Rethinking Money and Capital: New Economics for Qe, Stimulus, Negative Interest, and Cryptocurrencies

By Swapnil Pawar

While money and capital occupy a centre stage in our daily lives, we rarely pause to think about their real nature. Contrary to an intuitive and unstated belief of most people, money and capital are not resources but simply bidding tokens. This rethinking of their nature can free the collective energies of human race from several artificially imposed constraints that hold no water upon closer scrutiny.

The analysis in this book leads to many counterintuitive conclusions. For example, the fiscal deficit is the counterpart of the demand for net savings by individuals and not an evil to be battled. Inflation is sometimes an indicator of more egalitarian distribution of incomes and not always a scourge that hurts the poor. There is a strong case for negative real interest rates on risk-free debt.

The book employs these and several other such inferences into a broad program for reinvigorating our economic policy towards a better life for all.

• Language: English
• Publisher: One Point Six Technologies Pvt Ltd
• Release date: Jul 18, 2022
• ISBN: 9789355591296

Swapnil Pawar

Swapnil Pawar is a fintech entrepreneur working on bringing blockchain into the mainstream finance. He has been a quantitative finance professional with an experience of over 17 years. He is a keen researcher of macroeconomic theory and its practical applications. His first book (Anatomy of Froth) focussed on the Global Financial Crisis of 2008-09. He writes regularly in various media on finance and economics.Swapnil is a graduate from IIT Bombay and a post-graduate from IIM Ahmedabad. He lives with his wife, Chhavi, in Ahmedabad. He can be reached at [e-mail]

Book preview

Preface: Rethinking Macroeconomics of Money and Capital

What Prompted Me to Write This Book?

I had been studying monetary macroeconomics since 2011. The global financial crisis and the actions it prompted from governments made me think seriously about the fundamental nature of money and capital. As I thought more about it, I came across several startling realizations – which ran quite contrary to one’s commonsense-based understanding. Initially, I put that down to the typical inaccuracy a non-expert is likely to have of the nuances of a specialized field. However, as I continued to study further, I came across several ideas that seem clearly unorthodox and yet sensible. More importantly, they seemed to be more logically consistent with observations than the conventional theories one is taught under the banner of economics.

It is around this time that I also realized a broader issue with the very subject of macroeconomics of the mainstream. This is the issue of excessive reliance on oversimplified models of human economic organization. To me, it seemed to undermine the very basis of mainstream economics as a useful study of real-life economies. Since then, I have lost faith in what is variously called mainstream economic thinking, neoclassical economics, and orthodox economics. As I continued to lose faith in it, I also realized that most of the economic debate in media, academia and government is still largely informed by and contextualized in this very erroneous thinking. This observation prompted me to write this book.

The intent of this book is twofold. Firstly, I have attempted to examine some of the major themes of our times (fiscal deficits, inflation vs growth, monetary policy in recessions) from first principles instead of using an existing theory. This leads to several interesting conclusions. Secondly, I have tried to arrive at some implementable solutions for our times, in the context of both developed economies and emerging economies.

Foundational Ideas Explored in the Book

Given the topic at hand, the book explores multiple connected themes. I have tried to list down a few central ideas that mark the departure of this book’s approach from mainstream economics.

1. The defining characteristic of capitalism is protection, accumulation, and growth of wealth for individuals.

It is not, efficient allocation of resources and maximization of production of goods and services, as is usually claimed.

2. Money and financial wealth are contracts, not resources. They originate, move about, and disappear within their own self-contained circuit, dissociated from real economy. The total stock of money is endogenously determined by the economic actors and institutional constraints. The same goes for the total stock of financial capital.

Money+Capital don’t merely facilitate transactions and store value in an inert manner but act back on the real economy – shaping decisions and not just facilitating them.

3. Most of the conventionally accepted economic ‘laws’ (supply and demand, marginal utility, etc) do not apply to money and financial capital. Instead, we need to use stock-flow consistent accounting coupled with behavioral tendencies of economic actors to arrive at the drivers of the evolution of money and financial capital.

The initial chapters explain these ideas further. These re-descriptions matters because they have important implications, some of which are listed below.

a. The primary driver of capitalist economies i.e. protection, accumulation, and growth served a useful purpose to further the growth of the real economy until the late 20th century. However, it is starting to distort the real economy in recent decades. Left unchecked, it will lead to a quasi-feudal society.

b. The objectives of fiscal and monetary policy are political questions and not economic ones.

The primary objective function of policy need not always be to maintain the stability of the relative value of money and financial capital. It can also be it is to use the institutional framework around these contracts for macroeconomic stability and human welfare.

c. The government has a sufficiently large array of tools in the monetary and fiscal institutional structure to improve stability and welfare – most of which is underused or unused due to the legacy theory of money and capital.

d. Laws/norms governing the evolution of money and capital apply at the aggregate level and are best studied through approaches like agent-based models. Such approaches allow the complexity of aggregate behavior to be retained. Shortcuts of the conventional theory such as the representative economic agent lead to inaccurate models and forecasts.

The above lists are not the summary of the book. I have devoted the starting chapter to that. The central idea and their implications are more along the lines of reasons to explore the approach taken here.

Audience

The book is targeted at the well-informed individual who has wondered about the matters of macroeconomics from a distance – presumably on account of lack of direct expertise in it. It is aimed at anyone who does not take mainstream economics as the final word. I am not expecting the reader to have studied economics or finance. The only expectation from the reader is one of patience. The topic at hand is somewhat complex. The reader is also likely to have been bombarded with strong but incorrect claims of the existing mainstream in various forms – be it editorials of half-baked economists or analyses of equity fund managers. I request the reader to have an open mind and stick with the arguments presented to their logical conclusion. Rest is up to the strength or lack thereof of the ideas presented in the book!

Chapter 0

Summary of Main Arguments of the Book

The idea of this chapter is to explicitly state the conclusions of this book right at the beginning since they are somewhat surprising. These are then followed up through the rest of the book with supporting thoughts, conceptual explorations, and facts. Many of these inferences may appear jarring or counterintuitive. This chapter is not a place to explain them fully. Hopefully, as the reader covers more and more of the subsequent chapters in the book, she will reach the same conclusions. At the very least, she would understand the basis of the conclusions.

Let us get started!

1. Left to itself, a pure laissez-faire economy will grind to a halt. Much has been made of the invisible hand that guides the butcher and baker to help one put together a meal, without the benevolence of anyone. The extension of this common-sense approach in mainstream economic theory is that a fully unregulated economy where markets decide everything is self-sustaining and internally consistent. The corollary of this dogmatic belief is that any intervention in the functioning of markets causes distortions that are bad for the participants in the economy.

Neither the belief nor the corollary is arrived at using any analysis – both are assumed to be fundamental truths of human existence! A relatively simple simulation through agent-based models shows that this belief is false, even in theory. The logic of the invisible hand, appealing as it may be, is inherently microeconomic and applies to individual transactions or a contained subset of the overall economy. At the macroeconomic and aggregated level, it can be shown that a pure laissez-faire economy will grind to a halt, irrespective of demand functions for goods, labor, and capital equipment. The standard tendency of such an economy is a continuous fall in production accompanied by an increasing concentration of wealth.

2. Money and finance are not resources, unlike land, intellectual property, or minerals. They should not constrain capacity utilization, growth, and consumption in an economy. However, in the present economic system, they do. We have situations of spare productive capacity and spare labor combined with unmet demand, across many economies in the modern world. This is a grotesque sub-optimality arising because of money and capital being treated as a resource.

A thorough analysis (taken up in the book) implies that money is merely a bidding token for real resources and represents only relative purchasing power. Financial assets like bank deposits, government bonds, equity stocks are advanced forms of money– they are effectively current money converted into remunerative contractual future cash flow obligations. Hence, what applies to money applies to financial assets too. Neither money nor finance is a resource that really should come in the way of consumption or capacity expansion.

3. There is an inherent and growing mismatch between the supply of money savings and demand for it, in most modern economies. A capitalist economy is characterized by firms that seek profits and individuals that save. Both these participants are constantly looking to accumulate money profits and money savings. Their demand for money profits and savings is relatively constant and generally increasing. This demand is met by ‘dissaving’ by some firms and in recent decades, by the government.

The only sustainable version of dissaving that conventional theory allows is the capital expenditure by firms since fiscal deficits are frowned upon. However, such capital expenditure by firms is, by its very nature, volatile. Hence there is a mismatch of steady and growing demand for money profits/savings on one hand and volatile supply of money dissaving on the other hand. Also, capital expenditure cannot be a perpetual source, even in theory. As the pace of investments dampens over time, the ‘supply’ of dissaving to fund the demand of money profits/savings dwindles. In the meantime, the ‘demand’ for money profits/savings continues to be strong and institutional arrangements for the same get more and more entrenched.

This flaw is already becoming apparent in the developed economies of today, which can be said to be in a post-industrial epoch of their evolution, with falling real investments. It will continue to become more visible as real investments continue to fall further and the growth of fiscal deficits starts to run into political opposition.

4. The endgame of the modern capitalist system left to itself, is either a return to a quasi-feudal society with extreme levels of wealth concentration or revolutionary and unpredictable changes in a socio-economic organization. A constant tendency of the capitalist mode of economic organization is an increase in wealth concentration. This is not through a coordinated conspiracy but simply through routine operations of the system. The ultimate effect of such a constant increase in wealth concentration is a likely return to feudalistic economies. In such a set-up, a few will control almost all the means of production while the majority will toil in production facilities in exchange for a subsistence income. This was the nature of early industrial society as well as the late feudal society. Now that the golden age of capitalism has nearly drawn to a close, a return to a similar mode of organization is not unlikely, even if it happens over a few decades. Only significant institutional innovations on the fiscal and monetary policy side offer better paths of evolution. Some of these institutional innovations include universal basic income, proactive and counter-cyclical fiscal policy, and negative risk-free real interest rates.

5. The natural level of risk-free interest rate is negative. This refers to the nominal rate minus inflation, and the return on short-term government debt. This rate should turn mildly positive only in situations of full capacity utilization and overheating. In all other times, money should not generate positive returns for being held in a risk-free manner. It should cost something to hold money thus. This is because money is an open-ended call option on goods and services and hence should have a cost attached to its holding, rather than a return. At an aggregated level, there may be a case for a positive real return on money in the special case of highly inflationary situations, where reducing consumption has an upside for the economy as a whole. In all other situations, the risk-free real rate should be negative.

Over and above the base rate (risk-free and short term), the risk premia should of course be positive, as they are at present. In other words, any real return should be the result of some risk being taken. The natural rate of return on money that is held as it is, without being spent, should be negative.

6. Fiscal deficit is not inherently bad. The most common source of dissaving for meeting the demand for money profits/savings in advanced economies of our day has been fiscal deficit. In the US, EU, and Japan, for many years fiscal deficit has funded the shortfall between the demand for money profits/savings and the supply of money dissavings (real investments and net exports). The fiscal deficit is inflationary only during the special case of full capacity utilization.

For many of the modern advanced economies fiscal deficit is the only certain way to maintain full capacity utilization on a sustained basis. In its absence, many economies are likely to be faced with the conundrum of empty hospitals and closed factories despite a lot of untreated patients and a large unmet demand for goods and services. It is incorrect to treat the government as a household or firm that should run a surplus to be considered ‘sound’.

The size of fiscal deficit/surplus is an important policy matter. Fiscal policy is different from expenditure policy and should be run by an independent government body. Fiscal policy can be used to stabilize the economy (for advanced economies) as well as to grow it aggressively (for emerging economies). It should be run by an independent body within the government – say a ‘Fiscal Policy Board’. It will be to fiscal policy what the central bank is to monetary policy.

7. A modern-day government cannot be forced to default on its debt denominated in its local currency. Given the mandate of a typical central bank to keep the interest rate in its target band and its ability to expand its balance sheet without limit, should the need arise, there is no situation in which a modern government runs out of ‘money’ to pay its obligations. This applies to virtually the entire debt of the US and Japan, while Eurozone is complicated by its own institutional design. Even for smaller economies like India, the local currency debt is free from default risk. The claims of bond-market vigilantes are inconsequential given the institutional design of modern banking, central bank, and government debt. A caveat due to the balance of payments with the rest of the world applies for some smaller economies – however, that still does not make the conclusion incorrect, but just a bit more complicated.

8. Inflation is not an exclusively monetary phenomenon, nor can it be contained by interest rate increases alone. The celebrated conclusion of Milton Friedman is, to state it plainly, simply wrong! As we will see, to say that inflation is a monetary phenomenon is either a trivial statement or an incorrect one, depending on the definition of what ‘monetary’ is. In either case, it is irrelevant. Inflation is a ‘real’ phenomenon insofar as it can arise from real economy interactions without money supply growth and government intervention. Likewise, it can be dealt with using non-monetary means. More importantly, there is no theoretical basis for inflation targeting being practiced by most modern-day central banks.

In fact, one can argue that the range of inflation targeted by most central banks is too narrow and quite unrelated to the assessment of the demand gap. Especially for high-growth economies, a wider range of inflation can be lived with, even more so when it is driven by the supply-side. The general preference for low inflation at the cost of growth primarily serves the interests of rentiers at the expense of entrepreneurs and labor.

9. Universal basic income (UBI) is useful for macroeconomic stability and growth. In most analyses of UBI, it is proposed as a ‘necessary cost’ that welfare-oriented governments should seriously think about. This apologetic formulation of UBI is misguided, even if humanitarian. In reality, UBI is beneficial to all participants in the economy. It has the tendency to put a floor on consumption demand. Besides, as detailed in a later chapter, simulations of agent-based models suggest that a pure laissez-faire economy may be made to work sustainably simply by adding a constant new money stock to all participants in the economy. Hence, one can argue that UBI works to partly offset the activity-reducing effects of a standard laissez-faire economy, noted above.

The money spent through consumption by most of the recipients of UBI will find its way to the profits and savings pools of the better-off participants in the economy – thus making everyone happy. In other words, the profits of firms and savings of richer folks are likely to be higher in a UBI-based economy than in an economy working purely on laissez-faire. Since virtually everyone can be better off without anyone being worse off, UBI seems like an upward shift of the Pareto-optimal curve!

Based on the above observations and inferences which are covered in the book, some recommendations emerge for advanced economies and emerging economies. These are also covered in greater detail in the last few chapters. The below is meant to be a teaser for these chapters.

Recommendations for Developed Economies

diamond Reform the institutions surrounding government debt.

Square Remove the obsession with the size of fiscal deficit and the stock of government debt.

Square Create a board of fiscal policy that will manage the size of fiscal deficit/surplus in line with capacity utilization inputs, without getting into the details of the specifics of expenditure.

Square Use counter-cyclical fiscal policy at all times. During recessionary periods, use fiscal deficits to achieve near-full capacity utilization. Conversely, run balanced budget or fiscal surplus if nominal aggregate demand exceeds the capacity of the economy.

diamond Make the interest rates on short-term government securities negative in real terms in all situations other than full capacity utilization. Increase real rates to a positive level only when aggregate nominal demand is starting to exceed the capacity of the economy.

diamond Use universal basic income to sustain a minimum level of consumption across the population. Keep UBI mildly countercyclical.

diamond Make the monetary system robust.

Square Make capital adequacy requirements for banks pro-cyclical i.e., increase capital cushion required during periods of high growth and reduce it during periods of low growth.

Square Add equivalents of capital adequacy requirements on capital market activity – to reduce the volatility in debt-driven economic growth.

Recommendations for Emerging Economies

diamond Have an activist fiscal and monetary policy directed at a rapid accumulation of production capacity.

Square Use money systems aggressively to push for rapid accumulation of physical production capital. E.g., capitalize banks aggressively and create new lending institutions to expand capacity rapidly.

Square Keep capital adequacy requirements very low for productive capacity expansion and infrastructure development.

Square Create large pools of money for bank recapitalization.

Square Expand net exports to avoid getting bogged down by capital account repercussions of an unorthodox fiscal and monetary policy.

diamond Remove the belief about ‘capital’ constraint. Do not treat money and finance as a resource that may constrain growth. Move to treat money as a bidding token instead, which can be managed proactively and for welfare ends.

diamond Reform the institutions surrounding fiscal policy and government debt

Square Do not obsess over the size of fiscal deficit or the total size of government debt.

Square Direct fiscal resources to skilling of the population and infrastructure development.

diamond Alter the attitude about and policy response to inflation.

Square Do not obsess about a narrow range of inflation. Target stability of nominal GDP instead.

Square Widen the tolerance band for inflation.

Square Use counter-cyclical fiscal policy to control overheating.

Square Use interest rates only sparingly for inflation control.

diamond Make the interest rates on short-term government securities negative in real terms in all situations other than full capacity utilization. Increase real rates to a positive level only when aggregate nominal demand is starting to exceed the capacity of the economy.

A Guide to Reading the Book

While I would prefer if the reader read the whole book, the following are some ideas for prioritizing should the need arise.

1. If the reader has the time to read exactly one chapter, I recommend chapter 3.

2. For readers keen on some new ideas and original thinking, chapters 2, 3, and 4 should work. Advanced topic 1 is novel too.

3. Readers keen to understand the future of money, central bank digital currencies as well as cryptocurrencies, can go to chapter 7 first.

4. If the reader’s primary interest is in practical policy implications, chapters 8, 9, and 10 cover these. Chapter 10 in particular is focused on recommendations for India.

5. For a better conceptual understanding of government debt and fiscal policy, chapter 5 is relevant. Advanced topic 3 is also relevant for this.

6. For a better understanding of inflation, chapter 6 is useful.

7. Readers keen to understand the stock-flow consistent operations of the monetary system, advanced topic 2 is ideal.

In general, the advanced topics are meant for readers that don’t mind diving deeper into nuanced conceptual arguments. I have had fun exploring most of these. You might too!

Chapter 1

The Alternative Model

Before we get into a full-fledged revision of how we think about money and capital, it is important to state the proposed model explicitly. This chapter is aimed at that.

Money and Capital Are Tokens and Not Stores of Value

The conventional model is based on a fundamental belief that money and capital incorporate value – in the form of purchasing power. This model implies that while this value may vary, a sound policy keeps it stable and predictable.

In the model I am proposing, money and capital are tokens of exchange and storage. They attempt to mirror, to varying degrees of success, the value inherent in human society. The source of value is the collective of human beings – organized in some form or other, to further their individual and collective goals. As human beings go about their social interactions, they get into various transactions including contracts. Money was invented to smoothen these interactions.

Capital is an account of ownership. Its value arises from its use by society. The money-based transactions for use may not cover all relevant costs and benefits of a capital asset. There is no ‘inherent’ and ‘inalienable’ value to a capital asset other than its use by human beings.

Well-Being of Human Society Outweighs the Sanctity of Protection of Purchasing Power

There is an unstated social contract in a capitalist society – the protection of the value of accumulated capital and the ability of its owner to freely use it supersedes everything else. This is often summarized as ‘right to private property’. The underlying theme is that if some money and capital have been legally acquired by someone (whether by virtue of return on capital, luck, inheritance, hard work, innovation, or any combination of these) the society as a whole agrees to respect the purchasing power of that accumulation.

The corollary of this belief is that society will not proactively engage in taking away – directly or indirectly – this accumulated purchasing power.

In my proposed alternative model, the institutions of private property, money, and capital are subservient to social wellbeing. These institutions are not coded in our DNA – they were invented by human society to organize a significant improvement in its material wellbeing over the last few centuries. It has worked well. However, the social contract is increasingly irrelevant, since its primary objective of significant improvement in material wellbeing of overall human society has been met, at least in the developed world. The same social contract has proven incapable and even detrimental to the ongoing phase of human society’s evolution – namely wider dissemination of the improved standards of living to the poor in the developed world and to the masses in the developing world.

This social contract is also limiting the ability of human society to fight the global challenge of climate change – and to aid the wider aspiration of sustainable human living.

Human society threw away feudalism when it stopped working. The current model is showing all the signs of being outdated and it is high time we, as a species, went back to the drawing board!

Real Economy vs Money Economy – Tail Wagging the Dog

A connected matter is the confusion of the real economy with the monetary economy. The very term ‘capital’ means different things to different people. Many economists see it as the productive resources of an economy – which may be represented as shares and bonds but are ultimately assets producing some goods or services that are useful to someone. In other words, capital assets are relatively stable arrangements of matter, energy, bytes, and rules that can direct matter, energy, and bytes in a manner that is desirable to some human being or their organization. This is a real-world asset.

To a saver, capital is a ledger entry that enumerates her purchasing power. She doesn’t care a whole lot about what ultimate movement of matter, energy, or bytes is done to enable this ledger entry. Her only concern is that this entry maintains its value and grows – so that she can exchange it for something else or pass it on to someone else. This has led to the situation of modern economies where the financial markets dominate real-world choices – a case of the tail wagging the dog!

In the previous 3-4 centuries, this distinction probably held human society in good stead as we went about building factories, intellectual property, and so on. However, it also led to the emergence of a chasm between the behavior of owners of capital and its end-use. The increasing distance between the real-world assets and their ultimate owners has led to all sorts of challenges – not the least of them being climate change.

More importantly, the split has led to a strong preference for maintaining and growing the capital as seen by the saver as against the capital as seen by the economist. This has led to a lot of confusion in terms of what matters more – the real economy or the monetary economy.

In my proposed model, the real economy supersedes the monetary economy. Hence the concerns of improving the real-world assets are more important than maintaining and growing the ‘owner side’ of the capital.

Fungible Money vs Non-Fungible Real-World Assets

An important corollary of the real-world vs monetary/financial world split is that all assets are reduced to being measured in a very straight-jacketed manner. Since we measure everything in money terms and track our collective wealth in the form of capital assets, we are inclined to see everything as being fungible. A toy factory exploiting workers and a very employee-friendly software firm are both equity stocks for an investor – with the only difference between them being their expected returns, dividend yield, and price volatility. Going further, bonds issued by the Greek government are as much a part of wealth as real estate investments in warehouses in Indonesia. The decision-making is simple – risks, rewards, and liquidity.

The fact that there are different implications of the operations of different real-world assets is lost in the translation of everything to money terms.

In my proposed model, money and capital are tracking tokens and the decisions are made at the level of actual real-world level of capital assets.

Politics vs Economics is a False Dichotomy

Debates like central bank independence often work with an implicit assumption – democratically elected officials cannot be trusted with important decisions related to money and capital. Technocrats with no answerability to the wider public are better placed to look after their interests. Populism may blind politicians into taking ‘wrong’ decisions that may ultimately hurt the common public.

This and similar arguments look to split the public sphere into ‘political’ and ‘economic’. The political sphere is where negotiations happen and different groups lobby for different outcomes – some win, some lose. The economic sphere is where the smart people from renowned universities maintain the stability of our economic lives – using ‘scientific’ rules and ‘data-driven’ decision-making.

This sounds more like the splitting of church and state in medieval Europe. Just like that case, it is simply a case of alternative power centers. To look at more recent examples, till the beginning of the first world war, the (unelected) House of Lords in the British parliament had significant power over the society – while allowing the (elected) house of commons to exist.

In my proposed model, there is no such split between ‘politics’ and ‘economics’. The two are inextricably linked. All economic policies and models have some political ideology underlying them (including ones proposed in this book). In explicitly identifying it, we can bring more transparency to the economic debates. One such is the case described next.

Historical vs Permanent Macroeconomic Truths

The Washington consensus and neoliberal economic thought have an air of being ‘fundamentally true’ as against being ‘historically true’. As we will see later in the book, the claim that ‘inflation everywhere and always is a monetary phenomenon’ is stupid. However, neoliberal economics is full of many such universal claims. Instead of seeing economics as a subset of human interactions steered by prevailing institutions, historical contingencies, natural elements, human behavior, and the like, neoliberal economic thinking has spent all its resources in trying to figure out ‘time-invariant economic laws’.

This approach is fundamentally flawed. Economics is not physics. It is closer to biology. There are patterns in how species develop but no ‘laws’. Biologists do not make any claims of such laws either. They are busy trying to find, refine, debate these patterns. Most of the mainstream economists on the other hand are busy trying to establish ultimate truths of human behavior and economic organization.

In my proposed model, economics is studied in the context of historical developments and prevailing institutions as much as ever-green patterns of human behavior. Instead of making totalitarian claims of ‘everywhere and always’ we will focus on ‘what is going on now and how to make it better?’.

Logistics of Money and Capital in the Modern World – Far Removed from Theory

A side-effect of the hunt for