Rethinking Macroeconomics And Finance

by: John M. Balder

Summary

Mainstream macroeconomic models missed the crisis in 2008, given the decision to ignore finance.

The errors in the mainstream approach were largely attributable to the incorrect belief that credit (debt) has no impact on the real economy.

Fortunately, people outside the mainstream were taking a "real world" perspective that provides a superior alternative to thinking about these issues.

The need to more thoroughly integrate macroeconomic and financial stability risk is essential before the next crisis arrives.

Perhaps the Queen of England said it best after the financial crisis hit in 2008: “Why did no one see it coming?” Over the past several years, I have been retraining myself in economics, with a specific focus on better understanding how money and credit are created. I am convinced these questions are the linchpin for understanding the role of financial stability in our current economic system.

In my opinion, the crisis in 2008 was a game-changer for the field of economics and finance. Mainstream macroeconomics completely failed to anticipate the crisis in 2008, given the flawed decision to ignore finance and credit (debt). This error was due to one of those unique decisions among economists to adhere to an age-old theory called Loanable Funds (which incorrectly states that the creation of credit (and debt) requires prior savings, so has no impact on the real economy). In the real world, commercial banks create credit via deposits, and through double-entry bookkeeping, money. Even the Bank of England, in a remarkably enlightening article (here) has recognized this truth, as noted here and here.

Fortunately, extraordinary work is being done outside the mainstream by people such as Dirk Bezemer (here), Steve Keen (here), Richard Werner (here), Claudio Borio (here) and Sergio Rossi (here), to name a few. They take a real world focus, working inductively with data in the real world and examine to the best of their ability how things actually work – Werner’s work is particularly inspirational, in this regard. Much of his research, ironically, involves accounting (not one of my favorite topics). Werner provides detailed mechanics as to how banks actually operate (creating credit and thus money) and he focuses, as does Bezemer, on the distinction between the use of credit to support capital formation and its use to support asset prices. There also is an economic justice component to this work that addresses the societal impact of the imbalances between these circuits on income inequality and GDP growth (for more about that topic, see here).

In my view, we would do ourselves an enormous service by tossing out Economics 101 and rebuilding a new, more inter-disciplinary version that better corresponds with the real world. I have no doubt whatsoever that this newly defined course will have far more relevance to students today, especially given that they have not witnessed a truly functioning economy. In fact, economics would benefit greatly if it were more accepting of other disciplines, including sociology, anthropology, etc., rather than insisting it be treated as a “science.” Andrew Haldane, the Chief Economist with the Bank of England and a thoughtful, creative central banker (is that an oxymoron?), has labeled macroeconomics a “methodological mono-culture" (see here).

Mainstream macroeconomic models' decision to ignore finance rendered them moot when the crisis hit in 2008. Fortunately, those outside the mainstream were continuing to push thinking forward, though they (as were Hyman Minsky and Charles Kindleberger throughout their respective lifetimes) were largely ignored. Given where we are today,. e.g., high levels of private sector debt, overvalued asset prices, weak growth, a Fed eager to raise rates and reduce its balance sheet, etc., I have little doubt that financial (in)stability will soon move front-and-center once again.

Financial crises are not “black swans:” They are endogenous to the operations of the economic and financial system. We need to recognize the inherent instability of our financial system and redefine economic theory so that it does a better job at reflecting these realities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.