The flawed philosophy of Rachel Reeves Central banks are not democratic

In 2018, in a pamphlet titled “The Everyday Economy”, a backbench Labour MP called Rachel Reeves attempted to untangle Britain’s convoluted financial system. To do so, she started by drawing upon the history of political philosophy — and the work of one philosopher in particular: David Hume, whom she grandly called “perhaps the most significant figure in the British Enlightenment”.

She didn’t mention another of the UK’s most celebrated political theorists, John Locke. Perhaps she should have read more widely. Indeed, some seven years on, as the now-Chancellor finds herself scrambling to reboot her plan for Britain, it’s Locke’s work on the economy that should be front of mind.

Much more than an academic, Locke was active in the rough and tumble of British politics. It was in the course of his political jostling during the coinage crisis of the late 17th century that he made his most influential arguments on the political nature of money. He recognised that the value of a state’s currency is ultimately set by fiat, and thus within the political power of the sovereign. The sovereign, after all, could alter the worth of the nation’s currency at the drop of a hat — a particularly devastating scenario given the fragility of the money system, which relies on the confidence of the populace. Should the sovereign decide to start altering the value of the currency indiscriminately, that confidence would erode. The whole monetary system, in other words, would fall apart.

To prevent this, Locke suggested that the sovereign refrain from using their political power over money. Instead, to ensure stability, he proposed that the sovereign maintain a fixed value of the currency — not because of any inherent worth of the coinage, as measured by precious metals, but because Locke thought that maintaining a consistent valuation would suggest as much. His plan, as Stefan Eich has observed, “was a political strategy to depoliticise money’s appearance”, making it seem as if the sovereign lacked the power to alter the value of money at any moment and for any reason.

In recent decades most contemporary states have followed Locke’s example, if not fixing the value of their currency in gold, then depoliticising it by putting it under the purview of an independent central bank. Then came Liz Truss, who in her campaign for the leadership of the Conservative Party began to question the independence of the Bank of England, and in the wake of her failed premiership blamed her fortunes on the Bank. The supposed neutrality of Britain’s monetary policy suddenly risked being exposed.

Labour subsequently attempted to put as much space between them and Truss’s questioning of economic policymaking practices as possible. Under the watchful eye of Reeves, the Government ran back into the arms of the BoE and the OBR, reinforcing its commitment to “sensible” economic policy, by which it meant depoliticised policy conducted by “sensible” experts. The storm, apparently, had passed.

But is the stasis we’re in any better? As the past fortnight’s U-turns have demonstrated, the Labour government finds itself hamstrung, unable to engage in transformative politics and susceptible to political challenge from the Right. We could be forgiven for asking: will that ever change? Or perhaps more importantly, would the storm really be worse?

Let’s start at the beginning. The conventional economic theory of money is rooted in a potted history of its use. That history goes roughly like this: before money, people bartered. They traded goods and services for each other. Bartering, however, proved inefficient, as each trade required a “double coincidence of wants” — I have to want exactly what you have, and you have to want exactly what I have. Money solves this problem. If everyone wants money, as a medium of exchange, there is no need to satisfy the “double coincidence”, as money ensures it is always satisfied.

There are (at least) two problems with this story. First, it is historically inaccurate. As far as economic historians and sociologists are concerned, there never was an exclusively barter economy. Money in the form of credit (and debt) has always existed. It was never the case that, as a table-maker, I would need to barter with each individual to get all the resources necessary to build tables; rather, it was more likely that the blacksmith had a ledger in which he recorded my debts each time I needed nails. Then someday, I might repay those with a table. Those ledgers, or more precisely the credit they recorded, was a form of money, a solution to the (never actually experienced) problem of the “double coincidence of wants”.

The second problem with the bartering story is the implication that money has no effect on production. Put simply, money makes trade easier. It does not change what resources exist, nor what technologies are available, nor how much labour is free. From this perspective, money has no influence on what could be produced in the economy. It simply makes trade, and therefore production, more efficient. And there’s nothing political about that. In economics this is known as monetary neutrality. Because money doesn’t go into building things or delivering services — there are no pound coins in your coffee or notes used in the construction of your home — it is merely a veil on the economy; without it the same things could be produced and created, albeit less efficiently.

The idea that money is nothing more than a veil on the real economy goes back at least to Hume’s essay on the balance of trade, in which he argued against mercantilist trade policies. (This essay did not feature in Reeves’s pamphlet.) Free-trade policies, he suggested, are the most desirable, because what matters to a nation’s economy is not its stock of money but rather its stock of goods and services — or perhaps more accurately, its capacity to produce real goods and services. Consequently, it does not make sense to stockpile gold and other forms of money as the mercantilists advocate. Instead, Hume argued, nations should “preserve money nearly proportionable to the art and industry of each nation”. Like Milton Friedman after him, Hume suggested that the role of good monetary policy was to ensure the supply of money matches the real economy.

But what this fails to take account of is the temporal dimension of production. It may be true that, without money, all the same production could take place, in the sense that the economic fundamentals are unchanged. But without money, the same amount of production would not in fact take place. From a realistic point of view, the efficiency and convenience that money introduces into the economic system inevitably affects what can be produced, where, and how much, in a given period of time.

Nevertheless, the theory of monetary neutrality is widely accepted, as is its corollary: if money is neutral, then so is monetary policy. The claim is deceptively simple. On this view, monetary policy governs how much money is in the economy, or the price of money, by managing short-term interest rates. It does not, however, influence the relative prices of goods. Consider the following illustration. Suppose a loaf of bread costs $1 and a gallon of milk costs $5. Now, suppose there is a massive injection of new money into the economy and a loaf of bread now costs $10 and a gallon of milk $50. The relative prices remain the same, so the price increase should have no influence on production. Thus, claim monetary neutrality advocates, monetary policy has no influence on the real economy.

Monetary policymakers, in this view, are like the ball boys and girls at a tennis match. They determine when to throw the balls onto the court or when to inject new money into the economy. If they do their job well, they enable the tennis players to play to the best of their ability, not breaking their flow, and allowing them to produce their best possible game. However, they could make mistakes, releasing lots of balls onto the court, causing the players to trip or get confused, or failing to give the players balls when necessary, causing the game to stop and the players to be unable to play. Getting monetary policy right, just like being a good ball boy, means preventing money from being a source of disturbance. A good ball girl cannot make the players better than they are. Similarly, conventional monetary theory suggests good monetary policy cannot improve real productive possibility. More money does not mean more production, just as more balls do not mean better tennis.

However, it can’t be that monetary policy is completely neutral. After all, if monetary policy has no effect on actual economic production, if it were impotent in relation to the real economy, why would we care about monetary policymaking at all? It simply wouldn’t matter. It would be like gravity policy. The reason monetary policy is not like this is that the neutrality claimed for monetary policy has one crucial qualifier: it is thought to be neutral only in the long run.

Hume recognised this in his essay. He argued that while money would not matter in the long run, in the short run an increase in money could cause a burst in economic activity. Back to the bread and milk. If the central bank were to inject money into the economy, all prices would not automatically adjust in tandem. Rather, it may be the case that the price of a loaf of bread would increase from $1 to $10 before milk went from $5 to $50, supposing it ever does. As such, in the interim, the change in relative prices (bread at $10, milk still at $5), could have a significant impact on the production and consumption of milk and bread. By claiming that monetary policy is neutral in the long run, but not the short run, the conventional view holds that by the time the economy reaches equilibrium, any effects downstream of monetary policy will be neutralised.

Which is all very well — except for the fact that money is not neutral, as we all know. Who has access to money — credit in particular — determines who gets to go to law school, buy a house, expand their business and so on. Conventional economic theorists would respond, well, yes of course this is true in the short run, but in the (theoretical) long run money makes no difference in the aggregate. But this is ridiculous. The person in real life with access to a loan to go to law school then becomes more likely to get a good mortgage because of their law degree. Their house then grows in value, which gives them more access to credit and income which they can invest, which allows them to make more money, and so on. This impacts not just the distribution of income in society but its aggregate productive capacity as well. The effects of short-run access to credit aren’t neutralised in the long run in which we actually live. Far from it.

And yet, despite this, the mainstream Left in both the UK and the US remains grounded in the monetary policy neutrality doctrine. Which brings us back to Reeves. She wants growth for Britain. Her supporters describe her as laser focused on it, her detractors as desperate for it. In any case, she has offered nothing transformational to secure it. Her theory of growth seems to be preventing the Tories from cutting taxes, discussing long-term planning reform (which could actually make a difference, but not anytime soon), and maybe someday building another runway at Heathrow to “make Britain the world’s best connected place to do business”. Oh, and not to do anything to piss off the City. Her theory of growth, in other words, is: let’s go back to the Nineties.

It is not the Nineties. The growth of the Nineties wasn’t built on production, but rather on selling off what Britain had, and now it’s gone. That won’t work again. Growth, like politics, is about the future. Reeves is focused on the past. The Nineties were the age in which Britain embraced monetary neutrality, exemplified by the 1997 decision to make the Bank of England independent. Reeves would do well not to make Locke’s mistake, again. Today, states all over the world have followed Locke in depoliticising money on the basis that, over the long run, monetary policy will have no effect on the real economy. And as many are now discovering, there are two issues with this. First, as we’ve seen, it’s not true. And second, to act as if it is neuters our political capacity.

There is almost nothing more fundamental to a state than its power to create money. We cannot just create money out of nowhere whenever we want for whatever reason and assume there will be no negative consequences. We can, however, just create money, and we have done that a lot in recent decades, to support war, to bail out ailing financial institutions, and to survive pandemics. Even in the face of this, we — and particularly the current British government — seem to have failed to grasp the obvious implication: creating money is a political choice and thus, in a democratic society, when and how the state creates money, and on what basis, should be a democratic decision.

Drawn from ‘Our Money: Monetary Policy as if Democracy Matters’.