1. Learning how the economy works is best achieved by a careful reading of Keynes’s General Theory.
2. The lessons of classical economics are not helpful in understanding how the world works.
3. Capitalist economies are threatened by the posiibility of excess saving, which could lead to secular stagnation: deficit spending is, therefore, good for the economy.
4. Fiscal policy is a poweful tool for economic stabilization, and monetary policy is not very important.
5. Policymakers should learn to live with inflation, because it is the cost of low unemployment.
6. Policymakers should be free to exercise their discretion in responding to changing economic conditions and avoid adherrence to a rigid policy rule.

So, that was 1991, this is 2012. Where are we now? Let me first point out the following. If Mankiw would have believed in his first dubious Keynesian proposition, than he would not have come up with some of the other points. He would have understood that Keynes would not have agreed with the propositions 2, 4 and 5 because they are not derived from the work of Keynes. The problem here is that Keynes and Keynesians fell apart in their positions without noticing it – the latter perhapd did notice it, but the former did not because he was dead. Anyway, this confusion is not Mankiw’s fault.

Proposition 1. then, is a bit of a strawman-Keynesian proposition, since nobody actually ever wrote that. Proposition 3 has made a powerful comeback: saving too much and investing it unwisely can lead to really, really big economic problems. Point 6 is something which at least Europeans are willing to discuss. After all, we had lots of rules (Maastricht and all that) and still the economy is in shambles. Following more rules and stricter rules is what some propose, but it seems very doubtful that this would help.

Only 21 years ago Gregory Mankiw published his paper, and still about the only thing that still looks good is his conclusion Does Macroeconomics Make Progress? ‘In some ways,’ he writes, ‘the history of macroeconomic thought seems like a pendulum swinging between two views of the economy. On the right is the classical view of a well-functioning economy, on the left is the Keynesian view of an economy fraught with market failure.’

UPDATE 28/01/2012: I have deleted the last sentence which before read: ” Hmmm… maybe it IS the pendulum?” I read what I wrote but still don’t know what I thought.

Looking back at this brief survey, we may perhaps discern two main tendencies which stand in the way of adopting a critical dualism. The first is a general tendency towards monism, that is to say, towards the reduction of norms to facts. The second lies deeper, and it possibly forms the background of the first. It is based upon our fear of admitting to ourselves that the responsibility for our ethical decisions is entirely ours and cannot be shifted to anybody else; neither to god, nor to nature, nor to society, nor to history. All these ethical theories attempt to find somebody, or perhaps some argument, to take the burden from us. But we cannot shirk this responsibility. Whatever authority we may accept, it is we who accept it. We only deceive ourselves if we do not realize this simple point.

Let me start with the first tendency: monism. The Merriam-Webster dictionary offers three definitions of monism, the last one being “a viewpoint or theory that reduces all phenomena to one principle“. Since many theories in monetary economics are abstractions of reality they might be called theories of monism. This does not mean that these kinds of models are without value. It’s just that these models might mistake norms for facts, and that they therefore might be wrong. The interest rate should serve as an example.

The traditional (neo-classical) view of the interest rate is that it coordinates debt over time. In an economy, some households have more money than they need to buy what they want to consume today. They are willing to make loans to households with funds that are lower than their planned consumption. Given that the debtors are able to repay, it makes sense for surplus households to lend money to deficit households. Given that deficit households are trying to find the lowest interest rate demanded, and surplus the highest interest rate offered, we have established some kind of equilibrium. This theory of loanable funds explains that the interest rate depends on the aggregated wishes of households to borrow and lend. If more households want to become deficit households, the interest rate goes up, and if more households want to become surplus households vice versa. Arbitrage and profit-maximization are the two principles that establish this equilibrium. The institution of debt, which is nothing else but borrowing and lending, is no longer a norm, but a fact. Nothing else is needed to explain the interest rate but optimizing agents in free markets.

The opposite view is that of the (Keynesian) liquidity preference. Here, the surplus households demand a compensation to part with their liquid funds. This compensation takes the form of an interest rate. The relative shares of potential deficit and surplus households influences the interest rate, but there is another scenario possible in which the mechanism breaks down. If there are expectations of falling prices, then lenders might not be willing to lend at any rate of interest. They know that the deficit households will somehow invest the money, but if all prices are predicted to fall, then there will be no lenders at any interest rate. The market for debt freezes, it has effectively broken down. Here, the norm of debt is not reduced to fact. Instead, uncertainty is introduced in the picture. While the interest rate at times is governed by supply and demand of funds, we don’t know exactly over which periods this will be the case. We do know that sometimes the interest rate doesn’t work, that no additional debt is created. We are aware of the norm of debt contracts and understand that the interest rate is not a fact but the outcome of a norm.

Only those that share the view of the interest rate as a liquidity preference are able to adopt a critical dualism. They understand that norms – or better, institutions – might have failed and that this might have produced a situation in which nothing is lend and nothing is borrowed. Those of the loanable funds theory can only explain this situation by stating that no household wants to be a deficit or creditor household and that therefore all households are in a position that cannot be improved. In the euro zone, we can be quite sure that when lending to some governments stopped this was not the case. Instead, it is an institutional problem that has caused some private credit markets to freeze. Some of these institutional problems lie inside the countries that are not able to borrow anymore, some lie outside those countries. A part of these problems lies with the design of the euro. Which leads us to the second concept that stands in the way of a critical dualism: the burden of responsibility.

Fear can drive us to shirk responsibility, and shift it to something or somebody else. Very often, institutions are created in order to shift responsibility from people to this institution. There are many examples, like courts and judges, or the central bank. The job of today’s central banks is inflation fighting. According to contemporary monetary theory, accelerating inflation is fought by creating less demand for factors of production, including labor. This means that when the central bank decides that inflation is too high the interest rate is increased. This should lead to less demand for investment and as a by-product, subsequently, to higher unemployment. Perhaps many people are not aware of this mechanism, but this is nevertheless what happens. As Popper has argued, whatever authority we accept, finally it is us who accept it.

Therefore, the European Central Bank as an institution overseeing a euro zone with unemployment rates in some nations in the double digits, negative growth rates and unsustainable debt burdens is not the responsible. It is the people of Europe who have to take responsibility with the social condition of the continent. They accepted the ECB as an institution that should oversee the monetary system, hence they are accountable for the outcome. Analyzing the faults and errors, a critical dualism is necessary in order to understand correctly the way things work and, when that is established, to improve European institutions by modifying existing and creating new ones. Europe, after all, can only advance when the lessons of recent history have been learned, and responsibility is shifted not to one country or another, but back where it belongs: to the voters that have accepted the design of the ECB and its fellow institutions, like the Stability and Growth Pact.

Germany issued debt on Monday for the first time with a negative yield, meaning that investors were in effect paying Berlin for the privilege of lending it money.

A €4bn auction of six-month bills drew a negative yield of 0.0122 per cent in a sign of Germany’s haven status amid the eurozone debt crisis.

That contrasts nicely with the evaluation of the current economic situation by Dennis Snower of the Kiel Institute for the World Economy, as reported by the NYT:

“Governments spend too much in good times, and they spend even more in bad times,” said Dennis J. Snower, president of the Institute for the World Economy in Kiel, Germany. “To have some constraints is a good idea.”

I guess I don’t even bother to ask on what kind of economics this evaluation is based on. The answer would be: none. This is 21st century rigorous economic thinking made in Germany (by the way: my own position is that of economists everywhere else: it depends.)

What a sad state, even for the dismal discipline.

“It is impossible to derive a sentence stating a norm or a decision or, say, a proposal for a policy from a sentence stating a fact; this is only another way of saying that it is impossible to derive norms or decision or proposals from facts.” (p.66)

Popper here examines the major problem of mankind: we have choices, and it is not so clear how those choices are ranked. We cannot derive from facts directly which policies to follow. Therefore, it is not surprising that the people on this planet do not share the same norms. We speak different languages, listen to different kinds of music, enjoy (watching) different kinds of sports, are ruled through different kinds of institutional setups, have decided to install more or less generous welfare states, and so on. It cannot be said that one institutional arrangement is better than the other, since that all depends on what “better” means. Better for whom?

This, however, should not lead to despair. There are some sociological laws which seem to be in operation. Popper thinks of “modern economic theories, for instance, the theory of international trade, or the theory of the trade cycle.” (p.69) He does not elaborate on this point, but I think he would think along the following lines. People in modern society exploit the division of labour, and therefore need to sell most of their produce. (In the old days, farmer were consuming what they produced.) It is only natural that they are looking for the highest price when selling. Due to differences in endowments of skills and/or endowments of factors of production, the price of a product in different locations will vary. In case of barter, the amount of products received in exchange for a given product will vary. People seem to engage in so-called arbitrage: they prefer to buy cheap, and sell dear. Arbitrage then would be what Popper calls a sociological law.

The second example is that of the theory of the trade cycle. Sentiments of optimism and pessimism drive the trade cycle, with the economy moving from boom to bust and bust to boom. During times of optimism, entrepreneurs use the cash flow to increase investments. We live in a world governed by profit-maximizing firms. During times of depression, entrepreneurs use the cash flow to repay external debt in order to avoid bankruptcy. We live in a world governed by firms repairing their balance sheets. Again, this seems to be a sociological law as defined by Popper. Let me quote a longer passage of Popper’s text (p. 69):

“These laws play a rôle in our social life corresponding to the rôle played in mechanical engineering by, say, the principle of the lever. For institutions, like levers, are needed if we want to achieve anything which goes beyond the power of our muscles. Like machines, they need intelligent supervision by someone who understands their way of functioning, and, most of all, their purpose, since we cannot build them so that they work automatically. Furthermore, their construction needs some knowledge of social regularities which impose limitations upon what can be achieved by institutions.”

From this paragraph it can be inferred that central banks can be seen as institutions which should mitigate the trade cycle, which follows sociological laws. Social regularities like “animal spirits” will limit the potential success of central banks, but nevertheless a central bank might be useful nevertheless. Historically, central banks have been used to stop the financial system from de-leveraging completely. In a bust, all firms might try to sell their financial assets at the same time. There would be no buyers in the market, which would lead to reductions in the price of financial assets. In the extreme, this can lead to wide-spread bankruptcy.

Central banks can discount financials assets (“bills”, in the 19^th century) and provide liquid funds (“money”) until the depression has stopped. The banks can then buy back their assets with the money, returning to the situation before the bust. This works only when the problem is one of liquidity, and not widespread insolvency, with lots of non-performing loans producing losses for those that hold them. This function of a central bank is called “lender of last resort”.

The European Central Bank (ECB) is an institution that was constructed to provide a currency for a group of nation states. It was built without the “lender of last resort” function in mind: normally the financial assets discounted in emergency liquidity provisions during times of crisis are sovereign bonds. However, the idea of the ECB financing sovereign bonds of nation states was discarded as not politically convenient. Governments should not be able to rely on the printing press when levels of national debt would rise to dangerous levels. The ECB is the only central bank in the Western world that lacks the lender of last resort function. That is why we have the real estate boom in Ireland and Spain play out mostly as a sovereign debt crisis. In order to bail out banks, governments took over large chunks of debt. This debt included many non-performing loans. Now, sovereigns themselves are in trouble.

In the words of Popper, the designers of the euro did not understand the social regularities of the trade cycle. In the 1990s, when the ECB was designed, the dominating theory was that of Real Business Cycles (RBC). Business cycles are started by exogenous “shocks” in the real economy, either on the supply side or the demand side. Culprit number one is the government, which might shock the economy by discretionary monetary and/or fiscal policy. In the model, the interest rate regulates consumption and saving over time. Shocks can be mitigated by rational households if only markets are competitive. However, the model failed to understand that business cycles can develop endogenously. It also failed to see that booms and busts depend very much on conditions in the financial markets. Last but not least, the interest rate does not coordinate saving and consumption over time. Aggregate demand plays a large role, especially during the downturn, when households prefer the repayment of debt to consumption.

Apparently, intelligent supervision has been lacking also, since the ECB did not change itself much during the crisis. It did change some rules and became a lender of last resort of some kind, but the idea of shifting the burden of adjustment back to politics has failed. Those supervising the ECB are Europe’s politicians, so not all blame should be put on the back of the ECB.However, the behaviour of the ECB during the crisis was unwise. It has become a Dr Jekyll and Mr Hide, with its insistence on not bailing out sovereigns while at the same time providing liquidity to those sovereigns it was supposedly not bailing out. Instead of acting independently, the ECB let politicians get away with the “Greece story” of a sovereign debt crisis when in reality a crisis of capital misallocation in the European financial system occurred. Capital was not only burned inside the euro zone, but also through investing in assets connected to the real estate bubble in the US and the Ponzi-scheme like banking sector of Iceland.

Deriving policy from fact is not possible, according to Popper. However, some sociological laws do exist that need to be taken into account. It is the task of science in general and economics in the field of social interactions to find those (sociological) laws and highlight their consequences for policy. On this account, the discipline of economics has been a failure.

The capacity to learn from mistakes is a hallmark of good leadership. As the existential threat to the eurozone became clearer, EU leaders changed tack. On December 9 a change in doctrine reversing the Deauville PSI innovation was announced. In future, the eurozone would adhere to International Monetary Fund principles. Leaders also agreed on a new “fiscal compact” to enhance governance.

Unfortunately, despite reversing the Deauville PSI innovation, investor trust has not been regained.

Unfortunately is not the right term, I suppose. The trouble runs deeper as most of the ECB members fail to understand the basic ideas of money and banking. Government debt can be repaid by having a government surplus, or by using the central bank to roll over existing debt, which in the process might take some debt on its own books. The idea of euro bonds builds on this insight, and other ideas like the ECB as a lender of last resort do so as well.

The ECB has proven to be independent from economic thought outside its own paradigm. It does not exhibit good leadership as it constantly fails to learn the right lessons from its own mistakes or lessons from history. Jürgen Stark warned against a transfer union when this was what was needed to regain the ‘trust’ of markets. Hyperinflation was invoked when we were close to depression, and the banking crisis of the early 1930s would have been the right lesson. When just before and during the crisis primary goods prices spiked and created some tiny, tiny inflationary pressures, the interest rate was hiked up before it was put down again. These are all policy blunders. Private sector involvement is a blunder as well, and Hank Paulson has been taught that lesson not to long ago when he bailed out Fannie Mae and Freddie Mac and let equity owners down.

‘Government debt markets are about trust.’, writes Orphanides. I agree with that notion. Investors need to trust the authorities – like the ECB – and believe that they understand finance and monetary policy. This seems like the problem that we have. If the euro is not workable, then the ECB should say so and propose reforms. Waving hands and pointing out that it should only care about inflation is a childish way to escape responsibility.

The shift in economic and political power has been based on ideas, which themselves allowed the rich and the powerful to remodel Western societies. While scientists and others are searching for the causes of the crisis, one promising set of ideas has been largely ignored. It was paved long ago by Karl Popper in his two-volume edition of “The Open Society and Its Enemies”. Popper starts out from the idea that there is something called an open society in contrast to a closed society. Popper defines these on p. 186 (Routledge Classics, Vol. I):

“In what follows, the magical or tribal or collectivist society will also be called the closed society, and the society in which individuals are confronted with personal decisions, the open society.”

Defined like this, the Western civilization as it stands has been built on institutions that enable and enhance the open society. That does not mean that markets, where individuals decide on what to spend, rule supreme. Personal decisions might as well lead to a (democratic) consensus to build institutions that replace, complement or enable market solutions. These public institutions can often be run more efficiently than private institutions, and also can address questions of social justice.

In the following series of articles, the focus will not be on the provision of private or public institutions, but rather on the question who gets to decide these questions and what the consequences are for society. Thus I will follow Karl Popper’s book and highlight some text passages which I find relevant for today. In his book, Popper examines Plato’s thought and juxtaposes it with the ideas of his day (the book was published in 1945). I will take this one step further and against this background discuss recent developments in the Western world.

When quoting I will use the first of the two-volume Routledge edition (vol. 1: The Spell of Plato). The text is also available online free of charge at http://www.archive.org/details/opensocietyandit033120mbp.

Table of Contents (updated as I publish):

1. Social institutions
2. t.b.a.

• Hungary is turning into an authoritarian state (article by Kim Lane Scheppele)
• About the only economist talking sense in Germany is Oscar Lafontaine of DIE LINKE, which is partly a successor of the East German communist/socialist party (interview in German in the SPIEGEL)
• it seems that the Chinese property bubble might bust soon (FT Alphaville)
• the Spanish reform programme under Rajoy is an austerity policy, and it is not sufficient yet (and perhaps can’t be, but the cuts are not large enough even according to their yardstick; source: EL PAIS)
• North Korean strongman Kim Jong-il dies, creating political instability over the succession, and so does Vaclav Havel, former president of the Czech Republic

Now some observers will now talk about confidence and geo-political risk and the like. However, I would like to point out that societies have a risk-management tool at their hands which normally can be relied upon in good times as well as bad times. This tool is called democracy with a market system.

However, this tool seems to be having problems. We are supposed to solve problems using markets and voting for people who regulate these markets. What happens, though, is that some markets have created the problem and then the politicians who are responsible for regulating the markets have denied responsibility/misdiagnosed the problem/evaded all criticism. What went wrong? What do we have to do to get the leaders that maximize our utility?

This is a typical problem of society. Even the ancient Greeks thought about this issue, and Plato’s The Republic was written to answer this question. I have quoted David Hume recently, who wrote:

A Government may endure for several ages, though the balance of power, and the balance of property do not coincide. [...] But where the original constitution allows any share of power, though small, to an order of men, who possess a large share of the property, it is easy for them gradually to stretch their authority, and bring the balance of power to coincide with that of property.

David Hume, of course, more than Plato was a man of enlightenment. It is this movement which provides the foundation of today’s Western societies. We have become – in the words of Karl Popper – open societies, which distinguishes us from the closed, tribal societies of the dark ages.

Perhaps we have forgotten our roots, our joint history and this is why our situation seems so strange today. Economists assure us that we have avoided the worst depression since the Great Depression, but as a result we have returned to business as usual. The new standard includes mass unemployment in Spain and other countries, rising tensions in the European Union and giving up any meaningful fight against global warming.

Perhaps it is time to revisit the idea of open societies – and its enemies – and think about today’s developments in a historical and philosophical context. In the next few weeks, I will present some excerpts from Popper’s Vol. 1 and put them into a modern context. I believe that economics without philosophy falls short of generating a civilised society. Somebody else would perhaps be better suited to undertake this, but I can’t see anyone doing it.

1. Christian Noyer, the governor of France’s central bank, reportedly said that the UK should be downgraded, and not France.
2. British Prime Minister David Cameron is seeking to build a People’s Front of Europe in opposition to the Popular Front of Europe, as reported by Reuters.

Of course, it is good that Europeans discuss. However, it seems that the level of this discussion is quite low and (national) politics is determining the tone. Mr Noyer either does not understand that the UK can print its own money and therefore won’t have problems to repay even huge levels of debt, or he plays national politics. Mr Cameron – who rightly criticizes the ideas of Mrs Merkel – has apparently bowed to national(ist) politics in home and willfully discarded the option of delivering a summit result that we have seen more than once in the last years – which is, none.

The European economies are not synchronized, they have therefore different national interests. Debtor countries want low interest rates and eurobonds, creditor countries low inflation and no transfer union. This to me seems irreconcilable with the current European institutions. I think that 2012 will see the rise of more splinter groups as European economic policies that do not fit all will cause some national politicians to cry foul on Europe. The institutions that the euro was built on are partly responsible for this. European institutions are not by themselves pro-European, and those who argue against the euro are not automatically anti-European.

This summit should have proposed institutional changes to avert such a scenario. But if such changes are politically impossible, and the euro is doomed, then a speedy death is preferable to a prolonged and painful demise. A euro zone collapse in the immediate future would be widely perceived as a catastrophe, which should at least serve as a source of hope for the future. But if it collapses after several years of perverse macroeconomic policies required by countries’ treaty obligations, the end, when it comes, will be regarded not as a calamity, but as a liberation.

And that really would be worse.

I think he is right about seeing a euro exit as a liberation, but then I do not agree with the idea that it would be worse than an immediate collapse. The reason is that right now the European people do not understand the crisis sufficiently to be able to draw conclusions from its downfall.

Angela Merkel and other conservatives can claim rightfully to have constructed the euro. It was based on conservative thinking at that time, mainly that markets are right and governments are wrong. Hence government debt was heavily regulated, and the financial markets were given a free run. Real estate bubbles happened where Europeans were unaware of the consequences of too much debt (mostly because they had not had access to abundant credit before) and where regulation and oversight were weak. Many Spanish real estate tycoons were quite popular as presidents of Spanish football clubs, among them Real Madrid, before the crisis hit.

The crisis has shown that European financial market participants, mostly banks, invested unwisely. Financing real estate bubbles in Ireland, Spain and the US hundreds of billions were turned into non-performing loans. This is the euro zone’s problem, not Greek government debt. The fact that this needs to be repeated even today brings me back to my main thought. The European public has not understood what this crisis is about. If it would, the ratings for Merkel’s party would plummet quickly, although other parties like Socialdemocrats and Greens would share the burden as well.

Therefore, an exit from the euro now would mean that a) the European public (a.k.a. future voters) does not sufficiently understand the euro crisis and b) those that have through their policies contributed to the crisis are still in power and will get to redesign the problem if the euro breaks up now. That would very likely lead to national currencies, since the fiscal union has been the problem the whole time. The other option, a change of European rules to save the euro – a real reform project, and not some ballyhoo with results clouded in almost Orwellian euro speak – would probably be out of reach if the euro were to fail before the German (and French) elections of 2013 (and 2012).

Of course, any new loan to Greece is in fact a fiscal transfer. We have known that since April 2010 from the arithmetic of debt. If that is so and more money will be sunk in Greece and other countries, consider it as tuition for public education. Perhaps you think I am cynical, but the opposite is the case. The European public still has not understood the crisis, and it needs to do so before we get to rewrite the rules of Europe. If along the way some billions are spent to support some of the people affected in the worst way by the crisis, is it really that bad?