Lessons from monetary history: The quality-quantity pendulum

from Asad Zaman and WEA Pedological Blog

In the previous section, we saw how economic theories changed from classical to Keynesian to Monetarist over the course of the 20^th century. These changes were driven by historical events. Taking this historical context into account deepens our understanding of economic theories. This contrasts with conventional methodology of economic textbooks, which treats economic theories as scientific laws, which are universally applicable to all societies. In this section, we describe one of the central lessons which emerges from the study of money over the millennia.

The Battle of Methodologies (Methodenstreit)

In the realm of economic ideas, prevailing theories often align with the interests of powerful classes rather than the pursuit of truth. The late 19th Century witnessed the emergence of a supposedly “scientific” methodology, relying heavily on quantification, data, and mathematics, challenging the traditionally dominant historical and qualitative approach in economics.

By the 1920s, this so-called “scientific” approach triumphed, overshadowing and eventually abandoning the traditional qualitative method. This shift, which deprived economists of deep insights available from history, led to significant loss of understanding.

How to Learn Lessons from History?

Given that historical events are unique, learning from them poses a challenge. However, the process involves a learning-by-doing approach. The study of history aims to identify recurring patterns over time, isolating key elements leading to such recurrences. This allows us to forming hypotheses about the reasons for such recurrence. Evidence for and against such hypotheses can be provided, but conclusive proofs are not available in the historical method.

One example of a recurrent pattern is provided by Glyn Davies’ examination of millennia of monetary history: the quality-quantity pendulum. This video-talk aims to elucidate this pattern and explore the reasons for its recurrence.

Benefits of Studying History

Economic theories are inherently intertwined with specific societal contexts and cannot be fully comprehended in isolation from historical circumstances. A diverse array of monetary experiments, both successful and unsuccessful, has been conducted over time, offering valuable lessons for contemporary policymakers. Ignorance of historical insights can lead to the repetition of critical errors.

For instance, a deeper knowledge of history could have steered policymakers away from misguided policies during the Great Depression. Also, some lessons, especially those related to the Quality-Quantity Pendulum, only emerge from a long-term study of history, eluding perception in the short run.

The Nature of Money

Money, or its absence, has been a central force shaping historical events. Beyond a mere transactional tool, money involves strong psychological and social elements. Institutional mechanisms for money operate by instilling confidence and fostering social consensus on its value.

One of the easiest ways to create confidence, and a high-quality money, is to use actual gold: the value of the coin is exactly equal to the gold content of the coin. This approach has often been tried, and its limitations have often been rediscovered. Briefly, gold’s availability and quantity are often mismatched with the needs of a dynamic monetary economy.

The Problem with Gold: Not Matched to Needs of a Monetary Economy

In a monetary economy, production requires money. Producers must incur expenses, buying inputs, labor, renting land or machines first. Production comes later, followed by sales which should recoup the initial expenses, and provide profits. Without money, production would not take place, leading to economic recessions.  Excessive amounts of money can result in inflation. The quantity of gold, being beyond government control, has historically led to economic challenges such as recessions, depressions, and inflations.

Token Money

Efforts to create a stable and high-quality money, essential for economic prosperity, often involved the use of gold. However, gold’s limitations prompted the introduction of token currencies. Governments minted coins, providing official guarantees of quality and quantity.

Minting coins offered advantages such as government control over the money supply, supplementation through gold imports, and the flexibility to use debasement to increase money supply when needed, albeit at the cost of lowering its quality.

The Quality-Quantity Pendulum

The existence of a high-quality money, stable and beneficial for foreign trade, spurred economic prosperity and was often imitated by neighboring societies. However, the temptation to abuse this stability, in order to address emergencies, such as wars, would lead to excessive money creation (quantity). This, in turn, caused a breakdown of trust, resulting in high inflation and an unstable value of money.

Excessive quantity of money erodes public confidence, disrupting the institutional mechanisms that create its value. This causes economic distress to all. Efforts are then made to create high-quality money by restricting quantity and imposing constraints on money creation.

Lessons from History Not Found in Textbooks

The quality-quantity pattern is only discernible over centuries, challenging the perspectives of short-term thinkers. The historical battles between Quantity Theorists and Real Bills Doctrine, Bullionists and anti-Bullionists, Banking versus Currency schools, Monetarists versus Keynesians, and Minsky’s Financial Fragility versus Real Business Cycles are all replays of the Quantity-Quality battle.

Failure to grasp this perspective often leads to dogmatic adherence to one of the two poles. At any one point of time, the choice between the two poles seems clear and obvious. With a high quality money in hand, the arguments for a modest expansion of money are overwhelming. This brings great benefits to all. Also, when the value of money becomes unstable due to excessive quantities, the advantages of restricting production, and creating high quality money, also appear obvious to all.

Equilibrium is an illusion

The monetary pendulum is in perpetual motion, never at rest. Achieving high-quality money, paradoxically, creates the irresistible temptation to create more money, destabilizing the very equilibrium created by it.

Social Aspects of Money

Money is not neutral, neither in the short nor the long run. The psycho-social aspects of money, including confidence in institutional mechanisms, are central to its functioning. Historical events, such as rumors sparking a run on banks or the stabilizing impact of Mario Draghi’s resolute statement, highlight the non-neutral nature of money. These lessons stand in contrast to conventional textbook monetary economics.

In conclusion, the study of monetary history, with a focus on the quality-quantity pendulum, offers deep insights into the dynamic nature of economic systems. The lessons derived from this historical perspective challenge and enrich our understanding of monetary economics far beyond traditional textbook paradigms.