes of wealth and poverty – the “1%” that we read so much about.
The next section of the blog will then be on distribution – to provide enough for everyone we not only have to produce enough, everyone needs to have the income to purchase those goods. It is facile to say that all we need to do is redistribute wealth from the rich to the poor. What this section of the blog will look at is how changes in productivity impact on the distribution of wealth, and how those changes then impact on the productivity of the economy. Again, this will point to the changes that have to happen to have a functioning economy.
Having, in these two upcoming sections, pointed to the kind of changes needed to happen, the final section of the blog will look at the barriers to bringing this about. And unless I think of anything else, that will be it. I’m getting tired of writing.