MacMillanWhen assessing economic health and policies, it's helpful to reference theory and past experiences.
Unfortunately, many people love to reference ideas that are just false.
In Chapter 8 of his book "Pragmatic Capitalism," Cullen Roche challenges several widely accepted economic concepts that are actually harmful to our understanding of the financial world.
Titled "Economic And Monetary Myths That Persist," the section identifies 11 misleading ideas that keep coming up. We paraphrase here:
Myth 1 – The United States Is Going Bankrupt
People have a tendency to think of the U.S. government's balance sheet as the same as an ordinary household's. This leads to the fear that the U.S. will default on its debt obligations, like Greece, and fall into a recession and crisis.
Why it's false: Unlike a business or household, the U.S. government has the ability to tax, print money and borrow funds at a rate given by the central bank. It also is supported by a unified federal government, central treasury, and a central bank.The main problem with the country's deficit isn't how much it has available to spend, but the impact this spending has on the rest of the economy. The real limitation to U.S. spending is inflation, which would come from providing too much liquidity to the private sector.
"This is a vastly different issue than the constraint the US media usually focus on with regard to the budget deficit and the US government's ability to afford its spending. For the public policy debate to become pertinent, we need to move from the idea of solvency to government spending's impact on the productive base of the economy," Roche said.
Myth 2 – Quantitative Easing Is Debt Monetization And Will Cause Hyperinflation
Quantitative Easing (QE) is when the Federal Reserve uses open market operations and banking reserves to achieve lower interest rates. The idea of QE is often associated with money printing and hyperinflation.
Why it's false: In QE, the actual value of net assets doesn't change, just the composition of those assets. Roche likens it to switching from a savings account to a checking account. Because the underlying assets and operations don't increase, QE doesn't lead to an increase in money or inflation. QE can cause an increase in prices and demand for private credit, private sector assets, and balance sheet health.
"QE's primary mechanism is through its ability to alter psychology, thereby keeping rates lower than they might otherwise be. The magnitude of the rate effect is hotly debated and almost impossible to quantify," Roche said. "I think QE has some effect on interest rates and therefore positively impacts private investment and debt burdens. These are positive overall outcomes for the economy but difficult to quantify."
Myth 3 – Central Banks Exist Solely To Enrich The Bankers
The power and influence of the central bank can be overstated and misleading. The Fed's close relationship with banks has resulted in the theory that its only purpose is to serve and assist the banks.
Why it's false: Over time, the Federal Reserve has taken on more monetary policy and responsibility when banks are in trouble. But its basic responsibility as a clearinghouse is making sure the payments system is functioning. Without this, there would be little to no regulation at all in banking.
"The central bank exists in large part because the alternative to that setup is letting the banks run a nineteenth-century payments system in which their risk management goes largely unregulated or unmanaged by any outside body," Roche said. "This public-private hybrid system has teh appearance of a conflict of interest because the central bank serves not only the banks, but also the government. But on the whole the design is a fairly rational compromise between a purely public or purely private system. It's by no means perfect, but it's also not the conspiracy theory some make it out to be."
Myth 4 – A Credit-Based Monetary System Is Unsustainable
Disasters like when the housing bubble burst are a good indicator of unstable credit-based monetary systems. However, this is exaggerated in the belief that debt is always a bad thing, and fundamentally unsustainable.
Why it's false: In accounting, one person's liabilities are another person's assets. A loan from the bank means a loan liability for the borrower, and a loan asset for the bank. What determines whether this will be a good or bad liability is the value to be gained from that loan. Roche used housing as an example: If you use your loan to buy a house, that house becomes an asset worth more than what your current liquid assets could attain. This can be used to create more value now. "By allowing us to bring our future spending into the present, debt can allow us to also bring future production or a superior living standard into the present. There is a cost for this (the loan), but the overall impact of the debt really depends on how wisely you're using the debt," Roche said.
Myth 5 – The Free Market Can Solve All Our Problems
When dealing with policy, some extremists will argue that letting capitalism go unchecked will inherently resolve problems in the market.
Why it's false: It's possible to have too much of a good thing. Capitalism, when left alone, will solely pursue profit maximization and naturally turn into monopolies. Unregulated monopolies mean minimized wages, employment, consumer loss, and increased inequality. A well-run government has the ability to keep capitalism from becoming corrupt and harmful. "This doesn't necessarily mean we should chain down capitalists and make it undesirable or exceedingly difficult to pursue business activities, but I think we have to be careful about the idea that unchecked capitalism with necessarily serve the best interests of a society as a whole through a purely free-market system," Roche said.
Myth 6 – Consumers Matter More Than Producers
Markets are rarely in perfect equilibrium, and economists often debate whose interests matters more, producers or consumers? And people have a tendency to value consumer benefits more than producers.
Why it's false: It all depends on where the business cycle and credit cycle is. "The answer to this question about consumers and producers is not that one is more important than the other, but that both matter throughout the business cycle, and understanding potential policy or economic needs is mostly about understanding where we are in the cycle," Roche said. "Additionally we should view producers and consumers as two sides of the same coin. To multiply that coin we need not only health consumers but vibrant and innovative producers."
Myth 7 – Saving Finances Investment
The idea that savings equals investment, or S = I, is a common but oversimplified view on financial transactions.
Why it's false: Roche divides this into two different flaws. The first flaw is the idea that savings come from a set supply of loanable funds. However, banks can create loans and deposits simply by expanding their balance sheets, marking up both its assets and liabilities. "When a bank extends credit, it does not necessarily decrease its revenues, consumption, or income. It is a pure balance sheet change created from thin air," Roche said.
The second flaw is thinking of savings and investment as a simple transaction, and failing to take the results of saving into account. Roche offered an example scenario: "What if, instead of consuming your $50, you purchased a $50 production line ... Then you own a productive $50 nonfinancial asset. You have not consumed your income and it has not declined; your level of investment has increased by $50. In addition the seller of the production line will experience an increase in saving. Their saving has increased without your having dis-saved. Therefore in the aggregate investment often creates saving."
Myth 8 – The IS-LM Model Can Properly Explain The Economy
The IS-LM model, which stands for Investment-Saving, Liquidity-Money, is used in modern macroeconomics to understand the relationship between real output and interest rates.
Why it's false: The IS-LM model incorrectly assumes that saving finances investment, and that there is a held supply of savings available for banks (addressed in Myth 7). It also assumes that if savings increases, interest rates go down and investment goes up. This leads to the false belief that lower consumption and smaller government deficit would create more loanable funds. The creator of the model has even referred to it as a "classroom gadget," even though it is still widely used in people's understanding of economics.
Myth 9 – Growth Of Money Equals Inflation
Similar to S = I, the economic equation MV = Py is often misrepresented, where M is money supply, V is the velocity of money supply, P is the price level and y is the real GDP. According to MV = Py, increasing money supply and velocity of money spent can lead to inflation. This equation is then simplified into "growth of money equals inflation."
Why it's false: The main problem with this assumption is an extremely vague definition of the word "money." Economists generally use bank reserves and cash, but these only have an indirect impact on lending because they are not limited to a set amount of reserves. M also ignores other factors that make up financial asset value aside from money. Instead, M is mainly affected by the demand for loans by credit-worthy customers.
"Could more money lead to higher inflation? Of course," Roche said. "Does an increasing money supply automatically mean we are worse off or experiencing a decline in our living standard? It most certainly could, but the assumption that 'more money equals inflation' won't really tell you whether more money and potential inflation are actually good or bad."
Myth 10 – Hyperinflation Is Caused By Printing Money
Related to Myth 9, many people believe hyperinflation is a high rate of inflation caused by printing too much money.
Why it's false: According to Roche's research, hyperinflation's root cause is actually severe economic circumstances which resulted in an increased money supply. These include: a collapse in production, government corruption, loss of a war, regime changes, and ceding of monetary sovereignty. "While government debts and deficit spending can exacerbate a hyperinflation, they have not generally been the cause of hyperinflation but rather the result of other political and economic events," Roche said.
Myth 11 – Economists Have All The Economic Answers
To close, Roche warned against taking what economists have to say at face value.
Why it's false: Economic models are meant simulate reality, but are almost impossible to test on an entire economy. Therefore, much of what economists work with is theoretical and prone to guesswork. "Making matters even worse, much of modern-day economics has become politicized as economists are called on to advise on major policy using only theory and conjecture. Much of economics involves conforming a political bias with a worldview," Roche said. "Every school of economics has a specific ideology, and the political lines are clearly drawn. This doesn't even approach science. It's more like religion."