What would you say if I told you economists don’t actually understand how many of the most important entities in the economy work? That would be a pretty damning criticism of anyone who purports to be an “expert” on the economy, right? I write this on the heels of the recent uproar by economists and their complaints about how “non-experts” claim to be macroeconomic experts. I responded to this thinking saying that it is often the economists who are not the experts and that macroecon actually covers many fields that macroeconomists aren’t well suited to understand. For instance, take today’s Wall Street Journal where two prominent economists completely misunderstand the relationship between bank reserves and lending:
“M2, the broad measure of the money supply, has been growing at rates in excess of 6% since 2011. As the effects of this sustained monetary growth continue to be felt, and as banks transform their idle excess reserves into new loans and deposits—a process that is well under way—inflation undoubtedly will rise.”
No one who understands banks would describe the loan process in this manner. Reserves do not have some causal relationship with the decision making process that banks undergo during the loan creation process. That is, banks make loans and find reserves later if necessary, not the other way around. But these economists, who are essentially claiming that reserves can fuel high levels of inflation, are making a hugely important error about the way banks actually operate. It’s operationally wrong as I’ve described on so many occasions and it’s resulted in many poor predictions about the effects of QE and how reserve creation can lead to inflation (see here, here and here).
This isn’t just some minor point. It’s a hugely important understanding. If you don’t know how banks work then you really don’t understand how the macroeconomy works. And that’s the thing – so many market practitioners read the theoretical work of economists and just roll their eyes because there is obviously a huge disconnect between the political theories that many economists espouse and the operational realities.
The problem is that many economists aren’t really experts about the actual economy. They’re often political theorists working with a strong bias and theorizing about how things work in some unrealistic vacuum. Or as I like to say, much of modern day economics is politics masquerading as science. This isn’t some small problem either. Look at the list of prominent economists who have consistently made errors such as the one above in recent years. It’s a big problem because these are the people who many politicians rely on for guidance about how to implement future policy. Many of them flat out misunderstand how some of the economy’s most important institutions function at an operational level. And we’re all worse off for it.
I don’t mean to sound excessively harsh here. No one understands all facets of the economy. It’s such a complex and dynamic system that we shouldn’t expect anyone to fully understand it. Which is why economists should embrace help from “non-experts” at times. Macroeconomics is a big tent and economists don’t necessarily have a monopoly on understanding the economy.
* Sorry to all of the wonderful economists who do indeed have a sound understanding of the monetary system and its operational realities.
Related:
Understanding the Modern Monetary System
The Bank of England Debunks the Money Multiplier
Bank Lending is Primarily a Demand Side Issue
The Money Multiplier Doesn’t Exist Outside the Zero Lower Bound Either
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.