The above quote is attributed to Albert Einstein, and it is a typical one following Einstein’s motto “as simple as you can, but not simpler!” So, how could we describe the economy? Would we need to take into account the line by Einstein and be careful about descriptions that are technically correct but lose the essence somewhere along the way, or can we just start and describe physical things and the transformations of inputs into outputs without having to stop for some reflection?

I strongly believe the latter is the case. The economy is something in which goods are produced and then exchanged, but there is a lot more to it than this description would make you think. What about social justice in a system where workers specialise in certain tasks and this receive a money wage? What about the uncertainty for the entrepreneur who first pays workers and then gets his production process started? What is the role of money and banking in this process? Who has the power and why? What about individual rights and duties? Who protects the weak, and who is watching the watchmen?

Having just attended a conference which celebrated an economic journal, I believe that with the problems that we face today we need to rethink economics as the academic discipline. Nine years after the start of the sub-prime crisis, there were still presentations about DSGE models (nothing about SFC models), about government spending that would pay for itself (whereas the government cannot go bankrupt if it issues debt in its own currency), about a Cobb-Douglas production function that assumed that you can give a price to capital (here the alternatives are harder to imagine, but classical economists like Smith and Marx would come to mind). Where is the new economic thinking?

Let me slightly rephrase the quote by Einstein:

“It would be possible to describe absolutely everything scientifically, but it would make no sense. It would be without meaning, as if you described a capitalist process of development as an accumulation of capital and labour.”

Just as with Beethoven, the single parts and the whole have to be seen from completely different angles. Whereas there are many ways to listen to Beethoven, there is still only one academically correct way of “doing economics”, which is neoclassical economics. This is wrong and this needs to be corrected. One of the publications that celebrated its birthday today will shortly publish an article on the need for a Pluralist economics. Just as the last 100 years, the next will surely be intellectually stimulating!

The consolidated version of the treaty on the functioning of the European Union reads:



Article 145 (ex Article 125 TEC)

Member States and the Union shall, in accordance with this Title, work towards developing a coordinated strategy for employment and particularly for promoting a skilled, trained and adaptable workforce and labour markets responsive to economic change with a view to achieving the objectives defined in Article 3 of the Treaty on European Union.

Article 146 (ex Article 126 TEC)

1. Member States, through their employment policies, shall contribute to the achievement of the objectives referred to in Article 145 in a way consistent with the broad guidelines of the economic policies of the Member States and of the Union adopted pursuant to Article 121(2).

2. Member States, having regard to national practices related to the responsibilities of management and labour, shall regard promoting employment as a matter of common concern and shall coordinate their action in this respect within the Council, in accordance with the provisions of Article 148.

Article 147 (ex Article 127 TEC)

1. The Union shall contribute to a high level of employment by encouraging cooperation between Member States and by supporting and, if necessary, complementing their action. In doing so, the competences of the Member States shall be respected.

2. The objective of a high level of employment shall be taken into consideration in the formulation and implementation of Union policies and activities.

I am not a specialist in European law, but it seems to me that Article 147 (1) says that “[t]he Union shall contribute to a high level of employment by encouraging cooperation between Member States and by supporting and, if necessary, complementing their action. In doing so, the competences of the Member States shall be respected.”

How you could impose austerity policies in a policy framework like this is unclear to me. The failure of Europe is a political failure and maybe also a failure of legal institutions. It is an economic failure only in so much as the advise of many, many economists was ignored and a euro was set up that was almost designed to fail (the so-called Krönungstheorie says that this was deliberate) and when it did the economists were proved right but politicians were scared and panicked.

Posted by: Dirk | October 10, 2016

Money is a store of value … really?

The way that economists discuss low interest rates and the problems of savers seems to imply that they think we are saving by holding deposits at the central bank or, more realistically, at our commercial bank of choice. This idea was dispelled long ago by Keynes (1937), who wrote in his article in the Quarterly Journal of Economics:

Money, it is well known, serves two principal purposes. By acting as a money of account it facilitates exchanges without its being necessary that it should ever itself come into the picture as a substantive object. In this respect it is a convenience which is devoid of significance or real influence. In the second place, it is a store of wealth. So we are told, without a smile on the face. But in the world of the classical economy, what an insane use to which to put it! For it is a recognized characteristic of money as a store of wealth that it is barren; whereas practically every other form of storing wealth yields some interest or profit. Why should anyone outside a lunatic asylum wish to use money as a store of wealth?

Good point. Sadly, modern economics has returned to a state in which knowledge lost long ago becomes practically relevant. People have invested their savings in real estate, stocks, bonds, etc. The returns of these assets diverge quite significantly from interest rates set by the central bank (for instance, Chinese real estate performs quite well this year). So, neoclassical models with only one interest rate fall way short to make sense of our complex world.

Olivier Blanchard has distilled two assumptions that either make DSGE the prominent tool for macroeconomic research or they don’t. However, before this paragraph he writes that there are three propositions with wide agreement:

  1. Macroeconomics is about general equilibrium.
  2. Different types of general equilibrium models are needed for different purposes. For exploration and pedagogy, the criterion should be transparency and simplicity, and for that, toy models are the right vehicles. For forecasting, the criterion should be forecasting accuracy, and purely statistical models may, for the time being, be best. For conditional forecasting, i.e. to look for example at the effects of changes in policy, more structural models are needed, but they must fit the data closely and do not need to be religious about micro foundations.
  3. Partial equilibrium modelling and estimation are essential to understanding the particular mechanisms of relevance to macroeconomics. Only when they are well understood does it become essential to understand their general equilibrium effects. Not every macroeconomist should be working on general equilibrium models (there is such a thing as division of labor).

I do not agree with these positions, and many others don’t. Macroeconomics is about examining the causes for unemployment first. As secondary objectives, it is about economic growth and distribution, both of which already play a role when examining unemployment. Macroeconomics is not about general equilibrium. Blanchard confuses the method with field. When it comes to method, I would argue for a balance sheet approach. Equilibrium means that balance sheets have to be balanced, not necessarily at full employment. I have a book chapter for publication in 2017 sitting on my desk of which a first draft already exists (ResearchGate). Anybody interested in it is invited to comment on that draft.

I think that DSGE has shown itself to be useless when you need the macroeconomist – in times of macroeconomic crisis. Even worse, it can be used to give bad policy advice and analysis (see here) that is hard to falsify because the models do not lend themselves to empirical tests. It is a bit like trying to prove that dragons do not exist. Common sense is more helpful than a mathematical model that shows that a dragon is possible. The DSGE model shows that a very particular world is possible where wishes to save always trigger investment so that the economy is self-regulating. However, we can clearly see in the real world that it’s not. DSGE should be allowed to die.

Posted by: Dirk | September 29, 2016

Bank Of Japan: mark it zero, dude!

cnbcAccording to a recent video feed by CNBC, the Bank of Japan has negative interest rates, scrapped monetary base targets and controls the yield curve. Actually, it communicated that 10y bonds will have a zero interest rate. As a look at recent data shows, the BoJ is clearly achieving what it has announced. Somehow, all of these things used to be in the territory of monetary cranks when monetarism ruled for a blip during the 1980s:

  • negative interest rates
  • no monetary supply targets
  • controlling the yield curve (long-term interest rates)

Now, they are all reality, in one of the biggest industrial powers of this planet. Sometimes, things change rather quickly. It is now monetary theory that has to adjust to the new world we live in.

Posted by: Dirk | September 22, 2016

Paul Romer’s new paper: The Trouble with Macroeconomics

The World Bank’s chief economist has generated quite a stir with his new paper, which can be downloaded here. This is the abstract:

For more than three decades, macroeconomics has gone backwards. The treatment of identification now is no more credible than in the early 1970s but escapes challenge because it is so much more opaque. Macroeconomic theorists dismiss mere facts by feigning an obtuse ignorance about such simple assertions as “tight monetary policy can cause a recession.” Their models attribute fluctuations in aggregate variables to imaginary causal forces that are not influenced by the action that any person takes. A parallel with string theory from physics hints at a general failure mode of science that is triggered when respect for highly regarded leaders evolves into a deference to authority that displaces objective fact from its position as the ultimate determinant of scientific truth.

Of course, this is the perfect opportunity to refer to my new book on “The Troubles Macroeconomics”, mainly financial crises and the mass unemployment that results when governments don’t come to the rescue. This is not an assumption but comes out of a careful reading of the way the balance sheets work. In my book, I look at the generation of central bank money, commercial bank deposits, fiscal and monetary policy, QE, the TARGET2 system and the way that real businesses operate. I think that this is the way to go forward since balance sheets are quite objective. In a new paper, I call this “the balance sheet approach“, which is a new paradigm inside of which both some neoclassical and some heterodox economists are operating.

Posted by: Dirk | September 15, 2016

Spanish government pays hefty price for bank bail-out

According to Agencia EFE, the bank bail-out in Spain has left a slight fiscal problem (link):

El Estado ha recuperado 2.686 millones de euros de los 61.495 millones de ayudas totales que otorgó desde 2009 al sector financiero, lo que supone veinte millones más que los contabilizados hace algo más de un año.

In English: The government has gained back only €2.7 billion of the €61.5 billion that was given as aid to the financial sector since 2009, twenty million more compared to what was accounted for a year ago. Germany only paid €15.8 billion to save its larger banks, according to Handelsblatt. So, what went wrong?

In times of crisis, central banker usually follow the rule of Bagehot and lend freely, against collateral and at high interest rates, to those who are solvent. This should solve the liquidity crisis but it also means that insolvent banks will be gone.

In Spain, this was not applied. In Spain, all banks were saved, probably because the vast majority of them were insolvent. After the real estate boom many banks had a bad portfolio of assets consisting of billions of euros in real estate loans that turned into non-performing loans. The consequence of this is that the Spanish government will not get its money back because it lend to insolvent banks that probably will never repay the loans that the Spanish government gave them (against bad collateral, mostly real estate, I assume).

During the time of crisis, politicians probably did this to save the Spanish banking system. Europe (the EU) was not willing to step in, with Merkel saying that banking bail-outs are a nation-state problem. Of course, it is still dubious why the Spanish government should have bailed out its banks.

The Spanish CTXT magazine now has an article out (link) that is named “El no rescate de Rajoy, o cómo los españoles rescataron a los bancos alemanes”, in English: “The non-rescue of [Spanish president] Rajoy, or how the Spanish people saved the German banks”. Spanish banks owed hundreds of billions to German banks via the interbank market at the time of the crisis, and this was what seems to have mattered in terms of policy-making.

Advertisement: I explain the workings of the interbank market in the euro zone in my new book titled “Modern Monetary Theory and European Macroeconomics“, if you want to see some balance sheets modelled after real world institutions.

I have just published a working paper online (link) with the above title. What would John Maynard have thought about the euro zone crisis, and perhaps more importantly, what would he have done? The answer, most people think, is in the General Theory (1936), which was published 80 years ago. Why this is correct, there are other writings by Keynes in which he summarizes his ideas in much shorter space. The one that my article dissects is his letter to FDR, the US president, from December 31 1933. It was published in the NY Times and can be read online (link). Keynes describes three possible ‘techniques of recovery’, but argues that only one would be available at that time. I think that this letter is probably the best source to answer the question about what John Maynard would have done if he’d lived today. His point is monetary: if the monetary circuit experiences a slowdown, some actor must add more deposits into the economy to create more income and hence more demand. How do you add deposits and hence income to the world economy? Well, there are only three options. If you don’t pick any of them, you are not making sense and the crisis will persist. I find his reasoning very persuasive.

You can read my article online following this link (to the ideas/repec database, where you find a link to the pdf file).

In his 1936 “The General Theory of Employment, Interest and Money”, John Maynard Keynes already recognized that the idea that savings finance investments is wrong. Savings equal investment indeed, which is written as S=I. However, the way that this identity (roughly: definition in the form of an equation) holds is exactly the opposite. Here are two paragraphs from his chapter 6 (source) with my highlighting:

Income is created by the value in excess of user cost which the producer obtains for the output he has sold; but the whole of this output must obviously have been sold either to a consumer or to another entrepreneur; and each entrepreneur’s current investment is equal to the excess of the equipment which he has purchased from other entrepreneurs over his own user cost. Hence, in the aggregate the excess of income over consumption, which we call saving, cannot differ from the addition to capital equipment which we call investment. And similarly with net saving and net investment. Saving, in fact, is a mere residual. The decisions to consume and the decisions to invest between them determine incomes. Assuming that the decisions to invest become effective, they must in doing so either curtail consumption or expand income. Thus the act of investment in itself cannot help causing the residual or margin, which we call saving, to increase by a corresponding amount.


Clearness of mind on this matter is best reached, perhaps, by thinking in terms of decisions to consume (or to refrain from consuming) rather than of decisions to save. A decision to consume or not to consume truly lies within the power of the individual; so does a decision to invest or not to invest. The amounts of aggregate income and of aggregate saving are the results of the free choices of individuals whether or not to consume and whether or not to invest; but they are neither of them capable of assuming an independent value resulting from a separate set of decisions taken irrespective of the decisions concerning consumption and investment. In accordance with this principle, the conception of the propensity to consume will, in what follows, take the place of the propensity or disposition to save.

This means that investment is financed by credit. When banks create new loans, new deposits are credited to the borrower’s account. These deposits are additional deposits that did not exist before. When spending, the investment takes place (and rises by some amount) and the seller of the goods are services that constitute the investment will received bank deposits. This is income not spend, which means that savings go up (by the same amount). Hence savings equal investment, but not because savings finance investment! Before Keynes, Wicksell and Schumpeter wrote about this as well, so it was common knowledge that loans finance investment and not savings. Today, we live in a dark age of macroeconomics and monetary theory since this insight has been forgotten by most of the discipline.

Posted by: Dirk | September 8, 2016

James May (formerly Top Gear) understands modern money!

James May was suggested to be the governor of the Bank of England by an elderly gentleman sitting on a British racing green sofa (h/t to S. Angrick):

James May suggests to sort out the deficit: “I’d find out how much it was, and then I’d write a check for that amount from the Bank of England”. [Laughter in the audience]

People laugh because they don’t understand the mechanics of modern money creation and the answer sounds kind of plausible but also probably too clever, I assume. Actually, the British government could finance its deficit exactly the way James May describes it. The Bank of England “writes a check” to the government, which means marking up its account at the Bank of England. In return, the Bank of England gets treasury bonds of the same value. Problem solved! The government cannot go bankrupt because it is supported by the Bank of England. In reality, the Bank of England is not allowed to buy treasury bonds (gilts) directly from the government or the institution running the sale on its behalf (UK Debt Management Office). However, it can and does buy it when existing gilts are on the market. So, James May has said something funny that is also very clever…

For those who are interested in understanding modern money in the context of the eurozone (crisis) I can recommend my new book published last month at Routledge.

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