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MMT Macro Final Exam (1/3)

During the last two semesters, I taught Macroeconomics based on a new approach which re-incorporate the history that Economists forgot (See  Method or Madness?). The central idea of the course is that economic theories cannot be understood outside of their historical context. Conversely, economic history cannot be understood except by studying the economic theories (right or wrong) which were used by contemporaries to shape policy responses to historical events. The website for the entire course is “Macroeconomics“. In particular, Lecture 18B explains the principle of “Entanglement“. Below I provide Final Exam questions and answers, to give the flavor of the course. This post is about the first 4 out of 12 questions.

Q1: Stiglitz: “Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.” Explain the theory, and arguments for it. Then explain why it is sheer nonsense.

A1: The Theory:The Ricardian equivalence theory states that if government tries to increase aggregate demand through deficit spending, it will not succeed. The people will start saving because they expect that govt. will raise taxes to pay for the higher spending. As a result of saving, their current spending decreases, their current saving increases, hence resulting in no effect on aggregate demand.

Counter Argument: The assumption that govt. require taxation to generate resources and finance its spending is absurd as a sovereign govt. does not rely on taxes but can print its own money. There is no long run constraint on the government to balance budgets, and it can run any level of deficit forever. MMT states that the purpose of taxation is not to generate resources of govt. but to regulate consumption, redistribute income and in some cases to relieve inflationary pressure.

See also post on:   The Fallacy of Ricardian Equivalence .

Q2: Standard Theory: There are two ways to finance deficits – one is inflationary, while the other raises interest rates and reduces investments. Both methods cause economic harm. Explain the standard theory and explain the MMT view that this theory is sheer nonsense.

A2: There are two methods by which governments finance deficits.

1. Printing Money: Printing more money will lead to increase in money supply resulting in inflation.
2. Borrowing Money: It will increase in demand for loanable funds, leading to an increase in interest rate. This will increase cost of investment, as investment will go down. The so called “crowding out” for private investors, if they have to compete for finances.

MMT views: [i] Printing more money will not necessarily lead to inflation if full employment does not hold. In such cases, Govt. spending directed at the sectors with underemployment will increase employment which will raise output without increasing inflation.  Financing budget deficit by printing money will not create inflation because increased money is accompanied by increase output. Of course, government spending directed at sectors where full employment obtains will cause prices to rise in that sector (inflation). However, even this may not be harmful, since the increased price would signal excess demand, which would be met by an increase in productive capacity in the long run.  [ii]  Government borrowing does not cause “crowding out” as per traditional macro mechanism. The price of government borrowing from private sector is set by the policy rate determined by the Central Bank. This price is not affected by demand and supply considerations, since the Central Bank Open Market Operations ensure that the supply of money is adjusted to match inter-bank borrowing rate to the policy rate. Bank lending to private sector is done by money creation, and is not constrained by the money supply created by the Central Bank. Bank provide loans and then borrow reserves to meet the reserve requirements. The lending will depend on the demand for loans, the policy rate, and the market conditions (expectations). It will not be affected by government borrowing except indirectly. The indirect mechanism is that banks operate to maintain ROI at a certain minimum acceptable, or achievable level. If they can achieve the required rate of profits by utilizing certain investments in government bonds, they will not be motivated to lend to the private sector. This would a kind of “crowding out”, although the mechanism is very different from the standard theory.

Q3: The Central Bank cannot control both the overnight discount rate and the supply of money; it can only do one or the other. Explain this statement, and how it shows that the theory of the money multiplier is wrong.

A3: If the Central Bank decides on maintaining a particular discount rate, it will have to carry out open market operations to maintain this rate. If there are excess fund in the inter-bank borrowing market, there will be downward pressure on the inter-bank borrowing rate. The Central bank will have to mop up extra money by money market operations, to prevent the KIBOR from falling below a specified amount under the target policy rate. If the inter-bank borrowing rate rises above the target policy rate, the Central Bank must inject money to prevent the rate from rising above the specified target policy rate, The Central Bank injects reserves (HPM) by purchasing T-bills, and does mop-up operations by selling T-bills. The quantity of reserves being supplied or withdrawn depends on the policy rate, and cannot be varied independently.

The multiplier theory is wrong for two reasons. One is what has been pointed out above – the quantity of reserves being supplied to the private banking sector is not freely controlled by the Central Bank; rather it is varied to maintain the overnight discount rate at the target policy level. Secondly, private bank lending is not constrained by the reserves the that Central Bank creates. If the private bank finds a good loan (credit-worthy borrower with suitable collateral), it will not be constrained by lack of reserves. It will make the loan, and then borrow reserves to meet the reserve requirement. The Central Bank is required to provide these loans as demanded by private banking sector, so reserves will be generated as per needs of the private sector banks.

Q4: Explain the key identity of MMT: Government Injections + Foreign Injections = Private Surplus. Also explain the implications of this identity in terms of how we should think about government budget deficits and trade deficits (BOP).

A4: Government Injections into private sector money holdings are created by budget deficits, while Foreign Injections are created by Trade Surplus. Thus sum of these two injections equals the private sector surplus, which the sum of domestic household savings plus profits of domestic firms. This is further explained below

Budget deficit means that govt. expenditure is greater than govt. revenue. Govt. spending results in the earnings of the private sector while govt. revenue constitutes taxes collected from the private sector. Budget Deficit means that the government spends money into the private sector which it has not collected in taxes thereby injecting money into the economy. This money translates into a surplus in the private sector which creates profits and savings, and represents aggregate demand for goods and services coming from outside the private sector.

Trade surplus means that export receipts are greater than spending on imports. Domestic spending on imports is a leakage, and lowers the aggregate demand for domestic goods. Foreign demand is an injection which increases the aggregate demand, injecting foreign money into the domestic economy. The difference is the net increase in aggregate demand for domestic goods, which is paid for by foreign injections, which create private saving and firm profits.

This equality has enormous implications for fiscal and monetary policy. In an economy which runs a trade deficit, the private sector is spending more on imports than it is earning in exports. Thus net private surplus must be negative – the money being sent outside to foreigner can come from savings of households, or from losses (instead of profits) of firms. The government must run a deficit larger than this amount in order to make it possible for the firms to make profits and for the households to make savings. As MMT shows, and our classroom models confirmed, the government can run a deficit indefinitely, without worrying about sustainability. However this situation, with permanent trade deficit is not sustainable because the government and/or private parties must borrow foreign exchange to pay back foreign debt. That is, unless foreigners are willing to hold your currency in the long term. Only In situations of trade surplus is it possible for the government to balance the budget while the firms makes profits and household savings increase. Even in such cases, depending on particulars, it may be advisable for the government to run a deficit, in order to allow greater profits and savings in the domestic sector [There are many other ways to explain the implications of the fundamental sectoral balance equation of MMT]

Real Statistics: An Islamic Approach

The nominalist and positivist methodology at the heart of Western approaches lead to a discipline which is built on fraud. I am in process of constructing an alternative approach. I have been working on this for over a decade, and now I am ready for a final writeup. I am starting to put together a draft for a new textbook with this title. Comments be readers, negative or positive, and especially with respect to Comprehensibility, Clarity, and Coherence, of what I am saying, would be most welcome and helpful in improving my presentation. Mis-understanding of the nature and role of statistics is responsible for the devastating impact of ‘logical positivism’ on our thought processes — as in the effort to measure intelligence via an IQ test.

An Islamic WorldView

In the name of Allah, the Merciful and the Beneficent

Introductory remarks (regarding Draft of Introductory Chapter of a Planned Textbooks on this topic) The title creates a strong negative reaction in most people — what is the need to bring Islam into everything? Must we have an Islamic approach to adding 2+2, to distinguish it from the Western approach? The problem is that over-enthusiastic reformers have indeed done such things in the past. In the zeal to show how Islam applies to everything, they have misrepresented both Islamic teachings and the stock of existing knowledge, creating distrust and suspicion for similar efforts. But just because there are a thousand religions which are wrong, this does not mean that we should abandon the effort to paint Islam as the unique true religion. Just because there have been a lot of unsuccessful efforts at the Islamization of Knowledge does not…

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Do we need environmental ethics?

Environmental ethics is a field of applied ethics concerned with the ethical dimension of human relationship towards nature. The term environmental ethics covers a variety of approaches that can be roughly divided into two camps: anthropocentrism and non-anthropocentrism. Anthropocentrism refers to a human-centered approach to environmental problems that protects nature for humans. Radical anthropocentrism is often equated with the view that only human beings have intrinsic value, and sees nature as having only instrumental value. Non-anthropocentrism encompasses a variety of approaches connected by the belief that nonhuman entities also have value that is not reducible to anthropocentric interests. It often questions the propriety of human interests and preferences as a sufficient basis for environmental decision-making (Routley 1973). Environmental ethics is inherently pluralistic, representing a wide variety of socio-environmental values and beliefs. Its overarching goal is to prompt change in collective practices and individual behaviours.

Environmental ethics developed as a separate field of enquiry and action in response to the fact that ecological crisis is driven by human activities (Attfield 2017). Even though it is difficult to predict the scope and speed of environmental change—such as biodiversity loss, pollution, and climate change—the scientific community rests on consensus that contemporary environmental problems are humanly induced (see Gardiner 2010 in relation to climate change). This recognition led to problematising the human-environment relationship in ethical terms, and looking at environmental problems as moral ones.

Social change fostered by environmental ethics is meant to counteract what is believed to underlie the unsustainable, extractive paradigm of human activities: the attitude of dominion and the instrumentalist view of nature ingrained in the Western system of values. In this broad sense, environmental ethics advocacy diverges from the dominant neoliberal paradigm with its focus on human-centred values, markets and economic growth. But according to some environmental pragmatists, such a strong normative position and the rhetoric of intrinsic value may impair its capacity to induce a broader change because it is too detached from the existing social and political reality (e.g., Minter 2012, Norton 1984). There are also concerns about the effectiveness of grounding environmental action on moral foundations for different reasons. For example, John Pezzey points that relying on moral progress and philosophical arguments to really make a difference may be too slow; instead, appeals to solid scientific information may provide a sound and sufficient basis for expanding our horizons and motivating actions for sustainability (Pezzey 1992).

It looks as if the choice is between moral arguments and some kind of rationalism, or even scientism. Do we need an environmental ethics? I claim that we do. In face of scientific uncertainty regarding the scope of environmental hazards, we cannot avoid making judgments that are as much about values as they are about facts. Indeed, access to solid information is an important aspect of advancing environmental responsibility. But our beliefs about the world—which include moral beliefs and values—impact our perception and assessment of scientific information. Environmental ethics can facilitate expanding scientific horizons by looking outside of the box of our received systems of beliefs.

The dominant socio-economic practices exacerbate ecological problems and widen inequalities. Alternatives emerging in response to these problems call for a new societal narrative for economic practices (e.g., Daly and Cobb 1994, Söderbaum 2008). Environmental ethics articulates a trend that counteracts the extractive paradigm of human practices, unfettered economic growth, and insatiable human desires. A new societal narrative inspired by environmental ethics is based on the recognition of our share in the current, unbalanced situation. It is founded on ethical values of responsibility towards each other and the world, reverence for life, and respect towards other people and the planet (e.g., Schweitzer 1993, Leopold 1994).

The alternative paradigm informed by environmental concerns aims to challenge the status quo and implement a profound change in how we use our limited resources. That means a necessity of a complete makeover of economy, society, and individual behaviours. Such transition is urgently needed in order to move socio-economic systems towards a more sustainable and responsible modus operandi (cf. Dereniowska and Matzke 2014). It can be sustainably achieved by shifting emphasis on what matters to us. For example, a new narrative may promote sufficiency over efficiency and expanding our measures of success in welfare and well-being to better include environmental factors. This paradigmatic shift may also involve changing the norms of socio-economic interactions from those of competition and a search for profit towards more cooperation and appreciation of non-monetary values for a sustainable economy and society. Such a change will be more robust if it is based on a redefinition of the human relationship with nature from that of dominion over nature towards stewardship, duly noting our place within nature (not above it). 

Issues linked to environmental ethics broaden the scope of a normative reflection in economics and about economics in society. For example, this perspective helps to account for intrinsic motivation to care for nature. For many people nature has value on its own, independently of its usefulness for humans (see a study of Butler & Acott 2007 on the social perception of the intrinsic value of nature). Environmental ethics articulates these moral intuitions and promotes environmental values in wider society. It also stimulates some game-changing concerns for public policy. For instance, without sustainable environment there can be no sustainable economy. Preserving the environment means preserving conditions of life for us and for the non-human world. Furthermore, environmental problems are transborder issues, and it is our collective responsibility to address them in a global perspective. Adequate policy solutions will require curbing economic freedom through social justice and environmental regulations. The arising questions about the limits to growth and models for sustainable economies are deeply normative and become unavoidable. To answer them, economists need to team up with environmental and social scientists, and ethicists.

What we chose to value and to preserve ultimately says something about us. Through our practiced values we are co-writing a societal narrative that shapes our society and economy. A stance that is oblivious to values in virtue of ethical neutrality is still a normative choice that says something about us. Environmental ethics can encourage us to take a stand in times of crisis. It can also inform alternative principles of resource allocation and socio-economic security. Since the economics education for the most part is driven by the perspective that separates economic reasoning from moral one, engaging with environmental ethics has potential to open up alternative ways of thinking on contemporary problems. 

References

Attfield, R. (2014). Environmental Ethics: An Overview for the Twenty-First Century. Cambridge: Polity.

Bullard, R. D. (2005). The Quest for Environmental Justice. Human Rights and the Politics of Recognition. Berkeley: Counterpoint.

Butler, W. F. and T. G. Acott. (2007). An inquiry concerning the acceptance of intrinsic value theories of nature” Environmental Values 12(2): 149–168.

Daly, H. E. and J. B. Cobb. (1994). For the common good. Redirecting the economy toward community, the environment, and a sustainable future. Boston: Beacon Press. 

Dereniowska, M. and J. Matzke. (2014). Interdisciplinary foundations for environmental and sustainability ethics: An introduction. Ethics in Progress 5(1): 07-32. 

Horii, R. and M. Ikefuji (2015). Environment and Growth. In S. Managi (Ed.), The Routledge Handbook of Environmental Economics in Asia (pp. 3-29). London & New York: Routledge.

Leopold, A. (1994). A sand county almanac. And other sketches here and there. Oxford University Press.

Minteer, B. A. 2012. Refounding Environmental Ethics: Pragmatism, Principle, and Practice. Philadelphia: Temple University Press.

Norton, B. G. (1984). Environmental Ethics and Weak. Anthropocentrism. Environmental Ethics. 6(2), 131-148.

Pezzey, J. (1992). Sustainability: An Interdisciplinary Guide. Environmental Values, 1(4), 321–362.

Routley, R. (1973). Is There a Need for a New, an Environmental Ethic? Proceedings of the XVth World Congress of Philosophy 1:205-210.

Söderbaum, P. (2008). Understanding Sustainability Economics. Towards Pluralism in Economics. London: Earthscan..

Schweitzer, A. (1993). Reverence for Life. The Words of Albert Schweitzer. Compiled by H. E. Robles. Harper Collins.

The Hundred Years’ Peace

Below, I will reproduce extracts from the opening Chapter, titled as above, of Karl Polanyi’s  The Great Transformation: the Political and Economic Origins of Our Times . This is essential background in conjunction with the history of Central Banking which was covered in  Lecture 13  of  Advanced Macro II . The central concept underlying the course is that of “Entanglement (Lecture 18B) “ – economic theories can only be understood within their historical context, and also, history can only be understood in light of theories being used by contemporaries to understand and respond to this history. The first segment of the lecture was discussed in two previous posts.  “Origins of Central Banking“  describes the historical context within which the Bank of England was created. “Monetization, Maturity Transformation, and MMT“ describes the theoretical lessons about money and money creation that we learn from this history. The next segment of the lecture deals with the evolution of Central Banking over the period 1800-1914. To understand this, we need to study the history of these times. By an amazing coincidence, Karl Polanyi has identified this period as “The Hundred Years’ Peace“ . Below we provide extracts from this first chapter, partly for the relevant background, but also to illustrate his excellent writing style. Material in italics are my comments on the text:

First Section: Writing in the post WW2 period. Introduces the broad themes and concerns of the book as a whole. Explanation is built around four institutions — the now forgotten Institutional Economics. He argues that it was the collapse of the Gold Standard that led to WW2. This is what links Polanyi’s history to the understanding of roles and functions of Central Banks, which is our goal. He relates the Gold Standard to the myth of the Self-Regulating Market, which is at the heart of the market economy. This section is reproduced in toto, because it provides a broad outline of the main arguments of the book itself.  

Nineteenth century civilization has collapsed. This book is con­cerned with the political and economic origins of this event, as well as with the great transformation which it ushered in.

Nineteenth century civilization rested on four institutions. The first was the balance-of-power system which for a century prevented the occurrence of any long and devastating war between the Great Powers. The second was the international gold standard which symbolized a unique organization of world economy. The third was the self-regu­lating market which produced an unheard-of material welfare. The fourth was the liberal state. Classified in one way, two of these insti­tutions were economic, two political. Classified in another way, two of them were national, two international. Between them they deter­mined the characteristic outlines of the history of our civilization.

Of these institutions the gold standard proved crucial; its fall was the proximate cause of the catastrophe. By the time it failed most of the other institutions had been sacrificed in a vain effort to save it.

But the fount and matrix of the system was the self-regulating market. It was this innovation which gave rise to a specific civilization. The gold standard was merely an attempt to extend the domestic market system to the international field; the balance-of-power system was a superstructure erected upon and, partly, worked through the gold standard; the liberal state was itself a creation of the self-regulating market. The key to the institutional system of the nineteenth century lay in the laws governing market economy.

Our thesis is that the idea of a self-adjusting market implied a stark Utopia. Such an institution could not exist for any length of time with­out annihilating the human and natural substance of society; it would have physically destroyed man and transformed his surroundings into a wilderness. Inevitably, society took measures to protect itself, but whatever measures it took impaired the self-regulation of the market, disorganized industrial life, and thus endangered society in yet another way. It was this dilemma which forced the development of the market system into a definite groove and finally disrupted the social organi­zation based upon it.

Above paragraph introduces the theme of the “Double Movement” — Markets seek to expand, while Society seeks to protect itself from the deadly effects of the expansions of markets. See my  Summary of the Great Transformation .

[Omitted material]

Ours is not a historical work; what we are searching for is not a convincing sequence of outstanding events, but an explanation of their trend in terms of human institutions. We shall feel free to dwell on scenes of the past with the sole object of throwing light on matters of the present; we shall make detailed analyses of critical periods and almost completely disregard the connecting stretches of time; we shall encroach upon the field of several disciplines in the pursuit of this single aim.

First we shall deal with the collapse of the international system. We shall try to show that the balance-of-power system could not ensure peace once the world economy on which it rested had failed. This accounts for the abruptness with which the break occurred, the incon­ceivable rapidity of the dissolution.

But if the breakdown of our civilization was timed by the failure of world economy, it was certainly not caused by it. Its origins lay more than a hundred years back in that social and technological up­heaval from which the idea of a self-regulating market sprang in Western Europe. The end of this venture has come in our time; it closes a distinct stage in the history of industrial civilization.

A Failed Prophecy — Polanyi thought that WW2 had represented the self-destruction of the market society, and humanity would go back to saner ways of organizing economic production. Unfortunately, market society was restored with a vengeance, and now it is bent on creating a complete collapse of the entire planetary ecological system. Note the prescient words of Polanyi cited above: Such an institution could not exist for any length of time with­out annihilating the human and natural substance of society; it would have physically destroyed man and transformed his surroundings into a wilderness. This is precisely what is happening to the planet today directly as a result of the unregulated workings of capitalism. 

Polanyi argues that exceptional peace prevailed in Europe from 1815-1914 due to the working of “haute finance”. The interests of the financiers in keeping European powers from fighting each other were very strong, and it was this interest which kept peace between the powers. This peace interest rested on the gold standard, which permitted international trade at stable rates of exchange. Once the gold standard broke down, the economies of different European economies were de-linked, and this destroyed the interest of high finance in maintaining peace. 

Second Section: The Hundred Years Peace: Here Polanyi sets out the puzzle — explains how peace is exceptional in European history, and also explains that the century did not lack in issues over which wars take place. Thus, wars were prevented, and threats to peace extinguished, by operation of some special force which needs to be investigated.

The nineteenth century produced a phenomenon unheard of in the annals of Western civilization, namely, a hundred years’ peace—1815-1914. Apart from the Crimean War—a more or less colonial event— England, France, Prussia, Austria, Italy, and Russia were engaged in war among each other for altogether only eighteen months. A com­putation of comparable figures for the two preceding centuries gives an average of sixty to seventy years of major wars in each. But even the fiercest of nineteenth century conflagrations, the Franco-Prussian War of 1870-71, ended after less than a year’s duration with the defeated nation being able to pay over an unprecedented sum as an indemnity without any disturbance of the currencies concerned.

This triumph of a pragmatic pacifism was certainly not the result of an absence of grave causes for conflict. [Omitted materials – long list of potential war-causing conflicts of interests among the European powers. In each case listed, war was averted]

Thus under varying forms and ever-shifting ideologies— sometimes in the name of progress and liberty, sometimes by the author­ity of the throne and the altar, sometimes by grace of the stock exchange and the checkbook, sometimes by corruption and bribery, sometimes by moral argument and enlightened appeal, sometimes by the broadside and the bayonet—one and the same result was attained: peace was preserved.

Meta-Theoretical Note: A group (haute finance) with power and means protects financial interests by maintaining peace using a wide variety of means over the course of a century. This kind of explanation is shunned by positivist historians, who are now prominent in the field. If we only look at the surface of history – who did what to whom and when — we will be unable to see the underlying unity, because the same peace motive is expressed in a bewildering variety of surface forms.  

This almost miraculous performance was due to the working of the balance of power, which here produced a result which is normally foreign to it. By its nature that balance effects an entirely different result, namely, the survival of the power units involved; in fact, it merely postulates that three or more units capable of exerting power will always behave in such a way as to combine the power of the weaker units against any increase in power of the strongest. In the realm of universal history balance of power was concerned with states whose independence it served to maintain. But it attained this end only by continuous war between changing partners. The practice of the ancient Greek or the Northern Italian city-states was such an instance; wars between shifting groups of combatants maintained the independence of those states over long stretches of time. The action of the same prin­ciple safeguarded for over two hundred years the sovereignty of the states forming Europe at the time of the Treaty of Mimster and West­phalia (1648). When, seventy-five years later, in the Treaty of Utrecht, the signatories declared their formal adherence to this prin­ciple, they thereby embodied it in a system, and thus established mutual guarantees of survival for the strong and the weak alike through the medium of war. The fact that in the nineteenth century the same mechanism resulted in peace rather than war is a problem to challenge the historian.

Polanyi has now set up the problem he proposes to solve: Why did peace break-out? Why did historical events which led to wars in the past, did not do so over the Hundred-Years? 

Third Section: Explanation of the Hundred Years Peace as due to emergence of a Peace Interest — Haute Finance was interested in maintaining Peace among European Powers to protect global investments made across national boundaries. Very interestingly, he notes that literary discourse changed to reflect the peace interest. Patriotism went from being a prized virtue to a barbaric atavism! This change reflects the influence and power of haute finance. A very important theme throughout this work is the idea that a social purpose becomes effective only when it is made concrete and operational in the form of an institution. Institutions are embodiments of social goals. This ability to see through institution to the underlying spirit is extremely anti-positivists, and accounts for the clarity of Polanyi, and the confusion of the positivist historians, who can only string together sequences of observable facts without being able to discern the underlying causes. 

[Omitted material explaining the varied and complex constellation of classes with interests in maintaining peace]

Interests, however, like intents, necessarily remain platonic unless they are translated into politics by the means of some social instrumen­tality. Superficially, such a vehicle of realization was lacking; both the Holy Alliance and the Concert of Europe were, ultimately, mere group­ings of independent sovereign states, and thus subject to the balance of power and its mechanism of war. How then was peace maintained?

Fourth Section: After describing specific details of peaceful outcomes, the surface events, Polanyi turns to examination of the deeper causes , which led to these outcomes. In particular, he focuses on the role of haute finance. He describes how these transnational financiers had interest in maintaining peace, to protect their investments, and also how they acted to do so.

But the Concert of Europe, which succeeded it (The Holy Alliance), lacked the feudal «s well as the clerical tentacles; it amounted at the best to a loose federa­tion not comparable in coherence to Metternich-‘s masterpiece. Only on rare occasions could a meeting of the Powers be called, and their jealousies allowed a wide latitude to intrigue, crosscurrents, and diplo­matic sabotage; joint military action became rare. And yet what the Holy Alliance, with its complete unity of thought and purpose, could achieve in Europe only with the help of frequent armed interventions was here accomplished on a world scale by the shadowy entity called the Concert of Europe with the help of a very much less frequent and oppressive use of force. For an explanation of this amazing feat, we must seek for some undisclosed powerful social instrumentality at work in the new setting, which could play the role of dynasties and episcopades under the old and make the peace interest effective. This anonymous factor was haute finance.

Haute finance, an institution sui generis, peculiar to the last third of the nine­teenth and the first third of the twentieth century, functioned as the main link between the political and the economic organization of the world in this period. It supplied the instruments for an international peace system, which was worked with the help of the Powers, but which the. Powers themselves could neither have established nor main­tained. While the Concert of Europe acted only at intervals, haute finance functioned as a permanent agency of the most elastic kind. Independent of single governments, even of the most powerful, it was in touch with all; independent of the central banks, even of the Bank of England, it was closely connected with them. There was intimate con­tact between finance and diplomacy; neither would consider any long-range plan, whether peaceful or warlike, without making sure of the other’s good will. Yet the secret of the successful maintenance of gen­eral peace lay undoubtedly in the position, organization, and techniques of international finance.

Both the personnel and the motives of this singular body invested it with a status the roots of which were securely grounded in the private sphere of strictly business interest. The Rothschilds were subject to no one government; as a family they embodied the abstract principle of internationalism; their loyalty was to a firm, the credit of which had become the only supranational link between political government and industrial effort in a swiftly growing world economy. In the last resort, their independence sprang from the needs of the time which demanded a sovereign agent commanding the confidence of national statesmen and of the international investor alike; it was to this vital need that the metaphysical extraterritoriality of a Jewish bankers’ dynasty domiciled in the capitals of Europe provided an almost perfect solution. They were anything but pacifists; they had made their fortune in the financ­ing of wars; they were impervious to moral consideration; they had no objection to any number of minor, short, or localized wars. But their business would be impaired if a general war between the Great Powers should interfere with the monetary foundations of the system. By the logic of facts it fell to them to maintain the requisites of general peace in the midst of the revolutionary transformation to which the peoples of the planet were subject.

Organizationally, haute finance was the nucleus of one of the most complex institutions the history of man has produced. [Omitted materials detailing this complexity]

Haute finance was not designed as an instrument of peace; this function fell to it by accident. The motive of haute finance was gain; to attain it, it was necessary to keep in with the governments whose end was power and conquest. (…) The organization and personnel of haute finance, on the other hand, was international, yet not, therefore, alto­gether independent of national organization. For haute finance was able to serve a new interest, which had no specific organ of its own, for the service of which no other institution happened to be available, and which was nevertheless of vital importance to the community: namely, peace. Not peace at all cost, not even peace at the price of any ingredient of independence, sovereignty, vested glory, or future aspira­tions of the powers concerned, but nevertheless peace, if it was possible to attain it without such sacrifice.

Not otherwise. Power had precedence over profit. [Omitted historical materials to prove that national power considerations trumped commercial considerations]

International finance had to cope with the conflicting ambitions and intrigues of the great and small powers. (,,,) And yet by functional determination it fell to haute finance to avert general wars. The vast majority of the holders of government securities, as well as other in­vestors and traders, were bound to be the first losers in such wars, especially if the currencies were affected. The influence that haute finance exerted on the Powers was consistently favorable to European peace. And this influence was effective to the degree to which the gov­ernments themselves depended upon its co-operation in more than one direction. Consequently, there was never a time when the peace in­terest was unrepresented in the councils of the Concert of Europe. If we add to this the growing peace interest inside every nation where the investment habit had taken root, we shall begin to see why the awful innovation of an armed peace of dozens of practically mobilized states could hover over Europe from 1871 to 1914 without bursting forth in a shattering conflagration.

Fifth Section: Haute Finance promoted peace to protect international investments. Constitutional Governments, with budgets, and gold standard, were enforced, because these suited international investors — Austerity was required because expansionary monetary policies would adversely affect exchange rates and damage positions of foreign investors. IMF plays exactly the same role today — though this happened after Polanyi’s writing.  

Finance—this was one of its channels of influence—acted as a powerful moderator in the councils and policies of a number of smaller sovereign states. Loans, and the renewal of loans, hinged upon credit, and credit upon good behavior. Since, under constitutional govern­ment (unconstitutional ones were severely frowned upon), behavior is reflected in the budget and the external value of the currency cannot be detached from the appreciation of the budget, debtor governments were well advised to watch their exchanges carefully and to avoid policies which might reflect upon the soundness of the budgetary posi­tion. This useful maxim became a cogent rule of conduct once a coun­try had adopted the gold standard, which limited permissible fluctua­tions to a minimum. Gold standard and constitutionalism were the instruments which made the voice of the City of London heard in many smaller countries which had adopted these symbols of adherence to the new international order. The Pax Britannica held its sway sometimes by the ominous poise of heavy ship’s cannon, but more frequently it prevailed by the timely pull of a thread in the international monetary network.

[Omitted historical material which traces how haute finance operated across the globe, avoiding wars between European]

We have become too much accustomed to think of the spread of capitalism as a process which is anything but peaceful, and of finance capital as the chief instigator of innumerable colonial crimes and ex­pansionist aggressions. Its intimate affiliation with heavy industries made Lenin assert that finance capital was responsible for imperialism, notably for the struggle for spheres of influence, concessions, extrater­ritorial rights, and the innumerable forms in which the Western Powers got a stranglehold on backward regions, in order to invest in railways, public utilities, ports, and other permanent establishments on which their heavy industries made profits. Actually, business and finance were responsible for many colonial wars, but also for the fact that a general conflagration was avoided. Their affiliations with heavy industry, though really close only in Germany, accounted for both. Finance capi­tal as the roof organization of heavy industry was affiliated with the various branches of industry in too many ways to allow one group to determine its policy. For every one interest that was furthered by war, there were a dozen that would be adversely affected. International capital, of course, was bound to be the loser in case of war; but even national finance could gain only exceptionally, though frequently enough to account for dozens of colonial wars, as long as they remained isolated. Every war, almost, was organized by financiers; but peace also was organized by them.

The precise nature of this strictly pragmatic system, which guarded with extreme rigor against a general war while providing for peaceful business amidst an endless sequence of minor ones, is best demonstrated by the changes it brought about in international law. While nationalism and industry distinctly tended to make wars more ferocious and total, effective safeguards were erected for the continuance of peaceful busi­ness in wartime.  [Omitted Material: many examples of how commerce continued, despite wars].

Thus the new organization of economic life provided the back­ground of the Hundred Years’ Peace. (omitted historical details) in every case peace was maintained not simply through the chancelleries of the Great Powers but with the help of concrete organized agencies acting in the service of general interests. In other words, only on the background of the new economy could the balance-of-power system make general conflagrations avoidable. But the achievement of the Concert of Europe was incomparably greater than that of the Holy Alliance; for the latter maintained peace in a limited region in an unchanging Continent, while the former succeeded in the same task on a world scale while social and economic progress was revolutionizing the map of the globe. This great political feat was the result of the emergence of a specific entity, haute finance, which was the given link between the political and the economic organization of international life.

It must be clear by this time that the peace organization rested upon economic organization. Yet the two were of very different consistency. Only in the widest sense of the term was it possible to speak of a polit­ical peace organization of the world, for the Concert of Europe was essentially not a system of peace but merely of independent sovereign­ties protected by the mechanism of war. The contrary is true of the economic organization of the world. Unless we defer to the uncritical practice of restricting the term “organization” to centrally directed bodies acting through functionaries of their own, we must concede that nothing could be more definite than the universally accepted principles upon which this organization rested and nothing more concrete than its factual elements. Budgets and armaments, foreign trade and raw material supplies, national independence and sovereignty were now the functions of currency and credit.

By the fourth quarter of the nine­teenth century, world commodity prices were the central reality in the lives of millions of Continental peasants; the repercussions of the Lon­don money market were daily noted by businessmen all over the world; and governments discussed plans for the future in light of the situation on the world capital markets. Only a madman would have doubted that the international economic system was the axis of the material existence of the race. Because this system needed peace in order to function, the balance of power was made to serve it. Take this eco­nomic system away and the peace interest would disappear from poli­tics. Apart from it, there was neither sufficient cause for such an inter­est, nor a possibility of safeguarding it, in so far as it existed. The suc­cess of the Concert of Europe sprang from the needs of the new interna­tional organization of economy, and would inevitably end with its dissolution.

[Omitted Materials: Dizzyingly complex and shifting constellations of powers and economic regimes, but through all the changes, peace was preserved]

In the nineties haute finance was at its peak and peace seemed more secure than ever. British and French interests differed in Africa; the British and the Russians were competing with one another in Asia; the Concert, though limpingly, continued to function; in spite of the Triple Alliance, there were still more than two independent powers to watch one another jealously. Not for long. In 1904, Britain made a sweeping deal with France over Morocco and Egypt; a couple of years later she compromised with Russia over Persia, and the counter alliance was formed. The Concert of Europe, that loose federation of independent powers, was finally replaced by two hostile power group­ings ; the balance of power as a system had now come to an end. With only two competing power groups left its mechanism ceased to function. There was no longer a third group which would unite with one of the other two to thwart whichever one sought to increase its power. About the same time the symptoms of the dissolution of the existing forms of world economy—colonial rivalry and competition for exotic markets— became acute. The ability of haute finance to avert the spread of wars was diminishing rapidly. For another seven years peace dragged on but it was only a question of time before the dissolution of nineteenth cen­tury economic organization would bring the Hundred Years’ Peace to a close.

In the light of this recognition the true nature of the highly artificial economic organization on which peace rested becomes of utmost sig­nificance to the historian.

Concluding Remarks: Trans-national character of haute finance led to the emergence of a powerful force, backed by enormous amounts of money, which had interest in maintaining peace between European powers. This interest was actualized by the use of available institutions, namely the balance of power being maintained by the Concert of Europe. The balance of power ended in 1904 (as above). Also, the economic system based on exploiting exotic markets came to a close as about 85% of the globe came under European influence in early twentieth century — there was no more colonies to conquer. Breakdown of balance of power, together with the zero-sum nature of trade — one power could only benefit at expense of the other — led to the outbreak of WW1. Note that Polanyi’s account dynamites the methodology of modern economics, by showing the inseparable linkage between politics and economics, and also the necessity of looking at the historical context. This historical background provides the context for the study of the role and functions of Central Banks in the period 1800-1914, as discussed in Lecture 13, based on a paper by Goodhart. This analysis will be taken up in the next post.   

 

Monetization, Maturity Tranformation, and MMT

In a previous post on “Origins of Central Banking“ the history of  creation of Bank of England was described. In this post, we discuss the deeper lessons to be learned from this history, and how this supports the MMT view of the world. We also clarify and make explicit some key aspects of the banking process embedded in this history.

Monetization of Debt & Maturity Transformation: Crucial concepts, relevant today, to understand how banking works. King William borrowed GBP 1.2 million from BoE. The “loan” should be understood as a  maturity transformation  – a key to how banks work, even today. Assume for simplicity that BoE does not actually have ANY gold in its possession. It makes a loan to King William III (KW3) of gold (which it does not have) by opening an account in the name of KW3, and promising to honor all checks written by KW3. Now BoE has made a Loan which will mature in 5 years, so this is a long maturity loan. In order to honor incoming checks, BoE will borrow gold short term from Gold Dealers XYZ and pay off, in gold, anyone who presents checks written by KW3. We can simplify the picture by assuming that BoE borrows only on an overnite basis, but does so continuously every day, in quantities required by the demands presented to it. So, the long-term loan five-year loan is transformed into a sequence of over-nite loans; this is the “maturity transformation”. But why would BoE want to do this? Because it gains great benefits by “monetizing” the debt. The monetization occurs when BoE issues paper notes of GBP 100 each, for any purpose whatsoever. On the face of the note, it is written that BoE promises to pay the holder of the note GBP 100 worth of gold upon presentation of the note. This promise of BoE is BACKED by a Sovereign Guarantee – that is the promise of KW3 to pay BoE 1.2 million pounds 5 years from now.

House of Smoke and Mirrors! The surface appearances are so radically different from the underlying reality! Let us analyze in greater detail what appears to happen, and contrast it with what actually happens. On the surface, it appears that KW3 needed gold of 1.2 million GBP, and BoE had this gold, which it gave to KW3 as a loan. It will make profits from the interest payments on the loan on an annual basis – collecting taxes on behalf of the King for this purpose. At the end of five years, BoE will get back the gold that it gave to the King. This is a standard interest-based loan. This understanding of how banks operate reflects the “Financial Intermediation” theory which is faithfully depicted in textbooks, and shapes thinking of conventional economists (like Krugman) about how the world of finance works. Now let us look at what really happens, in order to be able to admire the amazing audacity and cunning of the financiers – no wonder they rule the world today.

BoE lends KW3 1.2 million GBP with nothing in its pockets! They simply open an account and put an entry in the ledger in the amount, showing the KW3 has a deposit of this amount. They borrow gold as needed to pay off incoming checks in gold. Of course, to be able to borrow, they need to have good credit. This creditworthiness is achieved partly because they have their own reserves of gold. But an important additional factor is the “monetization”: The counterpart to this deposit of 1.2m GBP in the name of KW3, is an incoming payment, due in five years, of 1.2 million GBP of gold. This is an IOU note by KW3 where KW3 promises to BoE 1.2 million five years from now. Now this promise of the King is the asset which BoE will monetize. BoE can create 1.2 million GBP worth of paper notes, all of which are backed by a sovereign guarantee. A 100 GBP note issued by the BoE is actually a promise to pay the owner of the note from the gold which the KW3 will pay the bank five years from now – this is the sense in which the note is backed by the sovereign guarantee.  However, the owner of the note might have an urgent need; he may not want to wait for five years to be paid in gold. No problem! Anyone who presents the note for encashment receives gold which BoE borrows in order to honor its long term guarantee. Once this system is operational and working smoothly, owners of the notes issued by BoE think of them as being “as good as gold”. The Bank of England honors all requests to convert notes into gold smoothly and quickly, without a hitch. People stop converting notes to gold because everyone is confident that this can be done. Once confidence in the promise of BoE is established, the BoE is in a position to print gold, because its notes are considered as being equivalent to gold by the public.

This is the bonanza for Bank of England – it acquires the ability to print notes which are considered as equivalent to gold by the public. The initial confidence in the notes is generated by the sovereign guarantee, and is reinforced by the ability of BoE to encash these notes for gold on demand. This ability depends on gold reserves at BoE and also on its ability to borrow gold as needed from other sources. Once it prints 1.2m GBP worth of paper notes backed by sovereign guarantee, it has already created 1.2m GBP of the (non-existent) gold that it loaned to King William — it does not need to get the money back, because it already created it!. This is why the BoE stated that the loan can be rolled over indefinitely. That is, at the end of five years, King William can (and will) say that I don’t have the 1.2million to pay you back, so give me another loan of 1.2million (plus accumulated interest) which is due in another five years. The BoE happily obliges the King by giving him a loan on paper which the king immediately surrenders to the bank as repayment of the initial loan, and the whole cycle repeats.

But this is not all; the implications of this heist of power of money creation are far more radical. No one is watching how much money is created by the Bank of England. Technically, it can only print 1.2 million GBP which are backed by the sovereign guarantee. However, as we have seen, this sovereign guarantee is an illusion – the King will never actually pay any gold to the Bank of England. What enables the bank to print notes is the confidence of the public that the notes are as good as gold. The BoE can print a lot more than 1.2 million pounds. The original loan to the King becomes only a side-show; the interest payments are also a side-show. The real game is that the power of creation of money has been transferred from the sovereign to the bank. Furthermore, this authority is enshrined in the law, in a charter signed by the King of England.

So, let us take a step back from the detailed analysis of this amazing theft, where the BoE actually stole the power of money creation from the sovereign state of England. Let us look at the bigger picture. The BoE not only gave KW3 the money that he needed, they also gave him a promise to provide him with all funds that he might need in the future. The principal of the loans that they would give to the King would never be paid back; the Bank would only collect the interest on the loans. The entire principal of the first loan (and any subsequent loans) stays at the bank in the form of an IOU from the King, and serves as a sovereign guarantee which authorizes the Bank to issue notes which are backed by a promise of the King. But the trick goes deeper, because this promise is actually an illusion – the king will never pay. So whereas the public trust in money created by the Bank of England is apparently based on the sovereign guarantee, it is actually based on something rather different. It is based on the ability of the Bank of England to smoothly and quickly convert notes to gold on demand. Once public confidence in this ability is established, only a small amount of gold is needed by the Bank of England, since confidence creates the impression that the paper is good as gold.  Secure in the knowledge that paper can be converted to gold on demand, people rarely actually do so since paper is much more convenient to carry and store than gold. Complications in this basic story created by international trade will be discussed later.

For a more detailed history of the origins of Bank of England, see my previous post on “Origins of Central Banking“. Understanding this history is extremely helpful in understanding the central claims of Modern Monetary Theory. The BoE can make any amount of loans to the King of England, and never require repayment from him because they can monetize all sovereign debt. They can convert the IOU of the King to money and use it for their own purposes. This power of monetization means that the IOU of the King itself is the money. We could take away the smoke and mirrors, and the king could issue his own IOU directly (without incurring interest payments on loans from BoE). The money would be fiat currency and circulate by sovereign authority – the law makes it legal tender. Here the widespread myth, still widely believed, that money must be backed by gold, is of great value to the financiers who possess gold (which the king does not). The King’s fiat currency is not backed by gold, but the BoE can issue currency which appears to have gold backing. So, it seems that the BoE currency is more “sound” to a public conditioned to believe that money is gold. In fact, using fractional reserve methods, the BoE currency is also unsound in the sense that there is never enough gold to back all of it.  In the final analysis, money is about trust and confidence. This trust and confidence can be created by a variety of tricks. In small communities, trust can be created by character – the movie “It’s a Good Life” shows the central importance of trust, and its relationship to the viability of banking.

The central message of MMT is that once the illusion of gold is removed from the picture, money is valued because everybody has confidence in it. This confidence can be safely created by sovereign authority. The King, or the state, can create any amount of money, without limits. There is no issue of sustainability of deficit. Creation of money has powerful effects on the economy, and printing too much money would definitely cause inflation, so it would never be advisable to freely print money. But the state does have the power to do so, and the state will never have to “pay back” for money it created today. The focus should shift from the wrong question of how the government can generate revenue to finance its spending, to the right question of what are the effects of money creation by the sovereign state? By analyzing the impact of money creation on employment, inflation, debt, we can figure out the right amount to create. The conventional idea of “neutrality of money” embodied in Real Business Cycles and DSGE models is a major obstacle in the path asking the right questions, because these theories say that the quantity of money does not matter.

An important side note here is that international trade matters a lot. As long as the paper circulates within the British empire, conversion to gold or otherwise does not make difference. As long as the gold is within the Empire, the BoE will be able to borrow it temporarily to meet its daily needs. But if the notes are used to purchase foreign goods, and foreigners demand gold in return for notes, gold will flow out of the empire, and this can create problems. We ignore these issues for the moment; these will be discussed in greater detail later. My talk at the State Bank of Pakistan provided an introduction to basic MMT concepts, to people schooled to believe in other theories of money:

Another similar introductory talk on MMT is “Key Insights from Modern Monetary Theory”  This post analyzed the opening shots in a battle which has raged through centuries, determining the fates of millions of lives: “The Battle for the Control of Money.” Today, this battle threatens the future of mankind on this planet. The central strategy in this battle is deception and creation of illusions. This is captured in the following scene from the Wizard of Oz — Dorothy and her team quake with fear in front Oz, the mighty and powerful, until Toto lifts the curtain behind which the magician is hiding. As Ellen Brown has pointed out in her wonderful book on The Web of Debt, the Wizard of Oz is actually an allegory about the powers of money creation, with OZ standing for ounce, as in a gold ounce.  If we have correct understanding of how the system works to provide massive benefits to creators of money, who get to mint money for free, we can easily fix it. So this understanding must be denied. Multiple myths are created which prevent understanding. The most basic of these is the myth of neutrality of money. If money itself does not matter, than what does it matter how it is created. The second myth is that banks do not create money, the banking system as a whole does, widely taught in textbooks even today. The third myth is the money multiplier story, according to which the amount of money in the system is just a fixed multiple of the high powered money created by the Central Bank. Increasingly powerful attacks, together with damaged credibility after the Global Financial Crisis, has led to a confession: “The Truth is Out: Banks Create Money“  The confession may be motivated by the need to regain credibility and hence to manufacture new myths to replace the old ones. The central question to ask about money is: “Who Creates It?”. As recent papers by Bank of England clarify, it is the private banks, and now, far more important, the shadow banks. It is these shadowy financial institutions which run the world today, by the power of the money that they create.

Rupee Over-Valuation

Published in  Dawn, May 19th 2019 . On similar theme, see: “Burning Billions“ and “Fear of Floating“. Post explains why the elite classes of Pakistan have chosen to keep the Rupee over-valued, even though it has had disastrously bad effects on the domestic economy.

The popular demand to ‘control’ the slide of the rupee ignores fundamental economic realities. The equilibrium rate is one at which the market arrives at naturally, without government interference. The only way for the government to keep the value of the PKR above equilibrium is to sell dollars at a cheaper rate, which artificially adds to the supply of dollars, and lowers the equilibrium price. The policy of over-valuation of the PKR is equivalent to an across the board subsidy on all imports. Anyone who purchases $100 receives $90 of it from private sources seeking to buy PKRs, while $10 comes from the government, which borrows dollars and sells them cheaply to keep the price of dollars low. Naturally this makes imports cheaper, because the government pays part of the bill. While occasionally it might make sense to subsidize strategic imports, it can never be sensible to provide across the board subsidies for all imports. Yet, in Pakistan, this is what has been happening for several decades. Governments have maintained significantly over-valued Rupees, effectively borrowing dollars to subsidize all imports. This is the simple explanation for our need to repeatedly borrow from the IMF, even though pundits pontificating on this matter have incorrectly blamed many other factors.  We will examine why this has happened, what the consequences have been, and how the problem can be remedied.

One of the deadly effects of over-valuation is the establishment of negative value-added industries, which make profits only due to the existence of government subsidy on imports. For example, subsidies make it cheaper for our oil czars to import oilseeds from Brazil and Malaysia, rather than growing our own sunflowers! Worse, over-valuation prevents valuable industries from coming into existence. Attempts at producing export-oriented silk, olive oil, palm oil, small electronics, and other light industrial products, have all faltered because over-valuation makes it extremely difficult to produce competitive products. India is able to produce domestic cars and mobiles because the Indian Rupee is under-valued making imports expensive. Pakistani efforts have failed because over-valuation makes imports cheap. China, Japan, and East Asian countries followed the opposite policy of under-valuation to industrialize. When dollar imports are expensive, due to over-valuation, then it becomes profitable to set up domestic industries which can successfully compete with imports. Creating domestic industries which can manufacture substitutes for imports made expensive by under-valuation is a key step on the path to industrialization. Under-valuation occurs when the government purchases $10 for every $100 imports purchased by public, bumping up the price of the dollar by adding to the demand. This allows the government to transparently collect money, avoiding corruption at customs, and creating desperately needed foreign exchange reserves for national benefit.

The question is why, when it is so harmful for local development, have we pursued a policy of mass subsidy to all imports over decades. Billions of dollars in subsidies goes to select industries which profit immensely from cheaper-than market value imports. These industries would collapse if the subsidy was withdrawn, and the value of the PKR was set by market forces (not the IMF!). More generally, the wealthy classes enjoy the subsidies on luxury imports.  But over-valuation is defended on the ground that the poor will have to pay more, even though the subsidy benefits the rich far more. The imaginative beneficiaries of the billion-dollar subsidies promote another half-truth to support this disastrous policy. They acknowledge that additional demand will be created by lower prices for Pakistani goods, but argue that our export industries are working at full capacity and will not be able to expand production to meet the additional demand. What they say is true in the short run – we may not see an immediate response in terms of increased exports.

In the long run, export oriented industries could come into existence to satisfy additional global demand created by cheaper PKR.  However, it is costly and risky to setup industries. Putting in the required large investments in production capacity requires confidence that the government will maintain its exchange rate policies. Given the power of the over-valuation lobby, it would be hard for anyone to have such confidence, in order to setup the industry. The domestic economy will never learn to produce if it is cheaper to import goods at prices subsidized by government borrowing. The long run health and prosperity of the economy requires either fair or under-valuation. The present policy of overvaluation works by borrowing dollars to subsidize imports, and cannot be sustained in the long run.

The Emergence of Logical Positivism

 

“Oh would some Power the gift give us, to see ourselves as others see us.” Just as we cannot see our own faces, so some insights about European history are only easily visible to outsiders. The philosophy of logical positivism is one of these areas, where the internal European account of what it is and how it emerged is radically different from the external account I will present below. To put it in one sentence, this philosophy is an effort to make Science a Religion, and in fact, the common religion of all mankind. Although we may labor under the misconception that this philosophy has been debunked and refuted, central tenets of the philosophy continue to command widespread allegiance. If you believe that the objective facts are superior to subjective opinions (and who doesn’t?) then you are a positivist. The efforts to quantify, measure, observe, a host of qualitative and unmeasurable phenomena, and the belief that everything CAN be measured, derive from positivist roots. These efforts have caused a lot of damage, one aspect of which has been documented in my paper on “Corruption: Measuring the Unmeasurable”.

The purpose of this post is to explain this point of view. A warning is in order — an external outsider view is, by definition, alien and strange, and bound to cause some discomfort. To learn from it, we must be prepared to walk for a mile in alien moccasins. There is a great prize to be won – a re-integration of our identities which have been seriously distorted by putting the head above the heart and prizing rational thoughts over subjective feelings.

First, we must start with the story of the loss of faith in Christianity in Europe. Again, there is a radical difference between the internal European account, and an external outsider perspective.

European Loss of Faith in Christianity

Internal, European Account: According to the internal, European account, Christianity (like all religions) was just a collection of superstitions: stories about unobservables like angels, God, afterlife, which were not empirically verifiable. When the Enlightenment began, Europeans learned to reason for the first time, and they understood that religion was just superstition. Then they rejected religion and have made tremendous progress by using the light of reason, instead of superstition. This cover story is extremely powerful, because it seems to be proven by the historical facts – Europeans conquered 85% of the globe by early 20^th Century, proving their superior ability to reason, and demonstrating the validity of the cover story. De-constructing this story and providing a satisfactory counter-narrative requires hard work.

The External, non-European Account: The real story of how Europeans lost their faith in Christianity is far more complex. We aim to explain some crucial elements of it here.  In 1492 a triplet of climactic events occured with devastating consequences which continue to reverberate in the corridors of history. One: Columbus sailed for the Americas, giving Europeans access to vast lands and materials. Two: The Reconquest of Islamic Spain was completed, giving Europeans access to millions of books containing knowledge gathered from around the globe and developed in the Islamic Civilization; this sparked the Enlightenment. THREE: But most importantly for our current account, Rodrigo Borgia purchased the papacy in 1492 and named himself Alexander VI. (see European Transition to Secular Thought – bit.do/etst1a). This was a critical moment within a chain of events described in The March of Folly by Barbara Tuchman in “Chapter Three – THE RENAISSANCE POPES PROVOKE THE PROTESTANT SECESSION: 1470–1530”. She writes that:

From roughly 1470 to 1530, … a succession of six popes (displayed) an excess of venality, amorality, avarice, and spectacularly calamitous power politics. Their governance dismayed the faithful, brought the Holy See into disrepute, left unanswered the cry for reform, ignored all protests, warnings and signs of rising revolt, and ended by breaking apart the unity of Christendom and losing half the papal constituency to the Protestant secession. Theirs was a folly of perversity, perhaps the most consequential in Western history, if measured by its result in centuries of ensuing hostility and fratricidal war.

The breakup of the church shattered the ideological unity of Europe and led to major wars, as well as political power struggles between Protestants and Catholics with extremes of cruelty towards each other. For example, one of the key fratricidal events was the St. Bartholomew’s Day Massacre (which may have been a model for the Red Wedding in the GoT). All this bloodshed and violence between Protestants and Catholics led to public dis-enchantment with religion as whole, and the idea that religion is the root of all warfare and conflict. This idea is still prevalent among secular modern thinkers, although countless deadly twentieth century wars show it to be false.

Trauma of Loss of Faith

Loss of faith is massively traumatic event. A Creator who knows and cares for us, makes our lives meaningful, and the eternal perspective offers strong solace against temporary tragedies of our mundane existence. Bertrand Russell describes how accepting the cold, harsh and cruel universe requires us to build our lives “on the firm foundation of unyielding despair.” The trauma of loss of faith had a dramatic impact on European intellectuals, as we now describe.

Rejection of Heart and Soul: One of the most significant impacts of this trauma was the rejection of the HEART as a source of Knowledge. This is exemplified by Descartes’ logic: “I think therefore I am”, whereas “I feel therefore I am” related far more closely to our life experience. But this second statement was not acceptable. The heart had been proven to be a deceiver – it testified to the existence of God, and gave us faith in unknown and unknowable mysteries, and hence it must be rejected. Henceforth, the Enlightenment Philosophers vowed to never to trust their hearts, and instead, only trust what they could touch, and see, and arrive at with cold logic. They rejected the heart and intuition, and made a commitment to use of REASON and EMPIRICAL EVIDENCE only as sources of knowledge.

Deification of Science

When you reject religion, you lose answers to the most important questions we face in our lives, such as the meaning of our lives. As I have explained in “Origins of Western Social Sciences”, the Social Sciences originated in the attempt to find new answers to questions previously answered by religion. In particular, faith in religion was replaced by faith in Science: in the IDEA that science will solve all problems of mankind. This is, on the face of it, an absurdity; only the trauma of loss of faith can explain how one could come to believe such a thing. We lead unique lives, every human being is unique and distinct, and every moment that we experience is like none before, and none after. The idea that we should search over previous experience for patterns to guide us today, actually blinds us to the unique potentials which exist now, which never existed in the past, and will not exist in the future. The idea the “science” could be a guide in terms of teaching us how to live our lives and to realize our human potentials, is a non-starter. Nonetheless, having lost faith in their religion, Europeans had no option but to put their faith in the potential of science to solve human problems. This faith persists today, even though science has brought humanity to the brink of destruction via an environmental catastrophe.

The Philosophy of Science: The project to turn science into the new religion of man led to extreme distortions in European ways of thinking (see Deification of Science for links to many readings). In particular, it led to the search for a philosophy of science which would prove that ALL scientific knowledge – based on observations and logic alone, with no intuition and emotion involved – would lead to objective facts which were certain. The worship of science also led to the ELEVATION of objective over the subjective. Science is based on the sacred facts out there, and not on wishy washy subjective opinions which vary from person to person and can change whimsically.  In fact, this was a huge reversal of priorities. What is most important for you and me are the questions of how we should lead our lives; who to befriend, what to believe, how to behave. The answers are necessarily subjective and personal, dependent on local and unique circumstances and environment; they are not “scientific” – universal laws applicable to all. This most important knowledge was ruled to be un-important, subjective, normative, as part of the process of deification of science. As a consequence of this, Western education today is a meaningless process of learning about the external world, which pays no attention to the most important questions we all face in our daily lives – that is finding the best ways to live our unique and precious few moments on this planet.

Emergence of Logical Positivism

It was these underlying trends that set the stage for the emergence of logical positivism. This philosophy asserts that all knowledge is based on observations and logic. Observations are objective, out there, verifiable, unquestionable and certain. Logic is the mortar we use to put together these bricks to construct the towering skyscrapers of scientific knowledge. The counterpart methodology to this worldview is the Axiomatic/Deductive scheme of geometry. Axioms come from observations and are CERTAIN. Logic leads to certainty in deductions. For an illustration of how this is a deeply mistaken approach to understanding the world around us, see Methodology of Modern Economics.

Elimination of Unobservables: There were many technical problems with the idea that science was based only on observables and logic. Many scientific objects like gravity, electrons, magnetism, were not observable. For details about how these problems were resolved, see my paper on  Logical Positivism and Islamic Economics (December 30, 2013). International Journal of Economics, Management and Accounting, Vol 21, No. 2, pp1-18. The central device used by positivists was to replace unobservables by observable manifestations; for example, replace unobservable preferences by observable choices, or unobservable gravity by the observable elliptical orbits of planets. This point will be discussed in greater detail later. Logical Positivism achieved dual goal of philosophers of science, which European intellectuals had been searching for, for centuries. This philosophy showed that SCIENCE leads to truth and certainty. At the same time, RELIGION is pure superstition, because it is centrally based on unobservables. Because it fulfilled a DEEP psychological need of Western intellectuals, it became wildly popular and widely accepted, despite many fundamental weaknesses, which eventually led to its downfall.

(to be continued) –

This post provides details on Logical Positivism, an issue raised briefly in section 2: Flawed Foundations of Modern Economics, in my paper on “Islam’s Gift: An Economy of Spiritual Development”. American Journal of Economics and Sociology, March 2019. A 23m video on this topic, which goes over issues covered in above post, was part of Lec 11 of Islamic Economics 2019 (bit.do/ie2019) at IIIE, IIUI:

This is complex topic, for which I have provided a thumbnail sketch of some important ideas which are not readily available elsewhere. My webpage linked below provides a large collection of links to articles related to various aspects of logical positivism

Collection of Articles & Video-Lectures on Logical Positivism

On the lighter side, I came across a great cartoon put-down of the Vienna Circle, which was responsible for the development of this philosophy.