The Economic Red Thread (Money)

How It All Began

Imagine growing up in a remote village in Amazonas and the head of your village tasks you with designing a new economic system. The natural question that follows is how would you do it? If this was my task, the system design would focus on absolute core needs such as food, safety, healthcare and education. I believe that if the system takes care of these hierarchical life necessities, then your fellow villagers can in the future spend more time on leisure, passion and self-actualization. When people have more time to focus on other things than base necessities, the world evolves and with evolution comes new inventions that in turn create even more free time. At some point in history, this thought experiment was how society functioned and the progress shows how our world is a process of continuous marginal improvement ultimately leading to the complex and interconnected economic system of today. In fact, economic growth first exploded during the industrial revolution because more people could provide for their families by using their brains when machines took over manual labor. Today, most western governments rely on economists to optimally apply collective brain power. The guiding principles of these western economists update with time, but there is one thing that is constantly on their mind when it comes to allocation of resources: money. I therefore believe that he most important function of a society is money and it is the job of our economy to distribute the money in a meritocratic fashion.

Adam Smith

Classical Economics: Adam Smith

In year 1776, famous classical economist Adam Smith wrote the now world renowned book, Wealth of Nations, which underpin classical economics. All students of economic theory have at some point learned about both Smith and his literary masterpiece. Above all else of Smith’s contributions is his legendary invisible hand theory, which remains popular among capitalists today. The invisible hand theory states that equilibrium prices are determined by natural forces in our economy. These natural forces are driven by people acting in their own self-interest by freely producing and consuming, which in turn creates balanced trade flows and natural price movements. The invisible hand theory is part of a laissez-far economic approach meaning that lesser government involvement equals a greater economy. The classical economic school of thought dominated the western world during the 18th and 19th century and evolved many western countries from monarchic rule based systems to capitalist economic democracies with self-regulation. Under monarchic rules, a top-down approach where one supreme ruler decided upon resource allocation often with protectionist tendencies was considered optimal. However, classical economists including Ricardo, Malthus and Mills used academia to promote free trade through basic supply and demand analysis, which slowly changed the views of those in power. If correctly applied, free trade maximizes the pie and increases life quality for both rulers and their subjects, which is why classical economics transformed society in the 18th century. Economists still expand upon theories that were introduced by classical economics and as a result, classical economics remains a dominant force in our society.

Irving Fisher

Neo Classical Economics: Irving Fisher

In the beginning of the 20th century, the leading school of thought was neo classical economics. While classical economic theory believed that equilibrium prices were based on the summation of underlying cost of materials plus labor costs, neo classical economic theory expanded upon classical theory by mathematically conceptualizing the idea of the rational economic human. In a stereotypical fashion, the neo classist believes that all individuals are utility maximizing robots and that all firms are profit maximizing machines. Before an action, however, both the consumer and firm with full information must first carefully weigh all possible options against each other and then select the optimal action at all points in time. These optimal actions in turn drive demand and equilibrium for goods and services. Neo classists therefore believe that equilibrium prices are a pure function of consumer and firm preferences, which obviously includes the cost of production. The biggest deviation from classical economics is that neo classism includes the concept of perceived value. Producing Coke and Pepsi might cost the same, but if people prefer Coke, then Pepsi’s price might be lower to compensate for its lower usefulness. This idea of rationality made neo classical economics attractive to mathematicians as well because they could start using math to find optimal solutions to all types of micro and macroeconomic problem. There are many famous neo classical economists including Kenneth Arrow, Paul Samuelson, and Irving Fisher. The latter is the most famous and pioneered work in intemporal choice in markets (theory of capital and interest rates), utility theory and econometrics. Fisher also has many famous concepts named after him. These concepts including the fisher hypothesis, fisher equation and international fisher effect are still taught to economic students today. Finally, Fischer’s research on quantity theory of money inspired Milton Friedman and monetarism, which is another branch of economics that is held dearly by many current economists.

John Maynard Keynes

Keynesianism: John Maynard Keynes

Keynesian economics is named after perhaps the most famous economist of all time in John Maynard Keynes. It is a beloved style of economics spanning both the 20th and 21st century, as it increases power to politicians by being an open proponent of fiscal and monetary intervention. Keynes grew up in the beginning of 20th century England, but surprisingly this famous economist graduated university with a degree in mathematics rather than economics. According to writer Zachary Carter’s book, The Price of Peace, Keynes interest in economics developed when he began his career in British civil service for the India office, which resulted in his first book, Indian Currency and Finance. Keynes colleague in the India Office, Basil Blackett, was impressed with Keynes mind for economics and therefore asked Keynes to assist him at the treasury department when a financial meltdown was looming on August 1st, 1914. Following the experiences at the treasury department, Keynes earned his respect in government by continuously coming up with solutions to various economic problems. What separated Keynes from neo classists is that he believed fiscal and monetary policy was needed to save the economy during severe hardship, while the neo classists argued that economies would stabilize naturally through supply and demand forces. In Keynes legendary economics book, The General Theory of Employment, Interest, and Money, he argues that the economic damage suffered during the 1930 Great Depression proved that monetary and fiscal policy action was needed to restore the economy. In this book, Keynes also argues that supply and demand equilibrium functions well at the microlevel, but not at the macrolevel, so it separated economics into micro and macroeconomics. His reasoning is that supply and demand forces will fail at the macro-level with the added complexity of total spending in the economy, which has an ultimate impact on output and inflation. Government spending should therefore be used as it can quickly revert the economy to its normal level by increasing the money supply, as inflation lags behind. Keynes referred to this as price stickiness. Another example of price stickiness according to Keynes is that workers would refuse to lower their wages despite it being rational (classical economics argued the opposite).

Stephanie Kelton

Monetarism, MMT and 21st economics

Monetarism and MMT are two economic styles that on many levels oppose each other. The latter takes Keynesian reflation to the next level by arguing for even more stimulus in economic recessions, while the former believes that central bank policy contributes to manipulated markets and inflation. According to Stony Brook economist, Stephanie Kelton, the central idea of MMT is to give governments with a fiat currency system the power to create money to fund important government projects in education, health care and infrastructure, as long as these projects do not create extreme inflation. MMT is actually not that much different from the Keynesian system because both theories assume that 1), loaned money pays for itself through growth and 2), the government won’t go broke because it is borrowing from its own central bank in its own currency. The difference between the two theories comes down to the supply and demand analysis of money. Under the current Keynesian system , governments levy taxes to pay for their liabilities. If the government is unable to pay its liabilities through these taxes, the politicians will then borrow money by issuing bonds. Issuing bonds increase the demand for loans, which in turn increase interest rates. When interest rates increase, private businesses and consumers are crowded out because if interest rates are high then businesses and consumers are unable to borrow money. However, MMT believers argue that interest rates do not have to increase when the economy receives an excessive amount of stimulus as the government can raise taxes to reduce excess money rather than raising interest rates. On the other side of the inflation argument is legendary monetarist economist, Milton Friedman. He is for an economy without discretionary/excessive monetary policy. Monetarists argue that excessive stimulus can have negative unintended consequences, which is worrisome given the amount of stimulus that governments have infused into the economy for a stabilization purpose during the corona pandemic. This could potentially explain why government debts in western economies are at record levels (Central banks hold most of this) and interest rates are at zero despite a stock market at record highs. However, the monetarist view is less popular among politicians because it means market forces decide where allocation of money should flow and thus decrease the importance of government.

Milton Friedman

Conclusion:

The main point of this blog is that there is no single approach that is the correct path to follow for our economy. Instead, the economy evolves continuously and adapts to overcome temporal challenges by balancing the present with the future. The same way that a villager sets the economic path for his village, Adam Smith learned his path from older economic sages. Smith then paved the road for future economists including Fischer, Keynes, Friedman and Kelton. From what I have learned, there is no right or wrong in economics because all of these economists are smart, but rather there is progress. Sometimes stimulus might be the right action and other times it is not. There is no way to test alternative histories in economics and this uncertainty makes economic so darn difficult, which is something that humanity must accept. What I do know is that great things are ahead. We must blend common sense with economic theory and then our world will prosper!

//Stay adaptive