Semester 2, Lecture 1: Baffled already!

Economics and Keynesianism

You know that when a lecture starts with “money is the rolling force of the universe – pure abstraction” that you are going to get totally confused… so I’m going to post my notes in the least confusing way possible (if I can). In this lecture we basically covered the economic strategies of Britain over the last 200 years or so, and some of the people who influenced them.

Chris started by arguing that we are all individual, not because of morals or feelings or values, but because of our net worth. We are all worth a different amount and that means that, because in life we trade on how much we are worth and how much we can barter because of this, each of our lives will be different. However the basis of this lecture is not so much the individual as the blanket schemes that govern the individual. Chris also emphasised that there is one thing that money and value cannot buy; poverty. I am not quite sure how this is relevant but it must have some sort of profound meaning which escapes me.

Adam Smith was a mechanistic economist, and was very influential. He argued that people respond to stimuli… pleasure and displeasure… rather than having a subconscious level. In this way, he thought that people are very easy to read by their ‘utility’, which I understand to mean the amount of pleasure and pain stimuli that they are measuring at one point in time, sort of like a thermometer. We seek to maximise the pleasure and minimise the pain and therefore maximise our utility. However, a definition that I have found on the internet says that marginal utility means “The additional satisfaction a consumer gains from consuming one more unit of a good or service”(http://www.investopedia.com/terms/m/marginalutility.asp), which has sort of confused me.

JS Mill, on the other hand, saw utility as an actual quantity that could be measured by price, rather than satisfaction. He saw no moralisation in it, simply value. This had political implications in that Adam Smith said that people must be free to maximise their utility, hence Utilitarianism where there are no restrains on the individual so they will, in theory, actively aggregate to produce as much as possible, which will benefit both the individual and society as a whole.

This is all linked to classical economics, with Utilitarianism (aka liberalism) playing a major role. This was a reaction at a moral level against the Kantean system of reality (categorical imperatives etc) and was based on Smith’s idea of the “hidden hand in the market”, that Free Trade stimulates economic growth and prosperity. To illustrate utilitarian ideals, Chris used the runaway train problem… a train is speeding down the tracks and can’t stop, hundreds of people are sure to die, unless you pull a lever to switch the tracks so that it goes onto a steady incline which will slow it. However, on this other track there is a rail worker who is deaf and blind and would be sure to be killed if the train comes that way. Do you kill the rail worker and save the hundreds? Or do nothing and let the hundreds die? For me, the real problem with this is that either way, innocents die. The Utilitarian answer would be to save the hundreds and sacrifice the one man.

Another example that Chris used was that of the NHS, they are more willing to spend money saving a young life who will contribute many more years to society than an old person that needs, for example an expensive hip replacement, because the old person has few more years to give in service to society. However, I see this as very cynical as sometimes (not often) organisations just want to help.

J M Keynes is, apparently, the person we have to blame for being in boring lectures and education , because he saw that economies were essentially unviable as soon as we were able to bring products such as grain and cotton etc into England, and so saw a need to set up other ways to increase public spending and put liquidity into the local economy.

Richardo thought up the” Labour Theory of Value”, which was contrary to Smith’s theories and suggested that utility is not purely subjective, but depends on the labour that is embedded in it.

Malthus’ “Iron Law of Population” was more interested in economic growth whereas Smith took a more static view rather than looking at changes over time. Malthus argued that the population was the main cause of change, growing geometrically (2 children each = equal, 4 children each = doubling population), while resources only grow arithmetically, causing an imbalance and leading to economic crisis. He argued that famine and disease control population, but the emergence of the welfare state has reduced the effectiveness of this so that the population/resources problem is growing bigger and bigger.

Marx is seen to be a mixture of both Richardo and Malthus’ theories and has been defined as a ‘contradiction of capitalism’. He argues that the free market constantly impoverishes people that work for wages because the Iron Law of wages means that the working class will never get out of poverty. They will never earn enough money to buy what they produce, because profit causes problems. Profit cannot be absorbed by society; there is always a gap and using profit margins only increases the problem. Therefore there is a recurring crisis of over-production and under-consumption. Chris points out that Marx is great at diagnosing the problem, but when it comes to finding a solution is trickier. If we treat the problem as he suggests, we will only be creating more problems. Therefore he saw this crisis as final and would result in a total collapse of the system. Thankfully, this hasn’t happened.

One of the main reasons that the economy didn’t collapse was the 1848 expansion of markets due to emigration and American economic expansion being used as a new source of capital investment. The 1849 gold rush also helped by causing huge migration, therefore reducing the strain of a large population on the resources available.

We now move on to the history of money. Money = pure abstraction in that it can be anything that carries out the function as a store of value and means of exchange. For classical economists, therefore, money is irrelevant. Money enables trade to occur. At first, they thought that the quantity of gold was constant and therefore could be used as a stable measuring stick for trade, then they discovered that they did not, in fact, have all of it, as huge reserves were discovered in South America (and other places?). This undermining of the traditional measuring stick of value caused inflation and in 1928, gold was no longer used to back currency.

Before 1844, there were no pound notes, only gold sovereigns (the world currency), then English banks began issuing ‘bank notes’ based on the gold reserves that they held. Banks found that they could issue more notes than their gold stocks because not everyone would be cashing in their bank notes at the same time. This meant that the concept of a Credit-Creation Ratio was set up, so that if £1 was held, £10 of notes could be issued. Bank notes were therefore backed by gold, but not directly transferable. The assessment of how stable the country or currency is acts as the defining factor on how much money you can make. A national monopoly was created in which the only money that is legal is bank notes from the Bank of England, which created a relatively stable currency.

Liquidity refers to what fills the gap between what labourers produce and what they earn by loaning the difference, therefore filling the deflation gap. It is the difference between the output of the country and the total purchasing power which is filled by printing money in proportion to the stocks of gold held. This ‘sound money’ allows the price system to be purely nominal.

Marshal attributed the 1880s economic depression to under-consumption, drying up goldmines and countries such as India and China hoarding money. The under-consumption, he argued, leads to liquidity crisis. He advocated a ‘loose money’ system where more money would be printed and circulated, creating more liquidity. However, he failed to comprehend the ‘money effect’, the idea that money has an actual effect on people in the real world, looking purely at the abstract concept of money. The idea that people are affected by money is a rejection of enlightenment rationalism. However, classical economists reject the idea of the ‘money effect’. Marshal said that because of the money effect, a nationalist monetary policy is needed to regulate the amount of money in the economy.

This is regulated via the interest rate which is the price of money, as determined by activity in the bond market. At the moment, the interest rate is about 1%. It is set by issuing government bonds (or ‘gilts’), the more guilt issues, the higher the rate of interest. This depends to a great extent on the legitimacy of the government issuing the bonds and the confidence in their economic policy (aka credit rating). However, there is a gap between the face value of these bonds and what people are willing to pay for them. They are, essentially, an IOU from the government.

The classical approach to Fiscal policy (taxation and government spending) is to regulate the bond market because what the government wants is a balance, for bonds and reserves to match. Bonds are therefore issued to regulate the economy and the purpose of taxation, to classical economists, is to pay off government debt, in the long run. However, Keynes argued that we should ignore the long run, and Keynesians see the purpose of taxation as being to regulate the aggregate demand (make sure that there is enough money to employ and pay everybody). PSBR is the Public Sector Borrowing Requirement, which is the number of bonds that will be issued in one year.

Despite all of these policies, since the 1920s there has been NO attempt to pay down national debt. Nowadays it is more about re-distributing the debt so that we can keep on functioning. The poor are seen as more likely to spend any money that they have while the rich are more likely to save, hence the introduction of income tax, to re-distribute the money so that the poor are spending. Therefore, we are using taxation as a way for the government to guide and regulate spending, rather than what politicians tend to tell us, that we are ‘working off our national debts’. Keynes believed that there should be no taxation except in social engineering.

Back to Smith, he argued that a Free State would work best, however it seems that we have a much more Active State, thanks to neo-mercantilism from the 1880s onwards, protectionism, the popularity of the national workshop concept to keep people employed (a way of putting liquidity into the economy and at the same time boosting morale), lots of state intervention directing economic activity and the introduction of the Welfare State, first in Bismark’s Germany (1880s), using an active state to integrate and subjugate the new German state, later done by France and the US. This nation-building strategy created liquidity, but at the same time devalued currency.

In the 1920s there was not enough gold in Britain to pay for the war, so Britain had to abandon the Gold Standard and simply print money, without the backing. This caused huge inflation, with too much money chasing too few goods; this led to speculation and rising prices which caused a huge stock market crash, leading us into the Great Depression. The neo-classical view argued for a ‘temporary market correction’ which mean reducing the cost of wages and money itself (interest rates) and putting a restriction on the number of bonds issued.

However, in 1925, Winston Churchill decided to take Britain back onto the Gold Standard system in a bid to bring us out of the Great Depression. He restricted the issuing and printing of money, however this only served to intensify the depression. Keynesians said that they should increase aggregate demand by printing money. This is expressed in the following formula:

Household Spending (C) + Private Investment (I) + Government Spending (G)
Y = C + I + G

This would use taxation to manage demand and cut inflationary expenditure (God knows how… I don’t understand this, if any-one does please explain in the comments!)


There were many problems with Keynesian theory:

1. Inflation and ‘stagflation’ – unemployment returns were ‘caused’ by inflation.
2. Increased role of the state meant a decline in freedom and went against Smith’s argument that a Free State would fare better.
3. It meant a destruction of profitability.
4. Orientation towards arms spending and militarism (as ways of increasing liquidity – ways to waste money which had no direct competition with the private sector and pumps more money into technological innovation) (aka Military Keynesianism).
5. Collapse of rational expectations.
6. Lame ducks/ picking losers/ protectionism/ failure to innovate/ scarcity of real investment funds/ bureaucracy/ racism (as seen in The Road to Serfdom).
7. The Keynesian idea that we are owed a living.
8. Central government planning undermines democracy, depends on a technological elite, means that policies do not necessarily reflect the General Will and can be seen as negative as politicians lie about the reasons for taxation.
9. Cheap credit, asset inflation leading to a ‘credit crunch’, bank failures leading to credit shortages, universal bankruptcy, possible currency collapse.

I don’t know if this is because I haven’t understood properly, but it does seem to me that whatever we do, there is no way to rectify the mistakes that have been made economically in the past, so we had better get used to living in debt… not the most cheerful thought, I have to say.