Neo-Classical Economics Misses What Matters

The time is ripe for good economic analysis from a progressive perspective. The Left has tended to have an understandable visceral dislike/distrust of markets. But this has had the effect of ceding discussion of financial policy to Wall Street practitioners and neo-classical economists, which effectively means that all debate starts with vague and incoherent premises such as “affordability” or “fiscal sustainability”, rather than evaluating government actions on the basis of real economic impact. Even ostensibly progressive economists, such as Paul Krugman or Bob Reich, still operate within this false paradigm to some degree. Perhaps these progressives are skating on the edge of what they believe to be possible, although since both have thrown a few bombs at the mainstream macro profession, one would expect them to feel less constrained by stale, wrongheaded thinking.

I suppose it is also difficult to shed old habits of mind, as Keynes frequently did. It can be quite devastating for these people when they finally realize the gold standard is over…and all that may imply. It fries brains to realize something they believed so long could be so mistaken, and have incurred such a cumulative social cost. But to take on the neo-classical truisms that hinder the ability of our government to implement policies which create full employment, universal health care, and genuine financial reform, we have to demonstrate a new way of thinking about modern monetary policy.

Fact #1: Government spending is NEVER limited by the government’s ability to tax or borrow, so long as the government issues debt in its own freely-floating non-convertible currency. In such a situation, there is never an issue of national solvency.

Government spending is never limited by its ability to tax or borrow. The U.S. Treasury can always make all payments as they come due, whether it is for spending on goods and services, for social spending, to hire workers, or to meet interest payments on its debt. We usually hear arguments that the government must “balance its books like a household”, a notion which contributes to some of the biggest misconceptions about government spending. Short of counterfeiting (which is a jailable offence), no household can issue Treasury coins or Federal Reserve notes. To be sure, government does not really spend by direct issues of coined nickels. Rather, it spends by crediting bank accounts. It taxes by debiting them. When its credits to bank accounts exceed its debits to them, that difference is called the “budget deficit”. No less an authority than our current Federal Reserve Chairman, Ben Bernanke, conceded as much during an interview with ’60 Minutes’ last year:

(PELLEY) Is that tax money that the Fed is spending?

(BERNANKE) It’s not tax money. The banks have– accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed.

Chairman Bernanke is illustrating that governments and households don’t spend the same way. There’s a big difference between spending your own currency that only you create, and spending a currency someone else creates.

Or consider this from another perspective:

Imagine a new country with a newly announced currency.

No one has any.

Then the government proclaims a property tax. How can it be paid?

It cannot, until the government starts spending. Only after the government spends its new currency does the population have the funds to pay the tax.

Fact #2: Demonstrating that a government faces NO OPERATIONAL CONSTRAINT in fiscal policy does not mean hyperinflation is the natural consequence of this policy.

True, our federal government can afford anything that is for sale in terms of its own currency. And if it spends too much after getting us to a state of full output (say, 90% capacity utilization and something approaching 0% unemployment), there is no question that this can generate inflation. And when that blissful state of affairs is reached, the government should restrain further spending or increase taxation as a means of curbing output and reducing those incipient inflationary pressures. BUT inflation is the constraint here, not some vague notion of “affordability” which has no applicability under our current monetary system.

TOLERANCE FOR INFLATION IS A POLITICAL LIMIT ON NOTIONAL SPENDING. It is NOT an operational constraint on spending relating to national solvency. The inflation would be from too much aggregate demand and a too small output gap. That would mean that fateful day would be an economy with maybe 2% unemployment and 90%+ capacity utilization and an overheating economy in general.

That sounds to me like the ultimate goal for deficit spending- so in fact if you think that government deficit spending creates inflation, then you are implicitly conceding that it works and that we can in fact “spend our way out of a recession” (or at least that the government can by filling the output gap left by falling private sector demand). In fact, with our countercyclical tax structure, strong growth that follows deficits automatically drives down the deficit, and can even take it into surplus, as happened in the 1990’s. In that case one must be quick to reverse the growth constraining surplus should the economy fall apart as happened shortly after 2001.

But if we do need to raise taxes to cool things down some day, we can start with a tax on interest income if we want to cut payments to bond holders or a financial transactions tax on the purchases of stocks, bonds, and other financial instruments.

There is also a question (a political one) as to how much output you want generated by the government as opposed to the private sector. The trick is to ensure that when government spends, it does enough to produce sustainable growth and other desired outcomes while at the same time ensuring that its spending does not have undesirable outcomes such as fueling inflation or taking away resources that could be put to better use by the private sector. But the paradox of thrift tells us that the desire to increase saving by the non-government sector will be thwarted by the income adjustments unless the government acts to “finance” their spending plans via deficit spending.

Fact #3: Operating under a gold standard system did not increase our economic prosperity or eliminate depressions.

Throughout history, devaluation of coins and attempts to restore “honest money”, have been commonplace. The gold standard was supposed to have resolved the problem of currency debasement, insofar as gold is said to have an intrinsic value (in contrast to “fiat currency”). Furthermore, the gold standard is said to have provided an external “discipline” against the depredations of seemingly endless government spending under a fiat currency system. Supposedly, things were much better during the halcyon days of the gold standard.

So let’s examine that history: In the 19th and early part of the 20th century, gold reserves regulated the domestic money supply. Money creation was determined by the amount of gold reserves. Bank deposits depended on 1) the level of gold reserves held by commercial banks and the central bank, 2) the preferences of the public for gold coins relative to other forms of money, and 3) legal gold reserve ratios. The primary attraction of gold as a basis for a monetary system is that its supply is limited, or at least increases slowly, whereas fiat money is limited only by the judgments of presumably fallible people. While the gold standard provided a stable monetary framework during much of its reign as the prevailing world monetary standard, it did not make us immune from a multitude of 19th and 20th century depressions.

In the course of the 19th century, there were a number of severe financial panics, which generated great economic hardship. The 1837 depression, for example, was triggered by a combination of factors including the failure of a wheat crop, a collapse in cotton prices, economic problems in Britain, rapid speculation in land, and problems resulting from the variety of currency in circulation. But by far the largest contributing factor was President Andrew Jackson’s pathological hatred of government debt, which he called a “national curse” and retired completely by 1835. A budget surplus continued for the next 2 years, after which a deep recession occurred. It was the second-longest American depression, with effects lasting roughly six years, until 1843. The panic had a devastating impact. A number of brokerage firms in New York failed, and at least one New York City bank president committed suicide. As the effect rippled across the nation, a number of state-chartered banks also failed. The nascent labor union movement was effectively stopped, as the price of labor plummeted. The depression caused the collapse of real estate prices. The price of food also collapsed, which was ruinous to farmers and planters who couldn’t get a decent price for their crops. People who lived through the depression following 1837 told stories that would be echoed a century later during The Great Depression. The aftermath of the panic of 1837 led to Martin Van Buren’s failure to secure a second term in the election of 1840. Many blamed the economic hardships on the policies of Andrew Jackson, and Van Buren, who had been Jackson’s vice president, paid the political price.

The crash of 1857 lasted for approximately 2 years, and was triggered by the failure of the Ohio Life Insurance and Trust Company, which actually did much of its business as a bank headquartered in New York City. Reckless speculation in railroads led the company into trouble, and the company’s collapse led to a literal panic in the financial district, as crowds of frantic investors clogged the streets around Wall Street. Stock prices plummeted, and more than 900 mercantile firms in New York had to cease operation. By the end of the year the American economy was a shambles. One victim of the Panic of 1857 was a future Civil War hero and US president, Ulysses S. Grant, who was bankrupted and only managed to recover his debts through a huge publisher’s advance on his memoirs.

In 1873, the investment firm of Jay Cooke and Company went bankrupt in September 1873 as a result of rampant speculation in railroads. The stock market dropped sharply and caused numerous businesses to fail. The resultant depression caused approximately three million Americans to lose their jobs. The collapse in food prices impacted America’s farm economy, causing great poverty in rural America. The depression lasted for five years, until 1878.

The depression set off by the Panic of 1893 was the greatest depression America had known, and was only surpassed by the Great Depression of the 1930s. It last 4 years. In early May 1893 the New York stock market dropped sharply, and in late June panic selling caused the stock market to crash. A severe credit crisis resulted, and more than 16,000 businesses had failed by the end of 1893. Included in the failed businesses were 156 railroads and nearly 500 banks. Unemployment spread until one in six American men lost their jobs. The depression inspired “Coxey’s Army,” a march on Washington of unemployed men. The protesters demanded that the government provide public works jobs. Their leader, Jacob Coxey, was imprisoned for 20 days.

At the turn of the 20th century, the ‘panic’ of 1907 disturbing enough to result in the creation of the Federal Reserve in 1913. The Fed was to be the lender of last resort to insure the nation would never again go through another 1907. Unfortunately, that strategy failed. As we now know, the Great Depression was the greatest economic calamity ever experienced by the US. The gold standard regime kept the Fed from being able to lend its banks the convertible currency they needed to meet withdrawal demands.

After thousands of catastrophic bank failures, a bank holiday was declared and the remaining banks were closed by the government while the banking system was reorganized. When the banking system reopened in 1934, convertibility of the currency into gold was permanently suspended (domestically), and bank deposits were covered by federal deposit insurance.

The Federal Reserve was not able to stop depressions. It was going off the gold standard did the trick. It has now been 80 years since the great depression. So the notion that somehow, if we embraced a gold standard, all would be well, does not stack up.

In fact, we should consider it a national blessing that our federal government can afford anything that is for sale in terms of its own currency. True, if it spends too much after getting us to a state of full output, it can get inflationary. So to that extent, there is a limit. But this concept MUST NOT BE BASED ON FALSE ‘GOLD STANDARD’ THINKING WHERE EVERY DOLLAR SPENT HAS TO BE ‘FINANCED’ BY AN OUNCE OF GOLD ALREADY IN EXISTENCE.

The consequences of overspending might be inflation or a falling currency, but never bounced checks. The government spending ought to be set with regard to results desired and competencies to execute plans—not out of some pre-conceived notion of what is “affordable”.

To repeat: to argue that a government’s deficit is never operationally constrained is not the same as arguing that there are no limits to government spending. These limits are political: The size of the deficit is irrelevant in itself. There is no meaning in the terms a large deficit or a small deficit. You have to relate them to the extent of labor and capital underutilization, which is a human measure of the aggregate demand deficiency. If households have been living beyond their means as a sector, it is because they have been dis-saving and increasing their debt levels year after year. But the situation would have been very different had the governments not pursued the surpluses in the first place and squeezed the liquidity of the non-government sector (mostly in this case the domestic private sector).

Our limits, then, must not be based on false ‘gold standard’ thinking where every dollar spend has to be ‘financed’ by an ounce of gold already in existence. There is also a question (a political one) as to how much output you want generated by the government as opposed to the private sector. The trick is to ensure that it spends enough to produce sustainable growth and other desired outcomes while at the same time ensuring that its spending does not have undesirable outcomes such as fueling inflation or taking away resources that could be put to better use by the private sector. But the paradox of thrift tells us that the desire to increase saving by the non-government sector will be thwarted by the income adjustments unless the government acts to “finance” their spending plans via deficit spending.

Very few ECONOMIC (as opposed to moral) arguments are made on the foregoing grounds, so we lose valuable debates to the right. A perspective which embraces modern monetary theory, as opposed to outdated “gold standard” rhetoric, opens up the policy opportunities a national government has – and leaves it to the political process to determine how they use those opportunities. That is a lot better than theories that tell us nothing about what the consequences of different government fiscal positions are, or that tell us lies about these policy choices (for example, the entire edifice of mainstream neoclassical theory).

We should evaluate decisions, including health care, in terms of broad social costs and benefits which accrue to our citizenry, not the economics of the “rentier” class, which places a premium on “affordability” and imparts an automatic deflationary bias, which precludes full employment. If budget deficits do not require Treasury financing, then this needs to be made plain and palatable for the citizenry to embrace, and painted as an opportunity rather than a risk.

We would start by eliminating the notion that society requires a buffer stock of unemployed people to discipline wage demands and protect profits. Not only is this immoral and inhumane, but economically inefficient. We can have both full employment and price stability via a Government as Employer of Last Resort. This new class of government employees, which could be called supplementary, would function as an automatic stabilizer, the way unemployment currently does. A strong economy with rising labor costs would result in supplementary employees leaving their government jobs, as the private sector lures them with higher wages. (The government must allow this to happen, and not increases wages to compete.) The reduction of government expenditures is a contractionary fiscal bias. If the economy slows, and workers are laid off from the private sector, they will immediately assume supplementary government employment. The resulting increase in government expenditures is an expansionary bias. As long as the government does not change the supplementary wage, it becomes the defining factor for the currency- the price around which free market prices in the private sector evolve. It will also enhance the effectiveness of traditional policies designed to improve aggregate demand because it will create a buffer stock of EMPLOYED personnel for the private sector to draw upon, rather than a reserve army of unemployed.

There is no reason for President Obama and his economic advisors blithely to repeat truisms that “unemployment is a lagging indicator” as a means of justifying further government spending. The reality of a double digit unemployment rate is de facto proof that government spending is too restrictive. His concern for the welfare of America and for the nation’s future is no doubt genuine. However, in the haste to renounce financing decisions which would, in fact, be very harmful if not impossible for a private business or a household, in their eagerness to accept uncritically the myths of neo-classical economics, the Obama Administration is overlooking the important differences between private finance and public finance. Only a misunderstanding of money and accounting prevents Americans from achieving a higher quality of life that is readily available.

MARSHALL AUERBACK is a market analyst and commentator. He is a brainstruster for the Franklin and Eleanor Roosevelt Institute. He can be reached at


Marshall Auerback is a market analyst and a research associate at the Levy Institute for Economics at Bard College (  His Twitter hashtag is @Mauerback