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In a rapidly changing world, ways of thinking which served us well in other eras, become obstacles to understanding, and reacting appropriately to change. Traditional economic theories, currently being taught all around the world,blinded economists to the possibility of the global financial crisis.The Queen of England went to London School of Economics to ask why “no one saw it coming?”.The US Congress appointed a committee to study why economic theories “dismissed the notion that a financial crisis was possible”. At the heart of this failure arewrong ideas about the role of money in the economy. All major schools of macroeconomics currently being taught around the globe teach that the quantity of money only affects the prices, and does not have any other effects on the real economy. Economists write that “money is a veil” – it hides the workings of the real economy, but does not play any role in it. Economists were blindsided by the crisis because models currently in use for policy making do not have a role for money, credit, banking, and debt, even though these were the factors responsible for the Global financial crisis.

The crisis made clear to all and sundry the vital role of money in the economy. Surprisingly, the mainstream economics profession has been extremely resistant to change. The same textbooks, theories and models which failed so drastically, continue to be used in teaching and policy making throughout the world. However, the space for unorthodoxy has expanded substantially, and a lot of new theories of money have emerged to challenge mainstream views. Among these, Modern Monetary Theory, which provides a radically different perspective on money, has emerged as a strong contender. This article aims to summarize some of the key insights of MMT, which creates new ways of looking at the world of fiat money that we live in today.

The starting point of MMT is that our thinking about money is conditioned by the view that money is based on gold, which leads us to ignore the radical differences between gold-backed money and “fiat” money, which comes into existence by government decree, and does not require any backing. With a gold-backed currency, the concept of a government deficit makes sense – the government must have gold, in order to spend it. However, with a fiat currency, a deficit must always be self-imposed; the government chooses not to print money in order to pay its obligations.The idea that the government does not have money to fund social welfare or investment is wrong, because the government creates money by sovereign fiat, and can always print as much money as it likes. MMT raises the question of why the government should impose taxes on citizens to generate revenue – why not just print the money instead? Readers who have been conditioned by economic theories will eagerly proffer the standard answer: because this will lead to inflation! But this answer is neither sufficient, nor satisfactory.

Based on his experiences as Governor of the New York Federal Reserve Bank, Daniel Tarullo has written that at present we do not have a working theory of inflation. Similarly, Joseph Stiglitz has written that the stable relationship between money and inflation broke down in the 1980’s, leaving us with no reliable guide to monetary policy. The Quantitative Easing program that was adopted in major world economies after the Global Financial Crisis involved printing huge amounts of money. However, to the surprise of economists, no inflation resulted, in conflict with standard theories of inflation. So, the idea that if the government prints money, inflation will necessarily result is not credible.

As experience of the past few decades has shown, there is no automatic relationship between printing money and inflation. A more sophisticated analysis is needed. MMT provides rather different answers to when and whether governments should print money, as well as the why of taxation. First let us consider the printing of money. Whether or not it is inflationary depends on how the printed money is used. For instance, if it is deposited in the accounts of billionaires and adds to their financial wealth, without being used for any other purpose, then it will not have any inflationary effect. If the money is used to purchase goods in a sector where the economy has excess capacity for production, then the demand stimulus will create an expansion, with increase in employment and in production. This is the Keynesian phenomenon – in a recession, where economy is below it peak production capacity, a monetary stimulus can create increases in employment without inflation. If the money is used to buy goods in sectors where economy is at peak productive capacity, then it will create inflation in the short run. What happens in the long run depends on whether the industry can expand to meet the excess demand.

Against this Keynesian possibility where printing money increases production and employment, there are many possible ways that money creation can harm the economy.If money is spent on land and stocks, this will lead to inflation in their prices. Money can also be used for purchase of luxury foreign goods, or transferred abroad in various forms. In such cases, increased demand for dollars would lead to depreciation of the exchange rates. Keynesian economists have suggested that dropping money from helicopters would be a useful policy to reduce unemployment in recessions. Modern Monetary Theory tells us that we need to be more discriminating in targeting the printing and distribution of money. If money goes to sectors of the economy where there is excess capacity, it will stimulate production and employment, without causing inflation. If it goes to domestic sectors operating at peak capacity, it will lead to domestic inflation. If it is exchanged for dollars and flows out of the country, it will lead to depreciation.

One of the key resulting insights is that the “deficit” numbers by themselves – whether in percentages of GNP or in absolute quantitative terms – are meaningless. The government can “sustain” any amount of deficit by printing money to pay its obligations. Of course, this is not a license for irresponsible spending. Creation of money, and its utilization in ways which do not enhance productive capacity of the domestic economy are sure to cause harm to the economy. Rather, MMT provides us with a license for responsible spending. If there are worthwhile projects which will utilize resources currently lying idle, then there is no need to be scared of the deficit numbers in spending on these projects. Viewed in this light, the project of building a million houses is not constrained by the budget of the government. Rather it is constrained by the availability of resources which are required for this purpose. If there is idle productive capacity in terms of labor, land, and materials, spending is this area will utilize them to the maximum. If the capacity does not exist, then a carefully balanced spending strategy, which builds capacity in a way coordinated with the increasing demand for utilization of this capacity, can be funded by deficit financing, without causing harm to the economy. Of course, it goes without saying that this requires skillful management and planning.

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This is the second lecture on Understanding the Rise and Fall of the Gold Standard — shortlink: bit.do/azifa2 — we start with a  Summary of First Lecture 

The first lecture discusses the Keynesian theory that the exact level of money in an economy is critically important – too little leads to recessions, while too much leads to inflations. Furthermore, domestic business cycles, and international financial crises are caused by pro-cyclical behavior of current artificial systems of money creation and international trade. Standard macro theories make it impossible to understand the economy because they assert that money is neutral, and does not affect the real economy – exactly the opposite of the Keynesian idea that the quantity of money is all important. Standard macro model currently in use throughout the world have no explicit role of money, banks, and credit, even though these factors are of central importance in understanding the world. Once we understand the vital role and function of money within an economy, it becomes possible to understand historical events of the twentieth century – whereas this is impossible using conventional macro theories. The first lecture summarizes how the colonial system came into being, and the monetary arrangement for a hard currency at the core and soft currencies in the periphery. This system of fiat currencies works fine within one system of colonies, where the value of money is decreed by sovereign fiat. For trading between different countries, the gold backed currencies were used. As European countries prospered by exploiting resources throughout the globe within their colonies, inter-European trade increased. The optimal quantity of money required for the domestic economy is not the same as that required for stable international exchange rates. The pro-cyclical money creation which is characteristic of the system creates cycles, and large cycles lead to crises on a routine basis. World War I was partly caused by the breakdown of the colonial trading system due to the end of expansion possibilities after the completion of the conquest of the globe. Efforts to restore the gold standard after World War I failed. The second part of the lecture discusses the post World War I history, with reference to the international financial architecture that emerged in the post-Gold era after World War I.

3100 Word Summary of Second Lecture on Global Financial Architecture

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[bit.do/azifa] Lecture 1 on Rise and Fall of the Gold Standard, on Friday 4th May 2018 in AR Kemal Rm at PIDE, by Dr. Asad Zaman, VC PIDE. 1hr 20m Video Lecture. Shortlink for Lecture 2: bit.do/azifa3

3100 word summary of lecture:

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This 1000 word article is the third in a series of posts on Re-Reading Keynes. It traces the impact of Keynesian theories on the 20th century, as necessary background knowledge for a contextual and historically situated study of Keynes. It was published in Express Tribune on 4 Nov 2016.

The Global Financial Crisis (GFC) has created awareness of the great gap between academic models and reality. IMF Chief Economist Olivier Blanchard said that modern DSGE macroeconomic models currently used for policy decisions are based on assumptions which are profoundly at odds with what we know about consumers and firms. More than seven different schools of macroeconomic thought contend with each other, without coming to agreement on any fundamental issue. This bears a striking resemblance to the post-Depression era when Keynes set out to resolve the “deep divergences of opinion between fellow economists which have for the time being almost destroyed the practical influence of economic theory.”

Likewise, today, the inability of mainstream economists to predict, understand, explain, or find remedies for the Global Financial Crisis, has deeply damaged the reputation of economists and economic theories. Recently, World Bank Chief Economist Paul Romer stated that for more than three decades, macroeconomics has gone backwards. Since modern macroeconomics bears a strong resemblance to pre-Keynesian theories, Keynesian theories have fresh relevance, as described below.

In the aftermath of the Great Depression, economic misery was a major factor which led to the Russian Revolution and the rise of Hitler in Germany. Conventional economic theory held that market forces would automatically and quickly correct the temporary disequilibrium of high unemployment and low production in Europe and USA. Keynes argued that high unemployment could persist, and government interventions in the form of active monetary and fiscal policy were required to correct the economic problems. Many have suggested that Keynes rescued Capitalism by providing governments with rationale to intervene on behalf of the workers, thereby preventing socialist or communist revolutions. There is no doubt that strong and powerful labor movements in Europe and USA derived strength from the economic misery of the masses, and also took inspiration from the pro-labor and anti-capitalist theories of Marx. While it is hard to be sure whether Keynes saved capitalism, we can be very sure that Keynes and Keynesian theories were extremely influential in shaping the economic landscapes of the 20th Century.

Keynes actually met Roosevelt (FDR) to try to persuade him of the necessity of an aggressive fiscal policy and of running budget deficits, in order to lift the US economy out of recession. He was only partially successful. FDR, like nearly all political leaders as well as economists of the time, was convinced of the necessity of balancing budgets: this is the same ‘austerity’ being touted today as the cure for economic problems. Leading economists like Lionel Robinson and Friedrich Hayek argued in favor of austerity, and said that Keynesian remedies were dangerously wrong. They held the view that the Great Depression had been caused by excessively easy monetary policies in the pre-Depression period, and Keynesian interventions in the form of further easy monetary and fiscal policies would only prolong the agony.

FDR was not quite convinced by Keynes, but was politically savvy enough to announce that he would not balance the budget on the backs of the American people. Accordingly, he did go against his personal convictions, as well as his campaign promises of balancing the budget, which he believed to be a sound and necessary economic policy. Keynes felt that the economic policies of FDR were timid and hesitant, and prolonged the recession un-necessarily. In light of contemporary experience of the tremendously aggressive expansionary monetary policy in the post-GFC era, we can see that bolder steps by FDR would not have caused the harms that he was afraid of. In fact, after the economy recovered somewhat, FDR went back to conventional wisdom and started reducing budget deficits in 1936. This created a mini-recession which has been labelled the “Roosevelt Recession of 1937”. Duly chastened, FDR embraced Keynesian policies with greater conviction, and increased deficit spending right up to the second World War. It was the effectiveness of Keynesian policies that led even arch-enemy Friedman to state that “We are all Keynesians now,” though he later recanted. Indeed, he master-minded the Monetarist counter-revolution in the 1970’s which eventually led to a rejection of Keynesian insights, and a return to the pre-Keynesian ideas of austerity as a cure for recessions.  Forgetting the hard-learned lessons of Keynes led to a recurrence of problems very similar to those faced by Keynes in the form of GFC 2007.

Following the GFC, there has been a resurgence of interest in Keynes and Keynesian Theories. In the “Return of Depression Economics”, Krugman argued for the continuing relevance of Keynes, and stated that we could end the Great Recession immediately by implementing Keynesian policies.  China implemented Keynesian policies, and used a fiscal stimulus of $586 billion spread over two years, to successfully combat the global recession created by the GFC.  Unlike countries forced to implement austerity, which further wrecked their economies, the Chinese economy was able to perform well in the aftermath of the GFC. The Shanghai index had been falling sharply since the September 2008 bankruptcy of Lehman Brothers, but the decline was halted when news of the planned stimulus leaked in late October. The day after the stimulus was officially announced, the Shanghai index immediately rose by 7.3%, followed by sustained growth. Speaking at the 2010 Summer Davos, Premier Wen Jiabao also credited the Keynesian fiscal stimulus for good performance of the Chinese economy over the two years following the GFC.

Meanwhile, even IMF acknowledged the failure of austerity, the anti-thesis of the Keynesian policy. Massive damage was caused to Greece, Ireland, Portugal and other economies which were forced to tighten budgets in response to the recession. In the see-saw battle between Keynesians and Monetarists, after three decades of darkness, the Keynesian star seems to be rising. Strange as it may seem, many fundamental insights of Keynes were never actually absorbed by conventional economists. Keynes himself said that he had the greatest difficulty in escaping the habits of thought created by an economics education. Mainstream economists never made this escape. As a result, Keynesian theories remain an undiscovered treasure offering deep insights into current economic conditions.

The website page has many links to related materials on L3: Impact of Keynes

I am planning a sequence of posts on re-reading Keynes, where I will try to go through the General Theory. This first post explains my motivations for re-reading Keynes. As always, my primary motive is self-education; this will force me to go through the book again — I first read it in my first year graduate course on Macroeconomics at Stanford in 1975, when our teacher Duncan Foley was having doubts about modern macro theories, and decided to go back to the original sources. At the time, I could not understand it at all, and resorted to secondary sources, mainly Leijonhufvud, to make sense of it. Secondarily, i hope to be able to summarize Keynes’ insights to make them relevant and useful to a contemporary audience. Thirdly, there are many experts, especially Paul Davidson, on this blog, who will be able to prevent me from making serious mistakes in interpretation.

Reasons for Studying Keynes

The heart has its reasons of which reason knows nothing.” Blaise Pascal

In line with the objectives of the WEA Pedagogy Blog, I am initiating a study group with the aim of [re-]reading Keynes’ classic The General Theory of Employment, Interest and Money. There are many reasons why I think this is a worthwhile enterprise. I hope to make weekly posts summarizing various aspects of the book, as we slog through the work, which can be difficult going in some parts. At the very least, this will force me to re-read Keynes, something I have been meaning to do for a long time. In this first post, I would like to explain my motivation in doing this exercise. Read More

The Global Financial Crisis of 2007 has led to a renewed interest in Keynesian theories. In particular, Krugman in “The Return of Depression Economics” argued that Keynesian ideas remain relevant to understanding 6196411489_a5cf9e16fc_bcontemporary recessions. To motivate this, he has used a real world example of the Capitol Hill Baby-Sitting Cooperative (BSC). According to an analysis by economists who were members of the Cooperative, the BSC suffered from a recession due to a shortage of “scrip”, the currency used to exchange baby-sitting services.

Krugman’s analysis is based on an intuitive and heuristic analysis by Sweeney and Sweeney (1977). However, the BSC is a very simple single good economy, where the sole function of money is to allow for inter-temporal trade. This simplicity allows for a rigorous analytic treatment. Our research was motivated by the idea of analytically validating the intuitive insights of the Sweeneys and Krugman. Is the BSC a Keynesian economy? Can a shortfall of money create a recession in this economy? A simple model which displays Keynesian effects should be useful in building understanding of these phenomenon in more complex situations.

A few authors who have analyzed the BSC economy have found Keynesian effects under the assumption of fixed prices. But in presence of fixed prices, the existence of an optimal quantity of money, and recession for low money is a triviality. The Keynesian rejection of neutrality of money is not based solely on sticky prices. In this paper, we create a simple model of the BSC economy to investigate the presence of Keynesian phenomena. The model leads to strange and paradoxical results, not available in earlier analyses. We list these results below.

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FullEmplWe are used to thinking that there is progress in knowledge. As we gain experience, the collective wisdom of mankind increases. The story of economics in the twentieth century provides the most amazing example of the opposite: How precious knowledge of vital importance for the welfare of humanity was gained and then lost. Many studies show that a meaningful job is the most important determinant of life satisfaction, and among the thing most desired by the general public. Economists learned how to create full employment, leading to a period of tremendous prosperity. How and why these lessons were forgotten provides a perfect illustration of the thesis that knowledge is shaped to protect the interests of the powerful.

Before the Great Depression of 1929, dominant economic theories stated that the free market automatically eliminates unemployment. Obviously, a theory which does not recognize the existence of a problem cannot provide solutions. Before the Great Depression, the economy was booming, with jobs for all and high levels of production. After 1929, factories lay idle, there was massive and persistent unemployment, and correspondingly high level of general misery. Why did unemployment persist, and how could we get the economy back to full employment of all the resources now lying idle? The revolutionary accomplishment of Keynes was to recognize the source of the problem, and provide an effective remedy.

Keynes argued that the key to the problem was depressed investor expectations about the future. Investors were afraid to produce goods because they did not foresee any demand. If they did take a risk and start producing, the demand would be created, because they would provide jobs to people in the process of production. People with jobs would have income and demand goods. Thus a favorable future forecast would create a self-fulfilling prophecy. People were not demanding goods because they did not have jobs. Producers were not providing jobs because they did not see any demand. This deadlock could be broken by the government in several ways. Lowering interest rates and making money cheaply available would reduce the costs of production, and might induce producers to take a risk on starting investments and production. Indeed, just printing a lot of money and throwing it from helicopters would be enough – people with money would demand goods, and producers would start hiring people to fulfill the demand for goods. The “Helicopter Money” scheme could fail for a number of reasons. The alternative was for government to step into the gap, and start hiring people itself. Even meaningless jobs like digging ditches and filling them up again would be enough to start off a chain reaction which would lead to full employment.  Using the secrets of Keynesian demand management, Western governments managed to achieve near full employment, and widespread prosperity for fifty years.

Unfortunately, general prosperity of the 99% does not suit the interests of the 1%. Full employment leads to an unruly labor class, who can walk out of unsatisfactory jobs to find a better one. Secondly, direct government investment can interfere with business profits. Thirdly, before the Keynesian era, politicians understood that business confidence was essential to economic prosperity and votes. Keynes freed the government from this dependence, much to the annoyance of business leaders.

The story of how Keynesian theories were ridiculed and discredited, and completely fallacious pre-Keynesian theories were re-furbished to take their place is long and complex, and cannot be detailed here. The punchline is that the remedies to today’s economic ills are known, but they are not being implemented because they go against the interests of the powerful. There has been a huge increase in debt globally; Debt forgiveness would remove the heavy weight dragging down aggregate demand which is weighing down the economy. Helicopter money is being dropped but into the vaults of the banks instead of the pockets of the public, and Keynes is being blamed for the lack of effectiveness of this ridiculous policy. Zero interest loans to producers are not working, so negative interest rates are being talked about. Meanwhile, everyone ignores the elephant in the room, a fully effective Keynesian theory which explains exactly how we can stimulate aggregated demand to revive the global economy.

Above 700 Words published in Express Tribune on Tuesday 30th  For short posts on diverse Topics see my author page on LinkedIn. Other works: Index . More material on Keynesian Economics. Some additional materials for readers of WEA Blogs:

Some of ideas are taken from Kalecki’s insightful note on why captains of industry resist full employment, even though it bring benefits to them as well. There is very strong evidence from multiple sources that their is a finance mafia in operation globally, which thrives on poor economic performance. This enables them to make multi-billion dollar loans and reap in interest payments. Enforcement of austerity is a crucial element in this scheme, since creation of Sovereign money — which is also done indirectly by deficit financing – by states would deprive them of their most valuable weapon — they have money while others don’t.  Keeping an economy starved of the money lubricant required for smooth functioning helps the 1% at tremendous cost to the 99%