4 realizations that will challenge the way you see economics

Because once in a while, it’s nice to talk about stuff you have no formal education on…

I’ve recently caught an interest in the way our economic world works. It started with binge watching the Thinkerview Youtube channel, a french channel in which a straightforward interviewer has a 2 hour unbridled conversation with a domain specialist.

Lots of concepts and terminology used in the economic discussions were quite obscure to me, so I decided to roll up my sleeves and learn the basics of how our economic model works. With the help of dedicated Youtube channels (such as the french Heu?reka), books and articles, I think I’ve managed to come up with a good basic understanding of the foundation of our economic model.

After many mind-screwing thinking and lots of illusions of understanding, I’ve put together 4 realizations that changed drastically the way I apprehend economic discussions and political debates about economy. I’m sharing them here in case it rings some bell on your side as well:

1. There is no economic reality

This is a belief, rather that a fact-based hypothesis, but it changed radically the way I react to political discourses and media debates about economics. To rephrase the premise, it seems to me as if the realities of our economic world (income inequalities, free-trade, competition, monopolies) reflect on the theories and axioms of the theories rather than the other way around. Put it another way, we create the rules, and the reality fits it afterwards, thus creating what media economists call “economic reality”.

Economics present itself as the empirical study of human behavior in a resource based world, but it is rather a collection of hypothesis that makes the foundation for a model enriched with equations used to predict outcomes of a specific situation. Most of the so-called “laws” of economics, such as the law of supply and demand, are mathematical models with sometimes complex equations based on common sense or ideal situations (no-money, fully transparent and totally free market for instance).
When faced with empirical studies, those economic laws often fail to predict the result or to fit the observations (french article).

This “no economic reality” premise helps me take a step back when watching or participating in a debate, when the common “we have to face economic realities” argument pops up.

On top of the hypothesis and ideal scenario on top of which economic laws are made, ideology plays a big role on the political decision about economy. Ordoliberalism for instance (the main economic ideology behind the EU politics), believes that the role of the state should only be to enforce the rules of the free market and concurrency. It should not intervene whatsoever on the macro-economics. Whether or not this is for the benefits of society wealth, it’s good to keep in mind the arbitrary perspectives of this model.

2. Only private banks create layman’s money

This was a major breakthrough for me in my path to understanding the economic cycles and money creation.

Basically, there are 3 ideas people (common and specialists) have regarding money creation:

• 1. Money is created by the central banks of each country or organization when needed.
• 2. Money is kept in deposit by commercial banks, but they can issue loans for an amount limited to a ration of their deposit. This actually “creates” money (because depositors still “have” their money safe in the bank, but borrowers now have new money as well). It works as long as the withdrawal rates of the depositors is predictable.
• 3. Money is created by commercial banks out of thin air when someone makes a loan, with virtually no restriction. It is just an accounting entry.

As it turns out, according to Richard Werner who did an empirical study of how money is created by the banks, the third hypothesis is the closest to the truth. When an economic actor takes a loan, the bank creates 2 lines (credit and debit), and that’s it, the deposit money is ready to run through the system.

Besides the counter-intuitive aspect of this fact that should I think be common knowledge, there is another consequence that could impact the way we think about our economic policies.

3. Most money is debt

97% of money consists of bank deposits (https://positivemoney.org/how-money-%20works/how-banks-%20create-money/). Those deposits come from the loans that common people, companies, finance industries or countries apply for a loan to a commercial bank.

What it also means is that without loans and debt, there is no money to feed the system. Indeed, when a debt is repaid, both lines disappear and there is less money in circulation.

So globally, debt precedes production. We cannot produce (thus have growth) without having debt somewhere (maybe not your newly self-founded business, but somewhere on the production chain there will be debt). Again, this is not a problem in itself, but I think it’s often disregarded by policy maker and media debaters.

Even more intriguing, most economists who come up with new laws and predictions do not take money creation into account. This can lead to different conclusions when simulating the model (https://www.youtube.com/watch?v=bdoEm_KnFdQ — french video).

4. Most transactions happen in the financial sector

It is quite hard to get data around the weight of the financial transactions (buying and selling existing assets) compared to the “real economy” transactions (direct consumption of goods and services), but overall, we can see that financial transactions account for more around 150% of the real economy ones. It can go far higher if we just compare the amount of all finance products compared with GDP.

The role of the financial system is to facilitated the transfer of money from lenders to borrowers, and offer liquidity for the supply to meet demands. It should also provides risk insurance to investors, in particular through derivatives.

But the increase of the weight of financing, especially for universal banks (banks that are commercial — create money from loans — and investment banks — invest on the financial sector), had major impacts on our (real) economy during the 2008 crisis and followup euro crisis., causing recession leading to unemployment growth. This was caused, in part by the double role universal banks (especially the too big to fail ones) plays: as loan creators (for house credits for instance) and as investors (of house credit derived financial products). Those institution are incentivized on money making at all cost, because they can then profit from this money in the financial sector.

That’s why more and more economists promote the reinstatement of the Glass-Steagall act, that prevent commercial banks from making certain form of investment banking.

How can you leverage these realizations

Basically, those fact-based observations made me wary of the economists side of political debates and mainstream media contents.

When someone defends for instance a cut in state spending to reduce debts and restore the country’s economy, I’ll check whether they are aware and mention that:

• Debt is what fuels our current economy
• Private debt is higher than public debt, and less regulated
• Reducing the role of the state in the economy fits a specific ideology, it is in no way the reflections of an underlying reality

Economics is not a one-sided empirical science, it is rather an ideology-fueled plurality of schools of thought that should be taken with a grain of salt before letting it dictate political decisions.