Many leading economists have come to agree with Nobel Laureate Stiglitz that modern economic theory represents the triumph of ideology over science. One of the core victories of ideology is the famous Quantity Theory of Money (QTM). The QTM teaches us that money is veil – it only affects prices, and has no real effect on the economy. One must look through this veil to understand the working of the real economy. Nothing could be further from the truth.
In fact, the Q
TM itself is a veil which hides the real and important functions of money in an economy. The Great Depression of 1929 opened the eyes of everyone to the crucial role money plays in the real economy. For a brief period afterwards, Keynesian theories emerged to illuminate real role of money, and to counteract errors of orthodox economics. Economists believed in the QTM, that money doesn’t matter, and also that the free market automatically eliminates unemployment. Keynes started his celebrated book “The General Theory of Employment, Interest and Money” by asserting that both of these orthodox ideas were wrong. He explained why free markets cannot remove unemployment, and also how money plays a crucial role in creating full employment. He argued that in response to the Depression, the government should expand the money supply, create programs for employment, undertake expansionary fiscal policy, and run large budget deficits if necessary.
Free market economists believe that markets work best when left alone, and any type of government intervention to help the economy can only have harmful effects. Even after the Great Depression, they continued to argue that the government intervention would only cause further harm, and the free market would automatically resolve the problems. However, it was obvious to all that the massive amount of misery called for urgent action. QTM was discredited and mainstream economists accepted Keynesian ideas, rejecting free market ideologies. US President Franklin Delano Roosevelt (FDR) started his campaign with orthodox promises to balance the budget but converted to Keynesianism when faced with the severe hardships imposed by the Great Depression. He later said that “to balance our budget in 1933 or 1934 or 1935 would have been a crime against the American people.” In the 1960’s, the aphorism that “We are all Keynesians now” became widely accepted.
Free market ideologues like Friedman and Hayek patiently bided their time, while preparing the grounds for a counter-attack. Their opportunity came when stagflation – high unemployment together with high inflation – occurred in the 1970’s as a result of the Arab oil embargo. They skillfully manipulated public opinion to create the impression that economic problems were due to Keynesian economic theories, and could be resolved by switching to free market policies. The rising influence of free market ideology was reflected in the election of Reagan and Thatcher, who rejected Keynesian doctrines. Milton Friedman re-packaged old wine in new bottles, and the QTM went from being a discredited eccentric view to the dominant orthodoxy. Throughout the world, including Pakistan, monetary policy had been based on the Keynesian idea the money supply should be large enough to create full employment, but not so large as to create inflation. However, monetarists succeeded in persuading many academics and policy makers of the pre-Keynesian ideas that money only affects prices, and has no long run effects on the real economy. Central Bankers were persuaded to abandon the Keynesian idea of using expansionary monetary policy to fight unemployment. Instead, they started to focus on inflation targets. Forgetting the hard learned lessons of the Great Depression led to The Global Financial Crisis. Excess money creation for speculation led to a boom in housing and stock markets, followed by a crash very much like that of the Great Depression. Chastened Central Bankers remembered Keynes and took some actions necessary to prevent a collapse of the banking system. A deeper understanding of money could have prevented the Great Recession which followed. The truth is exactly opposite of the QTM idea that money does not affect the real economy. In fact, money plays a central role in the real economy. The mystery of why, even after repeated rejections, such an obviously wrong theory continues to dominate will be addressed in later articles.
PS: For more material on this issue, see: The Vital Importance of Understanding International Financial Architecture — shortlink: bit.do/azifa
See also, 90m video on: Quantity Theory of Money: Five Flaws
WEA Pedagogy Blog 
The fact that speculation in land values was permitted. and that there was no attempt to halt it before the mortgage-lenders faced the crisis, was not the fault of there being cheap money. Had a resourceful government seen the crisis coming (and there was warning from at least one school of economic thinkers, which was igfnored of course), by controlling the speculation in land prices and easing its availability, and not by money control itself, could our disaster have been averted. The next time it will happen is about 2026, according to these Georgists.
A “deeper understanding of money” and BANKING revealed in less then 2 1/2 minutes
Paul, you didn’t properly explain the M1 money is unlimited in return time, but M2 money is so limited. Anyone with a chequeing account can provide post dated cheques and thereby create M2 money. The same applies to credit-card deals during purchases. In both cases the money must be returned after a limited time, and the fact that M2 is significant is only because of the continuous process of re-borrowing and re-returning the same sum. Since most people have a monthly income on their earnings and are likely to spend most of it on average over that same time, the average size of their deficit should be about half their salary, but since certain people prefer to pay in cash (M1), the ratio between these two amounts works out as about 4. Money is not a nut pile but neither can we think in terms of M1 and M2 being similar.
“Anyone with a chequeing account can provide post dated cheques and thereby create M2 money.”
DEFINITION Of M2 : M2 includes savings deposits, money market mutual funds and other time deposits
Post dated cheques are not M2 nor M1. In fact they are not “money” at all until the date arrives at which point the cheque is redeemed for bank credit, originally created as M1, someone’s scheduled debt to a bank.
Sure, I could accept a post dated cheque in payment. That does NOT “create money”. It merely delays payment in M1.
Sorry to inform you but a deferred cheque is M2, as are payments made through debit cards. How else would we be able to do business these days and what else to do it with but money, even if it is not so “real” as folding bank-notes.
Money in savings deposits is also used by the banks and is not (unlike some suppositions) pulled out of thin air.
There is no “money” in a savings deposit. Money is a CURRENT liability of a bank, not a DEFERRED liability. A claim on M1 (cheque, post-dated cheque or debit card purchase) is not M2. Read the definition of M2.
Banks don’t lend out our savings. They replace them with new M1 debt.
Voy a ser breve para aclarar sobre un tema no suficientemente tratado: el aumento del desempleo con elevación en la tasa de inflación durante tres décadas desde 1960 hasta 1990 tuvo que ver con la aceleración en el aumento de la población activa que no fue dotada del capital que recomiendan los fundamentos de la economía. Algo así como el incumplimiento de las condiciones para el crecimiento con empleo y productividad recomendadas por R Solow. Entonces sí se atendió a crear empleo de baja productividad porque no se disponía de capacidad productiva con su dotación de capital necesario.
Mis disculpas por las deformaciones del traductor. Escribí en spanish.