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The opportunity cost of our democratic deficit

Hector McNeill1

The state of democracy in this country has come to a very low ebb. The constituency has almost no participation in the formulation of policies but these are presented with poorly articulated options as lists in political party manifestos. Our political parties together have a membership of less than 1% of the size of the electorate and yet they set the agenda.

Often items in the lists are mutually contradictory. It is notable that on the fundamental questions of how the economy is to be managed, constituents are not even considered to have any point of view, or, if they do, parties are not going to take them into account.

This represents a serious democratic deficit. The opportunity cost is a persistent lack of public choice and an economy that is not aligned to constitutional principles. Monetary policy remains the main preserve of governments (Treasury) and the Bank of England. When was the last time any British political party asked for any suggestions as to how macroeconomic policy might be changed to be more responsive to constituent needs? And yet it is monetary policy that caused the 1929 Crash, the 2008 financial crisis and the impending 2020 financial crisis that was overtaken by Covid-19, real incomes decline, savings are non existent and prospects are bleak.

This article reviews this matter.

Jurassic Park

The notion of fiddling with the DNA of remains of animals that lived thousands of years ago with the intent to resuscitate them into living form to be able to observe them in a theme park is considered to be on par with science fiction. However, today many of our central macroeconomic policy instruments, the operational mechanisms for managing the economy, were formulated centuries ago by a powerful faction, when any idea of public participation in deciding how such a policy should operate, would never have been contemplated. Following several reform acts and women securing the vote, this remains the state of affairs. We are all in a Jurassic Park limited to the status of spectators. Observant constituents will have noticed that to be in the park we need a season ticket whose price keeps going up. The spectacle has been running for about 200 years, the show is not impressive, but no one has the freedom of not visiting the park or not paying the rising price of the season ticket. We are all in the park on a permanent basis and those running the park seem to be getting rather well off. The Exit was barricaded up centuries ago.

In 1929, the lack of effective regulations over the behavior of banks led to a largely debt sourced flow of money into a highly speculative stock market. Increasing numbers of companies and individuals raised loans against collateral such as real estate and houses and many banks fed this frenzy. When the collapse came companies and households lost their collateral leading to mass unemployment and lack of ready cash. The general knowledge of corporate performance fundamentals was poor and many regarded the Stock Exchange as a sort of casino as a means of making a high return in a short period. In 1936, John Maynard Keynes referred to the New York Stock Exchange as a casino and made suggestion as to how to discourage people of limited means from participating in its activities ( see: Keynes on stock markets ). It was also in 1936 that Keynes proposed his "solution" in the form of government debt and public works and what came to be referred to as Keynesianism.

These notions were applied during the war but more related to armaments procurement and land armies helping boost food production. It worked quite well but placed the country in debt. Between 1945 and 1965 in a period referred to by many as the "Golden years of Keynesianism" the British economy experience unprecedented growth. The economist Robin Matthews analysed the data and policy record only to find that the government during this period did not apply Keynesian policy instruments because unemployment was so low. Because Keynesianism had been accepted as the primary macroeconomic principle, many people confused the growth and close-to full employment in that period as somehow being related to Keynesianism; there was no connection. In the USA the New Deal ran on Keynesian lines and banking regulation was tightened in terms of due diligence applied to loans and a separation of retail and investment banking to avoid the retail banks financing speculative investment (Glass-Steagall Act of 1933).

In the 1970s through 1980s the international price of petroleum underwent major rises in unit prices and this created the condition of stagflation which combined high inflation with rising unemployment. The existing policy instruments for the control of inflation including high interest rates, high taxation and reduction in public works could not be applied because the form of inflation was cost-push inflation.

During this period "supply side economics" appeared" as a new macroeconomic paradign to address stagflation. This was taken up by the Reagan administration. Supply side economics doesn't have much to do with the supply side. It is a marginal tax rate reduction meant to encourage investment in higher productivity production to lower inflation. However, this was combined with very high interest rates which led to widespread repossessions of houses and farmland. Government deficit rose and public services and social service expenditure fell.

In 1991 the Glass-Steagall Act (1933) was ruptured when the Commodity Futures Trading Commission provided Goldman Sachs with a “Bona Fide Hedging” exemption to be followed by similar exemptions for other banks. This experience encouraged financial service lobbies to encourage a deregulation of financial services to return to the pre-1929 state of affairs. In the UK, a similar approach led to the repossession of thousands of homes. Bill Clinton signed off on the termination of the Glass-Steagall Act in 1999 through the Gramm-Leach-Bliley Act which effectively removed the barrier between retail and investment/trading activities in banks. In the UK, the Thatcher government deregulated deposit takers, such as mutuals, to become banks on the plc model (See: "The journey from 1971 to 2020 - the consolidation of financialization" ). Monetary policy, since the 1980s became the main macroeconomic driver, in a concerted attempt to make this the main source of money for economic growth, based on debt.

As a result, this period witnessed financialization taking over, culminating in the 2008 financial crisis. The initial tipping point was that too many loans for mortgages having been made to people unable to repay these with ease and at the end of November 2007 the Federal Reserve raised interest rates slightly. This led to failures. However, by this time many mortgage portfolios has been "rolled up" into "derivatives" or salable "financial instruments". So the banks that had purchased these as securities faced a serious liquidity crisis.
Exogenous money

The word exogenous signifies "something originating from outside the system" and this applies to bank loans which increase the "money supply" literally through a process of simply crediting a bank account with a number of currency units. This creation of money out of thin air has been explained in a Bank of England bulletin ( See: "Money creation in the modern economy" ). Therefore, not only does this constitute exogenous money this "flow" increases the volume of money measured in terms of currency units in circulation. Paradoxically this increase in money volume is used as the basis for measuring "economic growth", even although no increase in real production may have occurred.

Endogenous money

The word endogenous signifies "something originating from within the system" and this applies to the funds circulating in a stable money volume situation in which all payments made in the purchase of production of goods, services and capital goods (equipment for industry) flows into wages and income of owners to constitute the amount of money available for consumption within the same economy. In this economy, growth is related to relative unit prices and productivity and measured in terms of increased purchasing power or real income as opposed to the rise in the number of currency units (nominal funds) in circulation.

Sources and sinks

In this long run of about a century, this basically unstable system has constituted the Aggregate Demand Model (ADM) in which the source of "growth" is considered to come from exogenous money (see box on right). This provides the underlying logic to Keynesianisn, Monetarism, Supply Side Economics and Modern Monetary Theory. On the other hand, the limited sink of funds then becomes government revenue-seeking fiscalism involving taxation and levies. Government fiscal actions are marginally more exposed to constituency "oversight" than monetary policy because they pay taxes and levies. However, this system, runs in tandem with monetary policy "managed" by an "independent" central bank.

The maintenance of an archaic model

This model is largely based on the former colonial Charters, initiated in the 1600s. These were usually issued by royalty and were based on external investors introducing exogenous funds to establish colonies. The Charter issuing rulers's reward for such "concessions" was their receipt of taxes paid by the colonists. The USA "fought" against this in terms of British rule only to reintroduce the same system as the basis for domestic economic policy, as existed, and continues to exist, in the United Kingdom. In short, an undemocratic system was rejected and then embraced by the new "democracy" even although it had been judged to be prejudicial. As a result of this "economic management", constituents continued to have no say in monetary policy. This archaic model has changed little since its introduction, well over 400 years ago.

Lesson Number One
Endogenous and exogenous money, nominal and real growth

The run up to 1929 and to 2008 was associated with the rise in introduction of exogenous money into the goods and services consumption markets. Exogenous money is money introduced into circulation which exceeds the current money circulating within the supply side. This supply side endogenous money (see box on right) has a specific monetary flow which conforms more of less to Say's Law (See: "A clarification of the role and significance of supply side operations" ). Under this situation payments made to employees, owners and suppliers of output (such a capital goods for investment) constitute the money available for consumption or saving. Under such circumstances economic growth arises from savings being invested in more productive output leading to lower unit prices leading to higher real consumption because purchasing power of the currency will have increased.

Banks formerly made use of savings from endogenous sources to lever exogenous funds as loans under the fractional reserve system. This system can remain in equilibrium as long as genuine rises in productivity are achieved. However, an increasing amount of funds raised by governments to stimulate the economy through public works help raise employment for a specific period but the impacts on productivity are invariably more diffuse and, in many cases, nonexistent. As a result, there is a rise in exogenous money and stagnant productivity and less real growth.

With the unraveling of the financial regulations during the 1980s the flow of exogenous money increased, based on "securities" as reserves and "money market trading" rather than relying on savings from the supply side.

John Maynard Keynes considered savings to be thrift and expressed support for the "thrift paradox" which states that savings for an individual are of benefit to the individual but not to the nation if too many people save money. He considered this process to remove circulating funds, which is true. However, savings are only possible when people have already met their basic needs and have enough disposable money left over which they can place in a savings account earning interest and provide a base for fractional reserve based loans and investments. With the growth in money market transactions becoming the source of security for making loans, the financial intermediaries and banks did not have to rely on savings so this service to the supply side employed constituents was of secondary importance. This resulted in the solution to the 2008 financial crisis being quantitative easing, which combined close to zero interest rates with a massive provision for exogenous money. This was designed to provide banks with "cheap money". The interesting but destructive outcome was that exogenous money flows were affected, in terms of their impact, not by the thrift paradox of saving creating non-circulating money, since zero interest rates destroyed savings as an interest earning asset. The impact of exogenous money flows was to generate an even greater expansion in non-circulating money in the form of purchased assets such as land, real estate, precious metals and levered purchase by companies of their own shares.


A more recent treatment of the problems with the QTM can be found in 2 recent Charter House Essays in Political Economy in pdf format:

The following papers (pdfs) have been released:

Why monetarism does not work

Why the purchasing power of wages falls

These events served to demonstrate that the Quantity Theory of Money (QTM), which purports to relate money volume to prices and real incomes, does nothing of the kind. This is because the QTM identity does not include savings or assets, these markets are ignored. This is somewhat extraordinary given that on the other side of the balance sheet banks have been investing in derivatives, options and other instruments for many years. It would seem that the QTM was a convenient way to justify monetary policy decisions while masking the true effects and cost-benefit. The Real Money Theory (RMT) includes these variables and enables analysts to trace the diversion of exogenous and some endogenous money into asset markets. The effect is also to divert endogenous and exogenous funds from productive investment because asset market speculation offers potentially a higher return. Money velocity falls to almost zero and there are no effective savings with close to zero interest rates. The significant asset market inflation generates an inflationary leakage into to the goods and service consumption markets by exposing constituents to increasing prices and rents for land, houses, farm land and industrial buildings.

Lesson Number Two
Money types and constituency wellbeing

The fact that the majority of the constituency have no say nor are they provided with any means to influence monetary and central bank policies, represents a failure to uphold even the most basic principles of constitutional economics. When exogenous money has been used as the main driver of macroeconomic policies pre-1929, pre-2008 and post-2008 to date 2020, the risk to the economic status of the majority is raised. This is a result of, in each period, speculation in assets and financial securities overwhelming the normal processes of investment to secure higher productivity and real growth in incomes. The Keynesian or monetary notions of nominal increases in exogenous money secured by government debt constitute a measure of economic growth can only fall into the realms of economic logic if this increase is matched by an equivalent rise in productivity and real growth; it almost never is. The current declarations of infrastructure spending, ready projects and a construction revolution all fall into this category of creating employment but only marginal rates of growth in productivity and real incomes. Private acquisition of exogenous money has always led to transfers into asset markets and inflation in those markets, largely on a speculative basis. The direct beneficiaries are less than 3-5% of the constituency who can afford the ruling prices and who are associated with institutions and companies with lobbying power to maintain this inequitable system that exacerbates the problem of increasing income disparity, declining real incomes and rising debt of the majority.

In the case of financial instruments and derivatives, the source of risk in the pre-2008 period, and now, is the inadequate deployment of due diligence procedures associated with transactions and therefore such "assets" are associated with unknown levels of risk2 and in 2008 some went the same way as share prices on the 1929 New York Stock Exchange. Both turned out to be a high speculative risk of asset markets.

1 Hector McNeill is the Director of SEEL-Systems Engineering Economics Lab.

2 Because loan-based derivatives are sold by the issuers of debt (loans), the rolling up of thousands of such contracts into a single instrument breaks the direct relationship between the issuer of debt and their borrowers. As a result a derivative can have thousands of loans all with different levels of risk. Prior to 2008, risks were increased intentionally by some ratings agencies who happen to have been owned or had a business relationship with issuing banks, providing exaggerated ratings such as AAA to derivatives that should have had an uncertain or even junk status*. Therefore what appeared to be a derivative price that offered a high return was in fact a fraudulent and very high risk asset. This problem still exists, even when there is no fraud, because of the attenuated oversight of derivative content quality and the difficulty of gaining a more meaningful and cost-efficient assessment.

*  A derivative's rating is often a function of interest rates and general state of the economy related to the ability of debtors to pay the premiums. Therefore the push to sell off derivatives with uncertain ratings accelerated during 2007 because the holders realised that in spite of having being dihonestly branded as AAA, as a fraudulent sales technique, they were fast becoming junk derivatives.

Updated: 30/05/2022 (typos and clarififcations - no change in sense)

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