Like gold, diamonds last forever, and often experience similar price fluctuations to gold. These price changes are, in turn, like those of oil, which is also drawn from limited ground-based reserves. The ups and downs of the dollar prices of diamonds, gold and oil tend to follow each other rather closely during periods of accelerated US money supply growth. These co-movements help give insight into an ongoing puzzle about the relationship between oil prices and inflation.

One theory posits that oil prices are relative price changes that cause inflation. Another says the causality is the opposite: that inflation and the expectation of inflation cause oil price increases, and that both are, in turn, caused by the growth rate of the money supply.

In the 1960s and 1970s a popular theory circulated that inflation was not caused by money at all, and that theory has reared its head again, as oil prices and inflation have both risen during the ongoing Covid-19 pandemic and, now, with Putin's war on Ukraine as the pandemic subsides. The oil price theory of inflation is that oil prices are increased by monopolistic “price-gouging” behaviour on the part of the suppliers of oil. The origin of the idea was that oil suppliers are able to form a monopoly, so that they become the only suppliers of oil and therefore are able to dictate a monopolist world price of oil that maximizes their profit.

The monopoly was said to be the Organization of the Petroleum Exporting Countries (OPEC). In September 1960 OPEC began as a group of five nations trying to coordinate new oil production. Prices for a barrel of oil were denominated in US dollars, while the Bretton Woods monetary regime locked the US dollar price for an ounce of gold at $35.

The choice of using US dollars per barrel enabled the price of oil to remain stable as long as the gold standard lasted. The dollar oil price from the start of OPEC until the breakdown of the Bretton Woods system fluctuated very little, keeping at a near-constant $3 dollars a barrel from June 1953 to November 1970.

The spectre at the feast manifests in Shakespeare's Macbeth as the ghost of Banquo. A former ally whose progeny is prophesized to become king, Banquo is murdered by Macbeth's men. Banquo's apparition then appears at the feast, seated in Macbeth's chair and seen only by the orchestrator of his murder, who goes mad, bringing the festivities to a premature end.

Modern events can mirror such tales when those obsessed with power do anything to hold onto it. The spectre of inflation has loomed historically as a threat to civilized economic exchange whenever wars or crises have induced high government spending deficits, with tax revenue falling well short of expenditure. Rising inflation is destructive and is caused by government agents clinging to their discretionary power by printing money at increasing rates. Such inflation threatens to fell any economy in which a government incurs high budget deficits. When inflation rears its head, it wipes out the gains in income and wealth that growing economies foster.

Once government deficits become too high, potential future inflation threatens money's value. Inflation had, until recently, been moderate and well contained by monetary authorities (namely central banks). This required the conditions of international peace and fiscal restraint by governments so that central banks were not pressured to finance wartime or crisis spending through the purchase of government Treasury debt and by giving fresh money to governments to spend. When fiscal restraint is broken, central banks typically help finance spending, with the result that inflation either rises or is suppressed – with even worse consequences.

Restraint on the part of central banks is designed to ensure money value through low or no inflation. When low inflation rate targeting became a widespread policy internationally, central banks had clear objectives that everyone could measure and consider in judging their policy success. But, ever since the terrorist attacks of 2001, the US government has run unending and rising deficits as a share of national output. The central bank of the United States, the Federal Reserve System, in turn financed a large portion of this rising deficit by buying Treasury debt, which is how central banks “print money”.

Central banks conduct monetary policy for their governments and have oversight of the private bank system. Central banks evolved from private banking. The development of private banking hinged on how interest came to be a normal return on capital. It has a complex history, because religion has imbued interest with questionable morality. The main problem was that a lack of good regulation allowed “usurious” rates of interest to be charged that were considered too high.

For the first two centuries BC, Ancient Indian, Vedic, Sutra and Jatakas texts referred to usury as interest in a negative way. Religions and governments restricted or banned interest. Julius Caesar imposed interest rate ceilings, and in 349 AD all interest was banned in Rome. Pope Clement V banned interest in 1311 for Christianity. Judaism disallowed some forms of interest but was lax in regulating interest payments. Islamic law continues to ban interest to this day (Visser & McIntosh 1998).

Stable money during the Renaissance allowed private banking to flourish. This required innovative ways to avoid the prohibition on usury. Although the payment of interest was at first concealed, its use broadened steadily in ways that led to modern banking. In the fourteenth century the Genoese city state government borrowed money, creating public debt. The funding for such loans was provided by the private investors who helped build Genoa as a centre for transportation and trade. But, with the charging of interest prohibited by the Catholic Church, they resorted to indirect means for obtaining interest for loans.

A way to receive interest developed through the sale of “bills of exchange” between international branches of the same bank. The exchange of bills (debt owed by an entity) allowed them to be redeemed in a different currency in a different country for a set amount after a certain time, such as three months. Then the redemption was transferred back to the original branch, with the exchange amounts specified in the other country's currency such that a larger transfer was returned to the original branch than had left it. This incremental income acted as the interest payment for the length of the transaction.

In the Goldfinger movie of 1964, as based on Ian Fleming's 1959 book, the eponymous Goldfinger accumulates as much gold as possible for “50 years” and then attempts to render the US Fort Knox gold stock radioactive. With the Fort Knox gold reserve unable to circulate, the idea is that the value of the remaining gold stock should increase dramatically. This would be the result of an act of terrorism (“economic chaos in the West”) to enhance Goldfinger's personal wealth.

Although this might bring to mind the real and equally fiendish efforts by Russia's president, Vladimir Putin, to monopolize oil and gas wealth, consider the question of whether the act of making radioactive the gold in Fort Knox would devalue that gold at all. If everyone respected that the United States had the same amount of gold before and after Fort Knox became radioactive, then the price of gold would be unaffected. The gold would still be in Fort Knox, and it would still be valued at the international price of gold.

Friedman (1994) tells the story of Yap, an island in Micronesia that during the twentieth century used stone wheels (“fei”) for money hewn from limestone rock on an island 400 miles away. One large wheel had been made for an islander and was being delivered by boat; the boat capsized, and the wheel sank to the bottom. The islanders acknowledged that the islander owned the wheel in the sea and gave monetary credit against the value of that wheel even though it could not be retrieved.

The stone wheel story illustrates how an asset's value holds, even if it is not in circulation. The world may be less trusting than the people of Yap, however. It might not respect the US ownership of the Fort Knox gold if it was radioactive, which, like the Yap stone, could no longer circulate. If not, then this would effectively decrease the quantity of the gold from the rest of the world stock of gold. The decrease in the gold supply would make the remaining gold more valuable, as Goldfinger envisaged.

A decrease in gold, as in Goldfinger's scheme and Friedman's sinking of a stone near Yap, actually occurred in the United States when the SS Central America, or “the Ship of Gold”, sank in September 1857 with thousands of pounds of gold that New York bankers were awaiting.

Central banks faced a dilemma after the 2008 debacle over how to keep the global financial system from the type of broad financial collapse experienced in the Great Depression. The prolonged US negative real interest rates after 2001 set the tone for the globalized capital markets. As they did during the Vietnam War, countries responded after 2008 by following US-centric negative real interest policy.

Bretton Woods members supported the United States during the Vietnam War by buying up the US dollars used to finance it. This stabilized the fixed exchange rates of the Bretton Woods era with the US fixed price of gold. After 2008 democratic, globally integrated countries around the world followed US real interest rate policy to stabilize the floating exchange rates of the fiat era.

International central banking innovated policy to mimic the United States on real interest rates. By maintaining the same real interest rates, exchange rates could remain stable. If real interest rates were higher in a country than in the United States, capital would flow into that country and cause its currency to appreciate.

Countries followed US real interest rate policy across both developed and emerging markets. For example, China followed the US policy until 2014, after which it disengaged from the democratic capital policies of the international financial system, while still holding trillions of dollars of US debt (Csabafi, Gillman & Naraidoo 2019). Other international central banks had to react quickly to induce negative real short-term interest rates so as to avoid currency appreciation through capital arbitrage.

Arbitrage happens when, for example, capital savings can earn a real return of 2 per cent in a European market and only – 1.75 per cent in the US market. Then financial industry traders can move the capital from the United States to Europe to get the higher return on capital. Capital flowing into Europe would push down the return on capital in Europe. An equilibrium results whereby arbitrage possibilities are eliminated by equalizing the real return on capital, net of any arbitrage cost, across global capital markets.

Defining inflation was not always easy. Irving Fisher began this task in earnest in the early twentieth century. He organized the first meeting of the Econometric Society in 1930, was elected its first president and oversaw the first issue of the society's renowned Econometrica journal, which published the proceedings of its first meeting. The society's constitution was also published there, declaring that it was “for the advancement of economic theory in its relation to statistics and mathematics”.

Fisher had long been interested in price stability. He devised a statistical index that could be used to measure changes in the aggregate price level, called Fisher's (1921) “ideal” index. The next year he published a treatise on price indices, The Making of Index Numbers (1922), that included implementing the index to provide a historical sequence of data on the US price level during the high-inflation war years of 1914– 18.

The rate of change in the aggregate price level is the definition of the inflation rate. Fisher and others since him have applied this measure, or similar ones, to the US economy and shown how the index changes over time. This is typically presented as the rate of change at an annual rate.

This annual rate of inflation measures the change in the price index relative to a year ago. It is measured relative to the average price level over the current month compared to that average in the same month a year ago. Alternatively, the comparison can be to the average price level over the current quarter of a year relative to the average over the same quarter a year before. Equally, it simply can measure the percentage change in the index over a calendar year. This allows the calculation of an annual percentage change in the price level, as given from one month to the same month a year later, from one quarter to the same quarter a year later or on a calendar year basis.

Fisher showed how money changes in value in terms of the actual goods and services that people can buy with money. If you hold a dollar bill, then you can purchase one dollar's worth of goods.

Bad bank policy increases inflation rate volatility. Even worse bank policy causes inflation rates above market interest rates for decades. Savers suffer the consequences.

Without a comprehensive US bank insurance system throughout its history, except for that of the FDIC, Figure 4.3 shows that the US inflation rate was erratic with sharp fluctuations from 1774 to 1873, which marked the beginning of the gold standard. The US bank panics of the late 1880s experienced less inflation volatility until 1914, after which successive wars all coincided with highly volatile inflation rates. After the Balanced Growth and Employment Act of 1978 was passed, US inflation rate volatility decreased from 1983.

As capital markets developed after the civil war, private bank insurance began to shape itself through the clearing house system. After the failure of the Fed to provide similar insurance during the Great Depression, the FDIC was established, and the Fed maintained reserve requirements for banks, while mainly taking the role of financing fiscal deficits during war and crises through additional money creation.

The panic of 2008 revealed US complacency over bank policy. Financial market development saw increasing avoidance of both the deposit premium payment for the FDIC insurance and the reserve requirements of the Fed. Reserves in the Fed of 1 per cent of all commercial bank deposits in 2008 offered little support during the bank panic, and the banks experiencing panic were not covered by the FDIC.

In the good times, after inflation rate targeting took hold in 1983 up until 2008, the Fed entertained a “come as you are” party that left bank insurance policy in tatters. Its 2008 “macroprudential” banking policy launched a “Moonshot”, with the Fed newly hoarding excess reserves in a haphazard attempt at bank insurance policy for those outside the FDIC. As a result of excess reserves mounting up irregularly, rather than all being lent out as in previous history, the Fed temporarily shifted volatility from the inflation rate to capital markets.

This new volatility has been in the ascendant the entire time since the Fed's attempt to establish a bank insurance policy through excess reserves. The consequent capital market volatility affects the whole economy, deserving the “macro” part of the “macroprudential” moniker, but leaving “prudential” questionable at best.

Bagehot describes how the Bank of England should use its reserves to stem bank panics. His rule was to lend generously, at higher than existing market interest rates, to any bank needing reserves. This dictum is that the Bank should act as the lender of last resort. To do this the Bank needs to keep gold reserves both for the money supply and for some fraction of the deposits of the entire private banking system, such as an apprehension minimum of 37 per cent, in his example.

Bagehot says this minimum level is arbitrary, subject to change and something of an art to identify. But, regardless of the minimum fraction of reserves that are held in relation to deposit liabilities, the total reserves held are fewer than they might otherwise be because the Bank of England acts to pool all the reserves together. The Bank pools risk so that it can direct reserves to banks in sudden need, so each private bank's reserves that are held at the Bank are smaller than if there were no such central bank, as in France and the United States at the time. Speaking of the joint-stock banks, Bagehot (1873: 107) says: “Not only did they keep their reserve from the beginning at the Bank of England, but they did not keep so much reserve as they would have kept if there had been no Bank of England.”

Therefore, the British system of banking circulated more capital than other countries. In contrast, the “natural” banking systems of France and America at the time were designed around each bank keeping sufficient reserves to ward off its own individual bank failure. This natural, traditional system is equivalent to self-insurance by each bank rather than the pooling of risks of reserve demands into a central bank, as the Bank of England did. Bagehot (1873: 107) writes: “I have tediously insisted that the natural system of banking is that of many banks keeping their own cash reserve, with the penalty of failure before them if they neglect it. I have shown that our system is that of a single bank keeping the whole reserve under no effectual penalty of failure. And yet I propose to retain that system, and only attempt to mend and palliate it.”

Federal Reserve officials supply regulations to help banks. Although the information is difficult to find in Fed minutes, just ten banks hold almost all the excess reserves of the Fed system. These ten banks were in receipt of the new interest on excess reserves that the Fed decided to pay them from 2008.

Excess reserves are those reserves that are over and above what is required to be held at the Federal Reserve. Traditionally, banks had tried to keep the exact amount of required reserves, due at the Fed each week, with zero excess. From the second quarter of 1984 to the second quarter of 2008 excess reserves averaged $1.3 billion, a minimum that could be feasibly achieved.

Once the Fed began paying IOER, excess reserves averaged $1.75 trillion from the third quarter of 2008 to the third quarter of 2020. That is more than a thousand-fold increase, going from billions to trillions of dollars. This happened even though the interest rate paid was very low, and below the inflation rate.

Figure 11.1 shows how excess reserves quickly built up at the Fed, rising from zero to $2.7 trillion by the third quarter of 2014. They began to trend down after that, until rising again during the Covid-19 pandemic till the excess reserve data series ended in 2020. Since then these “excess” reserves are now just called reserves, and shot up to above $4 trillion in 2021.

The data series on excess reserves ends in September 2020, when the Fed changed its reserve requirement to zero. Therefore, reserves could no longer be called “excess reserves”, since a reserve requirement no longer existed. In addition, the Fed's name of “interest on excess reserves” was officially changed in July 2021 to “interest on reserve balances” (IORB).

The Fed had required reserves for banks for over a century, from 1914 until 2020, with a continual decline in the requirement evident as banks avoided it. Feinman (1993: 570) describes how depository banks had to keep 10 per cent of reserves on “transaction deposits” that were viewed as being subject to immediate demand:

The Bank of England is located around the corner from Lombard Street in central London. When visitors walk in through the door, very few ever view the vault's gold, the value of which is second only to that of the Federal Reserve Bank of New York.

The United States also holds gold, in its US Mint depository at Fort Knox, made famous by the movie Goldfinger. Movies about gold made in the 1960s were filmed when the Bretton Woods system bound together the Western alliance in a US-based metallic gold monetary standard. The US gold backed the US dollar, just as the Bank of England's gold backed sterling after the Bank Charter Act of 1844, passed by the government headed by Sir Robert Peel, as described in Bagehot's Lombard Street (1873).

Once the Bretton Woods system had broken down, we might expect that the gold would be dispersed, and be used to finance normal spending by governments. In the United States, the Gold Reserve Act of 1934 required the Fed to transfer ownership of its gold to the US Treasury. The Treasury owns the gold in Fort Knox, issues US debt in order to borrow to cover deficits when its spending exceeds tax revenue and could sell the gold assets to cover some of the government deficits.

In the event, however, the main repositories of gold during the gold standard period retain much of the same gold today as they did when currency was redeemable in gold. Central bank gold stocks have not been sold off. They languish indefinitely in vaults at the cost of security and storage space, despite the paper-based fiat world in which we live.

The US Federal Reserve Bank of New York has the largest depository of gold in the world. The New York Fed holds only about 5 per cent of US Treasury gold, however, which in total is worth about $11 billion in 2018 prices. The rest of the gold is held for other countries.

The US Mint stores the remaining 95 per cent of US Treasury gold, weighing in at 8,133 metric tonnes.

Inflation taxes your money because its value depreciates as price levels rise. Banks allow people to avoid part of that inflation tax. When banks provide credit cards to buy goods, and these are paid off at the end of the period, people can earn interest on their income deposits at the bank during the period. If that interest is as high as the inflation rate, they avoid some of the depreciation of currency that occurs from carrying around less cash during the period in which the price level rises.

Instead of carrying around currency that depreciates over the month, banks allow people to use private bank deposits for purchases and so avoid some of the inflation tax on public bank money in the form of currency. Having a well-insured bank system allows an optimal amount of inflation tax avoidance by people. Banking enables them to weigh the cost of the credit versus the amount of the inflation tax faced when using currency that depreciates.

When the bank system collapses in modern times, it can become harder to avoid the inflation tax. Even worse taxes can result, if the inflation rate is suppressed by bank regulators as they devise new means to provide insurance after the crash has already occurred. Having good bank insurance in place before a crisis is important because it can avoid the worse effects of bank panics.

Bank panics have long been a persistent feature of the US banking system. From 1873 to 1914, during the gold standard, the United States experienced a continual sequence of panics that decreased investment, leading to the creation of the Federal Reserve and, ultimately, the Federal Deposit Insurance Corporation.

The beginning of a US nationwide system of banking, in place until 1914, was created by the National Banking Acts of 1863 and 1864. Passed during the civil war to raise federal government funds, it allowed for the chartering of national banks that could issue the greenback notes, but in return for buying Treasury debt and depositing it at the Office of the Comptroller of the Currency. Banks also operated under state charters under these Acts, with their issuance of notes driven out in large part by the Acts imposing a new federal tax on state banknotes.

The Fed policy of price fixing in capital markets was part of an effort to bring reserves into the Fed. Required reserves of banks had been depleted to 1 per cent of all commercial bank deposits because of bank deregulation. With all but required reserves having been lent out before 2008, reserves had served as the foundation that the Fed provided for the aggregate money stock.

The monetary base is defined as “reserves plus currency in circulation”. The aggregate M1 is defined without reserves but with deposits at banks plus currency in circulation. The M2 aggregate and the post-2020 definition of M1 essentially equal the old M1, which included standard demand deposits, plus the money market funds that had been a part of M2. The monetary base, M1 and M2 are useful, along with the reserves alone, for investigating the stability of money demand since 1959. Specifying money demand with these different aggregates shows how money was shifted about by the long financial deregulation and the sudden refilling of reserves after 2008.

Money is used for two main reasons: as a means of exchange for goods and as a “liquid” asset for deposited funds that are invested. The liquid form of money is closely related to the exchange form, since both come from Treasury debt. When the Fed buys the Treasury debt, it creates reserves in private bank accounts at the Fed that subsequently leverage those banks’ deposits and investment when they lend out all except what is required – at least, until 2008, when the Fed's holdings of Treasury debt historically tracked the currency in circulation.

When money demand is stable, the use of it as currency, reserves and deposits is stable. With stable money demand, capital markets naturally hold less money when the cost of holding money rises. The cost of holding money rises when the inflation rate and market interest rates rise. This is especially apparent when money demand is presented as a ratio with respect to GDP output (Lucas & Nicolini 2015).

This practice is a common way to present money demand, since money demand tends to grow with output.

I have grouped American Republicans with British Conservatives because their way of thinking about the economy is similar, in the sense that they share a liberal economic heritage that is distinct from the more Christian tradition of the centre right in France, Germany and Denmark. Transatlantic links between economists and politicians are strong. Both Republicans and Conservative interviewees see the period of the Reagan and Thatcher governments as important watersheds in the movement from Keynesian to more market-conforming approaches. They confirm the judgement in much of the literature that market-conforming ideas have been more dominant in the “Anglosphere” than in continental Europe. First, I set out what the Republican interviewees say about their economic thinking and respect for economists, followed by the Conservatives. Surprisingly, given that their countries are home to neoclassical economics, they share a dismissive attitude to economists. But their reasons for being dismissive are different.

Republican context

Donald Trump was elected US president in 2016 despite many economists warning that he did not have a credible economic platform. He ended up violating sacrosanct economic principles of the Republican Party, such as free trade and balanced budgets, before his economic programme was derailed by the pandemic. I worked very hard to find Republican interviewees who wholeheartedly supported his economic policies, but most, even if they had never publicly opposed him, did not support his increased borrowing and/ or trade policies. Whether publicly for or against Trump, they saw him as a big economic departure for their party and were waiting to see what would happen next.

A degree of responsiveness to voters is necessary in a representative democracy (Dahl 1971). But the key reason that economic technocrats think politicians should cede control to experts is that they are too “responsive” to voters, who have short-term rather than long-term perspectives and do not know enough to judge what is in the interests of all. Economic technocrats see voters as forcing politicians away from delivering policy that is “responsible”. What views do politicians in the five countries share about their relationships with voters and the effects these have on their ability to deliver responsible economic policy? This chapter shows how close the relationship is: politicians see voters as “the sea in which we swim”. But it also shows that, as practitioners, politicians have insights into voters that go beyond the one-dimensional version of “giving in to voters’ demands” that tends to underpin the technocratic arguments.

“Understandably” self-interested voters

A starting point is to ask politicians what they think about voters when it comes to the economy. Do they think voters demand self-interested policies? I asked the general question “How do you think voters see the economy?”. I expected that some at least would segment groups of voters in their answers, claiming that some groups see it differently from others. But, instead, they nearly all felt comfortable with staying with the idea of voters in the aggregate, as the question had phrased it. In addition, nearly every politician, regardless of nationality or ideology, answered that voters see the economy through the lens of their own well-being – effectively, that they are narrowly self-interested. There was greater unanimity on this issue than on any other question I asked. A centrist Republican says: “I mean, voters tend to look through the economy in terms of how it's impacting them directly – right? And so, how are their pay cheques – you know, are they … rising, are they falling, is their neighbour out of a job?”

At the time of writing world leaders have just left the COP26 UN-sponsored climate change conference. The Conservative prime minister of the United Kingdom, Boris Johnson, arrived with a team of advisers from Number 10 and his chancellor of the Exchequer, Rishi Sunak, who made a speech on the economics of climate change on the conference's “Finance Day” (Sunak 2021). Sunak says his vision is for the UK to become the world's first “net-zero” financial centre, leading the way in promoting “green bonds” and encouraging firms to be more transparent about their environmental impact. Behind Sunak is a big parliamentary majority without many checks and balances, which should in theory give him and his party scope to articulate and achieve their economic goals. But, despite the UK hosting COP26, Sunak has been accused by Labour and Green Party opponents of undermining the economic drive to prevent climate change by cutting taxes on short-haul flights, and by being lukewarm on transitioning from economic dependence on fossil fuels.

We will never know whether, if Trump had won the 2020 election, he would have flown to Glasgow for COP26, or how much he would have talked about the economics of it while he was there. Although the United States has so far been the worst affected of the five countries in this study by climate change, it also starts from the lowest base of national-level measures to mitigate it. But the proportion of Republican Party politicians who argue that climate change is not happening, or that the policy approach should be nil, is declining. And the Democratic president, Joe Biden, arrived signalling action, with climate envoy John Kerry. Significantly, he also brought his secretary of the Treasury, Janet Yellen. In Congress the recent passage of the fiscal stimulus package shows that Biden may share a two-party system with the British, but he has less scope for action.

Part I shows some overall patterns in how politicians think about economists and voters across the five countries. In Part II I explore some of the ideological and national differences. I have had to take an asymmetric approach. If I had focused on a chapter for each country, it would have exaggerated the extent of national differences. I found that the centre and far-left interviewees across all five countries shared enough to warrant separating them out in a chapter on “the left”.

I selected the five countries on the basis that they reflected varieties of capitalism and varieties of style of democracy. Attitudes to economists seemed to vary according to the degree to which a country had a consensual political system, usually most obviously characterized by features such as frequent coalition government. It is beyond the descriptive nature of this book to ascertain whether the style of democracy is what causes the attitudes to economists. Other factors, such as economic conditions or intellectual cultures, may be equally important. I just note that there was a correlation. Therefore, I have grouped Denmark and Germany together, and, similarly, the two pluralist cases of the United Kingdom and the United States. However, the French interviewees were distinct in their attitudes to economists in a number of key respects, so they deserve a chapter on their own.

The final chapter in this section focuses on one aspect of politicians’ thinking: the economics of the environment. This chapter attempts to justify the stance taken throughout the book, that at least for the moment it is impossible to understand politicians’ attitudes to the economics of the environment without first understanding their attitudes to economic ideas more generally – the main subject of the book. In the same way, we cannot understand their attitude to economists who write on the environment without knowing that broader context first.