German economics ignores financial crisis

By Matt Usselmann

Last week, first the German financial paper Handelsblatt and then the venerable ZEIT published an article about teaching of economics at German universities. The surprising revelation: The financial crisis, which is now at least 3 years old, is hardly discussed in university lectures on economics. A surprise indeed! One would think that the biggest financial crisis since the Great Depression in the 1930s would by now be part of the teaching programme. Unfortunately not, here is what the article says:

"But in the lecture theatres, we have the same syllabus as we had ten years ago. The students are cramming macro-models which ignore the financial sector, analyse the behaviour of fully rational players in perfectly functioning markets, and make drawings of the same old equilibrium models."

So, the financial crisis is not part of the curriculum. That is certainly a bit scary, and does not bode well for the future. But the problem is, of course, that the traditional models that we have in the economy do not help us much. They will not describe the financial crisis that plagued us since 2008.

Hence our German economists have so much difficulty to find solutions to the euro crisis. As the euro crisis is, of course, in essence a continuation of the financial crisis of 2008. We therefore get disastrous advice in Germany, no matter where we look. Whether it is the head of the Munich based Ifo Institute, Hans Werner Sinn, or the senior economic advisor to the government, Wolfgang Franz, or even ex Bundesbank president Axel Weber. Senior and well respected economists all of them, but bad advice all around. Sinn calls for the end of the function of the ECB as "Lender of Last Resort" (a good discussion in English on this blog). Franz call for an end of ECB purchases of sovereign bonds which are contrary to prudent "regulatory policy" (a typical German economic concept) and a "mortal sin for a central bank". And Weber just handed in his resignation, after the rest of Europe did not want to dance to his tune. All continue to believe in the supremacy of market forces, although the evidence is clear. Had we followed their recommendations, we would already have had an even greater disaster: an unrestricted rise of bond yields and, even more worrying, the immediate bankruptcy of Greece.

However - this ignorance of economists of real world situations, which do not fit into their models, is not confined to Germany.

And, just to prove the point and by sheer coincidence, on the day the ZEIT publishes the article, a new book is launched. Steve Keen, professor of Economics and Finance at the University of Western Sydney, has written it and introduced it in London: "Debunking Economics". So, what is it he wants to debunk, what exactly is wrong with economics? I was there, listened to his his humorous and quite persuasive lecture, and bought the book.

In Keen's view, economics' weak points are exactly the ones that are already mentioned above. In the real world there is no perfect competition, there are no perfect markets, not only rational buyers and sellers, and above all no equilibria. But that is exactly how economics is taught. And that is especially true for neo-classical economics which is dominant in teaching. The time factor is hardly ever considered (the models are not dynamic), there are no feedback loops, or just an ignorance of the economically insignificant, but otherwise often very important factor of money or credit.

So how come economics professor Steve Keen attacks economics and economic teaching? After all, he has himself penned essays, as a young student, in which he urged both the abolition of monopolies and trade unions in order to let the invisible hand of the market do its stuff. So he tells us in his book. But his change of heart is, Steve Keen tells us further, due to his built in "bullshit detector". He realized, there is something wrong with the theories. They are not logically coherent, or have later been modified by authors, but are still in their previous version in textbooks. Or perhaps nobody bothered to even look at the theories in detail. So it goes on throughout the book - probably especially interesting for economists, or future economists, but also for laymen quite instructive and entertaining. (By the way, coincidentally Paul Krugman discusses the IS-LM model of economics this week on his blog , which is criticized the Steve Keen in his book. Similar issues are often discussed in Keen's book.)

But the biggest criticism of the models is this: They could not predict the crisis - no one saw any problems with huge mountains of debt which piled up, as this overhang of debt (the sum and private and public debt, an economy has to finance both) kept growing and growing. Credit, after all, is ignored by the majority of economic models. So Steve Keen has developed his own model. The further development is funded by the Institute for New Economic Thinking which recently awarded him a grant. Steve Keen has become known worldwide through own web page, where he now warns about the dangers of excessive indebtedness. A bit late, you might say, but he already done it since 2007, so quite a while before the chaos really broke out. He was one of the few economists who warned of the crisis, and has recently won an award for it.

So, as long as credit rises, the music continues playing, but as soon as credit stops the chaos begins. Even declining rates of increase in credit cause declines in aggregate demand. There is a strong correlation between credit and unemployment - and as long as credit is not increased, there are problems

So, simplified:

Aggregate demand = GDP + difference in credit

(Keen distinguishes between loans that are used productively - and those are use for speculation on higher prices. To be sustainable credit should only be used for productive purposes, and not speculative reasons)

Right then, it's not, as Fed Chairman Ben Bernanke has us believe, the "great moderation" which was the cause of long period of rising economic growth. It was the sometimes exponential increase in loan volume, which helped many countries to have their high growth rates.

Now we have the mess to clear up, what now? The solution, says Keen, is to write off the loans, and thus increase the carrying capacity of the economy for new loans. I personally got some problems with that plan. As we see right now in Greece, that before it comes to a debt write-off, the irresponsible lenders has long ago cast off their bonds. Moved it onto the taxpayer, via the European Central Bank, perhaps. I would suggest that a more equitable solution would be achieved through taxes and levies. To punish also those who wish for an invsolvency and hope for the crisis to worsen. And there are plenty of those - hundreds of billions of Euro (gross) have been bet on the bankruptcy of Europe with Credit Default Swaps. They will ultimately pay out if a country does not meet its obligations, but they keep growing in price as long as the crisis worsens.

However, asked about it, what should we do with the speculators and hedge funds, who would profit from a proposed debt write-off, Steve Keen argues that their claims should also be written off. Right on! Let us write off CDS before we write off debt. Simply ban CDS and abolish any claims arising from them! Brilliant idea!

So, "Debunking Economics", a good book for those who have a genuine interest in economics, and want to know why so much of what is proposed by economists, should be ignored.