Basics of Monetary Economies

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from Asad Zaman and WEA Pedological Blog

. . . conventional modern textbooks of economics do not correctly
describe monetary economies.. . .  For instance, a popular textbook
by Mankiw states that: . . .

I am planning to write a textbook on monetary economies. I will draft it section by section and chapter by chapter, and put down the drafts here for feedback and comments. The first section is given below – it is an introduction to the topic, and provides some motivation for the study, as well as hints of the methodology to be adopted.

Introduction & Motivation

A Monetary Economy is one in which the use of money is essential to the functioning of the economy. That is, without money, people would starve, and massive amounts of economic misery would result. Since monetary economies have dominated the world for centuries, this seems to us like a natural state of affairs. However, a study of history reveals that monetary economies came into existence only a few centuries ago, and eventually came to dominate the globe. Most pre-modern societies were not monetary economies. For instance, a feudal economy was not a monetary economy. The landlord owned the land, and workers on the land would receive all necessary support – food, clothing, housing, etc – from him. In return, they would work the land and produce crops, and provide other services. No money was needed for the basic necessities of life. The landlord could sell excess crops for money, and buy fineries from foreigners, but this was not essential for existence. Even today, in many areas of the world, rural subsistence economies far from urban centers are often self-sufficient, and can function without money. These non-monetary economies are excluded from the scope of our study.

Our goal in this textbook will be to clarify how monetary economies function, and how they have evolved over time. This is important because conventional modern textbooks of economics do not correctly describe monetary economies. In these textbooks, money does not serve an essential function. This point is recognized and articulated in these textbooks using the terminology “neutrality of money”. For instance, a popular textbook by Mankiw states that:

Over the course of a decade, for instance, monetary changes have important effects on nominal variables (such as the price level) but only negligible effects on real variables (such as real GDP). When studying long-run changes in the economy, the neutrality of money offers a good description of how the world works.

Exactly contrary to this, Keynes stated clearly in his landmark book entitled The General Theory of Employment, Interest, and Prices, that money plays an important role in both short and long run – it is not neutral. If money is neutral, then money plays no essential role in the economy, and so there is no essential difference between monetary and non-monetary economies. In this textbook, we will explain how money, far from being neutral, is a central driver of economic activity. Conventional textbook analysis, which takes money as neutral, leads to deep misunderstandings about modern real world economies.

The false assumption of neutrality of money led to the failure of economists to understand the causes of the Global Financial Crisis in 2007, and also to their failure to take corrective actions which could have prevented the Great Recession which followed. The battle of ideas, embodied in economic theories about money, is described in “Completing the Circle: From the Great Depression of 1929 to the Global Financial Crisis of 2007”. It is useful to briefly outline how economic theories changed over the course of the 20^th Century:

1. Classical Economists argued for the neutrality of money, along with other ideas, which lead to the conclusion that unemployment can only be a short-run phenomena. In the long run, unemployment will be eliminated by the workings of the free market.
2. Following the Great Depression of 1929, large amounts of unemployment which persisted for long periods of time was observed. This was directly in conflict with theories of classical economics.
3. Keynes then came up with a new theory, which had many revolutionary ideas, dramatically different from the assumptions of classical economics. One of the central ideas was that money is not neutral. In particular, in the labor market, the supply and demand for labor, and hence the rate of employment is strongly affected by the quantity of money available.
4. Keynesian ideas came to dominate macroeconomics for about three decades following World War 2. In particular, the idea that free markets will not automatically eliminate unemployment, leads to the necessity of the government policies required to create full employment. Application of Keynesian policies led to full employment in USA and Europe for about three decades.
5. The oil shock of the 1970’s led to the failure of Keynesian policies. Development of monetarism by the Chicago school of economists led to the re-instatement of pre-Keynesian ideas about the neutrality of money and the idea that free markets lead to elimination of unemployment. This came to be known as neoclassical economics, because it rejected Keynesian ideas, and went back to classical economics.
6. A concerted campaign was carried out by monetarists to discredit Keynesian theories and rebuild Economics on neoclassical foundations. See Understanding Macro III: The Rule of Corporations. This was highly successful. The Monetarists went from a minority and eccentric school to the mainstream orthodoxy by the early 1990s. It became impossible to publish Keynesian and post-Keynesian views in mainstream top-ranked journals.
7. Over the decade of the 1990s economic performance in the Western world became flat – fairly low growth, but no ups and downs of business cycles which had been characteristic of capitalist economies for a  long time. This led to celebrations of “the Great Moderation” by the monetarists. Robert Lucas, Nobel Laureate and leading Chicago schools economist, announced triumphantly in his Presidential Address to the American Economic Association in 2003, that we economists have conquered the business cycle, and from now on, recessions will not happen.
8. The Global Financial Crisis of 2007 took the economics profession by surprise, just as the Great Depression of 1929 had come as a surprise. Paul Krugman wrote the book “The Return to Depression Economics” arguing that insights of Keynes continued to be valid, and to provide deeper insights into the GFC than was available from leading neoclassical macroeconomic theories of the time. Paul Romer wrote a scathing article entitled “The Trouble with Macro” in which he argued that modern macroeconomics is based on fundamentally flawed doctrines, and leads to wildly incorrect predictions.

This is more or less the current state of affairs, as good alternatives to conventional macroeconomics are unavailable in the mainstream. The mainstream macroeconomic theories are based on assumptions which have no relation to reality. However, while mainstream macroeconomics rejected Keynesian ideas, a group of theorists known as Post-Keynesians have continued to develop the ideas of Keynes, building on his fundamental insights. This has led a branch of macroeconomics which provides much deeper insights into modern economies then the monetarism which dominates universities today. Our text borrows from these ideas. However, the critical innovation of this textbook is to study economic theory within its historical context. We must study the Great Depression, in order to understand Keynesian Economics, since the theory was developed to understand these events. Similarly, all social theory is developed as an attempt to understand historical experiences of a particular society, and cannot be understood as an abstraction, detached from this historical context. Studying economics within its historical context requires a methodology radically different from that currently in use, in both orthodox and heterodox textbooks of economics currently in use around the world.