Tag: economics

A manifesto for economic nonsense

Read this economic manifesto, realize that it is not only written by professional economists, but signed by dozens of academics from Oxford, Stanford, Princeton, Cambridge, Harvard, and the London School of Economics, and despair for the global economy:

A Manifesto for Economic Sense

More than four years after the financial crisis began, the world’s major advanced economies remain deeply depressed, in a scene all too reminiscent of the 1930s. And the reason is simple: we are relying on the same ideas that governed policy in the 1930s. These ideas, long since disproved, involve profound errors both about the causes of the crisis, its nature, and the appropriate response.

These errors have taken deep root in public consciousness and provide the public support for the excessive austerity of current fiscal policies in many countries. So the time is ripe for a Manifesto in which mainstream economists offer the public a more evidence-based analysis of our problems.

The causes. Many policy makers insist that the crisis was caused by irresponsible public borrowing. With very few exceptions – other than Greece – this is false. Instead, the conditions for crisis were created by excessive private sector borrowing and lending, including by over-leveraged banks. The collapse of this bubble led to massive falls in output and thus in tax revenue. So the large government deficits we see today are a consequence of the crisis, not its cause.

The nature of the crisis. When real estate bubbles on both sides of the Atlantic burst, many parts of the private sector slashed spending in an attempt to pay down past debts. This was a rational response on the part of individuals, but – just like the similar response of debtors in the 1930s – it has proved collectively self-defeating, because one person’s spending is another person’s income. The result of the spending collapse has been an economic depression that has worsened the public debt.

The appropriate response. At a time when the private sector is engaged in a collective effort to spend less, public policy should act as a stabilizing force, attempting to sustain spending. At the very least we should not be making things worse by big cuts in government spending or big increases in tax rates on ordinary people. Unfortunately, that’s exactly what many governments are now doing.
The big mistake. After responding well in the first, acute phase of the economic crisis, conventional policy wisdom took a wrong turn – focusing on government deficits, which are mainly the result of a crisis-induced plunge in revenue, and arguing that the public sector should attempt to reduce its debts in tandem with the private sector. As a result, instead of playing a stabilizing role, fiscal policy has ended up reinforcing and exacerbating the dampening effects of private-sector spending cuts.

In the face of a less severe shock, monetary policy could take up the slack. But with interest rates close to zero, monetary policy – while it should do all it can – cannot do the whole job. There must of course be a medium-term plan for reducing the government deficit. But if this is too front-loaded it can easily be self-defeating by aborting the recovery. A key priority now is to reduce unemployment, before it becomes endemic, making recovery and future deficit reduction even more difficult.

How do those who support present policies answer the argument we have just made? They use two quite different arguments in support of their case.

The confidence argument. Their first argument is that government deficits will raise interest rates and thus prevent recovery. By contrast, they argue, austerity will increase confidence and thus encourage recovery.

But there is no evidence at all in favour of this argument. First, despite exceptionally high deficits, interest rates today are unprecedentedly low in all major countries where there is a normally functioning central bank. This is true even in Japan where the government debt now exceeds 200% of annual GDP; and past downgrades by the rating agencies here have had no effect on Japanese interest rates. Interest rates are only high in some Euro countries, because the ECB is not allowed to act as lender of last resort to the government. Elsewhere the central bank can always, if needed, fund the deficit, leaving the bond market unaffected.

Moreover past experience includes no relevant case where budget cuts have actually generated increased economic activity. The IMF has studied 173 cases of budget cuts in individual countries and found that the consistent result is economic contraction. In the handful of cases in which fiscal consolidation was followed by growth, the main channels were a currency depreciation against a strong world market, not a current possibility. The lesson of the IMF’s study is clear – budget cuts retard recovery. And that is what is happening now – the countries with the biggest budget cuts have experienced the biggest falls in output.

For the truth is, as we can now see, that budget cuts do not inspire business confidence. Companies will only invest when they can foresee enough customers with enough income to spend. Austerity discourages investment.

So there is massive evidence against the confidence argument; all the alleged evidence in favor of the doctrine has evaporated on closer examination.

The structural argument. A second argument against expanding demand is that output is in fact constrained on the supply side – by structural imbalances. If this theory were right, however, at least some parts of our economies ought to be at full stretch, and so should some occupations. But in most countries that is just not the case. Every major sector of our economies is struggling, and every occupation has higher unemployment than usual. So the problem must be a general lack of spending and demand.

In the 1930s the same structural argument was used against proactive spending policies in the U.S. But as spending rose between 1940 and 1942, output rose by 20%. So the problem in the 1930s, as now, was a shortage of demand not of supply.

As a result of their mistaken ideas, many Western policy-makers are inflicting massive suffering on their peoples. But the ideas they espouse about how to handle recessions were rejected by nearly all economists after the disasters of the 1930s, and for the following forty years or so the West enjoyed an unparalleled period of economic stability and low unemployment. It is tragic that in recent years the old ideas have again taken root. But we can no longer accept a situation where mistaken fears of higher interest rates weigh more highly with policy-makers than the horrors of mass unemployment.

Better policies will differ between countries and need detailed debate. But they must be based on a correct analysis of the problem. We therefore urge all economists and others who agree with the broad thrust of this Manifesto to register their agreement at www.manifestoforeconomicsense.org, and to publically argue the case for a sounder approach. The whole world suffers when men and women are silent about what they know is wrong.

Now, let’s count the errors….

1. “we are relying on the same ideas that governed policy in the 1930s” Totally untrue… although like the interventionists of yore, these economists are attempting to blame nonexistent “liquidationists” for the problems their own policies have created. Do they seriously want to pretend that Milton Friedman and monetarism – the very Neo-Classical school whose conceptual models the Fed Chairman openly utilizes – simply never existed?

2. “the large government deficits we see today are a consequence of the crisis, not its cause.” This is partially true, but misleading. The large government deficits were a contributor to the crisis, not its cause. Both public and private borrowing are to blame, but it is true that as of 2008, in the USA, government accounted for only 14.8% of total debt outstanding. Furthermore, note that they disingenuously fail to note that federal borrowing has DOUBLED since 2008 as private debt has deleveraged.

And then there is the obvious logical blunder. If the large government deficits we see today are a consequence of the crisis, how can they possibly claim that those same governments have been cutting spending in an austerity push? From whence did those deficits come?

3. “it has proved collectively self-defeating, because one person’s spending is another person’s income” This is where we see the problem of the Neo-Classical model’s failure to account for debt. It isn’t the reduction in spending that is the problem, the problem is that the spending, and the income, was based on the false foundation of credit money manufactured out of thin air.

4. “At a time when the private sector is engaged in a collective effort to spend less, public policy should act as a stabilizing force, attempting to sustain spending.” No, attempting to paper over private “demand gaps” with public spending only exacerbates the situation. This is completely wrong and it is precisely what Bush and Obama were doing with their stimulus plans, which is why they failed.

5. “At the very least we should not be making things worse by big cuts in government spending or big increases in tax rates on ordinary people. Unfortunately, that’s exactly what many governments are now doing.” Observably incorrect. Most governments have dramatically INCREASED both their borrowing and spending. Austerity is a myth. The US government is not only running record deficits, it has DOUBLED its outstanding debt in only four years.

6. “After responding well in the first, acute phase of the economic crisis, conventional policy wisdom took a wrong turn – focusing on government deficits, which are mainly the result of a crisis-induced plunge in revenue, and arguing that the public sector should attempt to reduce its debts in tandem with the private sector.” Again, factually false. In Q1-2008, the U.S. federal government owed $5.3 trillion in debt. In Q1-2012, it owes $10.9 trillion. The US government has already been doing exactly what the manifesto demands and it clearly is not working.

7. “Every major sector of our economies is struggling, and every occupation has higher unemployment than usual. So the problem must be a general lack of spending and demand.” No, the fact that you only have a hammer does not mean that every problem you encounter must be a nail. The problem is not a general lack of spending and demand, it is a problem of excessive debt, both public and private. The Neo-Classical models have no means of either explaining the crisis or fixing it, which is why economists who utilize them keep turning to the same Keynesian and Friedmanite solutions, both of which have already failed repeatedly.

8. “In the 1930s the same structural argument was used against proactive spending policies in the U.S. But as spending rose between 1940 and 1942, output rose by 20%. So the problem in the 1930s, as now, was a shortage of demand not of supply.” Now, what happened in between 1940 and 1942? Anyone recall a certain historical event? WWII generated a massive demand for ships, planes, and tanks, which the government went into massive debt to purchase. It was paid for by the profits realized from the destruction of the industrial infrastructure of Europe and Asia.

The fools don’t realize it, but they are making an economic appeal for global war against China, Japan, and the EU.

Currency incoherency

Karl Denninger points out the observable difference in theory and practice on the part of those who deny that credit money is money:

I happen to find the esoteria between the gold bugs and various other flavors (and, in my view, mis-flavors) of Misean thought to be highly amusing. From my perspective there’s only one point worthy of consideration in this regard, and that is whether or not the particular economic model under debate counts all credit and currency as “moneyness” and therefore innately fungible when evaluating the impact of various policy decisions and strictures.

Sadly, few if any do, and thus I find them all flawed.

I further find it amazingly frustrating that those who claim that such a distinction is unimportant (or, at least, less important) think absolutely nothing of waltzing into the closest restaurant, bar or other establishment and whipping out their VISA card, pretending that it is currency. There’s a certain level of intellectual disconnection required to do that, you see, and it appears in people on both the left and right, conservative and liberal and among all particular monetary theorists. Indeed, most will simply argue that credit is nothing more than a time shift for which one pays a privilege in the form of a thing called “interest.”

Another observed monetary inconsistency is that those who claim to believe in inevitable inflation are not borrowing heavily. The logically correct thing to do, if you are sure that an inflationary or hyperinflationary scenario is in the works, is to borrow as much money as possible at today’s low interest rates, then purchase real assets such as gold that will appreciate in value and permit the repayment of the loans in the significantly less valuable dollars of the future.

If someone is proclaiming “inflation is coming” and “get out of debt” at the same time, the chances are that their monetary model is less than perfectly coherent.

This doesn’t mean that a gold standard isn’t to be vastly preferred to other monetary models, in that it is somewhat harder to abuse by banks and governments. But anyone versed in economic history will know perfectly well that the gold standard isn’t some sort of economic miracle cure either.

The IMF on no-reserve banking

Karl Denninger digs up the document:

In a financial system with little or no reserve backing for deposits, and with government-issued cash having a very small role relative to bank deposits, the creation of a nation’s broad monetary aggregates depends almost entirely on banks’ willingness to supply deposits. Because additional bank deposits can only be created through additional bank loans, sudden changes in the willingness of banks to extend credit must therefore not only lead to credit booms or busts, but also to an instant excess or shortage of money, and therefore of nominal aggregate demand. By contrast, under the Chicago Plan the quantity of money and the quantity of credit would become completely independent of each other. This would enable policy to control these two aggregates independently and therefore more effectively. Money growth could be controlled directly via a money growth rule. The control of credit growth would become much more straightforward because banks would no longer be able, as they are today, to generate their own funding, deposits, in the act of lending, an extraordinary privilege that is not enjoyed by any other type of business. Rather, banks would become what many erroneously believe them to be today, pure intermediaries that depend on obtaining outside funding before being able to lend. Having to obtain outside funding rather than being able to create it themselves would much reduce the ability of banks to cause business cycles due to potentially capricious changes in their attitude towards credit risk.

Read that however many times you need to until it sinks in folks, because this is what I and a few others have been saying now for a long time — and our ideas are not only not really new, they’re also factually correct.

The “extraordinarily privilege” referenced above, were you or I to engage in it, would be called what it is — counterfeiting. “Generating their own funding, deposits”, is exactly that — creating money out of “thin air” though the unbacked emissions of credit. It is exactly identical in form and effect to you running off $100 bills on your office copier. And for every other entity other than a bank, it is a felony.

But it is Congress that has this power according to our Constitution. A commercial institution that operates for profit should never have the right to literally steal from you at its whim, but that is exactly what unbacked credit creation empowers a bank with — the ability to take everything you have by debasing your purchasing power to the point that you are forced to hock, or even sell and abandon, any asset you possess.

This is important if you want to understand the financial crisis and the inflation/deflation issue. Contra what you’ve been taught, loans don’t come from deposits. The loans come first. This is the “credit money” of which Mises wrote and is the reason that the mainstream economists are so confused by their continual focus on M1/M2, which are just a small fraction of the real money supply, which is Z1+M1/M2.

So, the inflationistas are correct in one sense. Inflation has been worse than is reported by the CPI-U. Vastly worse. However, this also shows why the central bank has been talking about the need to fight off deflation via “quantitative easing” despite the fact that M1/M2 have continued to increase; Z1 has been flat for four years despite the heroic efforts on the part of Washington to prop up spending by taking on a larger share of it.

As I showed in RGD, the USA is closer to a no-reserve banking system than the textbook ten percent fractional-reserve one. The credit money is pure digital counterfeiting, but it spends as readily as legal tender.

Economics advances

In a modification of Kuhn’s theory of scientific revolutions, it would appear that political economy advances one character assassination at a time. In this case, Mike Shedlock finishes off what I started in putting Gary North out of his intellectual misery:

Obvious Falsehoods

Gary North does not speak for any deflationist, nor does he speak for all the inflationists. He acts as if he does. Sustained price deflation is certainly not inevitable, nor is price deflation inevitable in the short-term either. Since I am a staunch deflationist, and since Gary North is aware of my writing, it appears he is purposely making preposterous straw-man arguments just to be able to shoot them down….

Credibility Issues

People really get into serious trouble using phrases like “no inflationist” and “every deflationist” when they clearly do not speak for everyone, especially when they also need a lecture about changing attitudes and time-preference as well. Finally, it’s easy to setup a straw-man debate that you can win. It’s also easy to lose credibility doing just that.

Unlike athletes, intellectuals seldom seem to recognize when they are done. This is as true of scientists and economists as novelists; while there are the occasional rare exceptions, for the most part very few intellectuals have anything coherent or substantive to say beyond the age of 65. I suspect this has as much to do with a lack of energy as it does with an inability to focus or the mental ossification of age. It’s always alarming, whether one is reading a novel or a polemic, to realize that while the writer may not have lost the plot entirely, the intellectual equivalent of his fifth gear, his burst, his vertical, or his fastball, is gone.

One can be sympathetic, to an extent, in understanding why North is so skeptical about deflation. After all, he’s been hearing warnings about it for some 40 years now and it simply hasn’t ever arrived. But – and here is where his age appears to have become a handicap – the fact that something hasn’t happened in 40 years is totally irrelevant when viewed from the perspective of recorded history rather than one’s own lifetime. Every central bank has eventually failed. Every currency has eventually gone out of circulation. The future failure of the Fed and the collapse in the value of its notes, paper or digital, is not a question of if, but when. At 99 years and counting, the Fed has actually had a pretty good run by historical standards.

Even with more than 20 years of potential intellectual activity in front of me by my own rough metric, I’ve noticed an increasing inclination to take a “been there done that” approach to challenges based on my own experience and familiarity with the same old failed arguments presented time and time again. It is both amazing and irritating how often people continue to keep presenting the same futile arguments again and again and again. But it is important to resist the urge to dismiss challenges without first at least glancing over them and determining whether or not one’s previously successful rebuttals necessarily apply to them. After complacent laziness comes intellectual torpor and then complete stagnation.

But if we can understand Gary North’s failure to rise to the challenge posed by the following generation of right-wing economists, we cannot excuse it. No one is forcing him to remain in the ring contesting these issues, after all. Mish and I would be similarly to blame if we simply ignored the challenges to conventional and Austrian economic theory posed by the likes of Ian Fletcher and Steve Keen. I am perfectly aware that the more ideological Austrians are deeply affronted by my willingness to go off the reservation, but as I have noted in the past, I am not a joiner. Lacking all the benefits of the various intellectual establishments, even the lesser ones, I also lack the ideological restrictions that come with them and so I am free to follow the logic and the evidence wherever it goes. Mises was brilliant, but keep in mind that he did some of his best work nearly 90 years ago. Even if I lack his exceptional brilliance, I have the benefit of considerably more information at my disposal.

To a certain extent, my decision to begin writing the monster epic series on which I’m currently working was partly the result of realizing that if I don’t tackle these sorts of projects now, I am far less likely to do so in the future as I grow older. This realization has also influenced my next non-fiction project, which is going to be even more ambitious in its way than a mere one million word epic fantasy series.

The failure of North’s attempt to rebut the current deflationist arguments does not mean that Mish and I are necessarily correct in predicting the eventual failure of the Federal Reserve to continue its 99-year program of methodically expanding the money supplies through the continuous increase of debt. I freely admit that I didn’t expect The Helicopter to be able to maintain the substitution of federal debt for household and financial sector debt for four solid years. But can the Fed maintain this indefinitely? The history of socialized economies strongly suggests otherwise. Can they maintain it long enough to relaunch the private debt sectors? The inability of the current generation of college graduates, already saddled with heavy student loan debt, to find jobs or finance cars and homes, also suggests the likely failure of this strategy.

U3 vs EPR

It’s not the 8.3% U3 that matters, but rather the 58.4% EPR, which is down 0.2% from last month. That means unemployment is still rising as a percentage of the population, regardless of the number of new jobs reported.

Wrong on trade, wrong on money

Gary North isn’t merely a deceitful free trade dogmatist, he’s also off-base when it comes to monetary theory too:

John Exter — an old friend of mine — argued in the 1970s and 1980s that monetary deflation has to come, despite FED policy. There will be a collapse of prices through de-leveraging.

He was wrong. Why? Because it is not possible for depositors to take sufficient money in paper currency notes out of banks and keep these notes out, thereby reversing the fractional reserve process, thereby deflating the money supply. That was what happened in the USA from 1930 to 1933. If hoarders spend the notes, businesses will re-deposit them in their banks. Only if they deal exclusively with other hoarders can they keep money out of banks. But the vast majority of all money transactions are based on digital money, not paper currency.

Today, large depositors can pull digital money out of bank A, but only by transferring it to bank B. Digits must be in a bank account at all times. There can be no decrease in the money supply for as long as money is digital. Hence, there can be no decrease in prices unless it is FED policy to decrease prices. This was not true, 1930 to 1933.

Deflationists never respond to this argument by invoking either monetary theory or monetary history. You can and should ignore them until one of them does answer this, and all the others publicly say, “Yes. That’s it! We have waited since 1933 for this argument! I was blind, but now I see! I’m on board! I will sink or swim with this.”

First, North clearly doesn’t know what he’s talking about with regards to money from the Austrian perspective, which is why he is, like Friedman and the monetarists, focused on M1 rather than Z1. He makes the same mistake that Robert Wenzel made when trying to criticize Karl Denninger and me back in 2011, because he is only considering commodity money and fiat money, and thereby fails to take credit money into account, which, as Mises points out, must be considered in a developed monetary system.

In a developed monetary system, on the other hand, we find commodity money, of which large quantities remain constantly in circulation and are never consumed or used in industry; credit money, whose foundation, the claim to payment, is never made use of; and possibly even fiat money, which has no use at all except as money.
– The Theory of Money and Credit, p. 103 (1953)

Like the proverbial gorilla reading Nietzsche, Gary North looks at the historical monetary statistics but fails to understand what they mean. He ludicrously claims “there can be no decrease in prices unless it is FED policy to decrease prices”, an assertion easily disproved by citing the housing market, which has shown a steady decline in home prices since 2006 despite the desperate efforts of the Federal Reserve to prop them up. More importantly, North doesn’t understand that the reason the broader price declines indicative of deflation have not taken place at any point in the last 70 years is due to the constant growth of outstanding credit over that time, from $355 billion in 1946 to $54.6 trillion in 2012, an amount which absolutely dwarfs the $2.3 trillion in M1 that North erroneously believes to be the controlling factor.

North is factually incorrect. The vast majority of all money transactions in the current economy are not based on digital money, they are based on credit money. Please note that I am once more saying something that North falsely claims has never been said, as I am invoking both monetary theory and monetary history to make the deflationary case. One may reasonably attempt to argue that it is incorrect, but it is a blatant lie to claim that it has not been made. I’ve even addressed the obvious delta between M1/M2 and various measures of inflation that tends to cast doubt upon the monetarist position in the past.

The reason that prices didn’t collapse and monetary deflation didn’t occur in the 1970s and 1980s because none of the required deleveraging took place. Credit money continued to expand throughout, as debt outstanding was $1.6 trillion in 1970 and $12.8 trillion in 1989. Why are the deflationists likely – not certain – to be correct today when they were wrong before? Because the long-predicted deleveraging is finally taking place in the two largest credit sectors, Household and Financial.

Household has been deleveraging since Q3-2008 and is presently down $1 trillion. Financial has been deleveraging since Q4-2008 and is presently down $3.4 trillion. The only reason this private deleveraging hasn’t shown up as general deflation is due to the $5.6 trillion increase in Federal leveraging; the Federal government has literally doubled its outstanding debt in four years.

In addition to ignoring the fact that credit money is a much more important factor than fiat money, be it paper or digital, Gary North clearly doesn’t realize that everyone with any exposure to the economy will sink or swim on the Federal government’s ability to continue substituting its own ability to leverage for private sector deleveraging. So long as the government can continue to borrow and maintain that ratio, it can stave off deflation. But unless it can borrow infinitely, it cannot do so forever.

Too soon

It is very slowly becoming apparent to everyone but the mainstream economists that the USA has been in a depression since 2008:

The Great Depression that Federal Reserve Chairman Ben Bernanke claims to have averted has been part of the background radiation of our economy since at least 2008.

It’s just that like radiation — it’s invisible.

We’ve called it the recovery, the jobless recovery, the slogging recovery and more recently the fading recovery. We’ve measured modest growth in our nation’s gross domestic product to record that our so-called Great Recession ended in June 2009. And now we are saying that if this disappointing growth suddenly disappears, as currently feared, we will be in a new recession.

There is nothing more depressing than hearing about a new recession when you haven’t fully recovered from the last one. I take heart in suspecting that in a still-distant future, historians will look back with clarity and call this whole rotten period a depression.

Which, of course, is very close to what I have been repeatedly saying since early 2009, as The Return of the Great Depression was published on October 29, 2009, the 70th anniversary of the Black Tuesday crash on Wall Street. And some of you may recall the following failed economic prediction for 2011, which is looking at least partially correct for 2012.

One U.S. state and at least three major cities (100k population plus) will attempt to file for bankruptcy or federal bailout. (It’s unclear if states can file for bankruptcy and public employee unions will oppose the city filings.)
– December 31, 2010

“San Bernardino [pop. 210,000] on Wednesday became the third California city to declare insolvency, joining Stockton [pop. 291,707] and Mammoth Lakes [pop. 8,234] after officials say they filed an emergency petition for Chapter 9 bankruptcy.”
– August 1, 2012

Now, you are certainly welcome to dismiss my economic predictions due to my inability to pinpoint the precise timing with which these events will occur. But even in light of my temporal inaccuracy, I think it is worthwhile pointing out that these predictions are completely contrary to those made by the vast majority of economists and economic observers, many of whom are still talking about the ongoing recovery in the fourth year of the Great Depression 2.0. This failure to note the readily apparent is not unprecedented, as Megan McCardle noted in 2009.

I don’t want to push the Great Depression analogy too far, but what’s surprising when you go back to primary sources from 1930 is the optimism. I don’t mean to imply that everyone thinks things are just swell. But while you know that they are facing the worst economic decade of the twentieth century, they don’t. They’re expecting something more like the recession that followed World War I.

What was the big difference between the recovery from the 1920-21 recession and the non-recovery from the 1929-30 depression? Then, as now, the federal government decided to fight the economic contraction with economic stimulus. The reason that the Great Depression 2.0 will be much bigger and last much longer than its predecessor is because the debt overhang is larger and the stimulus attempts have not only been larger, but are global in their scope.

UK in depression

Even by the official statistics, the UK is in a recession again:

UK economy contracts by a shock 0.7pc. The figures from the Office for National Statistics are much worse than forecasts for a 0.2pc contraction. It marks the third successive quarter of contraction, leaving Britain in its longest double-dip recession in more than 50 years. The economy shrank by 0.3pc in the first quarter of the year, following a 0.4pc contraction in the final quarter of 2011.

Have a look at the large chart. UK GDP hasn’t been above 0.5% “growth” since the third quarter of 2007, and if one takes into account the margin of error in the various statistical revisions as well as the increasing G portion of GDP, it should be readily apparent that there has been no actual economic growth since then even if we follow the Keynesian lead in ignoring debt.

However, this isn’t a “double-dip recession” as is presently being reported, it is an ongoing economic depression that began in 2007 at the latest, and quite possibly as far back as 2001.

Book Review: Debunking Economics

Staking the Undead Economist

After nearly three decades of reading across a broad spectrum of economic thought, the two books on the subject I would most recommend are Joseph Schumpeter’s History of Economic Analysis and Murray Rothbard’s An Austrian Perspective on the History of Economic Thought. But now there is a third. After finishing Debunking Economics: The Naked Emperor Dethroned? I have to assert that Keen’s book is not only an absolute masterpiece, but may, in fact, represent the most important intellectual development in economics since The General Theory of Employment, Interest and Money was published in 1936. And if some of Keen’s more controversial assertions hold up over time, it will be the most important contribution to the literature since The Wealth of Nations.

Upending economics

Steve Keen’s Debunking Economics is less a critique than slashing out the legs upon which economics has rested for centuries. One of the pillars he topples has a direct connection to the deflation dichotomy, as he attempts to explain to Mish why the Federal Reserve’s big increase in bank reserves has not led to more lending:

That “increase reserves to increase lending” argument is so hard to shake, but reserves can’t be lent from simply from a double-entry bookkeeping point of view.

The way that accountants keep track of the “assets equals liabilities plus equity” rule is to record an increase in assets as a positive and an increase in liabilities as a negative (your liabilities rise, so a negative gets bigger). Reserves are an asset, as are loans, and shown as a positive. Deposits–which are created by a loan–are a liability and shown as a negative

So to lend to a customer, a bank has to show a negative on that customer’s accounts. This can be matched by a positive on the loans entry–because the loan has increased in size. No problem.

But if banks were to lend from reserves, they would need to record a minus there–reserves have fallen. And on the liabilities side, they want to … also show a negative. Whoops! No can do.

The end result of this logic is that reserves are there for settlement of accounts between banks, and for the government’s interface with the private banking sector, but not for lending from.

Banks themselves may (if they are allowed–I simply don’t know the rules here) swap those assets for other forms of assets that are income-yielding, but they are not able to lend from them.

As Keen points out in his book, it’s not merely an accounting perspective that suggests the conventional economic understanding of the relationship between deposits and loans in a fractional reserve system cannot be correct, but the empirical observation of banker’s activities as well. Loans not only don’t depend upon deposits, they usually precede them.

This also helps explain why the artificially low interest rates maintained by the Bank of Japan and the Federal Reserve, have not, as the monetarists expected, produced increased borrowing.