Money Demystified

Keynes's one man in a million

Central banks cannot create wealth but they can redistribute it. And the system confers a tremendous power upon those who exercise it. They are Keynes’s one man in a million

By John Phelan

I’ve found that if I write an article about taxes, whether its avoidance or the 50p band, it’s likely to generate angry replies. But when I write about monetary matters, interest rates or Quantitative Easing for example, there is often a silence. Perhaps this is because few people share my interest in it, perhaps it’s because they think it less important than I do. Or perhaps, to borrow from Keynes, it’s because monetary policy works “in a manner which not one man in a million is able to diagnose”?

The textbook functions of ‘money’ are familiar to anyone with a smattering of economics; a medium of exchange, a store of value, and a unit of account. But each of these functions is entirely dependent upon money maintaining its value. If the value of the pound fluctuates it is no more useful as a unit of account or measure than a twelve inch ruler which kept changing length. Money which declines in value is a poor store of value.
Historically, when its value declines beyond a certain point people stop storing their wealth in money and trade it for commodities as quickly as possible. This acceleration in velocity of circulation exacerbates the decline in value and can trigger hyperinflation. And money which is rapidly losing value can cease to fulfill the function of medium of exchange if people refuse to accept it, legal tender laws or not.

So the value of money must be maintained for it to serve its functions and value is determined by supply and demand. Money is demanded for transactions, buying and selling. A few coin collectors aside, people do not demand money for its own sake but because they wish, at some point in the future, to exchange it for goods or services.

Under our present system money is supplied by the central bank. If people demand money to facilitate transactions why do central banks supply it? The motivations of the central banks who supply money are not the microeconomicones of meeting transaction demand but macroeconomic ones which can change from time to time such as spurring GDP growth, decreasing unemployment, lowering inflation, exchange rate stability, or some combination of a couple of these. This is monetary policy.
Monetary policy is shrouded in mumbo jumbo but can be understood by anyone. Quantitative Easing, lowering the discount rate or the repo rate, Operation Twist, all of these monetary maneuvers executed by central banks essentially boil down to the same thing: the increase or decrease in the supply of money and credit to achieve some, one or two of the macroeconomic goals mentioned above.

When central banks reduce interest rates they purchase financial assets from banks with newly created money who then lend out some portion of this new money thus lowering interest rates. On the rarer occasions when they want to raise rates they do the opposite. Quantitative Easing is remarkably similar; it only really differs in that instead of buying short terms assets the Bank of England buys long term assets all of which, so far, have been UK government debt. Banks, in theory, then lend some portion of this new money out thus lowering these longer term interest rates.

There’s an obvious concern here. If money has to hold its value in order to fulfill its essential functions and if money supply is a crucial determinant of that value then won’t the tinkering about with the money supply affect its value?

But there’s another concern. Almost all the economic thinking upon which modern monetary policy is based models increasing the supply of money and credit as a once-and-for-all rise in everyone’s money holdings, proportionate to how much of the money supply they held before. This scenario is rather odd theoretically. If it’s true then monetary policy can have almost no traction and is pointless, all we will see are proportionate increases in price levels.

This line of theorizing is followed, it seems, simply to avoid thinking about the unpleasant consequences of monetary policy; the covert redistribution of wealth from the less well connected to the insiders and the permanent redistribution of wealth from those, like pensioners, on fixed incomes. 

These consequences follow inevitably from the inclusion of time, an integral part of human existence and of sound economics as cause and consequence can only take place through time. If we include time we can look at how these expansions in the supply money of money and credit come about when central banks purchase assets from a bank. This bank now has money to lend out which it does. Its interest rates may fall but so will its borrowing costs (what it pays the central bank). As we see today, such action can lead to the sort of false profits which trigger multi million pound bonuses.

But there is a further benefit to these early receivers, these insiders. They receive this new money when prices are at the old level; it takes time for them to rise. As such, these early receivers are able to use new money to buy goods, services and assets at the old prices. However, as they spend this money and it is then spent by the second receivers, and then the third receivers’ etc prices are bid up. By the time the new money reaches those farthest from the monetary injection, the politically least well connected, often the poorest, the new money will have lost this power. They will simply face higher prices. 

This is how monetary policy works. Central banks cannot create wealth but they can redistribute it. And the system confers a tremendous power upon those who exercise it. They are Keynes’s one man in a million and it’s in their interests, via mumbo jumbo, to keep it that way. Don’t let them.