Economics needs a Mark Twain Award

It makes far more sense than giving economists a fake Nobel Prize

There’s a famous saying attributed to Mark Twain that:

It Ain’t What You Don’t Know That Gets You Into Trouble. It’s What You Know for Sure That Just Ain’t So.

Apparently Twain did not in fact say that, but for this post, I’m going to behave like an economist and just assume that he did, because it is certainly true about economists. In fact, there are so many things that economist “Know for Sure That Just Ain’t So”, that economics should have a “Mark Twain Award for Confident Falsehoods”. It would be awarded for statements that are provably false, but which are confidently asserted to be true by economists.

The capacity for economics to believe falsehoods wouldn’t matter if they were the only ones deluded by their false beliefs. But they end up deluding the public, policymakers, and the media, because, to channel Donald Rumsfled, the public, policymakers, and the media “don’t know that they don’t know”. So we take the advice of economists on things on which they claim to be experts, and follow that advice, which leads us into economic catastrophes. We see problems where they don’t exist, and damage the economy by trying to fix these non-existent problems. We ignore real problems, which end up derailing the economy.

Obsessing about nonproblems and ignoring real ones has led to economic stagnation and financial crises in the West.

The clearest recent example of economists misleading policymakers is the Global Financial Crisis. This was caused by the growth and collapse of a private debt bubble. But they ignore private debt, on the assumption that lending is a “pure redistribution”, which transfers money from “savers” to “borrowers”. If this were true, then you could ignore private debt, because increases or decreased in private debt would not have any significant macroeconomic effects. This is how Bernanke put it in his book Essays on the Great Depression”:

Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects. (Bernanke 2000, p. 24)

Even a casual look at the data shows that this can’t possibly be true. The correlation between change in the level of private debt and unemployment for the USA is always significant: the correlation between the change in private debt and the level of unemployment for the 60 years between 1955 and 2025 is minus 0.34. When credit goes up, unemployment goes down, and vice versa.

This correlation rises as the level of private debt rises; between 1990 and 2015, when private debt exceeded 120% of GDP, is reached a staggering minus 0.93.

But this superficially positive role of credit sets us up for disaster over time. A rising ratio of private debt to GDP leads to a rising debt servicing burden for the private sector, and at some point they will switch from taking on more credit—as they did during the Subprime Bubble—to paying the debt level down. Credit then fell from plus 15% of GDP in 2007 to minus 5% of GDP in 2009, and unemployment more than doubled as a result.

If a theory implies that the correlation between credit and unemployment should be close to zero, and it actually turns out to be much closer to minus one, then this fact alone shows that the theory must be wrong. Obviously, credit has significant economic effects.

But Bernanke wasn’t even aware of this data, because his prior belief tells him that there’s no point even checking it. I am certain that he hasn’t even looked at this freely available data (debt data comes from the BIS, Unemployment data from the OECD).

This confidently held false belief led Bernanke to make possibly the biggest gaffe in the history of economics, when he told Congress, on July 18^th 2007, that:

Economic activity appears poised to expand at a moderate rate in the second half of 2007, and it should strengthen gradually into 2008. (Bernanke 2007, p. 4)

Just three weeks after his report to Congress, the Global Financial Crisis began. The rate of economic growth at the end of 2008 was minus 2.5%, versus Bernanke’s declaration to Congress, just 18 months earlier, that it would be plus 2.75%.

Bernanke made this mistake because he believes the textbook model of “Loanable Funds”, in which banks do not actually make loans. Instead, according to textbook economics, banks are “Intermediaries” that enable savers to lend to borrowers. He therefore ignored the data on private debt which his own organization collected.

You might have expected him to revise his views after this incredible error. Also, between the GFC and when he was given the “Nobel”, several Central Banks published papers rejecting the model of banks as intermediaries—most notably The Bank of England (McLeay, Radia, and Thomas 2014)and The Bundesbank (Deutsche Bundesbank 2017). But Bernanke didn’t change his views at all. His “Nobel” Prize lecture treated banks as intermediaries between what he called the “ultimate savers” and the “ultimate borrowers”, and none of the contrary Central Bank papers turned up in Bernanke’s lecture. I doubt that he’s even read them.

Given this stellar performance, Bernanke deserves to be the first recipient of the Mark Twain Award for Confident Falsehoods.

Why didn’t he learn from experience? Why did he ignore contrary analysis by other Central Banks? It’s because he lives in a bubble, in which everyone he interacts with is another Neoclassical economist, who also believes that banks are intermediaries, who have to borrow from someone else before they can lend. So, it isn’t just Bernanke who is wrong: it’s the entirety of mainstream Neoclassical economics, and also their relatives in the Austrian school of economics.

To know why they’re wrong, you have to understand something about which Richard Murphy and I are the experts, and about which the vast majority of economists are clueless. That’s accounting.

Now I know that accounting sounds about as exciting as watching grass grow, but it’s vitally important, because mistakes about accounting are quite literally responsible for almost all the economic woes we face today. The Global Financial Crisis, the stagnant Western economies today, crumbling infrastructure, rising inequality, overpriced housing, they’re all due to economists being clueless about accounting.

Unfortunately, politicians, journalists, and most of the public, trust the advice of economists about money because, hey, they’re economists—aren’t they the experts on money? Well no, they’re not: instead what they “Know for Sure … Just Ain’t so” about not just banking itself, but also money, private debt, and government debt. This is obvious when you put their beliefs into the form that accountants use to track financial transactions: double-entry bookkeeping.

Double-entry bookkeeping is a simple but profound way to keep accurate track of money. Its basic rules are:

• Classify all the claims that you have on other entities as your Assets;

• Classify all the claims that other entities have on you as your Liabilities;

• Record the difference between your Assets and your Liabilities as your Equity;

• Make two entries for every transaction, one showing its impact on you, the other showing its impact on the other party to a transaction; and

• Make sure that there is a CR (Credit) and a DR (Debit) entry in every transaction.

This last operation is what makes accounting difficult—you have to know what to classify as a CR and a DR entry, depending on whether you’re making that entry on the Assets, or Liabilities, or Equity columns in a ledger.

I’ve worked out a much simpler way to do this. Just use plus and minus signs—plus if a transaction increases an account, minus if it reduces it—and make sure that for the whole transaction, the equation “Assets minus Liabilities minus Equity” equals zero.

When you apply this to pronouncements by economists on monetary matters, you can show that economists confidently don’t knowing what they’re talking about.

A recent example of confident falsehoods turned up on Twitter in response to a post by Richard Murphy about how economics is inherently political. The discussion drifted onto the topic of whether the government creates money when it spends. A Tweeter with the name TheLege—who describes himself as a “Austrian” economist, and who works for a family office—confidently stated that the government doesn’t create money when it spends, because it first has to borrow from the bond market.

Another tweet from George Selgin disputed a claim I made that banks can’t lend from Reserves.

When you apply the rules of double-entry bookkeeping to these two very confident statements by TheLege and Selgin, you can see that they violate the rules of accounting. What they know for sure just ain’t so.

I’ll start with TheLege’s assertion that government borrowing from Bond markets is just like spending using his credit card.

Let’s say that whatever TheLege was buying with his credit card was worth $100. Then the transaction looks like this. TheLege gets $100 of extra debt, the shop he was buying from gets $100 of extra money.

Notice that this transaction affects both the Bank’s assets (the amount TheLege owes on his credit card), and the Banks’s liabilities (the amount in the deposit account of the shop that TheLege is buying from).

TheLege claims that what the government does when it “borrows from the bond market” is the same operation. It’s easy to show that this is false—that the two operations are not equivalent—using double-entry bookkeeping.

What TheLege is calling government borrowing is actually the Treasury selling bonds directly to the banks, in what are called “Primary Auctions” in the USA, and “Gilt Auctions” in the UK. To take part in these auctions, you have to have an account at the Central Bank—where those accounts are called “Reserves” by economists. In the auction, successful bidders transfer funds from their Reserves accounts to the Treasury’s account. This is what those auction transactions look like at the Central Bank:

Bonds don’t turn up on that table, because the Bonds are neither Assets nor Liabilities for the Central Bank; instead, they’re a liability for the Treasury, and an Asset for the Banks. So, when Banks buy Bonds from the Treasury and Primary Auctions, their Reserve fall while the Bonds rise. This is shown in the next table.

At this point, it’s obvious that TheLege’s claim that the government “borrowing” from the Banks is the same as him borrowing to shop is, at best, not strictly true. The private borrowing operation straddles the Assets and the Liabilities of the banking sector: TheLege’s debt to the banks increases, and so does the deposit account of the shop.

When the government sells bonds, on the other hand, everything happens on the Asset side of the banking sector’s ledger. TheLege is unaware of this because, like all Neoclassical and Austrian economists, he thinks he understands accounting, but he doesn’t.

Selgin’s confident statement that, “If they [Banks] can use reserves to buy securities, they can use them to finance loans”, is an even worse error. He is correct that banks buy securities using reserves: Reserves go down, Bonds held by Banks go up, and the fundamental accounting equation that “Assets minus Liabilities minus Equity equals Zero” is obeyed.

But applying the same operation to making a loan—Reserves go down, bank Deposits go up—violates that equation. This is because Reserves are an Asset, while Deposits are a Liability. A minus in the former and a plus in the latter do not sum to zero. This can’t be how banks lend.

What if we show the lending reducing reserves and increasing loans? Then the accounting works:

But how does the borrower get the money? The banks’ assets of Reserves fall and Loans rise, which obeys the accounting equation—but all the borrower gets out of this, so far, is a Liability, but no Asset.

The only way that the borrower can get an asset equivalent to the liability they’ve taken on with the bank is if the loan is in Cash. Then the increase in debt—the borrowers’ Liability—is precisely offset by the increase in cash—the borrowers’ Asset.

That might have been the norm in the 19^th century, but today, it’s obsolete. In today’s electronic banking world, when you take out a loan, the bank increases your deposit account by the same amount that it increases your debt. There’s no need to use Reserves to make a loan. The actual process of lending doesn’t involve Reserves at all, and is actually much simpler than the textbook model.

Why do economists resist this simple, realistic model of how banks lend? It’s because this means that bank lending has significant macroeconomic effects, and therefore you have to include the banking sector when you build macroeconomic models.

This is anathema to Neoclassical economists, because they have always believed that money doesn’t matter in macroeconomics. This is why they build models of the macroeconomy which don’t include banks, or private debt, or money.

To admit that banks create money when they lend, and this newly created money has significant macroeconomic effects, undermines their a priori belief that capitalism is fundamentally a barter system, and that the financial sector can be ignored in macroeconomics. So they stick with their “Loanable Funds” model of banking, despite the fact that it led them to be unaware of the approach of the Global Financial Crisis.

We suffered the greatest economic crisis since the Great Depression, because economists are more interested in preserving their paradigm from attack, than they are in helping us avoid economic crises.

In a subsequent post, I’ll show why the model of Loanable Funds led economists to ignore the rapid increase in private debt that led to the Global Financial Crisis. In the meantime, treat everything you hear from a mainstream economist as a case of the Mark Twain syndrome: the confident belief in something that just ain’t so.

Bernanke, Ben. 2007. “Monetary Policy Report to the Congress.” In. Washington: Federal Reserve.

Bernanke, Ben S. 2000. Essays on the Great Depression (Princeton University Press: Princeton).

Deutsche Bundesbank. 2017. ‘The role of banks, non- banks and the central bank in the money creation process’, Deutsche Bundesbank Monthly Report, April 2017: 13–33.

McLeay, Michael, Amar Radia, and Ryland Thomas. 2014. ‘Money creation in the modern economy’, Bank of England Quarterly Bulletin, 2014 Q1: 14–27.