Why neoclassical economics is one of the main culprits of the euro crisis

4 July, 2012 at 15:05 | Posted in Economics | Leave a comment

That the Euro has fallen into crisis a mere decade after its introduction is hardly surprising. The intrinsic problems in its design were evident to economists as widely separated intellectually as Wynne Godley and Milton Friedman.

One might hope that, with economists as disparate as Godley & Friedman able to agree that the Euro was always a bad idea, its unwinding—or at least the addition of the missing elements from a genuine common currency, such as fiscal union—could also be easily achieved. But current events indicate that Europe may persist with its unsustainable system until the social collapse and political disunity that Godley and Friedman anticipated finally destroys perhaps even the EEC itself.

There are many political reasons for this dogged determination to follow folly to its end—including the disparate benefits and costs of the Euro to different countries, the inherent inertia in multi-country political agreements, and Weimar Republic-based fears that fiscal expansion will cause hyperinflation.

But economic theory has also played a role, by promulgating the belief that government debt should be constrained, while private debt can be left unmonitored. This belief was entrenched in the Maastricht Treaty’s limits on public debt, and is being enforced today via the selective imposition of austerity programs on the weaker economies that are in breach of these limits.

The root of this belief is the Neoclassical “exogenous” model of money creation, in which “nothing is so unimportant as the quantity of money expressed in terms of the nominal monetary unit” (Friedman 1969, p. 1), the money supply is determined by the actions of the Central Bank, the level of private debt is determined by the supply of and demand for loanable funds, and private banks, as mere intermediaries between savers and borrowers in the loanable funds market, can be ignored in macroeconomics.

Ironically, though belief in this vision of money played a major role in the design of the European Monetary Union, and it is accepted by Neoclassical economists who argue for austerity as the solution to the crisis, it is also adhered to by Neoclassical critics of austerity. With unabashed hubris, this latter group—the self-described New Keynesians—are now claiming to be vindicated by the crisis, while appropriating Hyman Minsky and casting themselves as the future of economics in the process

Though it is laughable, this revisionism should not be treated lightly. IS-LM analysis, which those who are truly aware of the history of economic thought know was a Walrasian model masquerading as Keynes (J. R. Hicks 1935; J. Hicks 1981), was originally developed in what purported to be a book review (J. R. Hicks 1937) of The General Theory (Keynes 1936). There is thus a prospect that a disaster caused in large measure by imposing a Neoclassical fantasy on the real world (the belief in self-equilibrating markets) and which is being amplified by imposing yet another Neoclassical fantasy (austerity as an economic stimulus) will be used to entrench still a third Neoclassical fantasy as the pinnacle of post-crisis macroeconomics (exogenous money and a neo-Walrasian macroeconomics derived from it by adding in a pinch of imperfect competition and incomplete information).

While there is no certainty that this Neoclassical juggernaut can be stopped, it is certain that it will roll over non-Neoclassical opposition unless a coherent, empirically accurate, and compelling alternative theory is developed. In what follows I set out essential elements of that alternative—starting with the empirical point of divergence between the dominant Neoclassical explanation for the severity and longevity of this crisis, and an endogenous money explanation.

The endogeneity of the money supply means that banks, debt and money are essential components of macroeconomics: they cannot be ignored as in standard Neoclassical macroeconomics, nor caricatured by “patient lends to impatient” bank-less modified DSGE models …

Even at this rudimentary level, this monetary perspective has lessons for the EU crisis. Since the private sector is now deleveraging, its actions are reducing the money supply. If the government runs a surplus, this further reduces the money supply—and hence economic activity. Austerity therefore amplifies the downturn caused by private sector deleveraging.

At the same time, a government deficit is less effective than proponents of a government stimulus approach to the crisis have argued … since on the historical evidence, private sector deleveraging is likely to continue for a decade or more, given the level of accumulated private debt. Debt cancellation will be required as well if policy is to rescue us from this crisis.

Steve Keen

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