The limits and flaws in our economics

Summary: Economics is the social science with the greatest impact on public policy. At key points in our history, America’s fate is determined by the power of economic theory. Yet the news media make a hash of reporting it, and both political parties distort it for their own gain. Here is a great look at the problems and limits of today’s economic theory. How good is it?

Mathematical formulas on fire.
ID 115756539 © Viktor Bondariev | Dreamstime.

Against Economics” – Part 1 of 2.

By David Graeber in the New York Review of Books, 5 December 2019.
Reposted with their generous permission. Headings added.

Review of Money and Government: A Challenge to Mainstream Economics by Robert Skidelsky (2018).

The problem with economics.

There is a growing feeling, among those who have the responsibility of managing large economies, that the discipline of economics is no longer fit for purpose. It is beginning to look like a science designed to solve problems that no longer exist.

A good example is the obsession with inflation. Economists still teach their students that the primary economic role of government – many would insist, its only really proper economic role – is to guarantee price stability. We must be constantly vigilant over the dangers of inflation. For governments to simply print money is therefore inherently sinful. If, however, inflation is kept at bay through the coordinated action of government and central bankers, the market should find its “natural rate of unemployment,” and investors, taking advantage of clear price signals, should be able to ensure healthy growth.

These assumptions came with the monetarism of the 1980s, the idea that government should restrict itself to managing the money supply, and by the 1990s had come to be accepted as such elementary common sense that pretty much all political debate had to set out from a ritual acknowledgment of the perils of government spending.

This continues to be the case, despite the fact that, since the 2008 recession, central banks have been printing money frantically in an attempt to create inflation and compel the rich to do something useful with their money, and have been largely unsuccessful in both endeavors.

We now live in a different economic universe than we did before the crash. Falling unemployment no longer drives up wages. Printing money does not cause inflation. Yet the language of public debate, and the wisdom conveyed in economic textbooks, remain almost entirely unchanged.

One expects a certain institutional lag. Mainstream economists nowadays might not be particularly good at predicting financial crashes, facilitating general prosperity, or coming up with models for preventing climate change, but when it comes to establishing themselves in positions of intellectual authority, unaffected by such failings, their success is unparalleled. One would have to look at the history of religions to find anything like it. To this day, economics continues to be taught not as a story of arguments – not, like any other social science, as a welter of often warring theoretical perspectives – but rather as something more like physics, the gradual realization of universal, unimpeachable mathematical truths.

“Heterodox” theories of economics do, of course, exist (institutionalist, Marxist, feminist, “Austrian,” post-Keynesian…), but their exponents have been almost completely locked out of what are considered “serious” departments, and even outright rebellions by economics students (from the post-autistic economics movement in France to post-crash economics in Britain) have largely failed to force them into the core curriculum.

As a result, heterodox economists continue to be treated as just a step or two away from crackpots, despite the fact that they often have a much better record of predicting real-world economic events. What’s more, the basic psychological assumptions on which mainstream (neoclassical) economics is based – though they have long since been disproved by actual psychologists – have colonized the rest of the academy, and have had a profound impact on popular understandings of the world.

Nowhere is this divide between public debate and economic reality more dramatic than in Britain, which is perhaps why it appears to be the first country where something is beginning to crack. It was center-left New Labour that presided over the pre-crash bubble, and voters’ throw-the-bastards-out reaction brought a series of Conservative governments that soon discovered that a rhetoric of austerity – the Churchillian evocation of common sacrifice for the public good – played well with the British public, allowing them to win broad popular acceptance for policies designed to pare down what little remained of the British welfare state and redistribute resources upward, toward the rich.

“There is no magic money tree,” as Theresa May put it during the snap election of 2017 – virtually the only memorable line from one of the most lackluster campaigns in British history. The phrase has been repeated endlessly in the media, whenever someone asks why the UK is the only country in Western Europe that charges university tuition, or whether it is really necessary to have quite so many people sleeping on the streets.

Ignoring the magic of money.

The truly extraordinary thing about May’s phrase is that it isn’t true. There are plenty of magic money trees in Britain, as there are in any developed economy. They are called “banks.” Since modern money is simply credit, banks can and do create money literally out of nothing, simply by making loans. Almost all of the money circulating in Britain at the moment is bank-created in this way. Not only is the public largely unaware of this, but a recent survey by the British research group Positive Money discovered that an astounding 85 percent of members of Parliament had no idea where money really came from (most appeared to be under the impression that it was produced by the Royal Mint).

Economists, for obvious reasons, can’t be completely oblivious to the role of banks, but they have spent much of the twentieth century arguing about what actually happens when someone applies for a loan. One school insists that banks transfer existing funds from their reserves, another that they produce new money, but only on the basis of a multiplier effect (so that your car loan can still be seen as ultimately rooted in some retired grandmother’s pension fund).

Only a minority – mostly heterodox economists, post-Keynesians, and modern money theorists – uphold what is called the “credit creation theory of banking”: that bankers simply wave a magic wand and make the money appear, secure in the confidence that even if they hand a client a credit for $1 million, ultimately the recipient will put it back in the bank again, so that, across the system as a whole, credits and debts will cancel out. Rather than loans being based in deposits, in this view, deposits themselves were the result of loans.

The one thing it never seemed to occur to anyone to do was to get a job at a bank, and find out what actually happens when someone asks to borrow money. In 2014 a German economist named Richard Werner did exactly that, and discovered that, in fact, loan officers do not check their existing funds, reserves, or anything else. They simply create money out of thin air, or, as he preferred to put it, “fairy dust.”
That year also appears to have been when elements in Britain’s notoriously independent civil service decided that enough was enough. The question of money creation became a critical bone of contention. The overwhelming majority of even mainstream economists in the UK had long since rejected austerity as counterproductive (which, predictably, had almost no impact on public debate). But at a certain point, demanding that the technocrats charged with running the system base all policy decisions on false assumptions about something as elementary as the nature of money becomes a little like demanding that architects proceed on the understanding that the square root of 47 is actually π. Architects are aware that buildings would start falling down. People would die.

Before long, the Bank of England (the British equivalent of the Federal Reserve, whose economists are most free to speak their minds since they are not formally part of the government) rolled out an elaborate official report called “Money Creation in the Modern Economy,” replete with videos and animations, making the same point: existing economics textbooks, and particularly the reigning monetarist orthodoxy, are wrong.

The heterodox economists are right. Private banks create money. Central banks like the Bank of England create money as well, but monetarists are entirely wrong to insist that their proper function is to control the money supply. In fact, central banks do not in any sense control the money supply; their main function is to set the interest rate – to determine how much private banks can charge for the money they create. Almost all public debate on these subjects is therefore based on false premises. For example, if what the Bank of England was saying were true, government borrowing didn’t divert funds from the private sector; it created entirely new money that had not existed before.

One might have imagined that such an admission would create something of a splash, and in certain restricted circles, it did. Central banks in Norway, Switzerland, and Germany quickly put out similar papers. Back in the UK, the immediate media response was simply silence. The Bank of England report has never, to my knowledge, been so much as mentioned on the BBC or any other TV news outlet. Newspaper columnists continued to write as if monetarism was self-evidently correct. Politicians continued to be grilled about where they would find the cash for social programs. It was as if a kind of entente cordiale had been established, in which the technocrats would be allowed to live in one theoretical universe, while politicians and news commentators would continue to exist in an entirely different one.

Slowly responding to reality.

Still, there are signs that this arrangement is temporary. England – and the Bank of England in particular – prides itself on being a bellwether for global economic trends. Monetarism itself got its launch into intellectual respectability in the 1970s after having been embraced by Bank of England economists. From there it was ultimately adopted by the insurgent Thatcher regime, and only after that by Ronald Reagan in the United States, and it was subsequently exported almost everywhere else.

It is possible that a similar pattern is reproducing itself today. In 2015, a year after the appearance of the Bank of England report, the Labour Party for the first time allowed open elections for its leadership, and the left-wing of the party, under Jeremy Corbyn and now shadow chancellor of the exchequer John McDonnell, took hold of the reins of power. At the time, the Labour left were considered even more marginal extremists than was Thatcher’s wing of the Conservative Party in 1975; it is also (despite the media’s constant efforts to paint them as unreconstructed 1970s socialists) the only major political group in the UK that has been open to new economic ideas.

While pretty much the entire political establishment has been spending most of its time these last few years screaming at one another about Brexit, McDonnell’s office – and Labour youth support groups – have been holding workshops and floating policy initiatives on everything from a four-day workweek and universal basic income to a Green Industrial Revolution and “Fully Automated Luxury Communism” {see here and here}, and inviting heterodox economists to take part in popular education initiatives aimed at transforming conceptions of how the economy really works. Corbynism has faced near-histrionic opposition from virtually all sectors of the political establishment, but it would be unwise to ignore the possibility that something historic is afoot.

Money and Government.

Money and Government: A Challenge to Mainstream Economics
Available at Amazon.

One sign that something historically new has indeed appeared is if scholars begin reading the past in a new light. Accordingly, one of the most significant books to come out of the UK in recent years would have to be Robert Skidelsky’s Money and Government: A Challenge to Mainstream Economics. Ostensibly an attempt to answer the question of why mainstream economics rendered itself so useless in the years immediately before and after the crisis of 2008, it is really an attempt to retell the history of the economic discipline through a consideration of the two things – money and government – that most economists least like to talk about.

Skidelsky is well-positioned to tell this story. He embodies a uniquely English type: the gentle maverick, so firmly ensconced in the establishment that it never occurs to him that he might not be able to say exactly what he thinks, and whose views are tolerated by the rest of the establishment precisely for that reason.

Born in Manchuria, trained at Oxford, professor of political economy at Warwick, Skidelsky is best known as the author of the definitive, three-volume biography of John Maynard Keynes, and has for the last three decades sat in the House of Lords as Baron of Tilton, affiliated at different times with a variety of political parties, and sometimes none at all. During the early Blair years, he was a Conservative, and even served as opposition spokesman on economic matters in the upper chamber; currently he’s a cross-bench independent, broadly aligned with left Labour.

In other words, he follows his own flag. Usually, it’s an interesting flag. Over the last several years, Skidelsky has been taking advantage of his position in the world’s most elite legislative body to hold a series of high-level seminars on the reformation of the economic discipline; this book is, in a sense, the first major product of these endeavors.

Robert Skidelsky (2013), Getty Images.
Robert Skidelsky, Getty Images.

What it reveals is an endless war between two broad theoretical perspectives in which the same side always seems to win – for reasons that rarely have anything to do with either theoretical sophistication or greater predictive power. The crux of the argument always seems to turn on the nature of money. Is money best conceived of as a physical commodity, a precious substance used to facilitate exchange, or is it better to see money primarily as a credit, a bookkeeping method or circulating IOU – in any case, a social arrangement?

What is money?

This is an argument that has been going on in some form for thousands of years. What we call “money” is always a mixture of both, and, as I myself noted in Debt: The First 5,000 Years (2011), the center of gravity between the two tends to shift back and forth over time. In the Middle Ages, everyday transactions across Eurasia were typically conducted by means of credit, and money was assumed to be an abstraction. It was the rise of global European empires in the sixteenth and seventeenth centuries, and the corresponding flood of gold and silver looted from the Americas, that really shifted perceptions. Historically, the feeling that bullion actually is money tends to mark periods of generalized violence, mass slavery, and predatory standing armies – which for most of the world was precisely how the Spanish, Portuguese, Dutch, French, and British empires were experienced.

One important theoretical innovation that these new bullion-based theories of money allowed was, as Skidelsky notes, what has come to be called the quantity theory of money (usually referred to in textbooks – since economists take endless delight in abbreviations – as QTM).

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The QTM argument was first put forward by a French lawyer named Jean Bodin, during a debate over the cause of the sharp, destablizing price inflation that immediately followed the Iberian conquest of the Americas. Bodin argued that the inflation was a simple matter of supply and demand: the enormous influx of gold and silver from the Spanish colonies was cheapening the value of money in Europe. The basic principle would no doubt have seemed a matter of common sense to anyone with experience of commerce at the time, but it turns out to have been based on a series of false assumptions. For one thing, most of the gold and silver extracted from Mexico and Peru did not end up in Europe at all, and certainly wasn’t coined into money. Most of it was transported directly to China and India (to buy spices, silks, calicoes, and other “oriental luxuries”), and insofar as it had inflationary effects back home, it was on the basis of speculative bonds of one sort or another.

This almost always turns out to be true when QTM is applied: it seems self-evident, but only if you leave most of the critical factors out.

In the case of the sixteenth-century price inflation, for instance, once one takes account of credit, hoarding, and speculation – not to mention increased rates of economic activity, investment in new technology, and wage levels (which, in turn, have a lot to do with the relative power of workers and employers, creditors and debtors) – it becomes impossible to say for certain which is the deciding factor: whether the money supply drives prices, or prices drive the money supply.

Technically, this comes down to a choice between what are called exogenous and endogenous theories of money. Should money be treated as an outside factor, like all those Spanish dubloons supposedly sweeping into Antwerp, Dublin, and Genoa in the days of Philip II, or should it be imagined primarily as a product of economic activity itself, mined, minted, and put into circulation, or more often, created as credit instruments such as loans, in order to meet a demand – which would, of course, mean that the roots of inflation lie elsewhere?

To put it bluntly: QTM is obviously wrong. Doubling the amount of gold in a country will have no effect on the price of cheese if you give all the gold to rich people and they just bury it in their yards, or use it to make gold-plated submarines (this is, incidentally, why quantitative easing, the strategy of buying long-term government bonds to put money into circulation, did not work either). What actually matters is spending.

Nonetheless, from Bodin’s time to the present, almost every time there was a major policy debate, the QTM advocates won.

——- Tomorrow see part 2: why QTM is wrong but wins. ——-

David Graeber
By Guido van Nispen. Wiki Commons.

About the author: David Graeber

David Graeber is a Professor of Anthropology at the London School of Economics. He studies Madagascar, Europe, North America, theories of value, money, debt, politics, manners, magic, class, social movements, and social theory. He is the author of many books, most recently …

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Some good books about economics

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J Is For Junk Economics: A Guide to Reality in the Age of Deception
Available at Amazon.
Turbo-Capitalism: Winners and Losers in the Global Economy
Available at Amazon.

26 thoughts on “The limits and flaws in our economics”

  1. Thanks for a great article. Looking forward to the next chapter. Truth and Reality are really hard to perceive as they are clouded with so many theories and energized by pride.

    1. Mike,

      There is quite a bit of research about the increased availability of equity and debt capital – which is the effect of “shadow banking”. So far it appears to be surprisingly small. It has not affected the cost of capital. It has not increased the rate of innovation, business formation, or productivity growth.

      Why that is so remains unclear. Perhaps other changes in the US have offset its effects. These things are mysterious.

  2. This was a decent article, and mostly worth the time to read it, I wish the author had been able to attach more supporting documentation to his article. Sadly, the British audience it was written for is so wrapped up in the Brexit controversy that I fear it will not have any discernible impact on anybody.

    Although the author is probably not enough of an expert on the US to be able to write it for a different audience, the article might have had more impact if he’d aimed at a US audience instead of the UK.

    The Brexit controversy has reduced Boris Johnson to wishing he could be thought of as being as competent as Donald Trump. It has also deadlocked the British government into such a painful position that they are holding their third round of parliamentary elections in 4 years. Everything I’ve read suggests that the results of this election are likely to be even less functional than the last two. Ouch, makes me happy to be a US citizen.

    1. Pluto,

      “I wish the author had been able to attach more supporting documentation to his article.”

      I get that all the time for my posts of 1 to 3 thousand words. This is a ten thousand word article and gets the same comment. I’ll bet people write books and get the same response. It is the most generic and useless criticism possible.

      “that I fear it will not have any discernible impact on anybody.”

      You’ll see in part two that criticism of faux economics never has much impact. When it comes to politically-relevant science, the general rule is that people believe what’s useful. Neither analytical debunking or repeated failure affects beliefs. It’s a major problem of our time.

      1. Larry: “Neither analytical debunking or repeated failure affects beliefs. It’s a major problem of our time.”

        Agreed. I suspect it will take a Great Depression-like event to change that. The 2008 event shook things up but they settled back into place with disturbing speed when the recovery started.

  3. This reminded me of a spiel that heterodox (Marxian, in this case) economist Richard Wolff has given numerous times: why do American universities have two separate departments, economics and business, that on the surface should be teaching the same thing?

    1. Jon S,

      “why do American universities have two separate departments, economics and business, that on the surface should be teaching the same thing?”

      I don’t watch podcasts, but that’s an odd question. They are not remotely the same thing. Economics is a social science, consisting of a body of empirical data and theory.

      Business is a profession (using that term loosely). It consists of best practices from experience, practical considerations (e.g., laws, regulations, accounting rules), details about institutional operations (mechanics of raising capital), and a host of practical details that economists don’t need to know.

      It’s the same reason that Electrical Engineering schools are not part of the Physics Departments.

    2. JonS 7 December 2019 at 8:06 am

      Agree, economics could be make part of business curriculum. About one course should explain everything worthwhile. At Chrysler Corp. we had a full time economist who “coordinated” with GM and Ford Motor Co to make all forecast were pretty much the same. To simplify his presentation he reduced to traffic light presentation, i.e, RED is bad, etc. As far as I know none of what he said was given much consideration. Business can’t run on theory.

      1. Michael,

        “economics could be made part of business curriculum”

        It is. Why would you believe otherwise? These are the required economics course from Wharton’s MBA core curriculum.

        • MGEC 611: Microeconomics for Managers
        • MGEC 612: Advanced Microeconomics for Managers
        • FNCE 613: Macroeconomics and the Global Economic Environment
        • FNCE 615: Introduction to Macroeconomics and the Global Economic Environment
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  5. Reading this article, these words “What Matters is Spending” reminded me of the article you put up several days ago.

    Quoting because I believe it is important to clarify why.

    “No! The hyperinflation was a near-death experience, but they survived it. They went on to become much stronger. What brought them down was the Great Depression, starting with the 1929 crash. That probably would not have brought them down either. Many countries survived the Great Depression. But Weimar’s leaders hit the wrong button: they implemented austerity. Which was the opposite of what the successful regimes did. Such as the United States under FDR or Germany very first Keynesian – the man who was such a brilliant economist that he invented Keynesian economics before Keynes. Adolf Hitler. He had it figured when he came to power in 1933.

    He said, “I want to stimulate the economy, and spend lots of money.” Being Adolf Hitler, nobody was going to say “no” and talk to him about monetary constraints and balancing the budget. Everybody saluted and said, “Yes sir.” He did a massive expansion of the economy in every conceivable way. You were running an Arts Council in a small town and the local NAZI Gauleiter comes and says “Spend money.” You stage concerts, opera, and exhibitions of paintings. They built highways and cars, etc. Germany was stronger than Britain and France because Germany had smart policies and they had dumb ones”

    1. Der Maiden,

      That’s a great example – which I hadn’t remembered – showing the importance of getting economics right! Thanks for posting it.

      There is, as usual, more levels to this.

      (1) The historical importance of Hitler’s successful stimulus is lost history.

      (2) Conservatives love their faux history. They falsely attribute Weimar’s fall to the 1923 hyperinflation, not to the 1929-32 austerity.

      (3) Conservatives love their faux economics. Despite multiple examples in the 1930s of successful fiscal stimulus, conservatives still refuse to believe it.

      1. If Hitler had died in a car wreck in 1937, he would probably be remembered as an eccentric who nonetheless revitalized the German economy.

        As for conservatives and fiscal stimulus: I imagine some of this is the deep rooted hostility to giving someone something for nothing — especially if that person is in a situation where they seem to be undeserving. (However construed.)

      2. SF,

        Again, nicely said. The hostility of conservatives to the American people (mirrored on the Left by their desire to use us as lab rats) is amazing to behold. We are reminded of this every Christmas by these words from It’s a Wonderful Life – discussing commercial mortgage loans that allow working people to buy homes (not a govt program, no cost to taxpayers).

        “What does that get us? A discontented, lazy rabble instead of a thrifty working class. And all because a few starry-eyed dreamers like Peter Bailey stir them up and fill their heads with a lot of impossible ideas.”

        –- Henry F. Potter, leading banker and first citizen of Potterville.

  6. Larry,

    Regarding the points you posted in my reply, do you have books you can recommend to read about how the Weimar implemented austerity in the late 20s?

    I remember when I was school, all of the history books I read hammered in the point that hyperinflation was to blame for the Weirmar’s fall.

    Also, God I love David Graeber. He does his research and he isn’t afraid to practice what he preaches. He even reads books by Martin Van Creveld! Between him and Martin Van Creveld, their writings make for fascinating reading over culture, administration, life, death, war, necromancy, and economics.

    Oh, one more book you should add to the reading list.

    Debt: The First 5,000 Years

  7. It got really confused throughout this article, probably because I don’t really have that much knowledge re economics.

    One thing that jumped out at me is the reference to the hostility towards on orthodox economics. I think that can apply in a lot of ways. Take, for example Tucker Carlson. You wrote an article in January about his populist awakening; since then, he’s been in a tear, particularly in the economic and foreign policy areas. Now both the establishment sides are pissed off at him, the left for his mere existence and his supposed rascism,
    And the right for his noninterventionism and his immense disdain for libertarian economics. It’s a wonder he hasn’t been silenced yet.

  8. Came here via your Kunstler appearance, am enjoying.

    “Technically, this comes down to a choice between what are called exogenous and endogenous theories of money.”

    As a Canadian prole, the thing that puzzles me most about the US is healthcare. How can citizens dislike/hate each other so much that they don’t want them to have healthcare? It would seem that no system could successfully overcome citizens with such ill will for their fellows.

    I apologize for my writing. I hope I’m reasonably coherent.

    1. Because Americans are really, really dumb. Also, with the death of God in a society comes the institution of new gods; in this case, politics. When the other side is viewed as evil and a heretic, anything goes.

      1. Isaac,

        “Because Americans are really, really dumb.”

        If future historians come across that assessment, I’m pretty sure they will consider it quite “dumb.” That other people’s aren’t your does make them “dumb.”

        “in this case, politics.”

        Absurd. Periods of highly intense and polarized politics are common in US and UK history. Jonathan Switft (Gulliver’s Travels) was a political engineer, and his venomous pen was as sharp as that of anybody writing today. Ditto the early years of the American Republic.

    2. peasant,

      “How can citizens dislike/hate each other so much that they don’t want them to have healthcare?”

      Universal healthcare was unknown in anywhere until Britain’s NHS after WWII. Did everybody “dislike/hate” each other before then? While all the other developed nations now have, most of the world’s people don’t. Do the people in most of the world “hate/dislike” each other?

      India and China have healthcare systems similar to that of the US. A public safety net of varying quality, with many poor paying for their own.

      “I apologize for my writing. I hope I’m reasonably coherent.”

      Your comment was cogent, clear, and quite apropos!

    3. I do not think many Americans specifically want to deny other Americans health care. (Some, probably, sure. But there are many millions of Americans. You can find a hundred people in America who believe literally anything) Even those who may say “Yes, Donald/Ron/whoever, BOO! LET THEM DIE!” are saying this in the context of political rallies, and would probably not reiterate that opinion in a sober situation, where they are not signifying some other value by so doing.

      Most Americans do not have a meaningful experience with any system other than the one we have until they are very old, and Medicare is robust enough that most people who make it to old age are not going to leave massive medical debts behind. Our system sucks but for many people – especially the people in the middle classes who tend to have some political power – it at least sort-of-kind-of works.

      Part of why this is breaking down now, in my opinion, is that many Americans do have experience or clear knowledge of better systems, as well as not having the steady jobs that tended to provide steady health care.

      1. SF,

        Nicely said.

        I would put more emphasis on the effectiveness of conservative propaganda – which demonizes national health care systems. Remember what they said about Obamacare? Death camps, worse than slavery? Five years into it, the only effect is that more people have access to decent health care. I used to get a lot (a lot!) of traffic from the Instapundit. We broke over his mad propaganda, including that about national health care (here’s a tiny but amazing example).

        Propaganda works. As we become more tribal, it becomes even more effective. Annals of our time might be titled “a nation lit only by propaganda.”

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