Intellectual absurdity

The flaws at the heart of mainstream (neoclassical) economic thinking are revealing themselves in interesting ways. The latest is that mainstream economists are seriously considering a policy of intentionally inducing inflation (e.g. ~5%), an approach termed market monetarism. The idea is this will both reduce the burden of debt and improve productivity by allowing a real reduction in debt and wages. The irony is that it is only necessary because of an intellectual straightjacket they built themselves that was originally designed to reduce the likelihood of inflation. So they resort to a policy of inducing certain inflation rather that allowing measures that carry a small risk of inflation! This is absurd.

There is a perfectly sane alternative. The problem is collapsing demand because everyone in the private sector is trying to pay of their debts. Instead of inflating away debts demand should be raised by allowing governments to run deficits, i.e. spend more money into the economy than they extract through taxes. It matters little whether taxes are lowered or spending is increased - the important requirement is that there is a deficit. That will restore growth and enable the private sector to pay of their debts. And if done in moderation it won't result in inflation. In essence that is what the USA is doing now, though it is not deliberate policy. Instead, it is a consequence of a political stalemate whereby the Democrat-controlled senate refuses to cut spending and the Republican-controlled congress refuses to raise taxes. It is clearly working; there is some growth, unemployment is dropping, and there is no hint of inflation. In fact, inflation is below its target. Despite this many are still anxious that this policy will eventually bankrupt the government. It is not surprising that they believe this because it seems plausible and politicians and mainstream economists voice the same concerns. But this fear is groundless; the fact that mainstream economist appear to validate it reveals their dishonesty or ignorance.

One of the central neoorthodox beliefs is that governments must balance their budgets. Even liberals like Nobel prize-winning Paul Krugman, who accept that there should be deficit-spending now, believes that this should be followed by government surpluses in good years so that the debt can be paid off over the economic cycle. The fallacy at the heart of this is that it does not recognise that there is no intrinsic need for governments to raise funds in their own currency before they spend. This is because any sovereign state can create its own currency at will. This has been the case since the USA and most other countries abandoned the gold-standard in the 1970's, ushering in the era of fiat money.

While it is technically possible for any sovereign government to create unlimited amounts of its own money there are self-imposed rules in place to discourage them from doing this. The underlying rationale for these rules is to prevent excessive money creation, which could lead to inflation. But it is a serious misconception to think that money creation will always lead to inflation. In fact it is an essential requirement of any growing economy. What matters is that money creation should not be excessive. The best measure of whether it is excessive is whether there is inflation. As noted in a previous post, commercial banks have created almost all the new money in recent decades, largely because of self-imposed rules preventing governments from creating money. Money creation has been privatised.

The sovereign debt problem is entirely a consequence of the self-imposed rules designed to avoid inflation. It is not the same debt that ordinary people and businesses have, where there is an obligation to pay that can only be met by obtaining money from other parties through earnings (taxes) or loans. It is better understood as being savings that parties have deposited with governments (by purchasing bonds) because they wish to earn interest with minimal risk.

These rules require governments to match their spending with tax receipts and, if there is a difference, require them to borrow an amount equal to this difference from the bond markets. Since governments could create their own currency selling bonds is not essential. It is a rule, designed to impose discipline on governments, which can easily be bypassed. For example, in the past the central banks have purchased these bonds from government with money that they have created. This loophole has now been closed so, instead, central banks buy them in the secondary market, from third parties that have themselves bought them. This is quantitative easing. It is a roundabout way of the government gaining access to the money that the central banks can create at will.

Worrying about the government debt is absurd when you realise that it is just the result of a complicated set of self-imposed rules designed to avoid inflation. The debt would not exist without these rules. Central banks could just create the money and provide it to governments to spend with no obligation to repay. Instead they create it to buy government bonds on the secondary market. Since they have infinite capacity to do this governments can never be forced to default on this debt.

Of course the Eurozone is different because there is one central bank with multiple governments. The rules are therefore much more difficult to work around. No-one with influence objects when the Bank of England creates money to buy UK government debt. When the ECB does this there are furious objections and threats of legal action from other states.

So now that we are trapped in a recession that neoclassical economists failed to predict, and the measures that they previously advocated (austerity, deregulation, structural reform etc) are clearly failing, they are struggling to think themselves out of the imaginary box that they built. They have lived in it for so long that they think the walls are real, and appear to have forgotten why they were constructed in the first place. It is painful to watch.

The European Tragedy

One justifiable source of pride amongst Europeans is the European Union. As far as I know it is unprecedented in history to have voluntary integration and power-sharing on this scale. It represents a triumph of trust and cooperation over suspicion and conflict. This worked because it was done in a slow, organic way so that an appreciation of the actual benefits of previous integration fed back into support for further integration. These benefits lead to the trust required to sacrifice more power and independence to promote further integration. Countries queued up to join. The requirement to overhaul their institutions, laws and processes in order to qualify provided major benefits even before they joined. All this is remarkable when you consider Europe's uniquely dreadful history of war.

Unfortunately this achievement is now threatened by the disastrous consequence of monetary union. The design flaws of the Eurozone have severely damaged hard-earned trust between Eurozone countries. Unless it is radically redesigned or abandoned it likely to destroy the European Union.

This is tragic and ironic. Tragic because it threatens to discredit the voluntary power sharing and cooperation that is the triumphant achievement of the European Union. Ironic because the architects of the single currency fervently believed that monetary union would promote the great EU project. They were warned by many that a single currency would have catastrophic effects, unless there was simultaneous fiscal integration to ensure that the hardships we are now witnessing were prevented. They nevertheless pressed on. Perhaps they hoped that when these flaws became apparent they would be resolved by further integration. If so, that was a monumental miscalculation.

When the global financial crisis hit Europe the 'northern European' remedy of austerity was initially tolerated. Some apparently believed that this would solve the problem, despite being warned from multiple quarters that it would make matters worse. Others, who saw the flaws of the austerity solution, hoped that after some austerity and structural reform northern Europeans would sanction policies that relieved their misery. This has not happened. Austerity has been a dismal failure. Greece's economy has collapsed and Spain is collapsing - they are experiencing conditions worse than the Great Depression at its worst. Despite this the 'austerians' press grimly on, insisting on austerity in all countries with deficits, even those in recession. This is suicidal and other countries are finally beginning to appreciate this. France is about to elect a government that rejects austerity. They will find that they have many supporters. The fate of the EU depends on how northern Europeans respond. One of their number, the Netherlands, have already withdrawn their support for austerity, leaving the remainder, led by Germany, increasingly isolated. Will they overcome their deep fear of inflation and demonstrate some flexibility, perhaps allowing the European Central Bank to create money to fund a fiscal expansion? Or will they insist on sticking to the Eurozone rules? If they choose the latter then the deeply flawed Eurozone is doomed. And it is likely to take the EU with it.  The only participant with the power to stop this tragedy unfolding is Germany. Hopefully their powerful and enduring commitment to the European Union will help them overcome their fear of the actions required to save the Eurozone.

The Eurozone considers desperate measures

I think everyone now accept that there were serious design flaws in the Euro. The latest to attract attention is that while Eurozone Central Bank is strictly forbidden from lending to Eurozone governments, commercial banks are allowed, by the Basel rules on banking, to treat Eurozone sovereign debt as 'risk free'. Surely the two notions are incompatible? The reason that domestic soveriegn debt is considered risk free is that it is backed by its own central bank that can create money without limit. Involuntary default is therefore impossible.  However, sovereign debt in the eurozone is not backed up by the ECB, so it cannot be risk-free. Despite this various participants simply believed what it suited them to believe. Germans were satisfied that the ECB would never fund a government that got into difficulty and undermine the Euro's value. Banks (with the assent of their regulators) were happy to lend money to any Eurozone government, no matter how flaky, on the mistaken assumption that the ECB would back it up.

Now Eurozone banks have so much risky sovereign debt on their books that they are in danger of requiring a government bailout to prevent insolvency. That worries those who might lend to governments since it will aggravate their debt problems, putting further pressure on banks. It is another vicious circle, to add to the 'paradox of thrift' facing deficit countries.

The obvious solution is to allow the ECB to lend to governments, but this requires a treaty change, and Germany have repeatedly insisted that they will never allow this, in case it causes inflation. This is the logical equivalent of refusing a glass of water in case you drown.

Economists are trying to come up with a solution to this problem. The latest is financial engineering of the sort that you would have thought was discredited by the global financial crisis. The idea is to pool Eurozone debt and then divide into tranches with ~60% being senior - given first call on capital and income payments - and the remainder being junior and taking the first losses. The assumption is that the 60% would be 'very safe' and would be readily financed at low rates while the remainder would pay a much higher return.

Good luck with that! I expect the markets will be suspicious of these products unless they are backed by a central bank.  Anything else will need to pay punishingly high interest rates to attract lenders..

Is economics a religion?

Reading Steven Keen's book Debunking Economics is an intellectual treat. He lands numerous devastating blows on the assumptions underlying neoclassical economics. This is a fascinating example of a deeply flawed theory which has nevertheless become widely accepted. It is damning judgment on mainstream economists, who seem to think like religious zealots rather than scientists, ignoring anything that does not fit in with their unshakeable core beliefs. I am very pleased that I never studied economics at University. It would have been a waste of time, like studying evolution in the 17th century. Steven Keen suggests that those rescuing the discipline will likely be scientists from outside the economics profession, as reform from within will be strongly resisted.

Economist's biggest mistake

As a scientist I am familiar with the process by which scientific knowledge develops, at least in my own field. This understanding gives me some insight into what has gone wrong with economic theory.

Knowledge begins with a set of generally accepted observations about how something works, based on actual data, and this forms the basis of a model or hypothesis. Typically this model will have some assumptions built into it. Much of the debate will centre around (1) whether the assumptions are correct and (2) whether the model explains new data that comes in. Ideally an experiment should be performed and/or new data collected to test a prediction of the model. A model that explains new data and makes correct predictions will continue to be supported.

Conversely, if new data emerges that challenges the model then it should be revised. When revising the model it is also important to reconsider whether the assumptions are correct. Often a model is refined without changing the assumptions. The longer a model is accepted the more difficult it is to convince people to change the underlying assumptions.

The current models of how the economy as a whole functions are termed dynamic stochastic general equilibrium models (DSGE). The global financial crisis demonstrated clearly that DSGE models are wrong. They did not predict the financial crisis, they do not explain what is happening now, and they provide no clear route out of the crisis. The eurozone is modelled using a DSGE model. That has not gone very well!

When individuals have built their careers on particular models it is naturally very difficult for them to accept that they are wrong. They usually don't. Typically they come up with all sorts of special explanations as to what has happened. They try to preserve the essence of their model or come up with their own revision of the model that enables them to preserve their own reputation or prestige.

These people will tend to fight revisions by ignoring dissenting opinions or subjecting them to particularly harsh peer review. This is not necessarily a vindictive or even conscious process. It is a natural human instinct. If the discipline is dominated by such people it can take some time before incorrect models are revised. Sometimes it requires a generational change - i.e. the people have to change.

I have experienced this myself in my own field. Those proposing that T cells have a regulatory or suppressive role were largely ignored and marginalised for almost two decades despite publishing clear evidence. Only when a new generation emerged who were free to consider the evidence at face value and had not staked their reputation on rejecting regulatory T cells was the reality of regulatory T cells widely accepted.

Paul Krugman, like other neoclassical economists, supports dynamic stochastic general equilibrium models. One key assumption of these models is that banks play an insignificant role and can be omitted from the model. They are assumed to be just financial intermediaries, there for convenience. This largely explains why they were unable predict the global financial crisis, which was the result of an unsustainable accumulation of private debt (as a result of excessive commercial bank lending) and the eventual collapse of the resulting asset price bubble.

Many outside this consensus, such a Steven Keen, have long argued that commercial banking must be included in any economic models, if for no other reason that in modern economies, in which governments, like all other agents, are meant to balance their books, banks drive the process by creating new money when they make loans. This is a fact widely confirmed by central banks and bankers themselves. However, accepting this simple fact - that banks create money out of thin air - fatally undermines the models that neoclassical economist have long defended and staked their reputations on. That is why they are so reluctant to accept this aspect of reality.

In a series of blog exchanges between Paul Krugman and Steven Keen this debate has been played out. If you read the exchange it is clear that Krugman lost.

I greatly admire the man for his liberal views, and for asserting consistently that budget deficits are what are needed at this moment. If he is able to accept that he is wrong about the role and significance of commercial banks my admiration will have no limit.