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When fake knowledge peddled by macroeconomics starts to fail the ‘investors’

Last Tuesday, in Maastricht, I gave one of two lectures I presented in a series (the other was on the previous Monday night). The first lecture, which was public, focused on the Eurozone disaster and I outlined why an orderly breakup of the failed monetary union would be in the best interest of all (I will post video of that lecture next Monday). The next lecture, which was to staff and students only, focused on the failure of macroeconomics and I juxtaposed fake news with the fake knowledge of mainstream macroeconomics. I want to expand a little on that topic. The Wall Street Journal published an article last week (March 6, 2017) – Everything the Market Thinks About Inflation Might Be Wrong – which bears on the validity of Modern Monetary Theory (MMT) relative to mainstream monetary economics. What I would call actual knowledge (MMT) and fake knowledge (mainstream theory). The article is not without its issues but it correctly notes that the underlying basis of orthodox inflation theory is false and fails to explain movements in inflation.

The second lecture I gave last week is available via this blog – The failure of economics – reality and language – if you haven’t already caught up with it.

The theme of my talk was that the mainstream macroeconomists of my profession essentially peddle fake knowledge and have been doing so for some decades.

They hide their myths behind an elaborate facade of technicality accompanied by bravado and arrogance and stand ready to bully any dissent into submission at the drop of a hat.

They then indoctrinate the populace into believing their propaganda through the use of skilfully crafted framing and language that simplifies the message and triggers our intuition. It is a case of our intuition leading us astray such that we vote for political parties and leaders that make our lives worse rather than better.

They deny, obfuscate, lie, whatever you want to call it and then pronounce, when evidence catches up with them that they ‘knew it all along’.

The mainstream economics academy is Groupthink central really.

As a professor of economics I am meant to ‘profess’ and represent my discipline. Well, the vast majority of material that represents that discipline is a disgrace – poor fiction – and I would not recommend any students entering a mainstream economics program at all.

Unless of course you want to sit through at least three years of boredom and be lied to by pompous characters who push this fake knowledge.

Students are better off studying geology and learning about the neolithic age (which I have been learning about recently as a result of my current stay in Malta).

A few weeks ago, I wrote a letter of complaint to the Vice Chancellor (who is in the Australian context the operational boss) at the University of New South Wales complaining about the conduct of one of his economics professors who had not only written a piece attacking Modern Monetary Theory (MMT), which was full of ad hominem insults (calling MMT economists “a bunch of cranks”, “charlatans” and sellers of “snake oil” etc) but had also claimed that I (given I was the only MMTer named in his article) had said that:

… a monetary authority can extract an infinite amount of real resources through seigniorage.

I covered the original article in this blog – When mainstream economists jump the shark and lose it completely.

The original article had been published in the Conversation and they asked me to reply to it there after several people (not me) had complained about the scholarship demonstrated by the original author. I declined and preferred to reply using my blog as above.

I consider the Conversation to be highly problematic because it controls the debate through selective editorial decision-making – not the least being it allows appalling articles like the one in question here to be published without sufficient editorial proofing to weed out fake knowledge.

After some weeks, I received an official reply from the UNSW senior management claiming they protect “the concept and practice of academic freedom as vital to the proper conduct of teaching, research and scholarship within the University” and that the article by Holden was “part of normal academic debate”.

Further, they concluded that the professor in question “has acted within this ambit of academic freedom in contributing this article within his broad area of expertise” and that “there was nothing to suggest any misleading or deceptive conduct.”

The “nothing to suggest any misleading or deceptive conduct” usually requires the person making such a statement to demonstrate that they have indeed an evidential basis to back their claim.

My complaint had centred on his allegation that MMTers (including myself) had claimed that “a monetary authority can extract an infinite amount of real resources through seigniorage.”

I have never said that, written that, implied that or supported such a statement. It is thus a false allegation. Fake.

So now you know that the UNSW considers that “normal academic debate” to include highly-paid professors making false attributions and being encouraged to publish material where the central claim in the article is factually incorrect designed to degrade the academic reputation of others and justify the author’s use of ad hominem descriptors.

But I digress.

The Wall Street Journal published an article last week (March 6, 2017) – Everything the Market Thinks About Inflation Might Be Wrong – which also bears on the validity of Modern Monetary Theory (MMT) relative to mainstream monetary economics.

It carried the sub-title – “How much money a central bank prints may be less important to inflation than commodity prices”.

The article essentially reports on research from some economists – Deflating Inflation Expectations: The Implications of Inflation’s Simple Dynamics – which was prepared for a US Monetary Policy Forum in New York last week.

A summary of that research report appeared on March 3, 2017 – The Fed’s Favorite Inflation Predictors Aren’t Very Predictive.

The premise entertained is straightforward:

1. Mainstream economics – “both conventional wisdom and the Fed’s official communications” – think that inflation is driven by how tight labour markets are and “the expectation of future inflation”.

2. The researchers find neither is a good ‘predictor’ of future inflation.

3. “the strongest predictor of what inflation will do in the near future is what it has done in the recent past. In statistical jargon, we find that inflation is highly persistent, fluctuating around a slow-moving trend. This long-term trend is not sensitive to unemployment or to inflation expectations.”

So mainstream models of inflation are not very helpful for helping central bankers decide on monetary policy settings. Who would have thought!

The Wall Street Journal article expands on their findings.

It says that:

No number is more important for investors right now than inflation. The belief that it will continue to rise underpins the recent rally in financial stocks and the slump in government bonds. It is key to commodities, currencies and more.

Yet investors are in a quandary: Theories used to forecast it just don’t seem to work.

Apparently, this is sending shivers up the investment bankers “because bond yields broadly track interest rates” and “They need to predict inflation levels as well as how central banks would react” to set up their investment deals.

The WSJ concludes that:

After years of postcrisis monetary experimentation, it’s not even clear central bankers can do much about inflation at all.

In part, this is because the mainstream theories that the central bankers rely are just fake knowledge.

The WSJ notes that a dominant view in mainstream monetary economics follows Milton Friedman – such that “inflation is ultimately a function of how much money a central bank prints”:

That theory posits that if the economy has only two apples and two dollars, each apple has to be worth $1. When the central bank issues two more dollars, there is suddenly $2 for every apple: inflation. And what people think inflation will be in the future is crucial: Workers will bargain harder for pay raises if they believe prices will rise faster in the years to come.

Yet, after the 2008 crisis hit, central banks in developed economies slashed interest rates and printed trillions of dollars, euros, pounds and yen. Many investors and policy makers believed inflation—and a selloff of government bonds—would soon follow.

Two points:

1. Mainstream macroeconomic theories think central bank base money increases stimulate money supply increases through the money multiplier.

I have considered the flaws in that approach in these blogs – Money multiplier and other myths and Money multiplier – missing feared dead – among others.

I suggest you read them if you want a detailed discussion.

Part of their mistake is to think that bank lending is reserve constrained – such that when base money expands (bank reserves) the banks can loan out more and this drives inflation via excess spending.

The other mistake is in assuming that base money drives broader money (the money supply). It is, in the real world, the other way around, given that bank loans create deposits without any need for a prior pool of reserves.

The reserves come after the fact.

2. The mainstream thinks that if the money supply increases it directly causes inflation (via the Quantity Theory of Money). But an essential assumption is that the economy cannot respond to any further nominal spending growth because it is already operating at full capacity.

Once you realise that economies rarely operate at full capacity, then it is clear that a rise in the money supply (and nominal spending) will not necessarily be inflation.

Further, it becomes clear that continuous money supply growth can be accommodated without inflation if the productive capacity of the economy is also growing as a result of on-going capital formation (Investment spending).

The Wall Street Journal might have reflected on past central bank research reports that have brought real knowledge to this question.

For example, the Bank of England released a new working paper on May 29, 2015 – Banks are not intermediaries of loanable funds – and why this matters – which further brought the Bank’s public research evidence base into line with Modern Monetary Theory (MMT).

As a result it further distances itself from the myths that are taught by mainstream economists in university courses on money and banking.

In effect, the Bank of England paper confirms my accusation that the mainstream macroeconomics is just fake knowledge.

They emphatically state that the real world doesn’t operate in the way the textbooks construe it to operate and, that as a consequence, economists have been ill-prepared to make meaningful contributions to the debates about macroeconomic policy.

We read that:

1. “The currently dominant intermediation of loanable funds (ILF) model views banks as barter institutions that intermediate deposits of pre-existing real loanable funds between depositors and borrowers. The problem with this view is that, in the real world, there are no pre-existing loanable funds, and ILF-type institutions do not exist.”

2. “in the real world, there is no deposit multiplier mechanism that imposes quantitative constraints on banks’ ability to create money in this fashion. The main constraint is banks’ expectations concerning their profitability and solvency.”

The BoE paper outlines the basic mainstream model of banking – the “intermediation of loanable funds (ILF) model” – which is says:

… bank loans represent the intermediation of real savings, or loanable funds, from non-bank savers to non-bank borrowers. Lending starts with banks collecting deposits of real savings from one agent, and ends with the lending of those savings to another agent.

But in “the real world, the key function of banks is the provision of financing, or the creation of new monetary purchasing power through loans, for a single agent that is both borrower and depositor.”


The bank therefore creates its own funding, deposits, in the act of lending. And because both entries are in the name of customer X, there is no intermediation whatsoever at the moment when a new loan is made. No real resources need to be diverted from other uses, by other agents, in order to be able to lend to customer X …

… banks technically face no limits to increasing the stocks of loans and deposits instantaneously and discontinuously does not, of course, mean that they do not face other limits to doing so. But the most important limit, especially during the boom periods of financial cycles when all banks simultaneously decide to lend more, is their own assessment of the implications of new lending for their profitability and solvency.


The deposit multiplier (DM) model of banking suggests that the availability of central bank high-powered money (reserves or cash) imposes another limit to rapid changes in the size of bank balance sheets. In the deposit multiplier model, the creation of additional broad monetary aggregates requires a prior injection of high-powered money, because private banks can only create such aggregates by repeated re-lending of the initial injection. This view is fundamentally mistaken. First, it ignores the fact that central bank reserves cannot be lent to non-banks (and that cash is never lent directly but only withdrawn against deposits that have first been created through lending). Second, and more importantly, it does not recognise that modern central banks target interest rates, and are committed to supplying as many reserves (and cash) as banks demand at that rate, in order to safeguard financial stability. The quantity of reserves is therefore a consequence, not a cause, of lending and money creation.

Seems categorical.

A similar intervention came in 2008, when the US Federal Reserve Bank of New York, acknowledged the failings of mainstream monetary theory in the September 2008 edition of their Economic Policy Review – Divorcing Money from Monetary Policy.

That article demonstrated why the account of monetary policy in mainstream macroeconomics textbooks from which the overwhelming majority of economics students get their understandings about how the monetary system operates is totally flawed.

So it is no surprise that the Wall Street Journal reports that the real world is different to what economists thought it looked like.

The fact is that mainstream economists model a fiction and cannot really explain anything much about the real world.

While it is not the point I want to make in this blog, the findings of the paper cited by the Wall Street Journal are highly questionable.

In terms of the impact of labour market slack, the authors model this using a variable they call the “Unemployment Gap” (both contemporaneous and lagged one quarter.

The Unemployment Gap is computed as “the gap between the unemployment rate and the natural rate of unemployment” and they use a time series for the ‘natural rate’ from “the Greenbook estimates collected by the Philadelphia Fed’s Real‐Time Data Research Center”.

They also say that the results were not sensitive to using the CBO ‘natural rate of unemployment’ time series.

The Greenbook estimates are essentially judgements that the Federal Reserve Bank Open Market Committee (FOMC) members make, which reflect what they think is most likely to happen.

Natural rate estimates tend to come from running statistical algorithms through past data which essentially smooth out the actual unemployment rate. They can also come from ‘solutions’ to New Keynesian models where the long-run is invariant to short-run fluctuations driven by spending variations.

In English, this just means the resulting time series are unreliable and have little meaning. In general, estimates of natural rates can vary immensely around the actual unemployment rate – so we might be told that the natural rate ranges from 2 to 12 per cent – or within a range like that.


Which, in turn, means that the Unemployment Gap so derived has no particular veracity in terms of measuring labour market slack – that is, the extent to which wage pressures emanating from the labour market impact on costs and squeeze profit margins.

Even with those limitations, the authors find that:

There is evidence of a relationship to the unemployment gap: the estimated coefficients on the unemployment gap are negative and significantly different from zero at normal levels of statistical significance. However, they are quite small in magnitude.

In other words, in a statistical sense, the unemployment gap does provide ‘theoretically’ consistent and significant predictive power, but the magnitude of variations in the gap on inflation are small.

So what gives?

The clue is to think carefully about this.

In their Op Ed article the authors write:

First, there is un- and underemployment, what economists call “labor market slack”: When more people are out of work, it’s harder for employees to demand higher pay. This suggests that more slack results in lower inflation because when wages stagnate, so do prices.

Yet, when you read what they actually did in their research, you find they only use the unemployment gap variable. Quite apart from the validity of such a variable (and I am quite doubtful), the authors choose to use a very ‘narrow’ measure of labour underutilisation when over the sample considered there have been major shifts in the way that utilisation manifests, particularly in the US.

Two points:

1. They do not consider underemployment despite hinting that they have.

2. They do not consider the collapse of labour force participation (and the rise in hidden unemployment) in the US over the last decade or more. While some of that trend decline in participation is an ageing effect – see Decomposing the decline in the US participation rate for ageing – a significant amount is due to the rise of discouraged workers.

In fact, as this blog explains – The US labour market is nowhere near full employment – the US labour market remains well below full employment despite the substantial decline in the official unemployment rate.

I consider why this matters in this blog – Why did unemployment and inflation fall in the 1990s?.

Some years ago, I started re-estimating Phillips curve relationships (the link between labour market slack and inflation) by including broader measures of labour underutilisation, given that underemployment had risen substantially, even when unemployment had fallen.

The underemployed represent an untapped pool of potential working hours that can be clearly redistributed among a smaller pool of persons in a relatively costless fashion if employers wish.

It is thus reasonable to hypothesise that the underemployed pose a viable threat to those in full-time work who might be better placed to set the wage norms in the economy.

This argument is consistent with research in the institutionalist literature that shows that wage determination is dominated by insiders (the employed) who set up barriers to isolate themselves from the threat of unemployment.

Phillips curve studies have found that within-firm excess demand for labour variables (like the rate of capacity utilisation or rate of overtime) to be more significant in disciplining the wage determination process than external excess demand proxies such as the unemployment rate.

I also considered measures of the “quality” of the unemployment pool rather than just its size overall. So I argued that ‘quality’ (in terms of the disciplining capacity of unemployment to restrain worker wage demands) is related to unemployment duration and at some point the long-term unemployed cease to exert any threat to those currently employed.

The research reported in the Wall Street Journal article (and linked to above) ignores all these broader trends in the labour market and just reports on what is effectively a traditional orthodox Phillips curve specification.

It is no wonder they find little impact from the rather dubious Unemployment Gap variable.

My own modelling of these broader labour slack measures suggest that they are very successful in explaining the evolution of inflation.


The WSJ article is among many now that are coming out and challenging the myths peddled by mainstream macroeconomists. The bond market investors are finding out (finally) that trying to chase a dollar using mainstream theory is fraught.

Mainstream macroeconomics is largely fake knowledge. It has been categorically exposed by the deviations from usual behaviour in in the lead up and following the GFC.

There we have seen major policy shifts, new policy initiatives (building massive bank reserves), large fiscal deficits, and more – and, one by one, the main predictions of mainstream macroeconomics have come to nought.

But we didn’t need the GFC to expose the fallacies of mainstream macroeconomics. Japan has been doing a good, real world job of that for two and a half decades now.

That is enough for today!

(c) Copyright 2017 William Mitchell. All Rights Reserved.

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    This Post Has 11 Comments
    1. ‘Global Slack, US Inflation and the Fed’s Policy Error
      The Fed, along with most other central banks and international macroeconomics institutions (IMF, OECD, World Bank), relies on the standard Phillips curve theory that relates the rate of change of inflation to national measures of slack such as the output gap or the unemployment rate. In particular, labor market tightness is expected to generate wage pressures, which in turn would cause inflation to accelerate.
      The problem is that the standard, domestic, accelerationist Phillips curve no longer captures the inflation process. Figure 1 shows the US output gap vs. change in core PCE inflation over four periods: 1960-1973, 1973-1990, 1990s, 2000-2016. We have used quarterly data from the CBO and FRED. We see that the model worked from 1960 through 1990, weakened in the 1990s, and then disappeared after 2000.
      There are two competing explanations for the demise of the standard, domestic, accelerationist Phillips curve. The first is that because inflation expectations have become firmly anchored at the target (no one doubts the Fed’s willingness or ability to keep inflation in check), the inflation process has mutated so that the relationship that works now is between domestic slack and the level of inflation rather than changes in inflation. There is some evidence to support this hypothesis. See Figure 2. The competing explanation is the Global Slack Hypothesis which says that due to the integration of global markets, what now drives inflation is not domestic slack but rather global slack. Due to competition from global rivals, domestic producers in the tradable sector cannot raise prices when the domestic labor market tightens and wage pressures build. Instead, they either rebalance their global supply chains and off-shore production; or they lose business to their foreign rivals. In either case, domestic inflation is determined as much by global slack as by domestic slack.
      The evidence is mounting that the second explanation is the right one. What is especially compelling is the evidence that global slack is statistically significant in ALL countries for which data is available while domestic slack is significant is NONE since 2000. See Figure 3. The last column corresponds to global slack (“foreign gap”); no stars means the variable is not significant; three means it is significant at the 1 percent level.’

    2. The WSJ and other commentators may have begun to question the mainstream narrative, but this attitude hasn’t yet penetrated the skulls of McDonnell or Corbyn. At least so far as one can judge from their public statements.

    3. Warren Mosler has frequently stated that inflation abated in the early 1980s primarily because of Jimmy Carter’s deregulation of the US natural gas sector a couple of years earlier (rather than, say, because of Paul Volcker’s “nuclear” option of driving up interest rates to 20 percent).

      Can anyone please point me to specific research which demonstrates this claim?

      I believe Mosler, incidentally, not least because so-called “monetary gradualism” in the mid and late 1970s clearly exacerbated the rise in inflation, but also because 1970s inflation in general is easily explained just by the two oil shocks. Still, I would like a good source or two to share on the natural gas claim.

    4. Larry, Labour in the UK is in a hopeless situation: torn apart within itslef/espousing ‘neo-liberalism’ lite in its utterances about deficits/vilified by the press.

      Even if it were to try to explain to the populace that deficits aren’t the issue and Government Bonds don’t ‘fund’ anything they would be treated like mad people by the media. As Bill says, the language framing is too far gone and has become mental wallpaper. The next collapse of the system or war are probably the only things that might dent the armour of the dominant narrative.

    5. Simon Cohen,

      You said:
      “The next collapse of the system or war are probably the only things that might dent the armour of the dominant narrative.”

      The thought has entered my mind every couple of days. Very sad.

      I watched a lecture by Dr. Mitchell. In it, he said that there is this idea that people are supposed to serve the economy, not the other way around.

      For neo-liberals, regression and constantly living under a nation’s means is a virtue.

    6. “This argument is consistent with research in the institutionalist literature that shows that wage determination is dominated by insiders (the employed) who set up barriers to isolate themselves from the threat of unemployment.”

      That is, in essence, a form of rent seeking. You get the same on the other side of the fence in that firms try and setup barriers and moats to competition to defend their margin.

      The job of the state in managing the economy is to tear down these rent barriers and prevent oligopolistic behaviour arising. The only way out should be innovation and investment. All other avenues – branding, patents, copyrights, hoarding of land and commodities – should be closed off.

      And it means that the solution often put forward by the left – board of companies where workers and owners sit down together to divide up the spoils – can lead to the same oligopolistic setup where workers can’t be replaced and the company is too big to fail.

      Always remember that if you’re trying to operate capitalism, business failure is as important as business creation. You can’t let loss aversion stop that process.

    7. “larry says:
      Wednesday, March 15, 2017 at 20:41
      Postkey, where is your quote from? It is unattributed.”

      My posts with ‘references’ are not usually accepted!

      I have just ‘googled’
      Global Slack, US Inflation and the Fed’s Policy Error

      and reached the article!

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