Staying in Touch with the Real World

In the real world, supposed economic certainties are fast dissolving.

All the major central banks have adopted one form or another of “quantitative easing”. The IMF has reversed its advocacy of austerity as the proper response to recession. OECD research shows that widening inequality is not the price that must be paid for economic efficiency but is in fact an obstacle to that efficiency.

And, perhaps, most significantly of all, the Bank of England concedes that 97% of all the money in circulation was created by the banks out of nothing, and most of that took the form of lending on mortgage for house purchase. Indeed, they do more than concede – they explain in convincing and irrefutable step-by-step detail exactly how that process of money creation occurs.

In the academic world, however, things are different. The neo-classical certainties taught in the early 1980s by excited young dons and lecturers, convinced that they were privy to a brand-new approach to economic policy, are still being taught by grizzled veterans. A whole generation of students have been taught economics, not as a social science, but as a simple branch of business management and as a celebration of the “free market”.

They are believers. Their faith is not to be shaken by global financial crises and recession, still less by the apostasies of those prepared to evaluate doctrine against outcome. And they have their bibles. Huge numbers of students doing economics and MBA courses over the past thirty years across the globe have placed their faith in best-selling and apparently authoritative text-books, written by prominent professors in the best universities.

So secure are their beliefs that they bother little with anything new or different. They don’t keep up to date with the latest thinking and writing. Teaching is much easier if it is just a matter of pointing students to an unchallengeable and long-established text.

One such text is a book that is probably the best-selling book on economics across the globe. It is written by N. Gregory Mankiw, a professor at Harvard, with two New Zealand co-authors for the New Zealand edition, which is called Principles of Macro-Economics in New Zealand. It is the book currently used in New Zealand universities.

The book explains the banking function as follows: “Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. The term financial intermediary reflects the role of these institutions in standing between savers and borrowers.” It includes banks in the definition of financial intermediaries.

This is a standard description of what is often called the “loanable funds” role of the banks in providing finance to borrowers. It postulates that the banks merely put savers and borrowers in touch with each other and charge a small fee for doing so. It is devoutly believed by 99% of those who have been taught economics over the past 30 years (and that includes, no doubt, most bankers and economists, including a former governor of the Reserve Bank of New Zealand, as well as academics). It is accordingly almost never challenged. It is also totally wrong.

The money that banks lend has virtually nothing to do with the savings deposited with them. The volume of their lending, which goes on rising hugely year on year, is many times greater than the sums deposited with them, and is the result of a power that banks, alone amongst “financial intermediaries”, possess – the power to create new money out of nothing by making a bank entry that becomes a deposit (and therefore spendable money) in the account of the borrower.

This point has of course been well-established on many occasions in the past, and has recently been most authoritatively re-asserted, as noted above, by the Bank of England. It is of the utmost importance. It is the most significant single element in the consideration of monetary policy and its truth invalidates almost all of the macro-economic policy we currently apply.

The statement by N. Gregory Mankiw and his co-authors therefore cannot stand. But, when one of our leading universities, which uses the book as the basis of its teaching, was asked to correct it, they declined not only to do so, but even to consider the matter.

They mounted a number of excuses. Professor Mankiw was a noted authority and not to be challenged. Views that differed from his were merely theories or alternative interpretations. And – most surprisingly – academic freedom allowed them to teach whatever they liked, even if it was wrong.

Let us be clear. There is no room for equivocation in describing the banks’ function and their hugely important role in monetary matters. Either they are mere intermediaries or they are not. The undeniable facts – now well attested to for anyone who cares to look – show that the banks have become by far the most important creators of new money in our economy.

It is surely the role of our universities to teach what they believe to be true, to stay abreast with how that truth might be established, and to correct error when it is discovered. If they do not, can we wonder that the study of economics is in such a parlous state and that students round the world are protesting that their economics courses do not take account of the real world?

Note for British readers: The Mankiw textbook is widely used in the UK too, and the issues discussed here are equally relevant there.

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This post was written by Bryan Gould