Sovereign governments have the power to create money. Policies can be enacted to address public debt and deficits, as well as distributional unfairness. What are the consequences for sovereign nations of giving up their constitutional right to print their own money?
AUTHOR JESPER JESPERSEN
MONETARY CONVENTIONAL WISDOM
Money is power! We know it much too well from our personal experience. Especially when living in societies where the means of production is protected by private property rights. Money is the instrument of transaction used in modern societies to purchase goods and services and to acquire wealth.
AT THE MICRO LEVEL, money is the generally accepted means of payment. When money is used as the means of payment, in the form of notes, coins or credit cards, the deal is complete. This is a rather practical legal arrangement, – especially when the money instrument has a wide-range circulation. Hence, the positive argument for creating a monetary union.
FROM HERE the naïve microeconomic question follows: Why not just set up a single currency for the entire world economy, and one global central bank?
For a die-hard neoclassical economist, who views money from a micro perspective, this is the appropriate question to ask. Neoclassical theory views money as simply a means of transaction with no real impact: also known as the ‘Money is a veil’- argument. Following this argument, ‘one currency’ has only one kind of real effect: reduced transaction costs, – so the wider the monetary union, the better. (This was the main argument for creating the European monetary union, but the reasoning would also apply to a global level.)
IN FACT, money hardly appears in neoclassical (or new-classical) economics textbooks. For more than a century, the insignificance of money has been part of the neoclassical heritage: the ‘Neutrality of Money’ , see for instance Patinkin (1). It is argued that if money has an impact, it is due to people being irrational or acting out of ignorance: so-called ‘money illusion’. But according to neoclassical theory, such irrational behaviour will not last long: People will quickly learn their lesson, – that money is simply a veil. For instance, in the widely used General Equilibrium models (GE-models) or the DSGE- models, neither money, nor a financial sector, is appearing at all. Why? Because obviously ‘money has no real impact’!
”in the widely used General Equilibrium models.., neither money, nor a financial sector, is appearing at all. Why? Because obviously ‘money has no real impact’
NO WONDER the dean of the London School of Economics (LSE) got into difficulties answering Queen Elisabeth in May 2009, when she visited the university and asked: “How could it [the global financial crisis] happen?” Because according to the General Equilibrium models – it could not happen! In fact, no conventional neoclassical macroeconomist cares much about what happens in the financial sector. Their main concern is advocating for labour market reforms to reduce structural unemployment caused by lack of labour flexibility and a too generous welfare system, and to recommend a balanced public-sector budget.
WHY ARE neoclassical economists so focused on a balanced public-sector budget? The economists know that public sector expenditures are powerful. Governments can by public money direct the market economic system away from the private sector general equilibrium solution with full employment. According to the model this a ‘Pareto-optimal’ meaning that no one can get an improved economic outcome without reducing the utility of someone else. Any policy intervention has a negative impact at the market economic outcome due to its dislocation effect of economic resources. So, any budget deficit will disturb, in fact prevent, that the defined and model-designed optimum is realized. Instead they have constructed a vision of a perfect-market economic system directed by private business and households.
They assume that these rational private market actors are undertaking individually optimal decisions, arriving at a Pareto-optimal solution through the perfect market system.
IN ADDITION, neoclassical economists consider public debt as an economic burden on future generations, who has to pay back the accumulating debt at a later stage. They do not see the cause of the deficit as a consequence of the private sector imbalances and self-inflicted unemployment due to lack of effective demand, see below. Hence, it is important to secure ‘neutrality of the public sector’ by the requirement of a balanced budget preferably written into the constitution.
WITHIN WELL-FUNCTIONING and competitive marketplaces, individuals can make their own free choices without any paternalistic interference from government. Therefore, the recommendation in all cases is to deregulate the market system: Leave it to the individuals and to the market forces to direct the economic evolvement, – and money will have no impact.
SO, AT THE THEORETICAL BOTTOM LINE of neoclassical economic thinking is a ‘no trust in political intervention’ to correct the private market economy. Because, politicians are like any other agent self-optimizing only thinking of his/her own carrier, and not caring for the ‘common good’ or ‘society as a whole’). Which is also the argument behind an independent central bank – independent of the self-optimizing politicians.
MONETARY UNCONVENTIONAL WISDOM
MONEY AS A MEANS OF PAYMENT
In economic terms, money is the ultimate power, because, as Clower (2) forcefully stated, ‘money buys goods’. In a market economy you can get everything if you pay the price – and have the money. If you do not have the ultimate liquidity, in other words, the amount of money (means of payment), you must ask for credit. Credit means that you at a later stage return the agreed amount of money. And if not, you are in default and risk to be ‘bankrupt’. Keynes revolutionized monetary theory when he introduced the concept of uncertainty to macroeconomics: The microeconomic, i.e. behavioural consequences of individuals (and governments) not knowing the future, have macroeconomic impact.
To possess money means in modern societies having the ultimate, undisputed and reasonably secure (in real terms) purchasing power. Money is needed to undertake transactions. In fact, the gross domestic product, GDP, is defined as the aggregate value of transactions which create money income (wage and profit) (3). ‘Money makes the world go around’ as we know. Surely, you can buy goods and services (and capital assets, see below) ‘on credit’, but only if you can get either a bank guarantee or a bank loan. Even more importantly, firms waiting to sell their output need to fund current production either by retained profit, or more often by the use of bank credit (i.e. money), essentially to cover the costs of resources as well as the wages of workers and subcontractors.
As such, they have a time gap before they receive the expected revenue in ‘cash.’ There will always be a time lag between when the production begins (costs are incurred) and the firms receive the (somewhat uncertain) revenue – therefore credit and finance is of crucial importance in a monetary production economy. (4)
MONEY AS A STORE OF WEALTH
Money is a store of wealth. This is empirically a trivial statement; but it had to wait until Keynes (5), to be explained by – once again – uncertainty. It is exactly because of ‘we simply do not know the future’ (6) that money is an essential part of any portfolio choice model: the financial asset with less uncertainty attached (under normal social and political conditions). Hence, money is a ‘rational’ store of wealth when uncertainty prevails.
”Why are neoclassical economists so focused on a balanced public-sector budget?
MONEY CREATION – CENTRAL BANK LIABILITIES.
If money is power, then the right to supply money makes the issuer powerful. The demarcation of what items can serve as money is changing through time as can be read in histories of money, among other: Keynes (5). Money is defined by legislation and practice of means of payment. Political power (essentially government) can legally define, what is legal tender. This definition of the means of payment can be more or less wide ranging. A narrow definition limits the use of a ‘legal tender’ to payment of taxes, i.e. transactions with the government. A wider definition defines specific financial assets as ultimate payment, the acceptance of which, cannot be denied.
THE CONVENTIONAL VIEW on money supply is to consider central bank notes (and coins) as the ultimate means of payment, which can be used everywhere within the national jurisdiction. This view leads directly to the argument that the money supply is controlled by the central bank. While the gold standard was the core of the law regulating the activity of the central bank, there was a close relationship between the amount of gold and the number of notes in circulation. This link was definitively broken in 1931. Firstly, by the British government and shortly after by most Western countries. Two major changes followed from this institutional change in the 1930s of breaking the link between gold and the national currency:
1. the amount of central bank money became open ended
2. the exchange rate between the different national currencies became flexible.
Both changes were substantial; but the neoclassical macroeconomic literature was unprepared and unhelpful for this new institutional situation, where government via the central bank could print money on demand and the exchange rate became at least partly determined by market forces (and therefore speculation).
ON TOP OF THESE CHANGES came an increase in the use of direct interbank clearing of cheques drawn on ordinary costumers’ deposit accounts in private banks after the war. Cheques became means of payments accepted by government for payment of tax. During the 1980s came the electronic revolution and with that the introduction of credit (or debit) cards. Two kinds of uncertainty emerged when payment with credit cards became the common practice:
1. Was there ‘money on the account’? (if not, the card would, in principle, be blocked)
2. Was the private bank able to honour the amount drawn in the deposit account? (a matter of liquidity and/or solvency)
The problem of bank solvency was (partly) solved by a mandatory requirement for all private banks issuing credit cards to be member of the depositors’ guarantee insurance organized by the government. In EU the amount guaranteed is € 100.000 (in Norway it is still 2 million NOK, but under pressure to conform to EU standard) – deposits beyond this amount ran the risk/uncertainty of the bank going bust.
MONEY CREATION – PRIVATE BANK LOANS CREATE DEPOSITS
Today, more than ninety percent of economic transactions are undertaken by the use of private banks deposits which circulate as means of payment via credit card, mobile-pay or similar payment vehicles. Where do these deposits come from? The simple answer is they are created by private bank loans. Each time a loan is underwritten by a customer, the amount is credited to the borrower’s debtor account in the very same bank. Pop! – the amount of means of payment is increased by an equal amount.
WHEN THE DEPOSITS are used for a (final) payment, the amount of money is credited another deposit account, either in the very same bank or more likely in another bank; but the amount of money is, anyhow, not changed by this transaction. If the deposits leave the issuing bank, there will temporary emerge a liquidity ‘drain’, which at the end of the day can be filled by interbank loans (or lending via the central bank). In fact, the interbank market plays a very important systemic role by leveling the liquidity flows between banks day-by- day. Excess liquidity is hereby channelled to banks with a deficit of deposits, usually at a rate of interest set by the central bank.
AS LONG AS the interbank market functions smoothly, there is hardly any limit to the amount of money, which private banks can create ‘out of thin air’. It all depends on the demand for credit by firms and households, and banks’ attitude (and risk assessment) to providing such loans. As Hyman Minsky (7) convincingly has explained, the banking sector (as a whole) is historically characterized by waves of optimism, which at a certain stage collapse into a credit crunch followed by a financial crisis.
“more than ninety percent of economic transactions are undertaken by the use of private bank deposits… [which] are created by private bank loans”
PUBLIC DEBT, LIQUIDITY PREFERENCE AND MODERN MONETARY THEORY
THE FOLLOWING SECTION analyses monetary phenomena within a closed society to clarify the basic arguments. Nevertheless, the analysis would also be applicable to an economy with import and export of goods and services, flexible exchange rate and international capital control, like Great Britain in the 1930s and during the Bretton Woods era (where exchange rates were adjustable).
IF WE TAKE THE VIEW expressed by Abba Lerner in his Functional Finance 8 published in the 40s (ideas re-launched by Randall Wray in 2012 under the name of Modern Monetary Theory (9), the private and public sector financial imbalances must be analysed simultaneously. In stylized form, the public-sector budget balance has to be by accounting identities an exact mirror picture of the private sector excess savings. (10) An even more important macroeconomic identity is: savings equal real investment (within a closed society or with nations that have a balanced current foreign account). Hence, it is the interplay between private sector real investment and financial savings which determine the level of employment if all production is conducted in the private sector. Keynes’s (10) major contribution to macroeconomic theory was his demonstration that this ‘equilibrium’ between private real investment and financial saving could in principle occur at any level of (un)employment. In a closed society there is no self-adjusting mechanism within the private sector to secure full employment.xiii Falling nominal wages mean falling prices and/or falling effective demand.
UNEMPLOYMENT is caused by structural private savings in excess of private real investment. To close this gap of excess private savings, the public sector must take action. For instance, they could increase public real investment (or initiate other forms of expansionary fiscal policy). By running a public-sector deficit, excess private savings can be saturated by public bonds. Hence, public real investment has a triple effect:
1. reduces unemployment;
2. saturates private excess savings with secure financial assets (no crowding out);
3. increases the real capital stock (infrastructure, innovation, education, durable energy supply to the benefit future generations).
“Unemployment is caused by structural private savings in excess of private real investment. To close this gap… the public sector must take action.”
ACCORDINGLY, the private structural excess savings could therefore equally well be described as an excess demand for external financial asset (at full employment). In a closed economy, this means that if the government creates more effective demand, output and employment, the public-sector deficit can automatically be financed by private excess savings without necessarily making the rate of interest increase.
SO, THE REAL FINANCIAL CHALLENGE is to find the right mix between new issues of government bonds and of central bank money. This mix of bonds and central bank money will, of course, make an impact on the rate of interest dependent on how the private sector’s liquidity preference develops. If the private sector’s liquidity preference is unchanged, government can manipulate the rate of interest by changing the proportion of government debt to the stock of central bank money, which will have an impact on private real investment.
So, the real financial challenge is to find the right mix between new issues of government bonds and of central bank money. In fact, this is nothing new. The monetary policy which central banks, in broadly speaking all civilized countries, have undertaken in the aftermath of the financial crisis, under the name of Quantitative Easing, was to lower the longterm rate of interest. To what extent this policy has been a success, is not evaluated here. Suffice to say, the longterm rate of interest has never(!) been as low as it had been in the US, UK and euro-zone as when this monetary policy of QE has been undertaken – without, one should add, causing consumer price inflation.
“So, the real financial challenge is to find the right mix between new issues of government bonds and of central bank money.”
THE STOCK of central bank money has increased rapidly without causing wage or consumer price inflation. So, the classical quantity theory of money (QTM) and prices has obviously been discredited. It is equally obvious that the QE-policy has caused an asset price inflation which might have implications for future financial stability.
FORTUNATELY, it is less disputed that the QE-policy, and the low rate of interest, have had a positive effect by reducing the private sector structural excess savings. This positive development has happened via several channels, of which two shall be mentioned here: The first one is the impact of lower rate of interest on the speed of wealth accumulation in private pension funds, which reduces private passive savings. Secondly, a lower rate of (long term) interest will have an expansionary effect on private real investment. How strong these two effects are, will depend on circumstances; but they will, in any case, bring the labour market closer to full employment, and at the same time be a relief of the public sector budget.
TWO HISTORICAL EXAMPLES OF MANAGED AND MIS-MANAGED MONETARY POLICY AND FISCAL FUNCTIONALISM.
NEW DEAL IN THE 1930s
FRANKLIN D. ROOSEVELT took office in March 1933 and presented immediately a ‘New Deal’ to restore the American economy. Government involvement and regulation was increased in all sectors: banking, labour market, public investment, business support, agriculture, social policy and the gold content of the dollar. All these initiatives were presented by the President as part of his ‘fireside chats’ and summed up the following way “I hope you can see from this elemental recital of what the Government is doing there is nothing complex, or radical, in the process” (11).
ROOSEVELT WAS RIGHT. He was making this successful policy out of intuition and common sense for two straight forward reasons:
1. The economists of his time assumed a self-adjusting private sector. This was obviously wrong, as were the policy recommendations accepted by the Hoover administration that aimed for a balanced public budget which actually aggravated and deepened the recession.
2. All sectors suffered from lack of purchasing power due to broken banks and a broken market mechanism. On top of these Hoover-failures, Roosevelt had some positive experiences from his time setting up public investment while he was the Governor of New York State, although it was on a much smaller scale.
WHAT THE AMERICANS COULD SEE was an economy that started to grow by 8 to 10 percent each year except for the year 1937/38. Unemployment fell steadily, but it was not until 1943 it had fallen back where it was in 1929 (12). Why did it take such a long time? An important part of the answer is because the American economy had got stuck in a total collapse of gross private capital formation from USD 16 bill. to USD 4 bill. in 1932. The government could only partly fill in this gap by increasing public expenditure to USD bill (13). Recovery had to wait for a restoration in business confidence (and the war).
ALL WAY THROUGH HIS TIME IN OFFICE, Roosevelt faced difficulties in defending the growing public debt. He had to wait for Keynes arguments; but even Keynes had severe difficulties to convince the British politician of the constructive impact that public deficit and debt would have to rebalance the macroeconomic system and to reduce unemployment. This is still the current situation – public sector deficit and debt are considered as two macroeconomic imbalances which can be addressed separate from the private sector. It is even argued that a smaller public sector would be a relief and expansionary to the private sector, because ‘supply creates its own demand!’ (when of course it is the opposite which is true.) Otherwise, the call for austerity policy could only be seen as a cynical attempt to maintain unemployment much longer than needed.
“Roosevelt (..) presented immediately a ‘New Deal’ to restore the American economy. Government involvement and regulation was increased in all sectors”
THE EUROPEAN MONETARY UNION IN 21ST CENTURY
Looking at the European Monetary Union, it is striking that on average, decade by decade, the growth rate in GDP within the euro-zone has been the lowest ever since the since the Second World War. Growth trends have been reduced and the euro-zone has performed more poorly than the non-euro countries, – not to speak of the US. Many refined arguments have been offered by the euro-monetarists, see Jespersen (14). Among these arguments labour market inflexibility and persistent public-sector debt and deficit are ranking high. Forgotten are the first 25 years of the after-war period, where unemployment was around 1 percent and public debt ratio was constantly falling resulting in hardly any public deficit.
“This is a sad story of intellectual and academic desertion, – and political defeat. I am worried that one has to wait for another Roosevelt, or a so-called populistic revolt by the people…”
THE DEVELOPMENT in nearly all European countries has, of course, changed considerably. The major change is that the private sector has swung into a position of excess financial saving, mainly due to a reduced level of real investment in most (but not all countries). The fall in real private investment could be counterbalanced by either an expansionary monetary or fiscal policy designed specifically for each country, due to each the country having various business structures, institutions, and political preferences. But the euro-zone countries have given up the monetary sovereignty through their membership in EMU. They can no longer:
issue their own currency;
set their own short-term rate of interest and
manipulate the exchange rate. And there is not much help to get from the European Central Bank.
It is under the obligation of the EU-Treaty to secure a stable development of the average of consumer prices all over the euro-zone. This requirement causes a diverging development, because the rate of interest will be too high for countries in recession, and too low for booming countries. Exactly the same counts for the common euro-exchange rate. In addition to this centralized monetary policy, within the EU-Treaty, EU-governments are banned from financing the budget deficit via printed money or lending from private banks.
SO, FISCAL POLICY UNDER EMU must be financed via the bond market, which should not be a problem as long as excess private savings are there to absorb public securities by an equal amount. When the euro-monetarists and the Bruxelles-elite realized that there was no real limit to fiscal expansion during a recession, they became nervous because that would run counter to the political priority of a balanced, – and even better: reduced – public sector. Thus, to limit the potential fiscal policy, the Growth and Stability Pact was written into the EU Treaty in 1997. According to this pact, no EU-member country was allowed to run a budget deficit above 3 percent of GDP. If it still happened, for instance due to a collapse of private investments, government should make plans – and get them approved by the EU-Commission – of how to reduce the public-sector deficit by austerity measures in the middle of a recession! However, when the recession hit in 2009, a number of EU member-states undertook expansionary fiscal policy by increasing the structural public-sector budget deficit to match the hugely increased private structural surplus. This expansionary policy had the positive effect of breaking the downward spiraling of the GDP, and for a short while, the macroeconomic development was supported by macroeconomic theory and policy which made Robert Skidelsky conclude: ‘Keynes: the Return of the Master’ (15).
BUT, THIS OPTIMISM DID NOT LAST LONG, as the consequences of public deficits were very unevenly distributed among the euro-countries. Countries which also suffered from balance of payments deficits had to borrow abroad. Such was the case for the Southern European countries, whereas the Northern European countries, especially Germany, had a massive balance of payments surplus. So, Greece, Spain, Portugal, and later Italy, all had to go begging to borrow money from Berlin, Frankfurt and Bruxelles, as they were prevented from issuing money themselves. The borrowing conditions were tough, and seemingly straight out of the monetarist textbook: increased public savings and labour market reforms. This demanded policies that initially deepened and later prolonged the economic crises in the Southern euro-countries. The effects then spread to the entire euro-zone, where all countries had an excessive public budget deficit according to the EU-Treaty.
THE BERLIN/FRANKFURT/BRUXELLES AXIS had to realize that the Stability Pact was not restrictive enough to prevent financial instability, and it proved a challenge to the idea of the common currency as an integrating instrument. To prevent high uncertainty to unravel again, a Fiscal Compact was forced upon the euro-zone members and accepted by the other governments of the EU-countries (except Great Britain and the Czech- Republic). The countries were asked to amend their national legislation, or even constitution, in such a way, that no government, not even during a recession, should be allowed to undertake an expansionary fiscal policy of more than ½ percent of GDP.
IT IS NO WONDER that most European countries have been stagnating for more than a decade. The only expansionary effect has come from the European Central Bank. The bank lowered the euro-area rate of interest and initiated a substantial QE-program. The latter became a relief to the debt-burdened euro-countries and created a boost for the exporting sectors by lowering the euro/dollar exchange rate.
“It is no wonder that most European countries have been stagnating for more than a decade”
How can it be that unrealistic macroeconomic theories repeat themselves, after they were discarded by Keynes more than 70 years ago? It applies to monetary, financial, fiscal and labour market theories. One may question how it can be that hardly any conventional economist has objected to the ‘soundness’ of the Stability Pact or the Fiscal Compact although Europe has had such a poor economic performance? How can it be that politicians, either blue or red, have renounced on a number of national policy instruments without having any influence on how these policies are undertaken at the federal level? It creates the impression as though politicians are scared of being made accountable of the macroeconomic development and be in opposition to the crunching international financial markets, – and has accepted that the latter has been implemented into national law by parliament in a number of EU countries, among others by the social democratic led Danish government in 2012 – even when the economic recession was at its deepest.
THIS IS A SAD STORY of intellectual and academic desertion, – and political defeat. I am worried that one has to wait for another Roosevelt, or a so-called populistic revolt by the people, which seems to be under its way in Italy. In some way it makes no sense to wait for another Keynes – one is enough; his theories will be reawakened when the political climate is ripe to set a political agenda that gives priority to ‘full employment and a fair distribution of income and wealth’.
But still I am wondering, like Keynes did, why it is so difficult to explain to one’s academic colleagues that:
The private sector is not self-adjusting,
When there is an excess financial saving in the private sector it will cause unemployment,
Government may reduce this unemployment by a matching/mirroring budget deficit (which, in fact, is self- financing) that will disappear when the private sector turns around and starts to run a financial savings deficit.
There are, of course, many strategies to reduce excess savings and unemployment within the private sector: low rate of interest, redistribution of income and wealth from rich to poor, investment subsidies, reduced (tax) incentives to private savings (old age pension is heavily subsidized especially for the rich people) or a reduced number of working hours per week (16).
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- And it is not only in neoclassical textbooks ‘that money is neutral’, see for instance Whitta-Jacobsen, H.J. & P.B.Sørensen (2005), Intermediate Macroeconomics, New York: McGrawHill (p.62). This statement was also one of the favourite arguments used by prominent economists (and politicians) arguing in favour of giving up the Danish Krone and to adapt the euro: less transaction costs and a German rate of interest. Fortunately, the people and common sense in general overruled the neoclassical arguments, when the question was set to be decided on by a Danish (2000) and Swedish (2003) referendum. See also Patinkin, D. (1987), Neutrality of Money, in The New Palgrave: A Dictionary of Economics, edited by J. Eatwell, M. Milgate, and P. Newman, London New York Tokyo: Macmillan Stockton Press Maruzen.
Clower, R. W. 1967. A Reconsideration of the Microfounda- tions of Monetary Theory, Chapter 14 in Clower. R. W. 1969. Monetary Theory, Harmondsworth: Penguin book
There are few exceptions, but not relevant here.
These aspects of monetary theory are especially emphasized by Monetary Circuit Theory, see among other, Graziani, A. (2003), The Monetary Theory of Production, Cambridge: Cambridge University Press
Keynes, J.M. (1930), Treatise on Money, vol. 1 & 2, London: Macmillan
Keynes, J.M. (1937), The General Theory of Employment, Quarterly Journal of Economics, 51, 209-23
Minsky, H. P. (1982), Can ‘It’ happen Again? Essays on Instability and Finance, Armonk, New York: M.E. Sharpe
Lerner, A. (1944), The Economics of Control, New York: Macmillan
Wray, L. Randall (2015), Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems, (Second edition) London: Palgrave/Macmillan
- Public debt as a percentage of GDP fell in UK steadily from approximately 200 percent of GDP just after the 2nd world war to less than 50 percent in the early 1970s. This development was mainly driven by a GDP in current prices (due to real growth and rising inflation) which grew much faster than the public debt; In some countries e.g. Scandinavia there was even a public sector surplus for many years due to a deficit of private sector savings – caused by, among other things, a private housing boom. Keynes, J.M. (1936), The General Theory of Employment, Interest and Money. London: Macmillan
Rauchway, E. (2008), The Great Depression & The New Deal, Oxford: Oxford University Press (p.57)
Rauchway, E. (2008), The Great Depression & The New Deal, Oxford: Oxford University Press (p.5)
Lewis 1960 (p. 113)
Jespersen, J. (2016), The Euro: why it failed, London: Palgrave/Macmillan
Skidelsky, R. (2009), Keynes: The Return of the Master, London: Allen Lane
Keynes, J.M. (1931), ‘Economic Possibilities of our Grandchildren’ in Essays in Persuasion, London: Macmillan